Breaking with tradition
Written by Marek Handzel
April 2012
Marek Handzel explores how persistent low interest rates and uncertainties over Solvency II have forced a reassessment of Nordic pension fund investment strategies.
If you had looked at the make-up of a typical Danish pension scheme’s investment portfolio in 2002, then you would have found that the vast majority of its assets would have been domestic-based ones. A similar strong attraction to home-grown bonds, equities, property and alternatives existed within pension funds across Scandinavia at the time.
However, fast forward a decade and the picture looks very different. These days, for example, many funds don’t even have separate local equity buckets, but rather global ones, which, in turn, may or may not include domestic equities. This tendency to look beyond the Nordics for better equity returns has been taking place for quite some time now, but it is not all necessarily down to poor returns. Nordic equities have in fact performed relatively well when compared to other regions.
Nevertheless, as data from FTSE’s Nordic indices shows, 2011 was another volatile year for Scandinavian stock markets. It also reinforced the strong correlation between the region’s various equity markets, as they almost mirrored each other’s performances.
Schroders head of institutional sales in the Nordics Viggo Johansen says that diversification within the equity space, as well as a push for uncorrelated alternatives, has driven change and eliminated home bias towards the asset class.
But it is in fixed income that more recent and radical changes are taking place.
Low interest rates, as elsewhere in the Western world, have resulted in pension liabilities shooting through the roof. And the low yield offered by government bonds in the region has been exacerbated by foreign investors who have bought up national debt, seeing it as a safe haven during the sovereign debt crisis.
MFS Investment Management managing director of institutional sales within the Nordics Per Kunow warns that low interest rates are causing real concern.
“There is some empirical evidence that rates will take a very long time to hit a high trajectory, if indeed they do, and we think the situation will in fact play out sideways, for a number of reasons,” he says.
This threat of long-term low interest rates has led to funds looking elsewhere for better returns. After all, low interest rates indicate low growth, continued lower bond yields, and further volatility.
Affiliated Managers Group director of business development Michael Moth-Greve says that the old notion of there being no room in a portfolio for a global fixed income mandate has, as a consequence, disappeared.
“Take Denmark,” he says. “A lot of pension funds have had a high allocation to Danish mortgage bonds under the assumption that those were pretty low risk.
“Now what has happened is that the spread has increased quite markedly and it turns out there was a lot more risk there than meets the eye, or at least perceived risk. That has led a lot of pension funds to look away from the domestic market.”
This has pushed Danish funds – and other Nordic schemes – to engage with US high yield and emerging market debt, among other options. Even the Swedes, who have a stronger equity culture, have got in on the act.
Kunow cites the US as attracting attention as “the default rate is quite low and investors are well compen-sated in terms of spread”.
He points to the ‘crossover’ space between investment grade and high yield bonds, as a rich source of opportunity. This involves monitoring US companies and identifying those that have enjoyed investment grade status at one point but are currently classified as high yield.
“Over time they improve their balance sheets and while the rating agencies are debating whether or not to keep them high yield or give them an upgrade, we think there’s good opportunities to identify corporate bonds like that in terms of achieving returns,” he says.
The shadow of Solvency II
Market factors only form part of the story, however. The threat of Solvency II in particular is casting a shadow over investment strategies.
Neuberger Berman senior vice president Magnus Kristensen, who is responsible for Scandinavian distribution at the firm, says that pension providers and schemes are still wondering if they will fall into the regime, but realise that if they do then it will have profound implications for investment strategies.
“The CEIOPS regulations can be interpreted differently, as you are penalised more for taking on greater risk, investing in less liquid and longer duration instruments. But you require higher yield and longer duration to pay your policyholders,” he says.
Moth-Greve agrees. “Solvency II will have a big impact. You have to as a pension fund become more dependent on generating return from non-equity sources,” he says.
Kristensen says that Solvency II makes good sense, but in reality, the defined benefit-defined contribution hybrid, or ‘guaranteed’ product schemes that will have to adhere to it, will struggle. This will force them to drop their guaranteed benefits and become pure DC or ‘market-rate’ schemes, as a number in the region have already done.
Solvency II could also already be pushing smaller pension funds into either mergers with other larger ones, or into outsourcing their operations to insurance companies. Eggerston says that this is due to cost and the amount of administration that the regime will require from participants. Showing your regulator that you are transparent and working within the rules will be a drag on the smaller schemes, he claims.
A recent high profile example of such consolidation took place when the AP pension fund in Denmark took on FSP, the scheme for the financial sector.
“The market is ever more focused on being efficient and looking out for cost,” says Kunow. “Therefore that kind of consolidation will continue.”
Collaboration and sophistication
Some schemes that have no plans to merge are instead looking to work together to improve their investment portfolios and save costs.
PKA and Pensions Denmark recently agreed to carry out a joint infrastructure investment, while PKA has looked at sharing best practice ideas with Dutch scheme PGGM.
This combination of consolidation, collaboration and a move towards pure DC, points towards further innovation. The schemes involved in the former can use size and expertise to tap into new markets, while the latter can be more flexible with their investments. Looking for uncorrelated assets in the alternative space opens up as soon as the shackles of so-called ‘guaranteed’ products are thrown away.
Eggertson says that increasing alternatives is a real target for many schemes, with hedge funds, private equity and infrastructure high on their lists. “A lot of planning is to raise alternatives from 5 to 10 per cent of the portfolio to 20 per cent.”
Slow burner
A move towards larger alternative portfolios is not certain however, according to Kristensen, despite the fact that Scandinavian funds have a track record of being at the forefront of new investment frontiers.
“We have observed minor asset class changes,” he says. “There’s been a lot of coverage in the media about schemes buying into wind power, commodities, farming, infrastructure etc. However, when you look closely at the overall asset allocation amongst Nordic institutions, there are only a few that in the short term have made truly significant changes in terms of allocations to alternatives. They generally stick to basics and changes are in relative terms modest.”
Meanwhile, Johansen prefers to view the changes in allocation as part of an overall strategy, rather than a deliberate attempt to transfer money from fixed income or equities.
“We’re talking about more of an absolute return type of investment. So almost everything that will provide you with diversification is available. The name of the game is to get more stable, but slightly higher returns. Schemes are looking out for other ideas,” he says.
Ideas way beyond the shores of the Baltic Sea and the borders with Northern Europe, it would seem.
