Return to the straight and narrow

The past 12 months have been particularly testing for pension funds across the globe and the Norwegian pension system is no exception. Norway's two largest pension schemes, the NOK2,275bn (US$329bn) Government Pension Fund - Global suffered the worst losses in its history during 2008 with a 23.3% loss. Its domestic equivalent - the NOK87.8bn (US$12.3bn), Government Pension Fund - Norway suffered a similar fate reporting a 25% loss during 2008 with plummeting equity markets being blamed for the losses. However, with no end in sight to the market turbulence what are Norwegian pension funds doing to try and stem the tide of losses and get back on track?

The Norwegian pension market is primarily defined benefit with a small but growing defined contribution element. As a result managing liabilities will be a major theme going forward for the vast majority of Norwegian pension funds. As a rule the funding obligations of defined benefit schemes are taken on by life assurance companies rather than employers. These sponsors have to keep the scheme fully funded at all times and deliver an annual guaranteed interest rate of 3.35%. However, the steep declines in equity markets are making this task ever more difficult as schemes move to de-risk by decreasing their equity market holdings.

"The system has been tested to its limits over the past 12 months," said Barclays Global Investors client director Jeppe Brøndum. "The schemes had a long-term equity allocation of 40% to 50% which in some cases has been reduced to below 5%. The trend now is towards adopting a more risk centric strategy and indexing. However, pensions are a long-term investment and so cutting equity exposures in the way many schemes have is not the right thing in the long term. The key question is how do they look to get back into equities over the coming 12 months? 

Recent figures seem to bear this trend out with many life insurance companies and pension schemes slashing their equity allocations. "From the end of 2007 to the end of 2008 we have seen equity allocations for life insurance companies decrease from 23% to 12% on average," said Mercer market business leader Bengt Olav Lund. "Life insurance companies are moving increasingly into bonds and we've seen allocation increase from 25% to 36% over the year and we see the same trend for pension funds." 

Capital injection
According to the Norwegian Pension Fund Association's secretary general Rolf Skomsvold many schemes have had to ask their sponsors for further capital injections into the fund to ease the situation. 

"Some of the pension funds had reserves enough to cope with the situation," he said. "But we have seen some funds asking their sponsors for more capital." 

Lund agreed saying that: "In order to deliver the average guaranteed interest rate of 3.35% companies have had to utilise their buffer capital, so we have seen the amount of buffer capital available to Norwegian pension funds decrease during 2008. As a result the pension funds in the private and municipality sector have decreased their equity allocations from 33% at the end of 2007 to 27% at the end of 2008. Due to decreased buffer capital and equity allocations insurance companies and pension funds will have a challenge delivering high rates of return going forward." 

Where are schemes investing?
So as many schemes move away from the risks of equity investing what options are available to them in the current climate? In December 2007 the government brought in rules governing investment in alternatives. Under the rules allocations to investments classified by the government as alternatives were limited to 1% of a pension fund's total portfolio. These included hedge funds and fund of hedge funds. Total alternative investments were limited to 7% of the fund. So if allocations to alternatives are limited and equities are deemed too risky then how can pension funds go about meeting their liabilities?

"We are obviously seeing increased interest in fixed income - especially credit - but investors have also started thinking about when to enter international equities, again," said Brøndum. "Historically, Norwegian pension funds have looked to domestic fixed income but they are beginning to realise the need for further diversification."  

Property has also been a popular asset class.

 "Investing in property has been a very important tool for many Norwegian pension funds in the past and we've traditionally seen asset allocations of between 10-20% to property," said Aberdeen Property Investors, CEO Thomas Wolff. "Larger funds tend to invest directly within Nordic companies while the smaller funds tend to invest indirectly via property funds which tend to have a more international bias. One issue with property is that it tends to be a lot less liquid than other asset classes but for a long-term investment like a pension liquidity is less important than the long-term stable returns that you get from property investment."

However, over the long term Brøndum hopes that investors will return to equities once the investment markets start to stabilise and enable schemes to fully assess the best managers.
"Evidently pension investment is all about long-term active asset allocation and so the low allocations we've seen to equities recently are not sustainable in the long term particularly as we have seen limits put on investment in alternatives over the past year," he said. "However, once the dust has settled and investors have time to work out who has really delivered in terms of risk, liquidity and return they can really start to make informed decisions as to where to go next. As an asset manager if you can deliver on all three of these metrics then that is great." 

Problem or opportunity
While the outlook remains uncertain for pension schemes it's important to note that not all schemes are reacting to the crisis by retreating from equities. The Government Pension Fund - Norway announced its intention to increase its allocation to Russian equities in March. Despite suffering huge losses during 2008 the Government Pension Fund - Global is determined to turn the situation around over the coming year.  In the scheme's annual report governor of Norges Bank (the operator of the scheme) and chairman of the executive board Svein Gjedrem wrote:

"The fund is a long-term savings plan and capable of riding out large swings in the markets. This is the very foundation of the investment strategy with its high allocation to equities. Our ability to adhere to this strategy in a critical phase - even if this should last some time - is crucial if the fund is to deliver the returns we expect."

This view is backed up by Norges Bank Investment Management's communication adviser Vidar Korsberg Dalsbø who said current circumstances represented an opportunity for the fund and so the commitment to equity investment would not be abandoned: "In extraordinary times we learn more than usual. Our strategic choices are based on very long-term horizons, so we do not change the course based on current market circumstances," he said. "With that being said, we constantly review our strategy, approach and operations with the ambition of improvements.

"These weak market conditions suit us better than many others. We certainly see this crisis as an opportunity for the fund. A volatile market is something that we, in one sense, appreciate because volatility, in itself, should give you higher risk premiums in the assets you're buying. What is important for the fund is whether these investments turn out to be good investments in the long run. We are in a position where we can hang on to the investments for a long time." 

With this in mind the fund has been seeking to increase its allocation to equities. The Ministry of Finance recommended the fund increase its allocation to equities from 40-60%. As a result the fund made record purchases in the equity markets and currently owns approximately 0.77% of global equity markets. According to Dalsbø the fund's equity allocation hit 50% by the turn of the year and he expects the 60% target to be reached by the end of 2009.

Looking to the long term
Norwegian pension schemes have plenty of challenges ahead if they are to rebuild their depleted balance sheets over the coming year. However, the challenge does not end with investment returns. Norway, like other developed nations also faces the issue of increasing longevity which will place increased funding liabilities on pension schemes over the coming years. There has already been a move away from defined benefit provision towards defined contribution - it is a move that is likely to accelerate over the coming years.

"Over the past few years we have seen a move from defined benefit towards defined contribution partly as a result of higher pension costs and sponsor obligations," said Mercer's Lund. "As a result this move is evident in almost every branch industry in Norway including the financial services and oil industries. Historically sponsors have largely closed DB schemes to new entrants however it's becoming more popular to convert all members under the age of 52 into the DC pension." 

So it would seem that the current financial crisis could have even more far reaching consequences than first thought. The challenges go beyond the issues of meeting scheme liabilities and are now moving more towards questioning the long-term sustainability of the final salary pension model. Norway's pension industry stands on the brink of real change as the cost of meeting pension liabilities looks set to hasten the momentum towards defined contribution.