Strategies for volatile times

Chresten DengsoeHow ATP takes on risk on top of providing a guarantee

Higher guaranteed pensions is good news for members of Denmark’s biggest pension fund, but how is ATP’s new pension savings model holding up in volatile markets? Kristen Paech reports on the investment strategies the fund is pursuing to meet its goals.

When ATP, the DKK436.8bn (US$74.3bn) Danish labour market pension fund, introduced a new pension savings model in January this year, it didn’t bank on the financial markets tanking.

Under the new model, incoming contributions are split 80/20 into a ‘guarantee’ contribution and a ‘bonus’ contribution, meaning the pension fund bears most of the risk in adverse market conditions.

And you couldn’t get much more adverse than the global conditions of 2008.

While still in its infancy, early indicators suggest the model is holding up well in the face of extreme volatility, thanks to a range of measures implemented across the portfolio.

Chresten Dengsoe, chief actuarial officer at ATP, says a combination of diversification; opportunistic investment strategies and tactical hedging have enabled the fund to weather the storm and even increase pensions by 2 per cent as at January 1, 2009.

Although most risky assets did poorly this year, the investment portfolio nearly broke even, and the fund’s solvency remains above 120 per cent.

Over the first three quarters, the market return on ATP’s investment portfolio was -1.4 per cent, and the ATP Group, which includes the ATP, SP and SUPP schemes (the Special Pension Savings Scheme and the Supplementary Labour Market Pension Scheme for Disability Pensioners), suffered a net loss of DKK18bn (US$3bn).

ATP admits conditions are tough – in its third quarter report, the fund says a loss of DKK20-25bn (US$3.4-4.2bn) is expected in 2008, before additional provisions of DKK1.2bn due to increases in life expectancy and bonus additions to pensions and pension commitments of DKK5.9bn.

However, Dengsoe says, ATP’s financial strength has enabled it to invest “offensively” during the financial turmoil, which should prove positive in coming years.

Unlike many pension funds offering a guarantee to members, ATP is not forced to invest in lower risk assets.

This is because the model splits the traditional whole-life annuity into two parts, with the “bonus” contributions providing risk capital for new pension rights, Dengsoe says.

The bonus contributions – which afford members the option to have pensions indexed in future - are held in free reserves, for the dual purpose of financing indexations and providing risk capital for investments.

With new contributions adding 20 per cent to risk capital, the fund has room to pursue an investment strategy with a high return target.

The “guarantee” portion, which ensures a minimum pension at retirement, is set at current market rates on an annual basis, and in advance, and is fully hedged by interest rate swaps.

Under this model, members are guaranteed higher pensions yet neither the members nor the fund is exposed to increased risk, Dengsoe says.

ATP’s investment portfolio consists of five broad ‘risk classes’ – equities, credit, government bonds, commodities and inflation-protected assets.

The intention is for a higher expected risk-adjusted return through diversification, and to avoid large losses that could restrict the risk budget and threaten the fund’s ability to generate high future returns.

Dengsoe says the allocation of risk has been altered significantly since early 2007, and today, each risk class contributes to the portfolio’s return, while no single asset class dominates.

Equity risk has been reduced by half to about 40 per cent of total risk; government bonds and inflation-protected assets contribute about 20 per cent each; commodities contribute 15 per cent and credit adds 5 to 10 per cent.

The fund has also adopted an unconstrained approach to investing, allowing it flexibility in the instruments it uses to get the exposure it desires.

“Being unconstrained by benchmarks we tend to shy away from the assets currently in vogue and buy the unloved assets instead,” Dengsoe says.

“For example, our investment in credit amounted to less than 2 per cent of total assets before the credit crisis erupted. Since [then] we have more than tripled our exposure, particularly in less liquid assets that were marked down excessively.”

Put options have been used extensively to hedge against losses when insurance has been cheap.

In early 2007 ATP used long-dated put options to protect most of its equity portfolio against large losses, and in early July 2008 hedged its entire exposure against oil in a similar manner.

“Due to the put options, we lost only 5.6 per cent on our equities in the first half of 2008 whereas broad equity markets were down about 20 per cent,” Dengsoe says.

In line with its penchant for diversification, ATP has invested in a number of new assets and financial instruments.

In 2007 and 2008, the fund has increased its exposure to oil-linked bonds, and now has a global inflation-linked bond portfolio of about DKK50bn (US$8.5bn).
This year, ATP established a wholly-owned timberland subsidiary.

The new model also takes longevity risk into account, with longevity trends estimated using international data and calculated using a cohort mortality model.
As a minimum, the fund strives to increase the guaranteed pensions with inflation, plus the effect of longevity.