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Strong listed equity returns have seen the €15.8-billion ($20.8-billion) Finnish State Pension Fund, VER, increase the asset class to 40.3 per cent of its portfolio, up from 36.4 per cent at the end of 2011.

Timo Löyttyniemi, chief executive of VER, explains that the fund made net equity purchases of $74 million in 2012 while the values of its equities grew by 16.8 per cent, and another 7.4 per cent in the first quarter of 2013. “Equities are a wise long-term asset class in comparison to fixed income securities and government bonds in particular. Looking across the possibilities to diversify and bearing in mind negative real rates, there is a possibility that global economic growth will pick up,” Löyttyniemi says.

He also acknowledges a systemic shift from a prolonged bond boom to a new equity era is a possibility but says “the timing has been postponed” by central bank actions.

“Talk of low return expectations from fixed income has been around the financial community for a number of years already. Central bank actions and the real rate being negative have intensified this talk,” he explains. “But in an environment where the growth in the world economy is not there and [with] the Japanese central bank taking intervention into the next phase, there might not be room for a great rotation yet as long as central banks are aggressive in their policies.”

VER’s new equity allocation is “neutral” compared to a strategic allocation of 40 per cent, but marks a definite change of emphasis following an underweighting of equities and overweighting of fixed-income in 2011 and 2012. VER’s fixed income investments have been downsized from 56.6 per cent at the end of 2011 to 52.2 per cent at the end of March 2013 – and they returned just 0.2 per cent in the first quarter of 2013.

Few continental European funds run strategic equity allocations as high as 40 per cent. Löyttyniemi explains that VER’s freedom to run higher volatility and a longer investment horizon than solvency-bound corporate funds allow it a relatively high risk profile.

Sticking with Europe

The majority of VER’s sizeable equity investments are targeted at Europe and the Nordic region, some 62.5 per cent in all. VER was slightly overweight on its European strategic target at the end of 2012, with a 33.3-per-cent holding compared to a 32.5-per-cent target. Löyttyniemi says he is happy to continue a strong focus on the continent.

While Finns have been some of the most vocal critics within the eurozone of sovereign debt-troubled economies, Löyttyniemi emphasises that VER’s focus on large-cap European equities is intended to gain it exposure to global growth. “I’m a true believer that there are different challenges for international European companies and European governments,” he says. “And the divergence between corporate and government performance may be large.”

Another overweight can be found in VER’s emerging market equities portfolio. This has built up over the years to a 17 per cent share, currently exceeding the US equity holdings in the name of diversification. Half of the fund’s emerging market equities are invested in Asia and half elsewhere.

Keeping control of fixed income

VER’s equity portfolio is largely managed externally and close to half is run passively. It has opted though to control close to 75 per cent of fixed income in-house and runs it nearly entirely on an active basis.

This has enabled the fund to position away from certain sovereigns in the European debt crisis and make a play against bank debt. Löyttyniemi notes: “We have run a quite large underweight on financials in the past five years. Some times it has proved a good choice, at other times we have been hurt but it has helped manage total portfolio risk.”

VER was close to matching the size of its underweighted European sovereign debt holdings (35.3 per cent of fixed income) with its slightly overweighted corporate bond position (30.8 per cent) at the end of 2012. There is also a chunky 18.9 per cent in money markets and 15 per cent in emerging market debt, while the fund also runs a tactical high-yield position.

“We have enjoyed being with high yield and increased the credit side over the last five years,” Löyttyniemi says. Nonetheless, he speaks of low spreads between government bonds and corporate credit – resulting in continued debt opportunities for companies such as Apple’s record-breaking $17-billion offering – as “raising the warning signals” for investors.

Löyttyniemi is remaining watchful as a consequence. “We will not increase our strategic weight to credit and our high-yield side gives us a nice pick up, so we will be happy to stick to that to some extent”, he says.

Gentle alternatives growth

VER is also sticking to a plan to increase its alternatives holdings from their current level of 7.5 per cent to 10 per cent. “We were planning to make this increase more quickly, but the financial crisis forced us to be more cautious and we are now looking at good opportunities to make this increase if possible,” Löyttyniemi says.

Its most significant alternative investment position is in real estate, followed by absolute return. VER invests in absolute return funds that run a variety of strategies and has unsurprisingly experienced varied returns – the best performers in 2012 being credit strategies and the poorest quantitatively modeled commodity trading adviser funds.

The entire alternatives proportion is currently invested in external funds. The Finnish ministry of finance has prohibited VER from making direct real estate investments, but Löyttyniemi confesses that a more direct route for its $131-million infrastructure investments is a future possibility.

Performance obligations

While VER’s status of a buffer fund allows it to run a more traditional equity position, Löyttyniemi indicates it is interested in the art of gaining excess returns and says the fund’s Sharpe ratio (2.3 at the end of 2012) “will become more and more of a yardstick for our performance”.

VER’s Finnish investments range between 10 to 20 per cent of the portfolio, Löyttyniemi says, and he is perfectly clear about the fund’s primary role. VER was mandated by the Finnish government to focus purely on performance – it is asked to contribute 40 per cent of the country’s state pension costs every year and work towards a target of providing 25 per cent of the state’s total pension liability.

“Over the last 10 years I have been doing a lot of work to assess the impact of an institutional investors’ absence from a domestic economy and overall it is usually quite weak. As a country, it doesn’t matter where investment is coming from – an internal source or an international institutional investor,” says Löyttyniemi.

In the same sense you imagine Löyttyniemi’s eye for the markets will keep VER ready to seize opportunities, wherever they are, for years to come.

In 2010 PGGM conducted a study to see if it was possible to reduce the number of companies it invested in from 4000 to 400, based on its environmental, social and governance leanings, and still maintain it’s beta risk/return profile.

The idea was that the €133-billion ($174-billion) fund would better know and understand what it owned, and be able to better control those companies.

That experiment failed in that PGGM realised that while the ESG-based reduction in stock investments suited it’s responsible investment and long-term ownership preferences, it altered the beta profile and skewed the long-term cumulative risk.

The strategy persisted in its active responsible equity portfolios, and PGGM has an aggressive active ownership policy for all its equities portfolios.

However, in passive equities, where 90 per cent of the equities investments reside, about $44 billion in market-cap and smart beta strategies, the dual goals of it’s risk/return profile and responsible investment have been more challenging. PGGM is not alone in this problem, with ESG strategies tending to be active.

But now PGGM has developed an index in house, which measures the 2800 companies in the FTSE All World Index for their environmental and social policy and good governance.

The index re-ranks the companies based on these criteria, which also include a minimum threshold. As a consequence of this, about 200 companies that don’t make it into the index have been sold by PGGM, which amounts to about 1 per cent of the portfolio.

The capital is reallocated to companies within that sector, so the index is sector neutral.

There is a slight bias away from small companies, which don’t make it in to the index straight away. About 80 mid-to-large companies are on watch.

Matching profiles

Managing director of responsible investment at PGGM, Marcel Jeucken (pictured below), says the fund has a clear engagement, voting and exclusion policy, and the new index is an extension of its existing responsible investment activities.

“We believe responsible investment is important,” he says.

The threshold is also important and while he adds it could be higher, Jeucken says the approach is not to choose the top 10 or 50 per cent of companies because then it would need an active investment strategy.

“This is an approach that fits passive,” he says. “It meets our risk/return profile. We have the same beta risk/return characteristics as the past but we now also have an ESG selection instrument on top of our existing ownership instruments.”

PGGM believes that screening companies on ESG factors will reveal early warnings of where things go wrong, and engagement and exclusion can take place.

“We have built a system and a database, and we now better know the companies from an ESG perspective,” he says. “This strategy works if you have a strategy to be an active owner and engage, vote and exclude. The index doesn’t work alone. It is not black and white for us. We don’t blindly follow the index from third party providers as we have created our own ESG index and have an increased effort in engagement.”

The way it works

Last year PGGM voted in 3106 shareholder meetings and talked with 746 companies about improving ESG. It excluded 42 companies.

The new ESG index screens companies on 70 factors, varying from labour practices to climate policy and management or carbon dioxide emissions, and weights those factors to various sectors according to that their profiles.

For example, in banks the screens concentrate more on governance, but in mining it is an environmental focus.

The rule-based model uses external data, but the data points and weights have been determined in house.

Jeucken responds to the debate over whether ESG is a risk- or return-generating strategy by saying there is logic to both arguments, but that return fades away quicker.

However, PGGM has particular views on alpha per se. More generally, Jeucken says alpha is to be made but in small parts of the investable universe, which is why PGGM believes in a strategy of index and alternative strategies, not traditional alpha strategies.

ESG, he says, reduces risk over time – whether it be reputational or financial risk.

According to Jeucken, PGGM is willing to discuss the index with its pension fund peers and is open to the idea of sharing information.

Jan Tamerus, actuary director at PGGM, was instrumental in developing the new Dutch pension defined-ambition structure.

Back in 2006, he was involved in looking at the sustainability of the defined benefit system and in concluding it was not in fact sustainable, the idea of defined ambition evolved.

One of the key reasons for not going to a defined contribution structure is the Dutch social predisposition and, in particular, the focus on intergenerational risk sharing.

“There are two areas we don’t like about defined contribution: the risk sharing, especially the intergenerational risk, and no index targets in the system,” he says, describing defined ambition as conditional defined benefit.

“Our next area of study will be to look at ownership rights, the individual defined contribution way is more attractive to people, but we will see whether we can synthesise from defined ambition to defined contribution, and the only way to succeed in that is to have some solidarity elements in defined contribution.”

Intergenerational risk sharing defined

Tamerus concedes that defined contribution could be a more sustainable system because “you can go with the flow for more individual choices”, but he would like to see defined contribution changed in a way that will have more guidance rules about risk sharing and intergenerational risk in particular. It’s his new area of study.

“In The Netherlands we like intergenerational risk sharing, it’s very important. When we decided defined benefit was no longer sustainable, we looked at going to defined contribution, but there is no intergenerational risk sharing and no target, especially an indexed target, in the contract,” he says. “Those are the two elements why we didn’t want to go to defined contribution, so made defined ambition.

“The defined ambition structure is the same as defined benefit, but we have conditional indexed rights instead of unconditional nominal rights in combination with a policy of indexation. The focus is an indexed pension outcome instead of nominal guarantee.

“By skipping the nominal guarantee, we bring in premium stability and make the contracts shockproof – both elements of defined contribution.

“On the other hand we maintain the intergenerational risk sharing and the income-related target – both elements of defined benefit. Moreover, we make it an indexed target.

“I am very proud of the work but anxious to see it evolve. There is a struggle because some people have commented that we move the risks from the employer to the participants and at the same time take more risks, but that is not the way we will do it,” he says. “In defined ambition, the focus in the investment policy is on stable pension income in real terms,” he says. “Due to the dual focus in the current defined benefit schemes – nominal guarantee as well as an indexation policy – this will not lead to major changes. It is more the liability hedge that should be reconsiderd. Because of skipping the nominal guarantee, the nominal interest rate is less important.”

Managing the transition

The new pension legislation will be implemented in 2015 in The Netherlands, but the Pension Act needs to be ready this year. The first version of that will come out in the summer and put on the internet for consultation.

The details of the structure are such that the defined ambition target is calculated as the risk-free rate plus a risk add, which tries to measure the uncertainty associated with defined ambition compared to defined benefit, minus the indexation target.

The risk-free rate includes the ultimate forward rate, which is an estimate of what the short-term interest rate will be in, for example, 60 years from now. It is currently set at 4.2 per cent.

The indexation target means the benefits in a defined ambition structure will be indexed each year.

This factors in wage growth, so the promise is in real terms rather than nominal terms.

Dirk Broeders, senior strategy adviser at the Netherlands Bank (pictured below), which supervises pensions, says there are two things that are differentiate about defined ambition from defined benefit: it is indexed each year, and it is adjusted up and down based on realised investment returns.

The retirement benefit in the defined ambition system is still linked to the performance of pension investments; it comes out as an income stream annually adjusted to the performance of the investments.

Broeders, who is leading the project on defined ambition advice to government and the project on the communication to the public, says in the future funds can use the nominal contract (defined benefit) or choose the real contract (defined ambition).

“Maintaining a defined benefit system is unsustainable in the future. In an ageing society where people live longer, it is too difficult to promise certain benefit,” he says.

“This is a huge transition, a huge commitment and will put pressure on administration systems to keep track of each individual. It is very complicated and costly but maybe that is the price you have to pay to update your system for the future.”

Japan’s Government Pension Investment Fund (GPIF) has $1.4 trillion in assets and is the world’s largest pension fund. The institutional structure and the investment style of GPIF differ from those of other public pension reserve funds. This article describes how GPIF is structured and how it works,then compares it with Canadian and American public pension reserve fund approaches. Perspectives include the discretion exercised in investment decisions, information asymmetry, and accompanying agency and governance problems.

Read Managing Public Pension Reserve Funds from the Rotman International Journal of Pension Management.

The author, Nobusuke Tamaki, teaches at Otsuma Women’s University in Tokyo and is the former director general of the planning department at Japan’s Government Pension Investment Fund.

Sobering new figures in the latest report to highlight climate risk should resonate with trustees more than usual. According to the second study from Carbon Tracker and the Grantham Research Institute on Climate Change and the Environment, part of the London School of Economics Unburnable carbon 2013: Wasted capital and stranded assets, between 60 and 80 per cent of current fossil fuel reserves listed on world markets can never be used if global warming is capped at the 2-degree-Celsius increase targeted by policy makers. It means pension funds, renowned for their high allocations to oil and gas majors, are in danger of holding stranded assets, investments that have plummeted in value because of regulations to tackle climate change coming into play. Current values placed on many of these companies are based on the future development of reserves – coal, oil and gas groups spent $647 billion on exploitation last year alone, according to the report – yet when governments take action to limit carbon emissions, the exploitation on which these values depend may never be realised.

Lack of political will

Campaigners say galvanising pension funds to put strategies in place to tackle climate risk when many are in deficit or still reeling from the financial crisis is an uphill struggle. Funds have also been slow to respond because the long-term threat to returns still isn’t priced into high-carbon assets. Markets still believe that governments won’t put in place the policies needed to tackle climate change. “Market valuations are discounting policy action by governments,” says Nick Robins, head of the Climate Change Centre of Excellence at HSBC, although he does believe policy confidence is coming back. If so, the market could begin to react to long-term signals.

Other barriers to overcome include a dearth of high quality managers specialising in these asset classes. Passive investment strategies or strategies indexed against benchmarks also make climate risk difficult to mitigate, with current benchmarks coming under particular scrutiny in the report. “More forward-looking financial indicators are required if investors are to translate climate change risk into investment decisions,” argues James Leaton, research director at Carbon Tacker.

Who cares?

Yet amid the increasingly shrill calls for pension funds to wake up to climate risk, a handful of the most high-profile schemes have been leading on the issue for a while. Strategies include introducing climate-risk assessments into reviews, increasing allocations to climate-sensitive assets, using sustainability-themed indices or encouraging managers to proactively manage climate risk. In the United Kingdom these include the £34-billion ($54.7-billion) Universities Superannuation Scheme (USS) and Railpen, inhouse manager of the $30.4-billion pension scheme for Britain’s rail industry. The $3.29-billion Environment Agency Pension Fund, admittedly a fund drawn from employees working to reduce climate change and its consequences, is pushing a strategy targeting a 25-per-cent allocation to the green economy by 2015. “We take climate change into account in our investment strategy, asset allocation and via the fund managers we use – they have to understand climate change risks and opportunities,” says Howard Pearce. As head of the scheme, he urges “CIOs of every pension fund” to read the latest Unburnable carbon report. “Our pension fund seeks to avoid climate change risks and we monitor annually the carbon footprint of our investments,” he says. “Also, we have invested over $380 million in clean technology investments.” Investment strategies at the fund to hedge against climate change include exposure to sustainably managed forestry, farmland and infrastructure, says Pearce.

Others well aware of the issues around climate change and the threat it poses to their investments include Norway’s $582.7-billion Government Pension Fund Global, PGGM and APG of the Netherlands, Australia’s Local Government Super and California Public Employees Retirement System, recently ranked fifteenth out of the 1000 biggest asset owners for its disclosure and best practice around climate change risk. In South Africa, the Government Employees Pension Fund has said it believes its investments are vulnerable after calculating its exposure to fossil fuels.

Where to now?

For schemes only beginning to acknowledge climate risk, a first step is to find out how exposed they are and then to tell people about it. It’s a process that Catherine Howarth, chief executive of campaign group ShareAction, believes is starting to happen through ShareAction’s grass-root activism. It is encouraging pension scheme members to lobby their pension funds on climate risk and Howarth says the debate is starting to get louder. “Awareness is growing, although it is from a very low base. Most trustees haven’t had this bought to their attention by their asset managers, but they are starting to take climate change more seriously.”

Read the report here: Unburnable carbon

This paper from Matt Dobra and Bruce Lubich, of the Methodist University in North Carolina and the University of Maryland University College, respectively, analyses the relationship between governance, asset allocation, and risk among state and local government-operated pension systems in the United States of America. It is argued that governance influences investment decisions and risk profiles of public sector pension systems, creating the potential for agency problems to exist between decision makers, plan members and taxpayers.

Read Public pension governance and asset allocation here.