Page 525 – Top1000funds.com

Gert Poulsen, chief investment officer of the €3-billion ($3.9-billion) Danish charity Realdania, likes both property and the risk of earthquakes. The connection, Poulsen quickly adds, is not because he welcomes natural disasters, but due to Realdania’s distinctive history. Based in Copenhagen, Realdania was founded in 2000 when Danske Bank, the country’s largest lender, bought the mortgage bank Realkredit Danmark. Under the deal, Realkredit Danmark ceased issuing home loans. The net capital of about $1.8 billion was set aside to create Realdania as an endowment fund to improve the quality of Denmark’s built environment, with the new charity holding a strategic stake in Danske Bank.

Those origins explain both Realdania’s substantial Danish real estate assets, which accounted for 9.9 per cent of its total portfolio in 2012, and the fund’s large exposure to the financial sector through its Danske Bank holding. At the end of last year, Realdania owned almost 10 per cent of Danske Bank, more than made sense from a purely investment perspective; indeed, the stake made up 43.8 per cent of Realdania’s global assets. In addition to the Danske Bank stake and real estate assets, Realdania had an allocation at December 31, 2012 of 13.1 per cent to listed equities, 26.2 per cent in bonds and 5.5 per cent in private equity. Overall, the portfolio returned 17.2 per cent in 2012, compared with a negative 21.3 per cent return the previous year.

The attraction of non-correlation

Poulsen’s interest in natural disasters, such as earthquakes, stems from his desire to counter the market risk in Realdania’s portfolio, especially because of the heavy exposure to Danske Bank. He cites catastrophe bonds as a particularly effective hedging instrument for Realdania. Since 2010, the charity has accumulated a $25-million holding in these specialised securities, which are issued by insurance companies to reduce their liabilities when natural disasters occur. “Catastrophe reinsurance risk and bonds have the great attraction of being absolutely not correlated with our other investments,” explains Poulsen. “The risk of an earthquake is different from market risk.”

Timber is another alternative asset favoured by Poulsen. In 2008 Realdania made an initial $10-million investment in US timber in order to learn about the forestry market. “We felt we needed to be careful,” Poulsen recalls. “Now we have a better understanding of the drivers and issues in the sector, and have increased our holdings.”

To date, alternative assets – which also include hedge funds, commodities, and other insurance products – only represent about 2 per cent of Realdania’s total portfolio. Yet over time, Poulsen expects to expand its allocation, following a broadening of the investment mandate in 2010 to allow coverage of all asset classes. One of Readania’s eight investment managers specialises in alternative assets; in theory there is no esoteric product or security the fund would not consider buying, provided the perceived risk was not too great.

More than a financial investment company

While Realdania’s investment strategy has changed radically in recent years, the charity has retained its unusual governance model. When it was set up, Realdania simply took over Realkredit’s mutual structure. The charity is ultimately owned by about 160,000 property owners in Denmark, who elect its 109-member board of representatives. They in turn elect the supervisory board.

This organisation has led some critics in Denmark to contend that Realdania is essentially a financial investment company, rather than a proper charity. The charge is vigorously denied by Realdania, which points to about $1.8 billion in grants disbursed since 2000 for building projects ranging from landmarks such as Copenhagen’s Danish Architecture Centre to small community developments. In addition, Realdania sees itself as a hub of architectural and construction expertise. “We don’t just offer money, we also offer knowledge,” argues Flemming Borreskov (pictured right), Realdania’s chief executive, in a video presentation on the foundation’s website.

Kind of like a foundation…

Against this very Danish background, Poulsen is at pains to stress that Realdania has much in common as a financial investor with other large charitable foundations in Europe and worldwide. In particular, many philanthropic endowments – for better or worse – are heavily invested in the same way as Realdania in one sector, asset class or company due to the manner of their establishment. In Portugal, for instance, the $3.65-billion Calouste Gulbenkian Foundation derives the majority of its income from the Partex Oil and Gas Group, the company founded by the Armenian philanthropist Calouste Gulbenkian and bequeathed to the charity that bears its name. Similarly, the $7.7-billion Garfield Weston Foundation in the UK is largely financed through its controlling stake in Associated British Foods, the conglomerate created in 1935 by Willard Garfield Weston.

…but not really

Where Realdania differs from some endowments is in acknowledging that its own over-exposure to Danske Bank is an investment headache. In March, Realdania sold 5.2 per cent of the lender in a share sale that raised $955 million and reduced its overall stake to 4.9 per cent, with the proceeds ploughed back into the portfolio. According to Poulsen, “the reinvestment in other assets has contributed to achieving a more balanced investment portfolio to support philanthropic projects.” He adds that while Realdania has not yet decided how much more of Danske Bank it will sell, the charity’s desire to diversify its holdings is open knowledge.

Volatile and vulnerable

The need for more diversity is laid bare by the volatile performance of Realdania’s portfolio since the 2008-9 financial crisis, due in large part to its exposure to Danske Bank’s stock market performance. Like other Nordic lenders, Danske Bank was not heavily exposed to Greece and other debt-ridden southern European markets and, as a lender outside the eurozone, was insulated from the worst shocks of Europe’s sovereign debt crisis. However, as Poulsen observes, Danske Bank still suffered considerable collateral damage as a lender in a small country whose economy and currency are inextricably tied to the eurozone. “When the euro goes down, so does the Danish krone, and vice versa,” Poulsen notes. “Our country is not in this sense a safe haven from the euro crisis, even though some foreign investors seem to think so.”

Bouncy but unpredictable

By the same dynamic, Danske Bank recovered sharply in 2012, as fear of a eurozone break-up receded, with the lender’s shares gaining almost one-third in value. Realdania bounced back, posting the same return from its Danske Bank investment, which was almost double the portfolio’s overall return. Although the revival was welcome, Poulsen would much rather achieve smooth, consistent returns over time in line with Realdania’s annual average for the past 10 years of 5.6 per cent. In that way, he could ensure dependable income flows back to Realdania for philanthropic grants, which totalled about $200 million last year. That suggests Realdania will continue to sell down its Danske Bank stake, while exploring further the risk-reducing potential of alternative assets.

On one hand, the decision by one of the United Kingdom’s leading foods businesses, Dairy Crest, to plug its £84-million ($130-million) pension deficit with cheese smacks of desperation. Any proactive investment strategy to get the $1.2-billion pension fund back on track has been abandoned for a funding measure using unconventional sponsor assets to plug investment losses. On the other hand, isn’t the strategy whereby trustees get $93 million worth of maturing cheddar as security against the deficit if Dairy Crest goes bust a way to help ensure the beleaguered scheme survives in the long-term and a bid to recover a deficit in a more adventurous way? As funding and investment strategies become increasingly intertwined for the UK’s debt-riddled defined benefit schemes, it certainly shows a new creativity emerging in the market.

Asset backed funding, in which a company uses business assets to generate cash, which is then paid to the pension fund, first appeared in the UK back in 2007 when a handful of retailing groups used their property portfolios to fund pension deficits. It involves transferring the assets into a separate entity, such as a special purpose vehicle or partnership. Typically, assets used will generate income such as rent or royalties. According to consultancy KPMG, there were 10 asset-backed deals in 2010, eight in 2011 and seven in 2012. Deals involved blue-chip names such as engineering group GKN using intellectual property income from its patents as security, and drinks group Diageo, makers of Johnnie Walker and Smirnoff vodka, pouring $568 million worth of whiskey into its $1.3-billion deficit. Now the concept has gone one step further with companies exploring income receivables as pension guarantees and even brand value. Asset-backed funding hasn’t taken off outside the UK but, regulatory issues aside, there’s no reason why US corporate pension funds just waking up to the defined benefit nightmare (Boeing is the latest to close its scheme with liabilities of $75 billion) couldn’t make the leap.

Single solution

It seems to answer all kinds of knotty problems with one solution. Defined benefit schemes can’t expect asset growth to plug deficits in the current climate of low interest rates and poor returns, where static asset allocations definitely don’t deliver. Many funds won’t challenge traditional thinking, with only the biggest schemes with the strongest covenants recruiting the skills to push bolder strategies such as alternatives. And because gilt yields are at record lows, many companies hope deficits are inflated anyway – pension liabilities are calculated referencing bond yields so when yields are low, deficits are high. It has left sponsors even more reticent to put large amounts of cash into their pension schemes, which under UK law they wouldn’t be able to recover should the fund return to surplus. Asset-backed funding even neatly ticks this box as the assets are ultimately controlled by the business, reverting to the company at the end of the term.

Investment strategy too

It’s a funding strategy that positively impacts investment strategy too. Dealing with the deficit helps solve the bane of mismatched investment strategies in which schemes have plumped for risk despite ballooning liabilities. Asset-backed funding was the catalyst in a turnaround at the $9.6-billion defined benefit scheme of UK retailer Marks and Spencer, which slashed its deficit from $2 billion in March 2009 to $450 million last year. In 2007 the 120,000-member fund transferred $2.3 billion of the company’s property assets into a Scottish limited partnership with the M&S UK Pension Scheme. Under the partnership agreement, M&S retains control over the properties, however the pension scheme is entitled to receive an annual profit distribution earned through leasing the properties back to M&S. As a result, the M&S pension scheme was able to recognise the fair value of these future income streams as an asset in its accounts, leading to an improvement in its funding position. The scheme has pared risk to a 16-per-cent equity allocation, with the rest in bonds and fixed income, in contrast to most UK funds, which still allocate on average half their portfolios to equity.

More room to manoeuvre

But shaving deficits through asset-backed funding can just as easily help schemes maintain their levels of investment risk. Strong sponsor covenants mean schemes can better withstand shocks – the current wave of de-risking is attributable to weak sponsor covenants. It could offer confidence for cautious defined benefit schemes, which have whittled down their growth portfolios in favour of fixed income assets and derivatives, to push the risk premium of equities once again. Or, as one commentator put it, “help kick overly prudent investment strategies that manifest in holding too high an allocation to government bonds into touch.” In short, asset backed funding gives struggling defined benefit schemes more room to manoeuvre. They could hold their risk allocations, reduce risk or just use it to reduce the levy they pay the Pension Protection Fund, the lifeboat fund that says the UK’s 6316 defined benefit schemes hold a collective deficit of $366 billion, with the average workplace pension 83-per-cent funded.

The real value of cheese

Yet surely hazards lurk in the more unusual asset-backed funding structures. Are trustees getting the risk at the right price and how do they assess the value of cheese? How will the value of the asset change over time and what if salmonella infects the cheese or it melts and becomes worthless? And if cheese is suddenly such a valuable asset, why is it only fit for pensioners? Why not pay our corporate big cheeses in cheddar too? Trustees must be careful what assets they use and satisfied that they will hold value in the event that a company ceases to trade. I can see why companies and trustees increasingly consider asset-backed funding. Deficits are ballooning but sponsors lack cash and the 1990s era of contribution holidays is a distant memory. Members need security and investment strategy a kick-start. It’s just the cheesy strategy that smells a little off.

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.

Danish real estate charity builds balance