University of St.

Gallen Master of Arts in Banking and Finance

Do quantitative investment constrains lower long-term term pension fund performance?

__________________________________________________________________________________________

Research Seminar Pension Finance

Authors:

Alain Kunz alain.kunz@student.unsgi.ch 05-608-542

Mauro Baertsch mauro.baertsch@student.unisg.ch 05-607-494

Referee: Prof. Dr. oec., Dipl.phys. ETH Hans-Jrgen Wolter University of St. Gallen 6 May 2011

Introduction

1 Introduction
The paper examines the quantitative investment constrains for pension funds in Denmark, Netherlands, Sweden and Switzerland and delivers a comprehensive study on the long term investment performance of each system. The paper examines the question whereby quantitative investment constrains have a significant impact on the allocation of the investment portfolio and how are the long-term investment results affected by the given quantitative investments constrains. The four countries are comparable to each other due to similar building blogs of the pension fund system, similar life standard, national income per capita, welfare state and according to Melbourne Mercer Global Pension Index three systems are state-of-the-art pension systems. The Melbourne Mercer Global Index examines the pension system on the principles of adequacy, sustainability and integrity, whereby the Netherlands accomplished the highest score of 78.9 of 100 points, followed by Switzerland, Sweden (Mercer, 2010), however the system of Denmark is not included in the survey.

All four systems are equally structured and contain a so-called three-pillar system. The three pillars are differently financed and provide a direct, intertemporal or individualized transfer of wealth. The first pillar guarantees a decent minimum income for all citizens independent from their personal wealth or status of employment. The second pillar consists of supplementary pensions which are built up as part of people's terms of employment. The primary responsibility for these pensions therefore lies with employers and employees and it ensures a certain level of financial freedom depending on the accumulated wealth during the working period. The third pillar consists of supplementary personal pensions based on individual private savings.

The key macroeconomic and welfare issue arise from the choice of financing the system. In general two ways of financing exists. The so-called pay-as-you-go (PAYG) system suggests a direct transfer of wealth from workers to pensioners. The PAYG system has the advantage of offering immediate pensions, without waiting for assets to accumulate and moreover remove the inflation risk to pensioners. Davis (1993) points out, that the PAYG "can provide a higher rate of return to each generation, if the sum of wages and employment growth exceed the interest rate. However if they do not, then there may be a corresponding fall in rates of return and increase in costs per capita". Another disadvantage arise from the fact that workers and
2

Introduction

employers bear an increasing burden of social security contributions and affect the competitiveness of a country in a negative way. The other way to finance the system is by funding or in other words by accumulating of wealth within a pension fund system or on an individual basis. Davis (1993) suggests countries to use a mixture of both (Davis, 1993). The table 1 below deliver a summary of the above information.

Table 1: Overview of the Multi-Pillar pension system

Pillar I Financing Taxes / PAYG Pillar II Contribution from employer and employee (fully-funded) Contributions Benefits Taxes / PAYG Minimum amount, life long Members Citizens of a country or residents over a certain time Fixed amount Accumulated long Wage earners, over a certain minimum income or hours per week assets, life Individual Individual assets, depending on the accumulated amount Wage earners and selfPillar III Contribution from employee (fully-funded)

employed

Source: Mercer (2010)

The paper discuss delivers a survey of the different regulatory investments constraints and examines the direct impact on the portfolio. First of all we discuss the quantitative investment constrains, later the portfolio allocation is analysed and in a later part the real investment returns are considerate. In general the pension and other institutional assets manager display a strong "home bias". The paper examines if the lack of foreign diversification is greater in countries with more prudent investment constrains and how are the portfolio in a general structure allocated.

According to Reisen (1997) a pension fund does not only seek to maximise return. The pension fund also concentrated on the real purchasing power of their assets. In fact, due to currency fluctuations long term deviations from purchasing power parity (PPP) existed. The paper analysis only the quantitative investment constrains in the second pillar of the pension fund system. Pillar I is organised according to the PAYG and assets are directly transferred from workers to pensioners without an investment process. Pillar III is highly individual and a comprehensive study of the investment returns across different pension system nearly impossible. Pillar II on the other hand is in all analysed countries nearly similar organised and surrounded by a given law system.
3

Introduction

The article is structured as follows: In Section 2, we review the previous research on the investment constrains of the pension systems of Denmark, Netherlands, Sweden and Switzerland. Section 3 provides a comprehensive overview of the investment constrains in each pension system and provides an overview of the recent changes in the investment constrains. Section 3 furthermore provides a description of the asset allocation in each pensions system and Section 4 characterizes our data set problem. In Section 5 we conclude the results.

Literature

2 Literature
So far, relatively little research has been done on the investment constraints of international pension funds and the impact of the regulation on the overall real investment performance. The European Commission (1999) published a comprehensive study on international pension system and pointed a negative correlation between asset restrictions and investment returns. Alier and Vittas (2000) examine that in several European countries, including Germany, Netherlands, and Switzerland, government regulation impose quantitative limits on investment allocations with the goal to reduce volatility and even though employers operate in most cases with defined-benefit plans and absorb the investment risk. They concluded that a less volatile pension portfolio would normally imply a lower return and therefore lower replacement rate and pension. The opportunity cost of lowering portfolio volatility can be quite significant in case of a high equity premium. Queisser and Vittas (2000) examine the Swiss Multi-Pillar pension system closely and their analysis of the investment policies shows that Swiss pension funds used to be extremely conservative. The funds did not reach the investment constraints limits of any category of investments. Traditionally, Swiss pension fund managers interpret fund managing within the legal limits as good pension fund management. However, the study has furthermore shown that over the past decade pension funds have consciously increased their equity and foreign securities investments. The report of Queisser and Vittas (2000) provides an overview of the investments returns of the Swiss system compared to other countries. Given the extremely conservative Swiss approach it is not surprising that the returns of Swiss pension funds are relatively low. The average real returns on Swiss pension portfolios were 4.90 percent in the period from 1984 1998, whereby other countries such as Ireland, United States and United Kingdom reported an average real returns of 12.54 percent, 10.49 percent respectively 10.35 percent in the same period. The paper of Yermo (2003) provides a survey of investment regulation of pension funds worldwide. The report contains all quantitative portfolio restrictions applied to autonomous pension funds in OECD countries at legal levels. Antolin (2008) provides an analysis of aggregate investment performance by country on a risk adjusted basis by using relatively standard investment performance measures. The paper moreover describes the privately managed pension funds around the world and the regulatory environment they face. In the same year Tapia (2008) provides a more comprehensive description of private pension funds in twenty-tree countries. The report presents a new data set on the investment performance
5

Literature

achieved by privately managed pension funds, including annual real rates of return, annual geometric average of real returns, as well as a summary of statistic of these returns for various countries. The report by Hinz et al (2010) summarizes the effort undertaken by the OECD to compile information on privately managed pension funds and provides descriptive information on the design of the pension systems as well as a summary of the different approaches to investment regulation. The report concludes that the optimal portfolio allocation requires a sophisticated approach, which includes an intertemporal optimization of pension portfolios, which considers numerous variables, including the risk of the different financial instruments, age of individuals, human capital risk and individual preferences. The report points out that policy makers in various countries feel confident to define a limited number of lifestyle pension funds differentiated by boundaries on equity exposure is enough to design an optimal path of accumulation of pension funds. However, the report shows that lifestyle funds are insufficient to create an optimal path of retirement savings but can create the illusion to contributors that they are doing so. The report concludes furthermore to built life-cycle funds on well-defined benchmarks, and, consequently solely impose maximum limits on different asset classes might not be enough to optimize the future pensions of individuals. The OECD (2010) report describes the main quantitative investment regulations applied to pension funds in OECD and selected non-OECD countries. The paper publishing all forms of quantitative portfolio restrictions with minima and maximum applied to pension funds at different legal levels. Moreover the report provides a list of the main regulator changes during 2009. Interesting in context of this paper are the changes in BVV2 and OPP2 in Switzerland during 2009. The ceiling on foreign investments and the foreign asset class sub-limits were replaced by a single 30 percent ceiling on investments denominated in foreign currency, whereas hedging activities are allowed. In addition to this the ceiling on real estate was reduced from 50 percent to 30 percent, while the ceiling on mortgage loans was reduced from 75 percent to 50 percent. A further report publish by OECD (2011) summarizes the pension funds performance during 2009. The report presents a comprehensive overview on the real average investment rate of various OECD countries. During 2009, pension funds cross OECD countries realised a positive real investment rate of 6.5 percent on average, however the average asset values were still on average 9 percent below the levels of 2007.

Survey of investment constrains of pension funds

3 Survey of investment constrains of pension funds and portfolio allocation

The following section provides an overview of the quantitative investment constrains in Denmark, Netherlands, Sweden and Switzerland and discusses recent developments within the regulation body in each system. Moreover the section contains an analysis of the portfolio allocation and provides an inside to what extend the quantitative investment constrains are applied in the portfolio allocation of pension funds.

3.1

Denmark

Quantitative limits are in the Danish system applied on the asset side. The restrictions especially limit the share of assets which can be made in so-called "risky assets", notably equities. Furthermore quantitative limits are applied in order to decrease concentration of risks and achieve diversification effects. For example quantitative restrictions are applied to possible exposure on one issuer of mortgage bonds or the proportion of total assets which might be invested in the security of just one company or holding company. While quantitative investment limits are still in place however over the years a gradual move towards regulation based on the Prudent Person Principle (PPP) continued. The PPP limits emphasis on the pension institution to behave prudently, controlled and monitoring risk, rather than on quantitative limits. On the other hand over a longer time period the share of assets which can be invested in "risky assets" such as equities, has been increased. In 2001 the limits on the proportion of "risky assets" was raised from 50 percent to 70 percent. The reason for the increase was that some institutions had reached the former ceiling of 50 percent and still intended to increase the equity proportion. Andersen and Skjodt (2007) point out that the flexibility in the current Danish investment regulation is so great that asset allocation strategies are more influenced by internal asset and liabilities considerations or capital rules rather than by quantitative investment rules and limitations per se (Andersen & Skjodt, 2007). The Danish pension funds additionally face quantitative investments constrains on their investments in equities, bonds, retail investment funds, private investment funds. The imposed limits from 2001 remain and include an overall limit on equities of 70 percent, whereby not limits of equity investments in OECD countries exist. The bonds investments are limited to 70 percent, only if non gilt-edged, in addition private investment funds such as hedge funds or private equity funds face a limit of 10 percent. All other asset classes are not
7

Survey of investment constrains of pension funds

particular restricted by quantitative investment constrains. Table 2 in Section 6 provides a summary of the information.

3.2

Netherlands

In contrary to the tree other pension fund systems no quantitative investment constrains are in place in the Netherlands (OECD, 2010). However relative strong funding regulations are applied. Pension funds in the Netherlands are obliged to keep their pension promises fully funded. The Financial Assessment Framework, which is part of the Pension Act, sets out the requirements of financial position of a pension fund. A pension fund's financial position is reflected largely by the coverage ratio. The coverage ratio expresses the relationship between the fund's assets and the pensions to be paid in the future (pension liabilities). The minimum coverage ratio is 105%. This means that the capital must amount to 105% of the liabilities. Moreover a pension fund must hold enough equity to be able to deal with financial setbacks. The size of the buffers on average is approximately 125%. The greater the investment risks and the higher the average age in the pension fund, the higher the buffer requirements. In case of a funding shortfall, by definition a coverage ratio less than 105%, the fund must submit a recovery plan to the Dutch National Bank (DNB). The coverage ratio must regain the 105% level within 3 years (Funds, 2008). According to our narrow definition of quantitative investment constrains in this paper, the coverage ratio cannot by considerate as one. However, we bear in mind that the restrictive coverage ratio policy within the Netherlands pension fund system could have an indirect effect on the portfolio allocation and lead to investments with lower standard deviation.

3.3

Sweden

Similar to the Danish or Swiss pension funds, the Swedish pension fund system face quantitative investments constrains on their investments in foreign currency, bonds or fixed income instruments, private investment funds and commodities investments. Swedish pension funds are restricted in foreign currency investments. A maximum of 40 percent of Asset under Management (AUM) are allowed to be exposed to currency risk, exposure beyond 40 percent must be hedged. The restriction is in place due to that face that the liabilities of pension funds are denominated in domestic currency and typically Swedish equities are strongly exposed to currency risks. According to the quantitative restrictions Swedish pension funds are moreover obliged to hold at least 30 percent of AUM in fixed income instruments, whereby only fixed income
8

Survey of investment constrains of pension funds

instruments with a low credit- and liquidity risk are permitted. Only Government or corporate bonds with a high investment grade fulfil the restrictions. A third quantitative restriction limits the maximum amount invested in so-called Non-listed Assets. The restriction limits the amount of Non-listed Assets at a maximum of 5 percent, whereby only Funds or Funds of Funds investments with related to Private Equity and Infrastructure are allowed. Furthermore only funds with a transparent performance measurement are part of the permitted assets. However, the restriction excludes Real Estate investments. In contrary to investment constrains of other counties are all investments in commodities not allowed in the Swedish system. The investment in commodities are not considered as a conservative investment and therefore typically not part of "traditional" portfolios of institutional investors. Additional to the quantitative restrictions at level o the asset classes further regulations within the asset classes are in place. The restriction with the asset classes impact the asset allocation not directly, however are mentioned in terms of completeness. First of all it's not allowed to invest more than 10 percent of the AUM in a single counterparty or group of counterparties. Second, a maximum of 10 percent of voting rights in one single company can be hold. Third, the total market value of Swedish public equity may not exceed 2 percent of total market capitalisation. Fourth, a minimum of 10 percent of AUM must be managed by external managers to ensure cost efficient management of the other assets (Franzen, 2008). The Table in the appendices summarizes the above information.

3.4

Switzerland

The Swiss Federal Law on Occupational Old-age, Survivors and Disability Pension Plan (LPP) contains regulations which Swiss pension funds must apply for their investments. According to the investment principles pension funds asset have to be managed prudently to ensure the safety of assets, achieve a reasonable return on investment assets, substantial diversified of risk, and allow for the liquidity requirement of the plan1. The Swiss pension funds additionally face quantitative investments constrains on their investments in equities, bonds, mortgages and real estate. The currently imposed limits include an overall limit on equities of 50 percent including domestic and international equities. However, the regulation contains sub-limits on the foreign equities. In 2009 the 30 percent ceiling on foreign investment and foreign asset class sub-limits were replaced by a single 30 percent ceiling on investment denominated in foreign currency, whereby currency
1

Article 50 of the Swiss Federal Law on Occupational Old-age, Survivors and Disability Pension Plan. In addition, Articles 49-60 of the Ordinance on the Occupational Old-age, Survivors and Disability Benefit Plans (OOB2). 9

Survey of investment constrains of pension funds

hedging is allowed. In addition the ceiling on real estate was reduced from 50 percent to 30 percent and the ceiling on mortgage loans was reduced from 75 percent to 50 percent 2 (OECD, 2010). Furthermore a sub-limit on real estate in foreign counties exists, maximum one third of the real estate investments are allowed in foreign countries. Moreover alternative investments are now authorised as a possible type of investment with a ceiling of 15 percent. However, the latter must be made via a diversified investment vehicle and may not incur any reserve liabilities. In addition the new regulations to prevent the concentration of risks in single investment classes and to allow international diversification of pension fund investments are installed. The limits on investments in individual firms or with individual debtors were set at five and ten percent respectively, irrespective of their nationality3.

In a recent article Ammann and Zingg (2008) point out the quantitative limitations influence, in particular, the strategic asset allocation of pension funds. Amman and Zingg (2008, p.35) conclude that "the quantitative limitations, even if exemptions have become the rule, influence the asset allocation of Swiss pension funds to a great extent. The vast majority of pension funds in Switzerland structure their assets in domestic bonds, international bonds, domestic equities and international equities. This partially explains the strong home bias of Swiss pension funds" (Ammann & Zingg, 2008). Furthermore they conclude that the quantitative investment constrains are less important for the investment strategy within the individual asset classes.

3.5

Summary investment constrains

The section summarizes the above explanations. In contrary to all other countries Netherlands have no quantitative investment constrains, however relative strong funding regulations are applied. According to the definition the coverage ratio is not quantitative investment constrains, but in the portfolio analysis we bear in mind that the coverage ratio could lead to prudent investments. All other three pension fund system face quantitative investments constrains. The Danish pension fund have quantitative investments constrains on their investments in equities, bonds, retail investment funds, private investment funds. The bonds investments are limited to 70 percent and in addition private investment funds such as hedge funds or private equity funds face a limit of 10 percent.

2 3

Article 55 of the Swiss Federal Law on Occupational Old-age, Survivors and Disability Pension Plan Article 54 and 55 of the Swiss Federal Law on Occupational Old-age, Survivors and Disability Pension Plan 10

Survey of investment constrains of pension funds

Swedish pension funds are restricted in foreign currency investments. A maximum of 40 percent of Asset under Management (AUM) are allowed to be exposed to currency risk, exposure beyond 40 percent must be hedged. Further restrictions limit the amount of Nonlisted Assets at a maximum of 5 percent, whereby only Funds or Funds of Funds investments with related to Private Equity and Infrastructure are allowed. Only Government or corporate bonds with a high investment grade fulfil the restrictions. A third quantitative restriction limits the maximum amount invested in so-called Non-listed Assets. The Swiss pension funds additionally face quantitative investments constrains on their investments in equities, bonds, mortgages and real estate, an overall limit on equities of 50 percent including domestic and international equities. However, the regulation contains sublimits on the foreign equities. In 2009 the 30 percent ceiling on foreign investment and foreign asset class sub-limits were replaced by a single 30 percent ceiling on investment denominated in foreign currency, whereby currency hedging is allowed. In addition the ceiling on real estate was reduced from 50 percent to 30 percent and the ceiling on mortgage loans was reduced from 75 percent to 50 percent4 (OECD, 2010).

According to our analysis of the investment constrains we could expect a more aggressive portfolio allocation in countries like Netherlands and Denmark, a balance portfolio allocation with some alternative investments in Switzerland and prudent portfolio allocation in Sweden. Portfolio allocation of Denmark from 2001 2009

3.6

The Danish pension system applied quantitative limits are set with respect to the allocation within risky assets referring in most cases to the equity allocation. Further are there limits with respect to the so-called correlation risk, with the goal to diversify the concentration on the assets issued by counterparties. The focus on the diversification amongst the issuing counterparties got the focus at the latest with the recent financial crisis including the bankruptcy of one of the largest player within the banking system, Lehman Brothers. The rules in the Danish pension system led to the following historical development of their asset allocation. The safest asset class within the entire asset allocation is the so-called cash and deposits. The cash part includes current account and other short-term savings in the financial system, while deposits are considered as fund placed on deposit with a financial institution and does not include certificates of deposits or other short-term securities. This allocation lies within
4

Article 55 of the Swiss Federal Law on Occupational Old-age, Survivors and Disability Pension Plan 11

Survey of investment constrains of pension funds

the range of 0.3 percent and 2 percent with an average of 0.75 percent during the time series available. This low allocation is reasonable as the return generated are extremely low. The traditional fixed income allocation into bills and bonds issued by both the public and private sector makes by far the largest part of the entire asset allocation observed by the Danish pension system. This part consist of bills and bonds issued by the public administration both local governments and national debt. The allocation over the observed time series moves from 47 percent up to 70 percent of the entire portfolio with an average around 54.8 percent. After the recent financial crisis in 2007 a strong increase to this allocation could be observed at the expense of the equity allocation. The loans allocation consisting of consumer credit, bank loans, mortgage loans, financial leases and other kind of loans including commercial bills, hire purchases and other instalment credits and further types of loans not bound to bearer bonds. The allocation ranges within 0.01 percent up to 1.45 percent at the aftermath of the financial crisis with an average of 0.21 percent. The conclusion for the strong increase after (during) the financial crisis could be that the Danish pension fund managers saw opportunities within the loans market as result of the irrational behaviour of the financial market participants. The allocation into equities the socalled risky assets got in 2001 elevated to a cap of 70 percent instead of the old ceiling of 50 percent. The ranges into this allocation lies within 11.55 percent up to 39.72 percent with an average around 24.88 percent. Two interesting observation are that first of all the new as well as the old cap of 70 percent resp. 50 percent was never touched. This leads to the conclusion that the Danish pension fund manager did never capitalize on the full allowed investment allocation into equities. Second of all was during the financial crisis of 2007 the allocation almost the highest with 30.72 percent over the time series available. This leads to the conclusion that the market timing of the Danish pension managers is at least not optimal. The allocation into land and building consist of real estate including lands, buildings and other improvements owned by the pension funds. This allocation mostly consists of real (physical, hard) asset and display an adequate inflation protection. The allocation into this asset class ranges within 1.27 percent up to 2.74 percent with an average around 1.96 percent. The allocation remains more or less stable over the observed time period. The allocation into mutual funds compromise both retail and institutional funds that can be open-end as well as closed end. The allocation ranges from 2.4 percent up to 16.31 percent. While a constant decrease in the assets allocated to mutual funds can be observed since the recent financial crisis. The allocation into the part named as other investments consists of all financial assets not included in the other categories namely derivatives, trade credits and other accounts
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Survey of investment constrains of pension funds

receivables and payables. This part experienced a constant annual increase since 2001 with 0.04 percent up to its peak allocation in 2008 with 24.67 percent with an average of 8.32 percent.

Figure: 1: Asset Allocation Denmark 2001-2009

Asset Allocation Denmark 2001 - 2009
100%

Other investments
90%

80%

Mutual funds (CIS) Land and Buildings Loans

70%

60%

50%

40%

Shares

30%

20%

Bills and bonds issued by public and private sector Cash and Deposits

10%

0% Denmark 2001
Denmark 2002 Denmark 2003

Denmark 2004

Denmark 2005

Denmark 2006

Denmark 2007

Denmark 2008

Denmark 2009

Source: OECD (2011) Portfolio allocation of Netherlands from 2001 2009

3.7

No quantitative investments constrained are attached to the asset management within the Netherlands pension system. The allocation into cash and deposits in Netherlands pension system lies between 0 percent up to 4.31 percent with an average around 2.72 percent. The traditional fixed income allocation into bills and bonds issued by both the public and private sector makes by far the largest part of the entire asset allocation observed by Netherlands pension system, the ranging from 35.04 percent up to 43.54 percent with a more or less stable allocation over time. The allocation into loans seems more present comparing to the Danish pension system, with a range of 2.78 percent up to 8.09 percent with an average of 4.55 percent. The allocation into risky assets, namely equity lies between the range of 8.39 percent and 47.80 percent at its peak. Interesting is the allocation into mutual funds which was from 2001 up to 2008 not existent and experienced a strong inflow in 2009 with a allocation of 32.26 percent. The allocation into other investments, namely all investments that cannot be imputed to the other categories range from 2.86 percent up to 15.42 percent.

13

Survey of investment constrains of pension funds

Figure: 2: Asset Allocation Netherlands 2001-2009

Asset Allocation 2001 - 2009
100%

Other investments
90%

80%

Mutual funds (CIS)

70%

Land and Buildings

60%

50%

Loans

40%

Shares

30%

20%

Bills and bonds issued by public and private sector Cash and Deposits
Netherlands 2001 Netherlands 2002
Netherlands 2003 Netherlands 2004

10%

0%

Netherlands 2005

Netherlands 2006

Netherlands 2007

Netherlands 2008

Netherlands 2009

Source: OECD (2011) Portfolio allocation of Swedish from 2001 2009

3.8

As already prior mentioned the Swedish pension system faces similar quantitative investment constraints as the Danish or Swiss system mainly on their investment in foreign currency, bonds or fixed income instruments, private investment funds and commodities investments. The allocation into cash and deposits of Swedish pension portfolio lies between 1.16 percent and 3.0 percent with an average around 1.75 percent. This is in line what can be observed in the allocation of the Danish and Netherlands systems. The traditional fixed income allocation into bills and bonds issued by both the public and private sector makes by far the largest part of the entire asset allocation observed by Swedish pension system as with the other ones. The ranging from 45.97 percent up to 65.16 percent is more or less stable allocation over time. The allocation into loans seems less present compared to the observation of the one in the Netherlands, with a range of 0.00 percent up to 3.52 percent with an average of 0.64 percent. The allocation into risky assets, namely equity lies between the range of 12.42 percent and 35.52 percent at its peak with an average of 25.90 percent. Interesting is the allocation into mutual funds which was started only in 2006 with an allocation of 8.00 percent steady increasing up to 27.47 percent in 2009 with an average of 15.43 percent. The allocation into other investments, namely all investments that cannot be imputed to the other categories range from 0.16 percent up to 12.73 percent with an average of 4.32 percent.

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Survey of investment constrains of pension funds

Figure: 3: Asset Allocation Sweden 2001-2009

Asset Allocation 2001 - 2009
100%

Other investments
90%

80%

Mutual funds (CIS)

70%

Land and Buildings

60%

Loans
50%

40%

Shares

30%

20%

Bills and bonds issued by public and private sector

Cash and Deposits
Sweden 2001

10%

0%

Sweden 2002

Sweden 2003

Sweden 2004

Sweden 2005

Sweden 2006

Sweden 2007

Sweden 2008

Sweden 2009

Source: OECD (2011) Portfolio allocation of Switzerland from 2001 2009

3.9

The cash and deposit allocation within the Swiss pension systems exhibits compared to all other pension fund systems a relatively high average of 8.68 percents. The allocation ranges between 7.66 and 9.95 percent. Due to the lack of performance date no statistical conclusion can be taken, but the high cash and deposit allocation surly drags on the overall portfolio performance as this asset cash exhibits the lowest return due to the high liquidity. The allocation to bills and bonds ranges from 23.90 and 29.28 percentage with an average of 26.77 percent. The Swiss pension system is within the allocation to loans again an outlier with allocation ranging from 4.35 up to 11.19 percent, exhibiting an average of 7.15 percent. The average allocation to risky assets, notably shares, is 17.45 percent with a minimum of 11.67 and a maximum of 23.64 percent over the observed time horizon. The allocation to hard assets, notably land and building is on average 10.60 percent, ranging from 9.38 up to 12.29 percent. The average investment into mutual funds within the Swiss pension system is 25.46 percent. This allocation moved between 16.26 and 36.57 percent. The allocation to other investments, not classified in one of the other asset classes, exhibits a low allocation of around 0.83 percent on average when compared to the other observed systems. The range over lies between 0.56 and 1.20 percent. In none of the other analyzed pension systems was an allocation into private investment funds. This asset class consists of private partnerships and other institutional investment arrangements open only to qualified investors. The Swiss pension funds have on average an allocation of 3.72 percent and ranged from 2.80 up to 4.50
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Survey of investment constrains of pension funds

percent. It's not clear in the classification if in the other pension systems the allocation into private partnerships and other investment arrangements was allocated to "other investments".

Figure: 3: Asset Allocation Switzerland 2001-2009

Asset Allocation 2001 - 2009

100%

Private investment funds

90%

Other investments
80%

70%

Mutual funds (CIS)

60%

Land and Buildings

50%

Loans
40%

Shares
30%

20%

Bills and bonds issued by public and private sector Cash and Deposits
Switzerland 2006

10%

0% Switzerland 2001 Switzerland 2002

Switzerland 2003

Switzerland 2004

Switzerland 2005

Switzerland 2007

Switzerland 2008

Switzerland 2009

Source: OECD (2011)

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Description of data

4 Data
The former evaluation of the various quantitative investment constraints for the different pension systems was based on the data obtained by the OECD. Even though the data is consistent in regard to the definition of the various asset classes allowing to perform a comparison of the different pension systems, a quantitative analysis based on portfolio statistics was not possible with the available data of the OECD. Thereby, some restrictions on the data have to be taken into account. First, different time horizons were applied for the data of different countries. Consequently, only aggregated data for different time horizons was available and the last coherent survey over all OECD country pension systems was only available until December 2005 (OECD, 2008). Second, even thought the used return data for the individual asset classes was available from the OECD, the definition of the asset classes was not consistent among the different asset allocations done by the pension systems. As an example, OECD defines cash and deposits as current accounts and other short-term savings. Thereby, the do not include certificates and of deposits or other short-term deposits. However, a precise definition of short-term assets is not provided by Davis (2002). Therefore, the comparability of the returns to the respective asset classes (in regard to the asset allocation) was not possible. Given this constraints in the statistical evaluation of the different pension system we dismissed this evaluation as no coherent data basis was given.

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Conclusion

5 Conclusion
The paper analysed four state-of-to-art pension fund systems in Europe and analysed the investment constrains in each system, whereby we choose the Denmark, Netherlands, Sweden and Switzerland. The chosen the four pension fund system due to the similarities in the pension fund structure and the economic characteristics of the countries.

The findings of the paper is three out four analysed pension fund systems applied quantitative investment constrains. Opposite to the system applied within the Netherlands where there are no quantitative investment constrains at all. However, in the Netherlands the regulator restricts the pension funds no with quantitative restriction but they have to follow restrictive coverage ratios, which are not classified as quantitative investment restriction like it's the case for the pension system evaluated in the other three countries, but still limit indirectly the investment freedom of the pension system. The pension fund regulators in Denmark, Switzerland and Sweden decided to restrict the investment freedom of their pension funds with quantitative limits. Therefore, there exist quantitative limits on the maximum exposure that can be taken within the universe. First, there are limits with respect to the investment exposure within the domestic and foreign financial markets. Taking into account the fact that the pension funds liabilities are in the respective local currency and a to high exposure in foreign investments bears a currency risk which has the potential to decrease the asset side of the balance sheet not due to the performance of the investments but due to the devaluation of the foreign currency. Secondly, there are limits with respect to the maximum exposure into a single asset classes ensuring a broad diversification across the pension fund portfolio. The only asset class not targeted by the quantitative restriction is cash. Thirdly, there are limits with respect to the maximum exposure a pension funds can have to a single counterparty ensuring a broad diversification across the issuer of financial instruments. Overall the pension funds have to follow rules regarding the liquidity risk within his portfolio as ongoing pension liabilities have to be covered. This limits can be seen in the lower maximum exposure that can be taken within the alternative investment allocation, which have historically shown to be less liquid compared to bonds and equities, where larger investment exposure are possible.

However, despite all this quantitative investment constraints in place there was no case were a pension fund system in one of the countries effectively invested up to the maximum exposure allowed by the respective regulator over the analyzed time horizon. This observation lets to
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Conclusion

the conclusion that no final conclusion can be taken on the effective influence of quantitative investment constraints on the performance of the analyzed pension fund system of the various countries. Despite the missing data needed for the analysis of the pension fund portfolio statistics this conclusion can be taken.

The comparison of the pension fund system across four countries leads to following final conclusion that the pension funds in neither of the analyzed countries exploit the full potential of the quantitative investment constraints. Further, the hypothesis has to be tested if instead of quantitative investment constraints the long term pension fund performance is driven by the benchmark which the pension funds are evaluated against.

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Appendices

6 Appendices
Table 2: Portfolio limits of pension funds in selected asset categories
Country Equity Real Estate Commodities Bonds Retail Investment Funds Denmark
- 70% - No limit (if gilt-edged) - No limit, however Max. 10% in hedge funds - No limit (if giltedged), 70% (if non gilt-edged) - 70% (no limit, for UCITS with only listed gilt-edged bonds as underlying assets) - No limit - FSR: no limit (other bonds than those issued by a state or of equal quality must be issued by a credit institution or be guaranteed by such an institution -IR: no limit if issued by a state or of equal - At least 30% shall be invest in fixedincome securities - No limit - FSR: 0% - IR: Investments can only be made in funds that primarily invest in assets that would be allowed for direct investments. The type of assets in the fund must be added to directly owned assets of the same type and the total not - No limit - FSR: 0% - IR: Investments can only be made in certain funds that primarily invest in assets that would be allowed for direct investments. The type of asset in the fund must be added to directly owned assets.

Private Investment Funds

- 10% hedge funds, private equity funds and other funds

Loans

Bank deposit

- No limit (if giltedged) - 2% (if non giltedged) - No limit - FSR: no limit (only loans with some form of mortgage guarantee or equal security are allowed unless the debtor is the Swedish state or s Swedish municipality) - IR: No limit if the debtor is a state

- No limit

Netherlands Sweden

- No limit - 70% - FSR: 0% - IR: 25% (if quoted) 10% (if unquoted) - OP: no limit if quoted, 10% in unquoted

- No limit - FSR: Allowed, but only up to 4/5 or 2/3 of rateable value, depending on type of estate, or 70% or 60%, respectively, of the estate's estimated

- No limit -No allowed

- No limit - FSR: 0% - IR: 75% - OP: No limit

Switzerland

- 50% (overall limit in equities)

- 30% overall limit

- No limit, but Max 10% in alternative investments

- No limit

- No information, but Max. 10% in alternative investments

- No limit, but Max. 10% in alternative investments

- 50% mortgage (maximum of 80% of market-value of the real estate)

- 10% per bank (no overall limit)

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Table 3: Portfolio limits on pension funds investments in foreign asset categories

Country Global investment limit in foreign assets Denmark Netherlands Sweden
- No limit for OECD countries - No limit - Not more than 40% may be exposed to currency risk

Equity

Real Estate

Bonds

Retail Investment Funds

Private Investment Funds

Loans

Bank deposit

Switzerland

- 30% foreign currency (hedging allowed)

-10%

Table 4: Other quantitative investment regulations on pension fund assets

Country Investment limit in single issuer/issue Self-investment / Conflicts of interest Denmark
- Max 3% in securities issued by a single issuer (general rule). 2% for small non-listed companies. - Max. 40% in mortgage bonds issued by a single issuer - Max. 10% in receivable amounts issued by a single bank. - Max. 10% in units in a branch of an investments fund or in a investment fund 653- Max. 10% in Contracts of reassurance issued by a single issuer - Max. 10% in loans issued by a single issuer - Minimum 80% currency matching requirement. Euro can match up to 50% of other EU currencies (e.g. DKK) than Euro. -Ownership is limited to carry out activities ancillary to the activities licensed. -It is allowed, through subsidiaries, to carry out other financial activities. -It is allowed temporarily to carry out other activities to secure or phase out exposure already entered into, or with regard to restructuring enterprises. -It is allowed to carry out the following activities: 1. Agency activities for insurance companies under the supervision of the Danish FSA. 2. Establishment, ownership and operation of real

Other quantitative rules

Ownership concentration limits

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- Max. 5% for investment in a single property

property as a long-term placing of funds. -Max. 5% may be invested in shares of the sponsoring employer, in case of exceeding assets; it can be 10% maximum -None -None

Netherlands

-Diversification is required, but no quantitative rules

Sweden

- FSR limits: none. - IR and OP limits: - No limit for bonds issued by and loans granted to a state or an equally financially stable subject. - Max. 5% (10% if the total of these investments does not exceed 40% of the technical provisions and shares from the same issuer does not exceed 5% of these provisions) in shares, bonds issued by a single company and loans granted to the same subject. - Max. 5% in a single piece of real estate (or group of). -Max. 10% in a single investment fund

- FSR limits: none - IR limits: none - OP limits: investment in the sponsoring undertaking shall be no more than 5% and when the sponsoring undertaking belongs to group, investment in the undertaking belonging to the same group as the sponsoring undertaking shall not be more than 10% of the portfolio

- FSR limits: No investments in derivatives allowed. IR limits: see first table. No derivatives in assets held to cover technical provisions. Max. 20% in assets denominated in currencies other than the currency in which the liabilities are denominated. OP limits: Risks related to currency matching have to be limited

- FSR limits: none - IR limits: none - OP limits: none

Switzerland

- Max. 15% (5% for foreign assets) in debt instruments (except governments bonds, banks and insurance companies) issued by a single issuer - Max. 10% (5% for foreign assets) in equities of a single company.

- Max . 5% may be invested in the sponsoring employer.

- Investment in derivatives for hedging purposed only. - With a founded explanation the quantitative limits may be exceeded - Limits of foreign currency of 30%

None

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References

References
Alier, M., & Vittas, D. (2000, April 22). Personal Pension Plans and Stock Market Volatility. Retrieved 2011, from The World Bank:http://books.google.ch/books?hl=de&lr=&id=M 5QYM4phQ18C&oi=fnd&pg=PA1&dq=european+commission+1999+average+real+pen sion+&ots=Etk99Gn2tW&sig=iHV6CDpAfVsnXGyrbMjm0nRZ-hU#v=onepage&q=swi tzeland&f=false

Ammann, M., & Zingg, A. (2008). Investment Performance of Swiss Pension Funds and Investment Foundations. Andersen, C., & Skjodt, P. (2007). Pension Institution and Annuities in Denmark. The World Bank. Davis, E. P. (1993). The Structure, Regulation and Performance of Pension Funds in Nine Industrial Countries. The World Bank Financial Sector Development Department. Franzen, T. (2008). Restrictions on Pension Investing: A Swedish Perspective. Abgerufen am 20. April 2011 von International Centre for Pension Management:

http://www.rotman.utoronto.ca/icpm/details.aspx?ContentID=187 Funds, D. A.-w. (2008). The Dutch Pension System. Den Haag: Dutch Association of Company Pension Funds . Hinz, R., Rudolph, H. P., Antolin, P., & Yermo, J. (2010). Evaluation the Financial Performance of Pension Funds. Washington: THE WORLD BANK. Mercer. (2010, April 20). Melbourne Mercer Global Pension Index. Retrieved 2011, from http://www.mercer.com.au/globalpensionindex#How OECD. (2010). Survey of Investment Regulation of Pension Funds. OECD. Queisser, M., & Vittas, D. (2000). The Swiss Multi-Pillar Pension System. Triumph of Common Sense? The World Bank. Stewart, F. (2007). Pension Fund Investment in Hedge Funds, OECD Working Papers on Insurance and Private Pensions, No.12. OECD Publishing.

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References

Tapia, W. (2008). Comparing Aggregate Investment Returns in Privately Managed Pension Funds: An Initial Assessment. OECD Working Papers on Insurance and Private Pensions, No.21, OECD Publishing . Whiteford, P., & Whitehouse, E. (2006). Pension Challenges and Pension Reforms in OECD Countries. Oxford Review of Economic Policy, Vol. 22, No. 1 . Yermo, J. (2003). Survey of Investment Regulation of Pension Funds. OECD Publishing .

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