In an effort to safeguard the long-term sustainability of Finland’s pension system amid demographic pressures, new rules for private-sector earnings-related pensions are set to materially reshape portfolio allocations. The reform will technically enable pension insurers to raise their equity exposure to as much as 80 percent of total assets, a change that, according to Elo’s Head of Asset Allocation, Kari Vatanen, will significantly reduce the system’s overall diversification. One way to partially rebuild diversification, he suggests, could involve assessing whether externally managed diversifying strategies can be replicated in-house through the use of derivatives.
“My expectation is that there will be notably less diversification within the whole system and investment portfolios,” Vatanen tells AMWatch. While the new rules allow equity weights to rise to as high as 80 percent, Vatanen anticipates a more moderate increase of around 10-15 percentage points from today’s system-wide average of roughly 50 percent. “We do not know exactly what equity exposure will turn out to be, as that will depend on all market players’ moves and the average, but there will be plenty of space for new equity investments,” says Vatanen.
“My expectation is that there will be notably less diversification within the whole system and investment portfolios.”
If equity exposure rises by 10-15 percentage points, “this leaves an exposure of about 30-35 percent for other asset classes,” Vatanen explains. That, he notes, raises an important question: “What will be the possibility to diversify portfolios when other asset classes like real estate and hedge funds, as well as credit investments in fixed income, correlate with equities in a crisis?”
At the end of the third quarter, Finnish pension insurance companies managed a combined €170 billion in assets. According to data from the Finnish Pension Alliance (Tela), these were invested in equities and equity-like assets (54.5 percent), fixed income (23.9 percent), real estate (9.5 percent), and other investments, mostly hedge funds, (12.1 percent). “A mathematician would say that the principal component will dominate the risk, and there will be very few parts of the portfolio diversifying away from equities, so we will have to think carefully about how we bring diversification into the portfolio,” Vatanen tells AMWatch.
To address the decline in diversification potential, Vatanen sees two possible paths. “We are thinking about whether there are any diversifying strategies, whether we could build them through derivatives, or whether the smaller exposure to other asset classes outside equities is sufficient, and how to actively manage risk,” explains Vatanen. “We will have to revamp our risk allocation actively and according to how the market behaves, so my estimate is that overall, the Finnish pensions system will become much more active in terms of investment approach.”
“…overall, the Finnish pensions system will become much more active in terms of investment approach.”
At Elo, which manages €33.5 billion, most equity and fixed-income investments are already handled internally, a setup that naturally supports a more active investment approach. “If now roughly half of our total asset base is managed in-house, that proportion will be even higher in the future,” says Vatanen. “We outsource only frontier market fixed income and use managers in illiquid asset classes as well as hedge funds. In real estate, likewise, domestic assets are managed in-house, but international exposure is outsourced.” Taken together, the new rules mark a significant shift for Finland’s pension system, one that pushes portfolios toward higher equity exposure and, in turn, places greater emphasis on active risk management to achieve diversification.
