Kimmo Koivurinne: Equity investments only source of return in Q3 – how much equity risk is there?
The return on earnings-related pension investments this year has been modest. In Q3, pension assets grew by EUR 1 billion, totalling EUR 244 billion at the end of September.
Our most recent pension asset information as of the end of September may be found on the “Amount of pension assets” page.
Nominal yield in the private sector this year was precisely 3 per cent at the end of the year, which, at current inflation, is equivalent to a real yield of -0.3 per cent. In the public sector, yields were slightly better at the end of September: 3.9 per cent nominal and 0.5 per cent real yield. Among asset classes, only shares have offered a positive real yield as fixed-income investments, property and alternative investments have trod water. Of these classes, property investments are in negative territory, both in nominal and real terms.
Although Finnish pension asset yields are not, considering the investments’ risk level, weaker than in comparable countries, the total yields of pension assets for the past five- or ten-year periods are not flattering. In nominal terms, they have yielded an average of 6.1 and 5.4 per cent annually, which, when adjusted for inflation, means annual real yields of 2.5 and 3.3 per cent, depending on the period. Over a longer period of about twenty years, the nominal yield has averaged 5.5 per cent, and the real yield 3.5 per cent, annually.
Meanwhile, the global stock markets’ annual real yield has averaged around five per cent, while American shares’ real yield has been around seven per cent. One could ask why we do not invest globally, in a diversified fashion, in shares alone.
In pension investment, solvency regulation limits risk taking in the private sector. This is an attempt to strike a balance between yield and security: the law regulates the risk taking, meaning we invest assets with the aim of securing as high a yield as possible while taking the permitted risk. There is no equivalent regulation in the public sector; the pension provider’s administration or other body decides on the investment strategy and risk level of the investments. This is the case with the State Pension Fund of Finland: the Ministry of Finance decides its investment asset class limits.
The board of Keva, the public-sector pension provider, decided independently at the start of the autumn to raise the risk level of its investment portfolio. The aim is a higher long-term yield for investment assets. In the private sector, changes of this kind have been under consideration for some time. Raising investments’ risk level is not unheard of there, either. Steps in that direction have been taken since the start of the millennium.
Enabling better returns on investments in the private sector is one of the issues under consideration in the recently initiated pension reform.
How does the risk level of earnings-related pension investments look compared to the traditional 60/40 portfolio?
The 60/40 portfolio is a classic model developed by Harry Markowitz, who died last summer and is known for his modern portfolio theory. Per its name, the 60/40 allocation contains 60 per cent stock investments and 40 per cent bond investments. The central idea of the 60/40 portfolio is that the investor can combine returns from the stock market with the stability from the 40 per cent bond share.
Historically, the 60/40 portfolio has provided extremely high yields across market cycles. It has offered a diversification benefit as sovereign debts have provided yield when the stock market and interest rates have been in decline during downturns. From the mid-1990s until 2021, the 60/40 portfolio even yielded a better risk-adjusted return than shares alone. That is in spite of the fact that the 2008 financial crisis was followed by a period of extremely low interest rates which reduced the expect returns on fixed-income investments for a long time.
To generalize: the share risk is calculated to correspond to all other asset classes, apart from fixed-interest investments. Under this thinking, the average allocations of the private and public sector roughly correspond to a 70/30 portfolio. Or, in very broad terms, earnings-related pension investments already contain more risk than the traditional 60/40 portfolio.
However, the two cannot be reasonably compared directly, as earnings-related pension investments are diversified across a wider range of asset classes than the 60/40 portfolio. The aim of broader diversification is an all-weather investment portfolio which better withstands market fluctuations.
Thus, both private and public sector pension investments contain, in addition to fixed-income investments, a good 70 per cent of risk shares. In addition to listed shares, these contain less liquid equity investments, property investments and alternative investments. These off-exchange asset classes generally see less fluctuation in their market value, which reduces their riskiness in terms of risk metrics based on traditional volatility.
Now, part of the pension reform is aimed at raising earnings-related pension investments’ long-term average yield. This in practice means an even larger allocation than hitherto to sources of the statistically highest yields. This primarily includes North American and other key market shares listed on global indices. After the investment reform, the risk level of earnings-related pension investments will rise towards an 80/20 portfolio. Enabling this kind of risk level should be part of the investment reform.
In addition to raising the general risk level, I would consider the benefits of illiquid investments relative to their yields. In the light of current information, illiquid investments may correlate with traditional asset classes better than assumed, which reduces their diversification benefit and inflation protection value. This is particularly so when markets fluctuate more intensely.
It is essential to grasp that a greater proportion of shares than before will increase the fluctuation of pension assets’ market value. Continual review of yields over the long term is vital, keeping in mind the goal of raising the pension system’s long-term sustainability. A single poor period should not then lead to short-term demands for reduced risk.