Aug 3, 2007

Strategic Asset Allocation in CEE

World Bank advocated three-pillar pension systems have recently been implemented in many Central and Eastern European countries. The largest assets are accumulated into second pillar - predominantly defined contribution pension funds. These funds have usually no explicit benchmarks or return targets; nor defined liabilities. Instead, the synthetic liabilities are created by modeling different macro- and microeconomic factors.

The ageing population and low savings rate forced the Baltic States of Estonia, Latvia and Lithuania to transform their pension systems to a “classical” World Bank advocated three-pillar-system in 2001-2002. The First pillar, Pay-As-You-Go is the inter-temporal approach – current workers pay to the current pensioners. Demographic risks are reduced and diversified with the second pillar – a defined contribution (DC) mandatory personal pension plan. The second pillar has achieved very high penetration rates for those eligible (more than 75% of employees have joined in Estonia), and is by a wide margin the largest accumulated long-term asset group in the region (currently 6% of GDP). Because of DC, there are no benchmarks, return targets nor guarantees for returns. Finally, the third pillar consists of voluntary savings into various defined benefit or contribution plans with additional tax benefits. 

Given the defined contribution system, pension funds in the Baltic States have no explicit liabilities to meet. The asset allocation is mainly regulated only via limits on equity allocation. 

Since financial markets did not exist under the Soviet planned economic system, and people have no investment experience, they do not have any benchmark or reference rate to look at when evaluating investment performance. Therefore, when pension system was reformed and designed with no explicit liabilities, we immediately started to search for the implicit liability structure to meet. Our approach was the following:

we modeled long-term potential GDP and salary growth as well as inflation rates;

we carried out simulations on replacement rates (the ratio of retirement benefits to pre-retirement income);

we determined the required real returns of pension funds in an unconstrained opportunity set;

we constrained the expected returns with risk limits (mainly principles of diversification) and arrived to following conclusion:

We have to provide meaningful additional income after retirement by maximizing the total return of our pension funds over the clients’ full investment cycle, given the constraints and circumstances. Our performance is simultaneously measured by the following criteria:

Inflation rate – people want to maintain the purchasing power of their investments;

Prices of local assets – the return of the pension funds should reflect the development of domestic economies, and asset prices. In order to maintain the sustainability of the pension funds and diversification of risks, we have extended our definition of the “home market” to all CEE countries. We believe that the CEE region as a whole is already sufficiently large to provide diversified investment opportunities. At the same time, most of these countries face a similar growth and convergence story. Thus, we see that such allocation provides an opportunity to take part in the region’s growth potential while minimizes the country specific risks in investing just to a single (home) country.

Prices of global assets – domestic economies are very small in the global context, and local financial markets are under-developed and often highly volatile. Therefore, global investments improve the risk/return trade-off and should be a part of the portfolio. 

Obviously, our home market is not considered as a main investment universe (or “beta”) by anyone outside the region. It is usually considered as an "alpha" asset class to extend the returns of global portfolios. In our case, it is the "beta" - it is the home market, directly reflecting the environment of our implicit liabilities we want to match. We extend our risk/return spectra by incorporating global asset classes, such as the US, European and Japanese equities and bonds. Thus, one can say that we are in a situation where our “alpha” and “beta” are reversed as compared to the rest of the world – what is “alpha” for us is “beta” for others and vice-versa. 

We have shown that the extension of definition of “home market” to all over CEE can be used in order to achieve the prudent diversification, but not to loose out any of the underlying economic development. We argued that the use of global developed markets in the portfolio serves as overall extension of risk and return space. Further, we showed that our home market is probably considered as an “alpha” opportunity for the rest of the World.
Finally, it should be emphasized, that regardless of the method, the main goal of any asset allocation is to provide meaningful additional retirement income. Regarding risks – unsurprisingly, insufficient pension income is the true risk of all of the pension funds all over the World.

Robert Kitt has worked as the Fund Manager of the pension funds of Hansa Investment Funds since 2003. As head of the Group Investment Committee for the Hansabank Group, Robert created strategic and tactical asset allocation for pension assets in the three Baltic countries of Estonia, Latvia and Lithuania. Robert has investment experience of 13 years. In 1998, he joined Hansa Investment Funds as a manager of their fixed income funds. Prior to that, he held several positions in the Estonian Investment Bank and the North-Estonian Bank. He has also served as a member of the Supervisory Board of the Estonian Guarantee Fund since 2002. Robert has a BA (cum laude), an MA in Economics, and a PhD in Statistical Mechanics from Tallinn University on Technology. He has recently published several articles on the analysis of Leptokurtotic portfolios and long-memory processes in Physica A.  Robert is a lecturer in Finance at the Tallinn University on Technology and a frequent referee of dissertations.