Annual Report of the State Pension Fund of Finland for 2016

Sound return on investments in 2016

The economic environment in 2016 was variable. In the course of the year, the global economy began to show signs of recovery on a relatively broad front. The monetary policies of major central banks diverged when the US Federal Reserve adopted a cautiously tightened approach while the central banks in Europe and Japan continued to pursue accommodative policies. So far, the Finnish economy has failed to latch on to the relatively positive development taking place in Europe, even if some long overdue signs of recovery could be detected in Finland.

There were big fluctuations in the investment markets in 2016. Concerns related to monetary policies and China’s economic development caused the equity markets to fall sharply at the beginning of the year, but the recovery was swift. Similarly, most of the negative impacts of certain political developments that created so much concern earlier proved short-lived. In the last few weeks of the year, share prices increased surprisingly strongly, particularly in the US. Interest rates remained historically low throughout the year.

At fair values, the total return on the investments made by the State Pension Fund of Finland (VER) in 2016 was 6.7 per cent. VER’s average rate of return is 7.4 per cent for the past five years and 4.5 per cent for the past 10 years.
 

The real return was 5.6 per cent, which exceeds the long-term average expected return in the pension insurance sector as well as the average rate of return used as a basis for VER’s long-term financing calculations. VER’s five-year average real return was 6.3 per cent and 10-year real return 2.8 per cent.
 

VER has clearly achieved its long-term target return as defined by the Ministry of Finance, which is to earn a return that exceeds the cost of government debt. Over the past ten years, VER’s average rate of return has beaten the cost of net government debt by 2.0 percentage points. Since 2001 when VER’s operations assumed their current form, the total market-value returns earned by VER have exceeded the average cost of government debt by close to EUR 5 billion.

All the asset classes yielded a positive return in 2016. Of the large asset classes, liquid fixed-income instruments generated a return of 4.0 per cent and listed equities 9.7 per cent. Of the other investments, the best returns were yielded by infrastructure investments at 13.8 per cent and real estate investments at 11.9 per cent.

At the end of 2016, the market value of the Fund’s investment portfolio stood at EUR 18.8 billion. Of the investments made by VER, fixed income instruments accounted for 46.0 per cent, equities 45.0 per cent and other investments 8.4 per cent of the total.
 

In August 2016, VER’s Board of Directors adopted new principles of responsible investing and related procedures. At present, VER’s responsible investing policies are based on the UN Principles for Responsible Investment (UNPRI) and UN Global Compact. Another objective is to achieve full transparency of CRS issues in VER’s investment activities in all asset classes. VER is aware of the importance of slowing down climate change and the need to measure, report and reduce carbon footprints.

Fixed-income instruments

Liquid fixed-income investments

In 2016, the liquid fixed-income portfolio returned 4.0 per cent and its market value at the end of the year stood at EUR 8.4 billion. The duration of the fixed-income portfolio remained shorter than the neutral duration of the portfolio for the entire year.

After a jittery start, the interest markets performed very well during the first three quarters of the year. Only the UK referendum on the EU caused a temporary rise in volatility towards the end of June, but the rise in interest rates on even the most risk-exposed fixed-income investments remained short-lived. During the last quarter, the interest rates were affected by the expectations of more expansionary policy measures in the aftermath of the US presidential election and fears of growing protectionism.

The ECB’s decision in March to lower its interest rate and increase asset purchases and extend them to euro-denominated investment-grade company bonds buttressed the corporate bond market and euro area government bonds. Most government bonds and a substantial percentage of credit-rated company bonds carried a negative interest rate in Europe. The record-low interest rates in the euro area caused investors to turn their attention to the emerging markets, while the dovish statements of the US central bank (FED) early in the year and the sharp increase in the price of oil gave an additional boost to these markets.

During the last quarter, the returns on dollar-denominated emerging market stock were reduced by the increase in interest rates following the US presidential election, the strengthening US dollar and growing fears of protectionism. In December, the monetary polices of the US and European central banks continued to diverge further as the ECB extended its asset purchase programme from April to at least the end of December 2017, while the FED raised its refinancing rate by 0.25 per cent and revised up its estimate of interest rate levels in coming years. Additionally, the ECB reduced the minimum maturity of the bonds covered by the public-sector asset purchase programme to one year and removed the minimum yield requirement on eligible bonds equivalent to the ECB deposit rate. The difference in returns on US and German government bonds grew larger than it has been for decades.

As far as VER’s fixed-income investments are concerned, the best return was generated by the emerging bond market. All the sub-portfolios gave a positive return. During the reporting period, the money market portfolio was overweighted and government debt underweighted. Corporate bonds and emerging market debt were kept close to neutral allocation except for the last quarter when emerging markets were clearly underweighted.

At the end of the reporting period, direct investments accounted for 61.5 (65.5) per cent of the entire liquid fixed-income portfolio. At the end of the year, fixed-income investments were held in 300 (296) debt instruments and fund units in 38 (36) funds.
 

Other fixed-income investments

VER’s other fixed-income investments are in private credit funds. Most of the funds in the portfolio are private equity funds investing in non-liquid loans.

The non-liquid loan market continued to grow in Europe. Restricted access to bank financing has had an impact, particularly on small and medium-sized enterprises outside the Nordic Countries. The annual return on the portfolio in 2016 was 2.4 per cent, which fell short of the target return for the year. During the reporting period, investments (EUR 124 million) were made in three new funds. Unfunded commitments at the end of 2016 totalled EUR 199 (121) million.

At the end of the year, the weighting of private credit investments in the portfolio was 1.2 (1.2) per cent.

Equities

Listed equities

Even though the equity markets experienced intense fluctuations in 2016, the year ended on a positive note for investors. The return on VER’s portfolio of listed equities and ETFs reached 9.7 per cent. All the equity portfolios showed a positive return at the end of the year and the best yields were earned on listed US equities.

The global equity market opened to a jittery start in 2016 with prices falling sharply across the board during the first six weeks. However, this was followed by a general recovery of the equity market which was sustained until mid-April. In May, the equity markets played up again, but the biggest blow was received mid-summer when the result of the UK referendum on the EU was announced. The outcome of the vote came as a big negative surprise to the markets. For the next few days, large daily fluctuations occurred in the world stock markets. However, the markets recovered from this shock surprisingly quickly, with equities performing exceedingly strongly again as early as July. When the equity markets, contrary to all expectations, welcomed the outcome of the US presidential election, the rest of the year was bullish. In many respects, 2016 can be characterised as a year of big surprises.

In terms of market capitalisation, the value of the equity portfolio increased from EUR 7.3 billion at the beginning of the year to EUR 8.0 billion at the end. At the end of 2016, direct equity investments accounted for 30.2 (29.7) per cent and fund investments for 69.8 (70.3) per cent of the total. At the end of the year, VER held direct interests in 109 (101) companies and units in 62 (62) funds.
 

Other equity investments

At the end of the reporting period, VER’s other equity investments included investments in private equity funds and non-listed stock.

For the equity funds in VER’s portfolio, 2016 was a good year. At the end of it, the total return stood at 9.0 per cent. Underlying the high return was the positive development of the equity market, which was reflected in increased market valuations of the portfolio companies, and successful exits. To some extent, the yields were adversely affected by the increases in costs due to new investment commitments (‘J-curve effect’). During the reporting period, investments (EUR 108 million) were made in four new funds. At the end of the year, unfunded commitments totalled EUR 379 (356) million.

Non-listed equities included investments in SATO Plc and Logicor Ltd. Both companies generated healthy returns at 11.4 per cent. Additionally, VER took part in SATO Plc’s share issue in 2016.

At the end of the year, other equity investments in the portfolio accounted for 2.4 (2.1) per cent of the total.

Other investments

VER’s other investments are in real estate and infrastructure funds as well as hedge funds and risk premium strategies.

The real estate investment markets continued to develop favourably. Investments in both Europe and Asia generated a healthy annual return of 11.9 per cent. Four new investments (EUR 154 million) were made in funds, while unfunded commitments at the end of the year totalled EUR 255 (209) million.

Infrastructure investments generated a healthy return across the board reaching 13.8 per cent as a result of successful exits and generous dividends. During the reporting period, investments (EUR 175 million) were made in four new funds. At the end of the year, unfunded commitments totalled EUR 244 (74) million.

The return on hedge funds reached 1.0 per cent in 2016. Despite a promising beginning, the year proved challenging for CTA and equity strategies, which suffered from the reversals of trends in February and the rotation between the various equity market sectors. The best performance was put in by macro funds and the fund focusing on the Asian market acquired in the portfolio during 2016.

The time-weighted rate of return (TWR) on risk premium strategies in 2016 was 7.0 per cent. With risk premium strategies, the year was difficult for equity market factors, whereas carry and momentum strategies did well in the currency and fixed-income markets.

At the end of 2016, other investments accounted for 8.4 per cent of the total return on VER’s portfolio. The market capitalisation of the portfolio was EUR 1,579 (1,348) million. Of the assets invested, real estate funds accounted for 2.9 (2.7), infrastructure investments 1.4 (1.6), hedge funds 3.5 (3.1), and risk premium funds 0.7 (0.2) percentage points.

The state’s pension expenditure continues to increase

The Finnish employment pension system will undergo major changes as of 2017. The extensive pension reform adopted by Parliament in autumn 2015 will gradually increase the retirement age for old-age pensions and amend the criteria for the determination of the amount of pensions. The reform seeks to extend work careers and underpin the sustainability of both the pension system and public finances in general.

For a long time now, the criteria for the determination of pensions have been identical to those applied in the private sector and municipal systems; however, the transitional arrangements made at the time when the previous system was in place will continue to have an impact for a long time to come. Similarly, the reform effective as of 2017 will affect the individual pension systems very much in the same way in terms of practical implications.

Since the State Pension Fund (VER) is not responsible for processing pension applications or collecting pension contributions, the pension reform will not have any direct impact on VER’s day-to-day operations. However, the reform is significant to VER insofar as it affects the financing of the state pension system.

The State Pension Fund’s role in balancing government finances has grown and will continue to do so. In 2016, the state’s pension expenditure totalled nearly EUR 4.5 billion. As VER contributes 40 per cent towards these expenses to the government budget, the transfer to the 2016 budget amounted to approximately EUR 1.8 billion. At the same time, VER received approximately EUR 1.5 billion in pension contributions. Its net pension contribution income has now turned permanently negative, meaning that more money is transferred by VER to the government budget than VER receives in pension contribution income. This gap between income and budget transfers will continue to grow year on year.
 

In June 2016, the Board of Directors of the State Pension Fund adopted a strategy that defines its long-term objectives in greater detail. The strategy foresees that the 25 per cent funding ratio target specified by law will be attained by 2033, if not earlier. To achieve this, it is imperative that VER’s pension contribution income remains at the estimated level and that the real return on investments remains relatively high. At the end of 2016, the state’s pension liabilities amounted to EUR 93 billion and the funding ratio exceeded 20 per cent for the first time in history. Additionally, the strategy sets out the principles by which the risk level and basic allocation of the investment portfolio are derived from the target funding ratio established for VER, with due regard to the long-term target return defined by the Ministry of Finance.
 

VER’s administration

The State Pension Fund (VER), established in 1990, is an off-budget entity. VER is an investment organisation with a mission to manage the assets entrusted to it. The collection of pension contributions to the state pension system and related duties, just like the processing of pension applications and payment of pensions, are handled by the Local Government Pension Institution Keva. VER pays Keva a management fee for these services, which in 2016 amounted to about EUR 18 million.

The responsibility for oversight and control of VER’s operations rests with the Ministry of Finance, which is authorised to issue general instructions regarding the organisation of VER’s administration, financial management and the investment of its assets. According to standing instructions, fixed-income instruments must account for a minimum of 35 per cent, equities for no more than 55 per cent, and other investments for no more than 12 per cent of the market capitalisation of the portfolio.

VER’s Board of Directors has seven members, three of whom are appointed from candidates proposed by central staff organisations. The Chair of the Board of Directors is Jukka Pekkarinen and the Managing Director Timo Viherkenttä. The Chair of the Investment Advisory Committee is Eva Liljeblom.

In 2016, VER’s operating costs amounted to EUR 7.0 million, which represents 0.04 per cent of the average annual capital. At the end of the year, VER had 23 employees. VER invests in human resources by maintaining and developing the professional skills of the staff, which is important both for seeking maximum returns on investments and in managing risks.