World’s Top-Ranked Pension Funds Probed for Hedge Fund Use

Date: Tuesday, October 21, 2014
Author: Frances Schwartzkopff, Bloomberg

Denmark, home to the world’s top-ranked pension system, will toughen oversight of the $500 billion industry after regulators observed a surge in risk-taking linked in part to more widespread use of hedge funds.

The Financial Supervisory Authority in Copenhagen will require pension funds to submit quarterly reports on their alternative investments to track their use of hedge funds, exposure to private equity and infrastructure projects. The decision follows funds’ failures to account adequately for risks in their investment strategies, according to an FSA report.

The regulatory clampdown comes as Denmark deals with risks it says are inherent to a system due to be introduced across the European Union in 2016. The new rules will allow pension funds to invest according to a so-called prudent person model, rather than setting outright limits. In Denmark, the approach has proven problematic for the only EU country to have adopted the model, said Jan Parner, the FSA’s deputy director general for pensions.

“The funds are setting up for their release from the quantitative requirements, but the problem is, it’s not clear what a prudent investment is,” Parner said in an interview. “The challenge for European supervisors is to explain to the industry what prudent investments are before the opposite ends up on the balance sheets.”

Denmark, which has almost two years of experience with the approach after its early adoption in 2012, says a lack of clear guidelines invites misinterpretation as firms try to inflate returns.

EU Agenda

The new framework comes as European policy makers look for ways to spur a recovery by making some assets cheaper to hold. The European Commission on Oct. 10 decided to set a lower charge on asset-backed securities than the European Insurance and Occupational Pensions Authority recommended. The rule, which reflects the cost for funds of holding assets, means insurers face a 2.1 percent charge on AAA securities, compared with EIOPA’s 4.3 percent recommendation. For BBB assets, the charge will be 3 percent, versus 17 percent proposed by the EIOPA.

Denmark is telling its industry, rated the world’s best three years in a row by the Melbourne Mercer Global Pension Index, to take a conservative view on what a “prudent person” would invest in.

Underlying Risk

“Supervisors are not saying no, but we have to warn them not to get too enthusiastic,” Parner said. “There’s a concern that funds underestimate the underlying risk and get too high a concentration in certain areas, exposing funds to credit risk, which is cyclical and which funds haven’t previously had.”

Danish funds and insurers have overestimated the value of alternative investments they made while failing to adequately account for the risks, the FSA said in a February report.

Pension funds held 152 billion kroner ($26 billion) at the end of 2012, or about 7 percent of their balance sheets, in equity stakes and other assets sold on markets the FSA characterized as illiquid, opaque and thin. The agency said they need to account better for those risks and ordered reports from the third quarter. PFA, Denmark’s biggest commercial pension fund, said today it invested in a shopping mall in western Denmark as part of a strategy to increase its presence in retail properties.

Asset Valuation

“The industry needs to look further into the risks involved and the ongoing valuation of these assets,” Parner said.

The prudent person principle is part of a sweeping overhaul of insurance regulation that’s been more than a decade in the making. Solvency II, as the framework is known, will give companies greater flexibility to invest while tying capital requirements to the risk they face of being unable to meet their liabilities.

Effective at the end of next year, the directive sets risk-based capital requirements for insurers, mirroring reforms in banking. It also places greater weight on risk management by funds and regulators’ role in monitoring it.

“We’re moving away from a prescriptive setup,” Parner said. “More work has to be done Europe-wide in this area to be ready for the launch of Solvency II.”