The Cypriot pensions industry has come under unprecedented pressure in recent months. As a member of the EU since May 2004, Cyprus is obliged to adopt the European pensions directive, and it was duly passed into Cypriot law last November. In addition, it is expected that Cyprus will join the Euro-zone at the beginning of next year, a move that, at least in theory, will widen investment horizons.

And the country’s pension funds are facing these new challenges at a time when earlier problems have not been tackled. First, pension funds are equity averse following a 1999 crash on the local stock exchange. “Our stock exchange was only in the fourth year of its operation so there was an early-stage bubble and a lot of the provident funds burnt their fingers,” says Christos Akkelides, director of asset management services at Egnatia Financial Services (Cyprus). “There was an understandable ill feeling about the whole thing, which has continued to play down the role of equities.”

And although the EU directive has been enacted, Cypriot legislators have failed so far to provide a legal framework for pension funds in the private sector, the so-called occupational schemes that are overwhelmingly DC. “Currently all benefits can be taken at any time, without penalty and tax- free whenever somebody changes job or exits an employer voluntarily so the money is not locked up until retirement,” says Philippos Mannaris, head of the Hewitt office in Nicosia. “And there is a lack of portability between occupational pension funds so the latest statistics show that only a very small percentage of the retirement plans are actually used for retirement. So talking about long-term investment strategies is in many cases inappropriate because often the horizon is not very long. And there is also no framework for converting lump sums into an annuity.”

In addition, the DB pension funds for the semi-state institutions, mostly state-owned utilities, are facing a funding crisis.

“There are over 2,000 provident funds and 50 pension funds,” says George Psaras, managing actuary, social insurance, pension and provident funds local actuarial consultancy Muhanna & Co. The semi-state funds are facing the greatest challenges, according to a study by Muhanna and the University of Cyprus. “While some of the funds are well funded and cash rich the majority are not and the problem cannot be fixed easily,” says Psaras.

The study estimated the unfunded liabilities of the 50 major pension funds in the semi-government sector and municipalities at CYP760m (€1.3bn). The Cypriot government estimates 2006 GDP at CYP8.4bn.

But although the pensions industry may be under pressure, it is responding with a certain lack of urgency. “The reaction we have seen so far is quite limited,” says Mannaris. “There is a reaction, but it is slow.”

Says Christos Akkelides, director of asset management services at Egnatia Financial Services (Cyprus): “Broadly, the system here is a mirror of that the UK used to have in the 1950s or so. I say that because I don’t think we have caught up with developments since then.”

According to Psaras, “The funds were pushed into large actuarial deficits by generous benefits, underfunding, early retirement, and low or negative investment returns in conjunction with high salary increases.”

The low returns are a function of the equity aversion and a hangover from Cyprus’ previous restrictions on the free movement of capital. “From 2001 restrictions on the free movement of capital were gradually relaxed and all were lifted on accession to the EU in May 2004,” says Akkelides.

But this was only part of the problem. “Until a few years ago the interest rate in Cyprus was 9%, so by depositing the money with banks or buying government bonds the return was approximately 7%,” says Stelios Constantinides, manager, financial accounting at the Electricity Authority of Cyprus, the island’s second-largest fund. “But over the last four or five years the rate of interest rate has fallen and so the fund has a large deficit.”

“Rates had to be liberalised because we had to converge with the euro and they are now very close,” says Akkelides. “A 10-year government bond that in 2002 yielded 8% is now on the 4.25-4.35% mark. The difference means that now they have to take risks to generate higher real returns.”

That is also the dilemma facing the Cyprus Telecommunications Authority (CYTA) pension fund, the biggest scheme in Cyprus. “Until now our investment structure was very restrictive,” says Maria Danalou-Hadjigeorgiou, assistant manager, financial services at CYTA. “As a semi-governmental organisation our investments have had to be approved by the finance minister and we were more or less investing in government bonds and bank deposits. But following the passage of the EU directive we are in a transition stage.”

In fact the new law requires them to use professional advisers and find a way to fill any funding gap.

“We will have to look into that, make a better asset allocation and try to choose new types of investments,” says Danalou-Hadjigeorgiou. “We are in the process of selecting consultants to set the framework within which we should work, to advise on investment policy, on the portfolio structure, and so on. We started looking at just local companies but we withdrew from the process and are now considering global companies.”

The Electricity Authority has already appointed a firm with global reach. “Hewitt has presented an investment policy study and we are in the final stage of deciding our new investment policy,” says Constantinides. “The next step will be for the trustees to employ an investment adviser to assist with implementation of the Hewitt suggestions and with drawing up a strategic asset allocation. So I hope that we will see a beauty parade with major companies like Goldman Sachs, JP Morgan, Morgan Stanley and Merrill Lynch, as well as with smaller firms.”

But will major firms be interested in the small amounts available in Cyprus? Mannaris thinks so. “Many of the large European managers are here through various combinations - some directly, some for private wealth management, others through local representatives, anything that can get them business.”

This has its dangers, Mannaris adds. “The current fashionable products are capital guarantee products, many of which are priced on a retail basis and they have all sorts of issues around transparency, penalty fees for early exit and lock-in periods that are quite long. And then there’s an issue around what they provide to the pension fund. After the 1999 crash the word ‘guarantee’ became very valuable so come people took that into their products’ name and it became instantly attractive for some pension funds.”

He adds: “We want managers to start treating pension funds as pension funds. You can’t have a situation where both institutional asset management and private banking retail products are being offered to pension funds by the same provider. We would like to see providers coming up with institutionally priced products that are properly designed to address certain pension fund risks and can adequately fit within a fund’s investment strategy.”

Hewitt has already assisted the Hotel Employees Provident Fund, a DC plan that is the largest private sector fund, with its asset allocation strategy and manager search. “Based on an ALM study taking into account the demographics of our members that showed we had to deliver 5.64% per year with a volatility of 3.24%, our portfolio breaks down as 55% in bonds and cash, 15% in equities, 15% in real estate and 15% loans to our members,” says Marinos Gialeli, the fund’s general manager. “That is a very conservative approach, but we just did our investment strategy last year and the committee wanted to start slowly and increase the risk when it is more familiar with the investment process. It’s the first time that we are investing outside of Cyprus so we are testing the water.”

A key characteristic is that for historic and cultural reasons Greece is not perceived to be a foreign country, and this has asset management implications. “Pension funds don’t know international markets so are taking a step-by-step approach to investing abroad,” says Christos Kalogeris, manager funds management at Hellenic Bank Investments. “Their attitude has been that they lost money on Cyprus equities and they could lose a lot of money abroad. But a step in this direction was the establishment of a common platform between the Cypriot Stock Exchange and the Athens Stock Exchange.”

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