The Finnish pension industry is undergoing a series of changes that will have a profound influence on the asset management environment. At the heart of the transformation is a committee chaired by Ilmarinen CEO Kari Puro, which consists of representatives from employers and trade unions. Its role is to hammer out proposals on a series of issues ranging from investment regulation to taxation for presentation to the authorities.
“We have seven pension insurance companies, which are 25-30% funded and 70-75% PAYG,
providing obligatory statutory
DB earnings-related employment pensions that cover all people in gainful employment,” explains Matti Leppälä, director responsible for international and legal affairs for the Finnish Pensions Alliance (TELA). “We don’t have a second pillar because they serve the purposes that a second pillar serves
elsewhere.”
The contribution level is a little over 21.6% of a gross salary, with employers paying around 17% and employees 4.6%. No public money goes towards pensions, the only fiscal element being the so-called basic state pension for those with no employment history or with a minimum earnings-related statutory pension. Total pension assets at mid-June were in e96bn, which is in excess of 60% of GDP.
And the system works well. With Sweden, Finland has Europe’s lowest level of poverty among retired people.
But although the authorities have avoided a financial responsibility for the bulk of pensions they nonetheless make their presence felt, and the pension funds complain of a heavy regulatory hand.
“Regulation is an issue that affects asset allocation,” says Petri Kuusisto, outgoing director of investments at Varma. “There are two major elements: first the technical provision rate, or the return target which is set by the social and healthcare ministry, and second the solvency rules which determine how much solvency capital one needs for a given asset allocation. If we don’t achieve that return target the difference will be taken from the pension insurance company’s solvency capital and the lower the solvency the smaller the risk capacity. It’s a peculiar way to handle pension assets, it’s more like running a life company. There’s a lot of freedom for pension funds and pension insurers on individual products. The additional constraints come from the solvency requirements, the way it’s being calculated and how the solvency formula behaves. And those two issues are at the core the debate on how to achieve more returns.”
“The funded sector of the pension funds must show a 3.5% annual real return over the long term and this is a real factor,” says Leppälä. “For the last couple of years we’ve had above target level returns, real returns of more than 7%. But this was in a buoyant economy. The first years of the decade were very challenging. We have structural regulations that put unnecessary limits on investments, so that we could have had even better returns in the past and we should ensure that the rules would not be an impediment to securing the best possible returns in the future. So we are working towards the relaxation and reform of these rules.”
“We need to take more risk,” says Mikael Simonsen, head of tactical asset allocation investments at Ilmarinen. “Our aim is to increase the risk in the system but in a controlled way. This is required because as part of the PAYG system we are not fully funded. Currently our target is not to hedge the liabilities but rather to increase our reserves so that contributions from employers will not increase too much in the future. But another major question is the looming need to mark to market liabilities. We are not at present marked to market on the liability side now, but the knowledge that we eventually will be, imposes a market risk - futures contract - on our balance sheet.”
“We need to change the nature of the regulation so that we are not ticking boxes to check whether this detail is correct or not,” says Kuusisto. “We need a total risk review. You can never do that with one single mathematical formula, you need stress test-type scenarios. And modern finance has already developed such techniques.”
And this highlights the level of awareness among the authorities. “There have been people who, from our point of view, have not understood developments and the necessities in the investment market and the rapid change in the different investment instruments and the real risk that is involved,” says Leppälä. “If a detailed framework of asset classes and regulations on different types of investments is too rigid it limits investment opportunities.
“Investment bankers and others have developed vehicles that are like a bond but the risk is in equities or they are like equities but are actually real estate, and while the legal form of the investment determines how the risk is considered in relation to operating capital and solvency, we see that in reality it should be the real risk that is buried in the investment that should be considered and there should be stress test on the real risk. The prudent person principle should be introduced and we should move towards what is general practice in the European pensions investment market.”
“A challenge for Finland is that so many factors affect the investment process and investment policies of pension companies,” says Hanna Hiidenpalo director of investments at Tapiola Pension. “Decisions are made in different places so nobody really has an overall view of how the pension system and investment policies will be developed in the future. The focus has been far more on how the market and instruments behaved in the past but the biggest problem is that it is not forward looking and nobody is preparing for future challenges and opportunities.”

The issue of real estate as an asset class highlights the apparent myopia among officials. “For the finance ministry the question of taxation on real estate investment is one of principle,” says Leppälä. “Pension funds can invest directly in real estate through a real estate vehicle and rental income is tax free. But if the investment is made by an investment fund, which has the legal form of a limited company, it is taxed as a limited company, whereas in other countries there is a function approach that says that real estate is taxed the same way regardless of the institution that is conducting the investment.”
The tax is a disincentive to investing in property trusts. “There’s an inconsistency here,” says Hiidenpalo. “One way of approaching the real estate market is to put up a structure, and take a certain percentage of leverage. However, we can’t leverage our positions, although if we buy a fund which leverages its position that’s all right. Pension fund costs are in focus everywhere so why not here where it is very cost effective method?”
Many if these issues are being discussed within the Puro group, which expects to present its findings to the authorities in late September, with a finance ministry review of real estate investment regulation expected at the end of November.

One challenge to pension funds has been overlooked in this process. “The employer chooses between the pension institutions, and in addition to competing in serviced level and investment returns, if the returns are good enough they give refunds of contributions to the employer,” says Leppälä. “And that’s the main form of competition between the different pension institutions.”
“It’s not that we can just give money away,” says Simonsen. “The maximum rebate is a function of the allocation riskiness of the investment portfolio at year end, based on the solvency regulation. Initially, employers wanted to make sure that the pension companies would not get unnecessarily rich, so they made this rule that if you are too solvent you have to pay back the excess amount. Then they wanted to make sure that you don’t pay anything back if you are too poor. So if you are four-times your solvency border you have to pay back all of the excess.”
But what would it do to the pension funds’ funding position if they did not have to offer such premium paybacks? “It’s only marginal,” says Kuusisto. “The reductions are small and so have a small impact on the total economical funding status.”

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