Background

Arbejdsmarkedets Tillaegspension (ATP), also known as the labor market supplementary pension fund, is a supplementary pension plan of the state-funded first pillar old age pension in Denmark, which was established in 1964. The objective of ATP is to deliver a guaranteed nominal pension. On top of this, it aims to raise pensions in line with inflation by utilizing the returns from its relatively small return-oriented portfolio.

ATP is the largest pension fund in Denmark. As of December 2017, net assets under management were approximately DKK 768 billion ($118 billion),¹ with an annualized rate of return of 8.8% since 1997. The number of members exceeds five million. By 2050, it is estimated that over 50% of Danish pension payments will come from ATP and the state pension. The fund focuses on keeping costs as low as possible. In 2016, total costs amounted to 0.18% of assets.

Challenge

In their 2010 paper, Lars Rohde, at that time Chief Executive Officer (CEO) of ATP, and Chresten Dengsøe, Chief Actuary, discussed several challenges and reforms. They pointed out the pressure being put on the pension fund by (i) increasing life expectancy, (ii) overly high risk levels, (iii) diminishing financial performance as a result of poor financial markets, and (iv) declining interest rates. New financial regulations from the Danish Financial Supervisory Authority (FSA) in 2001 had changed the investment landscape significantly. Mandatory fair value reporting for pension fund liabilities was the hallmark of ATP's reform. Additional reforms involved raising a number of standards for transparency and risk-assessment and management.

The key issue was that ATP had a risk level that was too high to survive a financial crisis, given its solvency. As a consequence, the challenge was “to improve the fund's risk management.”

The process

As a response to the new financial regulations imposed by the government, ATP reassessed its investment strategy. This process took several years, and basically encompassed both the investment side and the liability side.

At the heart of each area lies the improvement of risk assessment and the creation of more value. As a result of the FSA regulation in 2001, ATP was at risk of failing the Danish stress test for financial institutions. In essence, this would imply that ATP was too fragile to handle extreme market shocks: “There was a 30% risk on a five-year horizon that ATP would lose its entire reserves.”²

This is why risk was the most important aspect for ATP to focus on. As a first step, ATP reformulated its objectives, on the one hand by guaranteeing a nominal pension and, on the other, by focusing on maximizing returns. As a consequence, ATP split its asset portfolio into a hedging portfolio, and a return-seeking investment portfolio. The former is designed to deliver a guaranteed nominal pension, while the latter is focused on generating supplementary returns that can provide for inflation linking. Of the premiums paid to the fund, 80% is invested in the liability hedging portfolio and 20% in the return-seeking portfolio.

Secondly, ATP decided to enhance short-term risk management in the return-seeking portfolio by means of a “dynamic risk budget.” This approach was intended to address the risk of losses. Essentially, ATP operates in a predefined risk tolerance range (“traffic light system”) that is dependent on its solvency. When ATP reaches the lower barrier of risk tolerance, it will increase risk, while at the upper barrier it will reduce risk until it is at a responsible and bearable level for the members of the fund. Alongside generating returns, ATP hedges tail risks. This is necessary because ATP has no sponsor.³ The fund's focus on risk elimination consequently helped ATP during the financial crisis. The main reason was that ATP had purchased insurance against extreme tail events cheaply, thereby limiting risk and portfolio loss.

Furthermore, ATP's investment strategy in its return-seeking portfolio is based on a risk factor approach: “The idea is that all investments consist of a number of basic building blocks—factors—which can be combined in various ways to achieve an investment portfolio with the desired risk profile.”⁴ The strategic asset allocation of the return portfolio in 2016 was listed as 49% based on the equity factor, 22% based on the interest rate factor, 11% inflation and the remaining 18% on other factors. By looking at all investments—both private and public—through the same factor approach, ATP is able to allocate risk where it is rewarded the most.

The outcome

By creating very strong mission and objectives and a strong process and risk management orientation, both in a very transparent and controlled way, ATP has built a sustainable long-term framework. Because the risk is so well and transparently contained, the Investment Management Organization can develop and maintain a highly sophisticated investment strategy within its boundaries. This helps build and maintain a competitive advantage, both because of the sophistication (no need for the board to understand all the details) and the agility that this provides.

Lessons for Achieving Investment Excellence

• ATP dared to be radically different from other pension funds, based on a changing regulatory context and disappointing results. This resulted in a strong, marked-to-market liability-oriented and risk-management-oriented investment framework.
• ATP has an extremely clear mission and objectives. In combination with a transparent short-term oriented risk framework, a highly sustainable setup is created.
• The combination of clear objectives and strong risk management makes it possible for the supervisory board to delegate the design and implementation of the investment policy to the Investment Management Organization.
• And this in its turn makes it possible for the investment management organization to create and maintain a highly sophisticated investment approach.