Investment approach and strategy
The financial balance of the general pension insurance scheme and consequently of the reserve managed by the FDC basically depends on macroeconomic factors. The major risk of a lack of financial stability consists of a slowdown in the growth of the working population or even a decrease of the latter. FDC’s return on investments has therefore only a secondary impact on the financial balance and a possible future deficit may not, under any circumstances, be financed by the return on investments. Given these facts, the principles of an asset-liability management could not be used as a basis for setting up an investment strategy. The set up of an investment strategy was therefore focused on an optimisation of the investments and a maximisation of the return with regard to certain factors, namely:
- liquidity requirement;
- investment horizon;
- risk tolerance;
- minimum rate of return;
- choice of investment categories.
The FDC has a very low liquidity requirement given that the general pension insurance scheme still has a surplus of contributions over pension liabilities. Therefore, FDC’s assets do not have to contribute towards an immediate financing of pension liabilities. Its investment time frame can consequently be characterised as a long-term horizon.
The value at risk (VAR) method expressed in percentage of the total assets is used to build up the risk budget. This concept, widely applied in the financial industry, identifies a maximum loss threshold that should not be exceeded with a defined probability over a specific time horizon.
In addition, a minimum rate of return of 3.80% was set. This target rate should at the least allow compensating the impact of the growth of real wages and inflation on the level of the reserve while, at the same time, covering the asset management fees.
The choice of the investment categories took place in two stages. The first stage was to decide on the overall allocation for which only traditional categories of assets (equities, bonds and liquidity) were taken into consideration, this in accordance with their respective degree of risk. These traditional categories of assets present a systematic risk premium and can therefore be modelled on the basis of historic data. In a second stage, other categories within the traditional categories of assets were considered in order to determine the more refined allocation, this again by taking into account the degree of risk specific to each investment category. This second stage allowed a qualitative improvement of the overall allocation and the specification of the regional structure of the overall portfolio. During 2008, the first investment strategy has been revised.
In 2012, the Board of Directors has conducted an in-depth review of the investment strategy of 2008 based in particular on:
- an update of the fundamental parameters that helped developing the investment strategy in place, especially the specific parameters used for calculating the expected return target and risk data;
- the identification of potential optimisations respectively refinements of the current investment strategy based on lessons learned from the financial crisis;
- the opportunities to incorporate new asset classes.
In this context, the update of the fundamental parameters showed a decrease in the expected return and an increase in risk, logical consequences given the low levels of interest rates and financial turmoil of the recent years. However, the expected return still exceeds the minimum rate of return, the latter having not varied.
It could therefore be concluded that the current investment strategy has been resilient throughout the crisis and has a strong fundamental base. The only optimization still providing some added value consists in a refinement of the latter by the introduction of specific new asset classes. As a result, it was decided to introduce, in a first step, two new asset classes in 2013, namely those relating to the small cap equities and emerging market debt. Afterwards and in a second step, the implementation of an asset class related to world real estate should be analysed. Finally, the given analysis led to the implementation of two new sub-funds in 2016 dedicated to this specific asset class.
Current investment strategy of the FDC
The overall equity portfolio has a strategic quota of 32,5% and is composed of global equities, emerging market equities and small cap equities portfolios. Due to the need for special expertise and knowledge regarding the emerging markets and the small cap equities, separate categories with a 5% respectively 2,5% limit have been introduced.
With regard to the bonds, the strategic allocation foresees a global bond quota of 25% hedged against currency risk. A quota of 26,5% was allocated to euro-denominated bonds. Given that global bonds provide an alternative to euro-denominated bonds, this nearly identical percentage allows a more effective diversification in an overall bond portfolio. It should be noted that the assets related to loans, transferred to the FDC at the beginning of 2009 by the former pension institutions, were incorporated into the euro-denominated bond category as they are very similar to fixed income securities in terms of risk and return. Finally, a quota of 2,5% has been allocated to emerging markets bonds, the overall bond portfolio thus amounting to a total of 54%.
Liquidity represent 5% of the total assets under management.
The property assets, previously managed by the former pension institutions and like the loans transferred to the FDC at the beginning of 2009, represent about 3% of the total assets and are entirely located in the Grand Duchy of Luxembourg. In order to integrate these assets most effectively, a Luxembourg property assets category was created with a quota of 5%. Also, a global property assets category with a 3,5% quota was created in order to avoid exposure to the Luxembourgian real estate market only. The overall property portfolio therefore amounts to 8,5%.