Kimmo Koivurinne: Decline in earnings-related pension assets in 2022 does not endanger pension financing

Roots in the 1960s, leaps in the 1990s and 2000s

Our earnings-related pension system, founded in 1962, initially only funded the future obligations toward private-sector employees’ and seamen’s pensions. In the late 1980s Keva began funding municipal employees’ future pensions. In addition, the State Pension Fund of Finland, VER, was established in 1990 to balance the state’s pension expenses.

In the initial decades the earnings-related pension system’s investments were rather modest. The main reason was a low pension contribution, which was then completely paid by employers, which left little over to be funded once pensions had been paid. At the start of the 1980s pension funds invested entirely in Finland amounted to a mere four billion euro altogether. Premium loans were at that time the pension providers’ largest single investment class, constituting almost two thirds of investments. They were followed by fixed-income investments, which made up almost a third. Equity and property investments only formed a few percent of the total.

In the 1990s pension investments changed following the reform enacted in 1997. There was talk of a baby-boomer pension bomb, which needed to be defused through higher yields. The reform set solvency rules for pension investors, in which pension providers’ investment risk was limited on the basis of solvency. Before the reform, investments had mostly been made in Finland, whereas nowadays the share of Finnish investments is less than a quarter. Solvency regulation created a framework within which providers could seek returns on the international financial markets. After the turn of the millennium, illiquid private equity investments and sophisticated hedge funds began to appear in investment portfolios, which were used to increase the diversification of asset classes and generate yields in a range of market situations.

Earnings-related pension investments have increased markedly since the start of the millennium, and the volume of pension assets has just about quadrupled in just over twenty years. One growth factor has been a deliberate increase in risk level, which in practice has meant a growth in the amount of equity and equity-like investments.

A highly volatile investment year

Generally speaking, one of the key effects of increased risk level is higher volatility of investments in line with the markets. In particular, short-term swings in market value are inherent to equity investments. The year of earnings-related pension investments in 2022 is a good illustration of this volatility. The year began with a situation in which investments carrying a direct equity risk made up 54 per cent (EUR 137 billion) of the total allocation, that is, of the total EUR 255 billion investment assets. Two factors paralysed the stock markets at the very start of the year: the first was sharply increased inflation, in response to which the markets expected steep interest-rate rises from central banks. Secondly, Russia’s invasion of Ukraine in February and the ensuing sanctions put pressure on energy prices as markets were forced to decouple themselves from Russian natural gas. The war raised concerns in Europe for the level and duration of gas stocks. On the global market, the immediate effects of the war were less pronounced. Certainly, the uncertainty caused by the war was seen on the commodity markets: Russia is a significant exporter of oil, gas and grain in world trade. Grain is also a key export for Ukraine.

In the US, inflation resulting from the previous years’ strong stimulus response to Covid reached levels last summer not seen since record highs forty years prior. Particular upward pressure on consumer prices came from energy and raw materials, which was also seen in prices for consumer goods. The combination of the war and inflation created general market uncertainty, which caused earnings-related investments to decline in the first half of the year by almost sixteen billion euro overall.

In the second half of the year the Fed’s tighter interest-rate policy began to have an effect and was evident in slower rises in inflation. On the stock markets, the changed interest-rate climate meant market quotations continued to decline, even though the worst impact of the first part of the year seemed to be in the past. European inflation continued to hit record highs, exceeding ten per cent year on year. In earnings-related pension investments, inflation and higher interest rates were reflected in a modest decline of two billion euro in the third quarter.

In the final quarter of the year, by contrast, stock markets rose slightly. The Chinese authorities relaxed their long-standing, and from a European perspective extremely strict, Covid restrictions, which returned risk-taking to the stock markets at the end of an extremely varied investment year. The passing of peak inflation also made the outlook for the European stock markets slightly more positive. The ECB’s interest-rate rise in December was slightly less than the worst expectations. These positive market signals at the end of year resulted in an increase in earnings-related pension investments by around one billion euro by the end of December.

Liquid asset classes, that is, quoted securities and fixed-income investments (bonds, corporate bonds) were significantly loss-making all year. Given the general market conditions, investments outside the stock market, such as in property and private equity, as well as unlisted equity investments, continued, anomalously, to offer positive nominal yield. Even though equity investments retained their value, even a little comically as stock prices simultaneously dived, it is worth noting that the total volume of equity investments almost halved compared to the previous year. The interest-rate environment that became normal last year following years of zero interest rates challenged all asset classes, and it will certainly be interesting to see how investments fare this year.