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Varma questions the future of inflation hedging as ECB sends easing signal

The European Central Bank’s latest round of easing sent a signal to institutional investors that their inflation hedges may be growing more pointless by the day. To cover future liabilities, the EUR 46bn pension fund keeps adding risk, but everything comes at a price.

Varma Chief Investment Officer Reima Rytsola. Photo: PR

In the northernmost corner of the euro zone, a USD 46bn pension fund says ECB President Mario Draghi isn’t giving his industry much hope that things will improve.

“So far, the less you’ve hedged, the better off you’ve been,” Reima Rytsola, the chief investment officer of Varma Mutual Pension Insurance Co., said in an interview in Helsinki after the ECB presented its latest stimulus package. “And the more exposure you’ve taken duration wise, which is the inverse of an inflation hedge, the better off you’ve been.”

“And when you listen to Draghi, you certainly don’t get the impression that inflation is about to come back,” Rytsola said. “So it’s pretty severe. And I’m not very optimistic that the ECB’s latest measures will do much to change the inflation outlook.”

The absence of inflation is just one of a number of unsettling signs that has funds like Varma worried about the implications of the current monetary environment. Far from reviving consumer-price growth, persistent ECB stimulus seems mainly to have created higher asset prices, making it increasingly difficult for pension funds to generate the returns they need to cover future liabilities.

Rytsola says he just keeps adding risk, trying to “harvest the illiquidity premia” where it can be found. He’s selling investment-grade bonds and buying alternative assets like real estate and infrastructure, but everything comes at a price.

“Due to super stimulative monetary policy, all assets have become expensive,” Rytsola said. “We don’t expect to find any free lunches, but it’s getting really difficult to find any asset classes that don’t seem to be expensive in some way. So that’s the dilemma.”

He says that “most of the tools needed to adapt to this environment have already been used. Just as the ECB is using the same tricks, so are we.” The fund uses external managers for about half its investing, and they “mainly handle the less liquid assets,” Rytsola said.

“And in this zero interest-rate environment we’ve gone more over to a passive investment style than an active one. Especially with global equities,” he said. “And that’s probably reduced a little our use of external managers.”

“In Solvency II, when you have to adapt to a continually lower interest-rate environment, you have to extend your duration all the time, and then you’re kind of locking your assets in a really long duration at zero interest rates,” Rytsola said.

“That’s why we see phenomena like a few weeks ago, when we saw 50-year euro swaps went into negative territory, and you know when you’re receiving a fixed 50-year negative rate, and that’s kind of locked in your investment portfolio of returns, that’s not an optimal situation.”

“It looks a bit like a vicious cycle to me,” he said. “To me it seems better to be outside Solvency II given the current negative rate environment.”

“For us, firms using Solvency II are a kind of a canary in the coal mine. That means that for us, there’ll be so many other firms that get in trouble first, which will probably trigger some kind of reaction, before we really take a hit.”

Varma manages employment-related pensions of about 900,000 Finns. Since 1997, Finnish employment-related pension investments have returned about 4.2 percent a year in real terms, according to the Finnish Pension Alliance TELA.

In the first half, Varma had the best returns from listed stocks, more than 15 percent, with investments yielding 6.9 percent overall. The Finnish Center of Pensions assumes life insurers generate at least 2.5 percent real returns a year by 2028 and 3.5 percent thereafter in the long term.

It’s worth noting that Finnish law doesn’t require Varma to comply with the same Solvency II rules to which much of the rest of the pension industry adheres. Rytsola says that’s an advantage in the current interest-rate environment.

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