Few pension funds describe their investments in terms of risk allocation. Danish pension fund, ATP, however is unlike most. Lars Rohde, CEO of the €50bn pension fund, partly credits ATP’s out-performance to how it treats risk. Last year, ATP’s investments lost only 2.8% while the S&P tumbled 38.5%. Taking the swap overlay into account, ATP delivered a positive 18.9% return in 2008. The pension fund has returned 6.6% year-to-date with a coverage ratio of 118% at the end of September 2009.

When one asks Rohde about the asset allocation of the fund’s portfolio, the conversation turns to risk. This is because ATP does not allocate to a particular asset class. It views an asset class through the prism of risk. The fund’s risk allocation is spread across equity, credit, inflation, commodities and interest rates. The surplus or free reserves, which is the amount over 100% of the coverage ratio (assets divided by liabilities) is also referred to as the risk capital of the pension fund. “Our free reserves allow us to take on investment risk. The free reserves define the risk capability of the pension fund,” notes Rohde. ATP began last year with a funding ratio of 123%, dropping to 113% by year end. This compares to large Dutch schemes which began the year with coverage ratios of 140% to 150%, ending the year at 90%.

Interest rate shield

“The way we manage risk is radically different to most pension funds,” notes Rohde who last week received the pension industry’s award for best European fund by IPE. ATP also applies its approach to risk to scheme liabilities, which are particularly sensitive to changes in interest rates. Indeed, a 1% drop in long-term interest rates translates into a €7bn loss for ATP. In order to minimise the impact of lower rates, ATP hedges its liability portfolio via a swap overlay.

The use of a swap overlay shielded the fund’s liabilities from ballooning just as interest rates dropped sharply during the financial crisis. “When interest rates continued to move lower we considered taking off the swaps. We decided from a risk perspective that we should not. If our guess about interest rates proved wrong, we were not prepared to live with the risks associated with taking off the swap. So with the overlay in place, we look like geniuses when rates go down and like idiots when rates go up generating losses on the swap side.” Higher rates, however, also have a positive impact on shrinking the scheme’s liabilities and contributing to the funding ratio and free reserves.

Rohde is not taking any chances which way interest rates may move: “We are sitting on a knife’s edge. On the one hand, there is a large risk of a new recession type of fall in equities and interest rates so that what we have seen in the last six months seems like a false start or a recession rally. On the other hand, there is considerable risk that we have seen the worst and interest rates will increase upwards as governments re-inflate their respective economies. Our job is to see that we fare well in both scenarios. If we have a strong view that interest rates will move higher, we can buy put options on interest rates and we are actively looking at some of these strategies all the time. However, it is important for us mentally to keep our short-term investment beliefs apart from our long-term business model which is to keep our liabilities fully hedged at all times.”

In addition to the swap overlay, ATP used a number of insurance strategies last year, buying far out of the money put options on equities and commodities. The move proved prescient adding €2bn on the asset side and mitigating its losses. Rohde describes the decision to bet against oil and equities in relation to freeing up risk capital for other investments. “Using options for hedging purposes frees part of our risk budget to take risk in other places, so buying options for us is not only insurance or taking risk off the table. It allows us to put risk on the table somewhere else.”

VB