An overdependence on equities was a major cause of Irish pension funds losing 40 per cent of their value last year – the worst performance amongst the 30 OECD countries, writes FIONA REDDAN.

WHILE THE financial crisis has battered pension funds across the globe, few developed countries have seen their private pension funds fall as significantly as Ireland has.

A recent survey from the Organisation for Economic Co-operation and Development (OECD) shows that amongst the 30 OECD countries, Ireland was the worst performer in 2008, with pensions slumping by almost 40 per cent, compared with a fall of just 8.5 per cent in Germany and 17.4 per cent in the UK.

Although Irish pension funds have started to recover, posting a 5 per cent return in the six months to the end of June, returns over the past five years are still in negative territory, indicating that there is still a significant hill yet to climb.

This is particularly worrying given the fact that private pensions and other investments provide a third of retirement incomes in Ireland, compared with the OECD average of less than 20 per cent.

The main reason Irish pension funds have performed so badly is their large share allocation to equities, considerably more than the OECD average of 36 per cent.

According to statistics published by Mercer, at the end of 2006 the average Irish managed pension fund had a total allocation of 78 per cent to equities, with just 12.3 per cent in fixed interest products, and less than 5 per cent in cash.

So when the financial crisis, which began in August 2007, started to take its toll on global equity markets, Irish pension funds, with their overdependence on equities and marginal allocations to cash, were primed for a crash.

At the time for example, more than 80 per cent of Bank of Ireland’s and KBC Asset Managements managed funds were invested in equities.

Also significant, is the fact that of the more than three-quarters of the average fund which was invested in equities back in 2006/2007, almost 20 per cent of this was in Irish equities, far above international norms.

Some of the most top-heavy were the Davy Exempt Managed Fund, which invested almost a quarter of the fund in Irish equities, and Bank of Ireland’s Managed Fund, in which Irish stocks accounted for 23.7 per cent.

Considering the collapse in the Irish stock market, it is no surprise therefore that Irish pension funds have performed so poorly.

While home country bias in itself is not unusual, such large-scale exposure to a market which accounts for less than 1 per cent of global markets carried significant risk, and is in part due to legacy issues arising from exchange controls which used to constrain investment in international equities.

At one stage, about 40 per cent of an Irish fund would have been in Irish equities.

However, while pension fund managers did reduce exposure, the buoyancy of the Irish market during the Celtic Tiger years, and the desire on the part of fund managers to keep in line with their peers, meant that allocations stayed at risky levels.

“From a theoretical perspective, Irish equities has always been a high risk market, but it had been delivering high returns,” says Fiona Daly, managing director of Rubicon Investment Consulting.

The familiarity of Irish companies also played its role. As Terry Devitt, investment director with Harvest Financial Services says: “Investors felt more comfortable with Irish equities so they formed a larger part of their funds than should have been the case.”

Another problem with such a high exposure to Irish equities was the fact that within the Irish market, financial stocks accounted for about 40 per cent of the market.

For example, at the end of 2007, AIB alone accounted for almost 15 per cent of the entire market capitalisation of the Iseq, while Bank of Ireland made up over 10 per cent of the index.

In addition to Irish stocks, funds also invested in Irish residential and commercial property, with people managing their own pensions particularly partial to property. As Devitt sees it: “The Irish being the Irish tend to be top-heavy in property.”

For those managing their own pensions and who purchased a house or apartment during the boom, this preference means that their fund is now dominated by a single asset.

“Buying an apartment for a pension fund can soak up a lot of capital, meaning you can be very top heavy in a single asset,” says Devitt. Moreover, with rents in decline, pension funds might need to release more capital to keep repayments up on the property, thereby increasing its concentration on a single asset.

So, putting all your eggs in the one basket can be a dangerous strategy to follow when it comes to providing for your retirement, and highlights the importance of spreading your risk in different asset classes across difference countries. As Devitt maintains: “There is no doubt that the past 18 months have thrown asset allocation into sharp relief for all pension funds and shown how important diversification is.”

But, having learned the hard way that pension funds should be diversified, what can be done about making changes now?

For people with self-administered pensions, selling up your existing holdings is not really an option at the moment, given the fact that share prices are on the floor. “At this stage of the game, there is no point in selling out. Instead you should hold on for the long term and use new contributions to dilute exposure to equities and property,” says Devitt.

One sector he does caution might warrant moving out of however, is Irish banking stocks. “Irish banks are not a one-way bet, and we’re saying to clients that they might consider selling some of their holdings,” he says.

However, while such an approach is an option for self-administered pension holders, members of defined contribution (DC) schemes may find their options more restricted. “It depends on what choices are available as part of your pension scheme,” Daly says.

“If the only option is between a managed fund and cash or bonds, if you are young enough you should stick to the managed fund. If, however, you have a choice between managed fund and international equity fund, then it might be worthwhile considering the international option for new contributions,” she adds.

In any case, DC members are likely to find that their pension fund’s exposure to the Irish market has been drastically reduced due to the market turmoil. For example, from 15 per cent at the end of 2007, the allocation from Irish managed pension funds to Irish equities has more than halved, dropping to just 7 per cent by the end of June of this year.

And one of the funds which was the most top-heavy in Irish stocks, Davy’s Managed Fund, has slashed its investment in Irish equities from almost 25 per cent to just 2.8 per cent.

While the reconfiguration can be explained to some extent by the collapse in Irish share values, pension fund managers are also investing new contributions away from the Irish market.

At the end of 2006, 40 per cent of the average Irish pension fund was invested in international equities, while just 12 per cent was in fixed interest. Now, however, 45 per cent is in global stocks, while almost a fifth of the average fund is in fixed interest products such as Government bonds.

Moreover, the position of Irish financial stocks has also changed. With the departure of Anglo Irish Banks, and the near collapse in values amongst the remaining financial institutions listed on the ISE, financials no longer make up so much of the Irish market, at about just 11 per cent.

BOIs weighting on the ISE fell to just 4 per cent at the end of June, while AIB had fallen back to 3.8 per cent.

For those in self-administered schemes, whose pension fund is largely made up of a property, selling up is also not really an option.

With property prices and rents on a downward spiral, Devitt says that many pension fund holders who invested in property have been saved by the decline in interest rates, which has made servicing the mortgage much cheaper.

If the property is producing rental income, then the best option is to simply wait out the downturn and look to dilute your exposure to property by investing new pension fund contributions in other asset classes.

However, for those who may have purchased in peripheral areas and who are unable to rent the property, the situation is more serious, with the property acting as a strain on a fund as the loan has to be financed from the capital within the pension fund.

With keeping the pension fund solvent a priority, it means that diversifying into other asset classes is much more difficult.