Pension Funds’ investment in commercial property

There is growing interest in Norwegian commercial property among Norwegian and international pension companies. The transaction market has never been stronger. How will current and future frameworks affect pension funds’ investment in property?

Over a three-year period, UNION Corporate and the law Norwegian firm Wiersholm have assessed how current and future frameworks affect the opportunities for pension funds to invest in commercial property. The assessment was conducted in collaboration with the Norwegian Association of Pension Funds.

Property is also an attractive asset class for pension companies

Property as an asset class has several features that are attractive to pension funds: Long-term contracts with secure tenants provide an inflation-protected cash flow into the portfolio, which is well suited to meet future pension obligations. Property also brings a diversification aspect to the portfolio in that property has a low correlation with bonds and equities.

Forms of investment in property

Current asset management regulations govern the proportion of the common portfolio that life insurance companies and pension funds can invest in property. Investments in property may be made through direct ownership and indirect ownership. Indirect investments may be made through:

Joint ventures: The pension fund as a financial investor enters into a joint arrangement with a property company which manages the properties
Club deal structures: Several pension funds club together to invest in one or more properties, and engage a manager for the properties
Property funds: Pension funds invest in a property portfolio which is managed by an authorised manager of alternative investments. In order for indirect ownership to be classified as property in the capital weighting, certain additional conditions must be fulfilled. The main conditions are as follows: i) the investment company must not be funded by loan financing, ii) operations must be limited to investments in property, and iii ) the ownership share in the company must have limited liability.

There are examples of pension funds investing in structures with external funding. In these cases, the investment will be categorised in group 20 in section 3-1 of the asset management regulations. This means that the individual pension fund’s total investment must not exceed 10% and the ownership share must not exceed 15%, otherwise it will be considered non-insurance.

Solvency requirements for pension funds after 1 January 2016

Act no. 17, dated 10 April 2015, on financial institutions and financial groups, which comes into force on 1 January 2016 (the Financial Undertakings Act), introduces the key provisions of the Solvency II Directive on insurance companies’ solvency requirements. The new Solvency II requirements are not applicable to pension companies in the new Financial Undertakings Act. However, the act contains a provision allowing the regulations to be fully or partly applicable to pension funds at a subsequent date, cf. section 14-16, second paragraph, of the Financial Undertakings Act.

The introduction of the Solvency II Directive in the Financial Undertakings Act means that the current solvency rules for insurance companies are superseded.
However, in a consultative document dated 23 June 2015, the Financial Supervisory Authority has proposed that the current solvency margin requirement for pension funds conducting life insurance business should be retained, but that the capital adequacy requirements for pension funds should be repealed pending new EU regulations. This is a natural consequence of the current solvency requirements for pension funds continuing until further notice.

Changing capital adequacy requirements

Existing capital adequacy regulations for pension funds and insurance companies require the fund/life insurance company to constantly maintain sufficient capital in relation to the quality of assets. This is imposed by applying a minimum capital ratio requirement (capital against risk-weighted assets). There is also a solvency margin requirement under the existing rules. It is proposed that the capital adequacy requirement be repealed with effect from 1 January 2016, both for pension funds and life insurance companies. Life insurance companies will be subject to Solvency II instead, while pension funds will only be subject to Solvency I ( current solvency requirements).

What will be the consequences of repealing the current capital adequacy requirements for pension funds? In isolation, it could be seen to give pension funds a competitive advantage over life insurance companies, although the solvency margin requirement will continue to impose limits on the obligations that pension funds can assume.

Caution in reducing the capital ratio beyond the current requirements

There is much to indicate that any exemption from the capital adequacy requirements will be short-lived. On 27 March 2014, the European Commission presented a proposal for a revised Pension Funds Directive (IORP II). It is uncertain whether the directive will be adopted and what content it will have. However, signals from the EU indicate that an IORP II Directive would make pension funds subject to capital adequacy requirements similar to the Solvency II requirements, but with simplifications related to reporting and risk management. But regardless of the destiny of the IORP II directive, there are good reasons for assuming that pension funds will be subject to capital adequacy requirements in the future.

According to the Financial Supervisory Authority’s assessment in the consultation paper dated 23 June 2015, the Financial Undertakings Act’s rules on the assessment of risk and capital should initially be applied to pension companies when the IORP II Directive is adopted. As pointed out by the Society of Actuaries in its consultative statement on 30 September 2015, the Financial Supervisory Authority also wrote that in on-site inspections at pension funds it was important to ensure that pension funds continue to develop processes for overall risk assessment of all significant risks, including risks not identified in the current solvency requirements.

The uncertainty as to whether the capital adequacy requirements will apply to pension funds after 1 January 2016 is unfortunate. However, pension funds should be careful about reducing the capital ratio much beyond the current requirements in view of the EU’s signals about the IORP II Directive and the Financial Supervisory Authority’s assertion that solvency assessment of pension funds should take into account risk not covered by the capital adequacy requirements.