Portfolio management implications of the Finnish solvency law for pension funds

OBJECTIVES OF THE STUDY The Finnish solvency law for pension funds determines, based on the pension fund's investment portfolio, a solvency limit, which acts as a risk metric and limits the risk taking of the pension fund. The aim of this thesis is to understand how the said solvency law behaves in different situations and what kind of investing it encourages. A new solvency law is currently being formulated, hence the subject is current and interesting. The focus of the thesis is on the new solvency law, but comparisons to the old law are made as well. The scope has been limited to the following research topics: 1. How does the solvency limit change as the portfolio allocations change? 2. What are the optimal portfolios implied by the solvency laws? 3. How sensitive are the optimal portfolios to parameter changes? 4. How do the required risk levels change as the solvency level changes? MATERIAL AND METHODOLOGY The current and the new solvency laws, as well as the portfolio composition of pension funds act as the material for the thesis. The research questions are investigated using models that have been built based on the solvency laws. The models' sensitivity to different parameters is investigated and portfolio optimizations are made based on the models. Simulation methods are used as well. FINDINGS As the thesis has a wide scope, also the results are varied. In general terms, the solvency law behaves as expected, reducing the risk taking of pension funds. The solvency law may also cause volatility in stock markets, as when the solvency level of a pension fund goes down, they would have to sell stocks in order to reduce their solvency limit. In terms of optimal portfolios, the new law is much more balanced in terms of allocations than the current law, which tends to favor e.g. real estate investments. The results also indicate that pension funds may have trouble reaching their required rates of return in the context of the current low interest rate environment. The required rate of return mainly depends on the solvency level of the entire pension system, which may be problematic for an individual pension fund, if its own solvency level is low