Institutional investors in Europe are finding it ever more tricky to shift their portfolios between asset classes in a bid to achieve the risk premium due, in part, to the wave of post-crisis regulations that are set to hit the region.

In recent years, big European buy-side institutional investors such as pension funds have moved more of their portfolios into fixed income as they have become less tolerant of short-term asset price volatility in equities as liability-matching strategies based on fixed income have become more prevalent.

And regulations are now beginning to play a bigger role in what asset classes institutional investors can and can’t invest in with new capital adequacy rules in Europe, such as Solvency II for the insurance sector, and quite possibly a similar regime for pension funds, called IORP II, set to be introduced that demand that more less risky assets, such as bonds, are to be held by institutions.

Recent data from the U.K. Pensions Regulator and Pension Protection Fund shows that the average pension fund now keeps just 38.5% of its assets in equities, down from 61.1% in 2006, the first year of analysis. In contrast, the allocation to fixed income has risen from 28.3% in 2006 to 43.2% today—the first time since it has been measured that bonds outweigh equities in the portfolios of pension funds.

“It is not surprising to see U.K. pension funds’ allocation to equities being overtaken by that of bonds, given the need to reduce risk as they mature,’ said Alasdair MacDonald, head of investment strategy at consultant Towers Watson. “Part of this shift is a result of recent market movements, but much of this is a deliberate attempt by many to de-risk.”

European institutional investors, though, are coming under pressure from the dual impact of low interest rates and a troubled European government bond market, which is depressing returns on fixed income investments.

“Usually the size of the risk premium required to achieve inflation plus 3% will be somewhere between the risk premium for equities and the risk premium for bonds, hence most pension funds have a mix of these two basic asset classes,” said a recent note from investment bank UBS to its clients.

“One of the biggest investment problems that pension funds face in the current climate is the magnitude of negative real short rates. In other words, the short-term interest rate is too low and is actually below the prevailing rate of inflation.

“Our analysis indicates that the risk premium for equities should be about 3.75%, and for government bonds about 1%. Whilst the current risk-free rate yields only 0.5%, an expectation for the total return to equities is about 4.25%. Clearly then, it is difficult to exceed an inflation rate of around 3% by any significant margin, and certainly a return of inflation plus 3% is very difficult to achieve.”

This is proving a hard blow to institutions whose portfolios are more and more dominated by bonds.

“Regulations and regulatory uncertainty have caused institutions throughout much of continental Europe to put off or limit alterations to investment strategies that would diversify their portfolios away from European government bonds and other fixed income investments,” said Marc Haynes, a consultant at Greenwich Associates, a consultancy.

“In order to truly guarantee the long-term solvency of Europe’s institutions, it may be time for politicians and regulators to consider some regulatory relief.”

In a recent survey, Greenwich, which interviewed 663 institutional investors in Europe, found that many were increasing their allocations of sovereign debt in a bid to meet Solvency II compliance requirements, while others were holding off on efforts to adjust the risk/return profiles of their portfolios until the implementation of the European Union’s AIFM directive, which will better govern alternative investments, and the finalization of other pension fund capital requirements.

All of which means that underfunded pension plans and insurance companies are scrambling to meet their funding requirements in the current investment environment without the flexibility to add appropriate levels of risk to their portfolios.

“We appreciate that the current economic situation presents a continuing challenge to trustees—low interest rates and low gilt yields have contributed to increased liabilities and deficits for many defined benefit schemes,” said Bill Galvin, chief executive of the U.K. Pensions Regulator.  

Martin Clarke, director for financial risk at the Pension Protection Fund, which is the safety net for the pension schemes of insolvent companies in the U.K., added: “We have to be extra vigilant about the continuing global financial crisis and the adverse effect it is having on the funding position of UK pension schemes.”