White paper on the Government Pension Fund: Laying the foundation for good and sustainable returns

White paper to the Parliament

2006 was another good year for the Government Pension Fund, as high petroleum revenues and good financial returns helped the fund grow to
NOK 1 891 billion. – As part of a regular review of the Fund’s investment strategy, we plan to increase the equity allocation of the Pension Fund - Global from 40 percent to 60 percent. At the same time, we are emphasizing the ethical obligations of the Fund, says Minister of Finance Kristin Halvorsen.

High financial returns
The Government Pension Fund is composed of the Pension Fund - Global (previously known as the Petroleum Fund) and the Pension Fund Norway. In the first dedicated white paper report to the Parliament (Stortinget) on the management of the Government Pension Fund, the Norwegian Minister of Finance Kristin Halvorsen noted that 2006 had been another good year for the Fund.
- Benign financial market conditions and high petroleum revenues contributed to another significant increase in the Fund to NOK 1 891 billion (around USD 300 billion), says Minister of Finance Kristin Halvorsen.

The Government Pension Fund - Global, which is managed by Norges Bank (the Central Bank), registered a 7.9 percent return (measured in local currency) in 2006 and stood at NOK 1 784 billion at the end of the year. Since 1997, the average annual nominal return has totalled 6.5 percent. Of this, the manager’s excess return last year relative to the benchmark amounted to 0.15 percent, while the average the past 10 years is a respectable 0.48 percent.

The Pension Fund – Norway, which is managed by Folketrygdfondet (the National Insurance Scheme Fund), enjoyed a 11.7 percent return last year (measured in NOK), while the average return since 1997 is 7.1 percent. The manager’s excess return in 2006 was 1.13 percent, while the 10-year average is close to the benchmark.

Review of investment strategy leads to increased equity allocation
The Government intends to increase the equity portion of the Government Pension Fund - Global from the current 40 percent to 60 percent.
- We now believe this represents an appropriate trade-off between expected risk and return. Since the first equity investments were made in 1998, we have gained experience and shown that we can handle volatility in returns without it undermining the Fund’s investment strategy or fiscal policy. The fact that we also have in place ethical guidelines for the Fund, speaks in favour of reviewing the equity allocation, says Minister of Finance Kristin Halvorsen. The change in the Fund’s asset allocation will take place over several years in order to minimize transaction costs.

Small-cap equities to be included in equity benchmark
The review of the Pension Fund - Global’s investment strategy has also resulted in an intention to increase the number of companies in the Pension Fund - Global by including the segment comprising small listed companies in the benchmark portfolio. Including small-cap equities in the benchmark will provide some diversification benefits and also give the Fund a broader exposure to the equity universe.

The White Paper also includes a discussion of the status of the Ministry’s effort to evaluate the possible inclusion of real estate and infrastructure as a new asset class under the Pension Fund - Global.

Investment universe expanded
One also intends to change the regulation of recognised markets and currencies. The Ministry of Finance has decided to move away from a detailed listing of which currencies and equity markets the Pension Fund - Global can be invested in. Instead, this decision will be delegated to Norges Bank. It is a precondition that there is in place satisfactory valuation, risk measurement and control procedures of the assets in question before such investments can take place.

New mechanism for excluding government bond investments
At the same time, there will be established a mechanism where the Ministry of Finance can exclude from the investment universe of the Pension Fund - Global government bonds issued by certain countries. This will provide clear lines of responsibility between the Ministry and Norges Bank. The bank can assess the economic and financial aspects of investing, while the Ministry has the possibility of excluding government bonds from certain countries. To avoid uncertainty associated with the purpose of the Fund’s investments, a decision to exclude a country’s sovereign bonds from the investment universe must reflect a broad political consensus. This will primarily concern countries subject to UN sanctions or where there are other international initiatives Norway is supporting. On the basis of the measures taken against Burma by the EU and other countries, the Ministry will issue guidelines to the effect that the Fund’s capital cannot be invested in any government bonds issued by Burma.

This exclusion mechanism will complement the procedure where the Ministry upon advice from the Council on Ethics can exclude equities and bonds issued by companies.

Ethical guidelines
The report addresses ethics and corporate governance, and contains, inter alia, a more detailed discussion of the corporate governance policies pursued by Norges Bank and Folketrygdfondet. The Fund’s ownership rights should be used with a view to ensuring that companies are well managed, respect human rights and protect the environment.  The Government will emphasise the interrelationship between use of ownership to influence companies and the evaluation of companies for possible exclusion. The exercise of ownership rights aimed at ensuring respect for fundamental ethical norms form part of a range of policy instruments, wherein which the exclusion of a company is the last resort. The report explains that in future the Government will be applying any decisions to exclude Nordic companies from the portfolio of the Government Pension Fund - Global to the Government Pension Fund – Norway as well. The report further states that the Government will evaluate the Ethical Guidelines for the Government Pension Fund - Global during the course of the present Storting period.

A new act on Folketrygdfondet
The Ministry is also submitting, in connection with the present Report, a proposal to the effect that Folketrygdfondet be organised as a separate legal entity pursuant to a designated special act, cf. Proposition No. 49 (2006–2007) to Odelstinget.

APPENDIX:
Background information on the Pension Fund
The Government Pension Fund was established with effect from 1 January 2006, encompassing the former Government Petroleum Fund and National Insurance Scheme Fund. The purpose of the Government Pension Fund is to facilitate government savings to fund the pension expenditure of the National Insurance Scheme, and to strengthen long-term considerations in the allocation of government petroleum revenues. To ensure that the petroleum revenues are contributing to the stable development of the Norwegian economy, the revenues shall be phased into the economy gradually, whilst the savings capital shall be invested outside Norway. The Government Pension Fund - Global contributes, by investing a significant part of the petroleum revenues abroad, to a capital outflow that offsets the impact of large and varying foreign exchange inflows from the petroleum sector on the Norwegian krone exchange rate.

The savings of the Pension Fund take the form of general fund accumulation. The Fund is fully integrated with the Fiscal Budget, in order to facilitate growth in the fund being a reflection of the State’s actual accumulation of financial assets. The Government Pension Fund does not have its own Executive Board or administrative staff.

Under the Pension Fund Act, the Ministry of Finance has been charged with managing the Fund. The Ministry determines the general investment strategy of the Pension Fund, as well as its ethical and corporate governance principles, and follows up on its operational management. The Government Pension Fund adopts a long investment horizon. The management responsibility includes ensuring that the Fund is managed with a view to maximizing return, given a moderate level of risk. This enables future generations to draw the maximum possible benefit from our savings capital as well. At the same time, we share responsibility, as investors, for the conduct of the companies in which the Fund invests. The Government is therefore concerned that ownership interests in the companies in which the Fund invests is exercised with a view to promoting good and responsible conduct, showing respect for human rights and the environment.

The Pension Fund is invested in securities issued by many different states and by companies in many different countries. Consequently, the risks facing the Fund are well diversified. The expected return and risk of the Pension Fund is in large part determined by the Ministry’s guidelines on how funds shall be invested. Norges Bank and Folketrygdfondet have been charged with the operational management of the Government Pension Fund - Global and the Government Pension Fund – Norway, respectively, within the guidelines laid down by the Ministry.

The management of the Government Pension Fund is subject to a high degree of openness. Stortinget is apprised of the investment framework and the Ministry’s follow-up of the Pension Fund on a regular basis. Operational management performance is also reported by Norges Bank and the National Insurance Scheme Fund on a regular basis. This is emphasised by the Ministry for purposes of strengthening the credibility of, and confidence in, the Fund and the fund structure.
 
The Government Pension Fund is one of the largest funds in the world, and its assets are growing rapidly. The Fund is large relative to the size of the Norwegian economy, and the return on the Fund will make considerable contributions to the funding of State expenditure in coming years. Focus on the management of the Fund has increased in line with the growth in its size. This underscores the importance of ensuring that the investment strategy of the Pension Fund, and its ethical and corporate governance guidelines, have the firm backing of Stortinget, and that the Ministry reports thoroughly on its follow-up of operational management.

The present Report primarily addresses matters relating to the management of the capital of the Government Pension Fund. More general issues relating to the management of the petroleum revenues, the position of the Fund within overall economic policy, as well as how much of the oil revenues should be spent and how much saved for the future, are discussed in the National Budget documents.