It's been nearly a decade since the Swedish pension system was established and the economic crisis is giving it its first test.
The system is set up as pay-as-you-go with incoming contributions used to pay the benefits of current retirees while five so-called AP funds are used as buffers to cover future contributions.
But for the first time since this system was established in 2000, Sweden’s pension liabilities have outpaced their overall assets and regulators are questioning whether the original set up works.
As a result, conversations are brewing about merging the five AP funds into one superfund with some SEK707bn ($US86.7bn) in assets.
“It’s a discussion that’s been going on since they started the system,” said AP4’s chief executive Mats Andersson. “In times like these, it’s pretty obvious the discussions will come again.”
A committee within the Ministry of Finance is already doing a review of the AP funds testing the feasibility of combining the funds. It is separately looking at whether or not more passive management should be mandated, said deputy director of the expert committee on public finance, Harry Flam. Flam said he plans to present the report this summer.
It’s against this backdrop of the potential of increased regulation that some AP managers are clamouring for more freedom. They are calling for a loosening of the investment guidelines that limit the funds’ asset allocations, claiming that will go a long way in helping prevent further losses.
Each of the five funds have been taking a hard look at their investment processes with some going as far as completely overhauling their investment styles in an attempt to boost returns. The funds have also generally been shifting more towards passive management in order to maintain equity risk without taking on excess active management risk.
The buffer funds – AP1, AP2, AP3, AP4 and AP6 – have come under attack for weak returns in 2008.
Coming into the financial crisis, the AP funds were at somewhat of a disadvantage because of their higher equity allocation, market watchers said. The AP funds account for approximately 10% of the overall assets in the pay-as-you-go system, but because of their role of using their investments to buffer against potential shortfalls, they take on equity risk to shore up returns.
On average, the funds hold about 55%to 60% in equities. This pummeled the funds in 2008 when the MSCI World Index was down over 42%.
Last year, the SEK173.3bn AP2 lost 24%, the SEK171.6bn AP1 lost 21.9% and the SEK16.4bn AP4 lost 16.6%. The remaining funds, the SEK181bn AP3 and the SEK16.4bn AP6 were down 19.8% and 16.6% respectively.
Rebalancing the system
In its 2008 report released in March, the Swedish Social Insurance Agency said the balance ratio, the ratio between assets and liabilities had fallen to 0.9672, meaning pension payments would need to be slashed the following year to re-balance the system. This “break” in the balance ratio is partly due to the poor returns of the AP funds.
In 2007, the balance ratio was 1.0026. The system is considered “balanced” when the balance ratio equals one.
Flam believes that eventually shifting to one pension fund is unavoidable. “It is obvious that in fund management there are economies of scale. We have four funds that are basically doing the same thing,” he said.
Flam’s “back of the envelope calculation” estimates the government would save some SEK1bn by only having one AP fund.
“I think it would be a good idea to evaluate the potential benefits of merging them,” said Wassum Investment Consulting’s senior investment consultant Nicklas Fahlström.
However, there were valid reasons for setting up the numerous AP funds. The government’s intention in setting up so many funds was to have investment diversification, said Fahlström.
“The second reason was power,” he said. “They didn’t want the funds to have political influence of Swedish public companies.” Fahlström said there was also a concern that a single fund would be so large, it could influence the markets when implementing trades.
“I’m not sure these reasons are valid today,” said Fahlström.
“Because of the investment restrictions, it makes sense that we look very similar,” said AP1 spokeswoman Nadine Viel Lamare. “So the government paid a lot to have diversity, that because of the investment restrictions, they didn’t get.”
Managing director at AP1 Johan Magnusson said: “The investment guidelines are old and they need to be looked at once again.”
Each AP fund must invest at least 30% of its assets in low-risk, fixed income securities, a maximum of 5% can be invested in private equity and a maximum of 40% of assets may be exposed to currency risk.
The funds cannot invest in commodities, cannot own shares worth more than 10% of the voting equity in a listed company and the value of the portfolio’s equity holdings cannot exceed 2% of the capitalisation of the Stockholm stock market.
External managers must manage at least 10% of the fund. The funds can invest in derivatives to manage risk and are allowed to invest in real estate without any restrictions.
AP3’s chief investment officer Erik Valtonen called the guidelines “outdated”.
Barring the investment guidelines, AP3 would invest more than 20% in alternatives within the portfolio, the current target allocation.
“For example, infrastructure is quite a good asset class for a long-term pension fund. So we would probably increase the allocation to alternatives. How much, I don’t know, but to some extent, certainly.”
AP4’s Andersson said the 30% limit on fixed income is too high.
Andersson said: “When we use ALM (asset liability modelling)... we end up with 80% to 90% equities and we can’t have that. So we end up with, in practice, 60% equities... we should have more than we are allowed to have.”
Wassum’s Fahlström believes in doing away with investment limits. “They should really not be restricted at all,” he said.
He believes the board of directors should have leeway to construct their own investment policies and then defend them to the Ministry of Finance, which oversees the AP funds.
But, he added staff at the funds do have the scope to implement their own asset mixes as long as they remain within the restrictions.
Return of the generalists
While each of the funds are tackling the financial crisis in their own way their strategies all demonstrate an underlying shift towards passive management.
AP1, for example, is overhauling the way it manages money by placing a greater emphasis on the top-down analysis than on bottom-up stock picking.
The goal was to focus more on the strategic asset allocation, as opposed to active management, said Magnusson. As a result, the fund plans to decrease its overall allocation to active management.
Separately, he said the fund is building up its alternatives capabilities. The fund has been actively trying to grow its private equity portfolio to reach its 4% target. Private equity is currently 1.1% of the total portfolio and the fund is aiming for an 8% real estate target, from a current allocation of nearly 5%.
AP2 has taken similar steps and has ramped up its passive management after returns of -24% in 2008.
“Given the turbulence on financial markets, a number of decisions were taken during the year to limit the risk in the portfolio,” read the fund’s 2008 annual report. “These included a decision in the autumn to reduce risk in equity portfolios managed in-house. Furthermore, the Fund’s positions in fixed-income and foreign-exchange markets were reduced.”
Meanwhile, the pension fund has reorganised its management structure and done away with its alpha teams.
In 2009, the fund’s investment teams consist of an equities management team, a fixed income team, an external mandate team and a team for strategic exposure and trading.
This is a turnaround for the fund, which in 2007 implemented the use of separate alpha teams – Swedish Alpha Strategies and Global Alpha Strategies. The fund also had a Quantitative Strategies team and External Managers team.
However, the 2007 structure “resulted in less diversification than expected,” according to the 2008 annual report. The new organisation, and the focus on passive management, is meant to “promote a clearer focus, featuring greater simplicity and flexibility.”
With almost all portfolios taking a beating in the market downturn, most Swedish funds have moved to take risk off the table, said Barclays Global Investors’ head of Nordic sales Rune Sanbeck.
“Before there was a very strong trend to separate alpha from beta,” he said. “Now there is a strong trend to take risk down. Not equity risk, but to take down active management risk.”
Rune said Swedish clients are demanding active mandates with tracking errors of two to three basis points, whereas one year ago, clients were allowing a tracking error of up to six basis points.
“There is a trend to make the organisational structure more traditional,” he added.
Pension provider AMF’s chief investment officer Peder Hasslev said: “For me, it is a return of the generalists.”
He continued: “We had a wave of specialisation. A lot of ‘the more focused you are, the better it is’. This was really the other way around. It was the big picture that got it more right than the rest.”
AMF drastically lowered its equity holdings in 2008, helping to stave off heavier losses than it would have otherwise.
The fund posted a -6.6% return for 2008, well outperforming the global equity markets. Total equity holdings were 34.5% at December 31, down eight percentage points from the end of 2007 and 16.5 percentage points from 18 months earlier.
Hasslev said it was his fixed income team that warned the financial crisis was taking a turn for the worse. “It was people in the fixed income department that perceived this threat much earlier than equity people did in general. Equity people, most of them are bottom up.”
Following their own path
AP3 is taking a different tack with an alpha/beta program that roughly paralleled that of AP2’s. Officials said they are sticking to the strategy.
AP3 has completely separated alpha from beta and done away with its separate fixed income and equity team. Now the beta team works to build equity exposure while the alpha team works against a monetary target to bring in excess returns.
“You could say that we are running an internal multi-strategy hedge fund,” said Valtonen. “Some people are doing proprietary FX trading, some fixed income mandates, a couple of long/short mandates and together they form a sort of multi-strategy hedge fund.”
However, the fund also sees value in passive management. The fund’s global equity portfolio is almost completely managed passively and Valtonen does not see that changing.
“Active management – old fashioned long-only active management – the time for that is gone,” said Valtonen.
AP4, however, is looking to increase its active management.
“I have a view on active management, because I believe you need to be flexible. Some years you should use less than others,” said AP4’s Andersson.
“Right now I think the opportunities are better than they have been for many years. Many of the managers are giving up and are selling stuff that they need to sell, rather than they want to sell. So the mispricing in the market has been great,” he said.
Andersson said the fund plans to increase its level of active management. “At the end of last year we were totally passive in global equities but we will gradually move away from that.”
Fidelity’s head of Nordic institutional business Asgeir Thordarson has also seen the trend towards more transparency and simplicity. He thinks Sweden’s equity culture will not go away but that a more holistic view on portfolio management will emerge from the economic rubble.
“There will be some changes in asset allocation. Not that the equity culture will go away, I think the equity culture in Sweden is stronger than that…but it will more be that holistic portfolio management will be more prevalent and this will probably lead to additional asset classes and more broadly diversified portfolios.”
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