Swedish AP system put to the test

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 pummelled 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 Fahlstršm.

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 Fahlstršm.

"The second reason was power," he said. "They didn't want the funds to have political influence of Swedish public companies." Fahlstršm 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 Fahlstršm.

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 Fahlstršm 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 (See Q&A on page 14 for more details).

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 thatÉbut 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."


Managers face bonus backlash
The furore over bonuses continued to build as the Swedish government recently moved to ban bonuses at all government owned companies.

The move came after Swedish pension fund managers and financial providers came under increasing attack for rewarding their employees despite negative results.

Executives at buffer pension fund AP3 and pension manager AMF have returned their bonuses. But officials at AP1 have held strong on their decision to reward their investment staff in 2008.

Going forward, however, none of the AP funds will be offered bonuses, according to new regulation approved on 23 March.

The pressure on pension plans comes against a backdrop of increased scrutiny of Swedish financial players. Swedish bank SEB came under fire in March for offering pay raises to senior management in lieu of bonuses. The SEB eventually scrapped plans to hike pay.

The current stance couldn't be more different to the previous view. Just one year ago, the government changed the bonus structure allowing up to four months of pay to be issued as incentive pay, up from two months previously.

AP3 spokeswoman Christina Kusoffsky Hillesšy said: "The government has received a lot of criticism for changing the rules last July."

AP3 chief executive Kerstin Hessius gave back the bonus she received last year for strong 2007 performance in an effort to quell the public outcry against incentive pay.

Hessius is not the first pension manager to return her bonus but she may be the first to return a bonus received for strong performance in 2007, when AP3 saw returns of 5%. She did not receive a bonus in 2008 because AP3 posted negative returns of 19.8% last year.

"Since the debate has been going on we decided to partially go back to our old system which means that the ceiling for management will be lowered from four to two months possible performance-based bonus. Moreover, no bonus will be paid to anybody within AP3 for 2009 if the results for the fund for 2009 are negative," said Hillesšy.

She added that the CEO and head of risk and financial control had not been part of the performance-based incentive scheme. The move to lower the bonus cap is moot now that the government has axed all bonuses.

Senior executives at pension manager AMF gave back their bonuses after a local paper reported the firm gave out over SEK1m (US$118,473). Spokeswoman Johanna Sarfati also in mid-March confirmed the board of directors held a special meeting on Saturday (14 March) after a local paper reported executives had received bonuses despite weak overall returns.

AMF had earmarked SEK419,000 for CEO of the mutual fund business Fredrik Nordstršm, who has also forfeited a bonus, said Safarti. His actual bonus amount for 2008 had not been calculated but would have likely been less than the SEK419,000 amount, she added.

Chief investment officer Peder Hasslev did not receive a bonus because the system posted negative total returns in 2008, but stated that had he received one, he also would have returned it.

AMF posted a -6.6% return for 2008 and an early cut in equity holdings helped to stave off further losses. The MSCI World Index was down over 42% in the same time period. Pensions buffer fund AP1 bucked the trend of its sister fund and held strong in its decision to issue bonuses to its investment staff. The pension fund paid SEK1.6m (US$188,495) to over 30 members of staff, an amount equivalent to one and a half weeks to up to four weeks of pay per person.

AP1's managing director, Johann Magnusson said: "That is difficult to understand, of course in a year when we lost SEK48bn. The majority of these people receiving a bonus did not receive any increase in salary last year and will not receive an increase in salary this year.

The investment team contributed more than SEK1bn in alpha and that is the reason we pay them. We had an agreement with our employees and we are not going to break that. But, the management group did not take any bonus."

AP1 spokeswoman Nadine Viel Lamare said the fund will comply with the new government regulations but declined to comment further.

Other funds did not issue bonuses because of the negative overall returns. AP4, for example, returned -20.8% in 2008 and no bonuses were paid out for that year, said the fund's chief executive Mats Andersson.

A bonus doesn't drop down from heaven, it's something that you get if you deliver what was decided on in advance," he said. When the government allowed pensions to receive up to four months pay last year, the board at AP4 adopted the new bonuses ceiling with some provisions.

"There are some restrictions - salary will be frozen for two years. Negative total returns, if that happens, means there will be no bonuses. If the four months of bonuses should be paid out, we need to deliver 50 basis points above the benchmark," said Andersson. "I think that's a fair trade-off in my view for the pensioners and for the staff."

Some pension officials believe the bonus restrictions could hamper their ability to hire quality staff in the future.

"We need to be competitive," said AP4's Andersson. "If I don't get the talented people in-house, I need to hire them outside. But I need to have good people inside. You need to find the people that actually can see the challenge and the beauty of having a mandate like we have, with no solvency risk, we don't have to report returns everyday... it's a unique mandate we have."

AP1's Magnusson also said the bonus structure has a negative impact on their ability to attract talent.

"It's important for us not to have that kind of system," he said. "We don't have (equity-related) long-term incentives but we should have short-term incentives. The private sector has both. So we need short-term incentives to compete."

"Of course," added Magnusson, "this market is not the market where you have the toughest competition right now."