AP funds separate and equal

The Swedish government reformed its pension system more than a decade ago and has since endured market extremes that would test even the most established benefit arrangements.

Back in 1998 when faced with the now familiar problem of rising pension costs exacerbated by periods of poor economic growth, the Swedish government overhauled the retirement system, introducing a national pay as you go plan. Over the next five years, workers were gradually enrolled into the scheme which sees 16% of an employee’s salary paid into a Notional Defined Contribution (NDC) plan and 2.5% into a Premium Pension (PP), both of which are converted into an annuity on retirement.

In order to ensure benefit payments can keep pace with rising longevity, the fund’s assets are supported by the Swedish buffer funds, better known as the AP funds. The funds invest across a variety of asset classes according to strict guidelines (see box out) in order to generate about 10% of the total assets. 

AP Funds 1 to 6, excluding AP5 which no longer exists, manage any surplus or deficit, while the seventh AP fund essentially acts as a default strategy for investors who make no active choice with their investment.

One-quarter of the contributions paid into the NDC plan goes to AP 1 to 4 and at the end of December 2009, these four reserve funds were responsible for collecting SEK203bn (€22.2bn) and redistributing SEK217bn.

The power of one

To understand the financial status of the Swedish pension system, when it is in perfect health its balance is expressed as 1; when it moves into surplus the figure climbs above 1; and when in deficit it falls below. In 2008, following the financial crisis, the figure fell below one for the first time since 2001 hitting 0.9672 having been 1.0026 in the previous year and from highs of 1.0149 in 2006. 

Consequently the buffer funds are now obliged to make additional payments to the Swedish Insurance Agency to help plug the gap, which has seen their costs rise yet further and had a negative impact on fund capital. However from October 2009, to better reflect the long-term nature of pension investing, the market value of the buffer funds was replaced by a three-year average to help smooth the impact of market volatility and give a ‘fairer’ picture of the Swedish retirement system’s financial health. The impact of the rebalancing, alongside slow economic growth and falling consumer prices, means that pensions will be reduced in Sweden by 3% and will not return to ‘normal’ levels until 2012.

Since the AP funds have failed to contribute to the financing of the Swedish pension system (see Chart 1) and there is considerable concern over rising costs, critics have started to question whether things are working as they should. Indeed, feelings were running so high that in January 2009, the government commissioned a review of the AP funds to see how resources were being used and if improvements could be made.   

In their report, Restructuring AP Funds for Scale and Global Impact, Swedish Financial Services Authority director Malin Björkmo, and Stefan Lundbergh head of the innovation centre of All Pensions Group (APG) in the Netherlands, made several recommendations for improving management. These centred on three main areas: creating more economies of scale; improving governance structures; and revisiting the investment rules.

Although the Swedish government had shown an interest in greater collaboration by merging the AP funds’ administrative functions via the Swedish Pension Agency in January this year, it has since rejected Björkmo’s and Lundbergh’s report after members of the Parliamentary Pensions Group failed to reach consensus on how to proceed. 

The collapse of the government commissioned review was then followed in 2010 by a collaborative study between the first four AP Funds which considered the potential for reducing administrative costs through increased cooperation between the funds’ respective business support units; an exercise which concluded that any kind of merger would prove counterproductive. 

AP2’s chief executive Eva Halvarsson said: “The results of these studies revealed that the potential savings would be fairly limited, would involve considerable establishment costs and pose clear risks to the funds’ business activities.”

While reform of the AP funds is far from dead and buried – the government claims it is committed to reducing costs in the pension system – the delay in finding a solution could prove costly.

Björkmo and Lundbergh said: “It should be kept in mind that uncertainty concerning the future of the current AP funds can in itself create costs.”

Looking ahead

In the mean time, the AP funds said they are still striving to improve systems and processes, and note that they already combine forces on responsible investment via the Ethical Council, and cooperate on tax related questions; accounting issues; common legal matters; and common voting platform for foreign holdings.

In a joint statement to Global Pensions the first four AP funds, said: “Each fund has very high ambitions to be as cost-efficient as possible. AP1, AP2, AP3 and AP4 already cooperate in a lot of different areas. We also continuously have an experience and knowledge exchange within several areas.”

And in a move to further develop current cooperation and promote greater transparency, the AP funds have established a special forum for collaboration, which will comprise the First, Second, Third, and Fourth AP Funds, as well as the Sixth and Seventh AP Funds. The idea is to reduce unnecessary expenditure within the framework of the existing organisational structures, while continuing to monitor cost efficiency as “a natural part of the day-to-day activities”.

The AP spokesperson added: “This will first and foremost involve the funds’ business support units and certain staff functions. This closer collaboration aims to reduce costs through increased transparency. It also offers the possibility of signing joint agreements with suppliers and business partners. At the same time, this collaboration must be formulated in such a manner as to avoid restricting the funds’ abilities to compete freely with each other.”

However Björkmo and Lundbergh question the value of the AP funds competing with each other since they failed to outperform their benchmarks over time. As Chart 1 shows, a competitive element has done little to enhance returns and the report’s authors said the funds’ focus should be on outperforming overall rather than outperforming each other.

Looking to the future, the AP funds claim that any decisions taken on merging their operations is “not a question for [us], it’s a question for the Swedish parliament”, yet they do have views on how costs and resources can be managed more effectively going forward.

The AP funds are keen to develop more cost-effective investment portfolios and most of the four funds have reformed their strategies over the past year, placing a greater emphasis on absolute rather than benchmark returns.

“Our responsibility is to ensure that these Swedish pension assets are invested as efficiently as possible. In pursuing this aim, we therefore constantly review every aspect of our operations to ensure and develop cost-efficient portfolio management that unites high quality with high security,” the spokesperson said.

However, in spite of an obvious desire to take active steps and reduce the drain on the public purse while improving their investment management, the AP funds also remain determined to protect at least some of the status quo. 

AP3’s chief executive Kerstin Hessius said: “Unfortunately, there is a tendency to focus on costs in isolation as income is harder to estimate. A simplistic debate undermines confidence in the pension system. Continuous monitoring and analysis of the pension system is paramount, but an informed debate is just as important.”

With so little immediate direction from government the AP funds’ future remains decidedly unclear. They seem to be grappling with the contradictory demands of maintaining a competitive element while engaging in greater cooperation. Yet, until they can prove they are adding value and running as cost effectively as possible, they will continue to face pressure to update their operations irrespective of the challenges that creates.

AP Fund primary investment rules

• At least 30% of assets must be invested in low-risk fixed income securities.
• No more than 40% of its assets should be exposed to currency risk.
• The Fund may hold shares corresponding to no more than 10% of the voting rights in any single listed company.
• Equity holdings may not exceed 2% of the capitalisation of the Stockholm stock market.
• A maximum of 5% of assets can be invested in private equity. Such investments must be made indirectly via private equity firms or mutual funds.
• At least 10% of a fund’s assets must be managed by external managers.
• May not invest in commodities.

Source: AP3 annual report 2009