Since the end of World War Two, Sweden has ranked as one of the most politically stable countries in the developed world. And yet despite this, a quiet revolution is underway in the placid, Nordic nation—one that could have financial repercussions for generations to come.
Nearly 14 years after it was first established, the country’s much-admired “buffer funds” system, which invests the bulk of state pension assets, is set to be overhauled. Five funds will become three and will be run under a new governance structure that should give them more flexibility to invest in unlisted assets.
That is the basic story. In reality, over the next few months the men and women of the buffer funds will attempt to navigate a series of known and unknown challenges. Supporters of the status quo will continue to argue against the changes, but as one affected CIO suggests, it is perhaps worth looking at the bigger picture.
Chief Investment Officer (CIO) saw Sweden as a perfect case study on the problems that come with growing pension funds, and promptly jetted off to Stockholm to find out more.
For the uninitiated, the AP buffer funds consist of AP1, 2, 3, and 4, which each manage more than SEK250 billion (€27 billion), and AP6, which has roughly SEK22 billion due to its specialist private equity mandate. Don’t ask about AP5—there isn’t one—and a default fund, AP7, is an entirely different animal.
Proposals published in March, after two years of debate, set out a plan to reduce the number of buffer funds by merging two away, which would swell the coffers of the remaining three by roughly SEK100 billion (€10.9 billion) each. This, according to the cross-party group of politicians responsible for the reforms, should reduce costs and introduce better economies of scale to the funds.
As CIO found out, handling an extra SEK100 billion is the least of anyone’s worries.
“They are talking about cost-cutting and are against active management—even though the AP funds all have positive returns from active management, they still don’t believe in it. The politicians are thinking of a long-only equity portfolio.”
US politician Bert Lance is often cited as having coined the phrase “if it ain’t broke, don’t fix it” (shortly before he resigned amid accusations of corruption). Now something of a cliché, it is used to attack those seeking to change the status quo.
The chances are it’s been muttered by more than one Swedish pension professional in the past two years (albeit using better English). Mats Andersson, CEO of AP4, could be one of them: “When I meet foreign colleagues who run similar mandates they are impressed by the costs and returns we achieve. In Sweden it’s not good enough. The system isn’t broken. I can’t really understand it.”
While Andersson’s tone is one of mild bemusement, over at AP3 Gustaf Hagerud is far more openly critical of the proposals.
As we sit in a meeting room at AP3’s Stockholm headquarters, the deputy CEO and head of asset management explains—with the aid of the whiteboard all Swedish meetings must utilise—that the economies of scale argument is “strange” given the AP funds’ already low operating costs. He is also very worried about an apparent aversion to active management from politicians.
“They are talking about cost-cutting and are against active management—even though the AP funds all have positive returns from active management, they still don’t believe in it,” Hagerud says.
“The politicians are thinking of a long-only equity portfolio of European large caps. They think that’s what we’re running. [AP3 has 10% in European equity.] We have made very good active returns. But they want to get rid of active returns and reduce risk.”
Before we get to the details, it is worth taking a step back in an attempt to understand why such tinkering is (believed to be) necessary.
One Nordic asset management sales executive suggests to me that the changes may well have their roots in the Swedish banking crisis of the early 1990s. Peter Englund, a Swedish economist and professor at the Stockholm School of Economics, describes in a 1999 paper how a period of deregulation between 1983 and 1985 lifted many restrictions on lending, fuelling an asset price boom that—with the aid of other financial wobbles around the world—unwound spectacularly between 1990 and 1992. A number of financial services companies, including the large Gota Bank, went bust. Sound familiar?
So emerged a conservative mindset within Swedish finance, particularly regarding regulation. This led to, among other things, the introduction of a “traffic light” system for pension fund solvency, ensuring private sector funds are always in surplus. Speaking at a Nordic conference last year, former CFA Institute CEO John Rogers urged other countries to follow Sweden’s example and embrace similar regulatory changes, as the country’s economy had emerged relatively unscathed from the financial crisis that had rocked much of the developed world.
It is this conservative mindset that may well have influenced the AP funds review, I am told. In the market crash of 2008 to 2009, high equity exposures across the four main AP funds meant pensioner benefits had to be reduced. This is exactly how the system was designed to work: removing the risk of cross-subsidy across the generations. But Swedish pensioners were not happy, and politicians were urged to look again at a system which had seemingly worked smoothly for nearly 10 years since inception.
Chairing the group tasked with the review was Mats Langensjö, a former senior director at Goldman Sachs and Aon Consulting. Together with a panel of independent experts, he was asked by the Swedish government in 2011 to review the structure of the AP funds in the context of the whole pension system.
Langensjö’s case for reform was that the AP funds were “not given that much attention” when Sweden last overhauled its benefits system in the late 1990s. “The pension system is well thought through but any professional would see structural problems with the buffer funds if they looked at them carefully,” he says. Chief among those structural problems are the “old-fashioned” investment guidelines. With stringent rules written into law, the four main AP funds look remarkably similar in terms of asset allocation.
Langensjö says: “The AP funds were launched just before the IT crash, they went through the financial crisis, they have been through a high interest rate environment, and are now going through a low interest rate environment. They need to have much more freedom to move with those changes.”
In addition, Langensjö claims the funds are effectively evaluating themselves under the current system, as each has its own independent board. His report recommended just one independent committee—the pension reserve board—to oversee the three funds and to be responsible for setting objectives, creating strategic portfolios, and monitoring performance.
(Art by Brad Holland)
Greater investment flexibility is usually seen as a good thing—it is doubtful any CIO would argue against this—but the idea of a single committee setting objectives, budgets, and designing target portfolios for all three funds is not one which sits well with those likely to be responsible for implementing what it decrees.
One reason for this is the fear of political interference—one that has been expressed by those outside, as well as inside, the AP system.
This fear is not unfounded: In 2009, the buffer funds had to bring in lawyers to convince politicians that the funds could not be forced to vote against bonus packages at listed Swedish companies. It is feared that without independent boards they may not be able to resist next time.
AP3’s Hagerud highlights infrastructure investments as an area of particular concern. Although he prefers to deal in local assets that remove currency risks and that his team understands well, he does not want to be “forced to make a bad investment” by short-term political moves.
Interestingly, Langensjö does not dispel this concern. His review argued for the pension reserve board to be more independent than the March report indicates it will be.
“We wanted to have a much more arm’s length approach with an independent pension reserve board,” he says. “It remains to be seen how independent it will be. If the money’s not there the state still has to pick up the bill, so there needs to be some kind of link to government.”
The structure of the pension reserve board, as suggested by the government’s report in March, also tasks it with setting budgets for the new funds. The AP funds, which have all made good money out of active management, are concerned the government and the new board will seek to push them away from active into passive.
AP4’s Andersson argues that, while active management comes with a higher cost, this is more than outweighed by the returns his fund has achieved. “Our cost of active management is roughly $10 million,” he says. “For paying that, we have made an excess return of $1 billion.”
He adds that constraints could threaten the AP funds’ ability to take advantage of long-term active management (they don’t have set liabilities like standard defined benefit pensions).
Even Langensjö is concerned by this development, which his review did not propose.
“It is very clear that the AP funds should have the full ability to achieve their objective,” he says. “Where [budget constraints] will lead I don’t know. I can understand the fear and the implications it can have depending on how the budget-setting system is set up.”
Hans Fahlin, CIO of AP2, says: “The funds are run in a very efficient way, and that’s been done repeatedly over the years. The multi-fund structure has not led to significant losses in scale advantage. I don’t think the commission’s report showed in any meaningful way that there would be [scale] advantages.”
Other independent voices have cast doubt on the “economies of scale” argument. Speaking to the Financial Times in March, Torbjörn Hållö, an economist at the Swedish Trade Union Confederation, said the cost/benefits case “seems weak”, while consultant Amin Rajan, chief executive of Create Research, added that “mergers justified on cost grounds alone rarely work in people businesses”.
“We wanted to have a much more arm’s length approach with an independent pension reserve board. It remains to be seen how independent it will be.”
It is interesting to note that Langensjö’s report suggested that a single fund—which would be worth in excess of SEK1 trillion, or €117 billion—could have been a preferable option in terms of cost savings, although it had already been ruled out by government. Some in Sweden think it should have been given more thought. Langensjö comments only that the expert panel “looked into” the idea, which it argued could be suitable because the buffer funds share a single objective.
Implementation is currently set for 2016 and details are expected by the end of the year, once the dust has settled from a September general election. There is much speculation—and some tantalising nuggets of information—about how the transition from five funds to three will happen. But, in stark contrast to Stockholm’s gloriously hot July sunshine, uncertainty is hanging over the AP funds like a dark cloud.
The parliamentary committee has already stated that one of the three funds will be based in Gothenburg. AP2 and AP6 are both based there and, as the latter is all but certain to close, the second buffer fund is likely to be relatively unscathed—although Fahlin is quick to point out that there are a number of ways the changes could be implemented.
For AP1, AP3, and AP4, the next 18 months could be very difficult. Mikael Angberg only joined AP1 as CIO at the end of 2013 and must attempt to implement his own processes while facing an uncertain future. And AP4’s Andersson, having turned around his fund from a serial underperformer to the star of the quartet, can only hope that his efforts and those of his staff have been recognised.
All this is almost certain to affect the funds’ chances of retaining staff and hiring new people, the bosses say—especially if the politicians succeed in a proposal to cap the salaries of AP fund staff significantly below their current levels.
Andersson says: “Salaries should be in line with the market and not ahead; that is how it is now. I still don’t know why they are trying to cut wages—perhaps there is an elemental distrust between the funds and parliament.”
“There is a risk that we will lose talented people because of the unknown,” says Hagerud. “Talented portfolio managers could leave and we can’t really hire anyone.”
Even Fahlin, whose fund is expected to survive the reform, says “there really is no point in trying to build teams or set up new units” before more details become clear.
“The parliamentary group is made up of MPs who have a mandate from the Swedish people to make these decisions,” he says. “This is democracy at work.” A stable democracy, historically—but one now likely to unleash chaos (intended or not) within its own highly respected piggy bank.
Note: An earlier version of this article stated that AP3 had been cited as the fund to be closed. CIO has since been informed that this is not the case. We are happy to clarify this misunderstanding.