Första AP-fonden’s role, together with the Second, Third and Fourth AP funds (AP2, AP3, AP4 and AP6), is to act as a buffer in the Swedish pension system.
This means that the Fund’s assets and investment returns will be used for payment of pensions in periods when pension contributions are not sufficient to cover pension disbursements. The assets of the AP funds also play an important role in preventing the need for balancing of the pension system. This steers the choice of long-term investment orientation.
What is the required level of return?
Första AP-fonden’s goal is to achieve a high return and thereby contribute to high and predictable retirement pensions. Above all, this means that the assets must be managed in a way that minimizes the risk for automatic balancing in the pension system as far as possible. It is also important that different generations are treated equally. The combined assets of the AP funds, together with the pension system’s other assets and liabilities, determines whether or not the balancing mechanism is activated.
Because the buffer funds account for only a minor share of assets in the pension system (see section Do the AP funds affect income pensions?) the Fund must start by studying how liabilities and other assets (contribution asset) in the pension system are expected to grow before it is possible to set the desired return target for the Fund.
In simple terms, growth in the pension liability is influenced by two parameters; the average rate of wage/salary growth in Sweden and demographic changes. The contribution asset, on the other hand, is determined primarily by the number of people working and paying in pension fees in Sweden, as well as the number of years they choose to work. The more people who are working, and the longer they work, the greater the contribution asset.
The latest figures from the Swedish Social Insurance Agency (from year-end 2007) show that the pension system’s assets only marginally exceeded its liabilities. Inflow to the pension system (pension contributions) and outflow from the pension system (pension disbursements) are naturally also important. Until the end of 2008 there was a net inflow to the pension system, but this is expected to be replaced by a net outflow starting in 2009. Despite this, the pension system is expected to remain stable for the next 50-60 and the assets appear to be growing faster than the liabilities.
Net contribution in relation to pension liability
2009–2069
Source: SSIA
Pressures on the pension system in coming years can be alleviated in two ways. The first is if Sweden’s economic development, primarily the employment rate, is so strong that contributions to the pension system are higher than projected in current forecasts. Another is a high rate of return on the AP funds’ assets. According to Första AP-fonden’s calculations, the buffer funds must produce an average annual return of at least 5.5percent for many years into the future. This is the key determinant for the Fund’s choice of long-term investment orientation.
Which assets can the Fund invest in, and what returns are they expected to produce?
The Swedish National Pension Funds Act contains rules stipulating how the assets of the funds may be invested. With the exception of the 5 percent that may be invested in unlisted securities, the Fund’s assets may be invested only in listed instruments. In real terms, this means that the Fund’s portfolio must include a mix of fixed income securities, real estate and equities in Sweden and abroad.
Over time, equities have produced higher returns than fixed income investments. This is visible in statistics from the US financial market, where long time series for different asset classes are available.
The diagram on the following page shows that since 1973, US government bonds have returned an average of 8.5 percent annually, while equities have returned an average of 11.6 percent over the same period. However, variability of returns has also been higher for equities than for government bonds.
Fixed income and equities, return over the past 35 years
Index = 100, 31 Dec. 1972
Sources: Reuters EcoWin, Lehman Brothers
Investment rules
- Investments may be made in all types of listed and negotiable instruments on the capital market.
- At least 30 percent of each fund’s assets shall be invested in fixed income securities with low credit and liquidity risk.
- No more than 40 percent of a fund’s assets may be exposed to currency risk.
- No more than 5 percent of the assets of each fund, may be invested in unlisted securities. Investment in unlisted shares may only take place indirectly via shares in mutual funds or venture capital companies.
- Each fund may own no more than 10 percent of the votes in a single listed company. The limit for unlisted venture capital companies is set at 30 percent.
- Each fund’s holding of shares in listed Swedish companies may not exceed the equivalent of 2 percent of the total value of Swedish shares on an authorized Swedish stock exchange or marketplace.
- At least 10 percent of the assets of each fund shall be managed by external managers by purchase of mutual fund shares or discretionary management.
- The funds may not invest in commodities.
Why do equities have a higher expected return?
The rate of return an investor demands from an investment depends on how risky an investment is considered to be. For example, an investment in a government bond is not associated with any appreciable uncertainty. As long as the government backing the bond does not go bankrupt, the investor knows in advance the exact yield the investment will generate if held until maturity.
One alternative is to instead invest and contribute to the financing of a profit-driven company. This can be done by acquiring shares, which give the investor a stake in the company’s profits and value growth. However, the rate of return is uncertain and depends on the company’s profitability, which is turn influenced by factors such as its own strategy, market trends, the actions of its competitors, etc. Since it is not possible to calculate the return on an equity investment in advance, it is by definition more risky than a government bond. In order to attract capital and conduct its operations, a company must therefore offer a risk premium - a higher expected return than the expected yield from a government bond. Otherwise, investors would never choose to buy shares and would instead prefer the less risky bonds.
Because of this fundamental connection between return and risk, equities are expected to produce a higher average return than government bonds. The same applies to the other types of assets in which the Fund may invest.
What does that mean for the Fund’s choice of asset mix?
The Fund has calculated that its role in the pension system requires an average annual return of 5.5%. To have any chance of achieving an expected return of that magnitude, only a small share of the Fund’s portfolio can be invested in less risky assets.
To determine the precise asset mix, the Fund carries out an analysis in two stages. In the first of these, the ALM study, the Fund analyzes liabilities and other assets in the pension system together with the return and risk attributes of other assets classes and the covariance between them. The study is based on the Fund’s assumptions about the expected returns and risks associated with investments in bonds, real estate or shares. These assumptions are derived partly from historical return and risk data from the entire 1900s. But the Fund does not believe that history repeats itself entirely, and has therefore made sizeable adjustments in the historical patterns to obtain better assumptions for the future (for details, see fact box on the ALM study). This study determines the Fund’s optimal long-term asset allocation given a global economy and financial markets in sustainable equilibrium.
In the next stage the Fund decides how this asset allocation needs to be reweighted based on an analysis of de facto trends in the economy, asset prices and risk premiums and how these are expected to change in a mid-term perspective (2–10 years ). Första AP-fonden calls the asset mix resulting from these analyses the strategic benchmark.
ALM study
By conducting an ALM study the Fund has calculated the level of return required from the buffer funds in the pension system. The same study also answers the question of what level of risk is appropriate. The fundamental aims of the ALM study are:
- to maximize the Fund’s ability to contribute towards upholding the desired status of the pension system, where one critical characteristic is that pension benefits are normally indexed for average income growth in Sweden.
- to manage the fund capital so as to minimize the risk for automatic balancing.
- to maintain neutrality between generations.
- to compute outcomes based on the Swedish Social Insurance Agency’s three scenarios for financial development of the pension system over the next 50 years.
The Fund has made assumptions about the level of risk and return that can be expected from investments in bonds, real estate and equities. The assumptions are based partly on historical data, but significant adjustments have been made. In short, these assumptions are that:
- a bond investment is expected to produce a return of around 2 percent above inflation – with some variation between regions.
- equities are expected to have an average annual return of over 3 percentage points more than bonds. Also here, there are variations between equity markets.
- real estate is expected to produce a return somewhere in between that of bonds and equities.
Although returns in the different markets will vary from year to year, these are the rates of return expected by the Fund seen over a longer period of time.
The Fund has used a model of the pension system and capital market to simulate the pension system’s development. In this model, the Swedish Social Insurance Agency’s scenarios have been linked to hypothetical trends in the capital markets over the next 60 years. For every individual year and outcome, a number of key variables are calculated and weighted together in a balancing loss figure for the entire pension system. The investment strategy that results in the lowest balancing loss determines the composition of the ALM portfolio.
This model is also used to decide on the mix within each asset class (sector allocation, type of security, etc.) to make the strategic benchmark as well diversified as possible and to analyze to what degree these assets should be hedged.
Conclusions from the ALM study
The Fund completed a new ALM study at the beginning of 2008. The study shows that the allocation between equities and fixed income assets is critical for Första AP-fonden’s ability to meet its return target. An allocation in which the Fund’s entire portfolio is invested in fixed income assets will result in failure to achieve the targeted return. With only fixed income assets in the strategic benchmark, the Fund’s return would be so low that the automatic balancing mechanism would be activated on many occasions.
Instead, it has been demonstrated that a portfolio containing a predominance of equities provides better scope for the Fund to meet its objectives since it is expected to generate a higher return over time, which is positive for the pension system. According to the new ALM study, the Fund should raise the share of equities in its portfolio.
Another conclusion is that the financial risks assumed by the Fund, in both equities and fixed income investments, should be given a wide spread in many global markets.
In a longer perspective, additional diversification of risk can be achieved through exposure to foreign currencies. Foreign currency exposure is spread across euros, US dollars, British pounds, Japanese yen, Norwegian kroner and emerging market economies. The chosen currency exposure provides a spread of risk that is independent from the Fund’s allocation between asset classes and regions.
Strategic benchmark
The ALM study culminates in a long-term investment strategy that that optimizes the Fund’s potential to fulfil its long-term obligations in the pension system. To finally determine the optimal asset allocation in the strategic benchmark, the Fund uses two additional analyses in a mid-term perspective (2–10 years) to identify whether there are imbalances in the economy, pricing errors in the financial markets or risk premiums that the Fund can utilise to further increase the expected long-term return.
Based on the results of the ALM study and mid-term analysis, the Fund began implementing the new strategic benchmark in May 2008. In view of the current turbulence in the financial markets, however, the Fund has chosen not to complete the implementation. At year-end 2008 the strategic benchmark consisted of 55 percent equities, 40 percent fixed income assets and 5 percent alternative investments. Foreign currency exposure was equal to 20 percent of total net assets.
The majority of equity investments are placed in foreign markets, primarily in North America, Europe and the Pacific. Of total equity exposure in the strategic benchmark, emerging markets make up nearly one tenth and Swedish equities one fifth. Allocation in the fixed income asset class is also spread across several regions – North America, Europe, Japan and Sweden – but the most important diversification of risk is attained by spreading the fixed income assets between nominal treasury bills, index-linked bonds and credit bonds.
The chosen strategic benchmark provides a wide spread of risk and is expected to give the Fund good potential, over time, to generate the level of return required in the pension system’s buffer funds.
Strategic benchmark, 31 Dec. 2008
The index for each asset class is shown
on the Fund’s website www.ap1.se.
