sou · H0B353 · 2012-08-24 00:00:00 — at ment (ICPM) has done extensive research on the relationship between pension fund size, governance and performance1. A 2011 study by Dyck and Pomorski found that the largest funds included in their study outperformed smaller funds on the order of 43–50 basis points per annum. 32.To summarise, given that the AP funds 1 to 4 do not have excessive operating costs on an international basis if measured as a percentage of fund assets, and have in fact a lower cost measure than some significantly large public pension reserve funds, the basis for further cost reduction may not be major. Furthermore, given that the costs do not appear to be excessive by international stand- ards, the performance measure of the funds made in the current and future reviews could arguably focus more on the performance of the funds against their long-term objectives as well as the long- term net investment return, and consider operating costs as a com- plementary, rather than as a primary performance criteria. 33.Finally, it should be noted that the has not reviewed the remuneration policies of the in depth, but they appear to follow good practice. That said, such policies should work to pro- mote performance in alignment with the long-term investment goals of the funds. Remuneration policies should be careful not to reward short-term performance to the detriment of the long-term objectives of the funds. Political pressure and interference of public pension reserves remains a high risk around the world, especially in times of eco- nomic stress. A structure of multiple, independent funds is a com- approach to addressing this risk as well as the risk of con- centrating too much power in a few hands. On the other hand, the visibility of one large, properly governed and independent fund may serve as greater protection to outside interference as compared to the relative anonymity of several smaller funds. That said, meas- 1 See research at /research_paper/research-papers uring the effectiveness of various approaches to mitigating political risk is quite difficult given the numerous shapes such risk can take. Given that the assets in a pension reserve fund ultimately belong to current and future pensioners, the funds and their management should ultimately be answerable to a countrys electorate which means they can never be fully independent of the political process. 35.It is important to note, however, that susceptibility to political pressure does not have to be correlated to the number of funds. The very public nature of the funds mission and the large amounts of money involved can make them an inviting target. Furthermore, the line between decisions made based on political and investment considerations is not always fully distinct. For example, during the financial crisis in early 2009, the Irish parliament directed the Irish pension reserve fund assets to invest in two ailing banks.2 Propo- nents said this was a decision based on investment considerations, whereas critics argued that it was a misuse of the funds assets. Another example of a significant change in a reserve funds man- date during the crisis was in where the government moved the date of the first payout from the pension reserve fund from the original scheduled date in 2020 to immediate payments as of 2011.3 Political considerations could also come into play is when invest- ment decisions are made based on ethical grounds. Defining what is ethical and what is not and to what extent such investment deci- sions favour a particular political agenda over providing the highest pensions possible to current and future beneficiaries can be diffi- cult to establish. 36.In 2009, the government issued a directive asking the AP funds to use their ownership rights in Swedish companies to help align the companies compensation policies with the governments guide- lines (, 2009). This directive raised the question as to what extent the decision-making power of the AP funds is independent of the government, and to what extent it should be independent. 37.The government should clarify whether the AP funds are inde- pendent in their exercise of voting rights. If it is decided that the AP funds cannot use their voting rights in listed companies to vote against government policies, then if they can vote and how they can vote should be established in a clear and transparent . To summarize, political interference and the concentration of power remains a risk in many countries, especially during times of economic uncertainty. Proper governance, transparency and disclo- sure and appropriate levels of risk control and supervision can mitigate, but not altogether eliminate this risk. Governance and oversight are further discussed in the governance section of this paper, found below. Mandate and High-Level Objectives: AP funds 1 to 4 39.The mandate of the Swedish AP funds 1 to 4 as defined by law is to manage fund assets in such a so as to achieve the greatest possible return on the income-based retirement pension insurance. The total risk level of the investments made by the Funds must be low.4 In addition, the funds must be able to trans- fer funds to the as required. 40.This type of over-arching mandate describing the ultimate pur- pose of the AP funds is typical for pension reserve funds. Given that this over-arching mandate tends to be quite broad, the gov- ernment or the governing board of national pension reserve funds must furthermore interpret their mandate in order to set their long-term investment objectives. The long-term investment objec- tive guides the funds in fulfilling their mandates by providing more specific long-term targets for the funds investments, and would also ideally provide some type of guidance, structure or benchmark against which the funds performance could be objectively meas- ured. Pension reserve funds such as the Pension Plan and the have expressed their long- term investment objectives in a transparent, targeted and measura- ble , whereas some other pension reserve funds long-term investment objectives are more vague in their formulation. 4 From the English translation provided by the Inquiry of the Act, Lag (2000:192) om allmänna pensionsfonder (AP-fonder). The interpretation of the AP funds over-arching mandate and the establishing of a high-level investment objective is done by each of the four AP funds independently. In practice, this has translated into four very distinct long-term investment objectives for 1 through 4, subject to strict investment restrictions codified by law. The lack of a coordinated and targeted investment objective for all of the AP funds and the lack of a concrete and common long-term performance measure has led the funds to mainly benchmark their performance against each other. The of an overarching and specific investment objective against which long-term performance can be measured is essential. The interpretation of the over-arching mandate by the four AP funds as expressed in their investment objectives of are as follows (as defined in their 2010 annual reports): Source: Interviews with the AP funds and the 2010 Annual Reports of 1 to 4 . 43.The over-arching mandate of the AP funds established in the law makes no reference to pension liabilities or the role which the AP funds are expected to play in the pension system as a whole. According to the 2010 annual report of the pension system, the pension systems total liabilities are currently funded by about by the assets of the AP funds 1 to 4 and 6. of the pension systems total liabilities are expected to be funded by future social security contributions made by Swedish workers. funding shortfall would mean that the so-called bal- ancing mechanism5 would be implemented and pension benefits would be adjusted downward accordingly (, 2010). The balancing mechanism was established to help keep the system financially in balance and to ensure a better balance between contributions into the system versus payments out between generations. 44.As of year-end 2010, the AP funds held billion – and this amount is expected to decline to SEK 400bn by 2040 (Ministry 5 If the assets of the pension system (the buffer fund plus the estimated value of assets in the form of contribution revenues) fall below the liabilities (accrued notional pension capital and capital value of outgoing pensions), then indexation of pensions in payment and returns credited to notional accounts are reduced by the ratio of assets to liabilities. The balance ratio for the year t is used to calculate the balance number or the need for activating the balancing mechanism in the year t+2. During a recovery period, which makes up for any reduction in benefits, pensions can be raised by more than inflation. See Swedish chapter of Pensions at a Glance. of Finance, 2011) due largely to demographic changes and pension benefits earned from the pre-2000 reformed public pension system. However, neither this pay out structure, nor the expected decline in the value of the AP funds, is made explicit in the high level objectives of the funds. 45.Likewise no reference is made to the fact that the performance of the AP funds has a direct impact on the payment of pension benefits, through the balancing mechanism. As these two factors are key elements of the purpose and functioning of the buffer funds they should be more explicitly included in the high-level, over-arching objective of the funds. Furthermore, the level of acceptable risk that the balancing mechanism be implemented and benefits cut, and the associated social, financial and political impli- cations that this would entail, should be directly taken into account when establishing the long-term return versus risk target. 46.It is interesting to note that the internal asset liability manage- ment () models of the AP funds have led them to the current and rather ambitious investment return targets – which they have not been able to meet, on average, over the past 10 years. To illus- trate the somewhat conflicting considerations that come into play, if the investment objective of the AP funds over the long-term is to maintain or improve the current funding level of the pen- sion system balance sheet, then this could imply that the funds take on a high level of risk in order to achieve high long-term returns (particularly if the total, underfunded level of the pension system as a whole in taken into account – which is driving the high investment return targets which the funds have set themselves). However, if the main objective of the funds is to minimize the risk of the balancing mechanism being triggered, then this would seem to imply a much lower level of risk. Given these considerations and the contradicting impacts they could have on the strategic asset allocations of the funds, the role that the funds are expected to play in the pension system as a whole and their ultimate goals with respect to funding levels, the balancing mechanism, and buffering the impact of demographic changes should be clarified. 47.The recommends following the international good practice followed by, for example, the Pension Plan and by the . A clear high level invest- ment objective in terms of a funding ratio, payout time and conse- quent real rate of return target should be put in place which is the same for all the funds. This should be established (and reviewed) by an independent body of experts answerable to Parliament (pos- sibly a group that would also be responsible for setting perfor- mance measurement criteria, nominating board members, etc.). The funds should report to Parliament on their performance rela- tive to these objectives. 48.It is extremely important that the objectives of the fund are set in law with parliamentary approval. The experience of other reserve and pension funds around the world in the wake of the financial and economic crisis has been that the long-term objectives of the funds have been overturned for shorter-term political needs. Clearly there needs to be a mechanism in place to review and alter the objectives of the fund as circumstances arise (changing demo- graphic factors etc.) – but this needs to be balanced with proper independence and oversight to ensure that the funds are able to operate in order to fulfil the long-term goals of the pension system. The monitoring of the funds should be done over a long-term basis in line with their long-term nature and investment targets. One consequence of having more than one fund is that the indi- vidual funds investment performance tends to be regularly com- pared to each other rather than to the overall goal of funding the public pension system. One advantage of multiple funds is that this system promotes competition among the funds, and introduces some diversification in terms of the asset liability management () processes and models used. However, a potential conse- quence is that herd-like investment behaviour may also be encour- aged. 50.The guidelines note that the governing body of a pen- sion fund should set forth in a written statement and actively observe an overall investment policy. 51.As a minimum, the policy should cover: How the fund intends to achieve the over-arching investment mandate of the funds; The strategic asset allocation (main asset ); The extent to which external managers may be used and how they are to be selected and monitored; To what extent and how investment management will be pursued; and The criteria for assessing the performance of the reserve fund and the different portfolio components. This is even more important for reserve funds. Reserve funds, like pension funds, require a clear mission statement and measura- ble objectives to enhance their efficient management and raise the accountability of the governing body. Reserve funds do not nor- mally have national competitors or even peers, as is the case with pension funds. , their performance (including not just investment performance but also their operational efficiency) can only be benchmarked against any initial objectives set or, as far as relevant, against foreign reserve funds. Furthermore, reserve funds support pension systems that do not typically have a full-funding goal in mind. Therefore, investment objectives may not always be readily established with regards to liabilities, time horizon or risk aversion. Reserve funds should have clear mandates and specific measurable objectives, such as a funding ratio and investment return targets. The performance of the board should be measured against these objectives. 53.OECD guidelines note that the strategic asset allocation of a pension fund should be put in place to deliver the investment objectives of the fund. The asset allocation should be set in the statement of investment policy and there should be a process for a regular review of that policy by the governing board, at least every three years. 54.The setting of restrictions on broad asset should be left to the board of the reserve fund as part of the design of the invest- ment policy. 55.The AP funds broadly comply with the recommenda- tions in terms of their investment policies. The issue is that, as dis- cussed above, the overall investment objective set by the AP legis- lation is so broad that the funds investment policies effectively have become their long-term investment objectives. In other words, the funds are effectively setting their own long-term investment objectives independently of each other which in our view does not altogether align with international good practice. The Guidelines on support the use of the person rule to meet a funds invest- ment objectives. This would also be the general recommendation for pension reserve funds. The guidelines do acknowledge that investment limits can also be used, providing they are consistent with this policy and do not inhibit adequate diversification or impede the use of asset-liability matching techniques. face additional restrictions intended to ensure diversification or to avoid direct control of corporations. Given the high level of expertise and strong risk-management functions in place at the AP funds, there does not seem to be any reason to believe that the application of the person rule would expose the reserve funds to undue risk. 57.If risk control is seen as an issue and considered a motivation for not implementing the person rule, then oversight of the funds by an external supervisory body (such as the authority which oversees private pension funds) could be put in place. Indeed, the would recommend such a move whatever the structure and investment backdrop for the funds. If the regulation is designed to address the issue of the potential market impact of the funds, this can be dealt with in other ways than via investment restrictions (as discussed below). 58.The previous review of public pension reserve funds noted that the investment rules for the Swedish funds were poten- tially restrictive (Yermo, 2008). The following restrictions by asset class have been applied since 2001: Only investments in capital market instruments which are quoted and marketable are permitted. Direct loans are prohib- ited. No more than of the funds assets may be invested in unlisted securities. These investments must be made indirectly via portfolio management funds or similar. At least of the funds assets must be invested in low-risk, interest-bearing securities. No more than of assets may be exposed to currency exchange risk. 59.The funds also cannot invest in commodities. 60.Regulations also apply which are intended to ensure diversifi- cation or to avoid direct control of corporations by reserve funds. No more than of a funds assets may be exposed to one issuer or group of issuers. Shares held in listed Swedish corporations may not exceed of total market value. Each fund may not own more than of the votes of any single listed company. These investment rules are more restrictive than other reserve funds – with major investment limitations only being in place in , and (see Yermo 2008). The requirement that at least of the funds assets must be invested in low-risk, interest bearing securities does not comply with the Guide- lines on , which do not recommend any floors on asset as these can distort markets. This restriction was put in place when private pension funds in were subject to similar investment regulation restrictions. How- ever, these funds are now regulated by the person rule, and there does not seem to be any reason why the AP funds should therefore continue to be bound by this rule – which they find restrictive, and could lead to suboptimal portfolios and potential over-exposure to certain types of unrestricted assets. The invest- ment restrictions mean that the diversification of the AP funds is less than some of their international counterparts, although they are more diversified than others. Source: Global Pension Statistics. 62.Furthermore, restrictive investment regulation works to under- mine the purpose of having four independent and competing buffer funds. The investment regulations restrict how the funds can construct their portfolios, which end up looking fairly similar, taking away some of the potential benefits of competition and diversification. 63.That said, the restrictions on over-exposure to a single issuer, voting rights of a listed company or the Swedish domestic market would seem more appropriate to maintain. These types of restrictions are common in jurisdictions that implement the pru- dent person rule (, 2006). 64.At least of the AP assets must be managed by external fund administrators – to fulfil the governments wish to isolate funds from political pressure. The do not make specific recommendations on the issue of internal vs. external management, but notes that the increasing scale of pension funds around the world has allowed the leading funds to build their internal resour- ces, capacity and expertise. Combining the AP funds or sharing certain functions may also allow them more scope to build centres of expertise in various investment categories and to invest in assets which require knowledge and scale (such as direct infrastructure investments, such as the leading Canadian funds are making). 65.The AP Fund 6 is governed by a separate law from AP funds 1 to 4. AP6 pays out no benefits and receives no contributions and has approximately one-tenth the assets of each of the other four AP funds. The AP6 funds mandate is to, within the framework of what is in the interest of the pension system, invest its assets in Swedish venture capital.6 According to its website, the AP6 fund invests in unlisted small and medium growth companies, either directly or indirectly through funds. 66.The has made no review as to the need for funding in the Swedish private equity or venture capital markets. Unlisted assets and other alternative investments such as infrastructure, both domestic and foreign, can be an important investment class 6 See the law 2000:193 on the . for pension funds. However, there seems to be no clear or direct link between the mandate for the AP6 fund to invest solely in the Swedish venture capital market and the best interest of the benefi- ciaries of the pension system. 67.The role of the AP6 fund within the pension system should be clarified. Furthermore, the decision as to which companies and projects to invest in and to what extent such investments are made should be made transparent and objective and be tied directly to the goal of providing the highest possible return. Otherwise, there is a large risk that such decisions could be at least perceived to raise questions of independence and conflicts of interest. Furthermore, the performance of the AP 6 fund and the level of its operating costs in relation to its level of assets should be directly measured in relation to its contribution to the overall goal of providing the highest possible return given the level of acceptable risk for the ultimate beneficiaries of the Swedish pension system. 68.The mandate of the AP6 fund should clarify that its invest- ments must be motivated by the best interest of the pension sys- tem, in line with the mandate for the other AP funds. Investment in unlisted assets takes expertise and specialisation which would argue for maintaining AP6 as an entity. One potential solution may be to embed the AP6 fund and its private equity exposure within the other AP funds. Merging or embedding AP6 within the other AP funds may improve the transparency and governance of such private equity investments and clarify the mandate. 69.Furthermore, should the other AP funds wish to make a strate- gic decision to invest in, for example, Swedish start-up companies or buy-out funds, then they would be free to do so under the pru- dent person rule as long as such investments are in the best interest of the pension systems beneficiaries, fit within their investment mandate, make sense in terms of their broader asset allocation strategy and are duly approved by the governance board. In other words, the decision to invest in the Swedish venture capital market should be made in the exact same as any other investment decision made by the AP funds. 70.On the other hand, if the objective of the government is to support Swedish industry, better defined policy tools could be used that are distinct and separate from the financing of the pension system. To summarise, if the AP 6 fund is to be maintained, then its mandate should be clarified and aligned with the best interest of the pension system. Also, the need for investment in private equity and venture capital should be formally expressed and aligned with the overall investment mandate of the AP funds, should be made consistent with the broader strategic asset allocations of the AP funds, and should not be limited to the domestic market.