sou · H0B353 · 2012-08-24 00:00:00 — The remit of the Inquiry has been to evaluate mandates, investment rules, guidelines, structures and fund management based on the need for more effectiveness and changes in the surrounding economic and financial environment. Particular analysis has been made of the objectives, mandate and investment rules of the Sixth AP-fund. It has not been part of the Inquirys remit to review the overall role of the buffer capital as a buffer fund in the national pension system. The Inquiry has made its considerations within the framework of the five-party agreement, which states that the buffer capital is to have purely financial objectives without regard to industrial or economic policy. Furthermore, the funds are not to hold a controlling interest as owners of Swedish listed companies. Finally the fund management is to be conducted independently of each other, especially in the case of shares issued by domestic listed companies. The remit includes conducting a comprehensive analysis of alternative fund management forms and capital management structures to find a structure and create a framework that provide for the greatest possible benefit to the financing of the pensions system, while allowing operations to be conducted appropriately and cost-effectively. The buffer capital is part of the national pension system The buffer capital was established in connection with the national supplementary pension reform in 1959, when three national pension funds were established. The reason for establishing three funds was to avoid a concentration of power, whether it be of state or private interests. Since then, the funds have enjoyed a relatively independent status. In 1972, the Fourth AP-fund was established with the task of investing in Swedish companies. The current AP-fund Act, which entered into force on 1 January 2001, emerged in connection with the implementation of the major pension reform adopted by the Riksdag (Swedish parliament) in 1998 in a five-party agreement. The main intention of the reform was to move from a defined-benefit system to a self- financing, defined-contribution system in which pensions are adjusted according to growth in the rest of the economy. The First–Fourth AP-funds were given new and identical investment rules and, compared with previously, greater fund management freedom and autonomy in relation to the Government and the Riksdag. , which was named the Sixth AP-fund, became the fifth buffer fund, but was allowed to retain its special investment profile. At the end of 2011, the total buffer capital corresponded to approximately billion. At the same time, the capital of the funds is part of a pension system that has total assets of billion, which means that at the end of 2011 this corresponded to approximately 12 per cent of the pension system balance sheet. According to the the buffer capital is expected to decrease over the next thirty years as the generation born in the 1940s enters retirement.1 Even now, with the current level, the buffer capital has limited ability to influence balancing2 on its own, but in times when the pension system is financially relatively weak, i.e. with a balance ratio close to one, positive contribution from the fund management can be significant for the pension system. With a declining capital base, the buffer capital will account for a smaller share of the total assets. The role of the 1In Report, Annual Report of the , published yearly, the present projections for the evolution of the system over the next 2Balancing means that pensions are not adjusted upwards in line with the income index or that they are even reduced. This occurs when the liabilities of the pension system are greater than the assets, i.e. the balance ratio is less than one. buffer capital as a demographic buffer, by contributing to the financing of the pension system, depends on its ability and capacity to generate returns on the funds portfolios. This is achieved through a structured investment process and conscious risk-taking. A minimum level for returns is to exceed the income index over a defined time horizon. The income index corresponds to the growth of average income and steers the upward adjustment of pensions. If returns exceed the growth of the income index, this means that the buffer capital is contributing positively to the financing of the pension system. However, based on the long-term role of the buffer capital, and the fact that high returns contribute even more to the financing of the pension system, the level of ambition should be higher. Part of global financial markets The management of the buffer capital, based on its mandate and objectives, means being one of many actors on the global economic and financial markets. The financial markets have developed con- siderably during the past 10 to 15 years and this Inquiry is being presented in the midst of a financial and debt crisis which has involved and will bring major changes in both the domestic and the global capital markets. The conditions and the external environ- ment for the current AP-funds have thus changed considerably since the introduction of the current legislation. Since the mid-1990s, the number of pension funds and institutional investors worldwide, and their assets, have tripled, which means there are several hundred other institutional investors that are larger or of equal size as the total buffer capital competing with the AP-funds for competencies and investment opportunities. This must be seen in light of the expected reduction of the buffer capital during the coming decades. Identification of problems and development needs of the buffer fund system Effective governance of pension fund management has significance for the returns and financial results. Structural failings and potential problems with current structures are affecting the ability of the buffer funds to achieve a high level of returns after expenses. The Inquirys proposals are aimed at improving the of achieving higher returns to benefit the pension system by: –clarifying the mandate and investment objectives of the buffer capital and its link to the pension system; –clarifying the division of responsibility between the asset owner and the asset managers; –reforming board appointment routines and clarifying the responsibilities and powers of board members; –considering how the fund management competence of the current boards can be increased; –considering how the investment rules can be made more flexible and adequate; –studying the arguments for dividing the buffer capital between several funds with identical investment mandates and examining alternative solutions; –reviewing the role of the Sixth AP-fund in the pension system. The buffer capitals role and investment objectives The main role of the buffer capital is to act as a buffer in the income-based 1st pillar national pension system. In times when pensions disbursed are greater than pension contributions, funds will be drawn from the capital. Inversely, the capital will grow if contributions exceed expenditures. Thus, the pensions can be maintained at a long-term sustainable level during years of strain on the system. The objectives of the Act with regard to investment activities do not provide adequate guidance on determining appropriate risk tolerance and expected returns for the management of the buffer capital. It is necessary to set an investment objective for the management of the buffer capital based on the financial position of the pension system and prevailing market conditions. This issue is central to the governance of the buffer funds. has important knowledge of the pension system and should therefore participate to a greater degree in the analysis of appropriate risk tolerance and expected returns for the management of the buffer capital within defined time horizons. The investment objective must be clear and provide a basis for evaluating the management. Depending on demographic and economic factors that influence the financial position of the pension system, the objective of management may vary over time. A firmly rooted investment objective for the management of the buffer capital will enable the evaluation to distinguish the pension systems mode of operation (balancing mechanism) from the performance of the fund management. This in turn allows a form of asset management that can utilise the comparative advantages of taking a true long-term approach. However, a principal responsible for the fund management is a prerequisite, which is currently lacking. The absence of a principal who can take a holistic perspective affects the legitimacy of the system. To justify up a buffer capital, returns on the buffer capital must at least exceed the upward adjustment of the liabilities in the pension system (income index). This can be a starting point in analysing the formulation of the fund management mandate with regard to returns and risk. Governance of the current AP-funds In formal terms, the current AP-funds are mutually independent state agencies on which the Government has limited influence. The Act states that the Government only exercises influence by: appointing boards, including chairs and vice chairs, determining remuneration and other forms of compensation to board members, appointing auditors, adopting the income statement and balance sheet of the funds and evaluating the management of funds on the close of each year. The role of the buffer capital is to be a buffer for the pension system so that contributions can be held over time. This role should not be confused with the state agency role of the AP-funds, which is to manage the buffer capital based on the provisions of the Act. Currently, the AP-funds shall themselves interpret the general provision of the Act on the objective of investment activities in terms of a more concrete, measurable objective. (The funds are their own principals.) In the latest annual evaluations, the Government, which initially following the reform evaluated and expressed a positive view of the objectives set by the funds, has not detailed its opinions regarding the commitments of the pension system or the different investment objectives set by the AP-funds. It is remarkable that the Government has not evaluated the objectives set by the funds for their operations during the past decade considering the turbulent period there has been in the financial markets with altered market con- ditions. The current structure of the AP-funds makes it difficult within the funds to organisationally separate the decision on the invest- ment objective from the overall operational decisions on fund management. The AP-funds have not achieved the organisational separation between the decision-maker and implementer of fund management investment objectives. The mutual autonomy of the funds precludes the funds from taking joint responsibility for the role of the buffer capital in the pension system. The unique position of the AP-funds among government agencies has resulted in neither the Government nor the Riksdag taking principal responsibility for the operations of the AP-funds in general. The funds are free-standing from each other and independent of the Government and the Riksdag in decisions on strategic and tactical allocation. The mutual independence of the funds does not preclude them from cooperating in other areas, if this is perceived as cost-effective, for example in securities administration, informa- tion technology, financial administration and human resource services. However, this has not taken place to any degree. Structure of asset management Asset management is a matter of making investment decisions on portfolio construction and market exposure. The most important decision for management results is the total risk level of the management, which determines the division between different assets in the portfolio. The AP-funds have advantages which distinguish them from other investors, such as good liquidity and the ability to take a long-term approach. It is likely that the risk level and the composi- tion of different risks in the portfolio need to be altered over time depending on the financial position of the pension system, which supports the idea of not locking capital into strict indexing – or any other strategy. The Inquiry considers that decisions on or passive market exposure should be based on the professional assessment of the asset manager and on expected risk-adjusted net returns. In-house asset management is often cheaper than external management in terms of costs, however this does not automatically mean higher net returns. If net returns from in-house management are to be as good as or better than those of external management, it is essential that adequate asset management competence can be recruited and retained. The ability to build up in-house competence depends on the organisations attractiveness. Advantages of inhouse management include reduced dependence on external suppliers of financial services and analysis. Disadvantages can include reduced flexibility for strategic and organisational changes. The Inquiry considers that this is a decision to be taken by the management of the asset management organisation based on its mandate and cir- cumstances. Studies and experience clearly show that there are clear eco- nomies of scale with regard to expenses for fund management and administration. The findings are not as clear-cut with regard to the assertion that there are economies of scale for net returns in general, this depends on management style and asset class. A disadvantage of managing a larger fund is the difficulty of taking on board strategies that are based on investments in smaller market niches (primarily domestic) or on the ability to quickly adjust the portfolio. With regard to a larger fund, studies clearly indicate much better returns in alternative asset . Available studies also indicate that in-house management is cheaper than external, which indirectly would indicate that there are some scale benefits of up an in-house asset manage- ment organisation. A larger fund is also better able to attract competence, which is crucial for success in the ever increasing global competition. With regard to the buffer capital, whose comparative advantage is its ability to have a long-term approach, the advantages of managing a larger fund are considered to outweigh the dis- advantages. The concern over market influence that existed when the current AP-fund system was established is less relevant today. Globalisation in general and the development of the Swedish stock exchange has meant that the buffer capital operates in another environment than was the case then. A joint buffer capital that is well diversified with regard to asset class, risk profile and geography should therefore not cause any problems of market influence on the Swedish stock exchange. Diversifying the capital across four AP-funds with the same mandate does not automatically lead to the buffer capital as a whole being well-diversified, on the contrary. If anything, the current structure is costly for the pension system, from a risk-adjusted returns perspective. The Inquiry considers that diversification which takes into account the total risk to the buffer capital as a whole should be based on an analysis of the entire buffer capital. between the four AP-funds has if anything had a negative influence. The management of the funds has become much the same. It has been more important that results do not deviate from the other funds in the short term than to implement a deliberate long-term strategy. Competition among the funds has also contributed to a misdirected focus on their internal costs. Concern over political influence on the management of the buffer capital is important and is shared by other pension reserve funds around the world. In other countries, the for politically independent management has been met through clear governance models and limits on powers and accountability. Apart from the division into several funds, the owner influence of the AP-funds is limited by not permitting ownership of more than 2 per cent of the Swedish stock exchange and 10 per cent of any individual company. With occasional exceptions, actual investments have steered well clear of these limits during the lifetime of the funds. The Inquiry believes that this indicates that the ambition of the AP-funds has been to act as financial investors in the best interests of the pension system. Division into four independent funds can reduce political influence, but it can also have the opposite effect because of underestimated responsibility and the difficulty of presenting a united front against political influence. A key aspect for the effective governance of an organisation is how homogeneous or heterogeneous it is. In general, a homogeneous structure facilitates decision-making and is therefore presumed to result in more effective governance. A heterogeneous structure with specialised departments and different interests makes it more difficult to reach consensus on decisions and therefore produces less effective governance. Other aspects are the number of departments in the organisation and the degree of separation between the depart- ments. A structure in which capital is divided into a heterogeneous structure with specialist funds is theoretically attractive, but has a number of problems in practice. The need for a department with overall responsibility for risk control and allocation means the structure can rather be viewed as one(1) fund with structural lock- ins. A homogeneous structure can comprise one or more funds with identical mandates. Crucial to the choice of the number of funds is the evaluation of the risk of power concentration versus economies of scale. There are of course alternatives in which a homogeneous and heterogeneous structure can be combined. Such solutions can be attractive in theory but involve a number of difficulties that need to be resolved in practice. The management of the buffer capital should be conducted in a responsible that takes sustainable development into account and therefore shows consideration for future generations. Via its role as a financial investor and owner, fund management can influence companies in the direction considered to benefit the pension system in the long term. In earlier preparatory materials, it is stated that the AP-funds are to take ethics and the environment into account in their investments without negatively affecting returns. In the report of ethical and environmental responsibility of the AP-funds (SOU 2008:107), it is proposed that the provisions of the preparatory materials are included in the Act and that basic values should be developed on which the operations of the buffer capital be based. Like ethical and environmental responsibility of the AP-funds, the Inquiry considers that there is a need for a common and living set of basic values for buffer capital management. However, the Inquiry does not share the Committees view that the preparatory text requiring the funds to take environmental and ethical considerations into account should be incorporated in the Act, since there is a risk that these will quickly become obsolete and may limit future higher ambitions. In the assessment of the Inquiry, it is preferable if ethical and environmental considerations are given a prominent place in the work to develop a common set of basic values for the fund management. The basic values should clarify what environmental and ethical considerations should guide the investment operations, and what trade-offs have been made in relation to benefits for current and future pensioners. The Inquiry considers that the deeper integration of ethical and environmental considerations in fund management is one of several factors in the ambition to create good conditions for the long term effective management of the buffer capital. Current investment rules for the AP-funds arose out of a concern to ensure politically independent fund management and limit risk- taking with the buffer capital. The investment rules are based on the regulations and financial models that set the tone at the end of the 1990s. The development of the financial markets in the 2000s has forced investors to question the link between risk and returns for different types of assets. What has been successful over the past 10 years will not necessarily continue to be so in the future. It is therefore inappropriate to set quantitative investment rules that are not in line with economic development. As a result, the current investment rules for the AP-funds have not always fulfilled their aim of limiting risk. The insufficient flexibility has made it difficult for the funds to diversify risks, which means some portfolios could provide higher risk-adjusted returns were they given greater degrees of freedom. The investment rules were inspired by the rules for private pension companies at the time. Their regulations have now been replaced with other types of guidelines, which further underscores the need for also modernising the guidelines for the future management of the buffer capital. Unlisted assets have become a more common feature of institutional fund manager portfolios. In the 1990s and 2000s, returns on private equity investments have been particularly high, benefiting investors who were both early and successful in their fund management selections. Because of the 5 per cent limitation rule, the First–Fourth AP-funds have limited ability to invest in unlisted assets which potentially could diversify portfolio pro- perties and increase risk-adjusted returns. Some of the potentially high returns are due to the greater diversification across successful and less successful investments which places increased demands on the investment organisation. Increased exposure to unlisted assets therefore requires a professional organisation with the relevant competence. The Inquiry has considered whether the reasons for quantitative investment rules are still valid or whether qualitative rules are possible (the person principle). Parts of the person principle – duty of loyalty, risk diversification and payment preparedness – are contained in the current Act. However, these do not have a prominent role in the discussion of investment pro- visions since the quantitative provisions of the Act are more conspicuous. The more process-oriented parts of the person principle are absent from the current Act. A fundamental obstacle to the introduction of the person principle for the funds under the current arrangements is that they decide the objectives for their own fund management themselves. Quantitative investment rules risk becoming outmoded as the financial markets rapidly evolve with new types of assets and investment instruments, and thus they are more inclined to contri- bute to poorer risk control, contrary to the intention. Removing the quantitative guidelines will give the management of the buffer capital the flexibility to better utilise its comparative advantages of being a long-term pension reserve fund. However, such a transition presupposes a clear investment objective and effective governance. The greatest potential for cost-effective buffer capital management comes from creating an effective and well-functioning governance model which allows a relevant fund management organisation and conditions to secure the best possible competence, risk model and investment process for the benefit to the pension system and prevailing conditions in the capital markets. This is more difficult to achieve if the capital is divided into several independent funds, than if the capital is managed by a cohesive entity. Each of the current AP-funds seems to have low costs from a national and international perspective, given the mandate of the funds.