The Swedish pension market has been one of the most dynamic in Europe throughout the last decade. In this period, a quiet revolution towards a defined contribution (DC) system has taken place, transforming the once defined benefit (DB)-heavy market into one now dominated by DC arrangements .
This includes a number of occupational schemes as well as the state pension system, where the AP buffer funds have completed a major restructuring into four SEK160bn (e17bn) funds with global balanced mandates and substantial outsourcing of assets. Together with the launch of a national open architecture DC scheme with some SEK125bn worth of assets, this has made Sweden a key target for many international investment managers.
The past two years have witnessed a restructuring of the pensions and investment consultancy sector, with several new firms establishing a presence, while a number of existing players have gone through significant changes. In particular, there is a clear trend towards a broader interpretation of the advisory concept as new players position themselves along the spectrum between traditional consultancy and pure product provision.
Anyone looking for yet more action will not have been disappointed this year; the market is reaching fever pitch with the imminent introduction of new pensions regulation. This relates to the implementation of the EU pensions directive on 1 January 2006, which is set to bring radical change to the way Swedish life and pension businesses operate.
The new system will offer the Finans Inspektionen (FI) an opportunity to link solvency capital requirements to the level of risk in the asset portfolio, while also taking into consideration the degree of liability matching. A traffic light system akin to the Danish one will be adopted, under which funds will have to undergo a number of stress tests to assess their ability to withstand severe market shocks. These tests measure the net effect on the asset-liability position of a defined set of changes in asset prices. Assets that do not provide a good liability match could carry a cost in the form of solvency capital requirements.
The flip side of this risk-based approach to asset allocation is the abolition of the current framework with quantitive investment restrictions, in favour of a more qualitative stance based on the prudent person principle, offering funds greater scope for diversification and flexibility in their investment activities.
There has been no lack of criticism of the FI proposals. In particular, the tough stress test for equities is under fire for forcing funds to reduce equity holdings and thereby reducing pensions. Indeed, with a requirement to withstand a 40% drop in market values to avoid a red light, the Swedish system in that respect is relatively strict compared with the Danish system; critics also point out that this could create a distorted competitive situation where non-domestic insurers would potentially compete on more favourable terms than their Swedish peers.
There are also some contentious issues in the area of matching. Under the current system with a fixed discount rate, liability duration has effectively been zero, and portfolio durations have tended to be short. With the proposed mark to market system for liability valuation, many funds are therefore running a considerable duration mismatch in their portfolios. Unfortunately, the long end of the Swedish bond market is comparatively thin, offering little opportunity for funds to match longer liabilities through increased exposure to longer-dated government bonds. This situation looks likely to prevail at least in the short term, as the National Debt Office (RGK) has made it very clear that it is currently not prepared to issue larger volumes of longer dated paper to meet the surge in demand.
Earlier this year, though, it looked as if the FI would offer funds the opportunity to go into euro-denominated bonds as an alternative, by assuming strong correlations in the traffic light model. But then it surprised the market in August by suddenly reversing its position. As a result of all this, supply-demand imbalances are now putting the long end of the Swedish yield curve under severe pressure and rates are currently at an all-time low. Clearly the prospect of locking in positions at such low yields is not attractive but some funds will have little choice other than to hedge.
On October 6, the FI presented the third draft of the traffic light model. In this version the yellow light indicator has been dropped and there is now only a red light, something that is arguably a softening of the model. Furthermore, the FI stated that it will not be publicising which companies are in red light unless it determines that the security of policyholders is threatened. In such a situation the FI would also take sanctions against the company and demand that a financial action plan is developed.
In terms of the stress test design and interest rate hedging, the third version favours Swedish bonds over foreign instruments, including euro paper, something that has left many funds disappointed. The consultation period for the third draft ends in October and by mid-November the final version will be presented.
Meanwhile, most funds are in the process of analysing their position on the basis of the second draft published by the FI in June this year, and despite strong performance in stock portfolios a number of them are likely to find themselves in red light territory. How they respond to this will clearly be dictated by the final draft of the proposals, but it seems inevitable that at least a number of funds will have to extend duration to some extent in order to cope with the solvency requirements.
There are essentially two market segments affected by the new rules. The first of these, comprising many of the larger life companies, have significant occupational pensions business on their books and will be subject to the new rules. Generally speaking these companies are now in reasonable shape after a few difficult years. But in the event of a red light, they could be faced with considerable and immediate commercial effects via new business and surrender options, if the FI decides to publish results on an ongoing basis, as is the case in Denmark. These companies could be expected to manage their position carefully, therefore, regardless of what actions the FI might take against them in the event of a red light.
The second group of funds affected is a number of sector-wide pension schemes set up as mutual life insurers. They tend to be smaller than the life giants, with considerably lessresources at their disposal, and they will find it quite challenging to deal with the new environment. Some of these schemes have not built up the same capital reserves as the life sector and are likely to be more vulnerable to the new tests.
Consequently, a key question in understanding how the market will react is how the FI’s final proposals will handle the publication issue and what sort of actions the FI will take against erring companies. In terms of publishing results, it would be practically impossible to keep this information from creeping into the public domain, since the information could easily be extrapolated from company accounts. In terms of the latter, the FI refers to the new system as a tool for supervision, rather than a strict regulatory framework, which may indicate a less rigid stance, with a degree of flexibility in each individual case in terms of agreeing a remedial action plan.
Corporate pension funds are generally not likely to be affected by the new solvency rules as they do not hold any liabilities on their balance sheet; the liabilities reside within the company under current legislation. These funds have had little investment restrictions to consider from the regulator in the past. However, they will be indirectly affected by the new prudent person approach via a more onerous reporting requirement, including a requirement to produce a statement of investment principles. Some view this as cumbersome red tape that will put even more pressure on thinly-resourced funds, and with the final version of the directive yet to be ratified by the Swedish Parliament, a group of opposition MPs is putting forward proposals to exclude these funds from the bill.
However, some fund executives point out that the fact that these funds are included should elevate their status and prominence and lead to increased recognition.
Martin Wahlgren is a member of ABN AMRO’s Pensions Advisory team. The views expressed in this article are those of the author and are not necessarily those of ABN AMRO