Swedish funds back in comfort zone
The first nine months under a new regulatory framework have passed without too much drama for most Swedish pension funds. The casual observer might be forgiven for raising an eyebrow at this comment, given the animated debate that raged across the Swedish pension industry for the best part of last year.
At the time, criticism over the design of the traffic light system encompassed most aspects and a key concern was the apparent demand-supply imbalance at the long end of the SEK bond market and the potential impact of large scale duration matching among pension funds amid the introduction of market valuation of liabilities. In the event, with buoyant solvency ratios pension funds were generally in little hurry to close their duration gaps, in particular given the historically low long bond yields seen at the time. With those yields moving up steadily over the past year it is starting to look like a more interesting proposition.
The first reporting date for the stress tests indeed revealed a largely healthy pension fund sector with less than 1% of assets in red light. The Finans Inspektionen (FI) is now busy testing the designs of the second stage of the stress test reform on a small group of life companies. Whereas the current system is focused on financial risks, stage two will add stressing of insurance related risks such as mortality. If all goes according to plan a final version of the traffic light system will be in place by 2007.
While most pension funds now tend to view a broadly matched asset-liability portfolio as a sensible base line position, a lot of work remains to put more liability focused investment processes in place. Implementing such a framework is time consuming and requires not only a rethink, but potentially an element of re-organisation as well. As ALM studies reflecting the new environment come through and results are interpreted and evaluated, we also see new benchmarks and risk budgets being put in place.
But although duration mismatch is typically a major unrewarded risk for pension funds from a strategic point of view, there is also a lot of scope for altering the risk-return profile of riskier assets. Many funds are reducing downside risk in their equity portfolios by deploying leverage in a disciplined way, either through option based strategies or via dynamic portfolio insurance. Increasing the efficiency of growth assets in this way may also mitigate some of the stress test impact compared to a conventional cash equity exposure.
With many pension providers operating in a competitive environment, it is crucial to deliver a robust stream of returns in order to maintain attractive bonus rates. In this context, pension funds are broadening out from mainstream alternatives such as hedge funds and private equity, into a new range of investments such as infrastructure and active currency management.
As the Swedish pension fund industry begun positioning itself in a new regulatory environment in early 2006, more change was about to come. During the winter, negotiations between the Swedish employer confederation and the white collar unions intensified around reforming the largest of the collectively agreed defined benefit (DB) schemes in Sweden, The ITP plan. And after years of disappointment and countless false dawns, in April this year an agreement for an all-new ITP plan was finally presented.
et to be introduced in 2007, this will see the birth of a hybrid solution where at least 50% of premiums will have to be allocated towards some form of guaranteed solution. The remainder will be open to individual choice across both traditional insured products and unit linked options. As benefits accumulate under the new plan, the Swedish provider landscape will begin to change; the birth of a system open to competition will effectively end the historic monopoly position of Alecta. Collectum, the administrator of the new plan, is currently selecting providers for the new platform and appointments will be announced in December this year.
A lot of the details remain unclear but many industry observers expect the selection criteria to limit the number of providers to a certain degree. Considering the negative experiences of the public DC platform PPM, which currently offers a choice of some 700 funds, it seems likely that the number of available products will also be restricted. Even so, an adequate model for individual advice will also need to be developed and inevitably this is another area subject to heated discussions.
Elsewhere in the industry, changes of a more evolutionary nature are taking place. More than five years have passed since Swedish pension reform heralded the creation of an all-new AP fund system. During this period the emphasis has been on building well diversified portfolios in parallel with increasingly refined investment capabilities.
As organisational structures become more firmly established, these funds are now taking decisive steps towards a greater focus on alpha generation. AP7 paved the way in 2005 by putting in place separate alpha and beta mandates for their Swedish equity portfolio, and the other AP funds are looking to develop complementary approaches to traditional active management. This is likely to see a much broader array of investments making their way into these portfolios.
Meanwhile, beta portfolios are getting an overhaul with the introduction of fundamental indexation.
For the majority of corporate pension funds the new regulatory framework is of limited relevance. The new ITP plan will have an effect over time but for the foreseeable future the key focus from a risk management perspective is the long tail of old final salary liabilities. In this context, international pension accounting is coming through as an increasingly important determinant of corporate pension management, putting the risks more firmly in the spotlight.
n most key ratios the Swedish plans rarely stand out as a major problem from a group level perspective. Foreign plans have tended to be a greater concern, typically through a combination of unfunded solutions and weak solvency. To improve control in this area many multinationals have formed some kind of global pension forum for the various parties involved.
As a consensus around the key objectives starts to emerge out of these efforts, a logical next step is to look at the process from a more structured perspective, mapping out the key risk exposures within some form of global ALM or risk budgeting framework. Many companies moving in this direction come to realise that developing a global policy on broad risk tolerance and permissible investment activities is one thing, implementation is another. The financial know-how in this area is abundant, but experience suggests that a combination of behavioural factors and local regulation is the real challenge to overcome.
The views expressed in this article are those of the author and are not necessarily those of ABN AMRO
Martin Wahlgren is Nordic head of Pensions Advisory at ABN AMRO Bank, based in Stockholm