Letter from the CEO

Stockholm, 20 February 2019

After a succession of years with stable economic development and favourable returns, 2018 was very turbulent, and many investments had weak or negative returns. AP4’s return for 2018 was -0.2% after costs. In this context it is gratifying that AP4 succeeded at generating an active management result of a full +2.3 percentage points towards AP4’s return relative to our benchmark portfolio. This significantly limited the impact of the weak markets on the portfolio’s return. During the year, Swedish Parliament decided on a first step towards more modern investment rules for the AP Funds, which took effect on 1 January 2019. It is of utmost importance that the second step announced in the modernisation of investment forms and types of instruments is carried out as planned in 2019.

Challenging year with negative return

In our 2017 Annual Report we discussed the future challenges we saw for the financial markets. Our conclusion was that we feared a period of lower anticipated returns and considerably higher volatility than what we had experienced during the preceding ten years. Against this background, combined with the considerably more robust financial position for the income pension system today than at its start in 2001, ahead of 2018 we determined that it would be more prudent to revise AP4’s long-term return target downward rather than raise the investment portfolio’s risk level.

Unfortunately, some of the fears we raised in the 2017 Annual Report unfolded already in the following year. 2018 was a year of periodically very high volatility along with weak and in many cases negative returns on financial assets. This can be illustrated in figures via the trend break we noted for AP4’s return. During the preceding ten-year period 2008–2017, AP4 delivered an average annual return of 7.3%, and fund capital grew from SEK 207 billion to SEK 357 billion, despite net outflows of SEK 43 billion to the pension system. This can be compared with AP4’s return for 2018, which ended at -0.2% after costs and a result of SEK -0.5 billion. The fund capital thereby decreased by SEK 7.3 billion to SEK 349.3 billion after the year’s net disbursements of SEK 6.8 billion to the pension system.

Strong active return in turbulent markets

Naturally, the year’s negative result is unfortunate, both for the national pension system and for us who work at AP4. At the same time we should remember that this is the first year since 2011 that AP4 has posted a negative result and the second year since 2008. In this context it is also important to remember that the annualised return for the last 10-year period (including 2018) is clearly positive and amounted to 9.9%.

It is therefore gratifying that AP4’s active management was highly successful in 2018 and significantly tempered the impact of the weak market on AP4’s total return. The active return for the year relative to our benchmark portfolio was +2.3 percentage points, and the positive earnings contribution was thus SEK 8.5 billion.

Most asset management units made a positive contribution to the active return, with Swedish equities and real estate at the foremost contributors. This clearly illustrates the value of broadbased and high-quality active management in the prevailing low-return environment.

An adapted and refined investment operation

Global growth is flattening. At present this is more noticeable in Europe than in the USA, and we believe it is likely that individual countries may fall into a technical recession (two quarters of
negative growth). However, a significant part of such a development has been taken into account in the financial markets’ expectations given the negative end to the year. Despite this we believe that the negative uncertainties dominate; we are thinking mainly of the central banks’ actions, Brexit, and developments in the various, complex trade discussions that are currently being held. The existence of the many different and distinct structural, political and geopolitical risks that we can observe today also entails that on the whole we can expect significant volatility also in 2019.

Over the long term we expect to see relatively weak economic development in the industrialised countries. Key factors behind this scenario include a normalisation of monetary policy, areas with a high level of debt, the demographic trend and weak political decision-making resolve. On top of this we are seeing indications of increased regional division, protectionism and mistrust in existing trade agreements, and a weakening of supranational institutions. If the tendencies in this direction continue and intensify, it could have substantially negative consequences economically, politically and socially.

To prepare ourselves for the major future challenges we see in conducting successful pensions management, in recent years we have re-examined and refined our investment platform. Three central starting points have guided us in our change work: first, build upon our historical strengths; second, maximally utilise the unique prospects for long-termism and flexibility that we have as a buffer fund in the public pension system; and third, build competence and structure to be prepared for the demands on asset management that our rapidly changing world entails.

More concretely I can mention the development and implementation of a new portfolio and decision structure with an accompanying change of the investment organisation. These changes have entailed, among other things, that we have added resources to the Strategic Allocation & Quantitative Analysis and Alternative Investments units. This has been done in part to
strengthen our overarching approach to AP4’s investment portfolio and in part to develop our competence and ability with respect to illiquid investments. A more overarching ambition has been to gradually broaden AP4’s risk profile, especially with focus on investments with long- and medium-term horizons.

Modernised investment rules

I have a very positive view of the initiative that was taken by the politicians in the so-called Pensions Group to modernise the AP Funds’ investment rules. Such a modernisation is necessary to give the AP Funds the conditions for modern asset management that can generate the best possible returns at the lowest possible cost. A modernisation that gives the AP Funds greater flexibility to perform their mission will ultimately benefit today’s and tomorrow’s pensioners. During 2018 a number of questions surrounding the AP Funds’ future investment rules were sorted out. The first step of the modernisation, which took effect on 1 January 2019, gives the AP Funds greater flexibility in asset allocation, mainly entailing lower requirements to hold liquid fixed income assets with high credit ratings and greater scope for illiquid investments.

It is very important that the modernisation as it pertains to overall asset allocation is followed by a corresponding modernisation of investment forms and types of instruments. It is therefore very positive that the Pensions Group – in a second step – is looking into the opportunities for direct investments in unlisted infrastructure companies, illiquid credits and co-investments in unlisted companies. A modernisation also in this area is a prerequisite for the AP Funds’ ability to purposefully and cost effectively use the greater freedom to act that the change in the first step conveys. I cannot stress enough the importance that this second step in the modernisation of our investment rules is also carried out.

AP4 invests very long term, and today we have a market situation with strained valuations in many cases. For this reason, portfolio changes will be made cautiously and stepwise over several years, and we will put great emphasis on ensuring that every
individual investment can be realised on solid grounds.

Higher level of ambition regarding sustainability

Sustainability is one of the greatest challenges of our time for which the political system, the business sector and civil society must work together to find solutions. More specifically, AP4 has identified climate change as one of the greatest systemic risks for long-term asset values. Reducing the carbon footprint is a prerequisite for stable future economic development and thus for our opportunities to perform our mission over time. Our hope is that AP4’s sustainability work can help influence development and that we, together with other investors, can contribute to a solution for the global climate challenge.

It is for these reasons that I welcome the fact that sustainability has now been added to the wording of the AP Funds Act with the clarification that asset management shall be conducted in an exemplary manner through responsible investments and responsible ownership. In this respect as well, the change is a modernisation and adaptation to the requirements today that are put on a long-term institutional asset manager with high sustainability aspirations. AP4 has a long tradition of working with sustainability issues in its asset management and today is at the international forefront in this respect. Certainly, the new legal wording spurs us to continue developing in the area of sustainability with the ambition to steadily retain our strong position over time.

During 2018 AP4 continued its work on reducing the carbon exposure in the global equity portfolio, which included among other things the sale of companies with exposure to thermal coal and oil sand. These constitute fossil fuels with high CO2 intensity per unit of energy, which we believe must be phased out as part of a global shift to a low fossil fuel society in line with the UN Framework Convention on Climate Change and the Paris Agreement. On top of this we are working continuously on developing our strategies for low carbon investments, where we are looking into the opportunity to broaden them to also include other types of resource efficiency, such as energy and water use, which benefits sustainability as well as companies’ profitability.

During 2018 AP4 also intensified its work with climate scenario analyses and on analysing and understanding important sustainability trends. Prioritised results of this work include greater competence that can be applied broadly in our investment work and a stronger ability to identify investments aimed at contributing to or benefiting from sustainable development. Examples of such investments that AP4 made in 2018 are a fund that invests in and contributes to the development of green bonds in emerging markets and a fund that invests in unlisted growth companies that have a market position and business orientation that are aligned with the transition to a sustainable society.

The intention of Non-Proliferation Treaty is to achieve nuclear disarmament over time. Today we are seeing significant modernisations and upgrades of nuclear arms programmes in many countries, which goes against the objectives of the Non-Proliferation Treaty, in AP4’s opinion. Ahead of 2019 AP4 has therefore decided to divest companies with operations related to this modernisation and upgrading.

Strong focus on corporate governance

Active ownership responsibility has long been a core principle for AP4. AP4 is a significant shareholder in the Swedish stock market, and we are the largest or second-largest owner in a dozen or so companies. As a long-term and engaged owner, AP4 acts with the goal of contributing to companies’ operations so that they develop, improve and are conducted responsibly and transparently. During 2018 AP4 exercised its owner responsibility by voting at the Annual General Meetings of 90 Swedish and 971 foreign companies. Ahead of the 2019 AGM season, AP4 is participating on the nomination committees of 33 Swedish companies.

Awards for AP4

AP4 received recognition through several awards in 2018. AP4 was ranked at the top among the world’s 100 largest pension funds on their approach to climate-related risks and opportunities in the international analysis conducted by the Asset Owners Disclosure Project (AODP) for 2018. The Task Force on Climate-related Financial Disclosures (TCFD) was formed in 2016 by the G20 with the mission to make recommendations for climate reporting. The AODP has analysed the Fund’s climate work based on the framework created by the TCFD.

AP4 also received a full five distinctions at the Investment & Pensions Europe (IPE) Awards in 2018. Of these, I would like to specifically mention the Gold Award for Best Long-Term Investment Strategy, which AP4 has thereby won for the third year in a row.

Naturally, we are happy to be recognised for our way of working and asset management. It is inspiring and motivates us in our continued development work.

In closing I would like to extend my great thanks to all of AP4’s employees. It was challenging year with respect to asset management, and the year’s negative result is something weighs heavily upon us.  However, the very strong asset management result that AP4 has shown significantly limited the impact of the weak market on the Fund’s total return. In parallel with our continuing asset management activities, significant actions have been taken to develop our operations. We employed major measures during the year with respect to the portfolio structure, and we are
gradually reshaping our investment portfolio, we have strengthened our competence in several key areas, we have further advanced our position as a global actor in sustainability, and we have yet again demonstrated our strength in managing Swedish equities and real estate.