AP4's long-term brief
AP4's long-term brief is to support the stability of the pension system through managing Fund capital with the goal of generating the best possible return over time.
The AP Funds – one tenth of the pension system
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Combined, the AP Funds work partly as a buffer, with the purpose of covering future pension disbursements, and their returns partly contribute to the long-term financing of the pension system. The AP Funds only constitute one tenth of the pension system's assets. The pension system's largest asset, representing around 90%, is what is known as the contribution value. The contribution value is the expected value of future pension contributions from the gainfully employed. The size of the pension system's contribution value is mainly affected by how long a person is gainfully employed (retirement age, for instance), wage increases and the number of people in employment. |
Pension system largely unfunded
The pension system is unfunded on the whole. If a large number of people retire without the inflow of a fresh workforce, an imbalance arises in the system. This imbalance affects both the contribution value and the AP Funds – the buffer – negatively. Having fewer people in employment reduces paid-in pension contributions (the contribution value). Concurrently, negative net flows arise; the paid-in pension contributions for the year do not cover disbursed pensions. This affects the AP Funds, the buffer, because money is withdrawn from the AP Funds in the event of negative net flows.
The AP Funds - an intergenerational buffer
As the large post-war generation of people born in the 1940s now retires, the amount of pensioners will increase compared with the number of people employed in the economy. When these "boomers" leave gainful employment, their pension contributions will cease and they will start to draw their pensions instead. Net flows have been negative since 2009. In other words, paid-in contributions are lower than disbursed pensions, and funds are withdrawn from the AP Funds to cope with the pension disbursements.
According to forecasts by the Swedish Pensions Agency, the net outflows will remain negative each year until the mid-2040s. The AP Funds, from which the funds will be drawn, thus act as an intergenerational buffer in the pension system.
Income index - minimum level for AP Funds' returns
The liability side of the pension system (accrued pension rights) is as a rule increased to the income index – the average income trend. To keep in pace, the asset side of the pension system – the AP funds and contribution value – must increase by at least as much as the income index, in order for the assets of the pension system to be as large as its liabilities.
During the period 2002–2011, the income index increased by 3.4% annually.
Outperforming the income index
AP4's return for the same period, 2002–2011, was above 4.1%. The Fund has therefore made a positive contribution to the stability of the pension system.
Demographic imbalances require higher returns
To maintain long-term stability in the pension system, it does not suffice for the AP Funds to deliver returns on a par with the income index. Forecasts regarding the performance of the pension system show demographic imbalances in the future.
The imbalances are arising in connection with the retirement of the generation born in the 1940s. Because of these changes, the AP Funds must deliver a higher return than the income index.
Requirements for the AP Funds to offset the imbalances
AP4's Board has established a long-term goal entailing that the Fund is to reach an average real (inflation-adjusted) total return of 4.5% annually. This, according to the Fund, is the average return required over a 40-year period for the pension system's assets and liabilities to balance.
The long-term return target has been calculated using analyses regarding how the assets and liabilities of the entire pension system are expected to perform in the long term, for periods of up to 40 years. The analyses are produced with the help of various assumptions, for instance expected trends in the number of gainfully employed people and pensioners, retirement age, the number of births, life span and immigration over the next 40 years.
The Fund's average real return over a ten-year period is evaluated in light of the long-term return target.
High return target requires high proportion of equities
In order for the AP Funds to deliver high returns in line with the estimated requirement, the return target of 4.5% in real terms, the AP Funds invest a large proportion of capital in equities.
Equities are the class of asset that has historically given the best return over long periods, and that can still be expected to give higher returns than fixed income assets in the long term. Equities are also associated with higher risk and a risk of higher volatility, in other words short-term share price fluctuations.
Proportion of equities in the pension system of 7%
Of the pension system's total assets, the proportion of equities is about 7%. These equities are in the AP Funds. Overall, in the context of the entire pension system, 7% is a relatively low proportion of shares in relation to the long period of time during which pension assets are managed.
Since the AP Funds collectively constitute just over a tenth of the pension system, this 7% of the total pension system means a relatively high proportion of equities in each Fund. One of the reasons for there being five buffer funds was to ensure risk diversification. AP4's proportion of equities at the end of 2011 was around 56%.
Long-term outlook in the context of pensions: 30-40 years *
The real (inflation-adjusted) return of equities has varied greatly over the past 90 years or so. The average real return on Stockholm's stock exchange between 1918 and 2010 was 7% annually; just over 10% annually in nominal terms.
Major differences in equity returns between different 10-year periods
Real returns on equities have, in various 10-year periods, varied sharply, from over 20% annually (1980s) to negative figures for other periods. Major differences between consecutive 10-year periods are common.
Historically, real returns on equities have been much more stable during 35-year periods. It is only in a 35-year perspective that the real value change for equities is reasonably comparable in terms of stability with the real wage trend in a 10-year perspective.
The real wage trend is what largely governs the value trend of income pensions. During the period 1918–2010, the real wage trend was 2.4% annually. The difference between the real trend for equities and wages has been largest in the last two to three decades.
30–40 years possibly fairer time frame
When evaluating returns on equities, very long time periods should therefore be used. In terms of pensions, 30–40 years might be a fair time frame.
AP Funds – higher returns possible in the long term
Equities are assets with expected high returns in the long term, but also high risk. The returns of the AP Funds can therefore be expected to vary relatively sharply between individual years.
This has also been the case for the present pension system since it was launched in 2001. With hindsight, 2001 can now be described as the peak of a stock market bubble. Taking that point as the start of the measurement period, shares have therefore generated returns far below expectations.
Financial crashes make achieving goals difficult
During the 10-year period 2002–2010, the Fund's real return averaged 2.5% per year, which was less than the target of 4.5%. The return fell short of the Fund's target because that period included two financial crises: 2000–2002 and 2007–2008, which largely impacted equity markets.
The significant impact of these events on the Fund's real return is apparent from the fact that in 2012, even with a zero real return in the same year, the Fund could exceed the target of a 4.5% average real 10-year return. This is because the steep market downturn of 2001–2002 would no longer be included in the evaluation period.
*Source: Orange report 2010, Swedish Pension Agency.