The Swedish pensions system underwent a complete overhaul in the 1990s. As a result of the reform, in 2001, the current structure of the Swedish AP funds was established, comprising four national buffer funds – namely AP1, AP2, AP3 and AP4. The smaller AP6, which only invests in domestic private equity, was also set up. The four main AP funds were given identical guidelines, including a new investment framework, and started out with the same amount of assets.

Almost 10 years later, the system has been through two financial crises and the AP funds have received their fair share of criticism. The criticism has not only been about losses, but also their failure to deliver on active management, unethical investment decisions and generally being too expensive.

The most recent point of debate relates to costs and the number of buffer funds in the system. As a red thread in the debate, there seem to be an underlying assumption that the AP funds are expensive. A report published in November by a government think-thank, Expertgruppen för studier i offentlig ekonomi (ESO), proposes that the government should immediately begin preparations to merge the AP funds into one. According to the report, the current system fails to take advantage of economies of scale and has not lived up to expectations.

The author of the report, Malin Björkmo, insurance and investment fund director at Finansinspektionen, the Swedish Financial Supervisory Authority, argues that many of the expected benefits of having several funds have not been fulfilled. When the system was set up, there were several reasons for having four main buffer funds. It was believed that not having all the assets in one fund would spread the risk and that one large fund would become too large an investor and lack flexibility. It was further believed that the competition between four funds would positively contribute to returns and that several funds would limit the state’s control and ensure the funds’ independence. But above all, the final structure was a political compromise between five parties, which took five years to agree on.

However, Ms Björkmo argues that the competition has not led to diversity. Instead, the four funds have surprisingly similar strategies and returns. Furthermore, she believes that one of the main downsides is that the current structure is very expensive as every fund has their own operations and administration.

Peter Norman, CEO of AP7, which manages the default fund in the premium pensions system, agrees with parts of the argument.

“By moving to one fund, you would miss out on the diversification, but the diversification effect of having four funds instead of one has been less than hoped for. On the other hand, if mistakes are made in a system with only one fund, it will be for 100 per cent of assets,” Mr Norman says.

Unsurprisingly, the four AP funds reject the assumptions in the report.

“Everybody knows that there are some economies of scale,” says Kerstin Hessius, CEO of AP3. “It’s provocative to have four AP funds just because economies of scale are not fully taken advantage of. But cost efficiency can’t be analysed without taking the value of diversification into account.”

Primarily, she believes that Ms Björkmo’s report has failed to properly analyse the advantages of management diversification. As a response to the report, Ms Hessius made her own analysis of the benefits with the current system.

“She [Ms Björkmo] hasn’t made any effort to analyse the value of diversification – just concluded that the funds are too similar. But with several funds in the system, you notice if one of them systematically underperforms. The results may differ from year to year, but if one fund constantly underperforms, there’s reason to take action,” says Ms Hessius.

That is exactly what happened with AP4, which over time presented returns far lower than the other AP funds, both in real terms and compared with benchmark. That resulted in a substitution of both the management and the board, and led to a change in investment strategy.

Furthermore, Ms Hessius argues that competition has positively contributed to keeping management costs stable and low. These have been constant at around 0.15 per cent of assets, which she says is cheap for a well diversified investor. In comparison, she mentions the Norwegian Government Pension Fund Global, which has somewhat lower costs, although they will increase as the portfolio diversifies outside equities and bonds.

Ms Björkmo is not surprised by the reaction of the AP funds, which she says is subjective. According to her calculations, merging the AP funds would reduce costs by more than SKr300m (e29.5m) a year. Further calculations suggest that by merging the funds, the assets would grow by SKr150bn over a 75-year period.

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