AP3, part of the Swedish state-owned pension fund group, is charged with generating "maximum possible benefit for the pension system by managing fund capital so as to deliver strong investment returns at a low level of risk". AP3's asset portfolio was valued at SEK 220.8 billion on 31 December 2010. Pension Funds Insider recently asked CEO Kerstin Hessius (pictured), how she has managed to get the fund to be considered a shining example of good responsible investment.

Pension Funds Insider (PFI): Sweden is often considered a pioneer when it comes to pension provision. What do you think has made you stand out?

Kerstin Hessius (KH): What sets us apart is that we saw really early on that longevity was going to become a problem. We started to raise contributions from employers and kept the extra money aside for when we needed it. Then when in the early nineties, as a result of an international slowdown, Sweden's financial and real estate bubble burst and caused a crisis, we saw that a reform of the pensions was needed. And we could implement it, quickly. All due to the funds we had stored from the excess contributions. So we (had a smooth transition) from defined benefit (DB) to defined contribution (DC).

The politicians also decided to integrate an automatic balancing structure into the way our system ran (in 2009). It's a national DC system where we are taking into account that the intergenerational balance should be neutral. We should all carry the same burden. With this automatic balancing it means that when assets are lower than liabilities we change the indexing in the system. So we index all the pension rights and the pensions paid with a lower index then our income index. We do this until the system is balanced again.

Our system is a funded pay-as-you-go system which is very unique and it is independent from the public finances. We can always afford our future liabilities. It is a safe system.

The only downside to all of this is that people do not know how high their future pension will be. The only thing we know is that our children will also get a pension.

PFI: What would you describe as AP3's core strength?

KH: Our core strengths are that we are innovative and relatively diversified. Our innovation is based on two things. Firstly, we have completely separated our Alpha/Beta portfolios; almost all active management is run in an absolute return strategy portfolio, not based on asset or index tracking.

Secondly, we have divided our portfolio into risk classes rather than asset classes. We are working with a strategy to dynamically manage the portfolio risk. Our opinion is that it is very important to manage the risks you have in your portfolio rather than just look at the assets.

Through this risk approach we are much more focussed on which kind of risks we have and how they relate to the return and volatility. We can also detect straight away if we need to lower the risk in our portfolio.

PFI: Last year AP3 made a profit of 18.3bn Swedish Kroner, which is a 9 per cent return – what was this mainly due to?

KH: It mainly came from equity and real estate, especially Swedish equities and Swedish real estate. They did really well last year, we have quite a lot of equity in general, but especially Swedish equity did well. Our exposure to this market is roughly 25% of the equity exposure and the total exposure to liquid equities is roughly 50%.

PFI: In the AP funds (which make up the Swedish national pension system), how would you describe AP3's role?

KH: We are independent from each other, every fund creates its own strategy and we are not allowed to work together regarding investment strategy, with one exception. AP1-AP4 jointly own the largest Swedish real estate company (Vasakronan), because it already existed before the pension system was reformed in 2001. However, in other areas we collaborate.

In 2006 the Ethical Council was set up together with AP1, AP2 and AP4 in order to engage with foreign companies on environmental and social issues. Engagement is both resource consuming and expensive, but by collaborating we can be more efficient as well as gain more results. We also collaborate to find possible cost-efficiency opportunities.

PFI: AP3 is a state-owned pension fund. How much does this limit you?

KH: There is a five party agreement on pensions. If changes are to be made in the pension system all of the five parties have to agree. Both the rolling government and the opposition are onboard so it is very stable. The advantage to this is that when we change governments nothing happens (to AP3).

There is no fear that the government will take out money from the schemes to fund its own deficit. Even the Minister of Finance can not do this. It is against the law to use the money for any political purposes – it is only to be used for the beneficiaries.

But there are some investment rules that limit us. The statutory investment limitations which are mentioned in the National Pension Funds Act state, for example, that we are not allowed to invest in commodities and we are required to hold at least 30% of our assets in fixed income securities with low risk. We also cannot invest more than 5% of our assets in private equity or unlisted assets.

This all stems back from the time that the reforms were implemented, they were working on the UCITS directives and some of this legislation is just a 'copy and paste' of that.

This also shows that there is a downside to the security of the five party agreement because it is very hard to get any changes through, even necessary investment changes. Everyone is afraid to touch the Act because of the events it might set in motion.

PFI: What would you like to see changed?

KH: The limits create some inflexibility for us plus we cannot diversify our portfolio as much as we would like to. As well as commodities, we cannot invest any more in unlisted assets since we have already reached our 5% legal limit. The investment rules somewhat hinder us in developing the most optimal portfolio.

PFI: How important is transparency to AP3 and what do you do to ensure maximum transparency?

KH: We bring out a full annual report and publish it on our website, there for everyone to see. We talk about our strategies, what we invest in, the talks we are involved in with other parties, everything. We also publish all our holdings in all asset classes on our web site. Moreover we publish a comprehensive, detailed corporate governance report as well as a report of the work of the Ethical Council. We try to be as transparent about our practices as possible.

PFI: What social role do you think pension funds can play when it comes to responsible investing and sustainability issues?

KH: We integrate these practices in various ways but mainly we have integrated it into our policy by making investments in things like green technology, green bonds, green companies (and other) sustainable ideas. As said, we own the biggest real estate company in Sweden and we are very environmentally aware. We really make an effort to be engaged owners.

We vote in 500 companies and we use engagement through dialogue as a tool to make positive changes in companies. We collaborate on ESG (environmental, social and governance) issues with other investors, we support shareholder resolutions when it comes to these type of issues and engage directly with many companies. We work hard on these issues and really try to make a difference.

We can not actively monitor and engage with all 4000 portfolio companies but we screen all of them to identify breaches against international conventions. Certainly we expect the big multinationals to adopt national standards and the UN's Global Compact Principles.

PFI: What do you see as the scheme's biggest challenge in the upcoming years?

KH: The biggest challenge I would say is communication. Pensions have been lowered and people are upset because they do not understand why we have this system and why they cannot get more. The challenge is to get people to respect the system we have and to really understand why generation neutrality is a matter of distribution of wealth between generations and why it is important.

We have to deal with the problems of people starting work later, retiring too early, the lack of people in the workforce and the fact that we're living longer. In general, people need to understand that they need to save more on a relative scale. I don't think people realise they need to finance another 25 years of their life while they are still in work.

Maybe we have made the communication too difficult in the past. Maybe we talk too much about relative value and should instead say "if you work for 40 years then you need to use this time to save for an extra 25 years after you finish". It is almost two-thirds of your active work time so you have to save. But you also have to accept that your pension will be substantially lower than your income.

The good thing though is that we experience no threat to our system from a fiscal perspective. Many countries find themselves in a tough situation and luckily Sweden is not one of them.

First published 17.05.2011

azeevalkink@wilmington.co.uk