Alight for full funding
Markus Hübscher, CEO of the Swiss Federal Railways pension fund, told Nina Röhrbein about his fund’s restructuring and new internal governance structure
Travellers on the efficient Swiss federal rail network probably don’t think too much about the pensions of the employees who help them get to their destination.
Members of the network’s CHF13bn (€10.6bn) Pensionskasse (PK SBB) - established in 1999 as the private successor to a former partially funded public scheme - work as train drivers, conductors and in related infrastructure such as rail track maintenance, telecommunications and power.
Like the majority of Swiss pension funds, the pension fund of the Swiss Federal Railways (SBB in German, CFF in French) is a cash balance scheme. The fund has been on a long journey since its foundation in 1907, and has had to overcome many obstacles on the way, including a low funding level. To do this, it took an unusual funding route.
When PK SBB started out in 1999, it was classed as a fully funded private scheme. However, the fund lacked reserves. Given half of its members are retirees, pensioners’ capital makes up more than 60% of the liabilities, these were badly needed soon after.
Since the 2001 collapse of financial markets, the fund has struggled with underfunding. After several recapitalisation efforts, the fund took rigorous action to tackle its funding situation and its approach to managing assets in 2009.
Since then, SBB employees and the Swiss government, as sponsor, have all boosted the funding level with extra contributions. In addition, an asset liability management study conducted between spring 2010 and summer 2011 led to a new approach to managing assets, to investment strategy and a new investment governance model.
“Unlike the majority of Swiss pension funds, we do not simply look at the yield we need to generate to meet our liabilities,” says Markus Hübscher, CEO at PK SBB. “Instead, we view the liability structure as the starting point or benchmark, in our investment strategy. However, given current Swiss market conditions, a one-to-one cash flow matching with a liability-hedging portfolio does not generate sufficient returns to pay the defined benefits to its members. Higher yielding asset classes are necessary to achieve the requirement. And this has, in essence, led to a split of the assets into a liability hedging and a performance seeking portfolio.”
The liability-hedging portfolio seeks to replicate liabilities, while the performance-seeking portfolio is designed to generate the additional returns to finance the benefits.
As a result, the investment strategy is derived from the liability structure, while previously the asset allocation was developed from an asset-only framework.
The transition to the new framework will be staggered over several years, accompanied by a new risk management process.
This approach has significant implications. Like many other Swiss funds, it invested in short duration assets in the belief interest rates would rise, despite its long-term liabilities. “In the past, we were not necessarily aware of the real risks this implied,” says Hübscher. “But, following a thorough analysis of the portfolio in our new framework, we realised that the short duration gap was the single biggest bet we had in our portfolio.”
Within its new framework, PK SBB introduced a risk budgeting process that determines how much investment risk the pension fund can take in relation to the liabilities, not the absolute volatility of the assets in an asset-only world.
“Today we can still go short duration, but it consumes risk budget,” says Hübscher. “We can also increase our equity exposure, but this will also use up risk budget.”
To be able to manage the fund in this new framework, a risk management system had to be developed. The system also produces risk breakdowns and analyses the sources of the risks taken.
“If you have a risk budget, you need to take into consideration the impact of tactical decisions in order to avoid violating the risk budget,” says Hübscher. “The risk budget should not be solely based on strategy but must also include any tactical decisions and implementation risks, such as those produced by actively managed accounts. We decided that the majority of our performance should come from strategy rather than tactics and selection and therefore a tight implementation risk budget was approved.”
Asset allocation has remained largely unchanged over the past two years; the pension fund’s main split is between fixed income and equities, with 58% and 22.5% respectively. The rest of the portfolio consists 8% real estate, 7% alternatives and 4.5% liquidity. A large portion of its bond exposure is invested in sovereign debt. The fund has also given its corporate sponsor a loan - in connection with the capital injected into the pension fund - which it will pay back over the next 20 years including interest. This currently makes up around 16% of the overall portfolio. Swiss bonds make up about 31%, euro bonds 4.7%, global bonds around 4.6% and mortgages approximately 4.2% of the overall portfolio.
With the new approach, the duration of the fixed income portfolio is set to increase over the next few years, which will free up more of the risk budget, and, consequently allow the pension fund to invest more in higher yielding asset classes such as equities and high yield. “We intend to maintain our current fixed income allocation but will increase our duration, the exposure to higher yielding asset classes and, as a result, increase the expected return of the overall fund,” says Hübscher. “On the equity side, we will significantly add to our emerging markets exposure, which is minute at present.”
The real estate portfolio is also changing. In the past, real estate inv estment trusts (REITs) or listed real estate companies made up a significant amount of PK SBB’s property portfolio. “We were not entirely happy with the REITs because we were essentially buying equity volatility through them while were looking for yield with low volatility,” says Hübscher. “Going forward, we will invest via investment funds or investment foundations [Anlagestiftungen] and reduce our exposure to listed real estate companies.”
Alternatives for PK SBB include allocations to private equity, infrastructure, commodities and hedge funds. The fund has been investing in private equity and infrastructure fund of fund structures for many years. But, with the new liability-driven approach, these asset classes will be reviewed as well. “The way we collect risk premiums is work in progress, which we will intensively review in 2012 and this includes investments in alternatives,” he says.
Next year the strategic asset allocation is set to comprise 59.5% fixed income, 25.5% equity, 8% real estate, 5% alternatives and 2% liquidity as a cash buffer.
As a result of the restructuring, the pension fund took the decision to outsource a greater proportion of assets to external managers. Today, only one portfolio - Swiss bonds - is still managed in-house.
“This portfolio must take cash management aspects into account,” says Hübscher. “We still need to be able to finance a technical outflow of around CHF400m annually, which is why we need to be careful not just to invest in 20-year bonds.”
The risk budgeting process and the active steering of the duration brought about the need for a new internal governance structure. A new, more risk-orientated, governance philosophy has been adopted and is currently being implemented.
At many Swiss pension funds, when issuing a new mandate, the new manager is chosen by the board of directors, approved firstly by an investment committee and given its final approval by the board of trustees (Stiftungsrat). “The question then arises who is ultimately responsible for the decision and the good or bad performance of the mandate,” asks Hübscher. “Is it the board of directors that made the selection, the investment committee that agreed to it or the board of trustees that gave the final approval?”
With the new governance structure, the pension fund no longer wanted to have shared responsibilities. Instead, PK SBB will split its investment process into decision-making, implementation and control.
“The individual bodies are now allowed to execute decisions within the range of their responsibilities, which in turn allows us to measure the success or failure of these decisions,” says Hübscher. “In short, we have created a value chain within the investment decision process.”
At the start is the board of trustees, which sets the risk budget and the implementation risk budget and defines the split between strategic and tactical decisions. In addition, it decides about any restrictions and the allocation of the portfolio. The weighting of the various asset classes is determined by the investment committee in line with the risk budget and the minimum expected return. The board of directors uses the implementation risk budget for the investment decisions.
The biggest challenges for the pension fund are low expected returns and high volatility in the markets as well as the low interest environment - particularly with a view to PK SBB’s underfunding and its large number of pensioners as pensions paid to them are fixed by law.