David Pauls and Peter Zanella argue that Swiss pension funds must keep up with underlying economic and demographic reality, and that policy makers should stop moving the goalposts

The Swiss pension industry has for some time resembled a slow-moving sport in which the referees keep moving the goalposts. As in most other developed countries, pension funds in Switzerland are facing solvency challenges, mainly due to low interest rates and increasing life expectancy. It is clear to most observers that painful adjustments need to be made, and these have profound implications for employees and employers. However, recognition of these facts by many pension funds has too often been slow in coming.

This creates false hopes for many pension fund members and potential pain in the future. While corporate accounting under International Accounting Standards (IAS) has for some time reflected economic reality through higher liabilities, pension funds’ local reporting – which is the basis on which trustees make benefit decisions – has been far slower to catch up. This makes the resulting adjustments all the more difficult and is threatening the solidarity that underpins the Swiss pension system. Employees’ expectations are being repeatedly disappointed as, despite recent strong asset returns, liabilities are regularly revised upwards as well.

The underlying drivers are economic and demographic. Even though bond yields have fallen to record lows over the past few years, the interest rate applied by many pension funds to measure their liabilities has remained high. Indeed, most pension funds had not adjusted their assumption for many years until very recently, when a newly mandated cap to these interest rates provided the necessary spur. These adjustments are only now starting to be made and as the interest rates being used continue to fall, liabilities will continue to increase. Most affected will be those pension funds with substantial pensioner populations, as these liabilities are particularly sensitive to such changes.

Coupled with these changes, many pension funds will need to update their assessment of future life expectancy for their members. At most pension funds, these are still substantially underestimated. For example, few pension funds currently allow for future improvements in life expectancy, despite the near-universal acceptance that such improvements are expected to continue. Such a view is certainly expressed by their sponsors as reflected in Towers Watson’s research, which shows that such improvements are currently reflected in the IAS figures for most corporate reporting in Switzerland.
Indeed, it can be argued that pension funds should be even more cautious when setting these assumptions, as they have a responsibility to ensure that funding levels are adequate. Life expectancy for new pensioners has been increasing by roughly one year per decade and many models – supported by Towers Watson’s own research – suggest increases in life expectancy may well rise even higher. However, liabilities for Swiss pensioners appear often to be substantially undervalued, even on current trends.

As a result, the current reported funding level (assets compared to liabilities) appears overstated for many pension funds as few have adjusted their assumptions rapidly enough to reflect current market conditions. Instead, they are only making gradual adjustments when lowering their interest rates and increasing assumed life expectancies for their pensioners. And so, despite healthy asset returns, funding levels seem likely to remain under pressure as necessary adjustments continue to lag.

This gradual approach, by which many pension funds reflect economic realities, has real consequences. Members are often provided with unrealistically high interest on their pension capital. Furthermore, they are often offered annuitisation rates at retirement that require substantial cross-subsidy from other plan members. And, although some pension funds have taken steps to reduce these rates, these discussions are politically highly charged, as shown in the failed federal vote in 2010 to reduce conversion rates. Delaying changes can mean even more substantial adjustments later, making any reductions all the more painful.

Many employees and employers had a taste of this following the start of the economic downturn in 2008. Employees often saw a substantial drop in the interest they received on their pension capital, in many cases down to 0%. Also, they were often required to make additional “recapitalisation” contributions. Many employers, some of whom were long accustomed to view their pension funds as defined contribution in nature, were surprised to be required to contribute towards recapitalisation as well.

A further rude shock can await members when their company goes through a restructuring. When part of a business is sold off, the pension fund may be considered, under the law, to be partially liquidated. In this case, the pension fund shares its surpluses or deficits with the departing group. However, pension fund trustees are under an obligation to protect the interests of the remaining members, especially if many of these are pensioners. Recently, several high-profile examples have shown that if the company does not step in to make good the difference, this can lead to significant cuts in the assets transferred to the departing members. This can leave them significantly worse off than they thought, prior to the transaction.

Indeed, pensioners enjoy special protection under the law. Their benefits may not be reduced, regardless of the solvency of their pension fund. The value of this ‘no reduction’ guarantee was masked during the rising tides of asset returns in the 1990s and early 2000s.

However, the low returns of recent years, coupled with maturing pension populations at many pension funds, are highlighting its value. Indeed, in some mature industries, pensioner liabilities are the majority of the total, leaving active members – who together with companies must bear the cost of any recapitalisation needs – highly exposed.
This is creating rifts in the solidarity that is the backbone of the Swiss pension system. For example, a political discussion is now taking place as to if and how retirees should also “contribute” in case of significant pension underfunding. Another political discussion relates to the individualisation of retirement accounts and the possibility for employees’ account balances to go down as well as up. And there is the long-running topic of the annuitisation (conversion) rates at retirement, which are partially enshrined in law and widely considered by experts to be far too high. These are resulting in continued (and increasing) inter-generational subsidies from young to old, which are not going unnoticed.

Pension funds are struggling to adjust. Many are taking steps to reduce risks, often through adjusting their benefit plans and asset strategies. Most are trying to limit the growth of liabilities by controlling the interest credited to members’ accounts. And almost all are at least half-heartedly hoping for an increase in bond yields which, although it would significantly reduce the value of bonds held in investment portfolios, could be compensated for by significantly reducing liabilities. However, much more should be done by trustees to modernise pensions accounting and to paint a more accurate pensions picture for members.

Meanwhile, corporate plan sponsors, who have long recognised these trends and reflected them in their own accounting, look on warily. They are growing increasingly concerned about the growing potential for recapitalisation payments in future, the impact on their workforce and the implications for their own ability to take strategic decisions.

Many are taking active steps to reduce other business risks, while encouraging trustees to focus on the changes they could make. But they would all be helped if decision makers would stop moving the goalposts.

David Pauls is director of retirement solutions and Peter Zanella is head of retirement solutions at Towers Watson Switzerland