Switzerland: Magic number crunching
Swiss pension funds have enjoyed a major recovery in the funding levels over the past months. But the fundamental problems remain, writes Barbara Ottawa
The figure 101.4% got many people in Switzerland excited when the asset manager Swisscanto announced the latest calculations for its Pensionskassen monitor in April. This percentage is the average funding level achieved by a sample of Swiss public pension funds aiming to be fully funded.
One of the first decrees issued by the supervisory body Oberaufsichtskommisison (OAK), established as part of the structural reform of the second pillar in 2011, was to allow public pension funds to choose whether they wanted to aim for full funding, like private Pensionskassen, or to continue relying on financial guarantees issued by the federal state, the cantons or municipalities. So far, the majority of pension funds have chosen not to defer the problem of financing but to aim for a full funding as soon as possible.
Swisscanto has also adjusted its Pensionskassen monitor and for the first time since year-end 2011 the average funding level of those pension funds aiming for full funding has passed the 100% threshold, as of end-March 2013. Public funds with a state guarantee managed to raise their funding level to 77% since 2001, 250 percentage points higher than at the start of the year, and much closer to the 80% they have to achieve over the next years.
Towers Watson has also recognised the “increase by leaps and bounds” in the funding level of major listed companies, mainly the result of good returns on equities, in its latest Global Pension Finance Watch.
Heinz Rothacher, CEO of the St Gallen-based consultancy Complementa, says: “Swiss pension funds are definitely in a much better funding situation than they were after the crisis, and they have also improved their diversification.”
Thomas Liebi, chief economist at Swisscanto adds: “The good market performance in the first quarter has helped but the fundamental problem remains.” He believes the discount rate (technischer Zins) of around 3.5% on average is too high and that it is dangerous to sit back when the markets are performing well.
Liebi would like the discount rate to be reduced, which would result in lower funding levels.
But, he argues, this would bring them “closer to economic reality”, making them fairer for young workers who are subsidising pensioners. “Similar to the financial discipline of governments, there is the danger of letting reforms slip when the situation has improved,” he says.
But some in the industry, like Christian Bodmer, head of investment consulting at Mercer Switzerland, warn against too much haste. “In fact, Pensionskassen should apply a discount rate of only 1.5% in the current market environment but it is absurd to go down that road as nobody is able to finance that gap of the funding level.”
Bodmer thinks it is better to soldier on for now and wait “for the historic lows to level out again”, but then adjust the discount rate step by step when returns have filled the buffers.
“The Swiss system has always been described as ‘safe’ but for an employee safety also means calculability and we will lose that when frequently adjusting the basic parameters to the market situation,” explains Bodmer.
The discussion on whether or not to change the way the funding level is calculated is not new. A decade ago, Zurich-based consultancy PPCmetrics suggested using a so-called “economic funding level” that takes the discount rate into consideration.
“An economic funding level would provide more realistic figures but the difference to the currently reported funding level would not be that great,” Rothacher believes. “It still does not give you a full picture of the quality of the fund.”
Liebi adds that Pensionskassen in theory have enough leeway to adjust the technical discount rate but that a 100% funding level looks better than a lower one. He also warns that using a more complex funding level might confuse members. “It is more about how the funding level in a Pensionskasse develops rather than an absolute figure,” Liebi says.
He also warns about long-term comparisons of funding levels with different underlying discount rates.
Rothacher suggests using a different approach to increase the fairness in the system. He would like pension funds to adjust the guaranteed interest they are granting on pensioners’ assets to match the usually much lower interest on assets of active members.
Indeed, he says this is happening at several funds, but of course only those with well-filled buffers can do that as they will still have to keep the pension pay-out level.
“This will also help strengthen the second pillar because more fairness in the system means that it becomes a less easy target for criticism,” says Rothacher.
Bodmer points out another problem in reducing the discount rate and with it the conversion rate used to calculate the pension of future members. He says: “We see people close to retirement taking out their money in bulk as soon as possible rather than opting for a pension pay-out when a Pensionskasse announces it is cutting the discount rate.” But he adds that many fail to manage the money themselves and get into financial trouble if they get very old. “It should not be the aim of the second pillar to shift this risk to the members,” warns Bodmer.
Rothacher also points out that overfunding is unfair for employees leaving the company because in many cases they do not get any of that excess funding buffer – so the truth lies somewhere in between.
Looking at diversification
In principle, market participants agree that the discount rate has to be brought down step-by-step, which means the adjustments will only take effect in a few years.
Until then, Swiss Pensionskassen face similar problems to their peers: alleged risk-free returns are too low for their needs but sitting on large bond exposures they fear rising interest rates as well, and the definition of risk has changed.
According to Rothacher, diversification is the answer to the problem for many Pensionskassen. And Liebi agrees: “Swiss pension funds have seen that diversification is the key to success.”
Bodmer adds: “Since the crisis, Pensionskassen are more broadly invested, they are diversifying more.” He adds that this is not only happening out of risk considerations but “almost more importantly” because the yields on some domestic investments is simply insufficient. The Swiss 10-year government bond is currently yielding between 0.8% and 0.9% to maturity.
This also means they are also looking at international diversification for their investments, for example by seeking European equity dividend strategies.
Analysts at Complementa have noticed an increase in equity exposure, with more searches for specialist mandates. But Rothacher adds that all of this is “not a major” shift as only 2-3% is being reallocated. As for the strong domestic bias among Swiss Pensionskassen, Rothacher points out that some listed companies, like Nestlé, are offering a global diversification based on their global operations.
In its findings on the first quarter figures of a sample of Pensionskassen, Credit Suisse noted a record high in Swiss pension funds’ equity exposure. Foreign equities alone account for almost 18% of overall allocations, just shy of real estate at 20.2%. Just before the crisis the level was 15%.
Domestic equities, on the other hand, accounted for 13.4% of portfolios on average, as at end-March 2013, still roughly the average post-crisis exposure.
Bodmer is convinced the shift towards high yield, emerging market debt and equity, and further diversification in the main asset categories, will be sustainable as Swiss pension funds are “not known for rash actions and quick changes”.
But he adds that alternative investments, such as private equity, hedge funds and non-domestic real estate, are still considered with caution as some funds were burned by previous investments.
“Some investment themes are treated ‘as poor relations’, in other words, they are not really being considered because of the ongoing debate around administration costs,” Bodmer says. “Some funds prefer to get something cheap but this does not mean it will get them the results they are after.”
He sees a major difference in the approach to risk between investors in Switzerland and their peers in the US and the UK. “The Swiss do not like volatility even if they have a long-term investment horizon and they believe less in things like the illiquidity risk premium. In total, this means they are sometimes too risk averse and are losing out on some return.”
The new diversification also means more complex investment structures and a higher administrative burden, which will further increase under the administrative cost reporting directive issued by the OAK in April, which introduces a new TER to be calculated by Pensionskassen.
In this much more complex environment, Rothacher reports that the number of Pensionskassen has shrunk from 2,700 to 2,100 over the past six years. Many companies consider pension funds to be an administrative burden which is not part of their core business, so they are merging funds or outsourcing them to a collective scheme.