The Swiss government is looking to lower the second-pillar pension system's conversion rate to avoid the need for further adjustments in the near future, finds Nina Rohrbein

Since 1985, when the federal law on occupational old age, survivors and disability insurance (BVG/LPP) came into force, every employee over a minimum wage and with a longer-term contract has had to be part of an occupational pension scheme, the majority of which are Swiss DC schemes, so-called cash-balance plans.

At the end of 2009, 87% of employees in Switzerland were in DC schemes and 13% in DB plans, compared with a 50/50 split in the 1970s. Only some large companies, cantons or cities still offer a DB scheme today. Excluding pension liabilities insured with insurance companies, the Swiss pension fund market comprised CHF600bn (€497bn) of assets in 2009, the majority of which stems from DC schemes. Only around CHF120bn are in DB schemes.

In 2009, contributions of CHF45bn were paid into pension schemes, of which 57% or CHF26bn were paid by the employers and 43% by the employees. Smaller employers often have a 50-50 split with regard to contribution, which is the minimum required from employers by the BVG law, according to Ernst Rätzer, pension insurance expert at Aon Hewitt Switzerland and deputy president of the independent institution Innovation Zweite Säule (IZS).

Employee savings plans receive the contributions from both employer and employee and have a conversion rate (Umwandlungssatz) - used to calculate pensions from accrued assets - of currently 6.9% for the minimum coverage required by law. For benefits above the legal minimum, lower conversion rates apply.

"The conversion rate is trending downwards," says Rätzer. "Until 2002, the conversion rate stood at 7.2%. Now it is due to fall to 6.8% in 2014. Some pension funds with benefits above the legal minimum already have a conversion rate of 6.4% or lower. Lower conversion rates are viewed as best practice, as it is not possible to cut benefits for pensioners. However, future benefit cuts are being discussed at a political level to better distribute the burden between pensioners and active members, if pension funds have to restructure due to underfunding."

But as long as contributions are not raised at the same time, Willi Thurnherr, head of retirement at Mercer in Switzerland, says that lowering the conversion rate is essentially a cut to benefits.

"A further reduction of the mandatory conversion rate, however, can only be decided in an amendment of Swiss pensions law, which, most probably, will require a referendum," he says.

The future appreciation of retired members' assets benefits offered to pensioners is often calculated with a discount rate (technischer Zins) of 3-3.5%, with some exceptional pension plans having a discount rate of 4% or above. For active members, however, due to the current low-interest-rate environment, the minimum interest rate on retirement savings is at its lowest ever at 1.5% currently.

At the end of 2009, around 20% of Swiss pension funds were underfunded, according to a poll, with statistics showing a total of 2,351 pension funds.

To meet the minimum return targets and benefit guarantees, Swiss pension funds must have 15-25% value fluctuation reserves, which are included in the funding level. In an underfunding situation, Swiss pension funds must recover to full funding level after three to five years. Severe rescue packages are necessary once funds fall below a 90% funding level.

DC plans in the Anglo-Saxon meaning of the term have existed since 2006 for employees earning over CHF125,280 per annum. However, at present Swiss law includes a minimum amount based on employee contributions in these plans. In other words, this offers a certain guarantee, a situation that Thurnherr believes will be rectified by parliament in due course.

According to Rätzer, the asset allocation hardly differs between DB and DC schemes in Switzerland. In 2009, pension funds were, on average, invested in 37.8% bonds, 26.3% equities, 16% real estate, 8.1% liquidities, 5.5% alternatives, 2.7% mortgages, 1.7% equities with the employer, 1% others and 0.9% mixed assets.

The exposure to equities fell over the years, from over 29% in 2007 to 26% in 2009. "Allocations to fixed income, on the other hand, have grown despite the low-interest-rate environment, with 10-year Swiss bonds currently yielding below 0.8%" says Rätzer. "Alternatives remain a question of faith. However, following the average growth in alternatives from 3.7% in 2005 to 4.9% in 2007 and 5.5% in 2009, I believe they will continue to rise."

Exposure to hedge funds has declined, although overall diversification in alternatives such as commodities and private equity is on the rise. However, overall exposure to alternatives remains below 10%.

On 1 January 2012, the structural occupational pensions reform became fully effective. While stricter governance rules already came into force in August 2011, the new supervisory system, with its top supervisory body (Oberaufsichtskommission) and new regulations of investment foundations, only followed at the beginning of this year. At the same time, new provisions regarding the funding of public sector pension funds also came into force.

In December 2011, the Swiss government published its consultation report on potential reforms to the country's second-pillar pension system, addressing issues such as the conversion rate and the minimum interest rate. In the report, the government suggested it would make sense to cut the conversion rate from 6.8% to 6.4%, or even lower, by 2015 to avoid having to make further adjustments in the near future.

It said the ultimate decision on the conversion rate should be left with the government or handed over to the Oberaufsichtskommission. The minimum interest rate could either be set by the board of pension funds themselves, or remain with the BVG commission and the government, while the report also suggested that the legal parameters for the discount rate might be scrapped and made more flexible.

The main challenge at present is the low-interest-rate environment, in combination with the relatively high guarantees. "The problem is that current pensions, which were agreed during periods of high interest rates and high return expectations, are untouchable," he says.

"This has resulted in an imbalance between the performance needed to finance the pensions for the current pensioners and that that remains for the active employees. In other words, we have a cross-subsidy from the actives to the pensioners, which is a big challenge."