A majority thinks the investment limitations are necessary, but too strict.

Most of the representatives of Swiss pension funds think that legal investment restrictions and guidelines are a necessary measure to protect the employee’s pension fund assets. At the same time, most of them are convinced that the restrictions hinder an optimal asset allocation. This reflects a common misunderstanding, that the restrictions themselves represent the boundaries of a pension fund investment strategy.

The law (BVG/LPP ) requires Swiss pension funds to manage their assets in such a manner as to ensure safe investment, an adequate return, appropriate diversification of risk, and sufficient liquidity. The law grants the board of the pension fund a great deal of autonomy when defining and implementing a suitable investment strategy. The relevant ordinance (BVV2/OPP2 ) provides more detail about what is allowed. However, to infer that the investment limitations prescribe suitable boundaries for all pension funds may lead to inappropriate investment strategies.

The original intent of the investment restrictions was to protect the accumulated contributions from losses by limiting investments in ‘risky’ assets, and on the other hand by allowing maximum exposure to what was considered ‘riskless’ . Risks were perceived on a single asset or, at best, asset class level, and not within the context of the total portfolio. In current practice this mindset lingers.

Articles 53 - 55 of BVV2/OPP2 list the permitted asset classes and corresponding allocation limits. For example, a maximum allocation of up to 25% in foreign equities is allowed. Overall, the foreign exposure must not exceed 30%. A pension fund blindly adhering to this given set of restrictions cannot implement a truly globally diversified investment strategy with reasonable return expectations.

On the other hand it is commonly assumed that a pension fund looking for a low risk strategy is allowed to put all its assets in CHF government bonds. Such a strategy does not meet the requirements of BVV2/OPP2 because of the lack of diversification. In addition, at least two kinds of risks should be taken into consideration.

(1) The required return cannot realistically be achieved in the current low CHF interest rate environment.

(2) Many pension funds hold a short average duration because they fear a rise in interest rates. This amplifies the return opportunities missed, because the term structure of interest rates is positively sloped most of the time.

They even could achieve a yield pick-up without taking too much risk if they were to align the duration of the assets to the duration of the liabilities.

Do the restrictions in practice prevent Swiss pension funds from implementing a reasonable long term strategy? They do not in the normal case, as one can see from the aggregate numbers. According to the last available official pension statistics, as of 2004 the average allocation in CHF bonds was almost 20% and as such it still was the largest asset class. An average of 17% was allocated to foreign bonds and 15% to foreign equity. These numbers show that foreign exposure was already more than 30%, on average, two years ago. Since then, according to a survey Watson Wyatt conducts semi-annually with a representative set of Swiss pension funds, the trend towards more foreign and alternative investments is obvious.

This suggests that the limitations in place have not completely prevented Swiss pension funds from enlarging the investment universe to gain diversification benefits. However, there are many more different and probably better ways to achieve the benefits of diversification than with a standard menu of traditional asset classes.


The strategy must be long term

The duration of the liabilities is typically very long, which requires a long term investment horizon. Article 50 BVV2/OPP2 requires pension funds to establish a strategy based on their liabilities.

The appropriate tool to do this is an asset liability modelling analysis (ALM) that takes into consideration all factors known today. An ALM simulates the effect of various economic, demographic, and structural scenarios. The result is a set of possible investment strategies from which the board of the pension fund can choose the one that best fits its preferences.

If the chosen strategy happens to depart from the legal limitations, the pension fund will generally still be allowed to follow that path, under the following conditions: It has to

❑ show that it has developed an investment strategy based on its risk capability,

❒ document the strategy with proper investment guidelines, that clearly state, among other things, what the objectives are, how it is organised and who carries which responsibilities, the valuation and monitoring/controlling process, and the adopted code of conduct, and

❒ produce special report addressing each deviation from the legal limits, to be submitted to the regulator with the annual report (article 59 OPP 2). There is actually a caveat leading to a contradictory situation. The risk capability of a pension fund is determined by its current coverage ratio (ratio of assets to pension liabilities). Consequently, a pension fund with a coverage ratio below 90% will find it virtually impossible to diverge from the investment limitations even if it was a reasonable long term strategy to allocate a substantial part in asset classes with a higher risk-reward profile and beneficial diversification properties. The existing investment limitations do not provide for sufficient diversification across asset classes in cases when it is particularly needed. The probability to recover in the long run is reduced.

The regulations in place lead to misinterpretation. One reason might be the temptation to keep to the rails instead of going the own individual way to achieve ones objectives. The pension funds that do set their strategy within the bounds given by the regulation can be lulled into a false sense of security because they do not breach the law. But they tend to ignore the fact they first and foremost they have to set up a diversified strategy. Since there is no unique optimal strategy, the board members must determine the solution that best fits to the risk capability of the pension fund.

Antoine Cuénod is a chartered financial analyst at Watson Wyatt Worldwide, Switzerland


Investments in sponsor


ntil the end of 2005 a pension fund was allowed to have up to 20% of its assets invested in its own sponsoring firm, eg in its bonds or stocks, or as a loan. This raised a number of issues. Not only is there a serious potential conflict of interest, but it also put the pension fund at considerable risk should the sponsor firm go bankrupt. The good news is that the 20% limit has been reduced to 5%, effective January 2006. One could reasonably argue that such investments be completely removed from the allowed investment universe of a pension fund, but given political realities this was not feasible. The bad news is that a lot of mainly mid sized firms used this opportunity to finance business projects at seemingly favourable conditions and now find it difficult to quickly refinance it.