Switzerland: Efficient, secure and transparent pension funds
The relative benefits of a pension fund are impossible to judge as each stakeholder has a different level of expectation. Gérard Fischer looks at ways of defining a ‘good' scheme
It is difficult to determine what constitutes a ‘good' pension fund as the perspective of each stakeholder group differs considerably. Young employees want the lowest possible contributions as they don't expect to benefit from current pensions. Employees close to retirement prefer a high pension, for example through high conversion rates. Pensioners want security for their pension benefits, preferably inflation protection. Parents want the highest death and disability benefits possible. Employers and employees alike want the highest possible returns for improving benefits, but at the same time, they now want to avoid excessive risks and cover ratio shortfalls.
Since part of the payout is defined benefit in nature, and payable only in years or decades to come, an objective comparison between pension funds is barely possible, and different assumptions can lead to completely different results. The preferences of stakeholders cannot be met simultaneously, and favouring one group, such as new retirees, will take place at the expense of other stakeholders. However, some common goals can nevertheless be defined.
All participants want an efficient pension fund and efficiency means optimal performance in cost-benefit terms. The cheapest pension fund is therefore not necessarily the most efficient. This applies to general administration and management, as well as to asset management. Although visible costs are fairly easy to compare, any comparison must also include hidden costs such as management mistakes, incorrect or incomplete advice, opportunity losses through bad investments, redundant or missing reserves and/or disproportionate advantages for specific stakeholders. The costs can then be compared with benefits provided. A complex defined benefit plan or a defined contribution plan with flexible investment and buying options will involve a higher cost level than a fund which covers only the mandatory part and is maintained in a simple and straightforward manner.
The issue of investment and management costs of pension funds has been a recurring theme for many years. Depending on the political purpose, they are also often used as an argument against the second pillar by comparing these costs directly with the first pillar.
The general and administrative costs for Swiss pension funds (excluding assets) for 2009 showed an average of CHF310 (€230) per member, the median value being CHF276. Per fund, an average of approximately CHF52,000 was spent on specialists. For all participating funds combined, the total spent on pension specialists was approximately CHF14.9 m. With about 2.2m beneficiaries in the participating funds, this results in a pro capita amount of approximately CHF7. The mean value per fund for the inspection body amounts to approximately CHF35,000, and for the supervisory body to CHF8,000. All in all, the cost of the ‘control pyramid' is around CHF12 per capita. Asset management costs have been surveyed for many years, and show a wide range with a mean value of 0.18% of total capital assets.
Since our study does not survey the services and flexibility of funds, no general statements can be derived concerning efficiency. In addition, there can be considerable cost fluctuations from year to year, especially for consultancy costs, while external factors such as mergers, partial settlement or modification of pension rules, special audits or statements or additional reports prompted by legislative or supervisory bodies may regularly result in temporary cost increases.
Although the results should be interpreted with caution, it can be concluded that even with a saving of one-third of administrative costs, pensions would increase exponentially. Furthermore, asset management costs should be associated with investment requirements. Investing in Swiss government bonds is certainly more economical than direct real estate investments or investments in emerging markets with their corresponding diversification and return potential, but it will hardly lead to a real preservation of capital, let alone a real increase in value.
Simplification of rules and requirements would probably be the most effective way to reduce costs, but the growing political demands on the second pillar in recent years have often led to additional expenses.
The practice of pension funds to contract out asset management and negotiate terms with the help of consultants, also suggests a relatively high level of efficiency. Upward pressure on cost levels can be dealt with most effectively if there is transparency and a competitive environment. The more the pension funds become compulsory consumers of services due to new rules, the less competitive the environment will be. These relatively low administrative costs also mean that further savings in this area can still not prevent an adjustment in the conversion rate to reflect increases in life expectancy.
Security of benefits
All participants want a secure pension plan. Pension payments should be on time and retrospective contributions should not be necessary. The financing of current and future benefits should be managed smoothly and correctly. Costly mistakes in processing or compliance should be avoided. Security also includes the prevention of abuse or fraud.
The second pillar rests on contributions from employees and employers, with capital gains included as a fixed ‘third contributor'. The pension funds plan a target rate of return, and only when this is achieved can future benefits be provided as expected.
A number of results from the Swisscanto survey underline the need for change. The average return achieved in 2009 was a remarkable 10.5%, and is one of the highest ever achieved in the of occupational pension system, but this was only partially able to offset the -12.7% collapse of the preceding year.
These large fluctuations indicate the investment risks that pension funds bear in order to achieve the required returns, which also implies a lack of certainty to achieve the required rate of return over a longer period. Volatility has increased in the wake of the financial crisis, and has therefore exacerbated the problem for pension funds in their search for high yields with acceptable levels of risk.
The results also show targeted returns were not achieved over longer periods. For example, over the last five years only 3.1% was generated per annum, while the required rate of return of the participating funds is set at 3.9%.
The investment situation today is fundamentally different from that in the 1990s, when the minimum nominal rates of return were easily achieved due to inflation rates that remained high. At the time, shortfalls were largely a theoretical problem for professionals. The investment situation has changed drastically, however. Although the long-term effects of the credit crisis cannot be reliably predicted, it can be concluded that the high levels of debt of various countries at increasing interest rates will lead to a massive aggravation of the debt problem, and accordingly the pressure towards low interest rates is likely to continue. This means that the anachronistic minimum conversion rate as defined - contrary to economic realities - by the federal council, can also be expected to come under pressure.
Funding stipulations are still only truly transparent for specialists and open to interpretation. This is also true at the supervisory level. But transparency and clarity are basic requirements for participants and are prerequisites for trust in the second pillar.
In terms of transparency and confidence, Swisscanto's survey does not offer answers. The national referendum on the conversion rate in 2010, however, has shown that many members no longer understand the pension system and appear to have voted against a reduction of benefits due to doubt and mistrust. The biggest challenges are therefore likely to be found in this area. All participants can help in dealing with this challenge; the pension funds and associations by communicating clearly and transparently, the supervisory bodies by restoring confidence, adequately punishing the occasional cases of abuse and concretely identifying funds with insufficient capital (including the public service pension plans), and the politicians by simplifying regulations and addressing the real challenges of longevity and low capital market returns.
The second pillar is a central and necessarily political element of social security, and holds a considerable position. This is why the discussion about securing and further developing occupational pensions is so important. Nevertheless, we would like to close on a positive note. Pension funds have undeniably taken in their stride the second stockmarket crash within a decade. The number of insolvencies among pension funds fell to an all-time low last year. Benefit promises can generally be provided in their entirety, and the high immigration levels in Switzerland create a counterbalance against demographic ageing, which also relieves the second pillar. Compared with neighbouring countries. which in most cases do not have an extensive funded pension, Switzerland comes out relatively well.
The prospects for the second pillar are not exactly secure, but they are clearly better than the first pillar of state pension provision, which will most likely meet considerable financial difficulties in the next few years. The achievements of the second pillar will then most likely be rated more highly than today. Until then, the system has to rely on its proven strengths: there seems to be no other way.
Gérard Fischer is CEO of Swisscanto Group