The asset allocation of Swiss pension funds is subject to detailed government regulations. As the granularity of these regulations has been relaxed over the years, some say that Switzerland is well on her way to adopt the globally established prudent investor standard. Christian Dreyer begs to differ
Switzerland has a world-class pensions system which ranks second only to the Dutch in Mercer's recent Global Pension index. Its funded second pillar has the highest per head accumulated savings in the world. Yet, the system has a number of issues, some structural, some regulatory. They may have to do with the fact that Switzerland was one of the pioneers in introducing a mandatory system a generation ago. Indeed, this year the second pillar celebrates the twenty-fifth anniversary of the introduction of the Occupational Retirement Act in 1985. Nevertheless, other countries are diligent students and have since overtaken the pioneers in some respects.
The system is predicated on a voluntary paternalistic, employer funded culture and practice, which has been moulded by law into a mandatory system. This is still visible in the large number of very small plans with few assets. Following the introduction of the law in 1985, this disparate market structure has remained frozen, with merely gradual consolidation taking place in the meantime.
No less than 96.3% of Swiss plans hold assets below CHF1bn (€796m), whereas the 28 largest plans hold 45% of all assets cumulatively. Note that these numbers represent the situation in 2008, but were only been published in late 2010 (Bundesamt für Statistik, Die berufliche Vorsorge in der Schweiz 2008).
A regulatory framework has been built to accommodate the requirements of that market structure: there are detailed quantitative asset allocation limits targeted at the overwhelming majority of plans that are too small to have sophisticated in-house asset management resources. Nevertheless, there is an optional exemption from those limits available to those institutions able to justify non-compliance.
This regime with its primacy of quantitative limits is increasingly at odds with what has become a global de-facto standard of institutional asset management regulation, ie the prudent investor standard. This is a legal concept that has its origin in the Anglo-Saxon common law trust and was codified most influentially in the US Employee Retirement Security Act (ERISA 1974) and, more recently, in the Uniform Prudent Investor Act (UPIA 1994). Through the European Union and OECD, it has spread into more non common-law jurisdictions. Since 2005, all members of the European Economic Area, but not Switzerland are obliged to adopt the prudent investor standard for their pension funds in compliance with EU Directive 2003/41/EC. Even more comprehensively, in early 2006, the Organisation for Economic Development and Co-operation (OECD) adopted Guidelines on Pension Fund Asset Management, which recommend incorporation of the prudent investor standard into the regulatory framework for its members' pension funds. Note that Switzerland is a full member of that organisation.
Neither the EU Directive nor the OECD Guidelines are specific about the content of the prudent investor standard. This is no omission of the lawmakers, nor is it unreasonable because, in essence, the standard is meant to remain open for development. A contemporary interpretation of the standard would include the following key aspects:
• Duty of "care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims" (ERISA)
• Knowledge and application of industry expertise and best practices,
• Focus on (auditable) due process rather than (unknowable) outcomes,
• Exclusive duty of loyalty to the plan and its participants in cases of conflicts of interest,
• Application of the duty of care to the portfolio as a whole rather than to its individual constituents
In conceptual terms, however, it is clear that the prudent investor standard is the polar opposite of quantitative limits. Quantitative limits imply an asset allocation sanctioned by government, presumably based on Hayekian pretence of knowledge, whereas the prudent investor standard defers the responsibility to allocate assets to an unspecified number of private agents.
This does not mean that the prudent investor standard could not make use of quantitative limits where appropriate: a limit on investments in the sponsoring firm is a good example. This limit makes sense because it precludes an otherwise inevitable, important conflict of interest. Yet, limits are to be deployed with the utmost restraint. While the EU Directive does not establish its own limits (except for own firm investments), it does not prevent member states from maintaining quantitative limits. But it places severe constraints on the scope of allowable limits, to the extent of making them virtually ineffective. In practice, there is a grey area between pure instances of either approaches: Under the primacy of quantitative limits, the prudent investor's duties of care as described above should be employed within the limits' permissible ranges. Under the primacy of the prudent investor standard, quantitative limits will be employed with restraint.
Going back to the Swiss regulatory framework, it is important to note that the regulator does not refer to the prudent investor standard, even though the relevant regulation has been revised very recently. Also, while the number and scope of quantitative limits have been reduced, they have been maintained as the primary policy instrument. It is still at the sole discretion of the fund whether or not it wants to exempt itself from the application of the limits. The fund management is under no obligation to assess whether it ought to take the exemption in order to arrive at an investment policy that better serves the interests of plan participants. Nor is there an exclusive duty of loyalty in cases of conflicts of interest, which may go a substantial part of the way in explaining the incidents that have come to light recently.
It is thereby evident that the primacy of quantitative limits remains in force. The follow-up question would be whether the government has missed a golden opportunity to follow the OECD's recommendation and adopt the prudent investor standard with the stroke of a pen when it revised the relevant regulation recently.
In my view, it acted responsibly in not yet doing so. In a 2002 OECD paper, Russell Galer identified five factors that support a successful incorporation of the prudent investor standard:
1. The pension fund's governance framework.
2. The role of the regulatory authority in rule interpretation.
3. Monitoring, reporting and disclosure.
4. The role of the judiciary.
5. The availability of adequate remedies.
It is well beyond the scope of this article to assess in detail how the Swiss regulatory and judiciary framework does with respect to these factors. Anecdotal evidence points to a need for substantial modernisation work to be put in place before the ambitious transition to the prudent investor standard should be undertaken with a promise of success.
Christian Dreyer advises institutional investors as managing partner of Tertium Datur