Talking Heads: Ask the experts
Switzerland suffered a currency shock this January after the Swiss National Bank’s decision to abandon its euro peg. Investors are grappling with negative bond yields and interests rates on cash deposits. This situation has sparked fears that the second-pillar could come under strain given rising liabilities, a high statutory conversion rates for annuities and low expected returns on assets. But overall funding levels are high and inflation is low so the picture is not that bleak. IPE asked experts to assess the situation and share their thoughts for the future
Swiss pension fund managers are mindful of the current market situation but I do not think the general sentiment surrounding the domestic pension fund system is negative. The very low interest rate environment poses some challenges, but most funds are managing well. Aside from current market conditions, there are various issues to be tackled, some of which will be addressed by upcoming regulation. Our Risk Check-up study shows that, at the end of last year, second pillar funds were fully covered on aggregate for the first time since 2007. The average return last year was of 6.3% and the coverage ratio increased to 107%.
The main problem is that people are getting older. Proposed pension reforms, including raising women’s retirement age from 64 to 65, introduce flexibility in retirement and reduce the conversion rate from 6.8% to 6%. Pension fund experts agree that these measures are not sufficient to fill the gap in the retirement provision. The proposed reduction of the conversion rate is not sufficient – looking at the current market situation, it should be below 6%. In terms of asset allocation, pension funds need to further diversity their bond portfolios to protect themselves from interest rate hikes. But because countries are deeply indebted, we may have low interest rates for longer.
Heinz Rothacher, CEO
To some extent, the negativity surrounding Swiss pension funds is justified. The required return to finance the statutory minimum conversion rate of 6.8% lies between 4% and 5%. Interest rates have been well below this target for years and with negative interest rates, the gap has further widened. In particular, those pension funds with low contribution rates face unfunded pension obligations. The main burden lies with young contributors because the return on their capital is used to finance the gap. Considering they bear much of the risk, they are not being properly rewarded.
Despite low safety cushions, many pension funds are increasing their investment risk by allocating funds to equities, credit or illiquid assets. Given the distorted markets, the reward may not turn out as expected. In addition to these measures, pension funds seek to lower their financing needs. Funds that insure supplementary benefits have more flexibility in lowering the conversion rate. But if interest rates were to stay low or negative, pension funds might have to increase employee contributions.
The long-term challenges are structural. Life expectancy is significantly underestimated. Combined with lower expected returns from financial markets, this leads to a massive underfunding of the system. People are still unaware of this major challenge and politics suppresses any serious reforms.
Gabriele Giraudi, head of investment consulting
Negative interest rates are a real challenge for Swiss pension funds. As well as low yields and negative cash rates, they face higher costs for hedging foreign currency. Over the past three years, pension funds have been actively reducing their exposure to high rated bonds as the risk/return profile is not favourable at all. They are moving to equities and to non-traditional asset classes like private equity, infrastructure, catastrophe bonds and loans. They are also actively searching for alternatives to cash. These efforts required more governance and due diligence, which increases overall costs. However, even with very low return expectations on fixed income and a very strong Swiss currency, Swiss pension funds are not under threat. Expected real returns remain sufficient given the negative inflation level.
But once there is no reasonable, risk-controlled method to achieve the required rate of return, the only thing left to do is change the parameters on the liability side. This is being discussed at many levels and some restructuring is unavoidable. In the long term, the toughest challenge will be for the pay-as-you-go element of social security. Increasing longevity puts pressure on the system, though at least it is possible to predict these trends some decades in advance. The financial equilibrium of social security is highly dependent on the population age structure, which itself highly depends on unpredictable immigration flows. At some point, immigration to Switzerland will slow down, the population will start ageing and deficits will start rising fast.
Dominique Grandchamp, senior investment consultant and Cristophe Steiger, principal (pictured)
Swiss pension funds are dealing with some important issues, but this is clearly not the beginning of the end for the system. For some pension funds, particularly those that have a high proportion of retirees, the situation is challenging as they currently have to pay negative rates on cash holdings, and cash is an important part of their asset allocation.
But on average, the allocation to cash of Swiss pension funds is relatively low. Also, due to the negative inflation rate, members are still receiving some return in real terms. The real issue is the long-term development of the system. The expected return of the average strategy is decreasing significantly, to a level that is insufficient to finance liabilities and maintain coverage ratios. Increasing the expected return of the strategy, and therefore the risk tolerance of the fund, is something few pension funds can afford. At the moment, however, they are simply reviewing their strategies, and changes will be made later this year. Building more sophisticated portfolios by increasing diversification may not be the right answer for everyone, particularly for small funds with a low governance budget.
It is likely that many pension funds will discuss at individual level increased employer and employee contributions. As far as legislation goes, reforms may have a positive impact but pension funds have to keep abreast of market developments, which unfold much more quickly.
Pascal Frei, partner
The current financial situation of most non-public, institutional pension funds in Switzerland is rather positive with funding levels above 115%, as reported by the Swisscanto survey as of the end of March this year. However, the near-term future of Swiss pension funds can be seen as challenging, due to the uncertain economic environment, underscored by low expected asset returns, negative yields on bonds, and expensive equities and real estate markets. Furthermore, benefits are based on relatively high conversion rates. Therefore, we see a gap between the assumptions underlying the retirement benefits and realistic return expectations on investments.
Most of the non-mandatory pension funds have been reducing their conversion rates in-line with decreasing expected returns. In terms of investment strategy, most of these plans have reduced their portfolio duration either by increasing exposure to liquidity or to shorter duration bonds. To compensate for low expected returns, pension funds are increasing their exposure to risky assets notably via equity risk premia, which is a concern from a risk perspective.
It is paramount to keep a long-term strategy and not make rash decisions that jeopardise longer-term objective. Diversification of risk premia is really important to maintain a viable level of risk across the entire portfolio. The challenge for pension funds is therefore to be proactive and innovative, to increase their asset returns, while keeping in mind their risk tolerance and long-term objectives.
Fabien Delessert, investment consultant (top) and Nicolas Girardoz, senior consultant (bottom)
The current environment is challenging pension funds’ asset allocation decisions. However, in the short term they are achieving positive results on their assets. In our view, pensions funds have sufficient reserves in hand to bridge normal market fluctuations. In the longer run, challenges might arise from paying interest on pension liabilities that the pension funds can no longer cover with their investment results. Pension funds need to stick to their asset and liability structure. However, to achieve their target return, they might need to alter their investment strategy to include other return sources. We see them evaluating alternative investments like infrastructure. However, since law limits the allocation to alternative investments the impact will not be significant.
Regarding negative interest rates on cash, the allocation to this asset class needs to be minimised and conditions need to be discussed with partner banks. Within fixed income, pension funds should ideally follow an active approach to profit from duration management as well as coupon, credit and roll-down return.
At the regulatory level, several topics are to be discussed, including longevity, the pension conversion rate, the minimum interest rate on liabilities and the retirement age. The overall goal is to retain the current level of benefits. However, current discount rates used to calculate pension liabilities are still very high and are not aligned to the economic circumstances according to International Accounting Standards. This will harm pension funds that cannot achieve performance higher than the discount rate.
René Raths, head of pension fund