Swiss lifestyle funds in favour
Following the global trend, many Swiss employers have switched to defined contribution (DC) plans and a number of large funds have announced that they are in the process of switching their defined benefits arrangements into DC schemes or that they will be considering this in the near future. Moreover, Swiss pension funds are progressively moving slowly towards a higher degree of individualisation.
This may, at first sight, appear to bring new perspectives and opportunities for financial services providers but the reality is actually quite different. DC plans in Switzerland are substantially different than under the Anglo-Saxon model and their structure can actually be assimilated to a ‘cash balance’ plan. According to Swiss legislation, such plans must provide their members with a guaranteed return of 4% pa on all or a portion of their invested assets.
In addition, it is normal practice to define a fixed rate for converting lump sums into pensions at retirement age, and minimum conversion rates apply on the first layer of coverage (BVG minimum benefits). Also, death and disability benefits are provided within the fund. Thus, the financial risks resulting from the fund’s investments, its risk benefit experience and from increasing life expectancy remain within the pension fund, where they are typically borne collectively (rather than by individual employees or the employer).
In other words, a traditional Swiss defined contribution (ie, cash balance) plan only differs from a defined benefit plan by the way benefits are determined, but there is no transfer of responsibility as such from the employer to the employee. This means that while a change in the benefits structure may result in a change of the investment strategy of the fund, all assets remain pooled with the pension fund. There is therefore limited impact in terms of investment structure. As such, a major change in the asset management industry is unlikely.
The pension funds legal framework of Switzerland is also not very propitious to individualisation of benefits. By imposing a 4% per annum return guarantee on (a portion of) the plan member’s assets, the current legislation clearly does not favour the implementation of flexible benefits. Pension funds wishing to implement transparent and individualised investment solutions are obliged to design creative (and sometimes complex) plan structures. Although there are very few funds that have implemented individual investment choice structures, their application for “top-hat” or supplemental plans is gaining ground, particularly amongst pension funds from companies in the financial sector.
The approaches used for plans with individual investment choice vary significantly. The fund’s size and company’s philosophy are important factors when selecting the approach to be adopted but the initial trend has clearly been in favour of “lifestyle” funds, which consist of giving employees a choice of different investment risk/return profiles instead of a complete asset allocation choice.
Lifestyle funds are easier to implement and require much less administration than funds organised along asset class lines. They are therefore more appropriate for most pension funds given the fact that total assets invested in supplemental plans are generally not substantial. Lifestyle funds have also the advantage of offering “tailor made” asset allocations for employees who may find it difficult to compose their investment strategy themselves and thus represent an intermediate step to offering a wider choice of investment options. Lifestyle funds also reduce the risk for the pension fund, which is ultimately responsible for the assets, of being held liable as a result of members adopting totally inappropriate strategies.
There are different ways of implementing lifestyle funds. A number of funds that have implemented employee investment choice for their (supplemental) plans use a type of attribution method where a minimum return is guaranteed during the year and surpluses are attributed at year end based on the effective performance, after the constitution of appropriate investment fluctuation reserves. This approach is not transparent and goes only part way to embodying a true DC approach with employee investment choice. The traditional unitised approach found in other countries is not necessarily the most widely used, partly due to lack of software support, although this changing and there is increasing recognition that pension funds have the choice between the unitised and the attribution approach.
The range and nature of funds available for DC plans depends on the pension plan‘s size and the selected approach. For a fund offering its members the opportunity to select individual mutual funds, the typical objective is to provide a reasonable range of investment alternatives from different investment managers, including index funds. The number of funds offered will typically depend on the appropriate balance between sufficient choice and administrative complexity of the plan relative to its asset size. For lifestyle approaches, multi-manager structures with a combination of active and passive layers are recommended in pure investment efficiency terms, but practical and administrative issues tend to push smaller plans to work with a single investment manager offering a full range of products, including net asset value calculation on a regular basis.
The important factors for selecting DC fund providers are similar to those for a traditional investment manager and the evaluation involves both quantitative analysis (past performance, level of risk, style, size, etc) and qualitative assessment of the investment process (investment discipline, approach, team, depth of research, etc). Additional emphasis is placed on administration issues and total expense ratios.
Note that given the intricacies of Swiss legislation, investment managers have not generally offered administration services for DC plans. Because they are often intended for different type of client, mutual funds can, in addition to higher administration costs, also have extremely variable and high management fees deducted from their net asset value. There are in practice numerous mutual funds running at more than 1.5% pa of expense ratio, and experience shows that unless they are of exceptionally good quality (which is not often the case), they will consistently underperform the relevant benchmark over the long run.
In summary, we can conclude that the shift under way from defined benefit to defined contribution plans is unlikely to have any substantial impact on the investment management industry in the near term. New opportunities are arising for DC fund management providers with the increased interest for flexible investment plans but these are currently limited in size and number. Within the current legislative framework, the evolution will be slow but steady as companies seek to test the limits available.
Gioacchino Puglia is senior investment consultant with Watson Wyatt in Zurich