Since January 2012, leading a blissful underfunded existence has no longer been an option for public pension funds in Switzerland. Instead they have to choose between two options, either full capitalisation (Vollkapitalisierung) of 100% plus reserves, which they must reach within 10 years, compared with the five to seven years for their counterparts in the private sector.

Alternatively, if they are granted a deficit guarantee by the canton, they can opt for part-capitalisation (Teilkapitalisierung) of 80%. They have until 2052 to reach that target.

“Those opting for part capitalisation want to avoid an excessive accumulation of capital, arguing that public communities cannot disappear and therefore will always have new entrants to the scheme,” says Dieter Stohler, director at the pension fund Publica. “The proponents of fully funded pension funds point out that discriminatory treatment of private pension funds versus public ones is inappropriate and that, as the second pillar is based on capital cover, any underfunding should be eliminated sooner rather than later.”

“With part capitalisation, some of the benefits come from a pay-as-you-go-type arrangement, in other words through higher contributions from current employees and employers which in the second pillar, is an alien concept,” says Roland Guggenheim, principal at Mercer in Switzerland.

There is a clear east-west divide among public pension funds in Switzerland, with those in the French-speaking part of the country – Fribourg, Geneva, Jura, Neuchâtel, Ticino, Vaud and Valais – suffering a much higher degree of underfunding than their counterparts in the eastern, German-speaking part, where some cantons, such as Appenzell and Obwalden, are fully funded. The Aargauische Pensionskasse (APK) already addressed its underfunding in 2007, becoming fully funded in 2008. This means part-capitalisation is primarily common in French and Italian-speaking Switzerland.

In the German-speaking part of Switzerland, only Bern, Zug and Basel-Stadt want to start with part capitalisation. Bern and Zug also aim for full capitalisation in their regulations.

In the cases of Basel-Landschaft, Thurgau and St Gallen, politicians and voters backed full funding for the pension funds.

Those that opted for part-capitalisation, on average, had a funding level of 75.8% at the end of the third quarter, according to the Swiss pension fund monitor by Swisscanto, up 0.6% on the second quarter. But for some, such as Geneva, the funding level can be as low as 55%.

The City of Bern pension fund targets part-capitalisation despite having a 94.4% funding level at the end of 2012. But a cut in the discount rate from 4% to 2.75% in 2014 will leave its underfunding at just 84.5%, which was one of the reasons behind its decision.

It is similar for Basel-Stadt. “After changing its discount rate, Basel-Stadt realised it was closer to 80% funding than 100%, which is why the government suggests it opts for part-capitalisation,” says Jérôme Cosandey, project leader at Swiss think-tank Avenir Suisse.

According the Risk Check-up Study 2013 of the consultancy Complementa, 73%, of Swiss public pension funds were underfunded at the end of 2012. A report by the Oberaufsichtskommission, entitled Berufliche Vorsorge, found that 48 of 66 pension funds were underfunded, also equivalent to 73%.

But how do Swiss pension funds reach their selected funding targets?

The pension fund for Basel-Landschaft (BLPK) expects more than half of its CHF2.2bn (€1.8bn) deficit to be paid for by its municipalities and participating employers, while the remaining CHF1bn will come directly from the canton, after just over half of the canton’s population backed a proposal by the canton government for it to be fully funded.

The canton will borrow the outstanding amount and allow the municipalities and employers to repay the loan in stages, only charging interest in line with the BLPK’s chosen discount rate. This means the BLPK should be fully funded by January 2015, from its 80% funding level at the end of 2012.

Switching from defined benefit (DB) to defined contribution (DC) is an obvious step to take to stabilise funding levels. “In the German-speaking part of Switzerland, all pension funds have switched from DB to DC, with the exception of Basel-Stadt,” says Patrick Spuhler, head of pension fund consulting at Swisscanto in Basel.

Others have raised the retirement age for their workforce, in the case of Basel-Stadt from 63 to 65.

Other options include raising employer contributions, demanding cash injections from the employers, asking for additional contributions from employers and employees, reducing benefits and abolishing early retirement.

“When you look at all 22 underfunded cantons, it has been a mix of measures taken,” says Cosandey. “It depends on the size of the underfunding. If the canton has solid finances, a lump sum may be appropriate. If it is deep in the red, they may want to find measures to postpone payment.”

In short, while the regulator prescribes two options to choose from the pension funds have leeway to tailor the solutions in the implementation phase.

“The BLPK, for example, granted municipalities and communes some flexibility during amortisation,” says Mario Almer, head of investment controlling and board member at Complementa. “They can amortise in a much shorter time period than the 40 years chosen by the canton or even make a lump sum payment.”

“The conflicting interests are between the local authorities, the other participating employers, the active members and in Switzerland, as a direct democracy, the voters,” says Daniel Ritz, director of institutional clients at Unigestion. “Each of the groups will try to protect its own interests. Therefore, a compromise needs to be reached.”

“It is always a combination of employer and employees shouldering the extra demands,” says Guggenheim. “Generally pension funds want to share the burden equally, although employers tend to pay more due to their financial strength.”

An alignment of the conditions of public with private pension funds can help increase support among voters, according to Almer. The BLPK did this through a switch to DC, the change to a new collective foundation (Sammeleinrichtung) structure and the adaptation of the new regulations of canton law on top of the full capitalisation.

In mid-October, the Thurgau pension fund decided it would be a fully capitalised pension fund from 1 January 2014. “How to fill the funding gap will now be addressed in a social and fair framework,” says Rolf Hubli, chief executive at Pensionskasse Thurgau.

Many of BLPK’s participating municipalities felt they had been forced to accept the changes and have founded a municipal initiative, which demands that the canton pays for the entire funding gap. Some are considering leaving the pension fund, as was the case with the Canton of Zurich pension fund in 2011 and 2012.

“But leaving is costly too, as they have to cover the gap,” says Cosandey. “However, if the age structure of a municipality is relatively young with only a few retirees, refunding might be cheaper if they continued on their own.”

Guggenheim adds: “It is not always wise to leave the pension funds because the departing employers will still have to pay for their past funding gap, even if it just means receiving reduced benefits. They cannot escape the past even if they hope to find better pension provisions for the future.”

APK took the Rudolfstetten-Friedlisberg municipality to court – it was one of the 45 employers that left the pension fund in late 2007 when the pension fund demanded extra capital injections from its employers to make up for its underfunding. APK demanded CHF1.15m for leaving. The court however decided the parish would only have to pay CHF103,483.

Hubli says employers should not only be comparing costs but view them relative to the benefits provided when comparing pension funds.

“The benefits of these plans are still not addressed,” says Peter Zanella, head of retirement solutions at Towers Watson in Zurich. “Many Swiss pension funds still offer very generous benefit packages, which is alarming, as is the technical interest rate many of them still apply. If they applied the correct rate, most funding levels today would on average be 10-30% lower.”

According to an Avenir Suisse study, the funding gap for cantonal pension funds amounts to CHF44bn using a 3% rate. This is an average of CHF69,000 per pension fund member at the end of 2012.

In the French-speaking part of Switzerland the gap is on average CHF127,000 per head and in the canton of Geneva CHF174,000.

The Swiss Chamber of Pension Fund experts reduced the reference discount rate from 3.5% to 3% at the end of September 2013. However, some pension funds still have higher discount rates of up to 4%.

Almer assumes the investment strategies will not change upon full funding, whether pension funds opt for part or full capitalisation. Instead they are informed by risk appetite and return strategies.

“Independent of the funding level, we always have to take the risks versus returns into account,” says Hubli. “It is important to consider the individual structure of the pension fund, the active member to pensioner ratio, the average member age and whether the pension fund has positive cash flows or outflows. The risk strategy should always be chosen in respect of these factors.”

But Spuhler concludes: “If a canton moves its pension fund to full funding immediately, the pension fund will struggle to find sufficient investment opportunities.”