September's shock devaluation of the Swiss franc halted the decline in the value of Swiss pension funds' foreign assets. On the other hand, ultra- low rates are putting extreme pressure on funds. Nina Röhrbein assesses asset allocation in the light of these extremes

As Switzerland has fared economically better than Europe and the US, the Swiss franc has become a safe haven currency. Swiss pension funds with a currency overlay benefited from the franc's strength over the last two to three years as the value of their foreign assets diminished.

But when the CHF hit record heights and the EUR/CHF exchange rate an all-time low of 1.03 in August, the Swiss National Bank (SNB) stepped in by introducing a floor for the EUR/CHF exchange rate of 1.20 in September.

According to market participants, the action taken by the SNB has not had a direct influence on the asset allocation of Swiss pension funds. However, as a result of the SNB's intervention many pension funds decided to stop actively hedging their euro investments in the belief the bank had done the hedging for them.

"From a Swiss pension fund perspective, the intervention by the SNB was welcome because it stopped the fall in value of foreign assets at least in the euro-zone area," says Christoph Ryter, president of the Swiss Pension Fund Association ASIP.

At the very least the intervention led to a debate about currency hedging.

The other issue is how long the SNB will maintain this policy.

"The question is whether hedging still pays off as long as the exchange rate remains around the 1.20 mark," says Ryter. "This is not easy to answer because if the exchange rate experiences volatility, investors still risk a loss up to 1.20. There is also a tiny risk that this level will not be kept by the SNB."

"The worry about when the SNB might lift the floor is stopping many pension funds from making any changes to their investment strategy with regard to currency hedging," adds Reto Wild, vice president and investment consultant at Complementa Investment-Controlling. "Once the floor has been in place for a year, they may feel more comfortable in making changes."

While the floor is set to remain in place for an unlimited time, market participants expect it to be lifted at some stage.

Lower and ultra-lower
The biggest worry for Swiss pension funds is the current extremely low interest rate environment. A 40-year Swiss government bond yields only 1.5% at present, while the yield to maturity for a 10-year Swiss government bond stands at around 1%. Swiss pension funds say they still need to pay a guarantee of 3-4% to their members, and some more if they have a high number of pensioners.

"Swiss schemes cannot meet their pension promises only through bond investments," says Wild. "And with this low interest rate environment also comes the worry that interest rates may increase again quickly, which will strongly impact bond-heavy portfolios and lead to losses."

Swiss pension funds need to think carefully about what to do next, as equity markets remain volatile and the domestic property market has dried up.

To generate a higher performance, says Christian Bodmer, head investment consulting Mercer Switzerland, they need to invest in a broad mix of asset classes.

"But they are most likely to look in the same asset class category first such as non-domestic bonds including emerging markets debt and high yield, as it is easiest" he says. "The second step is to gradually invest more in equities and other satellite investments such as alternatives."

But due to a lack of alternatives and risk budget constraints, many pension funds remain conservatively invested in bonds despite knowing that this could lead to problems once interest rates rise.

"If interest rates rise, the coupons will not even generate the required minimum returns," says Werner Hertzog, market director at Aon Hewitt Switzerland. "There will be book losses in the short to mid-term but on the other hand, new bonds will be issued with higher rates of return, meaning pension funds could be break-even within four or five years, depending on the duration of the portfolio."

Felix Kottmann, CEO of Kottmann Advisory believes that over the next five to 10 years, Swiss pension funds cannot generate sufficient total returns at affordable investment risk with portfolios of bonds, equities and Swiss real estate alone. Too many pension funds, he says, almost blindly trust their consultants by following their subjectively limited asset class universes without asking critical questions about objectivity or attractive alternatives. Others instinctively know their large allocation to bonds and static equity portion will cause them problems but do not know where to invest. Only a few pension funds and their external advisors, according to Kottmann, are preparing themselves for rising interest rates by going short duration and investing in more time and resource-consuming alternatives with up to 15%, including particularly hedge funds and long-short commodities.

"The pension funds that are already invested in alternatives such as hedge funds, private equity and commodities will continue to do so," adds Stephanie Spozio, senior consultant at Ecofin Investment Consultancy. "Others are still sitting on the fence contemplating what to do because alternative asset classes may also contain equity risk."

However, the real problem is that current Swiss pension promises are simply too high.
"The challenges that Swiss pension funds face today cannot be solved simply by a change in investment strategy," says Ryter. "The pension promise is based on too high return expectations, which is why there is no way around raising contributions and/or reducing benefits. Pension funds have already been reducing their conversion rates, which are used to calculate pensions from accrued assets."

In 2009, several pension funds fell below a funding level of 90% and had to raise contributions from both employer and employee as well as lower the interest on the active employees' capital due to measures imposed by the regulator.

Bodmer says: "If this low-yield environment continues for a while, the whole benefits structure may have to be reviewed because the discount and conversion rates of Swiss cash balance plans are set at too high a rate."

A sign confirming that not all is well in the Swiss pension system has been the action taken by the Swiss federal government in early November: the minimum interest rate in the second pillar was cut to 1.5% for 2012. Since the creation of the second pillar in 1985, the minimum interest rate has been lowered from 4% to the current 2%.