Pension funds are feeling the pinch in the sovereign debt crisis, writes Gérard Fischer, CEO of Swisscanto. In the long term, they can only deliver their promised benefits through a better distribution of assets, income and recapitalisation contributions between generations
A strong currency does bring advantages. But Swiss investors, including Swiss pension funds, have suffered clear disadvantage, especially during the past two years of strength of the Swiss franc. They have run up losses in foreign currencies, while interest rates have remained low. The crisis of sovereign indebtedness in Europe and the USA has driven the value of the Swiss franc upwards. As Switzerland's pension funds account for their assets and liabilities in francs, this appreciation has hit them hard: firstly, they have suffered from sharp adjustments, especially on the equity markets; secondly, they have been affected by exchange-rate losses on their foreign-currency investments. From the end of 2009 to October 2011, the euro declined 18% and the dollar by 15% in value against the Swiss franc. Before intervention by the Swiss National Bank (SNB) to weaken the Swiss franc, even greater losses were temporarily sustained.
All this has led to a further marked fall in the cover ratio of the Swiss pension funds, which had been slowly recovering after the financial crisis. Based on its annual survey of pension funds, Swisscanto estimates that the cover shortfall among private pension funds at the end of September stood at nearly three times its level at the beginning of this year. The latest available figure is 37%. This shows how severely Switzerland's pension system has been affected by market turbulence and the strength of its currency.
Unreliable input from the third contribution source
In principle, Swiss pension fund assets are funded from three different sources: employees' contributions, employers' contributions and the income earned from investing them on the financial markets. These investments act as a "third contributor". While income from this source was substantial in the 1990s, it has shrunk significantly or dried up since. To ease upward pressure on the Swiss franc, the SNB has also reduced interest rates. Yields to maturity on Swiss government ten-year bonds currently stand at below 1%. However, the pension funds are saying they need a 3.5% target yield to finance their promised benefits. To achieve higher yields, they have to accept greater risk exposure of their investments. This situation is unlikely to change in the immediate future, as Swiss government financial and economic policies are fundamentally different from those of Switzerland's main trading partners in the EU and USA. So the long-term upward pressure on the Swiss franc will be fairly relentless. The pension funds must therefore appreciate much lower capital market yields on Swiss francs in future.
Higher risks require larger fluctuation provisions
Investors who accept greater risk to increase their returns must expect lower income than from a risk-free investment, even in the longer term. Fluctuation provisions are necessary for precisely this contingency. This is because they guarantee a high proportion of pensions and give a pension fund the necessary risk-bearing capacity. If fluctuation provisions are too large, they can be distributed to pensioners and members in work. In the event of a shortfall, the provisions have to be built up. In practice, there are various ways of achieving this:
• Lower interest rates on the capital of pension scheme members in work (the Swiss federal government has recently decided to do exactly this);
• Reduce the rate at which accumulated capital is later converted to an annuity (rate of conversion of vested benefits);
• Increase employees' and employers' contributions; employers must pay at least as much as employees.
However, the results of this for individual members can be unfair. For example, for members who have helped to form fluctuation provisions over the past five years by receiving lower rates of interest on their money, then retire and gain nothing from these provisions which they have co-financed.
It is also unfair if pension scheme members convert their vested benefits on retirement at an excessive rate, causing an actuarial loss to those still in work. After retirement, they no longer have to contribute to the recapitalisation of the pension fund. Fluctuation provisions in practice ensure constant redistributions among pension scheme members. Winners or losers, members really have no comeback. These problems become more acute through the statutory minimum interest rate requirements, or benefit decisions which privilege or disadvantage a certain age group. The consequence is recapitalisation measures, always paid for by members in work. Pensioners are protected.
More flexible pensions enhance security and fairness
To preserve a pension fund's long-term security without unintentional redistributions, there are two measures it must take. Firstly, benefits promised and paid must match the available capital. This seems to be obvious but, in reality, it is often not followed. Indeed, there is a reluctance to adjust to longer life expectancy and lower capital market yields. Secondly, capital savings - and the income earned from them - must be distributed in full and transparently. Costly guarantees must be avoided, limiting the chance of funding gaps emerging.
Not giving guarantees obviates the need for fluctuation provisions. The advantage is that pension fund managers no longer have to make assumptions about future returns at the time of allocation, because income, too, is definitively allocated. Pension entitlements arise from life expectancy and available capital. Because the latter rises and falls with market trends, pensions are also variable. This would do much to distribute the money more fairly.
At times of higher inflation and higher interest rates, another advantage of this solution would be that variable pensions also equalise inflation. This is not the case at present, because pensions are not index-linked. If these amendments were adopted, the recurrent political debate on the ‘right' level of minimum interest and conversion rates would be defused, because all returns achieved would be allocated to pension scheme members.