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Persistent low interest rates are making it harder to achieve risk-free returns. Pension funds will need the tailwind of friendly stock markets, argues Peter Bänziger

Stock market performance in the first months of 2012 provided Swiss pension funds with a boost as market increases allowed their cover ratio situation to improve. In the case of private sector pension funds, the estimated asset-weighted cover ratio increased in the first quarter by 1.9% on the previous quarter, to 105%. A similar picture was evident for public sector pension funds, where the cover ratio increased by 1.8% to 89.9%. According to the Swisscanto survey, the funds achieved an average asset-weighted return of 2.5% in the first quarter.

Despite these positives, we must recognise that the sovereign debt crisis is repeatedly returning to the fore. It is also highly unlikely that we will rediscover the market conditions that existed before the financial crisis of 2008-09.

New investment environment
We are in a period of transition, which will affect the conditions for pension funds as managers of large assets over the next few years. There are essentially two factors that bring about fundamental changes: firstly, national governments have intervened to a massive extent in order to combat the financial crisis, with intensified regulation as well as rescue and stimulus packages. The enormous sovereign debt incurred as a result is at the expense of future growth. Secondly, many industrialised countries are facing higher rates of unemployment, which is presenting challenges for pension systems. Consequently, conditions have changed so dramatically that we have to attune ourselves to a new phase, referred to by some in the US as the ‘new normal'. This expression refers to an economic environment that will be much more difficult than that of the past 25 years. The main features of this environment include:

• High levels of sovereign debt
• Weak economic growth
• High unemployment
• Declining economic significance of the US
• Stronger regulation
• Lower returns.

We believe that political decisions relating to the debt crisis will continue to ensure wide fluctuations in the stock and bond markets. On the whole, economic prospects are not that bad. For the US, as the leading economy globally, we expect to see attractive GDP growth in the current year. On the other hand, economic indicators are painting a worse outlook for the euro-zone.

The data on the investment policies of Swiss pension funds, which Swisscanto has been collecting for several years, show that the average asset allocation has been stable over time. The latest figures available to us at the end of 2011 differ only slightly from previous values.

Roughly two-thirds of the pension funds did not make any adjustments to their strategic asset allocation last year. Where there was an adjustment, it was done for portfolio optimisation. For example, among private sector pension funds, 17% made adjustments explicitly as a result of the low interest rate environment.

It is interesting to look at the detailed information on what adjustments were made. In the Swiss bonds segment, 56% indicated they had reduced their strategic allocation. This is in stark contrast to the Swiss real estate segment, where 55% of the funds increased their allocation.

CHF bonds less attractive
The adjustments made show how difficult it is to achieve risk-free returns. Within bond portfolios there has been a reallocation towards areas with greater potential returns. Thereby, 46% of the funds reduced their government bond allocation, while 46% also made allocations towards corporate bonds. This trend is continuing: 68% are planning to reduce their allocation to sovereign debt in 2012. As for bonds in the debt-ridden ‘PIIGS' countries, Swiss pension institutions are not heavily exposed. 62% do not have any securities from these countries, and for 36% the allocation is no more than 10% of their total bond portfolio.

The decision by the Swiss National Bank to set a floor of CHF1.20 to the euro is at least acting as an effective free currency hedge for pension funds. With this in mind, the logical consequence should be that the difference in interest rates between risk-free euro and Swiss franc investments will disappear. It is now possible to take advantage of the surplus returns in euro instruments and sell CHF bonds.

We remain sceptical towards instruments from euro countries with high rates of return, however. Bonds in Norway and Sweden are presented as alternatives; their currencies are undervalued like the euro, but they have good credit ratings. Of the highest rated countries, Australia boasts the largest surplus return compared with CHF bonds. We expect that the price floor for the euro will remain in place. Therefore, if the price remains within the range of CHF1.20, investments in the euro do not need to be hedged. We prefer corporate to government bonds. A large number of companies are likely to survive a mild recession without major losses. However, we have started taking up a more defensive position.

Equity: still indispensable
In our assessment of equities, we have become more cautious. In our opinion, the mainly favourable assessments given to the European stock markets call into question an even greater reduction in overall risks. Much of the negative news that has been expected is likely to have already been factored into prices. Moreover, we are noticing a renewed positive trend in earnings revisions. We favour value over growth stocks. In the context of our investment policy, the equity allocation for the euro-zone remains overweighted, together with the US and emerging markets. At sector level, we favour the food and beverage, healthcare, banking, software and energy sectors, whereas we are more cautious in insurance, telecoms and utilities.

Asset class opportunities and risks
The period when it was possible to achieve good returns with minimal risk are over. We rate the most important areas as follows:

• Bonds: Interest rates are going to remain at low levels for some time; consequently the risk of longer maturities can be tolerated in government bonds. Securities from countries with poorer credit ratings earn higher interest rates, but in light of the debt crisis the risk/reward ratio remains unfavourable. The situation with corporate bonds is better, even though their prices came under pressure despite solid balance sheets and profit figures. There is profit potential in foreign currency-denominated securities in the short term, due to the overvalued Swiss franc. However, the long term risk/return ratio is unfavourable.

• Equities: The low valuation of stock markets puts the ‘naturally' high risk of this asset class into perspective. We consider the risk/reward ratio favourable. Currently, stock in high-dividend companies is interesting. Their returns are much greater than those of comparable bonds and provide a better inflation hedge.

• Precious metals and commodities: These remain a classic building block for the diversification of a mixed portfolio. Commodities are likely to benefit once the economy gets back up to speed, especially in emerging countries. Caution should be applied to gold in its physical form, because there is volatility caused by speculation. Shares in gold mining companies, however, have been left behind by the growth in the price of gold and are therefore attractive.

• Real estate: Swiss real estate has a moderately clear advantage in terms of returns compared to bonds and therefore remains in demand. Investments in foreign real estate are usually made via listed real estate companies and as such are associated with at best unwanted equity risk.

Pension funds that are diversified and willing to adapt their strategy depending on the situation will stay on course, even if surprises cause a sensation in the near future.

Peter Bänziger is chief investment officer of Swisscanto

 

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