Against a backdrop of high statutory guarantees and all-time low interest rates, sustainable financing of liabilities poses a key challenge for many pension funds. Companies also need to keep control of the impact on their balance sheets of pension liabilities booked under IAS. A final question that arises in this context is how to give equal consideration to the interests of active insured members and pension recipients when setting the technical interest rate and pension conversion rates.
Recently, much attention has been focused on the variable pension model in Switzerland. Criticism has been levelled by employees’ associations in particular, alleging that this approach transfers risks from the pension fund to the insured members. In actuarial terms, this issue raises several complex questions, especially in connection with the valuation of pension liabilities as well as the related assessment of long-term financial market trends and demographic assumptions. Ultimately, however, the objective is to arrive at a fair balance between the interests of active insured members and those of pension recipients.
In specific terms, the aspect of balancing interests can be seen in the ongoing redistribution between active members and pensioners. This cross-subsidy is the result of pension promises based on excessively high guarantees or assumptions that lack the appropriate financing.
Amazingly, younger members seem to take virtually no notice of this massive redistribution, and even trade unions show little interest.
On the basis of the de facto pension guarantee, the Swiss occupational pension system gives members the advantages of legal certainty and reliable planning. Although it has basically proven its merits in the past, the somewhat inflexible system-based technical parameters are now leading to unequal treatment of the different groups of beneficiaries (active members or pensioners).
The question now arises as to whether and how this unequal treatment can be counteracted. One of the solutions proposed is to increase flexibility, not only for the technical parameters but also for benefits, for example by means of variable pensions.
In every case, the sustainable valuation of liabilities is a prerequisite for setting pension levels. The factors that govern pension levels are the technical interest rate and assumptions about mortality trends, and there are a number of good examples that clearly show the significant impact of mortality assumptions on the level of the technical rate. Apart from life expectancy, the technical interest rate is the main factor that determines retirement benefits. Setting this rate is an equally sensitive task, with the influences of various valuation philosophies at play.
Three approaches have emerged in practice:
• The regulatory interest rate as per Swiss GAAP FER 26 (regulatory ‘going-concern’ valuation);
• The market-consistent interest rate as per IFRS and US GAAP (market-consistent ‘going-concern’ valuation);
• The risk-free interest rate as a liquidation valuation as per PKST (economic or ‘risk-bearing’ valuation).
Since FRP 4 came into force on 1 January 2012, the applicable technical interest rate for the financial statements of pension funds must not exceed the reference interest rate of the Swiss Chamber of Pension Fund Experts – currently 3% – by more than 0.25% without expert justification. This interest rate is determined as follows: two-thirds according to the average performance of the Pictet 2005 BVG 25 Plus-index over the last 20 years, and one-third according to the yield on 10-year Federal bonds less a margin of 0.5%. Consequently, the interest rate obtained in this way intentionally includes market risks. Due to on-going low interest rates and the financial crisis, many pension funds have had to make substantial reductions in their rates, for instance from 4.5% to 3% or even lower.
Our research shows that over 40% of SMI companies’ pension plans already had a conversion rate of less than 6.6% in 2009; which rose to over 60% by 2011. Our projections also suggest that a further reduction of the technical interest rate can be expected in the medium term.
The Swiss Chamber of Pension Fund Experts’ IAS recommended interest rate, currently 2%, is used for the valuation of pension liabilities that have to be reported on company balance sheets with maximum-market consistency. It corresponds to the rate for AA-rated corporate bonds, so it is not entirely risk free but, nevertheless, provides a realistic measurement for very secure investments.
The formation of reserves, as per PKST or the ‘economic’/‘risk-bearing’ method, by an autonomous pension fund would lead to a costly misallocation of financial resources. Moreover, the benefit level appears to be set too conservatively.
On the other hand, a valuation based on the risk-free interest rate would be particularly effective in cases of restructuring or employee divestments, where the annuities related to a group of pension recipients have to be transferred with the minimum of risk to another pension provider, for instance through a buyout. Continuation of existing pension provision is rendered impossible in these cases, so it may be necessary to assess the financial situation according to the criteria for liquidating balance sheets.
A conversion rate based on a low-risk technical interest rate of 2% (market-consistent valuation) is between 5.3% and 5.6%. Against the backdrop of the current macroeconomic and demographic situation, the level of a minimum conversion rate that is guaranteed in the long term – which is also highly likely to be sustainable and can be reliably financed – should lie approximately in this range.
There is clearly a considerable difference between the statutory conversion rate and the low-risk actuarial conversion rate, and this ultimately impacts the level of retirement benefits. However, this gap can – and should – be partially offset by greater flexibility in pension provision. The idea here is that pension recipients who draw their pensions on the basis of a sustainably guaranteed minimum conversion rate can be granted bonus pensions to enable them to benefit from investment income in excess of the minimum interest rate.
As a general rule, every guaranteed benefit should be geared to market conditions, with the valuation based on a relatively low-risk investment (eg, AA-rated corporate bonds as per IAS). On the other hand, the non-guaranteed component of the retirement pension would be paid in relation to the return on assets effectively earned in the medium-to-long term.
The introduction of a variable pension component (bonus pension) together with a sustainably defined minimum conversion rate (on a low-risk basis) would deliver a series of considerable advantages:
• The costs of complex guarantees would be eliminated. The pension fund could therefore invest in instruments with more risk, thereby enhancing its opportunities for above-average returns on assets. These funds would potentially be available to increase benefits;
• Transfers between active insured members and pensioners would be eliminated;
• The costs incurred due to the divestment of groups of pensioners would no longer be borne unilaterally by the active insured members;
• Real or nominal future additional earnings due to inflationary trends would automatically benefit the pensioners, with no reductions;
• The constant efforts to achieve adequate funding ratios would be scaled down, thereby enhancing pension funds’ stability;
• Reduced guarantees would in turn reduce the amount of employer liabilities that must be reported as per IAS;
• The ‘time bomb’ of inadequately covered liabilities could be defused;
• The stability of the second pillar would be increased, with corresponding reputational gains.
Of course, the disadvantage of introducing a variable pension model is that the guaranteed pension level of the insured members is reduced. However, the need for adjustments to benefits is a consequence of the macroeconomic and demographic reality, and this must ultimately be accepted by policymakers and the public.
Nevertheless, the insistence on benefit promises that can no longer be financed or whose costs must be unilaterally borne by one group of the insured members (especially insured persons aged younger than 50) is also a question of justice. If we do not want to over emphasise the much-praised inter-generational solidarity, the current system must be adapted. To this end, all approaches that promise to correct the current prevailing imbalances should be welcomed.
Whether we like it or not, this will ultimately entail a reduction of certain guarantees, which will have to be accepted if we are to have a sustainable pension system.
Peter Zanella is director of retirement services at Towers Watson in Switzerland