Liabilities crucial focus for Swiss schemes

As funding levels of Swiss pension funds deteriorate, liability management is moving to the fore. Assets cannot be relied on alone to solve funding gaps, particularly given the dilemma of lower reserve levels

While the government calls for schemes to lay out recapitalisation measures, plans to cut the minimum conversion rate for benefits are being challenged, potentially threatening the future security of Switzerland’s pension system.

According to the Swiss Federal Social Insurance Office’s (FSIO) latest figures, 60% of Pillar 2 schemes are now in deficit. The picture has dramatically worsened in 2009 with 7% of funds falling into deficit in the first quarter and those with less than 90% increasing 4.3%.

“These figures are optimistic,” says Martin Siegrist, pensions consultant at Swisscanto. Their research, based on fewer schemes, suggests 75% were already underfunded by the end of 2008, 65% more than 2007. “The reality is probably between the two,” Siegrist says.

Swisscanto estimate the average coverage ratio fell 17.6% in 2008 to 94.4% as at 31 December (2007: 112%). Declines were predominantly driven by falling domestic and foreign equity markets with the average scheme achieving an estimated average yield of -12%.

According to Dr Graziano Lusenti of consulting firm Lusenti Partners LLC: “It is the extent of the gap that really matters, not the number of funds in deficit. Ratios between 100% and 90% are still OK, provided there are no obvious liability imbalances, actuarial assumptions are realistic and expected returns are not out of the picture.”

The FSIO estimates around 20% of funds face deficits greater than 10%, but Swisscanto believes 25% is more realistic.

The FSIO believes schemes cannot delay considering recapitalisation methods. They must declare their financial situation to the authorities and lay out proposed counter measures by June 30th. Legally, funds must regain full funding within 10 years maximum.

In a statement, the FSIO warned: “Given current uncertainty, it would be inappropriate to rely on an improvement in the financial markets. There is a possibility that the situation will not repair itself or could even worsen. The deeper deficits get, the harder it will be for schemes to close funding gaps based on current investments. Recapitalisation methods that are brought in later will, therefore, be more painful. Schemes would do well to reduce funding gaps as quickly as possible rather than waiting until the situation deteriorates further.”

Despite the authorities' initially strict attitude, Lusenti says a more practical approach is necessary. “Despite calling for schemes to take immediate action, a balance needs to be struck. Forcing employers and employees to increase contributions while concurrently introducing economic stimulus packages is counterproductive and contradictory. It would be too tough on the economy as a whole.”

In order to reduce liabilities, the FSIO believes a sinking of the conversion rate for benefits, currently 7.05% for men and 7% for women, cannot be delayed.

The FSIO says current levels present considerable danger as schemes would need to take greater risk to achieve above-average returns. This is particularly acute for those already in deficit whose reliance on higher returns is already prevalent.

A reduction to flat 6.8% by 2014 is already agreed, but parliament believes a further cut to 6.4% by 2015 is necessary.

However, a referendum against the second cut achieved the required 50,000 signatures by April 2009 to force a vote by the Swiss population raising doubt whether the reduction would actually be enforced.

In recent weeks, a growing number of interest groups have spoken out against the cut including the 200,000-member inter-professional Unia union as well as the Green Party and Social Democrats.
Pensions experts, meanwhile, agree the cut is essential.

Switzerland’s pension fund association, ASIP, representing 1500 schemes, opposes the referendum saying the security of the pension system would be endangered if the cut was not implemented.

Citing increasing life expectancy and financial market developments, Hanspeter Konrad, director of ASIP, says: “The referendum against the cut presents a danger to the stability of Pillar 2 and the pension system in general.” It is time, he said, to close the gap between expectations and reality.

Predicting the direction of the final vote is not easy.

Siegrist says: “It is a generational issue and depends who votes in greater force. If those in or close to retirement make up the majority, the rate cut will not happen. The older generation, for whom pensions are more pressing, is more likely to vote though. That is the danger of the referendum.”

If the cut is not voted through, the pressure on schemes will increase, creating a greater reliance on above-average returns to balance assets and liabilities.

“If the cut is not accepted,” Lusenti says, “It will have a significant effect on the financial equilibrium of Switzerland’s pension funds, particularly for those granting benefits at or close to the minimum conversion rate. The actuarial difference caused by a non-adjustment will have to be made good through above average returns, putting further pressure on resources.”

Many schemes, however, face a dilemma as higher-risk asset classes require a greater degree of capital reserves as downside protection. During 2008, reserves have been significantly hit. Swisscanto believes the majority of schemes no longer have any value fluctuation reserves, limiting their capacity for risk accordingly.

Lusenti argues schemes need to have a broad exposure to riskier asset classes such as equity. “By investing only in bonds and real estate funding levels would never improve.”

Contrary to most Swiss schemes, the 100.1% covered Pension Fund of Credit Suisse Group (PKCS) increased portfolio risk during the first quarter of 2009, raising equities from 12% to 17% in March, and building up a credit portfolio to benefit from credit spreads.

While international equity markets gained approximately 6% in Swiss franc terms in March, bond markets remained virtually unchanged in Swiss franc terms, posting a performance of around 0.5%. PKCS posted a positive performance of 0.6% in March and overall performance for the year to March 31, 2009 of -1.2%.

According to the FSIO’s analysis, if equities and similar securities improved by 10% a year for three years, 40% of schemes would still be underfunded if they fail to implement recapitalisation measures. If markets fell 10% a year over the same period, 80% of schemes would face shortfalls.

These estimates strongly support a cut in the conversion ratio.

Siegrist says many schemes have already begun lowering benefits as the minimum legal conversion rate is only applicable to 50% of a pensioner’s total pot.

“Individual schemes set rates for the other 50% so the average total conversion rate is already around 6.6%,” Siegrist says. If the second cut fails, those with lower funding ratios will be harder hit.

“It could spell trouble for the future,” he warns, adding many schemes could face significantly worse funding ratios from corporate restructuring in coming months.

As employees depart, pension entitlements are transferred to the new employer’s scheme. “If the proportion of leaving employees gets high enough, schemes could be forced to partially liquidate,” Siegrist says. Any underfunding would then be split between exiting and insured members, leaving remaining employees worse off.

Partial liquidation is legally required if 5% of a scheme’s capital leaves or the workforce declines 10%. “This could become a problem for quite a few schemes, especially those vulnerable to the current economic crisis such as exporters” Siegrist says.

“This process is just beginning,” he continues. “It is crucial that even schemes with between 95% - 100% funding consider what recapitalisation measures could be implemented if things deteriorate.”

Lusenti concludes: “Schemes have to accept the world is different and short-term returns will not be like recent years. Assets alone cannot solve the problem. Liabilities also require close scrutiny in terms of provision levels and whether they can be reduced. Cutting the minimum conversion rate is crucial for the stability of the Swiss pension system.”

WRITTEN BY EMMA CUSWORTH,
A FREELANCE JOURNALIST