The Swiss approach to pensions

Lynn Strongin Dodds asks what’s troubling Swiss pension funds in today’s market

Swiss pension funds have a reputation for being a conservative group, but even they could not avoid being squeezed by the credit crunch. Exposure to financials and a volatile stock market took its toll on performance. Reforming the system always seems to be a hot topic of debate, but if history is anything to go by, the wheels of change in Switzerland rotate slowly.

Not surprisingly, performance figures from the Swiss pension fund society (ASIP), carried out by Watson Wyatt, reveal that last year was a tale of two halves. Returns in 2007 were just 1.8%, a significant drop from
the relatively healthy 6.9% recorded in 2006. Median performance in the first six months was 3.6% but
that dropped significantly as the fallout from the credit crunch spread to European equities and different hedge fund strategies. The year ended with Swiss equities turning in a median performance of -0.3% while foreign equities enjoyed a 3.2% boost, mainly thanks to the resilience of emerging market stocks. On the fixed income front, Swiss bonds were -0.4% while foreign currency bonds stood at 2.3%.

While the majority of Swiss pension funds had either avoided or hedged the complex debt vehicles and structures that
caused the markets to plunge, their domestic large cap weighting was disproportionately skewed towards financial stocks, which were caught in the subprime maelstrom. This is especially true of UBS whose fall from grace continues to have a knock-on effect on the Swiss banking community as a whole.

The Swiss pension fund operates on a so-called three pillar system of state-provided, occupational and private pensions. Pillar one, the state pension, is determined by an individual’s eligible contribution years, earned income and any credits for time spent raising children or caring for relatives. Anyone who has paid social security contributions between the age of 21 and the normal retirement age – 65 for a man and 64 for a woman – with no interruptions,
will receive a full pension. The maximum annual social security pension is CHF 26,520. In the case of married couples, the amount is a maximum of CHF 59,780 each year. These are current figures and are expected to be amended in the future.

The annual payment individuals receive under pillar two, or the company pension, depends on the accumulated assets at the time of retirement. This is multiplied by a percentage, the minimum value of which is known as the conversion rate and set by the Swiss Parliament based on mortality and interest rates. Swiss occupational pension funds differ from those in other countries in that they are established as separate legal entities, independent of the sponsoring employer. As a result, most companies have established pension foundations that are managed by foundation boards with significant power over all funding decisions. They are appointed to define, implement, and monitor plan design, including plan amendments, as well as investment policies. Also, employee representatives must have at least 50% of voting rights in most pension foundations, so employer companies have limited influence over their governance.
Recent changes in legislation have allowed the foundations to run a temporary shortfall although they need to have a recapitalisation plan which also has to be approved by the government authorities.

Finally, pillar three is a privately-financed personal provision and is voluntary. Unlike normal savings, it has certain tax advantages and can be used as a means of closing pension gaps and to help individuals maintain a certain standard of living after retirement.

One of the biggest discussions taking place in Swiss pension fund circles concerns the area of diversification. In theory, the Swiss pension system is subject to technically strict investment limits. Foreign assets should not constitute over 30% of an overall portfolio and there are additional constraints on individual asset classes. For example, no more than 30% of the portfolio may be invested in equities and a maximum of 20% can be invested in foreign currency bonds. In addition, there is a 30% limit on CHF bonds. 

However, the restraints are viewed more like guidelines rather than rules set in stone. In fact, many Swiss institutional investors are taking advantage of the so-called extension clause of the investment regulations which allows schemes to breach these limits provided that they can justify their actions. One of the main drivers, according to a recent Swiss Institutional Survey, commissioned by Credit Suisse and conducted by Lusenti Partners, is the belief that the occupational pension law is too restrictive with regard to alternatives.

The general consensus among consultants is that the subprime crisis has underscored the need for pension funds to further diversify their assets. A typical pension fund portfolio’s alternative asset allocation of 5% is too insignificant to be considered material. It was not that long ago that Swiss second pillar schemes were underfunded and with minimal reserves due to the dot com bust and the impact on stock markets. While the recent boom revived their fortunes, few want to return to those dark days and there has been a greater push to add alternatives to the mix to generate higher returns and mitigate risks.

Peter Zanella, benefits practice leader, based in Watson Wyatt’s Zurich office, comments: “Some pension funds showed negative returns last year. They have too much of a bias in their home markets and I think diversification needs to be a bigger theme than it is in order for portfolios to generate higher returns. The big issues are around transparency and the functioning of the products. However, with proper governance and strategies implemented by skilled investment managers, then they can improve performance.”

Currently, Swiss pension funds are still top heavy in fixed income and equities, according to the breakdown provided by ASIP, which represents 74 pension funds with CHF 176bn and over 650 compiled portfolios. Swiss bonds account for 24.1% while foreign currency bonds are 16.7%. As for equities, the domestic portion is 12.6% with the foreign share at 25.2%. Hedge funds came in at 3.5%, cash was around 4.5% and other investments totalled 5.1%.

Real estate, at 8.9%, on the other hand, is considered a mainstream asset class although the global component is seen as alternative material due to the potentially higher returns. Many pension funds have been in the property game since the 1930s and view the asset as a bond substitute because it is low risk and produces steady, stable cash flows.

Dr. Benno Ambrosini, partner of LCP Libera, the Swiss subsidiary of the actuaries Lane Clark Peacock, adds: “Over the past few years, pension funds have increasingly been looking at alternative asset classes such as hedge funds, private equity and commodities. It is still, though, a very small percentage and there are few examples where alternatives are over 5% and fewer still where they are over 10% of an overall portfolio. What we have seen is the larger pension funds adopting these types of strategies while the smaller funds are staying with the traditional fixed income and equities split. Alternative asset classes can add significant diversification and therefore stability, especially in the recent volatile time.”

One criticism is that the Swiss are too focused on core satellite and passive index tracking strategies. Andrew Marks, vice president at T. Rowe Price, says: “I see the Swiss pension fund industry as being somewhat bi-polar. The demographics are extreme, with only 60 or so funds with over $1bn in assets under management in a total community of 2,000 plus plans. The top tier group is well-resourced, sophisticated and well supported by practitioners, while the smaller funds do not have the time or resources to adopt more modern techniques. They rely heavily on the plan sponsor's banking partners to manage their assets. At times, one sees even a private wealth management mentality about the way assets are managed.”

Martin Mlynár, managing director of Corestone, a multi-asset, multi-manager firm backed by Robeco, agrees, adding that “culturally, there has been a close relationship between local practitioner, private banks and consultants, but there is increasingly a desire for a more institutionalised way of managing money. This is because Switzerland is facing the same demographic issues as many other countries and things will have to change.”

Werner Koradi, a credit actuary at Hewitt in Switzerland, confirms that increasing life expectancy and the ability of funds to meet their funding requirements are the major topics of conversation today. Pension funds are also worried about the global impact of the credit crunch as well as the complexity of the rules and regulations that are in place.
This sentiment is backed by the Lusenti Partners study, which canvassed 172 Swiss institutional investors managing assets totalling CHF211.7bn (€123.9bn). It revealed that given a choice, the majority of institutions would opt for prudent investor rules as an appropriate framework for managing second pillar investments. They believe it
will not only help enhance performance, but also improve the responsibility of fund management, reduce volatility and improve the level of risk diversification.

According to industry participants, another source of concern is the federal government’s decision to raise the minimum interest credit payment for pensioners to 2.75% this year from 2.5% in 2007. Swiss pension schemes are obliged to pay a minimum interest-based increase at a rate set by the federal government. Over the years, it has been criticised for being inflexible and politically motivated with the government trying to strike a compromise between unions on the one hand and employers and insurance companies on the other. Given the bearish nature of Swiss markets coupled with the gloomy global economic outlook, some have questioned whether the funds will be able to meet the increase.

The switch from DB to DC is also on the table due to changing demographics and deteriorating coverage ratios. “There is a trend of a move away from the traditional DB plan to more of a DC type of system,” observes Zanella. “Several large companies have already made the move and I think we will see other DB plans vanish in the coming years.”
In many ways, the CHF 22bn (€13.8bn) UBS pension fund blazed a trail when it started the onerous task of migrating its members from DB to DC in 2001. The scheme is not 100% DC, but a cash balance plan, which means the pension promise is given by the scheme, and not by the employer. Currently there is only one default option,
but members can choose three contribution levels. It took about five years to complete the process but today, many funds are adopting a harder line. Instead of closing down the DB scheme to new members or going the buy-out route, they are simply transferring members to the new DC framework.

Lynn Strongin Dodds is a freelance journalist