It appeared to be a normal January morning in Zurich when the chief executive of a Swiss insurer began presenting his company’s results to investors. All at once, however, the phones of every fund manager present began buzzing, and some audience members started running for the exit.
Bemused, the chief executive continued his presentation, before having to abandon it altogether in the face of dwindling numbers.
In what has been described as the most dramatic currency intervention in decades, the Swiss National Bank had just announced it was removing the CHF1.20 cap on the franc against the euro. The SNB also pushed interest rates on deposits deeper into negative territory, at -0.75%.
The implications for Switzerland’s CHF800billion ($830billion) occupational pension fund sector, known as the second pillar of the industry, the first being the basic state pension, were considerable. The day the news broke, the Swiss franc surged 39% against the euro while the country’s main equities index, the SMI, dropped 10%.
Peter Zanella, head of retirement solutions at Towers Watson, the consultancy, in Zurich says, “The Swiss franc’s appreciation immediately had a very negative impact [on domestic pension funds]. There was a plunge in the Swiss equity market, while pension funds’ unhedged foreign investments were left in tatters.”
While fund managers and traders around the world lurched into action to close lossmaking positions and hedge their equity exposure, Switzerland’s pension funds began lobbying the central bank for exemption from the negative charges on deposits as a first step towards mitigating the damage.
The SNB denied the request. “The whole pension industry is very critical of this decision,” Zanella says. “Every pension fund manager is worried about what is going on.”
Bankrupt in a decade?
Switzerland’s pension fund professionals believe the currency turmoil and the negative charges have created critical problems for a retirement system already under strain. Some suggest Swiss pension schemes will be bankrupt within ten years as a result.
This is despite the fact that, by international standards, Switzerland’s occupational pension system is relatively robust; most of the country’s occupational schemes have an enviable asset to liabilities ratio of around 115%.
Yet Swiss pension fund managers have become increasingly nervous about their ability to maintain that ratio in the past 12 months, largely because they are legally required to pay retirees an annuity equivalent to 6.8% of their total savings on an annual basis.
This conversion rate – a subject of heated political discussion in Switzerland – is considered unsustainable. It was devised in 2003, when life expectancy was lower and performance expectations were higher.
Nervousness among pension fund managers about the strength of the second-pillar framework morphed into outright fear following the central bank’s January announcement.
Although Swiss equity markets have since bounced back, the problem remains that the country’s pension funds, which typically hold 5% of their assets in cash, are being charged to maintain that liquidity.
To avoid paying negative rates on cash accounts, pension funds are examining a number of extreme alternatives, from transferring cash into vaults or bunkers to leasing medical equipment or supplying cheap mortgages to retirees. Other schemes have looked at providing annuity payments to pensioners as a lump sum for the year to offload the liquidity risk.
First to sell
Further exacerbating pressure on the industry, Switzerland became the first government in history to sell benchmark ten-year debt at a negative interest rate in April. Jerome Cosandey, an economist at Avenir Suisse, the Swiss think-tank, says, “The situation was bad before January and it just got worse after that.”
These challenges have prompted an intense debate over which asset classes these pension funds should be invested in. Zanella says, “All these things together clearly create big challenges. Should pension funds still hold Swiss ten-year government bonds when yields are negative? I wonder whether holding Swiss government bonds is even legal, but what alternatives do they have?”
Although there is little evidence of a rush to buy alternatives and sell Swiss bonds, some pension funds have taken action. Axa Winterthur’s pension scheme has sold Swiss government bonds in favour of hedge funds and property.
The CHF21billion Migros Pensionskasse, the supermarket pension fund, similarly sold all its Swiss and European bonds with negative yields following the SNB’s January announcement. The CHF1.3billion Pensionskasse Stadt Luzern, the city council pension fund, has increased its maximum allocation for property to 38% of assets and shifted away from bonds.
Zanella believes other pension funds are likely to take on more risk “reluctantly” by investing in property, although he notes that “all pension managers [have doubts about] the true value of the [property market].”
The SNB is “very concerned” about potential overheating in the domestic property market, according to Cosandey.
He adds that although the Swiss stock market has recovered since January, there is growing concern that “the strong Swiss franc could reduce economic output and have a negative impact [on equities].”
Martin Eling, professor of economics at the University of St Gallen, is deeply sceptical about the benefits of dropping bonds in favour of alternative asset classes.
He has instead called on the government to cut the mandatory annuity rate, increase social contributions per employee and raise the retirement age – proposals that are likely to be put to a public vote in 2018. He believes that without such action Switzerland’s occupational pension schemes risk going bankrupt within ten years.
Eling says, “The new asset classes the [pension funds] are investing in are all good investments with higher return potential – but this comes with the cost of higher risk. That is the biggest concern for me.
“I am not 100% sure that [increased risk] is the optimal thing for the customers in the pension funds. The people who will pay for the SNB’s decision are those who want to save money.”
Switzerland’s occupational pension system, known as the second pillar of the social security framework, accounts for around CHF800billion of assets across 2,000 schemes.
Since the second pillar was established in 1985, the pension schemes have followed a defined contribution system whereby funding comes from employer and employee contributions.
Employees whose annual earnings exceed CHF21,150 ($22,140) are required to pay into their employer’s pension fund until the age of 65 for men or 64 for women.
At retirement, accumulated savings are converted into an annual annuity using a conversion rate currently set at 6.8%.
Consultants, actuaries and pension fund managers have long argued that the conversion rate is too high and risks destabilising the entire system. These fears have worsened in recent months in the face of low or negative interest rates on cash holdings and bonds.
In an attempt to improve matters, Swiss Interior Minister Alain Berset has launched a pension reform package, named Altersvorsorge 2020, which would lower the conversion rate to 6% and raise the retirement age for women to 65.
The proposal is being fine tuned by the government before it will be put to the public in a referendum expected to take place in 2018.
But Swiss pension experts are pessimistic about the likelihood of the package winning public approval. Swiss voters have rejected every pension reform proposal put to them over the past 15 years.
Copyright The Financial Times Limited 2015