- Despite the pandemic, Swiss pension funds generated a good performance in 2020, although results vary significantly from fund to fund
- Fluctuation reserves are rising, creating scope to pay higher interest on the assets of insured members
- 25% of pension funds have introduced ESG criteria but only 4% have a CO2 reduction target
- Redistribution from active insured members to pensioners slowed in 2020 but nevertheless continued
- Collective pension foundations accept a higher level of redistribution since they face a dilemma between adjusting technical parameters and remaining competitive
- Almost two-thirds of public-sector pension funds already envisage a retirement age of 65 for women
Swiss pension funds manage more than CHF 1,000 billion of assets for their insured members in pillar 2. Through their investment decisions, they also have an impact on the climate. In its 21st edition, the Swisscanto Pension Fund Study therefore expanded for the first time its survey to include a detailed questionnaire about environmental standards, social criteria and corporate governance aspects (ESG). The results show that pension funds are now definitely following the global trend towards sustainable investing, although they still have a significant need to catch up in connection with the climate megatrend.
According to the study, 25% of the 514 pension funds surveyed have integrated ESG criteria into their investment regulations, compared to only 8% in 2015. A further 9% of pension funds intend to introduce ESG criteria in the next three years. And finally, one-quarter are discussing the introduction of an ESG clause in their investment regulations but no decision has been made yet. Large pension funds with over CHF 500 million of assets under management are leading the way: 44% have already introduced ESG criteria, compared to just 14% of small pension funds. The fact that the majority of small pension funds needs to catch up is also demonstrated by the application of sector exclusion criteria, companies or countries in the investment process: 64% of large pension funds have introduced exclusion criteria, compared to only 29% of small pension funds.
However, all pension funds need to take action where climate measures and CO2 reduction targets are concerned: On average, only 17% measure the CO2 in their portfolio (large pension funds: 32%, small funds: 7%). A further 6% are considering introducing CO2 measurements. A negative picture emerges when it comes to specific reduction targets: Only 4% of pension funds have already introduced a CO2 reduction target (large pension funds: 8%; small funds: 1%) and only 11% are considering doing so (large pension funds: 17%; small funds: 6%).
The study shows that sustainable investing is becoming increasingly important, emerging as a third dimension alongside risk and return. New national and international regulations ensuring additional transparency and comparability are providing further impetus. “Climate risks are investment risks, since firms with CO2-intensive business models face the threat of a loss of value,” stated Iwan Deplazes, Head Asset Management Swisscanto Invest at Zürcher Kantonalbank. He added that in the transition to a climate-friendly economy, no one will be able to afford CO2-intensive portfolios in the future.
“The integration of ESG criteria into the investment process reduces risks. Given the large volume of assets under management, a significant contribution can thus also be made towards combating climate change,” said Deplazes. “All asset managers and pension funds have a particular responsibility towards young insured members who are already disadvantaged in pillar 2 as a result of redistribution from active insured members to pensioners. Systematically investing in a climate-friendly manner helps to end indirect redistribution from young to old at the expense of the planet.”
Equities are the new bonds for pension funds
The pandemic initially had an impact in 2020 but the rapid recovery following the sharp downturn in markets in the spring meant that pension funds nevertheless generated a solid investment performance: The average return was 3.97% (2019: 10.85%). However, there were enormous differences between the top-performing pension fund with a return of 12.30% and the worst-performing pension fund at –6.50%. The larger and more professional the pension funds are, the better they perform: Those with more than CHF 500 million of assets under management generate a higher return of 4.02% than the small funds at 3.90%. This difference is also evident over the long term: In the last decade, large pension funds generated an average annual return of 4.57%, outperforming small funds whose average return was 4.27%.
In the persistently low interest rate environment, the trends seen in terms of asset classes in prior years continued in 2020: On the one hand, the allocation to equities rose to a record level of 32.7%, while bonds fell to a record low of 28.9%. Within a decade, the allocation to bonds declined by 22%, while the allocation to equities rose by 26% and the allocation to real estate by 18%. It is noticeable here that the increased real estate risks are mainly concentrated among smaller pension funds: Looking at the one-tenth of pension funds with the highest allocation to real estate, they have assets under management averaging CHF 500 million – meaning they are only one-third of the size of the average pension fund. These pension funds invest 41.7% of their assets in real estate, compared to only 24.4% for pension funds as a whole.
The fact that equities have replaced bonds as the core investments is proving beneficial, as the top-performing 10% of pension funds show: The pension funds in question are of above-average size and have a significantly higher allocation to equities of 39.5%. Their performance over the last five years was 6.0%, far exceeding the average of 4.6%. In contrast, the one-tenth of pension funds with the weakest performance generated a return of only 3.2%; they are characterized by a significantly higher allocation to bonds of 32.8%. “In 2020, the difference in returns was not due to the higher allocation to equities; it was attributable to the stronger allocation to foreign investments,” stated Deplazes. “It is important to not only consider the risks but also the opportunities provided by a professional investment policy, since it is clear that the financial market remains an essential pillar, given its role as the third source of contributions. And it is only possible to generate attractive risk premiums through carefully considered and diversified risk-taking.”
Fluctuation reserves increased due to good performance
Viewed overall, Swiss pension funds are healthier today than they have been for a long time. Good returns have enabled them to improve their financial stability and increase reserves. The pension funds’ coverage ratio has risen to the highest level in a decade. Reflecting their good performance, the pension funds have more financial resources available and many are using them to increase their fluctuation reserves – substantially in some cases. For example, 69% of all pension funds have built up at least 75% of their target fluctuation reserves (2019: 63%).
At the same time, the downward trend in discount rates for pension capital and technical reserves has continued, albeit at a slower pace. Discount rates of less than 2% that were inconceivable a few years ago have now become a reality: 72% of Swiss pension funds use a technical interest rate of less than 2% in their calculations, compared to only 57% in 2019. Among private-sector pension funds, the technical interest rate averaged 1.59%, and it was 1.86% for public-sector pension funds. This is logical in view of rising life expectancy and the persistently low interest rate environment, since securing benefits remains the greatest challenge for pension funds. As the study shows, pension funds are now tackling this issue.
Conversion rates are falling even further
The bad news for the insured members of pension funds is that they will have to expect lower conversion rates. Those rates have decreased further in 2021. The average conversion rate is 5.46% for women who retire at the age of 64 and 5.52% for men who retire at the age of 65.
Conversion rates are today already largely below 6% and thus lower than the target value envisaged by the Swiss Federal Council as the minimum conversion rate for the current BVG revision. This shows how long overdue the adjustments to the legal framework are. However, the reduction that is currently being discussed is unlikely to be the last. Looking to the future, most pension funds expect further reductions in the conversion rate due to increasing life expectancy, low interest rates and limited actuarial room for manoeuvre. They anticipate that the average conversion rate for 2025 will be around 5.3%.
It is noticeable that in their regulations, almost two-thirds of public-sector funds already envisage the retirement age of 65 for women that has been the subject of political debate. This compares to only one-third of private-sector funds.
Redistribution is decreasing – but not among collective pension foundations
The pension funds’ solid investment performance allowed them to generate an average interest rate of 2.03% on the assets of active insured members in 2020 (2019: 2.64%), once again clearly exceeding the interest paid on pensioners’ capital. The figures vary significantly from fund to fund: While the average interest rate for the schemes of private employers was 2.17%, the rate for collective and community pension foundations of public-sector employers was only 1.48%. Pension funds with fully funded fluctuation reserves can provide a higher interest rate (2.29%) than those that have to continue building up reserves (1.84%).
“Fortunately, Swiss pension funds were able to reduce redistribution from active insured members to pensioners in 2020 because the interest rate differential developed in favour of active insured members. However, this comes at the cost of lower conversion rates,” stated Heini Dändliker, Head Key Account Management Corporate Clients at Zürcher Kantonalbank. This means that a slower reduction of technical interest rates has eased the pressure on reserves and conversion rates have been lowered further. “In view of the losses that the active insured members had to bear as a result of redistribution in the past, we welcome the fact that pension funds have largely funded their fluctuation reserves, creating more flexibility for active insured members,” said Dändliker.
In contrast, collective pension foundations accept a level of redistribution that tends to be higher: They usually offer higher technical interest rates and conversion rates compared to private-sector pension funds. Further, they pay less interest on pension assets. “Collective pension foundations are faced with a dilemma between adjusting their technical parameters and remaining competitive,” said Dändliker.
Significant rise in interest rates would trigger large losses in the short term
Alongside climate risks and potential corrections on the equity or real estate markets, Boards of Trustees should also consider the scenario of an abrupt rise in interest rates. There was a slight increase in interest rates in 2020 but they remain in negative territory. With the economy now recovering from the crisis, there is growing speculation about a hike in interest rates. “A massive interest rate shock would impact investments by destroying value in the short term: If the interest rate were to rise by 1% in Switzerland and abroad, the short-term negative effect on the entire portfolio of the pension funds would be 4.8%, according to our calculations,” said Iwan Deplazes. “That type of loss far exceeds even a simulated loss based on the scenario of the 2008 financial crisis. In the medium term, the insured members of the pension fund would, however, reap the benefits of higher interest rates.”