360°Benefits I News
The return of inflation and increase in bond yields has been significant in the last year and it raises a number of questions and potential challenges for pension funds and their sponsors. The rising bond yields (falling bond values) combined unusually with falling equity values during 2022 have led to significant reductions in Swiss pension fund coverage ratios wiping out gains from previous years. Indeed, the OAK reports that 29% of Swiss pension funds were below 100% coverage ratio at the end of 2022 compared to only 2% the prior year. This leads to higher risks and greater scrutiny for pension funds in 2023 because there are reduced buffers in place should there be any further shocks.
In this News we provide some commentary on the various market elements and developments affecting pension funds recently.
The last year or so has seen significant changes in the financial markets just at a time when one would have been forgiven for expecting things would calm down after the market volatility and turmoil due to the uncertainty during the global pandemic. Instead, geopolitical pressures in the last year have suddenly exacerbated already rising energy prices which have spurred on inflation to levels not seen for 20 years in Switzerland (and longer in other Western countries). This has led to an abrupt end to the unprecedented period of cheap lending and low interest rates that spawned from the last financial crisis 15 or so years ago. That is of course a simplification of the macroeconomic factors leading to this situation but the fact remains that over the last year Swiss inflation has returned strongly relative to the last 20 years, bond yields have jumped around 2.0% and there was a significant dip in pension fund asset values in 2022. Figure 1 puts this all into context over the last 10 years.
The 15 years or so of low bond yields have had a significant influence on the Swiss pension market. Slowly but surely and particularly over the last 5-10 years foundation boards have had to react by decreasing their technical interest rates (thus increasing their statutory liability for pensions) as a result of future lower investment return expectations. The question now is whether pension funds will increase their technical interest rates again to reflect the latest increases in bond yields.
Over the time of reducing bond yields, most pension funds did not reduce their technical interest rates as significantly as bond yields decreased over the same period due to the smoothed long term nature of the Swiss statutory funding regime. The advantage of this approach over that period meant that the increase in liabilities was not as significant as if the technical interest rate had decreased directly with bond yields. Bond values increased during this period (bonds increase with decreasing yields) and, along with reasonable increases in other assets of pensions funds such as equity and real estate, this meant that assets rose more than the relatively smaller rise in liabilities. Therefore, most pension fund funding levels remained in a solid position. The disadvantage with this approach (as evidenced during 2022) is that when bond yields increased sharply again (so pension fund bond values fell) there was no offsetting reduction in liabilities (very few funds have increased their technical rate due to the long term nature of that rate). To compound the matter, equity values dropped at the same time as bond values reduced so pension fund assets (bonds and shares) decreased significantly while the liabilities have remained broadly unchanged. Despite very strong asset performance by pension funds in the 2021 year, this combination of poor asset returns in 2022 (typically returns around -10%) and no change in liabilities has meant that close to 30% of pension funds were in statutory underfunding at the end of 2022 (source: OAK). Statutory underfunding is not the end of the world but it does reduce the options for foundation boards in relation to benefits for members including potential pension increases and also requires a formal plan to restore the pension fund to full funding within a reasonable period. Such a plan to restore full funding may also lead to additional contributions being required by the sponsoring employer and the members themselves.
As noted earlier, most pension fund coverage ratios reduced significantly over the 2022 year. According to the OAK more than 80% of pension funds had coverage ratios above 110% at the end of 2021 but that reduced to only around 30% at the end of 2022. More importantly, around 29% were below the key 100% coverage ratio at end 2022 which triggers pension funds to take additional actions and supervisory authority oversight. The average coverage ratio of these pension funds fell from 118.5% to 107.0% and while this is still above 100% it is worthwhile mentioning that typical target coverage ratios of Swiss pension funds are in the range of 115% to 120%. This buffer above 100% (the investment fluctuation reserve) is aimed to ensure that reasonable interest credits can be granted to member accounts even when there are poor investment years like 2022.
The increase in bond yields over the last year or so has been so dramatic that 10 year Swiss government bond yields are now higher than many technical interest rates used to value pension fund liabilities. Government bond yields are often considered a risk free rate of return so it is arguably over prudent that Swiss pension funds are discounting their future liabilities at a rate lower than government bond yields (particularly when pension funds also invest in other asset classes such as shares). A pertinent question now is whether pension fund boards should increase the technical interest rates which would have the advantage of reducing liabilities. It is a tempting prospect but needs to be balanced with the longer term nature of the Swiss statutory funding regime as referred to earlier which requires an element of conservatism when setting the assumptions. Foundation boards will need to think carefully having regard to investment market developments over the coming year at least.
An additional action of pension funds as they reduced technical interest rates during the last 5 to 10 years was that they also gradually reduced conversion rates used to convert retirement lump sums into pensions. This was aimed at ensuring that those pensions can be financed from the lower expected returns in the future. This had a direct impact on the pension levels of employees retiring. Perhaps an even more difficult question for foundation boards is when and if to increase conversion rates again if the bond yields stay at their current levels or increase further. Increasing and decreasing the technical interest rate with rises and falls in bond yields has the advantage that assets move partially in line with liabilities but doing the same with conversion rates has a direct impact on retiree pension levels. Foundation boards may therefore be reluctant to act too swiftly with increasing conversion rates again. For example, how would they deal with the inequitable consequence for the pensioners who retired during the period of lower conversion rates? Or is it simply bad luck?
Another consideration for pension funds and companies that may wish to de-risk their exposure to pension underfunding could be to secure the pensioner liabilities with an insurer or via cashflow matching strategies. The higher bond yields provide the potential opportunity for such an investment to be secured at a lower overall cost than has been possible for the previous 10 to 15 years. This would be in particular for those fund with very mature (high pensioner) profiles that have less scope to adjust to changing market conditions in the future. The market for selling pensioner liabilities to insurers in Switzerland has been almost non-existent in recent years but cashflow matching strategies remain possible. It is also possible that higher bond yields may trigger a change in insurer behaviour. In addition, there is new guidance expected later this year from the federal pension supervisory authority on pensioner transfers which may create some movement in the market.
Inflation can erode the value of pensions. Many pensioners rely heavily on their pensions to cover their living expenses so when those living costs rise without a corresponding rise in their pensions it can become problematic for them. Switzerland has seen a sustained and long period of minimal inflation and indeed inflation for the 20 years to the end 2022 was only 0.38% pa (i.e. minimal increases in the average cost of living over 20 years). This means pensions did not need to increase to maintain the basic living standards of pensioners. The question is whether no pension increases will remain a realistic possibility for pension funds if Switzerland sees a more substantial and sustained period of inflation in the future.
Further details on inflation and pension increases in our 360°Benefits I News earlier in the year. German or French.
In terms of future inflation development, it is unlikely that price inflation will continue at current rates in Switzerland but it is also unlikely that price inflation will return to the almost non-existence level seen over the 20 years leading up to 2021. Afterall, the Swiss National Bank target level for inflation is between 1% and 2% per annum and economist forecasts currently see Swiss price inflation gradually reducing towards that range over the next 2 to 3 years. With inflation present now and likely at some level in the future, deciding on pension increases are an additional burden expected to develop for foundation boards in the coming years while already facing financial security pressures (lower funding levels) and increased governance requirements including the new data protection law.
Another consideration in the new market environment is how it will influence the current trends in the market on the type of pension vehicle used by companies including:
One of the main reasons for AXA exiting the fully insured market and many companies moving away from fully insured funds was the sustained period of low bond yields (insurers must invest heavily in bonds). This was problematic for insurers to finance the historically high conversion rates set by the government and in addition, from a member perspective, made the interest credit expectations on account balances fall dramatically. With bond yields increasing again, one might hypothesize that fully insured providers could become more popular in the coming years again. This is certainly possible but we would also note that over longer time horizons it is fairly clear that asset portfolios including shares, property and other alternative asset classes perform better than bond only portfolios. We would suggest that members (and their employers) will remain awake to this reality over the longer term and employers wishing to maintain the best value for money pension solution for employees will generally continue to steer away from fully insured funds.
The gain in prominence from DC (1e) pension plans has partly been due to companies wishing to de-risk their pension balance sheets under IFRS and US GAAP (companies must report regular Swiss cash balance plans as DB plans while 1e plans do not impact the balance sheet). The rise of corporate bond yields has reduced such company pension liabilities more than the reduction in Swiss pension assets over the last year or so. This has improved the balance sheets significantly and many Swiss company pension balance sheets are in surplus which has relieved a lot of pressure. One contention could be that companies will have less interest in implementing DC (1e) pension plans as a result. We also don’t think this will be the case because there were other reasons for companies implementing DC (1e) plans such as:
In addition, there is no guarantee that bond yields and asset levels remain as they are now so we would expect that the trend towards DC (1e) plans will continue gradually.
The 2023 year has started rather positively for pension fund assets with returns typically between around 3% and 4% for the 4 months to the end of April. This is certainly welcome news for the pension funds that are trying to recover from underfunding and build up their investment fluctuation reserve buffer again. Nevertheless, there remains many challenges for pension funds to maintain and improve the financial security for their members including managing their asset liability risks, navigating the complexities of the new ESG investment world, considering potential mechanisms for increasing pensions and increased governance requirements including the new data protection law. We plan to update this NEWS in the coming year to provide again a sense of direction for Swiss pension funds.
