360°Benefits I News
After the market upheaval of 2022, 2023 brought back some market stability with positive investment returns while price inflation remained high relative to the last 20 years. In addition, pension reform continued to be a prominent topic for pension funds and their sponsors meaning that there is still work to do. Bond yields fell back a bit during 2023 reversing the dramatic increases seen in 2022 (falling bond yields mean bond value increases) and have continued to fall in 2024. This combined with solid equity returns meant that pension funds typically had positive 2023 investment returns (5-7%) resulting in a improvement in Swiss pension fund coverage ratios. The OAK reported that the number of Swiss pension funds with underfunding (below 100% coverage ratio) reduced back below 10% at the end of 2023. This meant that, while some of the losses from 2022 were not yet fully compensated, with the 2024 positive return so far at the end of June, most Swiss pension funds are now (finally) in a good financial position, on average.
In this News we provide some commentary on the various market elements and developments affecting pension funds currently.
2023 saw some relative stability in financial markets after the simultaneous equity and bond falls during 2022. Geopolitical macro events and higher energy prices remain prominent while inflation has started move back to longer term levels in most developed countries. However, interest rates continue to be kept at higher levels by central banks versus the last 15 or so years to keep control of inflation hikes that first broke out during 2022. In Switzerland, the situation has already mostly stabilised, but not in all countries. Figure 1 shows the development of cumulative pension fund investments, cumulative inflation and 10-year government bond yields. It shows that:
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) because of future lower investment return expectations. The question now is whether pension funds will increase their technical interest rates again to reflect the new economic environment.
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). In addition, equity values dropped in 2022 so pension fund assets (bonds and shares) decreased significantly while the liabilities have remained broadly unchanged. The situation has stabilized a little now with bond yields creeping back down at the same time as equity markets rallying so funding levels have improved again. However, more pension fund underfunding positions could be around the corner again if bond yields increase again, and particularly if that is combined with an equity market downturn (which is often the case). Economic cycles are normal and that means pension fund coverage ratios are meant to fluctuate and even sometimes go into underfunding but when in underfunding it does reduce options for foundation boards. Underfunding reduces the ability to award higher interest credits to member accounts and provide potential pension increases while underfunding 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. During 2024, we have experienced a slow but continued improvement in the financial markets and Swiss pension funds continue to adapt to and review their investment strategy to better match the latest economic environment. With differing interest rate policies of global central banks and the more proactive approach of the Swiss National Bank, there is much to analyse including considering currency exposure in Swiss pension fund portfolios (including currency hedging).
As noted earlier, most pension fund coverage ratios improved over the 2023 year. According to the OAK around 7% were below the key 100% coverage ratio at end 2023 which triggers pension funds to take additional actions and brings supervisory authority oversight. The average coverage ratio of these pension funds increased from 107.0% to around 110%, which was a welcome development after the reductions in 2022. Nevertheless, it is worthwhile mentioning that typical target coverage ratios of Swiss pension funds are in the range of 115% to 120% so certainly not all pension funds are in very comfortable positions. 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 in 2022. Nonetheless, at the end of June 2024, the situation is now much closer to a desired state, but we need to wait for the year-end results before any positive news can be distributed to insured members of Swiss pension funds.
As pension funds reduced technical interest rates during the sustained period of lower bond yields during the last 5 to 10 years, they also gradually reduced conversion rates used to convert retirement lump sums into pensions (since the low return expectations means higher cost of financing the same pension level). 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 the current relatively higher levels or increase again. 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? Certainly, before upping the conversion rate again, other actions could be considered regarding harmonising ages and conversion rates for males and females, if not already done.
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 particularly for those funds 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 depending on the size of the pension portfolio. We have heard recently that some insurers are considering quoting for securing pension liabilities (reinsurance contract to the pension fund), which may open an additional avenue for pension funds and their sponsors to secure their pension funds better. In addition, there was new laws released on pensioner transfers which seemed to confirm some legal opinions that it is possible for foundation boards to elect to transfer pensioners to other pension arrangements (subject to their fiduciary duty to all members – security of benefits maintained or improved for all members). The pension supervisory authorities have generally not been supporting such pensioner transfers (unless forced by an insolvent employer for example) but the new law and legal opinions in the market may create some movement in the pensioner transfer market.
Inflation erodes the value of pension savings and retirement income. 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 annual inflation for the 20 years to the end 2022 was only 0.38% (i.e. minimal increases in the average cost of living over 20 years). This means pensions did not necessarily need to be increased to maintain the basic living standards of pensioners (based on the official inflation calculation). The question is whether no pension increases will remain a realistic possibility for Swiss pension funds if Switzerland sees a more positive sustained period of inflation in the future. As noted above, cumulative inflation seen during 2022 and 2023 was around 5% over that 2-year period. More recently, we have seen a referendum approved which also increased the first pension pilar by one additional payment annually which represents a 8% increase in the first pilar pension (still to be implemented in 2026).
Further details on inflation and pension increases in our 360°Benefits I News from last year. German or French.
Annual price inflation has now reduced back below 2% in Switzerland and is now solidly within the Swiss National Bank target level for inflation of between 1% and 2%. Given this is the target level, it is unlikely that price inflation will return to the almost non-existence level seen over the 20 years leading up to 2021. With more normal inflation present now and likely at some level in the future, deciding on pension increases is an additional responsibility for foundation boards.
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). While we expect the trend away to continue, albeit at a slower pace, it is now clear for most that over longer term horizons an asset portfolio including shares, property and other alternative asset classes perform better than bond only portfolios, also to the benefit of the insured members. 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 identify the best solutions for their employees.
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 higher of corporate bond yields has reduced such company pension liabilities more than the reduction in Swiss pension assets over 2022 and now pension assets have increased further in 2023 (with only modest yield drops so far). 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:
The 2024 year has started rather positively for pension fund assets with returns typically between around 4% and 6% for the 5 months to the end of May. This is certainly welcome news for the pension funds that are trying to recover from underfunding and for those wanting to 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 changes to state pension benefits and potential 2nd pillar occupation pension fund reforms on the horizon (subject to referendum approval this September). We plan to update this NEWS in the coming year to provide again a sense of direction for Swiss pension funds.”
