Re-establishing balance

 

Swiss pension funds, like their global compatriots, have had a tough year. As the crisis hit performance and funding levels, schemes moved out of risk assets. The growth in international and alternative allocations looked set to stall or even reverse as the Swiss market performed better than other major economies.

However, for those rebuilding funding levels, reducing risk could be a Catch 22. Experts warned against panic reactions, urging everyone, including scheme managers, members and the authorities, to take a calm and flexible approach to recapitalisation with a greater focus on liabilities.

“2008 was the worst year for pension funds since the introduction of the BVG pension legislation in 1985,” according to BVK Pensionskasse head of asset allocation, Daniel Gloor.

Credit Suisse’s Swiss Pension Fund Index (CSPFI) showed total assets fell 13.25% in 2008, dropping 6.8% in the final quarter.

Lusenti Partners managing director, Graziano Lusenti, believed the situation could be far worse, however: “Based on broad asset allocation trends, 80% of Swiss schemes saw declines of between 10% and 20% during 2008,” he said.

As a result, funding levels fell significantly. Recent data from the Swiss Pension Fund Association (ASIP), suggested 60% of pensionskassen were now underfunded with an average coverage ratio of 96.5%. 

At the end of December 2007, SwissCanto figures put the average funding ratio at 106.65%.

While a few percentage points was not a big problem, Lusenti said, those with between 90% to 95% needed to look at both assets and funding options. Up to 15% of schemes would, however, be below 90%, which would be a real concern.

“This is the biggest issue facing Swiss pensionskassen,” Mercer’s head of investment consulting in Switzerland, Sven Ebeling said. “It will be hard for them to recover from last year and will take considerable time.”

Markets in free fall

As markets plummeted, many schemes de-risked, according to the CSPFI report, which said: “The last quarter of 2008 saw a substantial increase in the expected risk faced by the markets, and an even more noticeable reaction by market players, who actively reduced their risk exposure by shifting weight to other asset classes.”

Liquid holdings reached an all-time high of 8.84%, the report showed.

Pictet Asset Management, head of business development for Continental Europe, Udo von Werne said this was evidenced by increasing demand for cash and money-market funds, which doubled in 2008.

“There is a much greater risk-focus,” he continued. “Meetings used to dedicate 25 minutes to investment processes and five minutes to operational risk. This ratio has now almost reversed. Straightforward, simple products have proven most popular.”

However, lowering risk as funding fell has presented pensionskassen with its own dilemma.

“By holding cash and money-markets, schemes will potentially miss out on gains if the market recovers,” von Werne said. “Nobody wants to make the first move back into risk assets, but bonds could be the next bubble to burst if fiscal and monetary stimulation leads to inflation.”

Exposure to alternatives like hedge funds was already decreasing after starting 2008 on an up-trend. The CSPFI showed allocations dropped 0.35% in the final quarter of 2008 to 4.79%.

Gloor confirmed the BVK would reduce its weightings to hedge funds to the minimum level of 2% and commodities to its strategic level of 3%.

“While our attitude to alternatives has not changed dramatically,” he said, “We will decrease our hedge fund exposure. Hedge funds, particularly, have been badly hit by poor performance, illiquidity, discussions about high fees and Madoff. Opportunities still exist in this space, but we may decide to forgo these for the next three years.”

Swiss Canto head of asset management and institutional clients Peter Baenziger, said: “Those hedge funds that survive will find plenty of opportunity, even without significant leverage. They will most likely achieve positive returns next year, but not as much as equity will.”

In part, this move re-established the risk/return balance, Lusenti believed. “If schemes expect high returns with lower risk, they should realise that common sense dictates it cannot last long.”

The balance has already shifted, with schemes being “penalised” for taking risk. Figures from the CSPFI contradicted the theory that higher risk was rewarded by higher returns in the long-term. Average annualised returns fell more than 5% to 2% while risk increased around 1% in the fourth quarter of 2008.

Even pension funds that accepted only moderate annual fluctuation risk reported a negative performance, without exception.

According to von Werne, funds who implemented more aggressive asset allocation, diversifying across a greater number of asset classes and regions, performed relatively worse than more conservative funds.

Pictet’s LPP-40 Plus index of pensionskassen with allocations to hedge funds, private equity and real estate had better average returns (7.4%) between 1989 and 2005 than the less diversified LLP-40 (6.8%). During the same period the maximum annual loss (1990) was -8.8% for the LPP-40 Plus versus -11.5% for the LPP-40.

In 2008 things reversed. The more diversified strategy of the LPP-40 Plus returned -20.67% for the full year, but the more conservative LPP-40 fell only 17.28%.

Gloor warned, however: “While diversification didn’t work properly in 2008, it would be wrong to conclude that it had failed. 

“Investors need to appreciate that it will have a limited impact in times of crisis and to move away from diversification would be dangerous. We believe there is still a strong fundamental case for diversifying across different geographies and asset classes.”

The lack of protection provided by diversification has been particularly acute for Swiss pension funds, given the relative outperformance of the Swiss equity market in 2008 compared to other major economies. In Swiss Franc terms, the SPI, pensionskassens’ preferred equity index, fell 34.1% versus –42.3% for the S&P500, -44.8% for the MSCI World and -47.6% for the DJEuroStoxx50.

“As traditional diversification failed for most Swiss funds we may see some significant changes in schemes’ asset allocation based on a new and different perception of risk and its sources,” Ebeling said. “Some may even consider re-increasing their domestic holdings. Whether the latter is prudent or not will require careful analysis.

“Given the unusually high concentration in the SPI of a small number of predominantly pharmaceutical stocks, spreading risk continues to be essential. We may see a new concept of diversification evolve, but it is not yet clear what that will look like.”

Ebeling also warned that asset allocation alone would not solve schemes’ funding problems. He urged them to closely examine liabilities, saying: “It would be irresponsible to rely on assets alone to improve their financial situation. Pension funds have to look at how they can better manage long-term liabilities too.”

This view was shared by Lusenti, who said: “In many cases current benefits are too high versus contribution levels. Asset allocation and sound diversification can only have so much impact on a fund’s financial well-being. Many schemes need to take another look at long-term liabilities in this new environment.”

Changing benefits

Benefit levels have already become a contentious issue in Switzerland as the government is trying to introduce a reduction in the legal conversion rate to 6.4% by 2015, representing a cut in pensions of 10.4% for men and 11.2% for women.

Although some questioned whether this initiative would be agreed by the unions, Gloor believed the majority would see the sense of reducing payouts. “This will likely to be voted through,” he said. “In an ageing population, it is right that people should agree to lower pensions, but this is still not broadly accepted by scheme members.”

The government could also improve the long-term funding status of schemes by lowering the Mandatory Minimum Interest Rate (MMIR) they are required to pay on contributions, currently 2%. The gap between actual returns and the MMIR grew significantly in 2008 to 16.47%, according to Credit Suisse.

Gloor said: “Reducing the minimum interest rate would relieve some of the pressure on pension fund liabilities if the markets continue to be unstable or fall further.”

ASIP believed the MMIR should not only be cut in 2010, but schemes should be allowed to set rates individually based on actual retrospective returns. 

ASIP chief executive, Hanspeter Konrad said: “The authorities have an important role to play in terms of lowering the burden on pension funds. They need to refrain from being excessively prescriptive about how schemes recover from this crisis. They must also recognise the status of pension funds as long-term investors and take a flexible approach regarding the timing and actions required to get funds back to fully funded status.”

 Von Werne backed up this view, saying: “2008 has been an important stress test for funds, but the case for diversification remains strong and is important that nobody, including scheme managers, members or the authorities, reacts in panic. It is crucial that pensionskassen take another careful look at both assets and liabilities as they work towards recapitalisation.”

Baenziger added: “The responsibility lies with all of us to make the best of the current situation through transparency, integrity and professional conduct in order to maintain the trust in the Swiss pensions system and manage its future success.”