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Low Interest Rates: What Private Investors Can Learn from Pension Funds

The low interest rate environment is making it difficult for private investors to invest their money profitably. However, they could glean potential investment strategies from pension funds. 

The persistent low interest rate environment poses a challenge both for institutional and private investors. In response to this, many Swiss pension funds have adapted their investment strategies, with the percentage of bonds in their portfolios reduced in favor of equities, real estate, and alternative investments.

Only Investing in Low-Risk Products Barely Produces a Return

As part of its new pension fund study, at the end of 2016, Credit Suisse asked just under 200 Swiss pension funds what are the biggest challenges for them. Ninety-three percent of respondents consider the prevailing low interest rate environment as one of the three major problems facing employee benefits insurance and more than half identified it as the biggest challenge.

In a context in which low-risk financial instruments, such as money market investments or federal bonds, barely yield a return or even yield negative nominal returns, it has become increasingly difficult for pension funds to generate the income needed for the sustainable financing of their benefits without accepting higher investment risks.

Equities, Real Estate, and Alternative Investments Gain in Importance

Accordingly, the composition of the assets of Swiss pension funds has changed markedly over the past few years (see Figure 1). In 2016, bonds remained the most important asset class. However, at an estimated 31%, the percentage of bonds was as low as in 2000. Conversely, at 30%, last year the average weighting of equities in the pension funds' portfolios was at its highest level since the turn of the millennium. Meanwhile, allocations in real estate (19%) and alternative investments (9%) achieved record levels.

According to the Pension Fund Index of Credit Suisse, in the first quarter of 2017, the weight continued to shift away from bonds to equities and real estate. The observed shifts in the investment structure can be partly explained by price developments on the financial markets, but active strategic decisions by the pension funds in particular have also played a significant role.

Pension Funds Moving Away from Bonds in their Investment Strategies

Proportion of asset classes as a percentage of the total balance sheet of Swiss pension funds (not including assets from insurance contracts), 2016; change in the proportion between 2011 and 2016 in percentage points.
Source: Swiss Federal Statistical Office, Credit Suisse 

Pension Funds Increasingly Investing Money Abroad in the Low Interest Rate Environment

Sixty percent of the funds surveyed have implemented measures on the investment side in response to the low interest rate environment. A particularly large number of pension funds increased their weighting in foreign equities (see Figure 2). In real estate, too, a certain diversification into foreign investments is evident, although the overweight in the home market (known as "home bias") remains extremely strong for this asset class.

The pension funds have increased the proportion of their holdings in Swiss real estate, in particular through indirect investments. Within alternative investments, the subcategories of infrastructure, insurance-linked securities, private equity, and senior loans in particular have either been newly introduced or expanded. However, it must be pointed out that alternative investments are still not part of the investment strategy of many pension funds.

Pressure on Yields Is Causing Swiss Pension Funds to Find Alternative Ways to Invest

Proportion of pension funds as a percentage; only pensions funds that have modified the weighting of the asset classes in their investment strategy due to the low interest rate environment.
Source: 2016 Credit Suisse Pension Fund Survey

Private Investors Can Match the Investment Strategies with Funds and ETFs...

It is not only pension funds, but also private investors, who are finding the low interest rates a challenge. But how much can the latter learn from the investment behavior of the former? After all, it is well known that private investors differ from institutional investors, such as pension funds, in many aspects.

For instance, due to the amount of assets under management alone – the average total assets of a Swiss pension fund in 2015 was around CHF 440 million – institutional investors have a greater selection of investment instruments to choose from. Furthermore, size and cost benefits generally go hand in hand. However, by using funds and ETFs, private investors have the opportunity to diversify their portfolio even for small amounts and indirectly invest in potentially high-yield, but otherwise difficult to access, asset classes.

Conversely, unlike private investors, Swiss pension funds are subject to statutory investment guidelines, which, among other things, specify maximum percentages for asset classes, limiting the investment possibilities as a result. For example, pension funds are not able to hold more than 50% of their assets in equities; the limit for real estate is 30% and for alternative investments the maximum is 15%. Even though these upper limits may be exceeded in justified cases, only a minority of pension funds have taken advantage of this option up to now.

... And Invest in Highly Diversified and Alternative Investments

Despite all the differences, there are still investment principles that apply to both institutional and private investors. This means that when looking for sources of returns in the current low interest rate environment – which could still continue for a while despite the gradual normalization of global monetary policy – it is not just a question of whether equities should be further built up at the expense of bonds. On the contrary, it is also important to look for attractive options within each asset category.

In the case of bonds, this means also considering investments in lower credit qualities (e.g. corporate bonds or government bonds from emerging markets), for example. In the case of equities, as well as diversification by country, there is also the option of diversification according to sector and market capitalization. In addition, diversification and expansion of the range of investments using alternative instruments should always be given serious consideration.