Pension funds: Balancing risk and return
Over the next two decades, demographic changes are set to put the risk ability of pension funds to the test. Credit Suisse economists have researched the factors that influence the situation and have concluded that instead of minimizing high-return equity investments, an increase in risk may actually be more advisable at this point in time. An individual analysis of the investment strategy, taking into account obligations, is essential in this case.
Challenges – high life expectancy and low interest rates
Two factors have changed fundamentally since the introduction of employee benefits insurance:
1. Life expectancy has increased significantly
2. Interest rates have fallen rapidly and are expected to remain low
This means that any pension assets saved need to last for a longer period of time. Over the long term, low interest rates will lead to reduced returns on money market investments and bonds, for instance.
Reduced returns or a declining "third contributor"
The Swiss pension fund system is structured in such a way that insured persons each have their own dedicated savings – also known as the "prospective benefits funding method." This system is now under increasing pressure.
Pension fund capital comes from three sources: The primary and secondary contributors are employees and employers. Their combined contributions form the retirement assets, which are invested in the capital markets by the pension fund, either as equities or bonds. The return obtained through this process is also known as the "third contributor."
At the start of the millennium, this third contributor began to be less reliable. While the average return on pension assets was 46% between 1987 and 2000, between 2000 and 2017 it was just 26%. Weak equity performance between 2000 and 2008 was the main driver of this reduced return. On the other hand, CHF nominal value investments have delivered a positive return thanks to falling interest rates.
According to the latest Credit Suisse study "Second pillar: a growing gap between generations," pension funds will face particular challenges in the future in relation to returns on lower-risk money market investments and bonds. If interest rates stabilize or increase, there will be a negative effect on returns on nominal value investments.
Factors influencing pension fund investment strategies
The investment horizon is key when establishing investment strategies. The distribution of retirement capital between the active insured and pension recipients and the liquidity of a pension fund both have a significant influence on the investment horizon. Both of these risk factors are set to worsen in the future across the entire pension fund market.
The challenge of the baby boomer generation
Alongside increasing life expectancy, there is another demographic factor that is causing concern for pension funds – the high birth rate between 1950 and the beginning of 1970. The generation born during this period is now gradually reaching retirement age, and this is having an impact on the age structure and liquidity of pension funds. The investment profile is likely to change.
Although the traditional prospective benefits funding method would have been structured on the basis of no redistribution taking place, today this redistribution is already a reality as a result of excessively high conversion rates. Without extensive reforms, redistribution will continue to increase as a result of the impending wave of baby boomer retirements. For employees with incomes above CHF 127,980, the BVG-1e plans offer an opportunity to avoid redistribution and to personally influence the investment strategy.
The result: There will soon be more capital with pension recipients than with the active insured.
As a result of these demographic changes, pension funds are shifting retirement capital – a strategy that is likely to present some challenges. While in 2015 the active insured accounted for 55% of retirement capital, with 45% allocated to pension recipients, this distribution will be significantly different by 2045. By then, the proportion of pension recipients will be 57%, and by 2065 it will have risen to around 60%.
Cash flow is becoming negative
The fact that pension recipients are outnumbering the gainfully employed active insured in the composition of pension funds will also have an impact on the liquidity of the funds. The following infographic depicts a cash flow projection (in CHF million) for the Swiss pension fund market, based on expected demographic developments up to 2065.
Changing risk ability of pension funds
The upcoming wave of retirements will impact the risk ability of investment strategies in three ways:
1. Shorter investment horizon
The retirement capital of pension recipients has a shorter investment horizon than that of the active insured, so lower-risk forms of investment are chosen for this capital.
2. Declining liquidity
If the cash outflow for retirement benefits exceeds the cash inflow from contributions, assets will be sold. These outcomes also impact the investment strategy, as it may be necessary to sell equities at an unfavorable point in time.
3. Ability to take remedial action will decrease
In the event of a shortfall, there are two remedial measures: Either minimal interest can be paid on the retirement capital of the active insured, or additional contributions can be paid – also by the active insured. However, because there will be fewer active insured than pension recipients in the future, these remedial measures will gradually become less effective.
Nonetheless: Higher-risk equity investments will still be made in the future
If we consider the distribution of provision for future policyholder benefits the sole risk factor, as a rule of thumb around 50% of the pension fund assets of 65- to 74-year-olds should be invested in nominal value investments, with the figure rising to 100% for those over 75. The idea behind this is that, from the pension funds' perspective, the capital of older beneficiaries is invested with less risk.
For the year 2015, this would mean that 33% of the provision for future policyholder benefits (the money of both the active insured and pension recipients) would need to be invested in safe nominal values. For 2045, this figure increases to 46%.
It can also be concluded that, in 2045, it would still be possible to invest 54% in higher-risk asset classes without violating the rule of thumb for nominal values. Currently, equity and real estate components make up 55% of pension funds. Maintaining this figure or even increasing the equity component is subject to the discretion of the pension funds, and also depends on a comprehensive examination of the respective risk ability. In light of the sustained low interest rates and the demographic challenges, this sort of analysis becomes increasingly important over time in order to exploit the return potential of the capital markets.