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Pension Funds: The Anxious Wait for a Rise in Interest Rates

Credit Suisse Study on the Challenges for Swiss Pension Funds

Today Credit Suisse publishes its study entitled "Challenges for Pension Funds 2012 – Current Mood and Background." A survey of more than 200 Swiss pension funds shows that the currently low interest rates represent the greatest challenge for pension funds. At present it is no longer realistically possible to generate the minimum interest rate through almost risk-free investments. Although rising interest rates lead to a reduction in the value of the bond portfolio, higher interest rates have a positive impact on the financial situation of pension funds over the long term. Real estate investments represent another challenge. The survey makes clear that numerous pension funds are insufficiently diversified in the area of direct real estate investments. Moreover, high conversion rates and high technical interest rates in the Pillar 2 system mean that funds from active members are being redistributed to pensioners. The study estimates the volume of this redistribution at around CHF 3.5 billion in 2010 alone. Despite initial criticism from the industry, the pension funds surveyed are now broadly in favor of structural reform for Pillar 2.

After a decade of persistently low interest rates, the Pillar 2 system faces challenges. In their latest study the economists of Credit Suisse analyze the key challenges cited by the pension funds surveyed: low interest rates, the trend toward real estate investments, redistribution from active members to pensioners, and structural reform.

Rising Interest Rates Have a Positive Effect on the Funding Ratio in the Long Term
For 80% of the pension funds surveyed, persistently low interest rates count as one of the top three challenges. Unlike in the 1990s the minimum interest rate can no longer be achieved through practically risk-free investments such as Swiss federal bonds. Increasingly the financial markets are failing to perform as the "third contributor." But also rising interest rates can present pension funds with problems because the value of the bond portfolio declines. On average, bonds account for 35% of the investment capital of pension funds and are thus their most important asset class. Over the long term, however, the reinvestment of bond coupons and redemption values at higher interest rates makes up for the loss in market value. A simulation of three interest rate scenarios shows that the sooner and the more steeply interest rates rise, the stronger the value of an average pension fund bond portfolio increases in the long run. Rising interest rates bring the additional benefit that the present value of pension obligations falls, which therefore has a long-term positive impact on the economic funding ratio. Consequently, 73% of the pension funds surveyed see mostly positive impacts from rising interest rates.

The Diversification of Direct Real Estate Investments Is Often Insufficient
Almost half of the pension funds have reacted to continuing low interest rates by reducing the ratio of bonds that they hold in favor of other asset classes, principally real estate. Between 2000 and 2010 the average proportion of investment capital held in the form of real estate rose from 12.5% to 16.5%, among the highest proportion of any country in the world. According to two thirds of the pension funds surveyed, the main reason for investing more heavily in real estate was the prospect of higher returns and the low volatility of such investments compared with other asset classes. Direct real estate investments, however, present the pension funds with challenges in relation to diversification. Smaller pension funds have little opportunity to diversify their real estate portfolio on the basis of a variety of characteristics such as location, utilization or age. For example, 52% of the pension funds surveyed own fewer than 10 properties. As an alternative, the pension funds could make good their lack of diversification in directly held real estate by investing in real estate investment trusts, funds or equities. The survey shows, however, that many pension funds whose direct real estate holdings are inadequately diversified in geographical terms hold only a small proportion of indirect real estate investments.

Redistribution from Active Members to Pensioners Totaled CHF 3.5 Billion in 2010
Rising life expectancies, weak returns from the financial markets, and the general political framework mean that unforeseen redistribution mechanisms have begun to operate in Pillar 2 pension plans. One of the most important of these is the creeping redistribution from active members to pensioners. Based on the survey data, Credit Suisse's economists estimate that this redistribution amounts to around CHF 3.5 billion for the Swiss pension fund system as a whole in 2010. This is equivalent to around 0.6% of the balance sheets of Swiss pension funds. The problematic aspect of this process is that if there are no corresponding adjustments to the relevant actuarial parameters this redistribution will happen year after year. The redistribution comes primarily from two sources. If the pension fund applies too generous conversion rates for new pensions, this results in retirement losses that eventually have to be made good by active members or employers. The survey shows that the conversion rates applied by 64 of the 68 pension funds surveyed are too high. As a result, retirement losses amounted to an estimated total of CHF 1.0 billion in Switzerland in 2010. For current pensions there is redistribution from active members to pensioners if the technical interest rate is set too high and the retirement capital of pensioners therefore attracts a higher rate of interest over the long term than the retirement assets of active members. The survey shows that in 2010 the average pension fund "paid" its pensioners a technical interest rate of 3.5%, while active members received only 2% because of the weakness of the financial markets. The redistribution that resulted from this interest rate differential between active members and pensioners totaled approx. CHF 2.5 billion in 2010 in Switzerland as a whole.

Pension Funds Are Remarkably Positive About Structural Reform
In 2010 the Swiss parliament approved structural reforms to occupational pension provision in order to bolster confidence in the Pillar 2 system. In contrast to the many negative responses that were heard in advance of the structural reform, Credit Suisse's survey shows that the vast majority of pension fund representatives are positively disposed toward most aspects of the structural reform. Pension funds are most critical of the proposed supervisory structures, particularly the new superintendance. They fear that the structural reform will drive up administrative overheads, increase cost pressures, and make it more difficult to find members for the board of trustees. At the same time many of the pension funds surveyed expected the structural reform to deliver improved transparency and a more positive image for the pension funds. One aim of the structural reform was to improve governance. However, the opportunities for insured members of the pension funds to exert influence have remained negligible and are limited mainly to the election of their appointee to the board of trustees. One way of improving this situation would be to extend the range of options available in each individual's pension plan. However, enhanced freedom of choice for individuals, which would represent a big step in the direction of a competitive system, is not a pressing priority for the pension funds surveyed. Enhancing the possibilities for fund members to have their say in the running of funds could be an alternative to enhanced freedom of choice. Other options, besides strengthening the significance of elections to the board of trustees, could be consultative votes or assemblies. However, the pension funds do not see the greatest need for political action in the area of governance. Instead they see it in the possibility of adjusting current pensions and in the abolition of the minimum interest rate and the minimum conversion rate.