In the spotlight: occupational pensions
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Director, Tax and Legal Services
Swiss occupational pension funds face substantial funding challenges, primarily because of a combination of two problems: low interest rates and increasing longevity. A quick definition of terms will make the significance of these mechanisms easier to understand. Pension funds calculate their pension liabilities based on two actuarial assumptions: the so called discount rate and the expected time the pension will have to be paid depending on how long the pensioner lives (longevity).
The discount rate is the interest rate it is assumed will be necessary to pay out a pension over the whole period for which the pension is due. Based on this long-term perspective, the discount rate is fixed at, say, 2.5%. A simple example: a pension fund promises a pension of 10, for which it needs capital of 200. The following year the capital is no longer 200 because a pension of 10 has been paid and interest has been earned on the remaining capital. In reality the interest earned depends on the market situation, and normally doesn’t correspond to the discount rate. When performance on invested capital is in reality lower than the assumed discount rate of 2.5%, the remaining difference must be financed from other sources. This is one key component of the problem currently faced by pension funds, employers and their active members.
The other main actuarial assumption pension funds have to make is longevity. Naturally you can never know how long an individual pensioner will live and hence how long their pension will have to be paid. Pension funds therefore use actuarial tables of assumptions, which are usually updated every five years on the basis of large populations of insureds. In the past 50 or 60 years, longevity has increased by around one year every ten years.
To illustrate the implications for funding pensions, let’s take the hypothetical example of a pensioner who retired twenty years ago. At the time this person retired, discount rates of 4% (much higher than present rates) were normal, and longevity was two years lower than now. So the pension promise made to this pensioner back then was much too high because it was based on assumptions that were much more optimistic than the present reality. This equates to a funding problem.
To give some idea of the actual scale of this problem, consider that the most recent so-called reference discount rate set by the Chamber of Swiss Pension Fund Experts back in September 2015 was 2.75%. Pension funds will use the reference discount rate as a benchmark to define their individual discount rate. A rolling calculation done by PPCmetrics for March 2016 shows a reference discount rate of only 2.42% – a decline of more than 0.3% in a matter of only a few months. With Swiss Statistics putting the volume of money set aside as reserves for pensioners in this country at about CHF 300 billion, and assuming that this was calculated with the reference discount rate of 2.75%, it would be necessary to increase these reserves by around CHF 10 billion simply to cover the shortfall for current pensions that has arisen since the end of September 2015. Consider that these figures only relate to existing pensioners and liabilities, and don’t even take account of the increase in longevity, and it all adds up to massive financial challenges.
As things stand at present, the funding of pensions can primarily come from only two sources: the active employees and the employer. In the worst case (in an underfunding situation) this could take the form of increased contributions from active members and the employer.
Even if there is no underfunding, active members will suffer from low performance on invested capital at a much earlier stage. When the performance is lower in reality than the discount rate on which the calculation of the pension liabilities is based, active members must indirectly subsidise pensioners by accepting reduced interest credits on their own savings. Over the long term this will lead to significant gaps in the savings of active members – a painful reality that in effect means that younger working people are being expected to fund retirement benefits they will never enjoy themselves because they have taken a cut in the interest paid on their retirement assets in favour of the pensions paid to people who have already retired. Not only this, but the younger an active member is, the higher life expectancy will be at their retirement age, resulting in an additional decrease in their pension expectations.
Basically there are three options for resolving the issue: active members work longer to accumulate more savings, the savings level is increased to achieve a similar outcome, or benefits upon retirement are reduced. Most probably a combination of all these options will even be necessary.
Theoretically there are a number of other variables that could be tweaked to solve the funding problem. But at the moment the legal, political and cultural framework means that only small improvements are possible. For example, the pensions paid to people who have already retired could be reduced. But according to the current legal understanding, it’s simply not possible for a fund to reduce the pensions paid to people who have already retired.
Reducing the pension promise for active members by cutting the so-called conversion rate (the mechanism used to determine the amount of pension someone is paid on the basis of their retirement assets) is also a legal no-no as far as the mandatory part of occupational pensions is concerned. It’s true that within the framework of the ‘Altersvorsorge /prévoyance vieillesse 2020’ legislative project, the conversion rate is to be reduced step by step from 6.8% to 6.0%. But this is still perceived as being too high by pension specialists. In another area there’s also the matter of political will: even though the OECD famously declared two years ago that in terms of retirement age, ‘67 is the new 65’, any politician earnestly pursuing an increase in this country at present is likely to seriously upset their constituents. Any moves in this direction would require a substantial change in the public’s mindset: people would have to start managing their expectations in terms of when they will retire, how many hours they will have to work in their lifetime, and what portion of their pay they’re prepared to invest to assure themselves of a decent pension once they retire.
On the other hand, Swiss companies can’t afford to reduce pension expectations too much. They have to tread the line between resolving the pension funding issue and remaining competitive as an employer in Switzerland and as a business operating in an international setting. With prices in this country so high, companies have to balance all these considerations to achieve a good compromise for all the parties involved. They have to be able to show employees that they pay fair salaries and provide for fair pensions. But they also have to show their investors that they have a solid balance sheet. If the Swiss employer value proposition is a fine mechanical watch, pensions are one of the small, but important, cogs in the mechanism.
Until difficult decisions are made at the political level and the general mindset regarding pensions has changed, the solution to the funding issue is likely to consist in a range of smaller measures. One move pension funds can consider is to pay retirees part of their assets as a lump sum rather than granting a pension for the entire assets accrued over the active period. This avoids the longevity issues for the fund. Another option could be a transition to flexible pensions, where only a part of the pension is guaranteed. Pension funds should also be taking a good look at their investment strategy in the light of their liabilities. If liabilities increase and a pension fund fails to adapt its strategy, the risk in terms of the volatility of returns increases significantly – a risk that pension funds can ill afford on top of all the other challenges they face at present.
Low interest rates and growing longevity are combining to create a serious funding problem for occupational pensions. While this is an issue in other countries too, the specific political, cultural and historical circumstances in Switzerland are creating a unique set of challenges when it comes to solving the funding problem. Until these challenges have been resolved, the people responsible for steering pension funds into the future will have to look very carefully and honestly at the situation and decide what combination of smaller steps will be required to keep their fund in shape and make realistic promises it can deliver on.