The Swiss pension system is a great achievement and has, for the most part, stood the test of time. But parts of it have become a bit worn with age. Especially in the second pillar, a number of external and internal factors, such as the difficult market environment, the demographic development, investment inefficiencies and cross-financing from actives to pensioners, have driven down the expected future pension benefits quite significantly over the last years. Not surprisingly, the Swiss system only ranks 12th in the 2020 Mercer CFA Institute Global Pension Index. In 2015, Switzerland still ranked 4th. If the pension reform deadlock continues, Switzerland is likely to lose further ranks.
While the decrease in benefits is bad enough for all future pensioners, women are especially hard done by due to their – on average – higher likelihood of working part time and average lower salaries leading to lower contributions, resulting in a 90% median pension gap in Switzerland.
Now, a Swiss pension fund might argue that many of these issues are beyond their control. And this is certainly true e.g. in the case of overdue pension reforms that should target the demographic issues and BVG conversion rates, or the fact that Swiss government bonds have negative yields for a while now.
However, looking at the investment side also shows where pension funds can make a real difference. 37% of the average pension is financed out of investment returns. Our calculations show that an increase from 2 to 4% in interest credit for a salary of CHF 85k in an average pension plan can result in a 49% increase in expected pension benefits in retirement.
 Bundesamt für Statistik.
 Swisscanto Pensionskassenstudie.
Get investments right – for the beneficiaries’ sake
We believe that there are five principle areas that should be targeted by Swiss pension funds in order to increase investment returns and thus, by extension, increase the expected outcomes for their pensioners:
1. Strategic Asset Allocation
The strategic asset allocation is the most important decision and forms the basis of the investment efforts and outcomes of the pension fund. True diversification is key, with a focus on risk factor diversification rather than a pure diversification by asset class, which can result in unwanted concentration of certain risks. The degree of required factor diversification can vary depending on risk tolerance and the expected development of the pension fund.
Equity risk is typically the dominating portfolio risk, due to the relatively high volatility compared to other risk factors. However, risk needs to be understood as a multi-dimensional concept and every investment strategy is recommended to be reviewed based on scenario analyses.
Strategic asset allocation is also a way to realize potential for higher investment efficiency. The average Swiss pension fund shows a significant home bias, with more 30% of the portfolio concentrated in CHF Fixed Income, and 12% in Swiss equities. An optimized, balanced portfolio would aim for broader diversification while decreasing home bias and capturing multi-asset factors including Emerging Markets and Small Cap. In addition, harvesting illiquidity premia through private markets investments should be strongly considered as a strategic choice.
2. Active Management
If applied properly and selectively, active management can be a key source of added value, and making use of a manager’s skill to outperform markets can lead to higher return expectations. Additionally, some attractive markets such as non-listed Swiss real estate are only investable through an active investment style by their very nature.
Mercer’s research shows that top-rated managers across all asset classes have been able to provide an average outperformance versus benchmark of 1.4% p.a. since inception. Looking at single markets and segments, e.g. US small cap, we see some good potential to generate alpha which is mainly driven by market efficiency. The less efficient a market, the greater the opportunity for skilled managers to create outperformance.
3. Dynamic Asset Allocation
In the management of a pension fund portfolio, dynamic asset allocation provides opportunity to benefit from market movements away from fair asset prices. If applied in a consistent manner, it will not only drive returns but can also mitigate risk. A very good example might be the extraordinary spike in high yield credit spreads during COVID-related market turbulences in early 2020. In March 2020, we started advising our clients to capture that opportunity based on our belief that it will only last for a short period and will be able to contribute significantly to portfolio returns with a lower downside risk compared to equities.
For Swiss pension funds, especially in the smaller and medium sized segment, we often see two major challenges in the implementation of dynamic asset allocation:
1. First, they need to have the resources to monitor capital markets, identify relevant investment ideas and, most importantly, need to have the expertise to identify relevant investment solutions in which they want to invest.
2. Second, they must have implemented investment processes that allow such short-term investment decisions. If it takes two months for the whole process from idea generation to implementation, the opportunity will often be gone.
These factors should also be considered within a pension funds governance framework that keeps pace with increased complexity.
Sustainability factors are gaining increasing attention, and for good reason. The consideration of ESG factors in the investment strategy will ultimately pay off and deliver better long-term risk and return outcomes. Pension funds that take a broader perspective can improve risk management and access new opportunities if they are able to reflect long-term sustainability trends in their portfolio.
5. Investment Governance
Pension funds should be governed like a corporation. As such, you would also expect that different business areas, like the investments business, are given strategic objectives that can be translated into measurable targets. If you steer the pension fund like a business, you will also need to decide how you can most efficiently operate it and make clear decisions as to which tasks should be kept in-house and where it would be more efficient to delegate them.
For a small and mid-sized pension fund, it may be very costly to build up a fully-fledged investment organization, and it might be much more efficient to engage a professional partner who can support the Board of Trustees in the design and implementation of their investment strategy. If you select an implementation partner, you can typically benefit from an investment platform that helps independently selecting and implementing best-rated managers at competitive costs and having robust risk management processes in place.
A state of the art investment governance allows the Board of Trustees to free up time no longer needed for the day-to-day business and to focus on the most important strategic questions. For example: Are our pension benefits attractive and sustainable for our employees?
“A governance advantage enables our clients to access timely information, respond quickly and make effective decisions. This helps them to manage risk and capture emerging opportunities. Good governance underpins everything we do as an investment partner.”
Mick Dempsey, Global Head of Investment Solutions & OCIO services.
To learn more about the topics discussed in this article, feel free to reach out to us.