September 2009


Switzerland has relatively lax laws regarding funding. Samuel Sender, of Edhec, talks about the challenges this poses...
swiss_flag.jpgTo conclude our series on pension fund regulation drawn from a recent study – Impact of Regulations on the ALM of European Pension Funds, sponsored by AXA Investment Managers – we turn to Switzerland, which has relatively traditional and flexible regulation. It has the second largest pension fund industry per capita in Europe and a very large mandatory second pillar with equal contributions from employers and employees. 

As in the UK and Germany, pension insurance (protection fund) supplements the relatively lax requirements for technical provisions (underfunding is also permitted).

Funding requirements
Investment guidelines, which relied heavily on quantitative investment limits, were revised in 2000 to impose fewer quantitative limits and introduce the ‘prudent man rule’, equivalent to the prudent person principle, which emphasises diversification. It is expected that in the future quantitative limits will be simplified further still.

Funding requirements are based on relatively flexible valuation standards. Assets are taken at market value, but for liabilities an equity risk premium is allowed for discounting. In practice, the rate is often the yield of the Swiss Confederation bond with a maturity of ten years plus an equity risk premium, weighted by the share of the investment in risky assets, minus a safety margin. The equity risk premium is measured on a historical basis. Naturally, pension funds without any allocation to equity cannot claim that they expect above-average returns on their investments and report lower liabilities as a consequence.

Since 1 January 2005, pension funds have been allowed temporary underfunding – but they must disclose information about the shortfall amount, explain the reason for the shortfall, and create a recovery plan to bring the fund back to a fully funded position.

The Swiss Federal Council (Bundesrat) is currently debating a bill that would require all local and federal authority pension schemes to be 100% funded by 2038.

The board of ASIP, the Swiss Pension Fund Association, would like to align pension fund requirements with IAS19 requirements and therefore argues that pension funds should aim for 130% funding. For IAS39, after all, full funding is higher: PBO liability is higher than statutory ABO liability.

A buffer is required for risk-taking. The extent of this buffer is currently left to the discretion of the appointed actuary, but the goal of the regulator is to create a framework that – though more flexible – is gradually brought into line with the requirements made of insurance companies.

Quantitative restrictions
Quantitative restrictions are still significant. Quantitative limits are often imposed by the regulator to protect plan members from exaggerated risk exposure and subsequent losses, and to provide incentives for risk-free asset allocation.

However, risk-free asset allocation in ALM is exposure not to the cash account but to the replicating portfolio, and such exposure is not always facilitated by quantitative restrictions. Moreover, quantitative restrictions often reduce the ability of the pension fund and of the asset manager to diversify risk exposures. In Switzerland, for example, allocation to foreign assets is limited to 30% of investments, and allocation to foreign equities to 25%.

As such, these restrictions are at odds with the prudent person principle adopted by Swiss law. Swiss pension funds must therefore strive for a balance between the flexibility afforded by the prudent person principle and the constraints imposed by quantitative restrictions.

A pension fund that adheres blindly to these restrictions will miss out on many possible diversification benefits. Blind adherence constrains not only the equity allocation, but also the bond allocation. When allocating 25% of the investment portfolio to foreign equities, only 5% of the portfolio can be allocated to foreign bonds. Given that Swiss bond yields are lower than those of the rest of the world as well as to once and possibly future Swiss pension inflation, this is a significant restriction.

Pension funds can work around these restrictions by demonstrating the adequateness of their strategies in a special yearly report addressing each instance of deviation from the legal limits. A pension fund that has sound (ex-ante) investment principles and justifies (ex-post) its strategy may deviate from quantitative restrictions.

It is largely pension funds that are both large and well funded that take advantage of this possibility. By contrast, pension funds that either lack research and reporting capabilities or have a lower funding ratio need to apply quantitative limits.

In addition, the law stipulates that the board of the pension fund have a full grasp of the strategies implemented. This stipulation raises another obstacle to investing in complex instruments such as structured products or derivatives, as the board needs to show that it understands the risk-return characteristics of such investments – with traditional investments such as equities and bonds, on the contrary, there is no such stipulation, even though their real risk-return characteristics are arguably as difficult to model and understand as those of some structured products or hedge funds. Strategies that are easy to understand are not necessarily adequate.

Trapped funds
When firms naïvely use an equity risk premium to discount liability, there is a risk of being trapped after market downturns. After all, when the value of assets falls, so do estimates of the risk premium. The fall in equity prices subsequently increases the reported value of the liability and therefore further lowers the funding ratio, in a way that is frequently not monitored by risk management, which focuses more closely on asset risk than on asset-liability risk.

As we have seen, the benefits paid out to participants are strictly regulated. By setting the guaranteed interest rate as well as the conversion rate, the regulator actually simplifies the liability analysis. It is simplified all the more by Switzerland’s stable regulatory environment. However, by failing to recognise inflation in the regulatory liability value, and in the funding ratio, the regulator may be failing to provide incentives to manage inflation risk adequately.

Overall, situations that result in shedding most equity exposure and suppressing all indexation to the economy and to prices on the asset side make it is impossible both to replicate liabilities as they are and to offer the indexation promised. It is probably for this reason that, in regulations that allow discounting at an equity risk premium, funding requirements are generally relaxed after falls in equity prices, as we have seen in Switzerland.

• Samuel Sender is applied research manager at the Edhec Risk and Asset Management Research Centre

©2009 funds europe

Executive Interviews

INTERVIEW: Put your money where your mouth is

Jun 10, 2016

At Kempen Capital Management, they believe portfolio managers should invest in their own funds. David Stevenson talks to Lars Dijkstra, CIO of the €42 billion manager.

EXECUTIVE INTERVIEW: ‘Volatility is the name of the game’

May 13, 2016

Axa Investment Managers chief executive officer, Andrea Rossi, talks to David Stevenson about bringing all his firm’s subsidiaries under one name and the opportunities that a difficult market...


ROUNDTABLE: Beyond the hype

Oct 13, 2016

The use of smart beta investing continues to grow. Our panel, made up of both providers and users, discusses what the strategy actually means, how it should be used and the kind of pitfalls that may arise when using this innovative investment technique.

MIFID II ROUNDTABLE: Following the direction of travel

Sep 07, 2016

Fund management firms Aberdeen and HSBC Global meet with specialist providers to speak about how the industry is evolving towards MiFID II.