In this section, authors share their views on economic and financial topics.
Switzerland’s pension landscape is operating in a challenging environment: Most pension funds need to generate a net return – or required return – of between 1.5 and 2.5 percent per year in order to sustainably finance their promised obligations. At the same time, 10-year Swiss government bonds offer a gross yield of only around 0.4 percent, while the overall domestic-currency bond market, as measured by the Swiss Bond Index, yields no more than 0.9 percent. So why do pension funds continue to hold significant allocations to fixed-income investments in their portfolios?
A Paradigm Shift Since the 1990s
Conditions in the early 1990s were entirely different: The required return of pension funds was significantly below prevailing interest rates. Pension funds could meet their obligations without taking on risk simply by investing in high-quality bonds. The interest-rate environment also allowed them to grant additional interest credits to active members without assuming investment risk.
For insured members, however, these were difficult times. High inflation led to a substantial loss of purchasing power for both pensions and accumulated retirement savings. In other words, despite high interest rates, the purchasing power of many retirees and active members declined in the early 1990s.
Financing Through Gains From Member Departures
As today’s Federal Act on Vesting in Pension Plans had not yet entered into force, many pension funds were also able to record so-called gains from member departures. When changing jobs, insured members lost part of their accumulated retirement savings because pension funds were not required to transfer the full amount. These gains provided an additional source of funding for pension funds, further reducing the pressure to generate investment returns.
It is therefore hardly surprising that cash, bonds and mortgages together accounted for around 60 percent of total assets in 1996. However, this figure overstates the actual allocation, as investments were only required to be reported at market value from 2005 onwards, following the introduction of Swiss GAAP FER 26.
The Ex-Ante Attractiveness of Bonds
From a purely return-oriented perspective, Swiss government bonds are never attractive ex ante compared with equities. The reason is simple: The expected return of an asset class consists of the risk-free interest rate plus its specific risk premium:
Expected return = risk-free interest rate + risk premium
Historically, the equity risk premium over Swiss government bonds has averaged around 4 percent for Swiss investors. At an interest-rate level of 5 percent, an equity investor can therefore expect a return of around 9 percent; at an interest-rate level of –1 percent, the expected return would be 3 percent. Bonds therefore always have a lower expected return than equities ex ante and are never attractive purely in terms of expected returns.
Bonds in Today’s Investment Environment
Bonds are therefore not primarily used to generate returns. Instead, they perform three key functions in modern portfolio management:
- Hedging liabilities: Duration or cash-flow matching to hedge guaranteed pension obligations.
- Additional returns and issuer diversification: Using corporate bonds to generate outperformance in portfolio implementation and diversify counterparty risk.
- Diversification of equity risk: Reducing overall portfolio risk when a pension fund lacks sufficient risk-bearing capacity.
- Hedging Liabilities Through Asset-Liability Management
In Switzerland, pensions in payment are guaranteed. This means that investment risks must be borne by active members and employers. In the event of underfunding, restructuring measures – such as additional contributions and lower interest credited to retirement savings – must be implemented.
Due to the low interest-rate environment and demographic change, particularly as the baby-boomer generation enters retirement, restructuring measures have become less effective for many pension funds. At the same time, employers and active members have become less willing in recent years to cover potential funding shortfalls attributable to retirees. Choosing an asset allocation that takes these circumstances into account is the task of asset-liability management.
Systematically hedging the liability side of the balance sheet has therefore become a key responsibility for boards of trustees. Bonds are particularly well suited to hedging pension liabilities because they increase in value when the cost of financing fixed pension payments also rises: falling capital-market interest rates lead to higher valuations for both bonds and pension liabilities.
The duration of pension liabilities is very long for most pension funds. Hedging them would therefore require large volumes of long-dated, high-quality bonds – instruments that are simply not available in sufficient quantities on the Swiss capital market. Unfortunately, the use of interest-rate derivatives is difficult under the current professional guidelines governing derivatives use by pension funds, which means such instruments are rarely used. It would be very helpful if the relevant guidelines, which date back to 1996 (!), were revised with regard to interest-rate derivatives.
Additional Returns and Diversification of Issuer Risk
To achieve higher returns, pension funds are often advised to shift from government bonds to corporate bonds. However, because corporate bonds contain an implicit equity risk, doing so increases overall equity risk. For a given total equity exposure, the direct allocation to equities must therefore be reduced accordingly.
A more sensible approach is to use corporate bonds to improve the diversification of issuer risk. Investors also sometimes assume that the corporate bond market is less efficient than the equity market and that it may therefore offer greater opportunities to generate above-market returns, or outperformance.
Diversifying Equity Risk
Many investors, including pension funds, underestimate the true loss potential of their portfolios during extreme market events, such as the dot-com crash of 2000–2003 or the financial crisis of 2008/09. Target fluctuation reserves provide only insufficient protection against such «black swan» events.
The risk-bearing capacity of pension funds is therefore limited. In recent years, pension funds have sought to improve portfolio diversification by investing in «new» asset classes. In some cases, however, this amounts to little more than illusory diversification. Delayed and smoothed valuation adjustments for highly illiquid assets – such as private equity, private debt and infrastructure investments – can create the impression that these investments provide diversification relative to equities.
At the same time, illiquid investments significantly restrict the flexibility of the responsible governing bodies and make risk management more difficult. Losses may only become apparent to decision-makers with a delay, meaning that corrective measures are taken too late. Moreover, most illiquid investments can only be sold at substantial additional discounts during a crisis. In practice, necessary portfolio adjustments therefore have to be made largely through liquid assets. Past crises have shown that this can result in suboptimal portfolio compositions.
Not a Return Driver, but an Attractive Defensive Investment
Even if investors cannot expect central banks to cut interest rates during future crises to the same extent as they did in previous major downturns – thereby producing a negative correlation and strong diversification benefits relative to equities – bonds remain an attractive asset class when the objective is to invest defensively.
Conclusion: Historically, bonds have rarely been major return drivers. Their core function has been, and remains, to reduce risk and hedge guaranteed pension obligations. Pension funds should not fear rising interest rates: interest-rate-related book losses on the asset side are offset by declining liabilities on the liability side when rates rise. Given the growing number of retirees, Swiss pension funds will need more high-quality, long-dated bonds than ever in the future.
Hansruedi Scherer was a founding partner of pension fund consultancy PPC Metrics, which he left in the summer of 2024. He is now a lecturer at the University of Bern and serves on various boards of trustees and boards of directors. In August, as part of a Swiss Financial Analysts Association (SFAA) club event, he gave a presentation examining why pension funds held bonds in the past and why they continue to do so today.
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