Pension funds have to pay interest despite high losses

Imagine the Federal Parliament writing the following into law: “Storms and global warming are prohibited with immediate effect.” And the political parties pat each other on the back – even though they haven’t changed the realities of life.

This is roughly the level at which Swiss politics works when it comes to old-age provision. In the second pillar (occupational provision via pension funds), the law still requires a minimum annual pension of 6.8 percent of the insured person’s accumulated retirement capital for the mandatory part – although nobody can guarantee the returns for such a level. The said conversion rate of 6.8 percent includes an interest rate guarantee of around 4.8 percent. The best approximation of the market prices for long-term interest rate guarantees are the yields on the presumably low-risk long-term federal bonds. Even after the rise in interest rates this year, 10-year Bunds are currently yielding just under 1.5 percent per year.

The pension funds have alleviated the problem through hidden top-down redistributions. In the non-mandatory part, the cash registers are free; for this part they actually pay lower pensions than would be justified mathematically.

Retirees get more

Nevertheless, the pension guarantees were too high overall in the past. This led to strong redistributions at the expense of younger people. An illustration of this: The interest on the pension fund savings capital of the working population was often far below the level of the interest rate guarantees for pensioners. But politicians also intervene directly in interest payments for those in employment. For example, the Federal Council prescribes a minimum interest rate for the mandatory occupational pension plan every year. On Wednesday, the Federal Council has this minimum for 2023 as for the previous year fixed at 1 percent.

At first glance, that seems modest compared to what pensioners get. According to a rough estimate, the interest guarantee for 2023 should be around 3.5 percent on average for all living pensioners. This order of magnitude, which includes an overall view of the mandatory and non-mandatory parts, is also well above the minimum interest rate set by the Federal Council for the capital of the employed.

But in view of the current financial situation of the pension funds, any positive minimum interest rate seems to be rather offensive. Measured against sector indices, the high reserves in the cash registers at the beginning of the year are likely to have melted away on average by now due to large losses on the financial markets. Stephan Wyss, pension fund expert at the consulting firm Prevanto, shares this assessment. According to Wyss, around 40 percent of the funds are likely to have a funding gap given the current valuations of assets and liabilities.

The political minimum

So why does the Federal Council still want to prescribe a positive minimum interest rate for all health insurers? The convenient answer: He follows the recommendation the BVG Commission, an advisory body bringing together the social partners, industry representatives and external experts. However, this body is also politically colored. While it uses a technical formula as a basis, it often deviates from it – and upwards rather than downwards. The range of proposals made by the individual commission members for 2023 ranged from 0.25 to 1.5 percent, the technical formula indicated 0.45 percent.

There seems to be something like a 1 percent policy floor. Previous formulas relied heavily on the yield on the long-dated Treasury; when they began to spit out uncomfortably low results, the BVG commission decided on a new formula. This increasingly took into account other asset classes such as equities and thus promised higher values ​​on average. The new formula has been in use since 2018. So far, however, the Commission’s recommendation has been above the result of the new formula in three out of five cases and below it only once. And in those two cases in which the Commission recommended a minimum interest rate of less than 1 percent, the Federal Council nevertheless set the mark at 1 percent.

The minimum interest only applies to the mandatory occupational pension plan. In the extra-mandatory period, the cash registers are free. According to industry experts, however, pension funds that still have certain reserves hardly ever pay interest on their total capital at a rate below the official minimum interest rate.

Appropriate rehabilitation routes

If you have enough reserves, you pay more than the minimum. Since 2010, the average annual effective interest rate in the industry has been just under one percentage point above the minimum interest rate (2.2 versus 1.4 percent). In view of the high returns on investments, the average interest rate for private-sector funds last year was 3.7 percent, which far exceeded the minimum of 1 percent. For the current year, the average should only be slightly above the minimum if the financial markets stop moving by the end of the year. Industry expert Stephan Wyss predicts an average interest rate of 1.25 to 1.5 percent for such a scenario.

Pension funds with funding gaps can also keep interest below the official minimum. Another possible restructuring measure is apparently painless: because of the rise in interest rates, many health insurance companies could also increase the calculated interest rate (“technical interest rate”), which they use to calculate future pension obligations back to the current present value. This can be justified under certain circumstances and suddenly improves the financial picture. According to observers, however, during the period of interest rate cuts, many insurers only lowered the technical interest rate with a delay; even after the trend reversal, a certain delay may be appropriate in some cases. You never know whether the trend in interest rates might not return soon.