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How low/negative interest rates are impacting pension industry? The Swiss case

Summary:
I had blogged about Denmark central banker being concerned about impact of low interest rates on pensions. Thomas Jordan, head of Swiss National Bank, in this speech speaks on issues facing pension funds industry. The situation even more acute in Swissland as it has negative interest rates: The first challenge that you as pension fund managers have faced for some considerable time now is the persistently low level of interest rates. These low rates are prevalent not only in Switzerland, but in all the major currency areas. For the pension funds, which traditionally have large holdings of interest-bearing investments, this situation naturally means lower investment income. In other words, the share of the ‘third contributor’ – the capital market – has diminished considerably. This

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I had blogged about Denmark central banker being concerned about impact of low interest rates on pensions.

Thomas Jordan, head of Swiss National Bank, in this speech speaks on issues facing pension funds industry. The situation even more acute in Swissland as it has negative interest rates:

The first challenge that you as pension fund managers have faced for some considerable time now is the persistently low level of interest rates. These low rates are prevalent not only in Switzerland, but in all the major currency areas. For the pension funds, which traditionally have large holdings of interest-bearing investments, this situation naturally means lower investment income. In other words, the share of the ‘third contributor’ – the capital market – has diminished considerably. This makes it more difficult for the pension funds to meet their existing benefit commitments.

……The decline in long-term interest rates also has implications for monetary policy and thus for short-term rates. What is known as the ‘neutral rate of interest’, i.e. the rate at which monetary policy neither holds back nor stimulates the economy under conditions of price stability, is also lower than it used to be. To achieve the same degree of monetary policy expansion in these circumstances, short-term interest rates must therefore also be lower now. This is one of the reasons why many central banks lowered their policy rates to zero or even into negative territory in the financial and debt crisis. It was because of this that the SNB, too, introduced a negative rate of interest on the sight deposits that banks hold with it.

…..While negative interest rates are unusual and should only be temporary, moderately negative rates are not fundamentally different in terms of their economic effects from interest rates above zero. As the negative interest rate has brought about an easing of financing conditions in the economy, companies are able to take out loans for investments at lower cost. For us, however, this so-called ‘interest rate channel’ is not of prime importance. Rather, it is the effect on the exchange rate that is decisive for Switzerland as a small open economy. With the negative interest rate, we can ensure that the traditional interest rate differential versus other countries is not eroded excessively. Any further narrowing of the interest rate differential would increase the upward pressure on the franc, which would lead to lower economic growth and higher unemployment.

On top of this longer life expectancy and better medical facilities creates its own sets of problems.

Another challenge that is sure to preoccupy you as pension fund managers is that of rising life expectancy – on the face of it a very gratifying development and, indeed, one of humanity’s success stories. Rising life expectancy is not only influencing the propensity to save but is also having a direct impact on the pension funds. Given an unchanged retirement age, it steadily lengthens the average duration of pension payments. This in turn results in higher payments and extra strain on the pension funds.

The consequences of these developments are clear. Lower inflation and reduced real rates of interest are resulting in lower nominal interest rates and are thus diminishing the pension funds’ earnings prospects. On the benefits side, increased life expectancy means that pensions are being drawn for longer, thus increasing the volume of savings capital needed to finance these benefits. As a result, the system becomes unbalanced.

What are pension funds doing?

the pension funds have not been idle in the last few years with regard to the challenges mentioned. As pension fund managers, you have shown moderation and great flexibility in initiating various measures to bring your pension funds’ income and expenditure into equilibrium over the long term as well. On the investment side, the exposure to fixed-income instruments has been reduced – given the persistently low interest rates – in favour of equities and real estate (cf. chart 4). Furthermore, the pension funds have again become more active abroad, and are keeping their liquid assets to a minimum. Indeed, liquidity as a share of total investment assets is currently at a historic low (cf. chart 5).

You have also had to take action on the benefits side in order to balance income and expenditure over the longer term. These cuts are painful and have been directly reflected in people’s insurance certificates. One example is the sharp reduction in the conversion rate for non-mandatory cover. Moreover, the technical interest rate9 has been lowered by 40% in the last ten years. This took account of the probability that income from the ‘third contributor’ would also be greatly limited in future.

Thanks to these measures, together with the favourable trend on the equity and real estate markets, the coverage ratio of the pension funds of private-sector employers has remained stable since 2015 – despite the aforementioned correction to the technical interest rate, which has the effect of reducing this ratio. These efforts are approaching their limits, however. As the adaptation of the portfolio structure is associated with increasing investment risks, larger
fluctuations in value are to be expected in future.

Lessons from other countries:

At the start of my talk I drew your attention to an international ranking of pension systems (cf. chart 6). In other countries, too, the population enjoys rising life expectancy while savers bemoan the low interest rates. Denmark and Sweden, for example, which are now ranked several places ahead of our country, have implemented far-reaching and thus painful measures to stabilise and modernise their pension systems. Denmark has linked the retirement age to
life expectancy, and Sweden is making the level of pension payments directly dependent on demographic and economic developments. These two examples show that it is possible, even in this politically fraught area, to find workable solutions.

There are opinions that SNB should use part of its profits for boosting pensions:

Ladies and gentlemen, the SNB is not responsible for social policy. But allow me to finish by stressing once again how important it is to us that Switzerland’s pension system should continue to perform its pivotal economic and social function as well as possible. We are also aware of how critical the situation is for the pension funds, given the persistently low interest rates. At the same time, we cannot say when the negative interest rate will no longer be
necessary. The SNB’s contribution to a strong pension system is maintaining price stability in our country.

Adapting the parameters to economic and actuarial realities is an ongoing task of both pension fund managers and political bodies – in normal as well as exceptional times. As pension fund managers, you have fulfilled your obligations and have taken action in the very challenging environment of the past few years. Switzerland’s political bodies, too, recognised some time ago that the pension system must take account of the economic realities. Some initial steps
have already been taken along this rocky road. But there is still a way to go.

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Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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