With liquidity carrying a negative interest rate and bonds generating barely any interest income at all, pension funds are increasingly forced to invest in other, more risky asset classes. However, there are limits to their ability and willingness to take risks.
Since the suspension of the minimum CHF-EUR exchange rate, financial institutions have been applying negative interest rates to larger sums of money deposited by institutional investors. Many institutional investors have therefore reduced their liquid asset holdings and distributed their cash among several financial institutions to take advantage of the available exemption limits. However, this strategy is of limited use, as exemption limits are continuously being revised downwards and effective implementation is almost impossible for some larger investors.
Return reduced to “deposit fee”
Nor do money market funds or cash holdings offer any real alternatives to holding liquid assets. Although the first are broadly diversified, their implied return is also negative. Cash holdings, in turn, are subject to considerable additional expenditure. Transport, insurance and storage are all subject to risks and do not come free. It is also unclear whether pension funds will be able to refeed the hoarded cash into electronic circulation free of charge at a future point in time. The more likely scenario is that the Swiss National Bank will intervene if pension funds try to circumvent its monetary policy by holding cash on a large scale.
Given that the additional currency risk is an undesirable factor from the investor’s perspective, liquid investments in foreign currencies are also of limited appeal. Hedging reduces the income down to the return that could be achieved with liquid assets in Swiss francs – a zero-sum game.
For pension funds, which usually hold no more than a small part of their fixed assets in liquid form, the problem of holding liquidity is less of a challenge. However, more far-reaching consequences arise from the negative interest rates, which virtually prevail over the entire yield curve. In conjunction with historically low credit spreads, negative interest rates have led to an investment crisis in the entire fixed-interest area. Even corporate bonds are not immune against negative returns.
In retrospect, the development over the recent years has also led to massive asset inflation outside the bond markets. Put simply, risk-free yields affect all income-generating asset classes via the discounted cash flow model. Risk premiums on equities or real estate are also very low in historical comparison.
Pension funds under pressure
Since their target returns have not declined to the same extent as the expected return on their investments, many pension funds are now facing a considerable return deficit.
Employee benefits institutions are obliged by law to invest their assets such that sufficient returns are guaranteed to pay interest on pension plan capitals and cover the costs. To meet this obligation in the current market environment, pension funds are effectively forced to take on higher risks with their assets. Since riskless investments – such as government bonds – are generating no returns or negative nominal returns, employee benefits institutions find it increasingly difficult to finance their obligations.1
In response to low interest rates, many employee benefits institutions have adapted their investment strategies in recent years. Primarily, they have reduced the share of domestic bonds in favour of equities, real estate and alternative investments. Many pension funds have introduced or increased subcategories, such as infrastructure, insurance-linked securities, private equity and senior loans, in the alternative investment field. Although bonds still represent the main asset class for Swiss pension funds, their share in the overall allocation has declined considerably over the last few years. By contrast, the quotas of real estate and alternative investments have reached record highs, with illiquid asset classes currently experiencing a revival. For instance, Swiss pension fund portfolios have the highest real estate quotas worldwide.
Risks may be underestimated due to return pressure.
Pension funds welcome any successful investment optimisation as an invaluable contribution to tackling their problems. However, they must ascertain whether they have the necessary risk capacity and appetite for taking such additional risks.
They must also have an understanding of the mechanisms of these asset classes and must ensure their efficient implementation. Risks may be underestimated due to return pressure. Where bonds are concerned, many investors are currently willing to accept lower credit quality and illiquidity in exchange for higher expected yields – for example in the case of high-yield or emerging market bonds. It should be remembered that, as well as higher overall risks, there is also a risk overlap with equities.
Cost is the deciding factor
As a side-effect of the search for additional returns in a low interest rate environment, cost aspects now play an even more central role in asset management. In a market environment where every basis point counts, employee benefits institutions are paying particular attention to asset management costs and the reported TER.
Measures on the liabilities side
Unfortunately, most employee benefits institutions will find that measures on the investment side will not be sufficient to restore the balance between income and obligations. Benefits granted in the past (pension commitments) are almost impossible to change. The difference between the promised implicit returns and the required actual returns must somehow be covered by the pension fund’s risk carriers, i.e. the active members and the employers. Future benefits, however, can be changed. Boards of trustees may be required to rethink their benefit targets and its financing.
1) Bond investments are generally regarded as low-risk. Due to extended durations in the major bond indices, the interest rate risk has increased significantly in recent years. On the one hand, lower interest rates automatically lead to longer durations; on the other hand, many issuers have taken the opportunity to borrow capital over very long periods at historically low interest rates. In market-weighted indices, the weightings of highly indebted countries such as the USA or Japan are constantly increasing, resulting in cluster risks. Moreover, indices do not immediately show how the weightings of individual credit rating categories shift over time. It is therefore possible that the risk may have increased although the bond ratio has not changed.