Switzerland's pension funds have so far refused to rebalance following the financial crisis. Emma Cusworth looks at the potential consequences
In the aftermath of the global financial crisis, consultants urged Switzerland’s pension funds to adopt a new approach to risk and recommended a strict adherence to anti-cyclical rebalancing. So far, their advice has fallen on deaf ears.
During 2008 and 2009, faced with extremely volatile and highly uncertain markets, many Pensionskassen chose inertia over short-term strategic rebalancing. After all, who wants to buy equities when they might continue tumbling?
By doing nothing and simply following the market, Swiss funds now face a conundrum: In order to achieve the returns required of them and merely maintain funding levels, there is no avoiding equities and other more-risky investments. But with little in the way of fluctuation reserves, and funding levels still not back to par, particularly among public schemes, is taking risk really sensible?
Following a catastrophic year, by the end of 2008 up to three quarters of Swiss schemes faced underfunding. Credit Suisse’s Swiss Pension Fund Index (CSPFI) showed total assets fell 13.25% during 2008, dropping 6.8% in the final quarter alone.
As a result, seven out of ten Swiss schemes surveyed by Swisscanto decided to delay rebalancing decisions in 2008, leaving many with equity allocation below strategic boundaries.
“During early 2009, when many Swiss funds should have been reinvesting in equities to build allocations back to strategic levels, the news was pretty bleak,” said Lusenti Partners’ CEO Graziano Lusenti. “Given the general funding situation – cover ratios significantly below 100% – it took a pretty solid stomach to buy again, as people expected to see further falls.”
The decision was not without repercussions, however: “Most of the funds who delayed rebalancing missed the stock market rally in 2009,” according to Sven Ebeling, head of Mercer Investment Consulting Switzerland. “Looking over the entire cycle, it would have been better to rebalance to strategic weights.”
Rebalancing has, unsurprisingly, become a hot topic for Swiss funds and their advisers with extensive discussion about how broad bandwidths should be, when allocations should be changed and where to.
Many advisers now strongly advocate a more disciplined, anti-cyclical strategy. This usually involves setting relatively narrow bandwidths for each asset class with allocations resetting to benchmark levels once an upper or lower limit has been breached.
PPC Metrics, a leading Swiss consultancy, recently carried out statistical analysis on returns from the average institutional investor’s portfolio between January 1960 and December 2009. They compared three key strategies: anti-cyclical with periodic rebalancing, anti-cyclical with rebalancing only when bandwidths were hit, and a pro-cyclical, buy-and-hold strategy.
According to their findings, net returns and volatility for the three strategies were 5.59% and 5.97%, 5.7% and 6.05%, and 5.43% and 7.54% respectively. “During the researched period, the anti-cyclical strategy with rebalancing when limits were hit achieved the highest net returns with an attractive risk/reward relationship,” according to PPC Metrics partner, Stephan Skaanes.
“While delaying rebalancing decisions in 2008 looked like a good decision in terms of adjusting risk, given funding and reserve levels, in hindsight over the whole cycle it was a bad decision,” he said. “Historically, we can see that an anti-cyclical approach which rebalances when bandwidths are breached would have paid off. Given current risk capabilities, it is recommended to take this into consideration.”
This approach does require funds to look at asset allocation in terms of risk first and foremost. So far, however, Swiss schemes’ attitude to risk management has forced the opposite, pro-cyclical reaction.
According to consulting firm Complementa, Swiss funds tend to invest according to risk-taking ability, reducing risk when funding falls and taking more when funding improves. “Looking at the average allocation trends since 1996, Swiss funds invest on a fairly pro-cyclical basis,” said Complementa’s CEO, Michael Brandenberger.
The fact so many delayed rebalancing suggests the same is true for this cycle. “The result, however,” Brandenberger said, “is performance which is worse than if they had stuck to their strategy.”
The key to success, it seems, is stripping out any emotional impact on strategic decisions with rigorous adherence to rebalancing rules.
As Swisscanto chief investment officer, Peter Baenziger explained: “Managing allocations by defining a constant portfolio risk is one possible approach for a dynamic asset allocation. It takes out the human element and means strategy is adjusted according to risk.
“Of course, historical analysis can’t prove that it will work in the future, but traditional strategies have not worked either: traditional models require greater levels of risk to achieve the same return.”
According to Swisscanto, the average Swiss fund requires a return of 3.9% just to maintain its funding level, which necessitates some risk. In order to improve funding and rebuild cash-reserves, however, Pensionskassen will have to generate roughly 4.7%.
“Traditional asset allocation will mean that funds have to take on heavy risk to generate the required returns,” Baenziger said.
Based on their analysis of the last ten years’ performance, to maintain current funding levels, the average Pensionskasse would need to allocate roughly 28.8% to equities, with a maximum drawdown of -14.7%. (At the end of 2009, the actual allocation was 26.9%.)
In order to improve their situation, funds would have to allocate 44.7% to equities, but maximum drawdown increases to -24.3%, meaning a 9.6 percentage point increase in risk for the extra 0.8 percentage point return.
Over the same ten-year period, using their dynamic asset allocation model with a target risk of 5%, would have produced a 4% return per annum with -5.32% maximum downside risk.
“Swiss schemes therefore have to take greater levels of risk for the returns in the traditional model,” Baenziger said.
Despite this, no Swiss pension funds have implemented dynamic asset allocation yet.
“We are seeing some serious interest in defining asset allocation limits based on risk factors,” Ebeling said. “It takes great courage to be the first in your peer group to move to a new philosophy though and this is an alternative way to look at portfolios.”
Some argue that there is little new theory involved: “This thinking sounds very modern, but it can also be called pro-cyclical versus anti-cyclical investment. Who wants to be pro-cyclical though? However, for many funds there may be no other choice,” said Markus Huebscher, head of the railways pension scheme, PK SBB. But despite the arguments around pro or anti-cyclical strategy, there does seem to be more unified thinking when it comes to protecting funds against future downside risk. This could lead to a shift in risk attitude and, ultimately, a more anti-cyclical approach.
Huebscher said: “They have already had to suffer increased contributions and a decrease in the interest paid on their capital. Other funds have not had to impose such severe consolidation measures so the door may still be open to them to get hefty capital injections, but shouldn’t we spend some time considering how to avoid getting back into an underfunded situation?”
Looking at the long game, Ebeling believed this crisis will have brought about a fundamental change of attitude towards risk: “Those with a higher coverage ratio can afford to take out some risk. Where schemes are underfunded, they need to implement more aggressive strategies, but there has to be some kind of safety net. Once schemes return to full funding, historically that would be the time to take more risk, now they are likely to be very conservative to protect themselves from the downside.”
This focus on protecting assets from another fall could force a change in mindset, Brandenberger believed: “We may see a trend towards a more systematically driven dynamic asset allocation model primarily because of the need to control downside risk, but we are at the very beginning of the trend. Very few Swiss schemes are currently using this kind of approach.”
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