SWITZERLAND - The Swiss government decision to lower the minimum interest rates for pension funds has been criticised by consultants who say that this could lead to "sub-optimal investment results."
After 17 years of maintaining the minimum interest rate at 4%, in July 2002, this rate was dropped to 3.25% and in May 2003, after three years of underperforming markets, the BVG Commission recommended a further reduction to 2.25%, effective January 1, 2004.
Beat Zaugg, practice leader, investment, Watson Wyatt Switzerland said: “The idea to cut rates was based on the prevailing market circumstances (the rate is largely based on the actual yields of ten-year Swiss bonds) as well as the fact that a large number of pension funds were underfunded.
“However, reducing rates may have had the opposite impact on pension funds - it could send a psychological signal to pension funds not to take too much risk. Therefore pension funds have sold in the equities markets when they should have held and brought in the fixed income market at the most unfavourable time.”
The minimum interest rate is the minimum required rate that pension funds have to apply on the obligatory element of the salaries.
Zaugg said that had the BVG raised rates, pension funds would have been forced to adopt a more riskier strategy which in the long term would have lead to higher returns.
“Most Swiss pension funds are extremely conservative- they have the same strategy both in upturns and downturns. They hold only 25-30% in equities as compared to pension funds in Netherlands and UK which hold 50-60%. Also, most pension funds do not have a clear strategy of taking tactical bets. By lowering interest rates, the BVG has created a situation which could lead to unintended negative results,” he added.
Even the BVG has acknowledged that by lowering the rates, pension funds will not take the risks to ensure higher returns.
BVG Commission said: “If the minimum interest rate is set too low, then this will quite possibly lead (investors) to be content with a far too defensive investment strategy.”
The Commission has now decided to review interest rates each year. But Zaugg believes that this is likely to cause even more confusion.
“We are now seeing a mis-match in the system. Pension funds should go for a long term strategy but now there is a short term element in their decision making because interest rates will be adjusted every year and worse the formula is not clear to the market.
“In future, the policy for the minimum interest rate should take into consideration the implications for the investment decisions of pension funds. More specifically, the policy should not strengthen pro-cyclical investment behaviour (and would ideally foster anti-cyclical behaviour). The investment return, as the “third contributor” to the pension fund alongside the employer and employees, is too important to the financing of pension funds to become a political football,” he added.
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