Negative Rates Drive Major Changes at European Pension Funds

Amid subdued returns, funds are starting to cut benefits or shift to defined contribution models to preserve their financial health.


In recent years European pension fund managers have been moving down the credit spectrum, wading into private markets, putting money into infrastructure and other illiquid assets — in short, doing almost anything to generate yield. But with negative interest rates strengthening their grip on Europe, many plan sponsors are realizing they can’t earn their way out of today’s dilemma.

So even as they do what they can to diversify assets, pension funds are moving to curb their liabilities by limiting payouts to retirees, shifting to defined contribution–type models from defined benefit ones and taking other steps to make sure the money doesn’t run out.

Consider Credit Suisse Group. The Zurich-based bank offers one of the more generous retirement plans in the country with the second-largest pension system in continental Europe. But the pension fund, like most others in Switzerland, was blindsided by the Swiss National Bank’s January 2015 abandonment of its exchange rate ceiling, which sent the Swiss franc soaring and bond yields falling deeper into negative territory than anywhere in Europe. The Sf15.6 billion ($15.8 billion) fund saw its return plunge to 1.6 percent last year from 7.3 percent in 2014.

Concerned that negative rates and ever-rising life spans put the financial health of the fund at risk, trustees late last year adopted a sweeping reform of the scheme that will gradually raise the retirement age, trim benefits for future retirees and shift workers with high salaries into a pure defined contribution savings plan for part of their incomes. “We do not want an underfunded situation,” says Matthias Hochrein, the plan’s chief operating officer.

In the Netherlands, which has Europe’s largest pension system by far in proportional terms, with assets worth nearly 184 percent of GDP, plans are also looking to tighten their belts. In recent weeks the country’s two largest plans — ABP, the €358 billion ($402 billion) pension fund for civil servants, and PFZW, the €173 billion plan for health care workers — have warned that they may have to cut benefit payments to existing retirees next year because low interest rates have reduced their funding ratios to just a hair above 90 percent, the threshold that triggers mandatory remedial action. For several years PFZW has declined to index pension payments to earnings, allowing payments to fall 13 percent behind earnings.

“The current system is no longer adequate,” PFZW’s CEO, Peter Borgdorff, told Dutch television in March. “We raise expectations among participants that we cannot keep.” On May 20 the government’s Social and Economic Council proposed a major reform that would transform the Netherlands’ occupational pension schemes into defined contribution plans with some level of risk sharing and a guarantee that pensioners would not outlive their savings. Borgdorff welcomed the report, calling it “good news because it brings us one step closer to a much-needed renovation.”

The £49 billion ($71 billion) Universities Superannuation Scheme (USS), the U.K.’s largest defined benefit pension scheme, also is taking action to contain its liabilities. In April the plan announced it would cap existing retirement benefits at an annual salary level of £55,000; people with higher incomes will be able to contribute to a defined contribution savings plan for the portion of their salaries beyond the threshold. The move, which takes effect in October, reduced the plan’s deficit from £12.4 billion to £5.4 billion.

Low interest rates are squeezing pension plans around the world. Many European governments are struggling to finance their pay-as-you-go social security systems, the first plank of every retirement plan. Fears about retirement security could drive up household savings rates and slow growth. “This is definitely something that could happen,” says Eric Chaney, chief economist at AXA in Paris. He attributes France’s high 16 percent savings rate in part to such fears: “People just don’t think that governments will pay the pensions.”

The latest wave of cutbacks is striking because some of Europe’s biggest and best-funded supplementary and occupational pension schemes are taking the lead. Credit Suisse’s funding ratio fell by 8 percentage points in 2015, but it still finished the year at 107.8 percent. USS manages one of the most diverse portfolios in Europe and produced annualized returns of 12.9 percent over the past three years.

What’s changed is the outlook. Rates have fallen to levels that would have seemed unimaginable a couple of years ago, and few see them rebounding any time soon. Most of Europe’s government bonds now yield less than zero; the Swiss ten-year bond yields (if that’s the right word) –0.31 percent.

That’s problematic for Swiss pensions because of the hybrid structure of the system: Workers accrue their own savings, as in a defined contribution plan, but at retirement those savings are converted by law into an annuity yielding a minimum of 6.8 percent a year as long as the person lives. (Average lifetimes are growing at a rate of about one month per year.)

The government has proposed a package of reforms, called Retirement 2020, to bolster the system. This package, which will be put to a referendum, includes a reduction in the conversion rate to 6 percent, though experts say that is still unrealistic. “It’s too high, we all know that,” says Peter Zanella, head of retirement solutions at Willis Towers Watson in Zurich. “But that’s what was politically possible.” Credit Suisse’s pension fund has diversified more than most in a search for yield. At the end of 2015, alternatives — hedge funds, private equity, insurance-linked investments, infrastructure and loans — made up 26 percent of its portfolio; real estate and equities accounted for nearly half; and bonds were just 17.3 percent. But the bank believed it needed to take more-drastic measures to assure the fund’s viability.

As part of its pension overhaul, Credit Suisse acknowledged today’s reality and lowered its technical interest rate, or discount rate for calculating future liabilities, to 2 percent from 3 percent; that caused the sharp reduction in the funding ratio last year. Then it reduced maximum income for accruing traditional pension benefits from Sf150,000 to Sf98,700; employees can contribute to a separate defined contribution plan from salaries above the threshold and take a lump sum upon retirement. The fund will also reduce the annuity conversion rate gradually over the next eight years, to as low as 3.8 percent for people taking early retirement. (It can pay a rate below 6.8 percent because its benefits exceed the legal minimum.)

Many Swiss pensions are looking to follow in Credit Suisse’s footsteps, including Publica, the Sf37 billion plan for federal employees. “We expect that interest rates will be quite low for the next five years,” says Stefan Beiner, the fund’s CIO. “We have to adjust.”

The fund has already tweaked asset allocation — halving its non-Swiss G-10 government bond holdings to 8 percent in favor of more real estate and direct lending — but doesn’t feel comfortable taking on more risk. “We think the probability of a downturn in the next three to four years is quite high,” Beiner explains. So the fund is considering reducing its annuity conversion rate, currently at 5.65 percent for 65-year-old males, and raising contribution rates.

USS trustees decided the U.K. plan “would struggle to deliver an unchanged set of benefits without putting an excessive reliance” on the 370 institutions that sponsor it, says Guy Coughlan, the plan’s chief financial risk officer. But the fund “wanted to keep as much DB as possible, especially for lower-income workers,” he adds. Hence the threshold for transitioning workers to a defined contribution plan: Some 80 percent of employees covered by the plan make £55,000 or less.

USS consulted with members before adopting the changes, and the feedback was generally positive, Coughlan says: “People acknowledged the need for having to make a change of this nature.” •

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