Switzerland
Compiled by Allianz Global Investors
Pension System Design
Goethe once described Switzerland as a combination of the ‘colossal and the well-ordered.’ The lofty Alps dominating 60% of the landscape account for the colossal, while the Swiss themselves provide the tidy, just-so precision that has them stereotyped as detail-obsessed bankers and watchmakers.
In terms of pensions, the Swiss market is also colossal and well-ordered. Despite a population of only seven million, the country has the third largest pension market in Europe with an estimated EUR 580 billion in pension market assets in 2006. The land of Alps, cheese and chocolate has a long history of pensions. It was the first country to publicly articulate the benefits of a multi-pillar approach to pensions (in a 1963 report accompanying the sixth revision of the old-age and survivors pension). It was also the first OECD country to impose a mandate on employers to provide occupational pension plans for employees.
The pension system in Switzerland has three general components: a first PAYG pension pillar (basic state old-age and survivors’ insurance scheme), mandatory second pillar occupational pensions and private (voluntary) pensions (third pillar). The compulsory second pillar system means Switzerland is one of the few countries where the three pillars contribute almost equally to old-age income.
Adverse capital markets challenged the compulsory second pillar system from 2000 to 2002. For the first time, Swiss pension funds were heavily hit by market fluctuations. As a result, ‘managing investment risk’ has been a predominant topic in the Swiss pension markets. The government stipulated guaranteed minimum interest rate was lowered in January 2004 to 2.25% (the first reduction from the ‘historic’ level of 4 to 3.25% took place in January 2003).
The interest rate was raised to 2.75% in January 2008 to reflect the average yield on seven-year government debt (2.6%). But in 2009 it will be lowered again to 2%.
It is intended that in future the minimum interest rate will become a floating rate linked to Swiss government bond yields. Lower interest guarantees have had a significant negative impact on the prospective benefits as outlined to employees in their annual benefit statements. As the high yield expectations of the 1990s can no longer be applied in calculating the prospective benefit, a new pension gap is opening up, which needs to be closed by increasing contribution levels.
The Swiss system is seen as strong and well-ordered, but many of its admired features are not the result of a thorough grand design. Rather, they stem from revisions that reflect the common sense approach of the Swiss when it comes to stable and fiscally prudent benefits. The Swiss three-pillar model is well equipped to meet future demographic challenges. In common with many other countries, Switzerland faces a deteriorating system dependency ratio due to an aging population and large increases in disability pensions.
Public Pensions
The old-age and survivor pension insurance (AHV – Alters- und Hinterlassenenversicherung) is the first pillar of the Swiss social insurance network and aims to cover the basic needs of retirees. The national (federal) public pillar was introduced in 1948 and absorbed pre-existing cantonal systems (some of which date back to 1904). Disability pensions were offered in 1960.
The AHV is obligatory and mainly PAYG financed. Since 1999, the AHV has also been partly subsidised through VAT revenues. The plan covers all persons domiciled in Switzerland, as well as those in gainful employment. The contribution rate is split equally between the employer and employee and set at 4.2% each. In addition, the government contributes approximately 20% of the cost of the benefits (16.4% provided by the federal government and 3.6% by the cantons).
The first pillar took 22 years to implement. Following the passing of a constitutional amendment in December 1925, it was finally introduced in January 1948. The plan has near universal coverage. As there is no contribution assessment limit but a maximum pension, the pension system contains two elements of redistribution: first, there is redistribution between generations and secondly between higher and lower wage earners. Though the first pillar only covers a small part of overall old-age income, combined with the income received from the compulsory company pension scheme, the aim is to achieve a gross replacement rate of 60% (currently around 58.4%) and a net replacement rate of 67.3%.
A person is eligible for an AHV pension as soon as contributions have been paid for one full year. Men are eligible from the age of 65 and women from the age of 64. The exact benefits depend upon the years of contribution and the relative average income during the insurance period. A full pension is paid if the person has paid into the scheme for the same number of years as others born in the same year. If the person has not contributed into the plan for the full period, a proportional pension can be drawn.
A pension may be received before reaching official retirement age, but the pension paid is adjusted accordingly (By between 3.4 and 6.8% for each year the pension is drawn early) A pension can be drawn later than the retirement age by one to five years. The amount paid increases by between 5.2 and 31.5% depending on the number of months payment is deferred.
Income is made up of total earned income plus bonuses for child rearing and care-taking. An unusual feature is that the income spouses earn during their married life is split and 50% credited to each spouse. The contribution made by spouses not employed outside the home is converted into income
The system features a low dispersion of benefits. The maximum monthly public pension (CHF 2,150) is twice the minimum (CHF 1,075). If the insured’s average annual income is less than or equal to CHF 38,700, then benefits amount to CHF 9,546 plus a variable amount equal to the annual income times 13/600. If the insured’s annual average income is more than CHF 38,700, then they receive CHF 13,416 plus a variable amount equal to average annual time 8/600. Low-income pensioners receive means-tested supplementary benefits. Total benefits amount to 9.1% of GDP, equivalent to 15.2% of covered earnings.
Many of the distinctive features of the Swiss public pillar were not original integrated into the plan when the system was first introduced. Such features as the low dispersion between maximum and minimum pensions, extensive government co-financing, the offer of supplementary pensions, the “Swiss” indexation of pension benefits, and the splitting of pension benefits between spouses, were added in revisions as a collective response to new challenges.
Occupational Pensions
The second component of the Swiss pension system (Berufliche Vorsorge/BV(G) – Prévoyance Professionelle/PP) is workplace-based and mandatory. Occupational pension funds already had a strong tradition in Switzerland when the referendum making them compulsory was passed in December 1972. For example, assets of occupational pension funds amounted to 40% of GDP in 1970. By 1985, when the legislation finally went into effect, occupational pension funds amounted to 60% of GDP.
The 12-year delay between the acceptance of constitutional amendments and enactment of implementing legislation is often blamed on economic problems caused by the oil crisis of the early 1970s. However, having already rejected one referendum on compulsory occupational pensions in 1968, Swiss voters only opted to make occupational pensions mandatory in the face of alternative proposals to nationalise all existing occupational pension plans and expand the public pillar.
Employees whose annual earnings exceed CHF 19,350 with the same employer are mandated to join the compulsory pension system under the Occupation Benefits Act (LPP), although it is voluntary for the self-employed and those who do not qualify in terms of earnings. The system stipulates a minimum level of benefits to be provided by all employers, but the mixture of compulsory/voluntary features of the system can be seen in the fact that many large employers offer benefits that go well beyond the prescribed minimum.
Depending on the insured’s age, the contribution rate varies between 7 and 18% for earnings between CHF 22,575 and CHF 77,400. The total contributions increase with age. The insurance scheme can be run by a company pension, state or private fund. Employee contributions must at least match those of the employee. Company pension plans can set terms and conditions in excess of these minimums, and most offer super-obligatory benefits as a means of attracting and retaining qualified people in a labour market that has experienced a persistent shortage of skilled staff.
Book reserves or internal funding of pension plans are not permitted for private employers in Switzerland. Occupational pension plans have to be funded externally. Furthermore, the funding vehicle must be set up in the form of an employee welfare foundation (‘Stiftung’), which is a separate legal entity serving as a repository for pension assets held independently from the employer’s general assets.
Larger employers will generally establish their own foundation, which may be:
- Autonomous: the foundation finances all benefits payable on retirement, death or disability;
- Semi-Autonomous: the foundation finances retirement benefits but reinsures death and disability benefits.
Smaller employers may establish a contract of participation in a collective foundation. In this case, the risk cover may range from fully insured schemes to schemes with only partial re-insurance for death and disability. Collective foundations are generally established and managed by life insurance companies or banks/investment management companies. The self-employed may contribute to voluntary plans.
Autonomous/Semi-Autonomous foundations
The foundation board has a general fiduciary duty to establish and implement the investment policy. There is no regulation regarding the employment of asset managers. Foreign investment managers, whether established in Switzerland or not, can be appointed.
Tax treatment of contributions and benefits
Approximately 80% of employees have pension cover under the system. The annual benefit equals 7.1% (men) or 7.2% (women) of the accumulated funds plus any interest in the individual accounts, which implies more of a defined benefit arrangement. However, a trend to defined contributions is noticeable. For example, it is becoming increasingly rare to find small or medium-sized companies with defined benefit plans. The trend to defined-contribution plans has also affected many large employers both in the public and private sectors.
Both employee and regular employer contributions are tax deductible. Special employer contributions above the normal annual contribution are also tax deductible. The extent to which such additional contributions are possible depends on the actual circumstances, with five times the regular contribution as a reference figure.
Employees who join a pension plan without or with only very small benefits accrued during their previous employment are allowed to pay additional contributions to make up for that gap in past coverage. The foundation itself is a tax-exempt organisation and it does not pay tax on its investment income. Employer contributions are not treated as taxable income to the employee. Benefits are taxed as normal income and lump sum benefits are taxed at reduced rates.
Benefits are normally paid in the form of an annuity. It is possible to draw a pension before reaching retirement age if the regulations of the pension fund allow. Death and disability benefits are also provided. Immediate full vesting and portability is required and indexing, although not legally required, is widespread.
Investment regulation
The compulsory occupational scheme requires certain minimum pension benefits based on a guaranteed interest rate of 2.75%. In line with this approach, additional voluntary defined contribution plans nearly always define a target interest rate, which is usually expressed as a guaranteed rate, such as 4% (formerly the rate for LPP benefits).
A pressing issue facing Swiss employers is the question of managing investment risk. Swiss pension funds increased their investment in equity to 33% in 2000 in order to profit from the high performance of international stock markets. The following bear market led to heavy losses. At the end of 2002, assets under management of Swiss pension funds were roughly one-third lower than they had been two years earlier.
Although the equity exposure declined to 25% in 2002, problems were aggravated by the steady decline in bond yields below the former guarantee level of 4%. The guaranteed minimum return rate now stands at 2.75% since the beginning of 2008.
Quantitative investment restrictions are quite detailed.
- Max. 50% in equity
- Max. 30% in Swiss equity
- Max. 25% in foreign equity
- Max. 50% in real estate
- Max. 75% in mortgages
- Overall limit on foreign investments: 30%
There are also limits for investments in securities of a single issuer and for investment in the sponsoring company.
Amendments to these regulations came into effect in 2000 and enabled pension foundations to exceed these limits on the base of a careful and diligent analysis of the situation of the foundation. Until the end of 2004, Swiss pension funds were required to fund their liabilities fully. Only some public pension funds were excluded from this rule.
New regulations passed in 2005 have relaxed this and allow pension funds to become underfunded for a limited time. But Swiss pension funds must inform the authorities of the size of any deficit, explain how the deficit came about, and detail the corrective measures that have been implemented to return the plan to a fully funded position. Swiss pension funds can force employees and employers to pay additional contributions to make up the deficit.
The second pillar has now accumulated large financial resources, equivalent to 122.1% of GDP. Overall, the pillar is highly fragmented with more than 4,000 funds (with affiliates) existing.
Outlook
The legal framework for Swiss pension funds was last altered in 2005 by reform of pension fund law and the signature of the bilateral treaties between Switzerland and the European Union. In addition, tax regulations that came into force in 2006 have provided several planning opportunities for Swiss pension funds.
Although the required minimum interest-rate guarantee has been lowered and improved stock markets brightened the outlook in the previous four years, managing investment risk is still the main challenge. This problem was highlighted again when it was reported that nearly half of all Swiss pension delivered performance below the 2.5% guaranteed rate of return in 2007.
In the future, only moderate growth rates are anticipated for the market, with total pension assets under management expected to reach EUR 689 billion by 2020.
Based on current policies, the PAYG pillar is expected to register a deficit by 2015. This reflects demographic change, such as increasing improved life expectancy. The old age dependency ratio is expected to rise from 23 in 2005 to 42 in 2050. As this trend develops, the pressure of growing transfers may generate the need for significant changes in the structure of the system.
However, due to its relatively low expenditure and redistributive nature and the existence of a robust and well funded private pillar, the Swiss pension system is better prepared to face the challenges of an aging population than most other OECD countries.