The minimum LPP rate or the peril of pension funds

I shared with you a while ago three years my questions about the Swiss pension system. In particular, I noted the weakness of the minimum LPP rate which continues to melt like snow in the sun. Since this article, the latter is now at 1%.

How can we explain such a miserable remuneration of our assets, taken from our salary without our consent? Ordinance 2 on occupational pension provision (OPP2) provides us with very valuable information on this subject:

1) Art. 51: The pension institution must aim for a return corresponding to the income achievable on the money, capital and real estate market.

2) Art. 53: Authorized investments:

a. Cash amount

b. Fixed amount debts (bank account, money market, bonds, mortgage securities, etc.)

c. Real Estate

d. Shares, shares, etc.

e. Alternative investments (hedge funds, private equity, infrastructure and commodities)

3) Art. 54: Limit per debtor: 10% maximum of the total assets can be placed on a single debtor (except if Confederation)

4) Art. 55: Limits by categories:

a. 50% in Swiss mortgage securities

b. 50% in equity investments

c. 30% in real estate investments (including 1/3 abroad)

d. 15% in alternative investments

e. 30% in foreign currency investments without hedging of exchange rate risk

In terms of restrictions, I expected much worse. It is still very open in terms of authorized investments and not very restrictive in terms of limits. You can go up to half of the portfolio invested in shares and the only limit in foreign shares is to cover the exchange rate risk if their proportion exceeds 30%. This really leaves enormous latitude to the pension funds.

Let's see how we could put together a basic portfolio that meets these criteria:

- Swiss shares: 50%

- Swiss real estate: 30%

- US Treasury bonds (20+ years): 10%

- Gold: 5%

- Cash CHF: 5%

Let's see what this gives in terms of income (without capital gains), according to the current market, for 100.- invested:

- Swiss shares: 2.8 x 50 % = 1.4

- Swiss real estate: 1.8 x 30% = 0.54

- US Treasury bonds (20+ years): 2.2 x 10% = 0.22

- Gold: 0 x 5% = 0

- Cash CHF: -0.75 x 5% = -0.0375

TOTAL: 2.1225

In other words, by investing according to the BVG criteria, even if you are affected by negative rates with 5% of cash in CHF, you immediately get, in hard cash, more than 2% of income! Even if you deduct a marginal tax of 20% that you would have to pay as a private investor (after declaration and recovery of withholding tax), you are still more than 50% away from what is offered by the minimum interest rate, just in income!

Apart from negative rates, another argument has very often been put forward by the funds to justify their miserable results: the performance of the financial markets. During the decade 2000-2010, this was at the very least catastrophic, with two major bear markets, so much so that the minimum rate then went from 4% to 2%. However, since the end of this decade, stocks have been breaking record after record, which has not prevented LPP rates from continuing their tumble.

Let's take our portfolio above and see what it looks like if we take into account the total annualized performance (capital gains and income) over the last ten years:

- Swiss shares: 8% x 50% = 4%

- Swiss real estate: 7% x 30% = 2.1%

- US Treasury bonds (20+ years): 5% (in CHF) x 10% = 0.5%

- Gold: 4% x 5% = 0.2%

- Cash CHF: -0.5% x 5% = -0.05%

TOTAL: 6.75%

It will be argued that it was an exceptional decade. However, if we look at the figures, we are quite close to the long-term historical trends. Real estate outperformed by about 2% per year, but cash underperformed by about the same amount. Shares and bonds are within the norm. We can therefore obtain an overall return of more than 6% with a portfolio meeting the LPP criteria. Let us now recall Article 5 of the ordinance: "The pension institution must aim for a return corresponding to the income achievable on the money, capital and real estate market". I do not know what the legislator meant by "aim for", but I doubt that with a difference greater than 5% we would be in the right place! It would be enough to launch the biggest collective action of all time. Volkswagen would almost seem like a choirboy next to it...

We have just seen that neither the legal constraints on occupational pensions, nor the interest rates on the Swiss franc, nor the performance of the markets can justify the catastrophic results of our pension funds. However, these arguments are frequently put forward by the latter. How can we explain such a difference compared to what we could and should even obtain from them?

First of all, there are the costs. The salaries of all these managers have to be paid free of charge and we are not dealing with simple interns here (maybe that is the solution?). There are a lot of "qualified" people who work for you, or rather on your behalf. Then there is the heaviness of the system. There are hierarchies and processes to respect which mean that the choices of the funds in terms of investment are made at a very Swiss pace. In addition, given the large amounts of money that they manage, they have more difficulty investing in small companies than an average investor.

However, the costs, the organizational burden and the difficulties of investing in small caps cannot justify this difference by far. Investment funds also charge fees of around 1-2% and are doing better for the most part. It should also not be forgotten that employers already pay administrative fees to pension funds. Index funds, with passive management, also show very good results, with very few costs. They do not have any burden or inertia at the decision-making level, they simply follow the indices. Regarding small companies, it is true that historically they do better than the market, but over the last ten years it is the large ones that have outperformed (certainly helped by our pension funds).

So where is the problem? Results that are constantly falling, this curiously reminds us of the law of diminishing returns, which states that the marginal return obtained by the use of a factor of production decreases, all other things being equal. The factor of production here is represented by the pension funds and their capital. All other things being equal means that they continue to operate in the same way, according to their legal and financial constraints, without ever questioning the system. Articles 53 to 55 of the OPP have the merit of forcing the funds not to put all their eggs in one basket. However, it is more than likely that the problem here is neither the eggs nor the baskets, but rather the henhouse. There is too much money going to the pension funds and they no longer know what to do with it. No wonder the rates are negative. Worse, it forces them to invest in anything and everything and at any price, as long as it is not cash denominated in Swiss francs.

Any investment fund manager would be fired on the spot with such poor results. But here in Switzerland, the land of banks, we consider that one percent on a mixed fund is normal. Surprisingly, very few people are offended by it. Perhaps because it is so complicated and no one understands anything about it, especially fund managers. It must be said above all that as long as it does not affect your wallet, you do not feel like you are losing anything. The "genius" of the LPP system is that you never receive any invoices (unlike health insurance funds). Everything is subtly stolen from your salary, the fruit of your labor, then put "in the warm" (although here we are closer to absolute zero), before being returned several decades later. It is only then that some people unfortunately open their eyes.

Even if we cannot change the system, as small investors we at least have one possible lever, the OEPL (Ordinance on the Promotion of Home Ownership by Means of Occupational Pension Provision). Thanks to it, we can partially or completely withdraw our BVG assets to obtain equity for our home, repay a mortgage or even finance renovation or capital gains work.

Our money is in principle better invested in property, as we have seen above, than in our pension fund. I say in principle because market prices are currently very high. If we buy too expensive and have to resell in the future at the wrong time, we risk regretting it. Note that the OEPL still protects us somewhat from having to part with a property because of a rise in mortgage rates. Indeed, not only can it allow us to obtain additional equity to reduce the loan, but it is also possible to request a new advance payment every 5 years, which allows the debt to be amortised and thus lower the mortgage tranches. It is therefore wise to lock in your rates for at least five years.

To be complete, let us also note that early withdrawal is only possible to finance your main residence. However, it is possible to re-let this property after a move… A good way to make your LPP profitable! By the way, LPP, does that mean Worst Performance?