Decline of the second pillar: LPP in danger and consequences for your retirement

The LPP is the Swiss occupational pension system which aims to appropriately maintain the standard of living prior to retirement. For those who do not work in Switzerland, or those who are not familiar with the pension system that prevails in this country, here are some brief explanations.

AVS

Old Age and Survivors Insurance (AVS - commonly called 1st pillar) provides the minimum subsistence level. That's the least we can say, since the pension is currently between 1,200 and 2,400 francs per month for one person. The principle of the first pillar is solidarity: working people (and their employers) pay the pensions of retirees. It has been in force since 1948.

LPP

With such amounts, we obviously don't get very far. For some employers, well before 1948, employees were insured with pension funds. For them, the AVS supplemented their pre-existing pensions, ensuring them relatively good conditions as retirees. The idea then arose to generalize this practice, by making it mandatory for a large section of the working population. The Law on Occupational Pensions (LPP - commonly also called 2nd pillar), was thus developed in order to fill the gaps in the 1st pillar.

However, it was not until 1985 that the second pillar was implemented for a large proportion of employees. While the first pillar is based on solidarity, the LPP is based on mandatory individual savings: workers (and their employers) feed a fund that will pay pensions once the official age is reached.

A model in difficulty

The two pillars of foresight have accompanied the rise of boomers. However, since the latter began to retire, the system has been under pressure. The number of active workers per retiree is falling, while life expectancy is increasing. It is obviously understandable that the 1st pillar, with its principle of solidarity, is strongly impacted by this new situation. What is questionable, however, is the impact on the 2nd pillar, which is supposed to be based on individual savings.

Individual savings are collectivized

The problem is that, if we do indeed save (obligatory) in the LPP individually, our money is invested collectively. The legislator has provided a sweetener to compensate for this inconvenience, via the 3rd pillar, which is free and totally individual (both in terms of savings and investments). However, with the 2nd pillar, a very large part of our retirement savings is forcibly taken from our salary and invested collectively, according to criteria that do not correspond to our age, situation and propensity for risk.

An investment strategy unsuited to assets

Ordinance 2 on occupational pension provision (OPP2, art. 55) limits the share of investments in shares to a maximum of 50%. However, according to the conclusions of the "Determinants of wealth", provided that one is not already retired from an official point of view, the ideal allocation in shares is around 75% of shares. This ratio makes it possible to ensure the best possible performance of investments over the long term in relation to the risks incurred. This means that the LPP, by capping shares at only 50%, de facto preterites the future annuities of active workers.

Results well below expectations

However, even with this ratio set significantly too low, our pension funds should still achieve decent results. 2019, I had fun creating a virtual portfolio corresponding to the LPP rules:

- Swiss shares: 50%
- Swiss real estate: 30%
- US Treasury bonds (20+ years): 10%
- Gold: 5%
- Cash CHF: 5%

This portfolio offered a return (excluding capital gains) of 2.12%, more than double the minimum LPP rate (floor rate at which your retirement assets must be remunerated), despite negative interest rates!

Market performance: a valid excuse at the beginning of this century

Pension funds have often highlighted, in addition to low interest rates, the poor performance of financial markets to excuse their catastrophic results. It is true that during the decade 2000-2010, this was quite bad, with two major bear markets. During this period, the Swiss Performance Index (SPI), which tracks the price of Swiss shares, including dividend payments, showed a modest increase of 15.3%, or 1.4% per year. Logically, the minimum LPP rate, during the same period, went from 4% to 2%.

The stock market is booming but our pension capital is not keeping up

However, since 2009, stocks have been breaking record after record, which has not prevented LPP rates from continuing their decline, down to 1% currently. My virtual LPP portfolio of 2019, had generated a total annual performance of 6,75% (income and capital gains) over the last ten years, which is close to the long-term trends that one is likely to obtain with a portfolio of this type. With a minimum rate set at 1%, we are therefore very far from the expected results.

Paradoxically, the Swiss Insurance Association wanted to further reduce this miserable rate, considering that it has been excessive for years! Article 5 of the ordinance specifies: "The pension institution must aim for a return corresponding to the income achievable on the money, capital and real estate market". Clearly, we are outside the rules...

History of the minimum LPP rate

Let's take a little time to analyze the evolution of the minimum LPP rate since 1998, and compare it to the result of the Swiss Performance Index (SPI). I also added a column with the conversion rate that I will discuss a little further down.

The stock market pays four times more

As already mentioned, the period 2000-2010 was particularly unfavourable for shares. Despite this, we can see that the performance of the SPI is more than four times higher than that of the minimum LPP rate. Another interesting point is that over 24 years, the SPI has performed less well than the minimum LPP rate on only seven occasions. In other years, it has clearly outperformed the minimum rate, with a few extremes such as in 2005, almost 32 points more!

The LPP rate falls and almost never rises again

We also note a slow and steady descent into hell for the minimum rate. However, in the long term, we do not see this decline at all with the SPI. Even if it has experienced falls, it has always recovered very quickly. The minimum rate shows an almost worrying inertia. It reacts several years late compared to the market, even going against the current of the latter. Worse, it has a very unfortunate tendency to fall when the market weakens and not to rise again when the market recovers.

The conversion rate

Now let's look at the conversion rate, which is also shown in the table above. This shows us how the accumulated capital will be converted into an annual pension. If you have a retirement capital of CHF 500,000 and the conversion rate is 7%, then you will receive an annual pension of CHF 35,000.

Pensions too generous in relation to life expectancy

What is striking first of all is the relatively generous nature of the current conversion rate, currently at 6.8%. According to the conclusions of theTrinity study, with more than 21 years of life expectancy since retirement, this rate should rather be of the order of 4.8%.

A barely detectable impact on the conversion rate

The pensions of current retirees are therefore too high compared to the means of the system. Just like the minimum rate, we note a slow and steady decline in the conversion rate over the long term. However, this decline is much less marked, at increments of 0.05%. Lowering the conversion rate amounts to reducing retirees' pensions, which is very unpopular. We therefore do it insidiously, in tiny increments, but it is not enough. Indeed, life expectancy continues to increase over the long term, despite the recent small decline due to the Wuhan virus. We have thus gained seven years of retirement since the 1980s.

Communicating vessels

Since it is not politically acceptable to lower pensions significantly, the only way is to finance them via the capital of current workers, thereby preteritizing their future pensions. The interest rate paid by the funds is thus nearly six points per year lower than what they earn on the markets, as we have seen above.

When we realize it, it is often already too late.

Few employees care about the minimum rate on their pension certificates, except perhaps those who are approaching retirement age. It is only when you reach the age of 60 that you really begin to realize how much you have contributed during your life, the total capital accumulated with interest and what that will mean in terms of your future pensions.

This explains why the minimum interest rate has literally melted in a relatively short time, almost to general indifference, while the conversion rate has barely moved. This bodes very badly for all current employees, who subsidize pensions that are far too generous in relation to the system's resources. They risk having unpleasant surprises in a few years if they have not covered their own backs.

Solidarity goes both ways

Solidarity between generations is important. The first pillar was designed precisely for this purpose. The working population finances the pensions of retirees. This principle is commendable and little contested. However, solidarity goes in both directions. Today, a retiree can hope to live another twenty years, which is enormous. The contributions paid during his or her life, as we have seen above, are insufficient to ensure the level of pensions paid today for such a long period.

The LPP has lost its original purpose

The principle of individual savings provided for in the LPP is misleading. Yes, savings are individual, but the money is invested collectively. To ensure the payment of the current large pensions, pension funds can no longer invest sufficiently in shares, which are considered too volatile. However, it is only the latter that would allow the pensions of future generations to be financed. De facto, the second pillar has become an improved first pillar, but has lost its original purpose.

We understand, of course, current retirees, who do not want to lose their assets. Whether you are an employee or a pensioner, it is never pleasant to suffer a loss of income. However, it is not fair to use the returns generated from the money contributed by active workers to subsidize the funding gaps in current pensions. The price to be paid by the younger generations will be colossal.

Sorry, there is no more money for your retirement

This topic was recently discussed in the program "Present time" from our state television. Here are a few selections:

• The SBB pension fund now has 25,000 pensioners for 30,000 active employees. It is necessary to withdraw 63 million francs per month for pensions, there is no question of taking risks with the fund's assets. Problem: safe investments no longer yield anything. The return that contributed to the 2nd pillar no longer plays its role.
• The director of the SBB pension fund: "We are from the wrong generation. It is really bad luck. We have to be careful, we cannot hold 70% of shares, because in the event of a crash, then we would have a problem paying out pensions. The fact of having a lot of pensioners pushes us towards a more defensive investment strategy. Many funds are in this situation. It is linked to demographics and the number of retirees is not decreasing."
• Virginie's mother on the "Generations" initiative, aimed at making pensions sustainable and fair: "I agree that something needs to be done, but attacking existing pensioners and their pensions... I don't agree. We need to find something else."
• Roland Grunder, co-president of the Swiss Council of Seniors, has joined the initiative committee called "for a 13th AVS pension" (!), classified on the left. He calls himself radical, but no matter, he is concerned: "Today, people of my generation cannot make ends meet. Reducing pensions means changing the contract. Touching our pensions today means reducing overnight what seniors have in their wallets. And we say to the younger generation: tomorrow, you will have less salary, there may be plenty of solutions. I'm talking nonsense, but work more, work differently, find a job that pays better. Seniors can't do that."
• Nathalie: "I have two generations above me who no longer work, and children below me who are not yet working. We are the only active generation out of four. The AVS system was set up when life expectancy was 65. My grandparents are 95. They have been retired for almost my age. They have been receiving a retirement pension for 30 years. My parents receive more money than Florian and I combined. In 30 years it will not be like now. There will be changes that mean that what we contribute to the 2nd pillar now, I don't think I will see it at 65."

Legitimate concerns on both sides

As we can see, the situation is complex, with front lines that seem unlikely to change. On the one hand, we have the younger generations who are worried about their future pensions and on the other, the current rentiers, who want to preserve their assets. Each of these concerns is legitimate.

Individual solutions for active and future retirees

Since it is unlikely that a reduction in pensions will obtain a political majority (66-75 year-olds have voting participation rates almost twice as high as young people), current workers have no choice but to find individual solutions. The Temps Présent report suggests a few options, such as multiplying income through various activities, learning to live with less or saving in a 3rd pillar.

These ideas all make sense. However, I would add two others that seem essential to me. First of all, invest in stocks from a young age. According to J. Siegel, these are the ones that offer the greatest profitability in the long term. Then, as I had already mentioned in the pass : have recourse to the OEPL (ordinance on the encouragement of home ownership by means of occupational pension provision).

Thanks to this subterfuge, we can partially or completely withdraw our BVG assets in order to obtain equity for our home, repay a mortgage or even finance renovation or capital gains work. Our money is generally much better invested in property than in our pension fund, given the low minimum BVG rate. We might as well save what we can still save...