Understanding how LPP portfolios work in Switzerland: composition, performance and investment limits

Occupational pension provision (LPP) is one of the three pillars of the Swiss pension system. In this article, we will take a detailed look at how a typical BVG portfolio works in Switzerland, its composition and its historical performance.

The fundamentals of the LPP portfolio in Switzerland

Occupational pension provision (LPP) is the second pillar of the pension system. retirement Swiss, supplementing the AVS/AI (1st pillar) and individual savings (3rd pillar). Pension funds manage the insured persons' LPP assets and invest them on the financial markets to generate returns.

The main goal of a BVG portfolio is to preserve the capital of the insured while seeking to achieve positive returns in the long term. To achieve this goal, pension funds diversify their investments across different asset classes, such as stocks, bonds,real estate and alternative investments.

The investment decisions of pension funds are governed by the Federal Act on Occupational Old-Age, Survivors' and Disability Pensions (LPP) and its Ordinance (OPP2). These legal texts define the management principles, investment limits and transparency and governance requirements.

The performance of LPP portfolios has a direct impact on the level of future pensions of insured persons. This is why it is important for pension funds to adopt a prudent investment strategy adapted to the profile of their insured persons, while respecting legal constraints.

Composition and distribution of LPP asset classes

A typical LPP portfolio is composed of several asset classes, each with its own risk and return characteristics. The main asset classes are:

1. Bonds: debt securities issued by governments, companies or supranational organizations. They generally offer stable but relatively low returns.

2. Stocks: equity securities in companies listed on the stock exchange. They offer a higher return potential but also a volatility more important.

3. Real estate: direct or indirect investments in real estate (residential, commercial, etc.). This asset class offers regular rental income and some protection againstinflation.

4. Alternative investments: non-traditional investments such as private equity, hedge funds or commodities. They aim to diversify the portfolio and generate returns uncorrelated with stock markets.

The allocation of asset classes within a LPP portfolio depends on several factors, including:

• The demographic structure of insured persons (average age, ratio of workers to pensioners)
• Pension commitments (coverage rate, technical interest rate)
• Pension fund risk tolerance
• Long-term performance expectations

Investment limits according to OPP2

The Ordinance on occupational old-age, survivors' and disability pension provision (OPP2) sets investment limits for each asset class, in order to ensure adequate diversification and limit risks. Here are the main investment limits according to OPP2:

• Actions: maximum 50%
• Real estate: maximum 30% (including 1/3 abroad)
• Alternative investments (including commodities): maximum 15%
• Investments in foreign currencies without hedging of exchange rate risk: maximum 30%
• Claims: maximum 10% per debtor, unless Confederation

These limits apply to the total assets of the pension fund and not to each individual portfolio. Pension funds can therefore adopt different investment strategies depending on the characteristics of their insured persons (for example, a more cautious strategy for pensioners and a more dynamic strategy for active members).

Historical performance achieved by pension funds

The performance of LPP portfolios depends heavily on asset class allocation and market conditions.

According to the study "Performance of pension institutions"published by Swisscanto in 2021, the annualized returns of Swiss pension funds over the last 20 years (2001-2020) are around 4%. The Credit Suisse Swiss Pension Fund Index, over a slightly longer period, and with more recent data (2000-2024), sets this result even lower, around 3%. The minimum LPP rate, set by the Federal Council, is even lower, currently at 1.25%.

Considering the opportunities offered by the OPP2 in terms of investment choices, it is surprising to see such modest results. An average annual performance of 3% to 4% does not in fact guarantee adequate pensions. The minimum LPP rate, set at an extremely low level, also raises questions.

I had already expressed my reservations about this. in 2019, emphasizing that the results should logically be around 6.7 % per year, which is double the current performance of pension funds. My analysis then focused on the period 2010-2019, a period particularly favorable to stocks and which could partly explain the observed gap. We will therefore update this analysis using more recent data covering a longer time horizon.

Backtests of BVG portfolios

For portfolio backtests I will use the instruments authorized within theOPP2, within the limits allowed:

• To represent the share in shares (max. 50%), I will use the ETFs EWL (MSCI Switerland) and SPY (S&P 500).
• For real estate (max. 30%), I will use a selection of several Swiss real estate listed funds. The SRFCHA ETF could also have done the job on this entire position, but unfortunately its history is relatively short (2011).
• For bonds (maximum 10% per debtor, except if Confederation), I will use ETFs TLT (US Government Bonds 20 years and above) and CSBGC0 (CH Government Bonds 7 to 15 years).
• For gold (maximum 15%), I will use the ETF GLD.

From these instruments, I will test four portfolios using the 50% limit in stocks provided by the OPP2. Note that I could have gone beyond this limit because it actually applies to the total assets of the pension fund, as mentioned above.

I will also test a wallet representative of Swiss pension funds, with a lower share in shares (around 30%). In this way we will have a complete view of the subject.

The backtest runs from 2004 to 2024, with performance indicated in Swiss francs. It therefore covers a period twice as long as my first analysis (in 2019). Above all, it includes the subprime crisis, the Wuhan virus crisis and the subsequent rise in interest rates.

The best portfolios, composed of 50% of stocks, mixed between the Swiss and American markets, with 30% of Swiss real estate, 10% of government bonds (US or CH) and 10% of gold, achieve an average annual performance of more than 7% per year.

Despite the crises mentioned above, this result is still higher than that obtained in my last analysis (6.7%). This is very far from the 3% to 4% annualized returns obtained by pension funds. This even represents almost six times the minimum BVG rate.

One of the explanations often put forward by pension funds to justify this underperformance is the ageing of the population. As the director of the SBB pension fund said: : "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 the 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."

They are not asked for 70% of shares. Moreover, in the balance sheet of their fund's assets, they are not entitled to it, according to the OPP2. In fact, the Pension funds hold an average of 30% of shares, with 1/3 Swiss stocks and 2/3 foreign stocks. The last portfolio we tested above is a representative example. Even in this case, with an extremely defensive allocation, the average annual return amounts to 5.42% between 2004 and 2024. This represents two percentage points more than the average return of pension funds and four additional points compared to the minimum LPP rate.

Safe investments are not profitable enough to pay all pensions. Pension funds therefore have no choice but to subsidise them by skimming investment returns, to the detriment of the future pensions of workers.

Impact on pensions

Percentage points have a major flaw: they tend to appear abstract and make differences seem smaller than they actually are. This phenomenon is even more pronounced when it occurs over a very long period of time. This is the famous snowball effect.

To make this more concrete, let's take the case of a person who starts paying into their retirement provision at the age of 25. They and their employer pay a total of 10,000 francs per year into a BVG account. To keep it simple, let's imagine that this contribution remains unchanged until their retirement age of 65.

Let's now take the different LPP portfolios above and see the capital obtained at retirement age as well as the annual annuity (depending on the conversion rate of 6.8%) :

• Best LPP wallet tested (yield 7.07%/year): final capital = CHF 2,159,445 / annual annuity: CHF 146,842
• Representative portfolio of what should be obtained with the pension funds (yield 5.42%/year): final capital = CHF 1,385,397 / annual pension: CHF 94,207
• Pension fund results according to Swisscanto and Credit Suisse (yield 3.5%/year): final capital = CHF 856,678 / annual annuity: CHF 58,254
• Minimum LPP rate (1.25%/year): final capital = CHF 515,669 / annual annuity: CHF 35,065

Impressive. We paid exactly the same amount each year and kept the same limits set by the OPP2. However, on the first step of the podium we find a retiree who can live the high life. Especially since there is also the AVS and a possible 3rd pillar.

On the other hand, we have the typical example of a retiree, like many, who will vegetate well below his previous standard of living, even if we add the 1st pillar. The one just above, who is not at the minimum LPP, is doing a little better, but he will have an interest in having insured the blow by saving, investing and/or by building up a 3rd pillar, if he wants to maintain his former standard of living. However, as we see on the second line, with the same investment policy, this retiree should obtain a very nice retirement, especially when we also add the AVS.

The minimum rate required by the Confederation is much too low. The pension funds are thus giving themselves a clear conscience by announcing annual returns between 3% and 4%. However, they should pay out on average, depending on their investment policy, nearly 5.5% per year. They could even go up to 7% by focusing more on shares. Article 5 of the OPP2 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 far from the mark.

Management fees can explain a few dozen percentage points, but not several points. A reasonable expense ratio for an actively managed portfolio is around 0.5% to 0.75%, while an expense ratio above 1.5% is generally considered high. For passive funds, the average expense ratio is around 0.12%. Gold, Pension funds are often passively managed, for reasons of simplification and in order to limit costs.

Social insurance

The LPP, like the LAMal and AVS, constitutes social insurance. This concept presents two major problems, directly arising from this name:

• Insurance : by taking out insurance, you delegate the risk management to someone else. In addition to the provision for covering the event, you pay significant additional costs, generally referred to as administrative. Whether you need the insurance or not makes no difference, these costs are taxed anyway. In other words, you are charged just for collecting your money.
• Social : risks are spread over many individuals, meaning that, in one way or another, a majority finances the needs of a minority. Spreading risks over a large number of people reduces individual responsibility through the phenomenon of social lazinessThis is all the more marked since social security is compulsory: "I have paid into it, I am entitled to it".

This results in a large forced flow of money from the individual to the institution in charge of social insurance (AVS, LPP, LAMal, unemployment, etc.). Because of the monstrous operating costs of the organization, the lack of competition, the obligatory nature of the levies, the social laziness of the insured, the high salaries of executives and managers, the money that goes back down to the beneficiaries is miserable.

The system benefits a minority: the institution in charge of social insurance, the State, private insurers, a few other intermediaries and some insured persons who abuse the system. The mechanism does not create wealth, it only diverts it to the benefit of crooks, who take your salary directly, without any risk of being caught. Those who are supposed to be protected by the social insurance in question pay the price: the money they receive in return is derisory.

Conversely, if the individual insured these risks himself, he would benefit from a better return on investment. By setting aside these amounts for the future, he would prevent vultures from stealing from his savings. He would benefit in the long term from the magic of compound interest. Moreover, while social laziness encourages the squandering of insured persons' money, the individual who self-insures has every interest in acting responsibly with regard to his nest egg.

Conclusion

The analysis of occupational pension portfolios reveals a worrying reality. The numerous opportunities offered by the compulsory pension system LPP, in particular through the OPP2, do not benefit pension fund policyholders.

The backtest results clearly indicate that it would be possible to obtain significantly higher returns, without necessarily taking more risk. This underperformance unfortunately directly impacts the quality of life of retirees. Pension funds should nevertheless be able to guarantee a decent, even comfortable, standard of living for all pensioners.

This raises questions about the management of funds and the transparency of operations carried out within these financial institutions. Questions can also be asked about the criteria for selecting investments, the skills of fund managers and the commitment to the policyholders who entrust them with their savings.

In the end, who really benefits from the funds invested in pension funds? Many intermediaries, certainly. But not really the insured, who should see their savings working for their benefit. The obvious inequity between the returns available and those achieved only accentuates doubts about the integrity and effectiveness of the pension system.

It is therefore not surprising that the vote on the 13th AVS pension has easily passed the milestone. Unfortunately, once again, it will be financed by the same pigeons who are already being plucked with the LPP.