Cost-benefit ratio of a pension fund: risk capacity

The topic of our 52nd anniversary flash is the risk capacity of a pension fund – a subject that has occupied our company intensively for decades.

Ideally, one should be insured with a pension fund that has a high risk capacity. Such a fund can take on higher investment risks, which in the long run result in higher returns. High returns from investments as the «third contributor» ultimately lead to higher benefits.

How can the risk capacity of a pension fund be measured? In Art. 50 para. 2 BVV 2, the legislator «offers» two measures: firstly the ratio of «total assets and liabilities», and secondly the «structure and expected development of the insured population».

The ratio of assets and liabilities can be summarized in simplified form by the coverage ratio of the pension fund. In Flash 49 we wrote that it is beneficial to be insured with a pension fund that has a high coverage ratio. However, this argument primarily relates to performance: a pension fund with strong reserves and a high coverage ratio has good prospects of granting higher benefits in the coming years (for example in the form of higher interest rates).

However, as a basis for assessing risk capacity and determining strategic investment risk, the coverage ratio has major weaknesses. The coverage ratio is a snapshot measure that can change rapidly on a daily basis due to stock market fluctuations.

When stock markets rise, the coverage ratio increases and with it the risk capacity. If one relied on this measure, equities would have to be increased when markets are at their highest. When markets fall, risky equities would have to be sold at their lowest levels.

The resulting procyclical investment behavior is detrimental to long-term investment returns. If the downturn is severe and the pension fund falls into underfunding, it also faces the so-called «gambling for resurrection» dilemma. In such a situation, the fund actually needs the returns from risky assets to recover, but based on the coverage ratio it no longer has the risk capacity to hold such investments. The coverage ratio as a measure of risk capacity is therefore not weatherproof.

A more robust alternative for measuring risk capacity is the composition of the insured population. A young pension fund with many active members and relatively few retirees has a positive cash flow and its balance sheet grows every year. This growth continuously «washes out» shortfalls or surpluses in the balance sheet.

In contrast, a pension fund with many retirees experiences a shrinking balance sheet and any shortfalls or surpluses become increasingly pronounced. Our conclusion: young, growing pension funds can tolerate higher investment risks than pension funds dominated by retirees.