Negative investment returns make themselves felt at pension funds

The Swiss Pension Finance Watch examines the impact of capital market developments on the financing of pension plans in Switzerland on a quarterly basis. This study is part of the WTW published Global Pension Finance Watchwhich contains all results of the most important bond markets from the year 2000 onwards. The study results are published quarterly. Their focus is on investment assets and liabilities. The survey covers pension plans in Brazil, Canada, the euro zone, Japan, Switzerland, the United Kingdom and the United States. The survey is based on International Accounting Standard 19 (IAS 19) and US GAAP FASB ASC 715. The index represents the quarterly development of the funding ratio under these accounting standards instead of reporting the otherwise typical funding ratio of Swiss pension plans.

Assets decline by 3.3 percent

In the first half of 2022, the significant and steady increase in discount rates offset the declining plan assets, resulting in a further net improvement in the pension obligations on the corporate balance sheets. In the third quarter, bond yields, on which the discount rate is based, were very volatile but closed only slightly higher than in the previous quarter. Compared with the end of the second quarter, pension obligations remained relatively stable overall. Corporate pension obligations under international accounting standards still remain around 20 % lower than at the beginning of the year, close to their lowest level in nine years. Plan assets declined by another 3.3 % in the third quarter, causing the WTW Pension Index to plunge by 4.4 %. As shown in the WTW Pension Index, the illustrative funded ratio (i.e., the ratio of plan assets to pension liabilities) fell from 129.7 % as of June 30, 2022, to 125.3 % as of September 30, 2022.

Negative investment returns: What they mean

For the first time in over ten years, bonds with the most important maturities for pension funds are recording negative investment returns. For pension plans with a term of more than ten years, this means under current conditions that the discount rate falls as the term of the plan increases (possibly by as much as 5 to 10 basis points). Under "normal" circumstances, the opposite is true, in which case a debt holder demands a higher yield as compensation for interest rate change and default risks the longer a bond's maturity is. "Despite volatile market conditions, very poor investment returns so far this year, and the unusual inversion of the corporate bond yield curve, companies can still expect to see an improvement in net pension liabilities on their balance sheets compared to the beginning of the year. On the other hand, the funding ratios of local pension plans are likely to have deteriorated significantly, as the technical interest rate underlying local obligations has remained much more stable," explains Adam Casey, Head of Corporate Retirement Consulting at WTW in Zurich.

For plans with durations up to 16 years, the discount rate improved in the third quarter, while the discount rate for plans with longer durations declined during the quarter. "The shape of the yield curve makes it difficult for companies that report their pension obligations on a quarterly basis to make a rough estimate of whether their obligations increased or decreased during the quarter, as this depends on the duration of the pension plan," explains Adam Casey. When there is an inversion of the yield curve, investors who buy bonds with longer durations are willing to accept lower compensation for their risk exposure than they would receive for exposure with a shorter duration. As a rule, the inversion of the yield curve is therefore seen as an indication that the market is rather pessimistic about the economic outlook for the near future.

Peak inflation soon or already reached - possible opportunities for investing in bonds

For pension funds, the 3rd quarter was again a negative one, although the brief respite in July somewhat offset the particularly poor September. The assets of a typical Swiss pension fund slumped by around 3 % in this quarter. The annual return is currently around -13 %.

As inflation continued to rise, the central banks had to respond with hefty interest rate hikes. It can be assumed that inflation in the USA has already peaked and will now slowly level off. In Europe, the peak is expected in the 4th quarter or at the latest in the 1st quarter of 2023. In Switzerland, inflation was still lower than in its neighboring countries at 3.5 % in August. "The expectation that interest rates will peak in the short to medium term makes an investment in bonds attractive again compared to equities," expresses Alexandra Tischendorf, Head of Investment at WTW.

Real interest rates are showing an increase, albeit still in negative territory. Within the bond segment, opportunities appear to be emerging in the area of investment-grade corporate bonds, as credit valuations have declined from their highs and default rates on high-yield bonds are rising.

It is important that pension fund boards of trustees do not lose sight of their long-term investment horizon and goals despite the challenges presented by the current environment, according to WTW experts. "Pension fund boards of trustees must continue to focus on the long-term, sustainable direction of their investment strategy. This includes aspects such as diversification of risk premiums, consideration of sustainable investment principles, and improvement of risk management and governance," advises Alexandra Tischendorf.

Source and further information: wtwco.com.