Bearing a heavy burden

Emma Cusworth: How has 2010 treated you so far?

Markus Huebscher: PK SBB's performance in 2010 has been consistent with the Swiss industry average yielding 0.4% for the year to 30 June. 

We have had an extraordinary CHF938m ($981m) injection from our corporate sponsor, SBB, but excluding this, our funding ratio deteriorated as we require 3.7% to break even. At the end of 2009 our actuarial coverage ratio was 84.4%. By 30 June 2010, we lost around CHF90m, decreasing the funding level to approximately 83.5%.

Emma Cusworth: When you joined last November, you instigated a 10-year plan to recapitalise the fund by 2019. How will you achieve that?

Markus Huebscher: We have announced a three pillar plan, which places a heavy burden on all parties involved with the costs equally shared.

The first pillar is the fund members. Active members are currently contributing an additional 2.5% of salary until 100% funding is reached. Interest paid on their capital has been reduced to the legal minimum, currently 2% for 2010 and 2011. Retired members, who account for 60% of our capital, contribute indirectly as benefits are not inflation adjusted. This has been the case for the last six years already, reducing their purchasing power by approximately 6%. Inflation adjustments will not be granted until we are fully funded and have established reserves.

The second pillar is SBB. They are matching active members' extra 2.5% and have additionally injected the one-off contribution of CHF938m in 2010. In 2007 SBB injected an initial one-off contribution of CHF1.5bn.

Pillar three is the Swiss government. The Bundesrat has expressed its willingness to grant the fund a one-off payment of CHF1.5bn. This has to be approved in the coming months by Parliament. We expect to know by the end of 2011 whether the government will definitely support the fund.

This government support is a controversial topic. Many Swiss people believe it is the responsibility of the fund members and sponsoring company to solve funding problems. Our situation is different though, and goes back to 1999 when it changed from a public to a private pension fund.

What many observers don't appreciate is that our underfunding is not a result of below-average investment returns or mismanagement. The chart demonstrates that PK SBB's performance is in line with the Swiss market. When the fund became private, however, the government provided 100% funding, but no reserves. At that time, the average Swiss scheme was 125% funded due to strong stock markets. PK SBB was therefore exposed to the tech bubble bursting and the current financial crisis without a financial cushion.

Emma Cusworth: How likely is your plan to succeed?

Markus Huebscher: Given the current investment strategy and policy, there is a 75% probability we will achieve 100% funding by 2019, assuming returns of 4.3% per annum for the next ten years. So far, we are on track.

We do, however, have to be prepared for returns being lower than were expected two years ago when the 4.3% target was calculated.  Since 2008, Swiss interest rates have dropped significantly, from above 3% to its current level of 1.4%. We cannot close our eyes to the effect that this will have on investment returns.

Lower interest rates have also had a dramatic effect on the liabilities of PK SBB and all Swiss pensionskassen. The economic value of liabilities using the yield curve has increased significantly compared to the widely used actuarial valuation.

Emma Cusworth: Have you made any changes to your asset allocation as a result?

Markus Huebscher: There have been some slight variations of a percentage point here and there, mainly due to cash inflows and other small adjustments, but the changes are predominantly market-influenced. We are currently carrying out an (asset liability management) study which we expect will set our future long and medium term strategy. 

We have also spent considerable time reviewing whether we were able to actively manage tactical over and under-weight positions versus the benchmark. Having decided we could not do this, we opted for a rules-based rebalancing approach with pre-defined bands for each asset class. 

In order to produce a well-researched solution, we commissioned an extensive, independent study looking at a number of aspects, mainly the width of the bands appropriate to PK SBB's asset allocation and the rebalancing strategy. The research applied a block-bootstrap approach to model return distribution. 

Setting the bands is a crucial element of any investment strategy. The wider they are, the more pro-cyclical the investment approach and, conversely, the narrower the bands the more anti-cyclical the approach. The next decision was the rebalancing strategy. Do we rebalance back to benchmark weights, the upper or lower band, or somewhere in between? The result of the study was very clear: taking into account trading costs and rebalancing frequency, rebalancing back to benchmark weights delivered the best outcome. The results from the study were subsequently introduced in Q1 of 2010. 

Emma Cusworth: How does this extend to your use of active versus passive managers?

Markus Huebscher: Our philosophy is ‘active only where we can expect added value'.

Emma Cusworth: How do you assess where added value exists?

Markus Huebscher: We are currently working on an appropriate policy.  

The issue regarding active vs. passive is not whether there are good managers available who achieve risk adjusted outperformance vs. a benchmark. In any market, you will always find a manager who is outperforming. This is true by definition. 

The real question is whether you believe there are inefficiencies in the market so the probability of finding a good manager who can consistently outperform is high. Sustainable outperformance in efficient markets is extremely ­difficult.

Emma Cusworth: The allocation to alternatives, where you have some active mandates, has increased 2.3%. since the end of 2009. Do you expect allocations to continue increasing?

Markus Huebscher: There has been a small strategic increase, but the ALM study will determine future allocation levels.

Alternatives' performance has been varied. Products with floors, like some of our commodities investments, have done very well, but private equity has been very unsatisfactory. Disappointingly, our hedge fund universe did not produce absolute returns in 2008 nor did it rebound in 2009 to compensate for the previous year's losses. 

Overall the results have been mixed and not what we expected - an experience shared by many other institutional investors in this asset class. The financial crisis led to a reassessment of the returns that alternative investments can achieve and their correlation versus traditional asset classes.

Emma Cusworth: The Swiss population recently voted against a further cut in the benefit conversion rate. Given the likelihood of mediocre market returns and the aggressive recapitalisation measures you already have in place, how will that affect PK SBB?

Markus Huebscher: It is not really that important for us as it only sets the minimum rate. PK SBB provides benefits above the regulatory minimum. 

Our rate is set based on official life-expectancy statistics from 2000 and a 3.5% technical interest rate for discounting future payments. We expect to convert to new 2010 figures, due to be published shortly.

Nevertheless the rejection of the cut is a drama: the low interest rate environment and the increasing life expectancy make a further reduction inevitable. From a political perspective, lobbying for the second cut was probably not wise for the second pillar of the Swiss pension system as we are already in the process of lowering the rate to 6.8%. 

Asking for a further reduction while the first cut is not even fully realised was certainly an important part of the Swiss population voting against it - no matter how justified the reduction really was. 

Of course, the market has changed and sometimes issues have to be addressed quickly, but it is also a question of the public's trust in the second pillar, whose reputation has already suffered as a result of corruption scandals this year.

Emma Cusworth: Do you expect allegations of corruption at BVK will mean an increase in regulation?

Markus Huebscher: One thing is clear: the scandal has not boosted confidence in the system overall and there is some risk that lack of trust in pillar two could increase pressure on government to impose more rules.

Given the fragmented structure of the Swiss pension industry, the government needs to ensure the rules and regulations do not continue to increase as they have in the last few years. Additional regulation means additional costs, which is particularly difficult for smaller schemes. Ultimately, no matter how much regulation is imposed, fraud will always occur. Unfortunately, that is human nature.

Emma Cusworth: What have you found most challenging, so far, in managing PK SBB?

Markus Huebscher: The underfunding and the harsh recapitalisation measures which we had to impose were, and still are, very difficult. 

What we do and how we act in terms of our investment philo­sophy and asset allocation in order to solve our funding situation is constantly watched in the industry. We are operating in a glass house where we have to be completely transparent and are being ­thoroughly scrutinised.