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Inflation, debt, and climate ... 2022 challenges of swiss pension funds

360°Benefits I News

By Michael Valentine and Maxime Corbaz | January 17, 2022

How can I build a portfolio that is robust against different future scenarios?

Managing the many headwinds faced by pension funds

The prevailing macroeconomic conditions and extra-financial background that includes climate transition considerations, represent a seriously challenging environment for pension fund investors. There also seems to be little consensus as to how to tackle the overall situation. However, there are a few headline issues that are worth focusing our attention on.

Firstly, although global debt is at a record high, it continues to grow, and it will be difficult to finance if interest rates rise to combat resurgent inflation while « post-pandemic » growth resumes. Under this scenario, the average pension fund performance will suffer, as fixed income investments represent between 20% and 30% of portfolios today. Secondly, the question as to whether inflation progresses to higher levels or gradually loses steam is already having an unsettling impact on markets. This dilemma needs to be carefully monitored and a clear understanding developed of what the different inflation scenarios imply for the different portfolio components. Finally, sustainability and ESG aspects have become an indispensable tool in the construction of more resilient investment portfolios. In this area, the transition towards a lower carbon economy will be a dominant theme for pension fund investors.

These three areas, together will a multitude of other factors, are interrelated and need to be incorporated within the overall governance framework, when making long-term, strategic investment decisions.

Building scenarios into ALM studies helps in anticipating impacts

A scenario-based management approach helps in visualising the impact of different economic environments on a pension fund, also in terms of liabilities. In addition, some of these scenarios may be used to test the effect of changes to key BVG parameters, such as the technical rate or the interest credited to the savings account of active insured members. There is therefore a need to enhance the ALM processes by adopting such scenarios and to continue to update the existing models to rationalize a more tactical approach, when needed.

Finally, understanding the underlying sources of return and risk in a portfolio – such as equity risk, credit risk or asset manager skill - is essential and should be part of the ALM process together with stress testing, inflation scenario analysis and climate change impact assessment. In a rapidly changing economic environment, best practice now demands a more an active management approach to ALM studies, including the use of a clear interest crediting policy that is dependent on funding level and the performance achieved. Overlayed on top, the overriding prerequisite for a successful ALM is strong governance.

Concrete ideas for implementation

But what can be done concretely in such a context? To build a portfolio that is robust under the possible future scenarios, rare are the asset classes that will provide adequate diversification under all circumstances.

These include insurance-linked securities and well-diversified real assets. In particular, current Swiss real estate portfolios can be significantly improved by adding foreign and infrastructure investments. The new investment category for pension funds "Unlisted investments in innovative technologies" recently introduced in the BVV2 can also prove to be an interesting addition in terms of expected return, diversification, and impact (for the dynamism of the Swiss economy and for sustainability). In terms of corresponding asset classes reductions, bonds are the obvious choice. Within the remaining and still important allocation to this space, quality and diversification can be improved, for example via green bonds, inflation-linked bonds, an active alpha approach in corporate bonds and selecting highly diversifying government bonds.

Regarding the transition to a lower carbon world, the winners and losers will be spread across different asset classes. The current political consensus setting decarbonisation targets to limit global warming is important. The net zero pledges made by governments should materialise in many new policies that promote investment in technologies and solutions that will facilitate this energy transition. As a result, companies able to adapt their business model to these new policies will see their value increase, while those that are unable to do so may experience significant headwinds. It remains to be seen how quickly these actions will be implemented, but the early movers will certainly have a significant advantage.

In this respect, WTW is a clear leader in developing modern solutions for the climate transition challenge. New, simple tools are now available to pension funds to model these risks, invest in a resilient manner and measure the efficiency of the existing portfolio with the help of climate transition indices.


Senior Investment Consultant

Head of ALM Switzerland

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