July 14, 2000 | Lecture on Social Security
Switzerland has traditionally maintained a strong international role as being both progressive and innovative with regards to its foreign-policy outlook and the structure of its economy. Nestled in central Europe, Switzerland's population of just over 7 million people have embraced cultural influences from Italy, Germany, and France. Yet in regard to its overall national retirement approach, Switzerland has pursued a largely independent direction. The stark reality for Switzerland is that it has one of the most rapidly aging populations in Europe. Such a demographic shift is best seen in the movement of dependency ratio data: the elderly dependency ratio (population aged 65 and over as a percent of working-age population) will shift from 23.6 percent in 2000 to 48.6 percent by 2030. A similar trend is seen in total dependency ratio data (population aged zero to 14 and 65 and over as a percent of working-age population), which will shift from 49.6 percent in 2000 to 77.0 percent by 2030.1
Underlying the Swiss retirement system is the Federal Occupational Retirement and Survivors' Insurance Scheme or AHV/AVS. This first-tier social insurance program, established in 1948, provides basic old age and surviving dependants' benefits under the first pillar for men aged 65 and women aged 62. Unlike other European social insurance programs, the annual AHV/AVS pension consists of a flat amount, or base index, combined with an earnings-related benefit, which is determined through the revaluation of average career earnings. Essentially this benefit is designed to provide subsistence benefits for the entire population.
"If the employee's earnings are less than three times the base index, the flat-rate benefit is equal to 0.74 times the base index; otherwise, the flat-rate benefit is equal to 1.04 times the base index. If the employee's earnings are less than three times the base index, the earnings-related part of the annual pension is equal to 0.26 times the revalued average annual earnings; otherwise, the earnings-related benefit is equal to 0.16 times the revalued average annual earnings. The revaluation factor that is applied to the average annual earnings depends on the average salary increase since the year the claimant first joined the social security system."2
Put simply, the resulting combined pension from the first pillar of the first tier for a single person lies between one and two times the annual base index (i.e. FR 12,060 (Swiss) (U.S.$7,307) and may not exceed FR 24,120 (Swiss) (U.S.$14,614)).
Like programs found in the United States (Social Security) and Canada (Canada Pension Plan), penalties exist if the individual retires early. Men can now retire without penalty as early as age 64, and after 2001, the retirement age will be lowered to 63. The pension is actuarially reduced by 6.8 percent for every year of early retirement. Women can retire at age 62, and for those born before or during 1947 the reduction factor is halved.3
Like so many European pay-go retirement pillars, supplements are used to augment the existing core. Such supplements include those for married couples and dependent children. Additionally a separate disability benefit is provided on top of the AHV/AVS. Contributions to AHV/AVS remain comparatively low when comparing Switzerland to countries like France or Germany. Both employers and employees are required to contribute 4.20 percent to the AHV/AVS social insurance program.
Many countries' pay-go retirement programs are facing growing deficits. Switzerland's AHV/AVS is similarly experiencing this trend. In 1998, expenditure by the first pillar rose by 3.5 percent compared with contributions that at the same time rose by only 1.3 percent.4 While the AHV/AVS is a pay-go system, a fund has been established called the Ausgleichsfonds that is theoretically aimed at generating earnings that will cover annual payments. In 1998, the fund's assets equated to FR 24.2 billion (Swiss) (U.S.$15.02 billion), with a return being generated in the first year of performance-orientated investment of 8 percent.
Like the recently established Canadian Pension Plan Investment Board, the Ausgleichsfonds maintains a conservative investment strategy, with 89 percent of assets being held in loans and bonds. Equities represent only a small fraction of the total portfolio, with 8 percent being invested in these assets in 1998. It is anticipated that with a more "liberal" investment policy, this overall investment level will increase. Investment in foreign equities is largely still not an option for the Ausgleichsfonds. In the case of similarly managed public pension funds internationally, external fund managers are partly responsible for the bond and share investments of Ausgleichsfonds.
Switzerland, Australia, and Chile remain the only three countries in the world that have mandated contributions by employees into pension funds in the second tier of the first pillar. The concept of compulsory occupational pension plans was adopted in Switzerland following a referendum in 1972. It was not until January 1, 1985, that the implementation of compulsory pension legislation (BVG) took place. Such legislation has had a profound impact on the retirement structures and provisions found in Switzerland.
Under BVG, all employees who are covered by the AHV/AVS system and who have earnings in excess of FR 24,120 (Swiss) (U.S.$14,614) are required to contribute to privately administered, compulsory occupational schemes. Both the AHV/AVS social security pension system and BVG interact closely in generating an approximate replacement rate of 60 percent for the worker. The maximum AVS pension is equal to at least 60 percent of earnings for a single person with annual income in 1999 of FR 24,120 (Swiss) or less. However, in the case of a person with an annual income three times that level (FR 72,360 (Swiss)), the maximum AVS pension is only about 35 percent of pay. The BVG legislation is intended to fill that gap. The combined AVS and BVG benefits replace 60 percent of annual earnings for a person with an annual income of FR 72,360 (Swiss)--but the replacement ratio tapers off for those with an income in excess of that amount.5
All pension plans that operate under the BVG system in Switzerland must be established by and function through a foundation (Stiftung/fondation). Like in Australia with its trustee structure, the foundation (similar to a trust company) is a legal entity that is separate from the sponsoring company. A collective foundation may be established for employers with a small number of employees rather than each small employer setting up a separate foundation. Such foundations receive compulsory contributions under BVG legislation from both employers and employees. These contributions vary according to age, from 7 percent (male, age 25-34) to 18 percent (male, age 55-65) of covered pay between FR 24,120 (Swiss) (U.S.$14,614) and FR 72,360 (Swiss) (U.S.$43,842). There are additional contributions of 2 to 4 percent for survivors and disability insurance, 1 percent to allow for the indexation of benefits, 0.02 percent for the security fund, and 0.2 percent for administration.6 Employers are required through the legislation to pay at least 50 percent of the contribution, with many paying a higher level for senior executives or valued employees. In summary, BVG legislation mandates minimum levels of supplementary coverage of all employees with annual earnings of at least FR 3,015 (Swiss) (U.S.$1,827) above the previously stated ceiling of FR 24,120 (Swiss) (U.S.$14,614). This arrangement under BVG legislation provides an offset to the AHV/AVS details contained in the first-tier pension requirements.
At the end of each calendar year, the assets accrued for each employee's pension account will be increased by a minimum of 4 percent along with contributions during that year. Higher returns can be credited, but under these regulations the member's pension will not be impacted during a period of economic downturn. In effect, a prescribed guarantee is built into the BVG retirement system concerning the minimum rate of return along with a minimum annuity conversion factor of 7.2 percent for accumulated retirement assets.
While the BVG system is effectively defined contribution (DC) based, many of the benefits actually paid exceed the minimum requirements and are formulated on a defined benefit (DB) basis.7 Equally a separate BVG security fund guarantees minimum retirement credits by extending coverage to DC as well as DB plans. These guarantee arrangements are unique among OECD countries.
"With an estimated FR 435 billion (Swiss) (277 billion euros) in pension assets as of June 30, 1998, Switzerland has the second highest private pensions market in Continental Europe (along with Germany and after The Netherlands)."8
Yet the regulations surrounding BVG funds are both complex and restrictive, especially in relation to the investment of pension assets. These restrictions effectively see investments minimized in equities, especially those outside Switzerland. In its simplest form these restrictions allow up to 100 percent of the fund to be invested in cash and Swiss franc bonds. With specific reference to bonds, pension funds can invest up to 30 percent in Swiss franc bonds from foreign issuers and 20 percent in foreign currency bonds. In terms of property, a 50 percent limit in Swiss property applies along with a 30 percent limit in Swiss equities. Finally, pension funds can only invest a maximum of 25 percent in foreign equities and just 5 percent in foreign property.
On January 1, 1995, ten years after the introduction of the compulsory BVG system, federal law was introduced that would have implemented full vesting and portability for pension plans. The fallout from such legislative initiatives has seen the diversity in pension fund arrangements narrow in Switzerland. Most plans fall into two categories: 1) final (average) salary defined benefit plans and 2) cash balance plans.
With the introduction of the new vesting laws, "most older-style defined benefit plans with age-related accrual rates have changed to a single accrual rate."9
Cash balance plans are often referred to as "defined contribution" or "BVG type" plans. Retirement benefits for employees participating in these plans are determined by the accumulation of a percentage of salary, which is usually related to age and the interest that is credited by the pension fund. As an aside, the reforms announced in 1995 also made provision for individuals to withdraw funds from their pension plan to purchase residential property.
As indicated previously, many BVG plans resemble, from a technical standpoint, defined benefit plans in that the pension plan as a whole bears the risks of longevity, investment guarantees, and risk benefits. Defined contribution plans, as seen in "Anglo-Saxon" nations, such as Australia, Canada, the United States, and the United Kingdom see investment returns being directly linked to employees' retirement benefits. Generally, these plans are not found in Switzerland.
While there has been significant growth in BVG funds, Switzerland has continued to maintain non-compulsory, second-pillar retirement funds that are sponsored by employers. These funds, like those under BVG legislation are organized through a separate legal structure known as a foundation or a cooperative society. Such second-pillar plans may interact with the compulsory, second-tier benefit through contributions that are above minimum funding requirements. Alternatively, the employer may set up a second pillar plan that is autonomous of the BVG legislation.
Individual personal savings products offered via a financial services entity such as a life insurance company provide Switzerland with a small but elaborate third pillar. These products are not only tax-advantageous up to a certain limit for the individual but also portable and flexible. Product growth in this pillar reflects changing savings and lifestyle patterns.
In conclusion, Switzerland has developed a highly intricate retirement system. This retirement system provides extensive coverage through retirement benefits in both the first, second, and third pillars. Moreover, Switzerland remains one of the few countries in the world that has introduced elements of compulsory retirement saving into the second tier of the first pillar. Yet this policy initiative is balanced by a strong propensity towards nurturing pay-go principles under an extensive social insurance program.
David O. Harris is a Research Associate and Consultant at Watson Wyatt Worldwide.
6. Suzanne Doyle, John Piggott, "Mandatory Annuity Design: A Preliminary Study," Revised version of a paper presented at the Society of Actuaries Conference, "Retirement Needs Framework," Orlando, Florida, December 1998, University of New South Wales, Sydney, Australia, February 1999, p. 6.