Comparing Pillar 2 to bonds

Investing / Portfolios
1

When talking about doing buy-ins in the second pillar most of the pros / cons are clear to me (lower return vs income tax rate advantage, etc.), but one thing that keeps popping over and over are folks saying something along the line of “I would dedicate a certain portion of my portfolio to bonds anyway so I just consider my pillar 2 as bonds”, and I can’t understand why would that be the case, so hoping to get some clarifications here and to see whether I am missing something :slight_smile: I mean, of course I understand that it has lower average return than stocks and less volatility but I feel like it’s just kinda smoothed out by the funding ratio management.

The way I see a pillar 2 pension fund is that there is an investment portfolio of some sort (some stocks, bonds, real estate etc.). So overall the return that one would expect to see is the return of such portfolio in a normal brokerage account, with some differences:

  1. The pension funds has a funding ratio, so basically a stash of gains it keeps when the portfolio does well and then pays out from when the portfolio does poorly. So there seems to be a perception of lower volatility, but ultimately this seems more of a accounting trick. If the funding ratio of the fund stays on average the same during the time one is invested - this effect basically cancels out, right? The two ways to get a higher-than-porfolio performance over the long term thanks to this effect are either:
    1.1 the funding ratio decreases over time (so you basically cover part of your losses with gains of people who were in the fund before you). But it might as well increase, so this seems to be a ~0 expected gain situation
    1.2 the fund goes underfunded and it must be extra-funded. But as far as I understand in this case the employees might also be required to extra-funded. It seems that there are some cases where only/mainly the employer would pay, but it’s not very clear to me
  2. There is some transfer of wealth because of the pension conversion rates being too high, so some of the earning are effectively used to cover the pensions of the current retirees

Since SNB rate is 0% we know that there is basically no way to earn anything in CHF with a very low risk profile. So at this point, what is the reason for seeing pillar 2 as some magic low-risk but somewhat good return instrument? Is it 1.1, 1.2 or something else?

2

What you describe in 1 is basically the fund taking on the risk for you, and why it’s much better than doing the same portfolio yourself.

Due to regulation it’s more or less guaranteed your pot won’t lose value (a lot of things would happen before you’d take a haircut, and the employer would pitch in as well).

Then it can take a lot more duration of liquidity risk (can have non liquid assets like RE, which in your own portfolio would be either highly concentrated and illiquid (if owning a place) orbe subject to market whims with high vol and premium /discount(through funds)).

Thanks to the reserve a pillar 2 is more likely to return the X% average expected from it’s allocation as return are smoothed. (Less sequencing risk)

And for 2: check your own fund my current fund (axa invest) has fairly minimal redistribution (going either way, when fund performs well, retirees lose out)

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3

I think the perception on this matter might differ from people who ever only got the minimal mandatory interest rate distribution (or close to it) in recent-ish history and people who have had meaningful distributions coming from their pension fund.

A stock is a participation in the profits of a company, with a participation to the decision process (voting share).

A bond is a contractual obligation from the company to pay a said amount at said interval of time for said duration and pay back said amount of money when it matures. If the issuer fails, you are paid before stock holders.

I feel that pillar 2 is somewhere between a corporate bond and government bonds, due to the heavy regulation and oversight they are submitted to. They’re not 100% safe but they’re safe-ish.

Technically, what you hold from the pension fund is an obligation to pay you (or your spouse/partner/child) said amount of money for said period of time if said set of circumstances happens. It is more bond-like than stock-like behavior for me.

For those with low variation yearly interest close to the mandatory part, it also feels more like bond interest than stock dividends: the pension fund can’t slash them (unless under extreme duress) and is contractually obligated to find a way to pay them. They’re not tied to the performance of the pension fund’s portfolio as those people seldom to never get to participate in the upside of the portfolio.

For those who have more participation in the upside of the portfolio, that could be considered a bonus on the mandatory interest rate giving the second pillar mostly bond-like behavior with some part behaving more like a stock.

Your observations seem right to me (I’m not expert) though it’s very rare to have pension funds require adjustment measures that cut into the participants benefits, due to regulation (other steps would have to be taken first) though, of course, said step can inclue de reduction in the interest distributed if they’ve been over the mandatory amount and a reduction in the conversion rate for future pensioneers. So some conditions are set but some benefits are not set in stone and can be adjusted to preserve the funds’ ability to fulfill it’s basic obligations.

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Theoretically, using the modern portfolio theory framework, your pension fund is different from bonds because it is highly correlated with stocks. Well, at least mine is.

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I think people say “I consider my 2nd pillar as bonds” because they want to have 100% stock portfolio in their direct investments. Maybe assuming 2nd pillar as bonds helps them feel comfortable.

In reality 2nd pillar money is locked until retirement so cannot fund capital needs at short notice (only allowed for few things) and cannot be used for rebalancing.

Thus 2nd pillar should be part of net worth calculation but I think considering it as part of portfolio is academic. For practical purposes the investor need to deal with 100% of risk & return of their direct investment portfolio.

For me 2nd pillar is actually kind of savings account. At the end of every year, you get interest and your pot is protected. Next year same thing happens and so on. How that interest comes is not really relevant because it doesn’t impact you.

Now if you have 1e that’s a very different story and it’s exactly like 3a.

P.S -: I like 2nd pillar and add even voluntarily. I just consider in my asset allocation calc when estimating risk of my portfolio

6

I have a very significant pillar 2a and totally considers it as bonds, with huge benefits. In my case, return cannot be zero and return averages 5%. So a safe investment with return (past performance) - golden. Add to that the 30+ % tax savings on volunteer contribution and you have an absolute no brainer. Also tax shield from wealth tax, a huge post in my budget. 2a allows me to go 100% stocks for rest of my investments

You say 2a not totally safe. Neither are bonds, actually. Debt/GDP for US >120%. In my case co is doing very well financally, finding ratio is good. So I am worried about many things but not that

Note I am months - <3 years from RE. I only built 2a once I was FI in stocks. If I was 30 and starting out, I would not contribute to 2a (yet), unless I would make >250k (unlikely)

7

You’re not wrong in your assessment from a fund’s perspective, but I’m looking at it from a different perspective.

Stocks and bonds are just means to an end. Many investors would aim for a mix of something risky with high expected returns, and something stable for, well, stability and wealth preservation. That’s, as you wrote, what pension funds are doing, as well. Bonds could be in either bracket, e.g. Swiss Government vs. junk bonds, but I guess people mean the safer part when talking about stock vs. bonds.

However, for me as insured person, I am getting a pretty predictable and even regulated return and my asset balance doesn’t suffer from market movements. So that’s basically what I would expect from the stable part of my savings, e.g. from something like bonds, money market or saving accounts.

And while I can’t use the assets for re-balancing, I could eventually take it out. I can also use it to pay off my mortgage, which in my logic is similar to a 100% guaranteed return.
A low one, at current interest rates and tax rules, but still more then a government bond or saving account would yield. Not really a return, but avoiding a negative interest arbitrage.

Anyway, our pension funds had a base return of some 2% in the past years, with some 5-10% in between, when the funding ratios exceeded the defined upper limits. Stocks did better, on average, but for me that’s not too bad compared to other safe options, and that’s not even accounting for tax savings on buy-ins :wink:

Long story short, it’s not magical, but fits at least my criteria for that part of my asset allocations and results are fine for now.

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8

I would say it depends on your reason to have bonds. If you want them so your net worth doesn’t drop as much in a crash, so you’ll feel better and are more likely to stay the course (i.e. not panic-sell), pillar 2 can be considered as bonds, or more precisely the stability/low-risk part of your portfolio.

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9

Sometimes likened to bond as it has a bond-like return in that:

  1. The principal is expected to be returned except in the case of catastrophic default
  2. Return is small and fixed e.g. 1-2%

In fact, the Pillar 2 is almost like a bond+

Because in addition to the bond like returns you also have:

  1. Potential for much greater returns
  2. An option to convert into an annuity at extremely favourable rates
  3. A tax advantage on contribution and while held in the pension wrapper
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10

Thanks everyone for the inputs.

Since there are many messages with similar points, if I may to try to group and summarize several arguments there is a consensus around something like “stocks, bonds etc. are whatever inside the pillar 2 and it does not matter much, as what matters is how the fund behaves externally: it is basically guarantees not to loose value and pay decent interest (mostly small but also potentially high in good years, so decent on average), does not matter how they do it”.

And I still do not get this point: I do want to know how they would do it :slight_smile: I understand that the volatility of the pillar 2 fund is much smaller than an all-stock portfolio, simply because they don’t keep all funds in stocks. But it seems like folks expect a return-to-risk ratio that can not be achieved individually by an investor, and it’s not clear to me how is that possible? Currently the risk-free CHF return is 0%, since pillar 2 promises to return something (and they do return) - they are clearly taking on a certain amount of risk. They use the overfunding stash to smooth the returns, also clear - but this is no magic bullet, it’s just hiding gains of one year from you to only show them in bad years. If the long-term return of their portfolio will be negative the overfunding money will run out eventually. So if the risk of the portfolio dropping down is really almost non-existent and returns are there, who is bearing the extra risk? Who is gonna pay if the long-term returns are bad?

Several people mention regulations and “many things would need to happen before”, I’d be curios to understand more. As far as I know the insurance is there only for the mandatory part (which is small and irrelevant for buy-in decisions cos they go into the non-mandatory part) and if the fund goes under employees also need to pitch in. So why wouldn’t we expect the fund to have the same probability of going under as we’d have with a similar portfolio privately?

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Wouldn’t this necessary come from reduced investment gains during your career to pay the extremely favourable rates to the current retirees? Of course if one avoids pillar 2 contributions to such a fund for most of the career and then joins one at the end - it’s great, but on average I’d expect these things to average out

12

My understanding, as a layman, is that there are 3 main parameters that would explain pension benefits having better risk adjusted returns than other investments available to an individual investor:

Tax benefits
Those occur outside of the fund, for the participant who can deduct their contributions but also inside of the fund as they have access to tax advantaged vehicles, in particular regarding withholding taxes, that non-pension vehicles would not have.

Risk mitigation for the individual participant
Other actors would step in if things start getting fishy, splitting the risk among different actors while the benefits go mostly to the fund participants (and the fund managers).

Ultimately, the Guarantee fund can step in and cover benefits for up to 1.5x the maximum salary (the cap being a salary of 136’080.- in 2025, so benefits that come for someone with such a salary would be covered, benefits for someone with a 150 kCHF salary would be capped as if they had a 136’080.- salary): Insolvency benefit cases | LOB Guarantee Fund

I’ll let other people develop that point as we have people with way better knowledge of the system on this board than I can hope to achieve.

Scale
Particularily on the Swiss real estate market, pension funds can scale their investments way beyond what an individual investor could. Building several complexes at once with standardized appartments and an ability to negociate good contracts is a definitive advantage for them.

The scale effect would also apply to investments in other financial assets as they can negociate better rates (for example for access to funds and/or fund management and/or forex) and could have access to some investments to which an individual investor could not. This is a double edged sword as they are also limited in how and in what they can invest while an individual investor would have much more freedom.

They probably have other advantages when it comes to financing and the type of assets they have access to which I don’t really know of.

Caveat
I do think that the caveat that you point is indeed real in that, we tend to consider pension funds as being on the guarantee of return of capital level of government bonds while they’re probably somewhere between corporate bonds and government bonds, with actual credit rating equivalent varying depending on the pension fund.

Part of the excess returns probably do come at the price of excess risk.

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It’s just the magic of pooled investment on a long term (indefinite end) vehicle (with regulatory guarantees). It’s a lot less volatile than anything that could be achieved individually.

Yes it’s not risk free in the sense of bond investment, but over decades a balanced portfolio hasn’t lost money which is why this is sound and the capital can be guaranteed.

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14

In a worst case: political / public pressure, employer pitching in etc.
Maybe you need to specify your question.

In the normal world, illustrative case study: 40 years of contributions, 20 years of 5% pensions, no re-distributions.

I guess a mixed portfolio can manage to do that, even in a low interest environment. I can’t be bothered to do the math right now, but it doesn’t feel to challenging.

Yes, you could do the same by yourself. But you don’t have a choice if you are an employee. And it kind of works. And there’re tax savings. :rofl:

15

Yes. That’s why the pension fund earns large returns but pays us only 1-2%.

Also the employer may also be pressured to step in to make good any shortfalls.

16

In some companies if coverage ratio falls very low, the company itself fund it via lumpsum payments.

If I try to understand your question, it seems to me that you don’t quite get how pension fund is able to generate the minimum return and capital guarantees.

I think it boils down to -:

  • experience
  • Portfolio management
  • Pooled resources
  • Ability to smoothen return profile
  • Long term horizon

For example -: if you put your money 1/3 in stocks, bonds & real estate. And let’s say average yield of real estate is 2.5%. This gives you 0.825% every year only from rental yield of 33% of the portfolio. Add to that dividends & coupons and you should be able to get to BVG min rates. Stocks will add to growth and bonds will add to stability.

People often think fund manager don’t know anything but they do know.

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17

During the negative interest phase, I’ve seen pension funds with 20% or less in stocks and 30% or more in bonds… and then you look at the interest history and it has been the mandated minimum for years :clown_face:

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Did the funds achieve their commitment ? Most likely yes

They are not trying to maximise returns like individual portfolios.