In response to the improvement in coverage ratios over the past year, an increasing number of Swiss pension funds are contemplating their investment approach given the breadth of macroeconomic challenges ahead. In fact, uncertainty around the future path of the US Federal Reserve’s rate decisions has dominated headlines of late. And one of the most important questions for investors today is whether interest rate cuts will come fast enough, amid stickier-than-expected inflation, to bring about a “soft landing” for the global economy.
Against this backdrop, our analysis shows that gold is uniquely placed to play an important diversification role in pension fund portfolios, not just in the current environment but over the long term too. Our analysis suggests that gold can help pension funds mitigate a key risk – uncertainty in their ability to pay pension benefits.
Gold achieves this by:
In the past few years significant changes have occurred in financial markets, contrary to expectations that conditions might stabilise following the volatility and turmoil witnessed during the global pandemic. Instead, geopolitical tensions have exacerbated already rising energy prices, driving inflation to levels unseen in Switzerland for two decades. This has abruptly ended the unprecedented period of low interest rates that had persisted since the last global financial crisis 15 years ago.
While this is a simplified view of the macroeconomic factors at play, the reality is that Swiss inflation surged – albeit less than in other developed economies – compared to recent history, and bond yields increased by around 1.5%. Chart 1 illustrates these developments over the past decade.
Against this backdrop we saw a significant dip in pension fund asset values in 2022. In fact, 2022 was particularly challenging since bond and equity valuations decreased simultaneously. According to Complementa’s “Risk Check-up” report,1 the average coverage ratio that year dropped from 115.3% to 104%. And while the picture improved in 2023 and has done so far in 2024 with the average coverage ratio estimated to have reached 112% by the end of June, it is important for pension funds to seek to maintain recent gains. This is especially so as worries surrounding the global economic environment continue to mount, geopolitical risk is on the rise (Chart 2) and the recent inflationary flare-up shows the shortcomings of government bonds as a diversifier.
Indeed, the correlation between bonds and equities remains positive, undermining the value proposition of fixed income as a portfolio diversifier. This has resulted in Swiss government bonds contributing a much larger share of total portfolio risk, i.e. around 30% in a balanced portfolio (Chart 3). It is important, therefore, to have assets that can help in this scenario rather than relying solely on government bonds as a diversifier.
Our analysis shows gold is a clear complement to equities and broad-based portfolios. A store of wealth and a hedge against systemic risk, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet short-term cashflow requirements in times of market stress.
Effective diversifiers are sometimes hard to find. In fact, many assets become increasingly correlated as market uncertainty rises. Gold, however, is different in that its negative correlation to equities and other risk assets increases as these assets sell off (Chart 4).
With few exceptions, gold has been particularly effective during periods of systemic risk, generating positive returns in eight of the ten worst years of performance for the Swiss equity index (Chart 5). In each of the remaining two years, gold outperformed the Swiss index, reducing overall portfolio losses.
Furthermore, investors have long considered gold a beneficial asset during periods of uncertainty. Yet, historically, gold has generated long-term positive returns in both good and bad economic times, outperforming many other major asset classes over the past 20 years (Chart 6).
The diverse sources of demand not only give gold a particular resilience but also the potential to deliver solid returns in various market conditions. Gold is, on the one hand, often used as an investment to protect and enhance wealth over the long term (counter-cyclical demand), but on the other hand it is also a consumer good, via jewellery and technology demand (pro-cyclical demand).
We have thus far outlined how gold can be an effective addition to a pension portfolio by providing diversification and contributing to long-term growth. Let us now illustrate how an allocation to gold can help reduce the reserve requirement and improve key risk metrics, i.e. volatility, value at risk (VaR) and expected shortfall. Improving these key metrics should help pension funds achieve their strategic objective: paying member benefits as and when they fall due.
Table 1 outlines a typical Swiss pension fund. The portfolio is split across equities, fixed income, real estate and other alternatives. According to Complementa’s risk check-up study, gold allocations – for funds that have an allocation – are between 1% and 5% of total AUM and fulfilled either through ETFs or a physical allocation. For modelling purposes, however, we assume the standard asset allocation has no gold in order to showcase the impact of adding the asset class.
Table 1: Asset allocation breakdown
| No gold | With gold | |
| Cash | 4.5% | 4.5% |
| Fixed income | 32% | 29.5% |
| Equities | 31% | 28.5% |
| Real estate | 22.5% | 22.5% |
| Other alternatives | 10% | 10% |
| Gold | 0% | 5% |
*Data as of 31 December 2023.
Source: Complementa, World Gold Council
The current reserve requirement framework is important. In fact, Swiss pension funds are required to maintain a reserve on top of the actuarial value of the pension claims they guarantee. The size of this buffer depends on the type of investments the pension fund makes, meaning a pension fund’s reserve requirement remains front and centre of pension fund managers’ minds when making asset allocation changes.
For the average pension fund without gold, the reserve requirement stands at 14.8% (Table 2). So in order to satisfy this target the fund should have a coverage ratio of 114.8% or above. The reserve requirement in our average portfolio is calibrated to give a 97.5% certainty on a one-year horizon; in other words, this implies that conformance gives only a 2.5% chance that the pension fund’s coverage ratio will drop below 100% in one year’s time.
Allocating 5% to gold, funded from a mix of fixed income and equities, could be an interesting option. The reserve requirement falls from 14.8% to 13.8% while the expected return remains broadly flat, leading to an increased return on reserve requirement ratio.
As a next step we look at the portfolio risk implications of adding gold to our average Swiss pension fund using Complementa’s proprietary risk model. Portfolio risk is measured using volatility, expected shortfall and VaR.
Once again, funding a gold allocation from both equities and fixed income may be a good option. The expected total fund return remains equal, while the portfolio risk is reduced. As a result the expected return-to-volatility ratio increases while VaR and expected shortfall fall (Table 2), illustrating that an allocation to gold can be a sensible and effective decision.
Table 2: Reserve requirement and risk properties
| No gold | With gold | |
|
Reserve requirement (97.5% confidence level) |
14.8% | 13.8% |
| Expected return | 3.3% | 3.3% |
| Expected volatility | 6.7% | 6.4% |
| Exepected shortfall | 14.4% | 13.6% |
| Value at Risk (VaR) | 11.4% | 10.6% |
*Data as of 31 December 2023.
Source: Complementa, World Gold Council
The reduction in risk comes from the diversification benefits gold brings to a portfolio. This is clearly identified by breaking down the contributors to VaR (Charts 7 and 8).
The improvement in coverage ratio levels over the last year and the breadth of macroeconomic challenges ahead may call for a sharper focus on risk management in Swiss pension funds. Funds that are focused on maximising outcome certainty will want to show a preference for an asset mix that meets return requirements while managing risk, therefore not overly increasing reserve requirements.
As demonstrated in our case study, an allocation to gold can help mitigate the key risk faced by pension funds – uncertainty in their ability to pay pension benefits.
Gold achieves this by:
Complementa’s proprietary risk model was designed for institutional investors. It is an asset allocation model and risk analytics tool to help institutional investors fine tune their strategic asset allocation processes and support investment decision making.
The returns are forward-looking estimates of total returns (in CHF, net of fees, nominal).
Return distributions in the tool are non-normal and fat tails are built into the tool assumptions.
Portfolio volatility is calculated based on copula functions (probability distribution functions). This takes into consideration that correlations between different asset classes are not constant over time.
The reserve requirement is based on stochastic simulation of 10’000 coverage ratio paths as well as the chosen asset mix, required return («Sollrendite»), confidence interval and reserve horizon.
Gold is modelled using Qaurum. The World Gold Council has developed a framework to better understand gold valuation. Our Gold Valuation Framework powers our web-based tool, Qaurum, which allows users to assess the potential performance of gold under customisable hypothetical macroeconomic scenarios. For the analysis, we have used an expected return of 2.3%, which is the average long-term implied gold return across the four pre-defined macroeconomic scenarios provided by Oxford Economics (4.7%) and adjusted down for changes in FX and implementation costs.
1 Complementa, a Swiss consultancy firm, annually conducts a comprehensive study on the status of Swiss pension funds:
https://complementa.ch/en/risk-check-up/
