Funding ratio of pension funds

When it comes to a pension fund’s financial health, the funding ratio is a key financial indicator. What does it actually involve? This guide contains everything you need to know about pension funds’ funding ratios.

What is the pension fund funding ratio?

The funding ratio provides information about a pension fund’s financial situation. Within the context of OPA, the funding ratio is thus one of the most important and well-known metrics for evaluating a pension fund (Pillar 2): It corresponds to the ratio between the pension fund’s available assets and its obligations towards its active insureds (active contributors) and pensioners. Essentially, the following applies: The higher the funding ratio, the better. A general guide is that 100 percent must be reached or exceeded.

What is overfunding?

If the assets of a pension fund exceed its obligations, the funding ratio is more than 100 percent, and this is referred to as overfunding. This means that the pension fund has set aside reserves and can distribute future profits, particularly investment profits, quicker to insureds , e.g. in the form of higher interest.

What is underfunding?

If there is a shortfall in coverage, the obligations of the pension fund are higher than its assets – the funding ratio is less than 100 percent. The pension fund must analyze the causes of the underfunding and implement restructuring measures if the underfunding is structural and if it is not possible to return to a funding ratio of (above) 100  percent in the medium term without measures. Foundations with a full insurance model cannot become underfunded. This is because both pension assets and obligations are completely outsourced to an insurance company that bears all the risks.

But to be able to compare pension funds’ funding ratios, you first need to know how they are calculated.

How do you calculate a pension fund’s funding ratio?

The funding ratio of a pension fund is calculated as follows: 

Assets divided by payment obligations, multiplied by 100

The assets include all of the pension fund’s assets (e.g. credit balances in accounts, equities, bonds, real estate, alternative investments) at current market value. 

The obligations of an occupational benefits institution in turn include:

1. the retirement assets of insured contributors
2. the actuarial reserves of current pensions
3. technical provisions

1. Retirement assets of active insureds

Active insureds are entitled to the retirement assets they have saved (also referred to as vested benefits) in their pension fund. On reaching retirement age, the capital that has accrued over the insurance term serves to finance retirement benefits (in the form of a pension, a lump sum or a combination of the two). The capital belongs to the insured and follows them in the form of vested benefits if they leave the pension fund before reaching retirement age (e.g. following a change of employer). In addition, insureds can have their capital paid out in legally defined cases (e.g. If they become self-employed, as part of the promotion of home ownership program or when relocating abroad).

2. Actuarial reserves for pensions

Actuarial reserves are the total amount that a pension fund must set aside at the current time in order to continue funding in the future the pensions that are already being paid out. This takes into account life expectancy, the technical interest rate and the pension amount.

3. Technical provisions

Technical provisions are financial reserves for all additional payment obligations that are foreseeable today, or that the pension fund expects in the future. For example, because the actuarial reserves for current pensions have to be revalued and increased due to falling interest rates, or because the retirement assets saved up by the insured when they retire are insufficient to fund the pension – leading to retirement losses.

Technical interest rate and funding ratio

If you want to compare the funding ratios of different occupational benefits institutions, you must also take a closer look at the respective technical interest rate.

What is the technical interest rate?

The technical interest rate is a mathematical interest rate that a pension fund uses to calculate how much capital it needs today to pay out future pensions. This is therefore not the interest rate that is used to pay interest on retirement assets. The technical interest rate should reflect the pension fund’s expectations for long-term returns, its risk capacity and its structure.

How does the technical interest rate affect the funding ratio?

The technical interest rate has a direct impact on the funding ratio because the actuarial reserves that are formed for current pensions depend on it. if a pension fund works with a higher technical interest rate, it is expecting higher investment returns accordingly. These additional revenues reduce the actuarial reserves to be set aside (the pension fund must therefore provide for fewer reserves today in order to fund pensions). So the obligations of the occupational benefits institution decrease while the assets remain the same: The funding ratio rises.

Pension funds should be cautious in setting the technical interest rate so that the assumed returns on the financial markets can actually be achieved with low-risk investments.

If a pension fund assumes a technical interest rate of 2 percent, it should also be able to generate a return of at least 2 percent over the next few years. 

Who determines a pension fund’s technical interest rate?

The technical interest rate is based on the specifications of a pension fund expert. This takes into account not only the expected net return based on the investment strategy, but also, in particular, the structure of insureds, e.g. the proportion of retirees. The defined technical interest rate can therefore vary from pension fund to pension fund. The board of trustees ultimately decides on the technical interest rate based on expert recommendations.

When comparing the funding ratios of different pension institutions, you should always take a look at the technical interest rate.

Compare pension fund key figures

There are a few things to bear in mind when comparing pension funds’ key figures: The funding ratio is one of the most important metrics when assessing a pension fund or collective foundation. However, it’s only a snapshot – and the funding ratio depends on a number of factors. For this reason, it should never be looked at in isolation.

In addition, there are a number of other dimensions that are of great importance for an assessment of a pension fund, but are not reflected directly in the funding ratio, such as

• the age distribution of the insureds
• the proportion of retirees
• the ratio of mandatory to extra-mandatory retirement assets
• conversion rates
• the investment strategy of the occupational benefits institution (including required target return)
• the risks covered by an insurance company
• the interest paid on retirement assets in recent years

If, as an employer, you would like to choose the right occupational benefits for your employees, there are a number of factors to bear in mind. The annual financial statements published by every occupational benefits institution are a good starting point. They contain relevant information and key figures.