Transformation of Dutch Pension Funds
Within all EU member states, governments face the challenge of financing the rising cost of state benefits for a population that is living longer. For the Dutch government, pensions are a current focus with the introduction of the Financieel Toetsings Kader (FTK), a new financial assessment framework for pension funds. Concerns about funding levels and the need for improved governance prompted the Dutch Central Bank (De Nederlandsche Bank/DNB) to introduce a series of reporting and funding requirements in an attempt to ensure that pension funds will be able to meet their future obligations. The most controversial change will be the new solvency test that the FTK will introduce, together with mark-to-market valuation of the liabilities.
The radical nature of the FTK is reflected by the fact it was delayed by one year, from 1 January 2006 to 1 January 2007. Criticism and lobbying from the pensions sector was a major factor in the postponement as well as the tight timeframe in which to make the FTK law before 2006.
Under the FTK, lower yields mean the value of the liabilities increases as well as the value of the fixed income assets, though to a much higher extent, because the duration is longer (16-year instead of five-year on the asset side). The different sensitivity is also due to the fact that, on average, 50 per cent of assets are invested in bonds, while the liabilities have a fixed income character for the full 100 per cent. As a result, with the FTK, cover ratios are low when interest rates are low, and that was the concern about meeting the solvency test requirements considering last year’s level of interest rates.
In addition, Dutch pension funds were also concerned about the FTK’s requirement that if the cover ratio drops below 105 per cent, a pension fund has a recovery period of just one year. This would be difficult for most funds to achieve as it could mean doubling pension contributions in order to meet the requirement.
Last year, until the Q3 of 2005, long-term yields declined so the value of liabilities increased and cover ratios declined further. As a result, pension funds bought more fixed income products, which brought loan rates down even further – this is the solvency trap. Since the end of 2005, there has been a reversal whereby long-term rates have increased, which has increased cover ratios. The equity markets also performed well in 2005. The performance of the financial markets has helped pension funds to adjust to the new requirements of the FTK as the cover ratio increased from 122 per cent (mid 2005) to 128 per cent (Q4 2005).
With interest rates increasing, a January 2007 implementation date is now a realistic goal. Despite its postponement and initial criticism, the FTK is more in tune with market reality and marks a significant change in the way Dutch pension funds will behave and function in the future.
The FTK combines an annual solvency test and funding framework.
The combined effect of these two elements is the need to close the duration gap between the fixed income assets (five-year) and liabilities (16-year) of Dutch pension funds. Many pension funds will not be able to show that the value of assets matches the value of liabilities on a one-year horizon with 97.5 per cent probability. These funds will have to change their portfolio to hold ultra long-term debt in order to meet the solvency requirements. This will affect an estimated €250m in fixed income assets and has already lead to a considerable flattening of 10-year to 30-year curves across Europe.
Traditionally, cover ratios were calculated assuming a 4 per cent discount rate on nominal liabilities. Dutch pension funds experienced a mis-match in assets versus liabilities under the old model following the decline in interest rates and equity markets that started in 2000. The movement in market yields did affect the value of assets and the ability to meet liability commitments but, because of the static way liabilities were calculated under the old model, this mis-match was often hidden.
Based on data from the DNB on the average Dutch pension fund, Rabobank has found that the actual (risks) coverage fails to meet the coverage required, which means that many Dutch pension funds would find it hard to meet the necessary cover ratios under the FTK.
The cover ratio is the value of the assets as a percentage of the value of the liabilities. Therefore a 105 per cent cover ratio means that there is a surplus of 5 per cent. The higher the risk level of assets, the higher the mismatch between assets and liabilities and therefore the higher the required cover ratio. By reducing this mismatch, the required cover ratio will also be reduced.
The new risk-based solvency test under the FTK determines how much equity, or equity buffer, a pension fund needs to have based on its asset mix. For example, if it had a fund with 50 per cent equity in bonds and 50 per cent equity in stocks, the formula determines how much the fund needs in terms of the cover ratio. If a pension fund doesn’t have enough solvency based on its asset mix, it has up to 15 years to reach the target funding level. The only way to achieve this is through a combination of reassessing the investment policy, increasing premiums and contributions, and reducing benefits.
This impact on the investment policy of pension funds will affect the Dutch economy as a whole. If pension funds increase their premiums it will dampen growth within the Dutch economy.
The most important risk drivers in the solvency test are equity and interest rate risks. As mentioned before, the FTK will have a significant impact on the investment policy of Dutch pension funds which are inclined to use a combination of re-weighting asset mixes and duration hedging. One of the ways to reduce the amount of equity needed according to the new model is to close the duration gap between the fixed income portfolio and liabilities. This will be a focus area for Dutch pension funds going forward – reducing the duration gap between assets and liabilities.
Pension funds have to maintain a margin for interest rate risk, which is calculated as the net impact of changes in interest rates on the assets and liabilities. As discussed earlier, the average Dutch pension fund has much higher interest rate sensitivity on the liability side (average duration of 16-year) than on the asset side (average of 50 per cent fixed income products with a duration of five-years). This is because the higher value of liabilities will outweigh the higher value of the fixed income securities on the assets side. As a result, under the FTK, lower interest rates are an unfavourable scenario in meeting the required solvency.
According to Dutch pension funds, the new model focuses on short-term risks while their liabilities are actually long term. Many feel that the FTK is forcing them to hedge short-term risks while they could be beneficial over the long term. In addition, the FTK favours bonds over equity even though equity would provide a higher return over the longer term. Dutch pension funds will have to take a closer look at short-term risks and this could be detrimental in the long run.
Another concern is that the present valuation of the liabilities will result in a higher volatility of cover ratios, which will impact balance sheets. In fact, for listed companies with pension funds, the International Financial Reporting Standards (IFRS) have also introduced market-based valuation of assets and liabilities. This has resulted in the transformation of pension funds from a system of defined benefits to a system of defined contributions thereby shifting the risk from the pension fund to the contributor. With IFRS, cover ratios are expected to show volatility in pension fund and company balance sheets.
The FTK, which combines present valuation for liabilities and solvency ratios, means that pension funds will have to close the duration gap between fixed income assets (five-years) and liabilities (16-years). Managers can either extend the duration of assets therefore resolving the mis-match, or change their asset mix to achieve the required ratio.
A further strategy to help comply with the FTK is a swap overlay strategy, which would also increase interest rate sensitivity on the asset side. By entering into a swap agreement, pension fund managers can receive a fixed long swap rate and pay the floating leg, which reduces the duration gap versus liabilities by raising the interest rate sensitivity on the asset side. This could reduce the interest rate risk to zero and cause the required cover ratio to drop significantly.
Last year, the interest rates were so low that many pension funds used a swap-overlay strategy as well as swaptions. The product characteristics of swaptions are different from a swap as with a swap the interest rate for the upcoming period is fixed but with a swaption the pension fund has the right, and not the obligation, to enter into a swap agreement. If the interest rates increase with a normal swap the cover ratio would not benefit but with a swaption there is potential to benefit (though the parties pay a premium for it).
The advantage of using swaps and swaptions is that they leave current investment policies intact and can offer the ability to enhance earnings by profiting from curve steepness and with a larger equity portfolio – as long as the risks are managed and mitigated effectively.
According to the DNB, Dutch pensions will become ‘safer’ and the requirements of the FTK will increase the probability of contributors having a sufficient pension fund when they need it, although pensions will become more costly. Mark-to-market valuation has heightened the awareness of Dutch beneficiaries who are looking into the valuation of their funds and solvency.
The FTK will also force pension funds to take a closer look at their asset and liability management. For example, funds increasingly realise that liabilities are a more natural benchmark for assets than market capitalisation. Funds will become more sophisticated investors and pay closer attention to their risk budget allocation.
There are currently 800 individual Dutch pension funds and, with the introduction of the FTK, there will be consolidation in the market. The regulation will require substantial administrative and technology investment for smaller pension funds, which will encourage them to merge with larger funds to cover the cost of complying with the FTK.
In addition, the introduction of the fair value of liabilities is a positive trend because the previous model of the fixed discount rate was not an accurate reflection of actual interest rates or hidden surplus or deficits. Fair value will make pension funds more aware of the actual risks they are facing and as a result lead to more transparency.
Even without IFRS or the FTK, pension holders are aware that market valuation of assets and liabilities is the right choice with the global shift towards market valuation.
The Dutch pensions market is in transition with new developments in tax (e.g. VPL – the new tax legislation), funding and accounting. These changes, as well as the FTK, are necessary for pension funds to realistically meet their obligations to beneficiaries. Present valuation of liabilities is a much sounder evaluation of solvency than using a 4 per cent fixed discount rate for liabilities, for instance.
Rabobank believes the FTK need not be considered a burden for pension funds but an opportunity for fund managers to reassess their portfolios and become much more knowledgeable and sophisticated investors.