With assets around some €2.8bn under management, Dutch scheme PNO Media, which represents 30,000 members across the Netherlands' media industry, may be small in comparison with some of its peers, such ABP and PGGM, but that doesn't mean it is any less innovative or meticulous in its operations - as its approach to liability driven investments testifies.


In essence all Dutch schemes now have to adopt a more aggressive liability matching strategy, where the liabilities become the scheme's benchmark, as a result of changes to Dutch pensions law. But some seem to do it better than others, and PNO is a perfect example.

The new law, known as the Financial Assessment Framework (FTK) effectively forces schemes to reconsider their strategy towards management of inherent risks.
With equity markets in decline, PNO says that by mid-2004, its solvency level was beginning to sound alarm bells. "Both the board and senior management judged the risk of underfunding to be unacceptably high. PNO Media already had a strong view that conventional asset categories would not be sufficient to achieve desired funding levels. The ideal strategy was defined as one that would offer the required risk reduction while maintaining a healthy upside potential," PNO explains.

This led to the scheme undertaking an advanced asset/ liability modelling study in conjunction with its consultant, Cardano. This led to new investments being introduced into the scheme's investment policy. "In anticipation of the FTK and what it would require us to do, this study led to us incorporating various derivatives strategies," says PNO.


Derivatives are fast becoming a technique few schemes to ignore because they help plug or hedge the liability matching gap that conventional fixed income products cannot. "The board approved a hedging strategy comprising two components," PNO begins. "The nominal interest rate risk we were exposed to was largely hedged by swaps, which virtually immunised the fund for interest rate fluctuations. Furthermore, protection against extreme equity risk was achieved by buying structured equity put options which allowed us to thus maintain the upward potential of the equity investments."

Using derivatives in the form of swaps to counter interest and inflation risk is not uncommon in liability matching solutions, but using them to counteract equity risk is. "We were the first European pension fund to implement a combined liability and equity hedge on strategic level based on an advanced ALM study," PNO claims.

PNO says once the board had decided to adopt a derivatives strategy to ensure PNO complied with FTK, the scheme wasted no time implementing it. "Close co-operation and short communication lines between the board, senior management and Cardano enabled both a swift but well-founded decision-making process and a rapid but adequate implementation of the strategy," the fund says. "The ALM study started during the third quarter of 2004 and at the start of February 2005 the derivatives strategy was successfully implemented, including finalised ISDA documents, the execution of transactions, the implementation of tools and procedures and setting up internal controls."

While many schemes grapple with how to find a suitable manager to take care of their derivatives, PNO has another trick up its sleeve. "A unique aspect of our derivatives programme is that PNO Media fully manages its derivatives strategy in-house," it boasts. This includes a full range of activities and services such as valuation, payments, unwinds and collateral management. But is much more than just a back office operation. "Managing the strategy not merely covers operational issues but also the active monitoring and dynamic adaptation of the strategy which moves and depends on both our solvency level and market conditions," it points out.

Developing its in-house capacity to manage derivatives was also helped by rising equity markets - even if at face value, this would seem strange, as rising equity values help the scheme's funding level without having to resort to changes like investing in derivatives. But what it does do, as PNO, point out is let the scheme take more risk. "Given the fund's medium-term view of rising interest rates, the interest rate swaps have gradually been over time - depending on solvency and interest rate levels - converted into ‘swaption collars', which are an alternative to forward swap contracts,"
the scheme says.

Every adjustment PNO made was based on research that considered both the fund's objectives and regulatory requirements. "Once the adjustments were approved, we were able to implement them very quickly since PNO had built up all relevant knowledge and experience in-house and the operations and controls framework was already fully in place," it adds.

But what has changed? "The ongoing risk monitoring and cost-efficient execution and operations management of the derivatives strategy has enabled PNO to convert itself from a scheme that was more or less underfunded into a scheme that now enjoys a high level of solvency. This has been achieved without taking any irresponsible risks, while continuously meeting the fund's objectives and regulatory requirements," PNO concludes.


Adopting a derivatives-led liability matching solution is no easy task. Before even contemplating derivatives, adapting the scheme to the concept of liability matching - whereby the liabilities become the benchmark and the scheme has to revalue its liabilities according to the value of bonds and not its assets - is hard enough as it requires a major rethink of risk and investments.

Where PNO has succeeded is in its determination to meet new pensions laws head on and be prepared for a smooth and seamless transformation. Having established a sophisticated and efficient in-house derivative management operation, it was able to use the derivatives inventively in other ways. As well as just hedging against inflation and interest rate risk to match liabilities, it has taken them to another level to hedge against equity market volatility and optimise returns from assets.