Zero coupon bonds as liability-based asset
The pension cover ratio is becoming more volatile with the introduction of market valuation for liabilities. To stabilise this ratio, the duration of assets will have to be increased by about 10 years. Zero-coupon bonds are the perfect instruments for doing this. Since they are scarce in the market, FundPartners is dedicated to develop such zero coupon bonds and has designed the first example - the Pension Bond 2025 - with a maturity of 21 years. Furthermore, zero coupon bonds can also be applied as a key ingredient for new hybrid individual pension arrangements.
In the Netherlands, change - for pension schemes - is all around. With major changes now taking place in the regulatory sphere, scheme administrators have to take a fresh look at how they adapt to the new parameters.
The fact that the laws surrounding pensions are changing is not unique. What is unusual in the current situation is that changes are coming both from the corporate accounting side and the angle of local pension law. And both share a central theme – the market valuation of pension liabilities.
The accounting change, under IAS19, contains two elements on this theme. The first is that pension liabilities, under the new international accounting standard, must be defined by market valuation. The second requires the converse of pension liabilities to be taken up in the financial statement of the corporate sponsor. Of course, this means that any volatility in the coverage of pensions assets will be felt in the corporation’s financials.
In local pensions legislation, there is a new Dutch pension law due to take effect in 2006. Under this law pension liabilities will have to be valued at market rates as well. This is a big change from the current practice that liabilities are valued at a fixed rate of 4%.
Whereas in the past the fixed discount rate for liabilities caused funding level volatility to be a direct result from volatility on the asset side, in the new environment liabilities explicitly become a second source of volatility. FundPartners has calculated that as a result of this the volatility of the cover ratio of pension liabilities for schemes in the Netherlands will increase by a factor of 1.7 based on the current average asset allocations of Dutch pension funds.
Clearly, schemes will have to take measures to stabilise the cover ratio. And as we see it, there are basically two options. Either pension schemes can switch from their current defined benefit systems to defined contribution arrangements, or they can try to stabilise the cover ratio by synchronising the volatility of pension assets with the volatility of their pension liabilities.
Although changing the basis of pension provision to defined contribution (DC) might technically solve the problem from the employer’s point of view, we don’t believe this is a feasible overall solution for the Netherlands. At least not in the way DC products are currently designed. As architects and engineers of pension solutions, we do believe that DC schemes designed as guaranteed horizon products combined with an individual financial planning tool could be a serious alternative. Especially for countries such as Germany, which are starting to build up funded pension schemes.
In the Netherlands however, most of the social partners want to stick to current defined benefit arrangements. When synchronising the volatility of pension assets with the volatility of pension liabilities, the duration of the liabilities are taken as a starting point. The duration is an indicator for the sensitivity of the valuation of the liabilities to changes in interest rates. The longer the duration the higher the interest rate sensitivity. Typically, the duration on pension liabilities is between 15 and 17 years whereas the duration of the (fixed income) investments is about five years. So, in order to stabilise the pension cover ratio, the duration of the pension investments needs to be tripled with an increase of 10 years.
The problem however is that there are hardly any euro-denominated bonds with maturities longer than 10-12 years, and since these instruments are coupon bearing, the effective duration is even much lower.
To illustrate the need for longer fixed-income duration, we have shown in Figure 1 the shape of cash outflow obligations of a typical pension fund in the Netherlands. For comparison, Figure 2 shows the duration of debt issues currently available on the euro-denominated bond market. Just where the gap is, becomes clear by transposing the shape of the first graph onto the shape of the second graph.
So there is now a strong need in the market for fixed-income instruments with a much longer duration than those that are currently available. Because coupons have the effect of shortening duration - as the intermediate coupon payments reduce the average maturity of the payments - we prefer zero-coupon bonds as a solution to cover pension liabilities. With zero bonds the maturity of the bond is equal to the duration as there are no coupon payments.
As zero coupon bonds are even more rare than long-term ordinary bonds, there is a challenge for the financial industry to engineer them.
FundPartners therefore has been investing resources into the know-how of designing and engineering zero coupon bonds for the purpose of extending the duration of pension investment portfolios as well as matching future cash outflow obligations.
At least within the Netherlands, Belgium and Germany we see a clear need for this type of instrument. Not only with pension funds but also with life insurance companies. To our knowledge, we are the only firm truly dedicated to developing such products.
But perhaps in the longer-term, bond issuers - governments, corporates and public/private partnerships, for example - should respond to the need for longer duration themselves as well. The duration for typical fixed income mandates for pension funds will change from a duration of five to one of about 15. Given this new set of circumstances, investment demand will change.
As mentioned before, the need for these long-term zero bonds has been made acute in the Netherlands by the simultaneous changes in both legislation and accounting standards. But we see a need for this type of liability-based products in the European market as a whole. We envisage long term zero bonds being used to cover future defined benefit cash outflow obligations, but also as a core element within new types of hybrid - ‘defined risk’ - individual pension plans.
Initially, we expect zero coupon bonds to be used as a tool to increase overall duration. The larger pension schemes in the Netherlands could use this type of instrument in combination with complex derivative structures.
For medium and smaller funds, this complexity induces a much higher burden on implementing and monitoring such derivative structures. Finally, life insurance companies might welcome the availability of long term zero bonds as well. We are entering an era where liabilities are more explicitly defined as the fund’s ultimate benchmark. Zero bonds are mirroring the way pension and life insurance liabilities are defined.
Reactions can be sent to:
Jeroen M Tielman, CEO, FundPartners, email: Jeroen.Tielman@FundPartners.com; tel: +31 35 5392280