Mariska van der Westen outlines the Netherlands’ proposed ‘ultimate forward rate’ within the new framework for pension funds, which aims to marry real and nominal objectives

On 30 May, the Dutch social affairs and labour minister Henk Kamp presented his long-awaited outline of the new pension system and matching supervisory framework. The new system is meant to accommodate both real schemes and the traditional two-faced scheme - which is nominal, but sports a ‘real ambition’.

The differences between the two flavours - nominal or real - are pronounced. Under the new system nominal schemes will be required to maintain capital buffers of 25%, some 5% over the current buffer requirement, to guarantee liabilities with 97.5% certainty.
Although they are allowed to offer compensation for inflation, if they can afford it, such nominal schemes cannot offer full indexation until their nominal funding rate hits 125-130%.

Real schemes, on the other hand, will have real liabilities from the start. They are considered to be fully conditional, so there are no buffer requirements. Pains and gains are borne by participants and pensioners and accounted for immediately, although effects may be spread over a decade.

Despite the differences, both real and nominal schemes will be held to account by the same set of rules. The starting point is still the so-called ‘risk-free’ inter-bank swap rate, just as it is now: this is the benchmark rate used to calculate the value of pension liabilities. For durations of 20 years and above, however, rather than opting for the market rate, the new financial framework will introduce a so-called ‘ultimate forward rate’ (UFR) as the discount rate. The UFR methodology provides “a stable and realistic prognosis of the long-term interest rate,” according to Kamp. The new discounting method is based on the methodology proposed by Solvency II, the framework for insurance companies.

If a pension fund’s objective is to index nominal liabilities for inflation, the base risk-free rate will be discounted at the rate of indexation, at minimum price inflation.
Subsequently, schemes may apply a uniform, market-consistent risk premium on top of the risk-free rate, which will be higher for longer duration liabilities.

So on top of the risk-free rate the fund needs to apply the rate of inflation it intends to cover, at minimum price inflation. Because most schemes will finance inflation compensation out of excess return, they can subtract a risk premium to account for that. So the discount rate equals the risk-free rate plus inflation, minus the expected return.

In addition, the financial framework will accept the 12-month moving average funding rate as opposed to the funding rate at any set moment as a basis for decisions, including benefit cuts.

In a sense, the introduction of the UFR seems a throwback to earlier times. “The UFR under Solvency II is based on two components - the long-term expectation of both inflation and short-term rates. For the euro-zone and a number of other major currencies including the US dollar and sterling, these components are estimated at 2% and 2.2% respectively, adding up to 4.2%. Since the estimation of the UFR is based on long-term expectations, it is envisaged that the UFR itself will, in principle, be constant over time,” says Neal Hegeman of Royal Bank of Scotland.

With that, it seems as though the Dutch pension system is reverting to the fixed 4% discount rate of yore. But while some hope that the UFR will immunise pension funds against the distorting effect of the current unrealistically low long-term swap rate, others worry that the pensions sector might be swapping the frying pan for the fire.

Kamp has indicated that pension funds may be allowed to apply the new methodology as soon as December 2012, when they must also decide whether or not to cut benefits in 2013. According to consultant Dennis van Ek of Mercer, the introduction of the new methodology has an immediate impact on the solvency outlook of pension funds.

“The ultimate forward rate as proposed would likely lift the average solvency rate by 6-8%,” says van Ek. “The combination of the UFR with the adoption of a 12-month average solvency rate would add a few more percentage points to the funding rate.”
The average funding ratio would end up at, or just above, 100% - high enough to prevent some of the planned benefit cuts.

However, for pension schemes hedging less of their interest rate risk than the national average - such as the larger industry-wide schemes, including the public sector giant, ABP - the beneficial effects are expected to be less pronounced.

Due to their limited interest rate hedges, the solvency rate of these schemes has taken a bigger hit than the average scheme’s funding ratio and the UFR will not suffice to restore funding rates by the end of this year to the point that cuts can be avoided, Van Ek warns.

Hedging headache
In addition, the UFR may introduce new hedging problems for pension funds, warns Hegeman. At first glance, you’d expect the UFR discounting method to reduce hedging levels, not increase them. With the prospect of the discount rate converging on a fixed rate after the so-called ‘last liquid point’ (LLP), there will be less need to hedge interest rate risk for longer durations: “Indeed, if the LLP is set at 20 years and a scheme has long-duration liabilities, this will significantly reduce the scheme’s hedging needs,” says Hegeman. “For a young pension scheme those needs may be reduced by as much as a third.”

According to Hegeman the convergence period - the portion of the rate curve following the LLP where the market rate converges on the UFR - can pose a hedging problem.
“The proposed methodology is based on the Smith-Wilson method, which perfectly follows the swap curve up to 20 years and then extrapolates so that the forward curve - and with it, also the swap curve - eventually converge on 4.2%. But to obtain a nice, smooth curve, the convergence is smoothed out, which makes the methodology sensitive to the gradient of the swap curve around the 20-year point,” he explains. “If the curve is strongly inverted, you’ll see that the extrapolated line will first dip a bit further before turning upward.”

Pension funds will have to hedge against this, “and to do this one-on-one you’d have to take on some very weird swaps,” says Hegeman. “Schemes would have to, for instance, buy a payers swap for the 15-year rate instead of a receiver swap, protecting themselves against an interest rate rise. That is counter-intuitive.”

There is a real danger that pension funds will have to spend money on protection from unintended side effects of a theoretical construct, rather than hedging against market realities. In addition, the hedge needs to be adjusted constantly, which may not be the best thing when markets are volatile.

“Clearly there are arguments in favour of using the ultimate forward rate as a discount rate, in particular the illiquidity that characterises anything beyond the 30-year point on the swap curve. But we had better give serious thought to the question of what we are getting ourselves into and whether it’s all still hedgeable,” says Hegeman.

Besides these technical issues, some experts are also concerned that the UFR might undermine the treasured fairness of the system by shifting too much of the burden of bad times onto younger generations. Cardano CEO Theo Kocken, for instance, is concerned about the gap between the proposed UFR and the market rate. He says: “People are suggesting a forward rate in year 30 of as much as 4.2%, which is far above the current market forward rate for 30-year swaps, but also 20 and 10-year swaps - all this while invoking the Solvency II regime - a framework that they otherwise reject in every way.”

Kocken is worried that politicians will find a way to “irresponsibly interfere with the private savings of younger generations,” he says. “It’s a shame that solutions somehow always seem to involve shifting problems to the young - preferably in ways that are invisible.”