Coming under pressure from all sides
The way in which the Dutch pension industry, Europe’s second largest pension industry in terms of assets, has responded to the worst market crash since 1926 says something about the way it has developed over the past 300 years.
The industry has its foundations in the professional associations of the 17th century, and is underpinned by principles of mutual support and social solidarity. As a result, it takes an essentially pragmatic approach to the problems it faces.
The three year bear market in equities that began in 2000 tested Dutch pension plans - many to the limit. Pension fund reserves as a ratio of pension commitments had averaged 150% at end of 1999. This had shrunk to 140% at the end of 2000 and 125% at the end of 2001. The average is now just over 111%.
Yet, in contrast to the situation some other European countries, Dutch regulators and pension
funds kept their nerve. Alain Grisay, head of F & C Netherlands, says: “We saw absolutely no panic in the Netherlands. We did see the regulators challenging a number of pension fund boards to produce plans about how they intended to come back to stronger coverage ratios.
But there was no forced asset disposal, and no injunction to reduce equities holdings.”
Equally impressive was the approach taken by the social partners to solve the funding crisis A series of negotiations between employers, employees and unions at a number of industrywide pension funds led to an even-handed solution of increasing contributions – including employee contributions – and reducing the indexation of pensions.
“I don’t think that there are many countries where people have been as fast and as pragmatic in agreeing to pay more and receive less. This has enabled them to make up for in part what the markets have taken away,” says Grisay.
The role of the Pensioen & Verzekeringskamer (PVK) , the pensions and insurance supervisory authority of the Netherlands, has been crucial in restoring equilibrium. The PVK has imposed solvency requirements that the probability of under funding should not exceed 2.5% over one year. If under funding does occur a pension fund must submit a recovery plan to ensure that it returns to full funding within 15 years.
The new solvency requirements will have an important impact on the management of pension fund assets and ultimately the benefits they are able to pay out.
Even well-funded plans now need to control their downside risk, says Cees Dert, global head of structured asset management at ABN Amro Asset Management in Amsterdam: “Even if a fund has a coverage rate of 140%, it could experience an unfortunate year after which it drops to 110%. That may not be a problem from the perspective of the PVK regulations, but it is a problem in the sense that when a fund is at 110% it has to become more risk-averse. It is then very likely that the expected return on its assets will drop. When that happens it will be difficult to offer indexation to the participants of the pension fund.”
Another constraint is the PVK’s new financial testing framework, (Financieel Toetsingskader or FTK) funding criteria for pension funds currently under development and scheduled to enter into force no later than 1 January 2006.
Dert says the combination of reduced surpluses and FTK criteria will compel pension funds to look for new strategies: “Eroded surpluses imply that many pension funds become more sensitive to further losses , so they may be looking for strategies where they try to further optimise the trade-off between expected return and risk of losses. This is will be reinforced by the FTK, which will provide quantified financial criteria for surplses that pension funds have to set aside.”
Further pressure on Dutch pension funds will come from the new international accounting standards, specifically IAS 19 and IFRS, where liabilities are valued at market value rather than the actuarial value typically used in the Netherlands today.
Dert points out that under the new regulations, the value of liabilities will become highly sensitive to interest rate changes. “We used to have volatility in the assets side but not on the liabilities side. Now we have volatility on both sides.
“In this situation, the only way a pension fund could reduce the volatility of its surplus and coverage rate would be if the value of assets and liabilities moved in the same direction. Otherwise it will increase.”
If pension funds fail to change their investment policies, they could run a considerable interest rate risk , Dert warns: “Some of them may be aware of this and they choose to take this risk as an active bet. But others may not be aware of it , nor are they aware of the fact that doing nothing now implies a huge active bet on interest rates.”
ABN Amro AM has analysed the consequences of this inertia, he says. “We have found that, with an unchanged asset policy, pension funds may well risk a fall in assets of a magnitude of 10% assuming an assset mix of 50% equities and 50% fixed income. For a fund with a coverage rate of 120%, that represents half their surplus.
“This is does not have to happen. One could implement changes in the investment strategy today that eliminate or strongly reduce those risks.”
Obbe Kok, head of institutional clients at ING Investment Management in The Hague says that IAS 19 will have a large impact on the way in which asset managers invest the institutional money in the Dutch market: “If you look at the IAS 19 rule the biggest influence on the balance sheet and profit & loss account of the sponsor will be the indexation risk and the duration mismatch. IAS and FTK will make existing risks more viable.
Of the two, duration mismatch is the more serious, he suggests. “ One of the ways to deal with that inflation risk obviously is inflation-linked bonds. Having said that, the euro market for inflation linked bonds – liquidity is zero and availability is zero. The alternative is to go the UK and the US, but then UK and US inflation is not the kind you want to hedge to. Dutch inflation, and at least euro inflation, is preferable.”
One solution that ING IM is currently considering on with ING Real estate is using property to hedge against indexation risk. “The principle is relatively simple. The financing costs of a real estate investment are not linked to inflation, while the income is linked to inflation. So the real estate investor will get inflation in its income while its expenses do not normally contaon inflation corrections. On the other hand the pension fund has inflation in its expenses but not in its income. So what we need to do is shift the inflation from the real estate part to the pension fund.
“The reason why pension funds invested in the past in real estate is as an inflation hedge. The only problem is that the inflation hedge obviously works from the income side, but it does not work – or is not good enough – on the property value side. But by splitting those two and leave the property value side with the real estate investor and strip the inflation income and bring it to the pension fund you have effectively solved the issue.”
The other problem pension funds face as a result of IAS 19 and FTK is duration mismatch, he says. The solution here is to use derivatives, such as interest rate swaps, to pump up the duration of fixed income portfolios.
One of the problems with the duration mismatch is the volatility in the financial statement of the sponsor, says Kok: “If the assets don’t fit the indexed liability, and there is a big mismatch, then the pension
surplus/deficit on the sponsor’s balance sheet will be very volatile.
“It’s not so much that by increasing the duration on the assets side you try to increase returns. It’s that you will decrease the volatility of the mismatch between the assets and liabilities on the sponsor’s balance sheet.
“But also from a stand alone position a pension fund will most likely want to reduce their duration mismatch to reduce volatility in the solvency ratio as a result of the introduction of FTK.”
So far, the impact of the market crash and the subsequent regulatory tightening has been slight. The typical allocation to equities was 48% before the equities slide. The latest estimates suggest the typical allocation is around 40%.
Hans Goossens, business director at Fidelity Pensions Management in Amsterdam, says there is little evidence of a flight from equities. “There are not too many pension funds where we have seen really substantial cutbacks in equities. What they are doing on the equities side is more a question of fine tuning, for example, from passive to enhanced. It is a natural response to market developments.
But all are agreed on one thing, he says. The good times, so far as equities returns are concerned, have probably gone forever. “Everybody has the clear belief that what we saw in the second part of the 1990s was completely exceptional. From a returns perspective it has been a once-in-a-lifetime event. So the expectations for equities for the present decade are way lower.”
A new development is that a typical pension fund mandate could now be a total return but long-only mandate, he says. “Pension funds are looking for a manager who can deliver 7% or 8%. They don’t mind if the market goes up 40% and he only does 10%. And if the market goes down 20% the manager should at least be in positive territory.”
Diversification is now an essential part of downside risk protection for Dutch pension funds. Peter in de Rijp, executive director Institutionals Fortis investment in Utrecht says the message about diversification has percolated down from the largest funds such as ABP and PGGM to the mid-sized funds. “If we look at the small- and mid-sized pension funds with assets of between E20m and E1bn the key thing that is happening is diversification. Until three years ago, these pension funds were experiencing some quite good years both in equity and fixed income markets, so there was really no big rush for diversification then. But nowadays the picture has changed quite dramatically.
“The key message we have brought to our clients for over two years now is that they should definitely diversify their portfolio away from pure euro government bonds and global equities – the typical mandate of a Dutch pension fund – into European credits, he says.”
“That was maybe the first diversification move in our client group that started a bit two years ago. Now we’re talking about European small caps, European convertibles and Euro high yield bonds, and absolute return products.”
The time is ripe for diversification of asset classes. Pension funds face problems increasing both their mainstream equity and fixed income allocations, in de Rijp says: “Funds that are facing difficulties with their solvency rate are quite hesitant to move further into equities. On the other hand funds are also worried that interest rates are so low – currently around 4% for 10 year euro bonds. So they are hesitant to put huge amounts of money into bonds at these low yields.”
Protection the downside with some upside potential is now the favoured strategy of asset managers. ING IM, for example, is developing the idea of ‘dynamic asset allocation’ for its clients.
Kok at ING IM says: “Tactical asset allocation between fixed income and equities has always been traditionally a fixed allocation with a possibility to have tactical allocation around a fixed norm. What we are discussing with our clients at least is the possibility of a dynamic asset allocation, which is something which we have already been doing as part of our insurance portfolio within the ING group for several years”
The asset manager sets a floor below which asset values may not fall. If asset values rise the managers can increase allocation to equities. But if they fall, they must reduce the equity allocation. The manager can leverage the equity allocation to take advantage of any upward potential.
“The floor would normally be the net asset value of your liabilities. If you hit that floor you would be fully invested in fixed income, with a duration matched to your liabilities so that you will know with great certaintly that your income will always cover your nominal liabilities.
“It’s a match between all your liabilities and assets if all your reserves have gone. So you always know that your liabilities are fully covered but from the reserve you still have the possibility to benefit from the upwards potential of equity markets.
Kok says this will suit the current market. “Everybody wants to benefit from the potential upward benefit from the equity market which most of the parties believe is still there. But on the other hand they want to make sure – especially if the sponsor is not that rich – that their liabilities are covered with a degree of certainty.”
Yet for some of the smaller Dutch pension funds, the combination of pressures – PVK, FTK , and IAS 19 - will persuade them that they have no future as independent entities. Grisay of F & C says the impact of IAS 19 and the PVK rules could be considerable: “If these two things happen there is no doubt in my mind that a reasonably large number of small pension funds will disappear in the Netherlands. And they will disappear simply because the numbers will not add up.”
Pension funds exiting the market have two choices: to join one of the industrywide pension plans or to outsource their entire pension fund to an insurer. Buying an insurance contract from a third party to cover pension liabilities is a traditional Dutch solution.
In these case, financial institutions that have both asset management and insurance benefits stand to benefit most. F&C, for example, part of the Eureko group, which also includes Dutch insurer Achmea. Grisay of F&C points out that this has created a win-win situation in the current Dutch pension market. “We work closely with Achmea, which is a large provider of that sort of insurance product. Obviously those insurance products are supported by assets under management. So in the case of F & C we are very well positioned to either continue to manage the assets of the pension fund or to get them back through the back door through the insurance company.”
Whether pension funds will take the traditional route to the reinsurance contract is questionable, however. Ronald Nagel, head of institutional services at ABN Amro in Amsterdam, suggests that insurers are unlikely to be able to offer attractive deals in the current environment: “Insurance companies had a very difficult time over the last couple of years because of their investment results. This is because they have guaranteed investment returns at a certain level, which did not work out well. I think that, going forward, the bids that they will put on the table for these insured contracts will probably be quite low given their new insights regarding the risks involved.
“That is a bitter pill to swallow for pension funds and they may find it more difficult to accept that new lower level. There will always be some companies that want to get rid of their risk to insurers but I am sure that most of them will only do that if really necessary and they have no other options.”
Fortis Investments’ in de Rijp sees a more sophisticated option for pension funds - using both an insurer and an asset manager: “Although pension funds are taking their liabilities to an insurance company, they are demanding the option from the insurance company to have at least two asset managers working on the asset sides of the reinsured fund.”
Fortis Investments, for example, has an arrangement where a large Dutch insurer reinsures the liabilities of a pension fund but the asset management is shared between the insurer’s asset manager and Fortis Investments.
“Until a couple of years ago that was hardly possible, but that is changing,” says in de Rijp.
For a corporate pension fund that is considering leaving the market, an alternative to a reinsurance contract is membership of an industrywide scheme. This process has been under way for some years. Aegon Nederland’s acquisition last year of TKP Pensioen, which manages the KPN pension fund and six others, is a high profile example of such consolidation.
Frans van der Horst, head of acquisition and client servicing at Aegon Asset Management, says current regulatory and accounting pressures will simply accelerate the process: “Consolidation is bound to happen. In previous days pensions were a nice thing for corporates and sponsors to have. In good times it was all good fun and it indirectly gave them some revenues indirectly. People have now said goodbye to that framework. “
Another feature of the Dutch pension fund scene could also change, van der Horst suggests. This is the tendency for smaller pension funds, with asset bases of between €500m and €700m, to outsource the management of their assets to a number of managers.
“Some funds will be asking themselves whether it really makes sense to outsource so small an asset base so small to four or five asset managers? In the UK pension schemes much smaller than that are interested in outsourcing to several asset managers but in the Dutch market it’s pretty unique.”
So what will the Dutch pensions landscape look like at the end of 2004? There will be fewer corporate pension funds. Pension fund assets will be distributed between insurers, asset managers or a combination of both. And pension fund strategies will be a combination of a search for upside potential and protection against downside risk. The approach will be, as ever, pragmatic.