Compound rate big mistake for funds – Van Nunen
NETHERLANDS - Fiduciary management consultant Anton van Nunen has claimed the condition of pension funds is less severe than portrayed, and instead argues much of funds' funding shortfalls can be attributed to the compound rate.
Van Nunen suggested in an analysis seen by IPE that the compound interest rate is arbitrary and "unfit for the job" of measuring pensions, as it promotes pro-cyclical investment policies.
As a result, he has proposed funds should instead be allowed to let go of the compound rate and adopt an interest rate that mirrors a long-term average.
"Throw away the mechanism by which a completely artificial accounting problem is created, and by which a tremendous impoverishment can be induced, and to some extent already has been induced," he says.
He believes when the compound rate should be critically evaluated to assess whether there is a viable alternative, when its use threatens to make most pension funds forego the indexation of pensions.
According to Van Nunen, a rate mirroring a long-term average is less sensitive to demand and supply issues at a certain moment in time, and would be a better indicator of long-term market developments.
He notes US regulators, based on arbitrary grounds, work with the so-called credit curve: "As credit spreads have risen substantially, that interest rate has risen, causing a lowering of compounded liabilities."
Major pension funds argued last week that up to two-thirds of the decline in their cover ratios, which now hover between 85% and 100%, was because of a steep drop in interest rates.
ABP at the time said the long-term interest rate dropped from 4.9% at the beginning of 2008 to the historic low level of 3.6% at the end of 2008, leading to an increase in pension liabilities.
The fund argued a drop in interest rates of just 1% increased liabilities by 17%.
Van Nunen suggested in his analysis the swap rate is currently at such a low level that €600bn worth of pension liabilities in the Netherlands are compounded at a rate which is 40 basis points lower than the risk-free sovereign rate.
That said, he said prescribing a fixed or more stable compound factor does not imply the new legislation of which the compound rate is part of should be described as a useless exercise.
"Important issues such as governance (check on expertise, continuity calculations, solvability calculations) have been dealt with. Rules have been put forward with regard to contributions (they should cover real costs) and a clear allocation of responsibilities has been prescribed. All these items are gains and they should be warranted," he concluded.
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