Driven to short-term views
Some 10 years ago, remembers Mn Services interim commercial director Pieter Kiveron, finance minister Gerrit Zalm was quoted as advising pension fund managers to make sure that there were four of them because then they could at least play cards. The implication was that otherwise they would have very little to occupy their time.
“Those times are over,” Kiveron adds.
And indeed they are. The trigger for the change was the market collapse at the beginning of this decade and the subsequent decision by the government and a remodelled regulator to ensure that pension funds should not find themselves vulnerable to a market correction in the future.
But the then regulator, the Pensions & Insurance Supervisory Authority (PVK), was partly responsible for the depth of the crisis, recalls Kiveron. “During the market crash, and some eight weeks before the market bottomed, the regulator wrote to Dutch pension funds stating that they should take precautions based on the low coverage ratio at that moment,” he says. “This action had such a negative effect on sentiment that the Dutch market performance was even worse compared with other markets.”
“At the time the reaction by the then supervisor was not much appreciated in the market and one could ask whether this provoked a lot of unrest,” adds Olaf Steijpen of ABP’s financial and risk policy department. “The way it was communicated, completely out of the blue, came as a surprise and did not correspond with how one would want a supervisor to behave.”
And the lesson that supposedly well-intentioned interventions can have unintended, and negative, consequences is one that many in the Dutch pensions industry feel the authorities should have taken to heart.
Among the initiatives is a new Pensions Act that is due to be implemented at the beginning of 2007, and the controversial new financial assessment framework (FTK) that it contains, which the pensions industry claims is an over-engineered response to the markets crisis and one that is having an unintended effect on asset allocation.
In addition, pension funds are having to come to terms with a new international financial reporting standard, IAS 19, which requires sponsoring companies to carry their pension liabilities on their balance sheet, and the coming into force in February of the EU pensions directive.
And along the way the government created a new regulator by merging the PVK with the central bank, the DNB.
“The one question I ask every politician, the supervisor and the social partners is: Why, when you see we had a good system with no problems in paying pensions and a really stable contribution level, do you think everything must change; what gives you the feeling you have to act as quickly as you do?” says Peter Borgdorff, director of the Dutch Association of Industry-Wide Pension Funds (VB). “I understand there must be changes to the system, but we have time, so take that time.”
“We faced two extremely bad years in 2001 and 2002 and not one of the more than 800 pension schemes in the Netherlands collapsed,” says Alfred Kool, managing partner in Kool Corporate Communications. “We had our problems and coverage ratios fell, but not one had severe problems.”
Steijpen agrees. “During the stock market collapse, funding ratios stayed close to 100%, so although there were a few exceptions, funds were still fully funded in a situation where liabilities were discounted at a 4% interest rate,” he says. “So you could argue that there was nothing to complain about.”
But the government is pressing ahead with its reforms and the pension law, including the FTK, is expected to go to parliament in the spring and be passed into law in time to come into force at the beginning of next year. For some in the industry this still holds open the possibility that the FTK can be amended by parliament to remove problematic elements. Others see it as a done deal that the industry had better get used to.
“One of the discussions connected with the FTK is the match between assets and liabilities and the principle of fair value, which together might lead to increased exposure towards the volatility of the interest rate,” says Kiveron. “There was always a need to match liabilities and assets, but to what extent do you allow room to manoeuvre? As a reaction, pension funds have increased their exposure to the bond market or interest rate-linked derivatives to match the duration gap. But what is the status of the bonds market – aren’t we at a record low from an interest rate perspective, won’t it rise, where is the balance? There is an effect because you are going to a fair market value with respect to the liabilities, but is it necessary to put this particular type of ruling into action so rapidly?”
“There’s always the problem of the long term and the short term, and pension funds cannot really cope with the short-term measures,” agrees Loek Sibbing, chairman of Corporate Pension Fund Association (OPF). “For example, at the present time pension funds feel forced to go into bonds. Currently they’re faced with low interest rates but what will happen in a couple of years when interest rates go up to 7%? Coverage ratios will be very high, and what will happen then? Will the surpluses go back to the companies or will there be premium holidays again? So it is quite volatile and that is not at all attractive for a pension system.”
Another challenge is the time the regulations give to pension funds to respond to a fall in their solvency ratio. The new regulations call for pension funds to achieve a solvency ratio of 105%, the requirement under the EU directive, within one year, while the DNB has set 130% as the level that pension funds should achieve and below which they cannot guarantee indexation of pension benefits.
“Because a scheme can stop for one reason or another, the regulator requires that funds should always have a minimum level of funding, and that’s the 105%,” says Jeroen Steenvoorden, director of pension fund for self-employed medical specialists SPMS. “If you fall below that you have to make it up within a year. And the issue with the one year period is that if interest rates fall from the current 3.5% to, for example, 2.5% we all have a huge problem because we would have to discount liabilities at the lower interest rate and profits would disappear. But then the FTK makes an exception, saying that if the whole market is going in the same direction the supervisor can allow a longer period to readjust.
“So if you are in the flow there is no problem, but if, like last year, all the pension funds have excellent returns but because some strategic bets did not work out yours is the only one that is below the 105% level, then you have just one year to make good. And some funds are asking the regulator to be more flexible and to extend the period to three or five years and say in advance how long it would be. I can understand that pension funds would like to have some security beforehand and not wait to see what will happen if there is a problem. And if they don’t have that security they may take less risk.”
The timing question has had a very weird effect on the assets, says Borgdorff. “Consequently, some parliamentarians have said they understand the problem, that the earlier proposal is not right for pensions and there are suggestions that the period be extended to three years. And I think that yes, three years is better than one year. But then why did we have to have all the rows with the DNB over the past two years when the only real problem is that politicians are not able to take a longer view?”
But Steijpen is more sanguine. “Since the discussions on the new regulatory framework started, the rough edges on a number of issues have been smoothed and the bottom line now is that we can live with the framework as it stands,” he says. “We also have to face the fact that, more or less, it is a reality. There may be certain changes here and there, but we are talking about details – it’s not something that markets or pension funds should expect will not happen. So from that point of view it is a fact and the discussions are over.”
He also suggests that there have been some misunderstandings on the side of the pension funds. “For example, on the issue of liability matching the regulator does not prescribe that one should match liabilities,” Steijpen asserts. “Of course, it’s true that by discounting your liabilities on the basis of nominal market interest rates your interest rate risk increases – while interest rate risk was very small in a 4% world now it is 40-50% of your total risk budget. That’s a reality and pension funds have to think about how they are going to handle that. However, the FTK does not prescribe that a pension fund must match liabilities and even if a pension fund is underfunded - which in the context of the FTK means a funding ratio that is less than 130% on average - it still has 15 years to restore its financial position. And 15 years is a rather long period. So the situation is not that pension funds are pushed into a corner, as I would be if the period were one year or so, when they would be left with no alternative but to hedge their liabilities. From that point of view the FTK is less black and white than is often assumed.”
Steenvoorden agrees: “The move to bonds is a risk, especially as everybody is doing it at the same time. However, the supervisor is not forcing you to match with bonds and this is something that we have know was coming for some time.”
However, the regulations as now seen do call for a pension fund that falls below 130% to recover the required coverage ratio within a year.
For Borgdorff the key issue is one of understanding. “As well as pension funds, the DNB also has responsibility for the supervision of banks and insurers, which are dissimilar types of organisations,” he says. “They have to be solvent on a daily basis, but with a pension fund you are talking about a horizon of 30 or 40 years – and the DNB seems not to recognise the differences.”
But while the FTK may have unsettled industry-wide pension funds, the real pressure may have been felt elsewhere. “Those suffering the most are the smaller corporate pension funds because they have less room to manoeuvre and perhaps they have less know-how,” says Kiveron.
“It’s always easier for a large pension fund with access to considerable managerial resources and with a high coverage ratio, than for with a pension fund that has to rely on external resources and with a coverage ratio that just meets the minimum,” says Sibbing. “But I know small funds with a good coverage ratio and an excellent management and large funds where some quality improvement is needed. So the size distinction is important when looking at cost efficiency or the ability to provide a certain level of service but if you look at the financial situation or governance issues there is not much of a distinction between small and large funds.”
But policy making is getting more complicated, Sibbing says. “You have to know the complete financial system within the financial framework and all the tools you need to meet the requirements, and if a board of trustees doesn’t have that knowledge, what can it do? Many smaller funds have outsourced their asset management, and two-thirds of smaller funds have also outsourced their pension administration. What they then have left in-house is policy making and the control over the outsourced contracts. How much further can they go? Of course there are new opportunities like fiduciary management, where you find a partner that help you with complex items so you can still continue with the pension fund, but it’s all one way, you cannot in-source activities because it is too complicated.”
There are a number of options for corporate pension funds that find that they cannot cope with the additional pressures, notes Kiveron. “They can rely more heavily on third-party providers, attach themselves to an existing industry-wide pension fund or to close down their pension funds and go to insurers,” he says.
“But pension fund managers do not consider the last option an attractive choice because insurers have a very poor reputation with regard to their administration and they are not seen as a very flexible partner - once you are in it’s difficult to get out. And there are many reasons for setting up a company pension fund - it serves to make an employer’s labour package recognisable to the employees and helps to build identity and loyalty, it’s also a vehicle to enable the tailoring of secondary benefits towards any specific needs the employees may have. Consequently, getting rid of the pension fund because of the problems has more disadvantages than possible financial consequences.”
The OPF is looking for alternative options. “Faced with the changes small company pension funds typically ask their consultants for help, at some considerable cost,” says Sibbing. “But all pension funds are in the same situation so this is something that could be co-ordinated for them all. So we are working on an OPF initiative, which we call ‘services’, to provide such models or frameworks to our members. We are in the process of examining the possibilities so we have not worked out the details but it maybe something that we could develop ourselves helped by consultants and by the supervisors, and that way we would know in advance that a solution would be accepted.”
And the brainstorming around this initiative threw up an even more wide-ranging proposal. “Somebody suggested it might be possible to have an own pension fund for company pension funds that want an alternative outside an insurance company and are not able to join an industry-wide scheme because they stand outside the collective agreements that underpin them,” Stibbing says. “We don’t have any hard and fast proposals at the moment, we are just in the midst of a feasibility study. There are some legal barriers to overcome but it is not impossible.”
And the suggestion that IAS 19 requires companies that have delegated their pension promise to industry-wide funds to report their pension liabilities on their balance sheet is a challenge too far for some funds.
“I want accountants, the controllers, understand that industry-wide pension funds are different,” says Borgdorff. “In fact they do understand, but they say it’s not about the different position of the pension funds it’s about the pension deal, and if you give a pension deal it creates an obligation to show the risks to the sponsoring companies. The situation now is that some pension funds have written to the sponsors saying that they are able to give data but not the required information, others say they don’t have a problem with the issue and will give the company the data, while the funds with real conviction say they won’t give any information as it’s not necessary.”
“While IAS 19 stipulates that companies should recognise pension risks in the balance sheet, we have argued from the outset in favour of accounting for pensions on a defined contribution basis, since this method is the only one which is appropriate to the specific Dutch situation of pension funds covering an entire sector of industry,” says Gerard van Dalen, director of pensions at Pensionfonds Metalektro (PME), the industry-wide scheme for metal and engineering workers. “This is because the companies affiliated to these pension funds have no other liabilities than the payment of contributions. Therefore, recognising pension risk in the balance sheet of a company that is part of an industry-wide fund gives a false picture of the risks involved. A company won’t ever have to pay a deficit, nor will it get its money back in the case of a high funding ratio. The only things that may vary is the contribution.”
“The debate is ongoing and is being moderated by the industrial employers’ organisation, the VNO-NCW, and I expect that we’ll know what the conclusion in two or three months after the reporting season,” adds Borgdorff.
But feelings are running high. “If IAS is to be insisted on, the consequence will be that more and more companies will be forced to shift away from defined benefit,” says Van Dalen. “The entire risk will be put with employees. That could mean the beginning of the end of the Dutch collective pension system for the market sector.”