The steep rise in inflation over the past months is yet to prompt changes in Dutch pension funds’ asset allocations. They believe they are already adequately protected against high inflation, and mostly emphasise the downsides of buying inflation protection.
Inflation figures in the Netherlands are currently among the highest in the euro zone, coming at 7.6% in January, the highest level in more than 40 years. Even though inflation risks to significantly erode their members’ purchasing power, pension funds appear relatively unconcerned about the phenomenon.
This may have something to do with the fact that pension funds’ investment policies tend to focus on maintaining a certain funding ratio. This task is not directly impacted by rising inflation.
Metal industry scheme PME illustrates this point noting that a rise of nominal funding ratios could well coincide with a decreasing real funding ratio, or the funding ratio corrected for inflation.
“But we believe that our allocation to equities and real estate makes us resilient against inflation over the long term, especially if inflation is predicted by the market and is a temporary phenomenon. If the real funding ratio decreases due to inflation, we expect this to correct automatically later,” a spokesperson for the fund told IPE.
Dutch pension funds have shown very little appetite for commodities and inflation-linked bonds, two asset classes often seen as inflation hedges.
Current investments in inflation-linked bonds total only some €19bn, according to figures from regulator De Nederlandsche Bank (DNB), while commodity investments have shrunk from more than €21bn in 2008 to little more than €5bn in 2021.
Many pension funds have ditched the asset class after years of disappointing returns.
Interest rate hedge
The main reason for the lack of action is that most pension funds feel protected adequately against inflation and interest rate rises because they haven’t fully hedged their interest rate risk.
“This is our most important protection against inflation,” said Roy Kroon, manager fixed income and treasury at pension fund PGB, which has hedged about half of its interest rate risk. By not fully hedging their interest rate risk, pension funds benefit from interest rate rises because this has a downward effect on liabilities.
Chief investment officer Marcel Roberts of SPMS, the pension fund for medical specialists, also noted that not fully hedging interest rate risk may protect against inflation. However, a rise in inflation is not necessarily followed by interest rate rises, he added.
“The current expectations are that interest rates will not rise dramatically over time,” he said.
As a result, more inflation protection may be needed if real interest rates remain deeply negative. But implementing inflation protection into a portfolio is more easily said than done, according to pension fund executives and their advisers.
Firstly, the market for inflation-linked bonds and swaps is limited in size and lacks liquidity. “This makes it difficult to quickly build a large position,” a spokesperson for healthcare scheme PFZW noted.
“Inflation protection also lowers long-term return prospects because of the inflation risk premium,” she added. Besides, PGB’s Kroon said existing inflation-linked bonds do not exhibit sufficient correlation with Dutch inflation to be seen as an effective hedge.
The Netherlands does not issue inflation-linked bonds itself, which leaves Dutch investors relying on German, French or Italian alternatives.
Given the perceived problems with investing in traditional inflation hedges, fiduciary managers advise pension funds to invest more in “less direct hedges” such as equities and real estate instead.
“Rents tend to go up in line with inflation while corporate profits also tend to follow inflation, albeit with a lag. Companies usually are able to pass on cost increases to their customers at least partly,” said Lukas Daalder, chief investment strategist for BlackRock in the Netherlands.
Michel de Groot, client advisor for pension funds at NN Investment Partners, also recommends a higher allocation to the return portfolio to tackle rising inflation. “The best inflation protection is to make sufficient returns,” he said.
Read the full version of this story in the March issue of IPE magazine