Dutch pension funds are not taking action to protect their portfolios against an increase in inflation. Some funds think they are sufficiently protected already while others believe rising interest rates will protect their funding ratios.
Fiduciary managers Achmea Investment Management, Kempen and Blackrock advised pension funds to increase inflation protection as long back as in October 2020, recommending a switch from nominal government bonds to inflation linkers.
One year on, inflation is rampant but pension funds have hardly increased their inflation-linked bond holdings
At a total of €14.9bn (less than 1% of total pension assets) according to DNB figures, allocations to inflation-linked bonds remain negligible for most pension funds.
“Many pension funds are hesitant to make changes to their investment policies because of the upcoming pension changes,” explained investment strategist Coen van de Laar of Achmea IM.
One of few pension funds that did buy inflation-linked bonds this year was the scheme for the Dutch pension regulator and central bank DNB. The fund has been investing 10% of its total portfolio in a mix of French and German inflation-linked bonds since January this year.
The investment has so far been lucrative for the fund, according to its president Roeland van Vledder. “It has lifted our funding ratio by a whole 1.3 percentage point,” he told IPE. The decision to increase the inflation hedge of the fund had nothing to do with inflation expectations, he added.
“In 2020, an ALM study we conducted showed that our portfolio was not sufficiently protected against a stagflation scenario, a low interest rate environment combined with higher inflation. The outcomes of this study triggered our decision to buy inflation-linked bonds,” he said.
Whether it still makes sense for pension funds that want to hedge inflation risk to buy inflation-linked bonds is questionable, since break-even inflation rates have risen fast since the start of the year.
Achmea’s Van de Laar said: “In hindsight, it would have been perfect timing to buy linkers a year ago, but right now inflation expectations have been creeping up to close the ECB’s long-term target.”
This makes the asset class less appealing, he believes. “In our base scenario for inflation, in which the world more or less returns to pre-Covid conditions, the expected difference in returns between inflation-linked bonds and nominal bonds is small.”
At the same time, Van de Laar noted the chances of a sustained period with high inflation have risen over the past few months. “We therefore stress in the advice we give to pension funds the need for a robust portfolio with effective diversification. Exposure to inflation protectors such as inflation-linked bonds, commodities and real assets should be part of this.”
At the end of September, the DNB pension fund had a funding ratio sufficient to index pensions next year. For relatively rich funds such as DNB it’s extra important to take inflation risk into account because they can index pensions. Other examples of such funds are ING and SPMS, the fund for medical specialists.
A spokesperson for the ING fund wrote in an email that the fund has been building up inflation protection “over the past few years” by buying inflation swaps and inflation-linked bonds.
At the end of 2020, the fund had an allocation of 7% to these instruments, which should “make the fund more resilient against unexpected inflation shocks, in order to maintain the ability to provide indexation to members at higher inflation rates,” the pension fund said in its 2020 annual report.
Director Jacques van Dijken of SPMS said that a rise in inflation does not directly impact the fund’s ability to provide indexation. Part of SPMS’s pension arrangement is a fixed annual indexation of 3%, regardless of real inflation levels.
“Members will only start to note inflation if it exceeds 3%. We could reconsider our investment portfolio if inflation exceeds the 3%-mark,” Van Dijken said. In this case, an allocation to inflation-linked bonds or inflation swaps could be considered.
He added: “For our investment plan for 2021, we conducted a study on this but decided not to include the category. Since the current pension system is about nominal liabilities, including inflation-linked bonds would also add a risk.”
Interest rate hedge
Pension funds with funding ratios insufficient for (complete) indexation, such as ABP, PFZW, Bouw, PME and PMT, are not directly affected by rising inflation. As a consequence, none of these funds has taken action to mitigate inflation risk.
ABP, Bouw and PMT all point to their relatively low interest rate hedge (respectively 27.5%, 40.3% and 44.4%), which the funds expect to provide protection against a further rise in inflation.
David van As, director of Bouw pension fund, said: “The most important measure we have taken against inflation is not to completely hedge our interest rate risk. Over the past years this has caused the funding ratio to fall as interest rates came down; but now we see rising inflation fears leading to the opposite effect.”
Wilse Graveland, head of fiduciary management at Kempen, does not know any examples of pension funds that have actively lowered their interest rate hedge to reduce inflation risk. But some of Kempen’s clients have decided not to increase their hedge where they should have done so to keep their effective hedge at the same level.
Graveland explained: “Because the UFR funds use to calculate their liabilities changed this year, funds had to increase their hedge to keep the same level of protection. But some have chosen not to do that because of an increase in inflation risk. Interest rate hedging is, in my opinion, a more effective tool to reduce inflation risk than inflation-linked bonds. In the end, you always pay a premium for expected inflation when using this instrument.”
The large sector funds still consider inflation a threat, however, but only in the long term. “In a scenario of high inflation and low real returns we see that pension outcomes deteriorate dramatically because indexation does not compensate sufficiently for high inflation. As a consequence, this scenario results in the worst pension outcome,” said Van As.
Healthcare scheme PFZW is equally concerned. “We may be able to partially index pensions if the funding ratio increases thanks to rising interest rates, but if inflation is high the resulting pension outcomes may be worse in real terms than was the case over the past few years when we could not increase pensions but inflation was low at the same time,” a spokesperson told IPE.
ABP and Bouw do however expect their investments in real estate and infrastructure will at least partially compensate for any increase in inflation.
“The value of these assets is correlated with inflation, resulting in higher returns in an inflationary environment,” an ABP spokesperson said. ABP also has a €20bn commodity allocation, which also protects against inflation, but this will be downsized dramatically as of next year following ABP’s decision to divest from fossil fuels.