Current regulatory developments facing Dutch pension funds are challenging, wide-ranging, and are changing the way we look at pensions. Either driven by the sudden end of the equity boom, changing corporate regulations, population demographics, or fair value accounting for pension fund liabilities, now seems to be the right time to reconsider the available options.
Apart from any projections regarding the sustainability of state pensions in the long run, the main discussion point is the continuous challenge facing the much-cherished Dutch fully funded pension system. Although it is premature to overhaul a proven system when obstacles arise, it is required to think about the possible implications of regulatory developments (local FTK as well as international IAS rules) going forward. One of the main issues stems from the approaching market valuation of liabilities.
The introduction of a new regulatory framework will change the way liabilities are valued to a ‘fair market valuation’ instead of using a flat 4% discount factor. The actual interest rate levels and the changes herein will get a direct influence on the liabilities. This means that changes in interest rates will create new risks in the form of liability volatility for pension funds and their sponsors. These liabilities have to be fully funded with assets, paid in by companies and current employees. Managing the substantial investment risks attached to these assets creates a growing worry for the corporate sponsor and the beneficiaries. This is an issue because structural under-funding of outstanding liabilities could result in higher premium payments going forward or the postponement of indexation policies.
The current duration mismatch
ABN AMRO sees the existing duration mismatch between assets and liabilities as one of the largest risks facing pension funds today. Most pension funds have nominal liabilities with an average duration of 15 years. A substantial part of their assets generally consist of fixed income portfolios benchmarked to indices that have an average duration of about five years. This is mainly a result of the reduced issuance of long-dated government bonds in favour of shorter maturities. In much the same way the inflation-linked bond market in the Netherlands is non-existent, making inflation risk management even more of a challenge. The existing mismatch between the duration of investment assets and pension liabilities creates a major exposure towards interest rate movements. When this mismatch is based on a chosen investment policy this might seem acceptable. However, if this is an unanticipated effect of the investment policy a change in interest rates could adversely affect the overall funding position. A pension fund should therefore ask itself: What duration mismatch are we willing to accept? Can we afford the existing interest rate mismatch?
Closing the gap
Closing the duration mismatch even partially has a very strong effect on the overall characteristics of the current portfolio. In Graph 1 the one-year risk of under-funding for an average Dutch pension fund, with a typical funding ratio around 110%, is illustrated. The graph shows the statistical probability of under-funding (vertical axis) versus the duration gap (horizontal axis). This analysis examines more closely the effect if either the weight of fixed income is increased or the duration gap is closed proportionally. As one can see, closing a part of the duration gap instead of decreasing a part of the equity weight more significantly reduces the one-year risk of under-funding. Such closure of the duration gap is thus a key element in adjusting to the new regulations. The striking feature in this is the fact that these regulatory guidelines will require Dutch pension funds to lower their one-year probability of under-funding to 2.5%, so more action needs to be taken to bring the portfolio in line with future requirements.
Volatility of the surplus
Pension funds face an important consideration. Is action required now, or can it wait until the regulations are implemented? The sense of urgency in dealing with the existing duration mismatch is an important issue. Graph 2 underscores this point. Consider a pension fund with a 100% fixed income holding, all invested in five year bonds. With a five year interest rate around 3.2% and a spread between the five year and the 15 year rate around 1.4%, the chart shows the situation whereby the five year interest rate goes up or down with 1%. Additionally it shows three scenarios for the difference between five year and 15 year interest rates: unchanged, flattening, or steepening. The arrows highlight the scenarios where the interest rate curve would flatten. As can be seen, such flattening would not be necessarily offset by a rising five year interest rate (the arrow on the right). All in all, a pension fund has to realise it places a large implicit interest rate bet when nothing is done about the current interest rate mismatch. The funding surplus can go up by 30%...or down. For pension funds with a more realistic asset mix of say 50% fixed income, this effect is approximated by cutting the change in funding surplus in half. In essence, it is questionable to what extend pension funds can afford such volatility of their funding ratio.
Matching the duration between assets and liabilities is realised by lengthening the duration of the existing fixed income portfolio. A pension fund can decrease the funding risk on a one-year horizon substantially by reducing this duration gap. Moreover, increasing the fixed income weight could lower the overall risk of under-funding closer to 2.5%. As this would result in a lower expected return, the remainder of the portfolio can be invested more aggressively in order to keep the overall expected return intact.
A fundamental understanding of the issues at stake provides for the development of possible solutions. Apart from ignoring the issues, there are several solutions to consider. These need to be tailored to the individual pension fund context by considering the needs and requirements of all stakeholders. The extensive advisory capabilities within ABN AMRO are meant to challenge and support this process. In this, the following elements are crucial considerations in adjusting to the new regulatory framework.
o Cash flow matching: The existing liability framework is individually matched with corresponding cash flows within the asset base, either on a static or dynamic basis.
o Long duration investments: Either discretionary or via funds. A more generalist approach can be taken by increasing the average duration of the asset base, eg, via time buckets. It is also possible to cover real inflation-adjusted liabilities by making use of inflation-linked structures.
o Diversification: Through reducing the duration mismatch substantially, the overall risk for a pension fund is reduced. By doing so, more room is created for possible diversification into other asset classes like specialties, and alternative asset classes. This will be of particular interest when the portfolio needs to deliver higher risk-adjusted returns.
o Defined contribution schemes: The liability structure can be changed by the implementation of a defined contribution scheme. These arrangements can be basic, additional, or top-up schemes in order to enable more individual participation or risk sharing. Defined contribution schemes should provide individually tailored investment profiles in order to be a viable alternative. Hybrid schemes, combining defined benefit schemes with defined contribution elements, are becoming more widespread.
The ABN AMRO offering
ABN AMRO provides integrated pension fund solutions in the Netherlands as well as globally. Its client-led approach is based and structured around a wide range of pension fund capabilities. ABN AMRO is therefore well equipped to cope with general or specific issues facing pension funds today. Financial Markets, which includes fixed income, treasury, structured products and risk management; Asset Management, providing traditional investment management, structured asset management, advisory and risk management; Pension Services, offering the implementation, administration, execution, and communication of pension defined contribution arrangements; Working Capital, which offers cash flow and liquidity management; and ABN AMRO Mellon, offering superior global custody and asset servicing capabilities.
For information on an overall or individual basis please contact:
Dutch Pension Team: email@example.com,
Financial Markets: firstname.lastname@example.org,
Asset Management: email@example.com, +31-20-6287672
Pension Services: firstname.lastname@example.org,
Working Capital: email@example.com,
ABN AMRO Mellon: firstname.lastname@example.org, +31-20-6281358