Flexible solutions in an ALM context
In the years ahead there will be significant and far-reaching changes to Dutch pension funds. New laws and regulations such as international accounting standards will become effective. Furthermore, it is widely believed that we will be confronted with a low yielding environment in the next few years. As the Dutch pension market is one of the most mature in Europe with around E600bn in assets, the effects of these changes are larger than in most other European countries. Last but not least, there is a growing need for transparency, cost reduction, and flexibility in making choices. For institutional clients AEGON has developed flexible solutions in an ALM context to cope with these developments and needs.
Guarantee contracts in the Dutch DB market
In the Netherlands pension plans are predominantly defined benefit (DB) schemes. A typical Dutch DB scheme is a guarantee contract in which entitlements are secured. Insurers guarantee the payment of the pensions accrued during the contractual term. This guarantee is for life, regardless of the development of market interest and mortality rates. As market interest rates approached the level of the technical interest (4%) in recent years and costs of guarantee surcharges increased, insurers started looking for solutions. AEGON, being a major player in this market, has developed solutions in relation to both assets and liabilities.
Flexibility on assets and liabilities
Following the Dutch pensions and insurance regulator (PVK)’s white paper on pension funds, pension funds’ liabilities will be valued on a market-to-market basis in line with the valuation of assets. Currently, the duration of fixed income investments is approximately five and a half years for most pension funds whereas the duration of liabilities (future cash flows) can be 20 or even 40 years. So if market rates change one percent, assets will change 5.5% and liabilities will change 20% or even 40%. This mismatch will have a major impact on a pension fund’s coverage ratio. By extending the duration of fixed income investments, the mismatch will be diminished. Although the absolute risk of investments will increase in an asset-only context, the relative risk against liabilities will decrease in an asset-liability context (see the table above). Furthermore, the return on long-term bonds is currently higher than the return on short-term bonds, so extending the duration does not only reduce risk but also enhance returns.
According to AEGON, however, cash flows should not be fully matched. A mismatch is necessary to enhance returns for indexation and other purposes, for example by investing in equities and alternative investments.
In many economic scenarios expected returns of alternative investments like real estate, commodities, hedge funds and private equity are higher than equities. Expected returns of credits, asset backed securities (mortgages) and high yield bonds are higher than government bonds. By diversifying investments into several asset classes the overall portfolio risk can be reduced without giving up return (or returns can be enhanced without increasing risk) because of the low correlation between different asset classes.
AEGON developed solutions for extending duration and diversifying investments such as diversified funds with or without a long duration overlay. In the table below you will find the expected return, absolute risk and relative risk for a traditional portfolio and three Strategic Allocation Funds from which two have a long duration overlay.
Lower costs for clients
Within guarantee contracts, pension funds can choose themselves for extending duration and diversifying investments within certain boundaries. This will not only have an impact on risk and return, but also on the client’s costs. By extending duration the investment risk for AEGON will diminish, resulting in lower guarantee surcharges. By diversifying investments expected returns will increase, resulting in higher returns above the technical interest. These excess returns are paid to clients annually .
AEGON’s solutions in an ALM context
By extending the duration of fixed income investments, the mismatch between assets and liabilities will be diminished, resulting in a less volatile coverage ratio. As the investment risk for AEGON will diminish, extending duration will result in lower guarantee surcharges as well. Finally, extending duration does not only reduce risk but also enhance returns because of the higher returns on long-term bonds. By diversifying investments into several asset classes the overall portfolio risk can be reduced without giving up return (or vice versa). All variables and their relations are illustrated in figure 1.
In the years ahead there will be significant and far-reaching changes to Dutch pension funds. New laws and regulations, a low yielding environment and a growing need for cost reduction and flexibility require a different approach. Especially in one of the most mature DB markets in Europe, the Netherlands, where guarantee contracts are common practice. AEGON, being a major player in this market, has developed flexible solutions in an ALM context to cope with these changes and needs. By matching assets and liabilities and diversifying investments, pension funds and AEGON are now better able to control their costs and risks and enhance returns.
Bas Knol (Product manager) +31 (70) 344 8246 firstname.lastname@example.org