FTK casts a shadow over custody
The collapse of the Dutch Government in June gave hope to some pension funds that the new financial framework, Financieel Toetsingskader (FTK), would be delayed. However, most observers believe this is a false hope and that the legislation, due to come into effect on 1 January 2007, will go ahead as planned.
Ross Whitehill, chief operating officer of custody risk rating company Thomas Murray Group, says while many people were hoping after the government collapsed on 30 June that implementation of FTK would be delayed, "you'd have to be brave to pin your hopes on that".
Rod Ringrow, managing director, Amsterdam at State Street, says there is a question in the market about whether the elections later this year will cause any further delay to the introduction of the legislation.
"If a different government comes to power, FTK may not be first on its list of priorities. I think it will be too late to change and there seems to be a general acceptance of the new rule change."
Despite the uncertainty, fund managers are grappling with the legislation. Says Whitehill: "Because FTK is such a fundamental change to the rules on assets and liabilities, pension funds are reviewing the custody area to ensure that their custodian and investment accountant is able to support these changes."
FTK represents a fundamental change for the industry, requiring that both assets and liabilities are valued on a marked to market basis. At present, the net present value of liabilities is calculated using a fixed discount rate of 4%.
John Gout, senior sales manager, Benelux at ABN Amro Mellon, says with only half a year to go before the implementation of the new financial framework, "pension funds and investment managers realise something needs to be done, particularly in terms of matching assets with liabilities".
Asked to identify the main issues facing his pension fund and investment manager clients, Egon Tibboel, director of the institutional investors division at KAS Bank has no doubt that the introduction of FTK is the dominant factor in the Dutch market. "This regime requires that pension funds supply reporting on their solvency position to the pensions regulator," he says.
Pension funds must satisfy two key tests to comply for this new regime, solvency analysis and continuity analysis. Under the solvency analysis, says Tibboel, pension plans must have a minimum 105% coverage of assets over liabilities. "Plans that do not meet this requirement must take appropriate action to ensure that this minimum level is achieved within a twelve month period," he says.
Plans that have a high risk weighting in their portfolios may attract a higher solvency ratio, for example a portfolio in which assets are invested only in equities could be required to maintain a solvency ratio of 135%.
Under the continuity analysis requirements, plans must provide predictive risk analysis on their assets and liabilities in the longer term. In order to comply with this requirement pension plans must implement comprehensive monitoring of how they expect their funding levels in the future.
In addition to the FTK requirements, Tibboel says a variety of developments, including changing demographics, new accountancy principles and new regulations are increasing pressure on pension funds to outperform benchmarks. "Outperforming the benchmarks implies using specialised and innovative investment products and strategies that will change the fund's risk profile. As a result, pension funds have to find ways to limit their risk exposure. Risk monitoring and risk mitigating techniques provide relief in this area."
Pension funds are using more risk management services alongside the traditional custody services and income generating services such as securities lending, commission recapture and treasury.
"Risk management is supported by compliance monitoring (does the asset manager stay within the parameters stipulated in the mandate?), asset rebalancing, attribution and risk analyses, performance measurement (how did the fund perform in real terms?), benchmarking (how did the fund perform relative to peer groups/universes?) and external (regulatory) reporting."
Tibboel expects most of KAS Bank's growth in the coming year to emanate from risk management and risk mitigation services on the one hand and (regulatory) reporting services on the other hand. "We expect growth in our services as an impartial risk manager," he says.
ABN Amro Mellon's Gout says the FTK requirement to more closely match assets and liabilities is having an impact on benchmarking. "Previously, pension funds investing in worldwide equities would use MSC II, but liability duration investment mandates are different and a composite benchmark has to be tailored. For example, the mandate might include a couple of long term fixed income bonds together with a couple of swaps. That is new and putting a good benchmark together that can deal with swap calculations will test some custodians."
Pension funds are moving to investment managers that can come up with fiduciary mandates or liability duration investments, says Gout. "As a custodian, we need to deal with both. One of the decisions pension funds now have to make is how they will match assets and liabilities - do they bet on interest rates keeping low or do they believe they will go up? I think in the final quarter of 2006 there will be a lot of action in the fixed income swap market because people will need to be making choices."
State Street's Ringrow sees a polarisation in the Dutch market with some pension funds, such as Philips going down the route of matching liabilities up to a particular maximum and then using more adventurous investment techniques with the remainder.
"This is one approach to beating the liability gap. Others, like Shell, have gone heavily into equities and have done well over the past couple of years."
The alternative investment space is generating plenty of interest from some of the large funds, with investment in either pooled infrastructure funds or direct investment.
"The direct investment is probably the most interesting development in the Dutch market. Some funds are adopting a long-term horizon and feel they can generate greater alpha if they invest directly in a toll road in China, for example."
While such an approach moves out of the traditional custody space, Ringrow says State Street sees great opportunity in servicing clients' moves into more illiquid areas.
Another trend Ringrow points up is consolidation of smaller fund managers in the Dutch market. "Some of the larger pension funds are also trying to offer external asset management to the smaller funds, using the expertise they have in the area. I am not certain this will develop into a long-term trend but it is something that you don't see elsewhere in Europe, apart from Hermes in the UK."