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FTK may lead to long bond dearth

Virtually the last act of Dutch pension and insurance regulator the Pensioen- & Verzekeringskamer before it merged with the central bank was to release the Financial Assessment Framework (the Financieel Toetsingskader – FTK) for consultation. Observers have gone so far as to suggest it could prompt a move from equities into bonds.
The FTK lays out the new supervisory framework that will apply to Dutch pension funds and life insurers in 2006. It will be discussed in the Dutch parliament in 2005 and is part of the country’s new Pensions Act, which will come into force in 2006.
The regulator says the new FTK will make it easier for small pension funds, while larger schemes can still keep to their own internal financial systems.
According to the 135-page document, small pension funds, with a low risk profile, will be allowed to assess their financial situation in an easy way.
This will only be applicable if pension funds have no more than 25% of their portfolio in equities. According to PVK chairman Dirk Witteveen,
the FTK should provide an easier financial reporting scheme to certain pension funds. As for larger funds, the FTK states that they can keep to their current financial reporting models if these have been approved by the PVK.
One important aspect of the FTK will be the changing role of the PVK for pension funds and insurers.
As the FTK will become operational for pension funds in 2006, the government has said there will be a lower solvency measurement of 97.5%.
Maarten Gelderman, the PVK’s head of quantitative risk management, says that the solvency standard, a value at risk model, is based on a once-in-40-year default scenario.
If this is the case, the PVK will assess if a change in premiums is necessary. The solvency risk of a fund is based on its investment portfolio and inflationary pressures. For all pension funds, liabilities will be accounted for against market value interest.
The 97.5% measure means that the Dutch pension funds will have a lower reference than international standards. If pension funds are not able to comply, the PVK will intervene.
One of the most fundamental changes under the FTK is that the liabilities of Dutch pension funds will be valued on a mark-to-market basis.
“Under the standard model, cover ratios should not exceed 130% to cover the unconditional liabilities. This is new and gives a bias for funds to move more into fixed income,” John Maskell, analyst at Barclays Capital, wrote in a research note.
According to Maskell, small funds holding less than 25% in equities are exempt from the FTK if they so wish.
Roland van Gaalen, a partner at Watson Wyatt Brans & Co in Amsterdam, says the new framework will lead to more demand from pension funds for index-linked bonds. “These have been issued in other European countries like France and Sweden for years,” he says. “The UK and US governments have also used them for a long time. The Netherlands, however, has never issued one.”
Van Gaalen is calling for the finance ministry to issue index-linked bonds. But he warns of market distortions.
“Dutch pension funds have hundreds of billions of euros in long-term liabilities. If they switch en masse to long-term bonds, that could lead to capacity problems in the market. The IMF also recently warned against that,” Van Gaalen says.
Van Gaalen’s comment echo those made by fixed income analyst Jitzes Noorman of Rabobank in a recent research note. He says the new framework will lead to Dutch pension funds moving “out of equities into bonds”, particularly into long-maturity bonds and inflation-linked bonds.
He argues the new framework will have “major consequences” for investment policies and liability management of pension funds. With interest rate risk being much higher at the liability side, Dutch pension funds will have to “raise the interest rate sensitivity of their assets”. Hence, the shift to long-term bonds.
In addition, Noorman points out the search for diversification could lead to increased demand for alternative investments, such as property, private equity or hedge funds.
A Dutch State Treasury Agency spokesman says the agency will not alter its issuing strategy in response to the new framework. He says it has a clear mandate from the finance ministry – “to issue at the lowest cost”.
He added that 30-year bonds – regularly requested by institutional investors – were not on the agenda as they are more expensive to issue and not as liquid as other maturities.
Time will tell if the last act of the PVK will be one it would want to be remembered by.

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