Funds on a higher plane
The Dutch love their coffee. The huge assortments on offer across the country are a legacy of the Netherlands’ long-established status as a great trading nation. The complexity and sheer sophistication of the product ranges and individual aromas are world famous.
Complexity and sophistication are also features of the country’s e480bn pensions industry, one of the most developed in Europe. Indeed some in and around the market – not least a few of the pension funds themselves – might feel that a purchase from one of the more recently established coffee shops in Amsterdam might be necessary to get them to a level where
they can understand the system, particularly current developments.
But it’s not really that impenetrable.
One of the main challenges facing the Dutch pensions market is new legislation that will make compulsory the valuation of liabilities according to the principle of fair value, which in plain English means market interest rates. So liabilities will fluctuate as interest rates fluctuate.
Hitherto liabilities were pegged to an arbitrary figure of 4%, which meant that funds could focus on return. As Gaston Siegelaer, project manager of the financial assessment framework at Dutch regulator DNB (formerly PVK) notes: “Up to now funds have used an asset-only approach. In future, funds will have to do their calculations based on a fair value of liabilities compared with the market value of assets. So the main change of focus will be defining the risk that will be acceptable for the pension fund from an asset liability point of view.”
Siegelaer argues that funds might welcome the new regime given that the long discount rate is a little above the fixed arbitrary 4% rate. “Funds can also calculate buffers in a more integrated way, so there is room for diversification,” he notes. Not only that, but the buffers that will be needed might be smaller.
But it’s not all good news on interest rates. Jeroen Steenvoorden, director of the Dutch Association of Company Pension Funds (OPF), points out that “the disadvantage of matching is that you will lose some of the upward potential and in the end that means higher costs and higher premiums, but the advantage is that the buffers that you will need will be smaller”.
Furthermore, the economic environment might not be right for the new legislation. Joos Nijtmans, policy adviser at the association of industry wide funds (VB), is concerned that “pension funds are forced to lengthen their duration, but at the same time most think that interest rates are going up, so it is better to have a short duration so that they can react and have a better return. So the timing is not good.”
Siegelaer notes that the new legislation is due to take effect in 2006 or 2007, and that pension funds can move over to the new regime any time between now and then. Siegelaer expects that a few funds will make a move this year and that momentum will build next year.
The increased use of tactical asset allocation among funds is a clear result of the focus on the market value of liabilities.
To this end one of the key assets that funds will employ will be long bonds. “The long-term challenge posed by the principle of liability matching will be supply of long government bonds,” says Steenvorden. “Funds will also have to look at the corporate bonds market.”
And although he agrees that the demand for bonds will drive supply in the long term, he points out that “in the short term there will be some tension. The swap market could be an interesting alternative”.
Meanwhile there is an increasing trend among funds to increase the long-duration bond allocation as a result of IFRS and the new FTK so as to reduce the duration mismatch. However, when all funds move in the same direction, risk-return profiles in the long-duration government bond zone will deteriorate.
“The market-based valuation of liabilities will lead to a situation where the old idea of cash and bonds being relatively risk-free compared with equities and alternative asset classes is not true any more,” says Erik van Dijk, chief investment officer at Compendeon, the new Apeldoorn-based pension and investment management firm that acquired and extended part of the activities of Pension Factory. “If you take into account liabilities you need a totally new mind set to solve the problem.”
What is needed is probably a U-shaped asset allocation structure in which equity portfolios are growing and, within the equity allocation investments in emerging markets, hedge funds and private equity should increase. “Combined with a relatively large allocation to cash and credits funds can create a kind of ‘bar bell’ structure in which the overall risk of the plan is not more than it was previously and there is less risk in terms of interest rate sensitivity,” says van Dijk. “That is exactly what you need if liabilities and duration mismatch are the problem. Because of IFRS, interest rate sensitivity is becoming a much more important factor than it was say 10 years ago.”
He adds: “If you want to make sure that your value at risk is minimised when liabilities are pressing, you cannot use the standard optimisation tools when trying to solve a realistic ALM puzzle. There is a clear mismatch between the technical and statistical possibilities of standard optimisers and the requirements of a real-life, useful ALM when taking into account all complexities that a fund has to deal with. That was one of the problems ALM specialists were facing. We see in the market now that pension plans really want to be sure that they can have all their restrictions and all the risk that they are facing incorporated into the plans.”
The willingness to take more risk will not necessarily be influenced by the one factor that we might expect to be critical: funding. Van Dijk predicts growing interest in emerging markets and hedge funds. “The more successful funds will try to look for further diversification of their strategies, especially with ongoing globalisation and increasing correlations among the traditional standard asset classes.”
It would seem logical that funds with lower solvency ratios have to move to lower-risk asset classes. “But they can’t do so any more,” says van Dijk. “With underfunding and low interest rates you will not win the war with cash and bonds. So what we see is that the ones that have the possibility to experiment will do so with the same asset classes as the ones that are underfunded and need to do something about it.”
As well as the risk involved with matching assets to liabilities there is another major area of risk, as Siegelaer explains. “The key question which is posed by our framework is how to measure the risk and spend the risk budget,” he says. “The answer will be different depending on the goals you have and will also depend on the available buffer and the financing contract with the sponsor.”
There is an overall tracking error budget so the pension plan and the asset manager can allocate their tracking error where they think the return will be highest.
Funds are increasingly hedging liability risk. “As well as using fixed income and lengthening the duration, liabilities can also be hedged using derivatives,” says Frits Bosch, partner at consultancy Bureau Bosch. “Funds are closing the funding gap successfully this way. It is a growing trend among the larger pension plans but it’s not yet sure that there will be much interest among smaller plans; expertise in this field is limited and I don’t know if they will trust external parties to do a swap for them.” Bosch notes that the pension fund of Hoogovens, the Dutch side of Anglo-Dutch steel company Corus, is using this technique.
The portfolios of Dutch pension funds have become more international over the years. Today non-Dutch equities account for about 85% of the total as funds have sought to diversify away from the very small domestic market. Steenvoorden notes that this the future funding rules increase the demand for currency matching.
Meanwhile, the allocation to real estate currently stands at about 10%. For the past 10 years real estate has been the best performing asset class. “Now pension plans wished they had 60% of their asset mix in real estate compared with the 7% to 10% that they have, but they are a bit too late,” says Bosch. “Now they see that real estate is an asset class which has a very long-term external duration which matches the pension liabilities very well. They feel that they should put more into real estate, but this could be dangerous because the timing could be wrong.”
In terms of asset allocation there are key differences between the two main kinds of pension fund: the industry wide funds and the corporate funds. Steenvoorden notes that the advantage of corporate schemes is that they sometimes have guarantees from a sponsor, depending on the sponsor’s financial strength. “If there are strong guarantees you can take more risk,” he says. “In cases of underfunding additional single premiums can be made. Sponsors can opt to pay more in bad times because they believe that, because of the additional risk that can be taken, they will pay less in the end.”
Funds are required to have solvency levels of at least 105%. The business of making up shortfalls in the industry wide sector is complicated by the fact that schemes have to contend with problematic labour relations among their many member companies. Furthermore, one-off premiums are more difficult to coordinate the more members an industry wide scheme has, not least because there will always be some member companies
that can’t afford to give more. The best that they can do is raise the level of future premiums. So there is less flexibility.
Unlike corporate schemes, industry wide schemes have clients and so are more closely regulated. “They fear what would happen if they did not stick to the index,” notes Bosch. “If their performance does not fulfil the so-called Z-score then the company client can go to another industry wide plan.”
Nijtmans notes that the average funding level among industry wide funds was about 111% at the beginning of 2004. In past years levels have fluctuated between 105% and 150%.
Industry wide funds account for about 70% of assets under management, with corporate schemes making up the remainder. In spite of the advantages offered by corporate plans they are in fact in decline as some companies which had an exemption from industry-wide schemes move to the industry-wide option. Steenvoorden says: “You need a certain economic size to run a pension scheme; more and more companies are thinking should we continue with our corporate scheme or do it another way.”
Nijtmans points out that the “complexity of the new regulations will be hard to deal with, especially for the smaller pension funds”.
There is an increasing trend among Dutch pension plans to move to external management. Van Dijk says: “I think this will increase in the near future under pressure of performance goals that have to be high to take into account the liabilities situation of many plans. Funds are more interested in tailor made mandates to make as much as possible of a link between the assets and the liabilities.”
He cites the case of the small and mid-size schemes that had a bad experience with the large balanced mandates that were controlled internally in terms of tactical and strategic allocation by an individual specialist. “This was either because that structure was too expensive for the smaller plans or the expertise that they hired was not good enough,” he says. “So now they hire a combination of specialist managers with a dedicated consultant that will perform the investment task for them to link the ALM to the tactical allocation.”
Dutch pension funds seem to prefer home-grown managers or international players that have a relatively big local presence. “We have the type of culture where there is a lot of communication, and even direct contact between people working in the plans and people working in the asset management community,” says van Dijk.
“There is much less of a ‘Chinese wall’ here than in the US or UK when it comes to professional communication between pension plan managers and specialists, asset managers
and consultants.” he says. Foreign parties that don’t understand this open, informal culture of relevant information exchange will have difficulty acquiring a lot of Dutch business.”
Meanwhile the predominance of defined benefit (DB) schemes in the Netherlands may be nearing an end. Steenvoorden highlights the new accounting rules due to come into effect next year for listed companies. “There may be a trend to collective DC schemes where there will be no guarantees from the sponsor, but instead premiums will be higher on a cost price plus basis to allow for the additional risk. The risk is being transferred to the pension board and in the end to the employee. There are two examples in the Dutch market already.”
Van Dijk cites the structural economic situation and the downbeat outlook for demographics. “Of course optimisation of the return-risk profile of pension plans is more important than ever as a result of this. But I would like to add that this will probably not be enough for quite a few plans. Structurally speaking, either premiums will have to go up or people will need to work longer. Judging from the political discussions of the last few weeks neither are popular so the solution will be to move from all DB to a combination of DB and DC. There will be DB plans for salary and wage levels up to a certain level and then above that there will be some kind of DC. We will probably see this in the near future.”
The changes that are on the way will make the whole industry raise its game still further. Timing issues may be an obstacle to some but most seem confident that the future will be leaner and fitter, if not necessarily more contented pension funds. This way
of tackling the funding issues is perhaps an example that other countries should follow. It is certainly no quick fix. Talking of which – anyone for coffee?