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Indexation ambition

Nina Röhrbein interviews Bernard Walschots, CIO of Rabobank’s Dutch pension fund

Amid the uncertainties of the new regulatory framework in the Netherlands, few pension funds have already decided whether to opt for a nominal or a real contract.

The €17.8bn pension fund for the employees of Rabobank is one of the few. It has decided to go for a nominal pension contract under the revised Dutch FTK framework, which is set to come into force on 1 January 2015.

The pension fund’s investment strategy is split between a matching and a return portfolio.
The matching portfolio consists of fixed income and a range of derivatives – the strategic hedge – that includes swaps and swaptions, equity-linked swaptions, equity puts and inflation swaps. Together these match the interest rate risk of the liabilities while protecting the surplus of the fund.

Rabobank Pensioenfonds bought this derivatives portfolio at the end of 2007 for a premium of €260m. It was created in a way that allows the coverage ratio to fall but not to break the level required by the regulator.

“While we did not foresee the financial crisis, we were aware of the fact that given the level of long-term interest rates and the evolution of the stock market, there was a distinct possibility of a downside correction,” says Bernard Walschots, CIO at the pension fund.
“We also wanted to hedge against the tail risk. The introduction of a new pension agreement – the first FTK – by the Dutch regulator meant that the sponsor, which at the time paid an extra €900m into the pension fund, said that it would not be willing to make any additional contributions if the fund got into difficulties. Under the new solvency framework of the FTK, liabilities were calculated marked-to-market, which introduced potential volatility into coverage ratios and strengthened our resolve to find downside protection.

“During the crises of 2008, 2010 and 2012 the value of this hedge increased enormously to over 25% of our balance sheet. In short, it has worked very well for us.”

When the fund took out the derivatives contracts it had a coverage ratio of 160%, whilst the required coverage ratio was 116%. As events unfolded across the markets, the fund  realised how much it needed the accrued cushion. The rise in longevity also cost the pension fund more than 10 percentage points in its coverage ratio.

But the overall investment strategy and its resulting good returns have had a positive impact on the fund’s coverage ratio. At the end of 2012, the coverage ratio under the ultimate forward rate (UFR) methodology was 118.3%, while it stood at 111.2% based on the swap curve.

“One of our biggest challenges is having to cope with negative real interest rates,” says Walschots. “The future of the Dutch pension system depends on the monetary and fiscal authorities ensuring an economic recovery for real long-term interest rates to go up again.
This is the main driver of coverage ratios and thus the extent to which the pension system is sustainable. Our swap-based real coverage ratio, for instance, is less than 70% whereas we should have a real coverage ratio of 100% if we want to index pension benefits.

“Currently the employer pays for the indexation of active members, while the fund pays the indexation of entitlements of the inactive participants as well as the pensions. The only reason we still index entitlements of the latter two groups is because we are confident that in the longer run we will be able to generate enough returns for the fund to be able to continue to pay out indexation.”

The matching part’s fixed income portfolio consists of government bonds, investment grade credits and some triple-A rated Dutch residential mortgage-backed securities.

The government bond portfolio itself holds 85% triple-A rated, core euro-zone government bonds and 15% triple-A rated, non-euro government bonds, while the credit portfolio exclusively contains euro-denominated credits.

The composition of the fixed income portfolio has changed over the last 12 months. It used to be made up entirely of triple-A rated euro-zone government bonds but with the number of triple-A rated governments declining, the concentration became so large that the fund decided to add some non-euro government risk.

Today, the non-euro-zone part of the portfolio includes Australian, Canadian, Danish and Norwegian government bonds.

“We do not invest in US Treasuries and UK Gilts because we believe these bonds contain more risk than is evident based on their rating,” says Walschots.

Fixed income currently makes up 49% of the overall strategic portfolio. Its weighting increased after Rabobank Pensioenfonds decided to sell part of the strategic hedge in mid-2012.

“Given where the coverage ratio was relative to the required coverage ratio as well as the low level of interest rates, the premium outlay we would have paid buying new swaptions would have been very high,” says Walschots. “If we protected our coverage ratio – the downside risk – through swaps in this low interest rate environment, we would severely limit the upside potential of our coverage ratio, meaning we could fall into a poverty trap. At the same time, we doubted whether the protection we received in return would have been sufficient, which is why we decided to sell part of the hedge. There was a two-way risk – not only would we have to hedge against the risk of a further fall in the coverage ratio but we would also have to ensure that once interest rates started to rise, we would benefit from their rise. If we did not do that, we would run another risk.”

Another issue favouring the reduction of the hedge was the discussion on the likely introduction of the UFR in 2012, the discount rate for the current value of liabilities, which pension funds have to apply in addition to a three-month average rate. The introduction of a UFR method was expected to exert upward pressure on swap rates.

In mid-2012, the interest rate risk of Rabobank Pensioenfonds was hedged for more than 90% before it was decided to reduce it to around 60%. The money extracted from selling that hedge, over €2bn, was put into a temporary fixed income portfolio – essentially a short duration bond portfolio – which like the strategic one invested 85% in core euro-zone bonds and 15% in triple-A rated, non-euro-zone sovereign debt.

The temporary nature of this portfolio is because the pension fund is undergoing a new asset liability management (ALM) study and the fact that the sponsor and employee representatives are negotiating a new pensions contract.

“Of course, we have to await the outcome of the negotiations, but it will undoubtedly mean that entitlements will be limited and less certain relative to what they are now,” says Walschots. “We will stick to a nominal contract but with the ambition to index the benefits.

“We will have to use the social partners’ conclusions as well as the risk preference of the board of trustees as an input into our ALM calculations,” continues Walschots. “Only then will we be able to come up with a new strategic asset allocation and a new strategic balance sheet management plan, the latter of which refers to the extent of which we want to hedge against risks.”

Walschots does not expect the current asset allocation to change significantly as a result of the selection of a nominal contract because the pension fund is already operating a nominal contract with an index ambition.

The majority of the return portfolio consists of equities, which make up 35% of the pension fund’s overall strategic portfolio. In addition, it holds 6% real estate and 8% alternatives including private equity, infrastructure and commodities.

In 2010, the pension fund decided to change its equity portfolio. It split into a developed and an emerging markets portfolio before implementing a strategy in which it diversified both investment styles and processes.

“We believe in active management, in other words we believe that we can realise excess returns above a market index by implementing smart beta strategies but also by looking for alpha,” says Walschots. “Nowadays, our developed markets portfolio is made up of a traditional alpha strategy combined with smart beta strategies, which over the past two-and-a-half years has led to a significantly higher information ratio and a clear outperformance. We are happy with the way we have approached this issue but will fine-tune this portfolio. Last year, we implemented style and process diversification in our emerging markets portfolio. After one year, the results look promising.”

At present, Rabobank Pensioenfonds is looking at smart beta solutions for its investment grade credit portfolio. In addition, the pension fund has decided to introduce a risk parity portfolio in the return portfolio, which will be implemented over the next couple of months.
The first allocation is €500m, but Walschots expects this to grow.

“If you believe that it is difficult for a pension fund to act quickly enough in changing economic environments then a risk parity portfolio is the solution,” he says. “The risk parity portfolio is a substitute for equity risk. Its volatility is comparable with an equity portfolio but it is a smart beta solution, meaning that its diversification is better than in an equity portfolio, which has highly concentrated risk. In other words, it is an optimal portfolio compared to the traditional model.”

Furthermore, the fund is analysing whether or not there is added value in introducing an emerging market debt portfolio.

On the alternatives side, the fund is trying to extend its private equity and infrastructure programmes to 2.5% of its balance sheet. Both asset classes currently make up 1% of the alternatives portfolio each.

“We have been investing in private equity for more than 15 years – and in infrastructure for over five years – but growth has been slow,” says Walschots. “We invest in the two asset classes because they add value but with such investments come governance challenges.”

The pension fund faces similar challenges in the fund of real estate funds it invests in as part of its property portfolio. “It is difficult to invest in international real estate directly because we would have to organise a network of agents and these umbrella funds are efficient,” says Walschots. “However, we prefer direct investments in real estate because it gives us the chance to control what we have in our portfolio.”

Therefore, the vast majority of the pension fund’s real estate portfolio is invested directly, to a large extent in the Netherlands, but also in a recently-acquired and sizeable residential portfolio in Germany.

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