Interest rate hedging in the wake of the Dutch Pension Agreement
The Pension Agreement downplays the importance of interest rate hedging, traditionally an area of high activity for Dutch pension funds. Mariska van der Westen sets out to dispel the myth that interest rate risk management will become increasingly less important to the country's schemes.
Two-thirds of pension funds in the Netherlands currently employ fiduciary managers, but despite a clear vested interest, fiduciary managers have so far been remarkably silent on the new Pension Agreement - the planned wholesale overhaul of the Dutch pension system.
In the upcoming issue of our sister publication IPNederland, four fiduciary managers break their silence to debunk the myth that interest rate risk management will take a backseat under the new deal, and to speak out against the popular concern that pension schemes will irresponsibly increase the allocation to risky assets.
"Lately every single self-respecting broker has produced a report to convince pension funds to sell the long end of their interest rate hedge, arguing that pretty soon everybody will be selling at the same moment because the new pension system will reduce the need to hedge interest rate risk," said Leen Meijaard (pictured), managing director and head of BlackRock's institutional business within Europe, Middle East and Africa (EMEA).
"Customers are calling us about this and we tell them: don't let them pressure you. If you believe the interest hedge is a good investment, by all means, don't sell it," he added.
Managers agree that the new regime will no longer "punish" pension funds for their exposure to interest rate risk and so hedging will become a matter of choice.
Mark den Hollander, managing director and head of investment solutions at ING Investment Management says: "Under the old system we strongly advise clients to strategically hedge a significant part of their interest rate risk, but under the new system hedging will be more likely to hinge on a pension scheme's interest rate expectations. The decision to hedge becomes an investment decision."
But managers unanimously rejected the view that interest rate risk management is set to become less important as "overly simplistic."
"Return expectations include an interest rate component," noted Ernst Hagen, head of fiduciary investments at F&C. "So when pension funds, under the new regime, begin discounting their liabilities against expected returns, they will be exposed to interest rate risks, albeit indirectly, and they may very well want to hedge against that."
He added: "It's a discussion we are having now with our clients."
In the same vein, fiduciary managers rejected the oft-heard concern that pension funds will increase their allocation to equities, simply to artificially buffer their funding ratios.
"The new supervisory framework doesn't deal with equity holdings any differently from the old one, so there is no real reason to allocate more to equities," said Meijaard.
Hanneke Veringa, Dutch head for AXA Investment Managers, does believe some pension funds will allocate more to equities, but rejects the notion that schemes will go overboard.
"The new deal does indeed allow for the possibility that pension funds increase the funding ratio by allocating more to equities," she admitted. "But funding ratios in and of themselves aren't of crucial importance."
"We take coverage ratios into account, but alongside other measures - such as return on investment, value at risk and volatility - that can be objectively measured independent of regulatory changes," she said.
"No matter how you slice or dice it, pension funds have a certain amount of money in their wallets and a certain amount of benefits to pay out. That isn't going to change if you change regulations or the way coverage ratios are calculated."
Ernst Hagen of F&C can imagine pension funds will, under the new system, be more keen to invest in categories with a clear link to the real economy. But he points out that the corresponding risk profile involves more stringent risk management requirements and, under the new regime, must be communicated clearly to plan participants.
Consequently, as a result of the new deal he and others actually expect more of a shift in risk management than a shift in strategic asset allocation. Absolute return and downside risks will become more of a priority, "ranging from simple put options to more complicated low volatility strategies," Hagen said.
Strategically, managers expect to see a greater demand for inflation-linked strategies and instruments, including commodities, property and to a more limited extent, infrastructure. In addition, fiduciary managers expect to see some strategic shifts within the equity space.
"Think of a shift to healthcare stocks, or gold mining, or high dividend. We might see some of that," said Den Hollander.
For more on the impact of the Pension Agreement, see the upcoming issue of IPNederland.