Theo Kocken welcomes the recommendations of the Frijns Committee, which would bring the FTK in line with the effective ambitions of pension funds to provide indexed pensions
The Dutch Frijns Committee has recently been investigating the investment strategies and risk management quality of the pension fund sector. Frijns made some very distinctive remarks, not only with respect to investment policies but including the relation between risk management and the pension contract - particularly the hindering role of the nominal focus of the current FTK instead of inflation-linked objectives. Most of the recommendations aim to establish ‘best practice', rather than calling for big changes in the law.
Risk management was a key item in the list of recommendations. First of all, it was found that the amount of risk taken didn't depend much on the maturity of the pension fund (for example, a high percentage retirees), even though a mature pension fund is not able to absorb much risk.
Many pension funds are gradually becoming aware of the ‘greying' aspects and changing dynamics. The number of funds that anticipate the mature character of their funds is increasing after the crisis. While a young pension fund would have been able to recover from a deficit in the 1970s following a sudden drop in cover ratio, that same pension fund will likely never be able to reach full funding again if it ends up seriously underfunded, say, a few years from now. This is due to the fact that pension funds gradually enter the payout phase - with profound long-term implications for employers and employees alike. (Cardano discussed this issue in a recent article for IPE's January edition, "Multi-stakeholder risk management".) In short, mature pension funds may not even have time on their side.
Too much focus on return should be avoided, Frijns concluded. Pension funds should pay more attention to the specific risk appetite of all beneficiaries - retirees, actives and sponsor - and make a bespoke risk profile that fits each of these stakeholders. Frijns also puts emphasis on the "implementation shortfall". It was not only strategic allocations that caused losses - in a number of cases losses were exacerbated by a gap between the strategic choice and the actual implementation. Frijns points to DNB research that reveals many causes for this gap - among others, that product providers had more risks incorporated in their products than the pension funds assumed and actual investment portfolios didn't always match the agreed strategic allocation.
Boards of the pension funds and their pension service organisation (or their fiduciary manager) should ensure there is a clear connection between the agreed strategic choices and the implemented risk in the portfolio. That requires extremely good communication on both sides. It also emphasises that any advantages that might be gained from segregating strategy from implementation may be outweighed by the many disadvantages. Service organisations need to perfectly understand the strategic pension issues, stakeholder dynamics and their inherent conflicts and act accordingly. You can't afford to be hit by surprises, just at the point when you need to rely most on your service providers.
Another point emphasised by Frijns is that it is almost impossible to steer a pension fund towards inflation-linked targets when the current FTK regulatory framework puts as much emphasis on the nominal funding ratio as the risk-objective.
Frijns suggested that inflation linked pensions should be the main focus, both in ambition and in terms of risk management. This is a valid point, although it is possible to find solutions that fit the nominal as well as the real (inflation-linked) funding ratio, those solutions are always complex and may be suboptimal compared to solutions for an inflation-adjusted world only. However, it should not be misunderstood - and I have heard this several times in reaction to the recommendations - that Frijns claims that the change to inflation-linked pension implies that the ambitions and the guarantees should increase (compared with the current nominal guarantee).
The real pension ambition can go hand-in-hand with lower levels of a hard inflation-protected guarantee. Frijns is not a call for higher guarantees, but an appeal for more sensible steering of both target and risk constraint in terms of inflation-linked pensions.The FTK regulatory framework doesn't require a nominal guarantee at all; it requires that funds live up to what they guarantee to their beneficiaries. If that guarantee is an index-linked pension but at a lower level than the ambition level, then that is fine with the FTK. I think as soon as some pension funds change their contracts in this direction, the rest might follow swiftly.
Theo Kocken is CEO of Cardano Risk Management in Rotterdam