With less than a year to go until solvency regulations change, the pensions industry in the Netherlands is gearing up to find the best liability-driven solutions to complex funding problems.
Pension funds in the Netherlands have always been driven very much by asset and liability management approaches, says Theo Kocken, managing director of Cardano Risk Management in Rotterdam. He says: “This has led to strategies that took into account long-term relationship between investments and for example inflation-linked indexation in the liabilities, all in relation to contribution and other policies.”
Among other changes, the top 30 pension funds and an increasingly large group of mid-size pension funds have started looking at the impact of fair value liability calculations as required by both IFRS accounting and the Dutch pension regulator.
These efforts are not only aimed at finding out what the impact on the current funding level is, but also the impact on future risks. This, says Kocken, is a much more complex exercise, especially since it requires a new way of thinking compared with the fixed-discount considerations in the past.
The last important shift is the solvency regulations, which will be effective probably as of January 2006, Kocken says, though he adds there are still rumours that it could be January 2007. This concerns the explicit solvency requirements – the ‘buffer requirements’ – to cushion a drop in funding level.
These four factors, says Kocken, have put pressure on many of the pension funds to make drastic shifts in their investment policies.
Roel Knol, senior sales manager at Robeco, says that liabilities will be the new benchmark for pension funds in the Netherlands. Instead of using 4% as the rate of increase for liabilities, schemes will have to use the yield curve.
“There will be a big problem, because if you match your nominal liabilities, the regulatory authorities will be perfectly happy, but the pensioners will not be happy because they will only get nominal pensions”, rather than benefits at their real, inflation-adjusted value.
Rob Lambregts, director and chief investment officer of the industry-wide Grafische Bedrijven pension fund, says that the new accounting conditions mean pension funds will have to work towards meeting their individual requirements.
“Fair value for the liabilities will result in even more emphasis on balance sheet management and risk management by pension funds,” he says. “This requires tailor-made solutions and there is no easy answer.”
The market valuation of liabilities appears for most funds to call for an increase in the duration of bond holdings in order to create a match and therefore the best possible coverage. Knol of Robeco says that the duration of liabilities in pension schemes will go up with the new rules next year, to between 15 and 16 years. This means that most portfolios will be carrying an interest rate risk of 10 to 11 years.
But the whole question of what is the best type of asset or asset mix to cover liabilities is far from simple. “There is a pricing issue,” says Jan Kars, practice leader at consultants Hewitt/Heijnis & Koelman. He points out that if large volumes of pension fund money were to be directed into long bonds, this would have a significant impact on the price and therefore yield. This could, in turn, make another problem worse.
On the other hand, there is another side to these bond market dangers. Yields, at the moment, are very low, says Kars. “There is a strong view that inflation will go up in Europe and therefore interest rates will go up.” In six months’ time, if this happens, then any
pension fund that had now opted to direct a large proportion of its assets into bonds would see a
significant drop in the value of its investment.
Pension funds have to make decisions taking everything into account, he says. They have to consider their own balance sheet, short-term changes in interest rates and the regulatory requirements they have to meet. “Liability matching is important,” says Kars. “But it’s more important that you take every thing into account and not just the one simple issue.”
Aware of the shortage of long bonds in the market, many asset managers have come up with their own solutions for pension fund clients seeking to increase duration. Netherlands firm FundPartners, now part of NIB Capital, says zero-coupon bonds are perfect instruments for stabilising the pension cover ratio when market valuation is introduced for liabilities, and increasing the duration of assets. It has developed the Pension Bond 2025, with a maturity of 21 years.
Robeco, says Knol, is about to launch a long duration bond fund, which is a traditional bond fund combined with a swap overlay.
In order to solve the problem of funding the indexed rises in pension benefits, Robeco would add inflation-linked bonds to the portfolio to reduce the risk, he says, and add non-correlated return-generating assets to the portfolio. These assets could be emerging markets equities, hedge funds of funds, real estate, managed futures or private equity, Knol says.
Providers are coming up with many different solutions. Nationale-Nederlanden, for example, together with ING Investment Management, is offering its new Flexible Security guarantee contract. The contract guarantees the future pension obligations of a company or a pension fund, no matter how market interest rates or the mortality rate changes.
Cardno’s Kocken says that both corporate pension schemes as well as industry-wide pension funds are now applying interest rate swap duration hedges and shifting part of their portfolios to longer bond programmes. The latter solution, he says, is hindered when using ‘alpha’ – active – fixed income managers, since they will find it difficult to make a proper alpha in this thin market.
Where pension funds use interest rate swap duration hedges, he says, there is a question whether they should be based on nominal products or real interest rate products, such as inflation-linked bonds. Theoretically, the answer is that conditionally indexed pension funds should opt for mostly nominal if their funding ratio is low, and increasingly inflation-linked if their funding level is very high.
On the problem of how to protect the solvency by means of, for example, equity protection with the help of options and so on, Kocken says this is less liability driven and more funding ratio driven, although these two have a lot to do with each other. “Low volatilities in the equity markets play an additional timing role here, endorsing these strategies at the moment.
“The last half year and the forthcoming two years, we expect a large part of the pension sector to apply this ‘duration (and equity) hedging’ way, comparable to the shift in Denmark a few years ago,” he says.