Long termism is the best strategy
The Dutch pension fund industry is in a state of confusion, maintained pensions expert Jean Frijns, who sees tension in the underlying structure of Dutch pension funds that militates against long-term investment horizons.
Frijns set out a clear analysis of the problems Dutch pension funds face in his address, “Reforming occupational provision in the Netherlands,” part of the IPE live web conference on ‘The challenges in meeting Europe’s occupational pensions liabilities, which took place recently. But he did not just enumerate the problems the funds faced – he also suggested viable solutions.
Under the current model in the Netherlands, defined benefit (DB) pension funds predominate. The problem lies in their risk allocation; this is “the weak point in our structure”, said Frijns to his online audience. “We have always had a model where the sponsoring company is at arm’s length from the pension fund, although I have to admit that sometimes the arm’s length is rather short for corporate schemes,” he pointed out.
For the bulk of industry schemes, which make up the majority of pension funds in the country, the role of the sponsoring company is limited and not always clear. The risk, then, is borne by the participants, “but this is not very clear either”, Frijns noted.
Given this set-up, Frijns pointed to a number of trends that are leading to a lack of confidence in Dutch pension funds. The first is a drop in solvency ratios – the current ratios are near minimum standards. The second is the effect of persistent low interest rates.
These two trends together serve clearly to highlight two additional trends, which are the industry’s underlying problems: an ageing workforce is making for ageing pension funds, making DB structure rather risky; and now that risk is highly visible since sponsoring companies are required to report pension fund solvency in their balance sheets, under IFRS reporting standards.
In this environment, Dutch pension funds are confronting problems on two levels: both in terms of strategy and structure, according to Frijns. On the strategy front, “stricter solvency standards lead to loss-aversion behaviour”, he maintained. This makes funds more expensive, particularly in combination with low interest rates. “The number one objective becomes minimising shortfall risk. Only after that can managers try to maximise returns,” explained Frijns. “Such strategies almost always lead to short-term investment horizons.”
The dilemma for investment managers is clear. They end up contending with unstable and pro-cyclical asset mixes, and a reduction in indexation. Overall such short-term strategies have been shown to produce returns that are considerably lower than traditional long-term strategies. Or, in Frijns’ words, “the normative stance a long-term investment_horizon is at variance with what the financial management of a pension fund would dictate at the moment. There is a tension between what investment professionals want to do, and what their financial officers are telling them to do.”
This is not the only conflict facing Dutch pension funds at the moment. Another relates to the consistent ageing of the workforce and therefore of the pension funds. Frijns notes signs of increasing tension between generations, because of conflicting goals: is the priority placed on indexing for retirees – or on building up reserves for the future to benefit the younger cohort?
So strategically, the dilemma for pension funds is to balance the varying needs of the age cohorts, at the same time as they have to contend with a low-solvency - and low interest rate - environment.
The other difficulties facing Dutch pension funds relate to the fact that they are structured rather like insurance companies. They have, according to Frijns, “risky balance sheets,” with large liabilities set against small equities components to cover them. “This is why they have to watch solvency ratios carefully,” he said. They are highly geared, unlike defined contribution (DC) pension funds, which are low-geared.
Frijns questions whether “this structure reflects the true economic reality of pension funds”. He believes the answer is no. “The participants in the fund only appear on the balance sheet as debtors, so the balance sheet no longer reflects reality,” he maintains, “and this has direct consequences for how you should look at gearing ratios.”
In sum, Frijns sets out the core of his analysis – for the Dutch pension funds, structure hinders strategy. And his recommendation? Stick with the traditional investment strategy of a long-term focus, and adjust the structure. However, he makes it clear that different funds will have to adopt different models, warning that there is no one-size-fits-all solution.
That said, he sees two possible base models. One is a low-gearing model, a traditional DC base, with explicit risk allocations and well-defined ownership. The other is a high-gearing model, rather like a traditional DB corporate or stand-along pension fund.
The current low interest rate environment does not favour the second, DB model, especially because it has to operate within strict solvency constraints. In addition, it relies on a dynamic asset mix, with the amounts of hedging varying over time. “From the standpoint of the long-term investor, this is inefficient,” Frijns stated. Also he doubts that this model is even sustainable if interest rates remain low, threatened in part by increasing intergeneration conflict.
A DB fund would require either higher contribution rates or lower indexation to survive, and either option would disturb one cohort of participants. One solution would be to increase the equity part of the pension fund, “but building up surpluses in a low interest rate environment is not attractive”, said Frijns.
At this point, Frijns suggested a thought experiment. “If we accept long-termism as an optimal strategy, how can we allocate risk, assuming the sponsoring company will not accept any risk?”
Frijns suggests a risk-tranching model more along the low-gearing, DC lines. The senior debt is allocated to the older participants, the junior debt to the middle aged participants, and the equity portion to the younger participants.
“This way everyone knows how returns are allocated. The question is, is such a model acceptable? Or is it too risky,” Frijns asked.
The simple answer is no. “The traditional model looks riskless, but it is not so. In fact, senior retirees are exposed to low interest rate risk now more so than they would be under the new model,” Frijns pointed out.
In the low-gearing model, the risk is concentrated in the equity portion of the portfolio, and is borne by the younger participants. However, they have greater human capital and thus have a higher risk capacity – and in addition, the greater risk is set against the possibility of achieving higher returns.
What this model does require to succeed is a rigorous restructuring of the liability side of the balance sheet, “so everyone knows the risks and rewards”, according to Frijns. Under this model, asset allocation overall would depend both on the age profile of the pension fund (and its participants) and on the risk acceptance or risk aversion of its active participants – there would have to be explicit risk-sharing rules between groups of participants.