Netherlands: Change on the horizon
It has been the poster boy of the international pensions world, but the Netherlands is now reflecting on recent failings following the publication of the Frijns and Goudswaard reports, writes Liam Kennedy, as the prospect of a real cover ratio looms on the horizon
Even central bankers can’t see into the future. “In an ideal world I take decisions today as a supervisor based on my knowledge about tomorrow. But things don’t work like that.” So said Nout Wellink, the governor of De Nederlandsche Bank (DNB), at the beginning of February before a parliamentary committee of enquiry into the financial system, as reported by the Dutch daily NRC Handelsblad.
Governance, whether of the financial system or of individual pension funds, is the topic du jour in the Netherlands right now. While Wellink may have received his fair share of brickbats for perceived failings in the risk management of the economy as a whole, pension fund managers have also come in for a fair share of criticism for missing years of indexation, plummeting coverage ratios and investments in complex strategies. Wellink’s comments were even pithier because while the governor confessed his human frailty, the DNB as pension fund supervisor, is also cracking down on the frailties of pension funds and their board members.
This crack-down is part of a concerted focus on pensions. Post crisis, The Hague’s social affairs and labour minister, Piet Hein Donner, appointed two committees - one chaired by Jean Frijns, former head of ABP Investments, to assess the investment policies and risk management of pension funds in the Netherlands, and another chaired by Kees Goudswaard, professor of applied economics and social security at Leiden University, to assess the social contract nature of pension fund agreements and the pension system as a whole. Both reports were published in January.
Both reports have profound implications for pension investment; Frijns for example concludes that pension funds have structurally paid too little attention to risk management and the execution of investment policy, and that the FTK pension solvency regime pays too little attention to the real nature of pension promises, even if such promises are not explicit in the case of most pension funds.
What’s gone wrong can be measured - by coverage ratios
The Dutch pension system is a poster boy among the so-called P13 group of leading pension countries. So what went wrong? According to Theo Kocken, CEO of the risk management and derivatives specialist Cardano, what happened was a combination of a mis-implementation of investment strategies and a lack of risk management at some pension funds. Of course, each pension fund has a specific asset and liability profile, but, in the aftermath of the financial crisis, there is a clear division between those pension funds that implemented sound risk management policies, for example through interest rate swaps and equity derivatives, and those that did not.
Furthermore, many pension funds had hidden risks in their investments that did not fit with the risk appetite that the board of trustees had agreed upon. The Frijns Committee for instance calls this ‘implementation shortfall’. And even after nine months of good equity returns, and with the average coverage ratio at around 109%, the effect is still measurable in coverage ratios. Pension funds that applied derivatives protection in a suitable manner are still 15% to 25% better off in their funding ratio thanks to this protection. In the midst of the crisis, these levels sometimes even exceeded 40%, according to Kocken.
“Despite their reputation as complex products, the derivatives applied by our pension funds are very transparent, and didn’t cause any surprises” Kocken says. “Simple derivatives aimed at protection worked extremely well when the shit hit the fan. Pension funds should think in terms of uncertainty, not probabilities, and make sure they can bear the consequences. Derivatives are able to avoid unacceptable outcomes.” Kocken also points out the profound sensitivity of today’s mature pension funds to shocks: 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 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. In short, pension funds may not even have time on their side.
While the debate may continue about the reliance on traditional risk metrics, like VAR, the simple contention here is that some pension boards entered the crisis effectively blindfolded in the back of a car that someone else was driving - not only were they not in control of the car, they couldn’t see properly where it was going.
While coverage ratios are a good quantitative metric, a healthy level can be the result of luck rather than skill and it’s less easy to measure the extent to which governance - or internal management - at pension funds and to a lesser extent at fiduciary managers has gone off track.
Dutch pension funds have adopted a range of asset management and administration models with some, like the railway or metal industry funds, owning a fiduciary manager, and others, like the ABN Amro pension fund, building up internal resources in the form of a so-called pension bureau. The metal industry funds PME and PMT are a case in point. Both are clients, and owners, of Mn Services (Mn stands for ‘Metaalnijverheid’, or metal industry), which traces its roots back to 1948 as the in-house investment and administration unit of PMT. In 2001, it became an independent entity solely owned by PMT and now acts as a fiduciary asset manager, with an office in London.
PME previously outsourced investment and administration to PVF Achmea. But after the appointment of Roland van den Brink in 2001 as managing director of PME (then known as PMI) and head of a small internal pension bureau team, the fund ended its mandate with PVF Achmea and made a series of specialist asset manager appointments instead.
In 2007, the PME fund negotiated a stake in Mn Services for itself in return for mandating the organisation with its then €21bn in assets, and Van den Brink returned to Mn Services. But at the end of January this year, PME came into the headlines again when the financial daily Het Financieël Dagblad reported that the DNB had dismissed the PME board. PME issued a statement strongly denying that this had been the case, claiming that the changes were part of a plan developed in partnership with the DNB. The fund said it would improve in three areas - in strengthening the board’s control over investments, strengthening risk management and increasing the level of independent expertise in investment management. Even if it is possible to argue over the semantics of the PME case, it is clear that the DNB has been engaged in intensive discussions with the pension fund. And this is the first time such a discussion between the DNB and a pension fund has become so public.
So if pension funds need greater and more effective resources, how can new structures, such as a pension bureau, be implemented without adding to the layers of bureaucracy that are already present at Dutch pension funds? And what, if any, is the role of fiduciary managers. Wouter Pelser, CIO of Mn Services, says his organisation set out at the end of 2008 to strengthen its dialogue with its clients and the resources it puts at their disposal in order to help them better fulfill their obligations.
Maarten Roest, a director responsible for fiduciary management at Kempen Capital Management in Amsterdam, believes most of his firm’s clients understand that they have to have enough knowledge in-house and says Kempen supports them by providing useful input. “In that sense the regulator poses a good question,” he says: “‘Do you understand what you are doing and can you explain to me what you have done?’ It’s not that you can say, I’ve hired a fiduciary manager and he is taking care of it. You have to be very sure what you are doing, conscious of what your plan is you shouldn’t give the idea that you have basically transferred risks to someone else and now it’s not your responsibility any more.”
What are the implications for fiduciary management?
Given their prominence in much of the debate on investment in the Netherlands, what are the implications for the way fiduciary managers construct, execute and market their strategies? Anton van Nunen writes in this issue (page 19) that fiduciary management itself is not to blame and argues that it has always had the management of solvency risk at its heart. He also says pension fund boards should always be in ultimate control - the determination of the risk profile and strategic asset allocation can never be outsourced to a third party.
There is likely to be more emphasis on the strengthening of internal resources, the people interviewed for this article unanimously concluded. An example, is the December 2006 deal, whereby the €4bn GBF pension fund for the graphical industry appointed Altis Investment Management in Zug, Switzerland, to implement a fiduciary insourcing strategy, providing the board with risk management, manager selection and monitoring advice.
This is hard to compare with the traditional fiduciary model advocated by Anton van Nunen, since it involves increasing internal governance using external experts to sit on the relevant committees. In any case, Van Nunen has consistently argued that fiduciary management and better governance are symbiotic - since the fiduciary manager will implement more effective but complex strategies, the client must increase resources to be able to hold the manager to account.
One fiduciary manager with an open architecture model using external managers feels it may be able to profit from a dissatisfaction with non-local players. “There is a lot of room for other parties because there are other trends such as strategic advice and strategic partnerships, which people are continuously looking at,” says Roest at Kempen. “Clients have become more aware that a number of Dutch investment managers are here to stay and that they are robust parties. They feel let down by the Anglo-Saxon parties that have come in but also have shown less interest in their clients in difficult times so I think the stability and commitment that some Dutch parties like Kempen have shown is a big plus.”
Gerard Roelofs, Towers Watson’s head of investment consulting for continental Europe, describes the strengthening of board-level expertise is now ‘almost obligatory’. He says a shift back to board control, coupled with greater investment committee expertise, could facilitate implemented consulting. “I can very well imagine the popularity of a form of implemented consulting whereby consultants try to help the board and investment committee make selections and undertake monitoring and strategy in a similar way to a fiduciary manager, but with one important difference: we are able to offer a truly independent view.”
Marc van Heel, head of business development for PIMCO in the Netherlands, is moderately sceptical about the future of fiduciary management given the constraints and tougher attitude of the DNB towards pension fund boards. “The interesting thing is the attitude of the DNB,” he says “In my view the PME case is a stark reminder that you cannot legally outsource your fiduciary responsibilities so in a way its going to be very difficult not to have a proper organisation yourself and why would you double up on costs, having a risk manager and a CIO and then outsourcing that to an external manager?”
A real interest FTK -and investment policy
An FTK that takes explicit account of implied future inflation of hitherto nominal promises would take realistic account of the fact that indexation of benefits, although currently expressed as an ‘ambition’ by most pension funds, is an actual objective over time.
It is also a very expensive objective. As Van Heel says: “The whole plea go to a real framework is a good idea but at the wrong time because we simply can’t afford to pay for it. The affordability of the pension over time is not sustainable, which has to do with expected returns that are too low in an environment in which risk appetite and growth is going to be low. If you move to a real framework…most pension funds would be in the 60-80% range. That is simply not a solution.”
Roest, expects a more explicit focus on inflation risk but says this requires more focus on the pension deal because most pension deals are nominal rather than real, and the regulatory system of the supervisor is also based on nominal pensions: “Basically you should review the whole system and emphasise more a real pension deal,” he says.
“We always talk as if a pension fund has one risk profile but there are different stakeholders and they all have their own risk appetite and profile,” says Roelofs, at Towers Watson. “We should take care of this and we should manage risks against those different internal profiles. We should also be aware that a risk attitude and profile is not static and does depend not only on the market but also on the funding ratio. We need to manage risks and implement investments more dynamically.”
Changing to an FTK that takes into account the implication of future inflation promises would also imply changes to the way that pension assets are managed.
Dutch inflation can’t be directly hedged in the OTC market, and some pension funds have historically granted indexation on a basis that is hard to hedge, such as wage growth in the industrial sector of the pension fund itself. Currently only a few Dutch pension funds actually hedge inflation risk using swaps -Kocken at Cardano says only about a third of his Dutch clients do so - unlike in the UK, where compulsory indexation has led to widespread adoption of inflation swap strategies.
Some people contacted for this article were in any case of the view that euro-zone inflation is always likely to be higher than that in the Netherlands - especially given the current ‘divergence’ trend in the euro-zone economies at the moment.
Kempen Capital Management has developed a Dutch inflation fund that invests in property freeholds, collecting ground rents from leaseholders that will be index-linked over time. “That is actually a unique and very safe way to create a Dutch inflation linked product” says Maarten Roest, director at Kempen.
Others choose to ‘hedge’ inflation through commodities or equities, or predict a renaissance for real estate. Warren Buffett style equity strategies could come into favour, as utilised by SPF Beheer for its clients. The firm, which is owned by the Dutch railways pension fund, has transitioned its traditional active equity mandates for Europe and the US to a 70-80 name concentrated long-term long-only equity portfolio with a value tilt. This accounts for more than 50% of the fund’s 30% strategic allocation to equities, with the rest accounted for by passive and emerging markets mandates. “We have implemented this, and completed the transition over two months at the end of last year to the beginning of this year,” says Marcel Andringa, CIO of SPF Beheer. “We expect lower volatility and it is easier to engage with these companies.”