NETHERLANDS - The average cover ratio of Dutch pension funds dropped to approximately 95% this week because of a steep decrease in long-term interest rates, Hewitt Associates has suggested.
Schemes which have not fully hedged their interest risks have been hit in particular, the consultant stated in research, as a 1% decrease on the 30-year inflation forecast reduced interest returns to approximately 2.5% and in turn created a disproportionate rise of their liabilities because pension funds must value their liabilities at market rates.
"An extra disadvantage is that pension funds' liabilities are being discounted in the swap curve, instead of in the government bonds' curve," said officials at Hewitt.
"At the same time, the swap rate is 0.3% lower than the interest rate on government bonds because of increased demand for swaps combined with a decreased supply from investment banks."
Hewitt has based its conclusions on an ‘average pension fund' with 16 years' duration on its liabilities and one-third of members as pensioners, which has an asset allocation of 39% equity, 43% fixed income, 11% property and the remaining 7% spread over hedge funds, commodities and liquid assets.
The consultant said it also assumed there was a periodically-rebalanced investment mix, a non-hedged currency risk as well as a 50%-hedge of the interest risk.
According to Hewitt, the average cover ratio had already dropped to under 105% last week, which tallies with figures from rival firm Mercer Consulting, which reported an average funding ratio of 102% among its 94 clients at the same time.
"The long-term interest rate of 3.6% at the end of November has dropped to 2.6%, which is so low that schemes cannot hedge their interest [risk] any longer," said a spokesman at Mercer.
The long-term interest rate was 4.85% at the start of 2008.
Rob Bauer, Professor of institutional investors at Maastricht University, also explained: "The main problem is that the financial assessment framework prescribes pension funds to value their liabilities at market rates. Because all schemes have started hedging, the interest rates are dropping."
That said, the pension sector must be careful in interpreting the phenomenon, in Bauers' opinion. "It is difficult to tell whether the FTK rules or external factors play a part in the rates drop," he argued.
Officials figures from pensions regulator De Nederlandsche Bank (DNB suggest the average cover ratio of the 650 Dutch pensions funds was still 144% at the end of 2007, followed by an 8% drop to 136% at the end of June.
Under the terms of the Pension Act, a pension fund is considered to be ‘underfunded' if its cover ratio is less than 105% and requires any scheme with a lower level to submit a three-year recovery plan to the DNB.
The pension fund must also indicate how it intends to rebuild its financial buffers within 15 years.