Break-out date draws near
The Netherlands’ industry-wide pension funds may well see their membership dwindle if companies opt out after the publication of the first Z score performance test next year. If, as widely predicted, some of the industry funds fail to meet their Z scores, member companies of those funds will have the opportunity to take their assets elsewhere.
Speaking at the Eurofunds conference in Rome last month, Frans Prins, the director of the Dutch association of industry-wide pension funds (VB), said that although membership of industry wide schemes is supposedly compulsory, there is in fact a little leeway. “Poorly performing pension funds can no longer be assured a stable group of participants,” he said.
The Dutch government introduced Z scores in 1998 to establish a threshold below which membership becomes voluntary. In short the score determines whether the policy and objectives of the fund, as set by the board, have been achieved. The scores gauge relative performance by comparing the annual yield from the fund portfolio with the yield of a standard portfolio, derived from the fund’s investment policy and represented by indices, over a period of five years.
Prins confirmed in the same speech that some of the industry-wide funds are indeed likely to fall below the minimum Z-score next year. To date no single fund has fallen below the standard level yet 13 of the industry wide fund clocked up a negative annual score for 2000. That some of the funds are expected to fail is down to the formula that calculates the Z score (see box). Basically the annual Z-score is divided not by the number of years but by the root of the number of years. “This means that the formula is more strict after five years than it is after three years, so therefore we expect that next year some of the funds will drop below the minimal level,” said Prins.
According to industry professionals, though, there are problems with the scoring mechanism. If a pension fund has a poor year or couple of years, then by the law of averages it becomes extremely hard to meet target by the fifth year. Prins maintains that a fund experiencing two poor years in a row is almost obliged to switch to passive management to guarantee it makes the Z score. (A passive strategy should give a score of zero or marginally more given management fees are typically less than the 0.15% in the formula.) The likes of State Street and Barclays Global Investors are waiting in the wings.
As an illustration, if a fund scores –1.43 for two years, it needs three consecutive scores of zero to meet the standard. SPA, the medical workers pension fund, achieved a score of –1.59 in 2000 so the notion of having two such lean years is not unrealistic. But a fund floundering for two years faces another option – rather than go passive, it can raise the stakes and shoulder more risk – rather like doubling up on black or red when playing roulette.
This is unlikely as pension fund managers tend are not known for their recklessness. But there is a feeling among some asset managers in the Netherlands that the introduction of Z scores has shortened pension funds’ investment horizon. These critics, admittedly, tend to be active managers. Passive managers are understandably less outspoken and defend the five year period as sufficient. “If you cannot implement your strategic decision over five years, who can really reassure you that they can over 20 years?” says one.
Nevertheless, Prins has criticised the five year period as being too short and stresses that if not extended, Dutch pension funds will have to go passive or go for broke. VB is also pushing for Z scores to be applied across the board, not least so members of industry wide schemes have some kind of yardstick with which to measure their alternatives.
“To be able to compare all the funds we think it is necessary to make the Z score compulsory for all funds and insurance companies. Now that the employers only know the Z score of the compulsory industry-wide pension fund, they will perhaps want to leave. They do not know the Z score of the pension fund or insurance company they are considering joining,” said Prins.
Given the technicalities involved with Z scores, they have yet to be honed. The scheme has been adjusted three times in as many years and still the tinkering isn’t over. Data from between 1992 and 1996 were used as a basis of the confidence level that 90% of funds would achieve the required level. Markets are far more volatile and the formula needs adopting so as to take this into consideration. Conversely, there are others who argue that if every fund makes the threshold, the government may have to make the system more stringent.
Despite its reservations, the VB has endorsed the scheme. Prins signed off with the following analysis: “The VB considers the exemption scheme not only as a threat but also, and above all, as an opportunity. The actual implementation of the exemption scheme by industry wide pension funds goes to show that ‘compulsion’ and ‘market effect’ do not have to be opposing processes. With the exemption schemes, the legislator has worked out a new balance between these two factors. Compulsory action is being applied, but not at the expense of everything else. Pension funds actually need to perform well. But to make this system work, the technical problems should be solved. And all pension funds, not just the compulsory ones should use this system.”