FTK: Will the new rules change Dutch pension funds' attitude to risk?
Wichert Hoekert and Geert-Jan Troost discuss the recent FTK changes and how they may impact risk strategies in the Dutch pensions industry
At the end of 2014, in the days before their Christmas break, the Dutch Upper House accepted proposals to change the law governing the financial assessment framework – the FTK. This brought to an end a process that began only a few years after the FTK was implemented in 2007. In the context of the national dialogue on pensions, which is far more radical in terms of changes to the pensions system, this adaptation of the FTK is considered necessary for short-to-medium-term maintenance.
Necessary maintenance perhaps, but the kind that requires all pension funds to reconsider their financial set-up. The changes to indexation rules and recovery plans, as well as for benefit reductions, are such that no fund remains unaffected. Fundamental questions have to be answered, such as about risk sharing and intergenerational fairness, as well as on attitudes to risk and risk profiles. As interest rate risk is the biggest contributor to the fund’s risk profile, policy responses to changes in regulation often imply changes to the interest rate hedging policy.
Changes to the FTK
At the heart of the changes is the aim of stabilising cash flows, both for contribution payments and for benefit payments. The most important stability enhancement for contribution payments is that funds using expected returns to set-cost effective contribution levels must fix these for five years, whereas before this was only optional. Although, this does not imply a fixed contribution, for example due to demographic changes that do have to be taken into account, it does mean a more stable contribution level. Given the current low interest rate environment, we expect funds to move to this expected return approach.
For benefit payments, significantly stronger restrictions for granting indexation, and in particular for catch-up indexation, have been introduced. On the other hand, as a consequence of new recovery plan rules, benefit reductions should be less frequent as well as less impactful. Interestingly, stronger restrictions on granting indexation should benefit younger and future generations, whereas less frequent benefit reductions should be beneficial to older generations.
In the future, conditional indexation will not be allowed at policy funding ratios below 110%. Full indexation can only be granted when the assets available to the fund above the 110% policy funding ratio are such that it is expected that full indexation can also be granted in all future years. On average, this is the case at policy funding ratios of around 130% – with that level depending on parameters such as the maturity of the fund, the targeted indexation level and the interest rate.
Funds that have had policy funding ratios of below 105% for six consecutive years will have to implement benefit reduction recovery plans to close that gap and there will no longer be a distinction between short- and long-term recovery. Recovery plans will, in principle, have a fixed 10-year term, whereas prior to 2015 all recovery plans would have had a more flexible end date. Benefit reductions may apply if a fund does not expect to recover to the new required solvency level within the term of the recovery plan. These reductions could occur throughout the term, but would be revisited on an annual basis with the same fixed 10-year term in mind. The regulator, De Nederlandsche Bank, predicts that 60% of funds will have to submit recovery plans based on their 2014 policy funding ratio, but that few, if any, will have to implement benefit reduction recovery plans.
Attitude to risk and risk profile
Under the new FTK, another core concept has been introduced, that of attitude to risk. In future, funds will have to determine and disclose their attitude to risk, which must be agreed with the social partners. This ‘risk attitude’ should function as the basis for shaping funds’ policies, including investment policy and be translated into a risk profile. Traditionally and logically, interest rate risk (and thus hedging) is a significant component of this.
In the years leading up to the revision, a number of parties argued against the strong focus on market valuation and nominal guarantees encouraged by the FTK. Some of the changes should diminish this and allow a greater focus on longer-term targets. The introduction of the policy funding ratio (the 12-month moving average of the current funding ratio) is one of these. That said, unfortunately, we doubt that the revisions themselves will succeed in diminishing the focus on nominal guarantees.
Impact on interest rate risk
Will these changes alter the Dutch pension industry’s typical ‘hope-versus-fear’ relationship with interest-rate risk? Funds are consistently torn between the hope for higher rates – supported by the forward curves in the market, for example – leading them to lower their interest rate hedges and fear for lower rates, getting hurt in the process. We believe that pension funds will alter their future hedging strategies – not so much driven by the new FTK rules but instead by actively reacting to low(er) interest rates.
We believe this because the changed calculation method to determine the policy funding ratio is unlikely to impact hedging strategies, but then neither did the previous three-months averaging method. Dutch pension funds are capable of distinguishing ‘reporting’ aspects from ‘strategy’, especially regarding interest-rate risk hedging. Secondly, we think the new required solvency (VEV) calculations favour government bonds and credits, while at the same time the EMIR regulations on derivatives have had an impact on how to handle derivatives, although these aspects predominantly concentrate on the instruments used, not risk appetite. Thirdly, we think the ultimate forward rate curve will remain unchanged for Dutch pension funds. Even if the current method were to be be replaced by the Smith-Wilson method, as has been debated with EIOPA to align with insurers, the impact on current long-dated risk hedging will be limited.
So why would risk strategies change? Discussions with pension funds are increasingly moving away from the ‘hope-versus-fear’ theme, as quantitative easing, low euro-zone growth and low oil prices, together with other disinflationary pressures, lead to lower rates and perhaps into negative territory. Instead, a more active, dynamic, approach is emerging. Traditional dynamic strategies were based on, for example, absolute interest rate levels that turned out to be myopic when designed at the then-prevailing rates and were prone to mean-reversion assumptions. Nowadays, more aspects are taken into consideration, initially complex sounding but ultimately more relevant.
For instance, suppose that rates do not move during 2015: what will the pension fund lose due to ‘rolling down the curve’? And how much is there to gain from term premium and carry? And what if rates fluctuate: will the assets generate the same convexity to compensate for the liability-driven losses? And suppose that rates start to increase: what would that mean for implied forward curves and credit spreads? Awaiting further economic and regulatory developments, these aspects will have an impact on funding ratios.
Like most of you, we do not know where rates are expected to go. But, regardless, these expectations are often skewed by hopes and fears. Therefore, to ensure strategy is not driven by emotion, a dynamic approach is recommended. This approach not only incorporates the things we expect but stays ahead of the unexpected.
Wichert Hoekert and Geert-Jan Troost are consultants at Towers Watson in the Netherlands