The Dutch revolution
“The Dutch pensions industry had come from being a virtually unknown pension power 10 years ago, to being the global pension revolution leader today,” said Keith Ambachtsheer, academic and strategic adviser to pension plans.
Ambachtsheer, who runs KPA Advisory Services in Toronto, was one of the high profile speakers to address the farewell syposium held in honour of Jean Frijns, CIO of ABP Investments, who is leaving the fund to chair the Monitoring Commission Corporate Governance.
There were a number of reasons for this rise in Dutch pre-eminence. “Dutch pension funds are separate entities by law. The largest ones, led by ABP, have become increasingly arms-length single purpose agencies in action,” he said.
“Maintaining a global leadership requires that this contribution be continued to be valued and fostered.” He added: “You are now leading the world in the reengineering of shared risk pension contracts.” These contracts can be regarded standards of fairness, transparency and sustainability, and are based on modern finance principles.
“Led by ABP, Dutch funds are now leading the global hunt for new, innovative investment opportunities.” The Dutch funds are now smart money, Ambachtsheer commented
Funds are actively engaged in a vigorous debate on the meaning of governance relating to pension funds. “I do not think there is a consensus yet here as to what exactly good governance in a pensions context means. But at least the right issues are being addressed and debated.”
Ambachtsheer went on to say the new Dutch model represents a major step forward in the actualisation in the pensions field on a global basis. “You are so far ahead of the North Americans in this area that I am actively organising workshops and flying in Dutch expertise. I did one such workshop in Toronto some weeks ago.”
The new model he regarded as neither DB nor DC in traditional sense. “It is a shared risk arrangement whereby they adjust benefits, contributions and investment policy over time to changed circumstances. In the hands of good management this can be a beautiful thing.”
One of the reasons for the Dutch dominance is leadership, Ambachtsheer said. He paid tribute to Frijns: “Good revolutions need leaders, otherwise they fizzle out or turn into chaos. In this context one person comes to mind, a truly integrative thinker not afraid to speak his mind, leading by example and patient enough to build a strong organisation of talented individuals.”
Investment issues in the 18 years Frijns had been with ABP were tackled by Alan Brown, formerly group CIO at State Street Global Advisors, who joins Schroders in London shortly.
The current emphasis on liabilities at the centre of pension funds concerns, he said, is highlighting the “large and completely unrewarded tracking error between conventional fixed income market benchmarks and the liabilities of typical pension funds”.
“As a result, I feel a move to more structured, more swap-based and more derivative-based fixed income portfolios will bring investors much more closely to a fund’s actual liabilities.” This should release currently wasted risk budgets to more profitable purposes.
The industry must learn from the past 10 years that the static practices it has been following spend too much time concentrating on the small risks and “leave us very flat-footed when the large risks come to the fore”.
“We can move away from the unrealistic assumptions that are at the heart of asset liability modelling today. We can adopt more dynamic policies that truly reflect the goals of pension funds and put the liabilities we are trying to meet at the very centre of our investment processes.”
The skill-based return efforts should be separated from the asset allocation to improve the chances of success. “We can stop wasting precious risk budgets in our fixed income portfolios. Today’s markets provide the tools we need to create structured fixed income solutions much more closely related to our liabilities.”
Brown added: “If we did all these things we would finally move away from Modern Portfolio Theory to truly modern portfolio management.”
But Frijns was not to leave quietly. He used the occasion to draw attention to his shortlist of crucial unresolved issues in the present pensions discussion in the Netherlands.
The first he addressed was the change in the design of the pension product. “The ambition of the typical Dutch pension product is to provide a series of inflation-indexed cash flows after retirement age – in other words a defined benefit pension.”
To fund this product a contribution rate is calculated, which depends on the expected real return on invested contributions. “Typical for the Dutch pension system is a rather strict solvency framework, which is, however, not defined in real terms, but in nominal terms,” he said.
“This framework applies to the balance sheet of the pension fund, which makes matters rather complicated and not very transparent. If, for the sake of simplicity, we transform these nominal solvency constraints into minimal nominal return guarantees for the underlying product, we can analyse the working of the system in terms of characteristics of the pension product itself.”
He said that there are four results: “The first is that the guaranteed product is no longer a defined benefit product but a defined contribution product with a guaranteed annual investment return equal to the expected real return that is used in the calculation of the contribution rate. One should be aware that the guaranteed return is in nominal terms. So, in normal times this guaranteed return is rather low, even lower than the nominal interest rate.”
The second consequence is that the investment strategy for a fund that has to offer this kind of pension product is well known, he said. “In essence it is a portfolio insurance strategy with an adjustable floor. The annual adjustment of the floor is equal to the guaranteed nominal return plus the level of indexation granted in that year.”
Third was that the efficiency of portfolio insurance strategies depends on the buffer relative to the floor, or, in balance sheet terms, the size of the surplus relative to the present value of the guaranteed future pension payments. “If the buffer is low, the probability that the portfolio insurance strategy runs into a trap of permanent low returns is rather high. The current market environment in particular is one with very high trap risk.”
He went on to say that fourthly, the efficiency of these portfolio insurance strategies can be enhanced by increasing the buffer. This, however, requires higher contribution rates, which is not popular among active members – or lower indexation, which is not popular among retired members.
Pulling it together, Frijns concluded: “the current regulatory framework confronts the pension fund with some awkward dilemmas; the penalty for not finding the right answers is an inefficient investment strategy.”
The other major unresolved issue he tackled is the changing nature of the pension fund itself. Here he argued that nowadays the typical industry-wide pension fund in the Netherlands much more resembles a collective defined contribution fund than a classical defined benefit fund. “The role of the collective of employers as financial sponsor and underwriter of the financial risk of the fund has almost completely disappeared.”
This implies that the sponsor no longer is entitled to the surplus of the fund and, what is more important, the participants can no longer be seen as creditors but in economic terms are “upgraded” to owners of and sole risk-takers in the fund. In the light of this, Frijns questioned the bookkeeping convention to talk about pension liabilities, in other words, liabilities of the owners to themselves. “Accepting this logic would have profound consequences for the way the balance sheet of an industry wide pension fund is structured.”
He saw quite a challenge for the accounting profession, given its new gospel that the balance sheet of a pension fund should be a fair representation of the underlying economic reality.
On the positive side, he saw possibilities to better define the way risks are shared between the groups of participants. In his ideal pension fund of the future, the active members should bear most of the risk (and be compensated for that), whereas the retirees could be given the role of annuity-holders. “In balance sheet terms, the active participants are the equity owners and the retirees the creditors,” he pointed out.
Other speakers included Arnold Schilder of the Dutch Central Bank, speaking about combating the financing of terrorism, and the Dutch Minister of Finance Gerrit Zalm, who also presented the royal decoration of a Knight in the Order of the House of Orange to Frijns.
The chairman of the ABP board of trustees, Elco Brinkman hosted the event. Tom Steenkamp, ABP boardmember, presented the farewell gift to Frijns, a specially produced book of academic and other contributions.