The Netherlands: Anxiety management
Nina Röhrbein gauges views on how the likely changes to Dutch pensions will affect investment and risk strategies
It is safe to assume that investors will be focused on the outcome of September's parliamentary elections, the results of which will affect the Pensions Agreement and consequently the investment strategies of pension funds.
"However, the national pensions agreement and upcoming elections do not play as big a role as one might think," says Bart Oldenkamp, director and co-CEO at Cardano Netherlands. "Pension funds are much more involved in dealing with the exacerbating euro crisis and preparing for the ultimate forward rate (UFR), the discount rate of the new financial framework for cashflow maturities of 20 years and above."
Any current political differences mainly concern the retirement age and not the UFR, which is why it is widely expected to be introduced.
"The UFR is too technical for politicians to bother with," says Jelle Beenen, business leader, Benelux, at Mercer Investments. "But recently there have been signs that civil servants are getting slightly nervous about the negative reactions to the UFR from the experts they have consulted. The elections could, of course, alter the Pension Agreement, but Dutch pension funds have become accustomed to uncertainty around policies. Major overhauls of investment strategies, asset classes and searches for new asset managers have therefore only taken place at a relatively low level over the last couple of years."
Risk management and reduction have been a recent priority for Dutch pension funds and as long as the euro crisis remains unsolved, they are reluctant to take on more investment risk.
Creating value and maximising returns is therefore less of a priority. "Many trustee boards are discussing when to lower their interest rate hedge ratio, which they hope may lead to capital preservation when interest rates eventually rise," says Mark Burbach, CIO at fiduciary manager Blue Sky Group.
"Because the UFR means a huge increase in the complexity of their risk management, one of the big dangers on the liability side is the risk of inertia and the halt to dynamic approaches while, on the asset side, pension funds cannot take too much risk," says Geert-Jan Troost, senior consultant at Towers Watson in the Netherlands. "This has already driven many pension funds to stop their operations and merge or go to an insurance company."
In the liability-hedging portfolios of Dutch pension funds there has been a steady sell-off of peripheral European countries in recent years. Pension funds concentrate on German, Dutch, Finnish and Austrian sovereign bonds instead. Non-euro government bonds have also progressively been included in the hedge portfolio, signalling that pension funds prefer currency risk over credit risk. When pension funds wanted to de-risk in the past, they reduced their overall exposure to the return portfolio, mainly equities. Increasing awareness of the risks of the hedge portfolio, however, has led to new steps to reduce risk within the return portfolio such as low volatility minimum variance equity strategies, which aim for equity returns with lower levels of risk.
Pension funds are also shifting towards fundamentally-weighted benchmarks for both equities and fixed income. They need to economise on the risk of the equity benchmarks, which is why they are looking at minimum variance and minimum-volatility benchmarks, with less emphasis on market-cap benchmarks. On the bond side, countries or corporates with a lot of debt make up a large part of the benchmark, but investors want to avoid exposure to the biggest debtors at present.
Another way of reducing risk in the return portfolio is to sell equity and transfer the resulting capital to asset classes such as high yield. The gradual increase in the weight of emerging markets continues to equities and to a lesser extent to emerging market, local currency-denominated debt. "If the euro crisis escalates, emerging market currencies are likely to appreciate against the euro, which is why exposure to non-euro currencies is one of the few tail risk-reducing hedging strategies," says Beenen.
Although alternative investments are less popular amid the trend towards transparency and simplicity, they are in favour to a degree as long as they are transparent and simple to understand, according to Troost. "But Dutch pension funds are still reluctant to invest in real estate, either because they already have an allocation which is underperforming, or because of the overhang in the real estate market," he continues.
Funds have, however, begun to cautiously dip their toe into Dutch mortgages via structured formats such as covered bonds. With banks moving some of their mortgage exposure off their balance sheet, the market plays to their advantage, resulting in good spreads on structured notes.
"We look for returns in less liquid assets, such as emerging market debt, high yield, private equity and real estate," adds Burbach.
The link to inflation in real estate and infrastructure is prevalent in the core asset classes without leverage, in other words direct exposure to the underlying buildings or infrastructure. However, those are difficult to come by.
"Commodities are better suited to inflation shocks than the day-to-day movement of inflation," says Beenen. "But the Dutch government will be pressurised again into issuing inflation-linked bonds, which a lot of pension funds will want to buy when their liabilities change from nominal to real."
Pension funds will have to opt for a nominal or real contract following the elections. Once that has been decided, fundamental discussions about the asset mix are likely to start again, believes Beenen. "Pension funds have already discussed which appropriate inflation-linked assets could be used in real contracts," he says. "But in day-to-day practice, it will be difficult to put on a real liability hedge due to the lack of available instruments, while some inflation-linked assets have their own disadvantages in terms of governance and evaluation."
He believes that most pension funds will shy away from the real contract in order to avoid conflicts and potential court cases with participants.
Troost agrees: "Traditionally, Dutch pension funds did not regard inflation-linked products, or investments, as a priority, which is why there is no automatic tendency towards real contracts. They are mainly invested in inflation-linked products for diversification purposes. More importantly, many funds struggle to meet their nominal liabilities - if they were to switch to a real contract it would increase the deficit even more."
At present, most pension funds are in the process of analysing the impact of the UFR but have yet to reach a stage where they can make a decision on what to do, according to Oldenkamp.
"With the introduction of the UFR, the way pension funds used to hedge may not automatically be the best form of risk management anymore," he says. "If pension funds do a hedge based on the regulation, they will be highly sensitive to any changes to the UFR by regulators. If pension funds continue to do an economic hedge, they may face funding level fluctuations beyond their control because they are measured against the UFR evaluation."
"We expect some of the 50 and 40-year interest rate exposures to be changed to 20 and 30 years because, from an accounting perspective, the UFR does not recognise 40 and 50-year exposure, which is why there is a trend away from cashflow-by-cashflow hedging," adds Beenen.
Under the new UFR framework, a 90% hedge can easily turn into a 120% hedge, which, once interest rates rise, would lead to lower funding ratios. Therefore, in the proposed framework, funds with a high interest rate hedge are almost forced to reduce it to below 100% in the UFR context. "To reduce the hedge percentage, pension funds typically reduce the long end of the curve and exchange it for shorter duration," says Beenen. "However, while taking the UFR into account, pension funds should remain aware of the real economic risks, meaning funds with a 20-30% hedge should continue to increase their interest-rate hedge."
"Our first ALM studies indicate that pension funds should not remove all of their long-dated investments under the shorter-dated UFR rule because their long-term economic exposure makes a big difference," adds Troost. "Unfortunately, a lot of pension funds feel closely tied to short-termism by the regulator and in the short term could be tempted to get rid of longer-dated LDIs. The danger, of course, is that you could lose the longer-dated ALM approach."
Over the summer, the ministry of social affairs and the regulator were set to talk about whether they would already make an adjustment in the evaluation principles of the UFR before the wider set of policies comes into force.