The Netherlands: It’s not easy to get right
Cees Harm van den Berg and Gerard Roelofs find that the UFR has led to heightened
awareness of interest rate risk and many funds have changed their hedging policy.
The system of setting interest rates for Dutch pension funds has undergone some major developments in the last couple of years. It started with a fixed discount rate of 4%, making life easy for a pension fund in the Netherlands: no volatile liabilities, no difficult calculations and no interest rate derivatives.
But the Dutch central bank (DNB) argued that this fixed discount rate was not a proper representation of the risk-free discount rate for long-term liabilities and introduced the market interest rate for pension funds, based on the euro swap curve.
Suddenly, pension funds found themselves visibly exposed to interest-rate risk and the hedging of this risk using (complex) derivatives. The market interest rate was used until January 2012, when the DNB started to use a three-month average interest rate to cope with decreased liquidity at the long end of the interest-rate curve(1). Although this seemed to be a temporary measure, it was only a prelude to additional complexity – the introduction of the ultimate forward rate (UFR) in October 2012(2).
It is unlikely that the introduction of the UFR will be the final step in the discussion surrounding the discount rate for pension funds in the Netherlands. The ministry of social affairs has asked a special committee to look into the UFR methodology and the parameters used for Dutch pension funds. It seems likely additional changes in the discount rate methodology will occur. This article discusses the current UFR methodology, its impact for Dutch pension funds, market developments and gives a short preview of the coming year.
The UFR has been set at 4.2% for year 60, in line with Solvency II guidelines. This is believed to be a fair representation of rates over the long term, composed of a 2.2% real interest rate expectation and a 2% inflation expectation. A forward rate of 4.2% at year 60 implies that one euro at year 60 will earn 4.2% interest in one year. Another important parameter of the UFR-methodology is the last liquid point, which has been set at year 20.
This can be seen as the last point on the curve properly reflecting the market rate and providing enough liquidity. Between year 20 and 60, the forward rate converges to the UFR.
The methodology for this conversion is different for pension funds compared to insurance companies. The Smith-Wilson methodology implemented by insurance companies introduced problems with interest-rate sensitivity around the last liquid point. Therefore, the DNB introduced a methodology whereby the forward rate represents a weighted average between the actual forward rate and the UFR, with weights increasing from 0% UFR at year 20 to 100% UFR at year 60. Weights are set by the DNB. This resulted in the curve presented in figure 1.
Impact on Dutch pension funds
The UFR curve provides higher discount rates than the current market curve, as can be seen in figure 1. Using these discount rates causes a lower present value of liabilities, which, in turn, results in increased funding ratios for pension funds. The average impact is shown in figure 2 for mature, average and young Dutch pension funds.
Apart from an increased funding ratio, the interest rate hedge efficiency also changes. The fixed UFR causes the longer-dated liabilities to show lower interest rate risk, but the hedging assets (still discounted with the market curve) do not change, resulting on average in an ‘over hedge’. Other influences of the UFR methodology are:
• Significant decrease of interest rate risk for maturities beyond 30 years, due to the fixed UFR on the long part of the curve;
• Increase of interest rate risk for 20- and 25-year maturities, due to the impact of the last liquid point on interest rates beyond that point;
• Increased attention on the convexity aspect of interest-rate hedging, since convexity of liabilities is reduced, while convexity of the hedging assets remains unchanged.
Pension funds may decide to base their interest-rate hedge on economic (market) risk or UFR (regulatory) risk. Whichever hedge is used, pension funds have to accept that from now on their funding ratio is subject to UFR risk. However, they are still subject to ‘real’ economic risks in their balance sheet. It is therefore important that both risks and therefore both types of balance sheets are monitored periodically and it is advisable that additional monitoring is done for different maturity buckets. The UFR influences not only total interest rate sensitivity but also the risks along the different maturity buckets. There is a fair chance that an average pension fund has an over-hedge for longer-dated maturities on a UFR basis.
The decision to hedge interest rates on an economic basis or on a UFR basis is specific to individual funds, but the DNB has already expressed its opinion, stating that economic risks must take priority for pension funds(3). This is illustrated by the required solvency position that pension funds must report on. A pension fund that finds itself in a so-called ‘recovery situation’ is not allowed to increase its risk profile expressed in terms of required solvency (ratio). The calculation of this ratio is based on economic risk and a pension fund changing to hedging UFR risk would see an increase in required solvency.
Many pension funds gained an insight into the impact of the UFR methodology on their liabilities and interest-rate hedging policy in the fourth quarter of 2012. The results were blurry due to differing policies and instruments used for hedging. For some under-hedged pension funds the UFR provided a step towards a (higher) strategically preferred hedging ratio. Unfortunately, for some pension funds showing high hedge ratios, the UFR caused an over-hedge. Participants realised that an increase in the interest rate could adversely affect its funding ratio, which caused some pension funds to change their hedging policy in total or along the curve. Overall, the introduction of the UFR for pension funds resulted in an increased awareness of interest rate risks along the curve. The majority of pension funds still hedge interest rate risks using the market curve.
Asset managers and consultants have shown their capabilities in assisting clients in dealing with the UFR and subsequent changes to the hedging portfolio. Even though some adjustments were small, we have seen managers closing longer-dated duration funds, forcing investors to find different solutions.
As 2013 appears to be a transition year for the Dutch pension industry, large adjustments might be postponed until more details of what may come are available.
The ministry of social affairs has installed a committee of ‘wise men’ to look into the suitability of the UFR-methodology for Dutch pension funds. Their mandate is to look into the different parameters (last liquid point, convergence period and level of UFR) used in the methodology and its perceived impact for the pension industry(4). Their remarks and conclusions will be presented before 1 July 2013. The Dutch pension industry is – once again – facing an interesting year.
Cees Harm van den Berg is an investment consultant at Towers Watson in Amsterdam and Gerard Roelofs is head of Towers Watson’s investment business for continental Europe
1. Maatregelen DNB verkleinen onzekerheid over pensioen, 6 januari 2012 http://www.dnb.nl/nieuws/nieuwsoverzicht-en-archief/nieuws-2012/index.jsp
2. UFR geeft pensioenen aanknopingspunt in woelige markten, 3 oktober 2012, http://www.dnb.nl/nieuws/nieuwsoverzicht-en-archief/dnbulletin-2012/dnb279070.jsp
3. Q&A’s septemberpakket pensioenfondsen (update 30 November)
4. Commissie UFR, http://www.rijksoverheid.nl/nieuws/2012/12/21/commissie-ufr.html