Pension funds have to be clearer about the distribution of gains and losses, according to draft FTK legislation published earlier this year. Under the new framework, funds will be obliged to set out how they will deal with financial shocks, and when they will grant indexation and catch-up indexation rights where benefits have been cut.
Each fund’s policy on contribution reductions should be included in its actuarial and technical notes (ABTN). Funds are restricted when it comes to such reductions, which are only possible where the fund reached the minimum capital requirement including solvency buffer and has achieved its stated ambitions over the previous ten years, including those relating to the recognition of conditional indexation.
The reformed FTK will anchor in law the creation of a financial crisis plan, describing the rules a fund may implement swiftly if the coverage ratio drops low enough to risk ambitions not being achieved. In a departure from the current rules, funds must state the framework it will adopt if the coverage ratio remains under the minimum funding rate for more than five consecutive years.
Spreading the cost of shocks
The current financial rules require pension funds to reduce nominal liabilities if the minimum coverage ratio is below 105% after three years of recovery. After the 2008-09 financial crisis, funds were permitted extended recovery periods of up to five years on a temporary basis, although this still did not affect the short notice imposition of benefit cuts.
As long as pension funds remain underfunded in terms of the capital requirement – including solvency buffer – they must produce a new recovery plan each year, stating how it will reach the required level within a minimum timeframe of 10 years. Funds must make up 10% of the shortfall each year by reducing indexation or increasing contributions. In extreme cases, reductions in benefits in payment are permitted, this has not changed.
At a glance
• The new FTK creates rules on the sharing of gains and losses, with strict procedures on indexation.
• Funds must create a financial crisis plan.
• Recovery plans may stretch to 10 years but underfunding should not extend beyond five years.
• A 12-month average ‘policy coverage ratio’ replaces the current market rate as the most important measure.
• But there will be a higher minimum capital requirement including solvency buffer.
• The feasibility test replaces the current continuity test.
The 10% increment only applies to recovery periods of 10 years. If funds choose a shorter period they must recover a greater share of the shortfall each year. Mature funds will be expected to choose shorter recovery periods.
Since pension funds annually renew their recovery plan, they could in theory remain in recovery for years since they will not be required to target a minimum coverage level as now. But, there is no intention that pension funds should remain underfunded for more than five consecutive years – and after five years they will have to choose between cuts or additional employer contributions.
There is no longer any wiggle room when it comes to indexation.
Pension funds will have to outline their indexation policy in advance and the cabinet has agreed further conditions. For example, pension funds may only grant indexation if the policy coverage ratio is higher than 110% and then only if the indexation can be delivered consistently.
A rule of thumb is that pension funds may use 10% of the buffer above 110% for indexation purposes. Funds that have granted less indexation than their stated ambition will be able to make catch-up payments but under strict conditions – the fund must hold assets higher than the minimum capital requirement including solvency buffer and be in a position to grant regular indexation.
A coverage ratio applies in both cases. The highest of the two is the starting point for establishing the catch-up indexation and the same rule of thumb applies as for regular indexation in that 10% of the surplus can be used. Where reductions to nominal benefit entitlements are to be reversed, the same conditions are applied as for catch-up indexation.
Pension funds retain their existing ability to smooth break-even contributions – by averaging the market rate over the previous ten years or by dealing with expected returns. It is unclear how funds will be expected to undertake the latter, but they will clearly have to take indexation into account when setting premiums. New parameters apply for expected returns (see panel on assumptions) and pension funds will be able to set an expected return for no more than five years.
Forget monthly coverage ratios and daily market prices. The average coverage ratio of the past 12 months will be the key measure. This ‘policy coverage ratio’ will be decisive for the most important decisions concerning cuts or indexation and the monthly coverage ratio will only apply for funds that have been under the minimum capital requirement including solvency buffer for five years or more. Cuts will not be required as long as the policy coverage ratio is above this level, even if the actual rate is below the target.
How the reformed FTK deals with the issue of assumptions
Pension funds will be permitted to use their 2009 assumptions, when setting contributions for 2015, but new parameters were adopted this spring.
The biggest change is a reduction in the maximum rate of return on government bonds from 4.5% to about 2.5%, taking current rates into account.
Expected wage growth has also declined, from 3% to 2.5%. Inflation (2%) and equity returns (7%) remain the same.
The new approach to fixed income is consistent with the way liabilities are calculated, with the same percentage (the UFR-rate) for risk-free investments.
The determination of asset classes takes into account current pension fund practice. Fixed income distinguishes between government bonds and corporate bonds (credit), with an expected return of 3% – somewhat higher than triple-A government bonds – for credit. Real estate distinguishes between listed and unlisted property, with listed real estate in the equity category. Non-listed real estate is a separate category with a forecast return of 6%.
In addition to listed equities, unlisted property and commodities, there is a category of ‘other equities’, which includes hedge funds and private equity. This bucket has the highest expected return at 7.5%.
The 12-month average is a less volatile measure than the current coverage ratio. The three-month average discount rate, which was introduced in 2012, will no longer apply, but this does not mean that liabilities will be set by means of a risk free market interest rate. The ultimate forward rate (UFR) will apply, although it will be calculated differently from 2015 and extended to a partial market rate for long maturities. The regulator will only assess the UFR coverage ratio and the policy coverage ratio derived from it, even if funds use their own internal market-based calculations.
The minimum capital requirement including solvency buffer – the buffer above the assets that funds must have to meet the nominal liabilities – will increase from around 21.7% to 26.6% based on a three-year average calculation by the regulator, the DNB. The DNB has assessed the impact of further buffer requirements based on individual risk requirements, at the behest of the government, with equity risk in particular requiring higher buffers and a special requirement for active management.
The feasibility test replaces the continuity test. Funds must demonstrate each year that the expected pension outcome at fund level is consistent with expectations and is balanced.
The risk element of the feasibility test allows funds to see how it would fare across all scenarios. This should allow it to demonstrate that the pension outcome will not differ too greatly from the expected outcome in a downturn and the fund itself may set the definition of the term “too greatly”.
The fund defines in advance the bandwidth within which the pension outcome may differ from that which is expected. The bandwidth may be adjusted in line with changes to expectations. A fund need not change its strategic investment policy if the expected outcome falls as a result of external shocks.
If the feasibility test shows that the expected pension outcome will deviate too far from the expectation, the social partners should determine whether further measures are needed. This is also the case if the established result threatens to be lower than the lower limit.
The sustainability test forms the basis of member communication on such matters as pension outcome, purchasing power and risks. Secondary legislation takes into account the feasibility, comparability and transparency of the test, aiming towards a prescribed set of variables that will apply across the industry.
Prudent person principle
The prudent person principle is the starting point for investment policy – the fund invests on behalf of all members and this principle will be outlined in legislation, partly by means of qualitative assumptions. Pension funds will have to determine investment bandwidths per asset class, which should encourage proper risk management design.
Terms such as quality, security and liquidity will have to be better defined, and attention paid to organisational structure, independent risk management and to appropriate agreements with internal and external investment managers. Complex investments will require sufficient knowledge and experience on the part of the board.