Changes to Dutch pensions could mean greater interest in DC structures, such as premium pension institutions (PPIs), argue Gerard Roelofs and Michel Iglesias del Sol
Recently, we have seen remarkable developments in the Dutch pension market:
a move away from market valuation, benefits cuts, a rapid decline in the number of pension funds and new structures facilitating the management of DC schemes. How can these developments be explained and can we still regard the Dutch pension market as a trend setter for the global pension industry?
New pension agreement
While market volatility was reaching record levels and bond markets were making a clear distinction between ‘core' and ‘periphery' countries in the euro-zone, social partners in the Netherlands have been negotiating a new Pension Agreement. Under this, pension providers will have to choose between two ‘financial assessment frameworks', the so-called FTK1, and FTK2. This choice, however, is part of the collective labour agreements and will have to be made individually by every pension fund.
FTK1 is considered a stricter version of the current regime, which means a continuation of the current practice of market valuation of both asset and liabilities, but with a higher level of required funding reserves. This will, especially in the current low interest rate environment, lead to higher costs.
FTK2, however, entails some drastic changes as this regime targets fully conditional (‘soft'), yet inflation-adjusted pension accrual. Current descriptions contain a fixed, real discount rate for the valuation of liabilities. This discount rate is no longer based on market interest rates, but is determined as the expected rate of return on investments, minus inflation, once every five years.
Under FTK2, buffers are not required (but allowed) and any deficits in pension funding will be reversed through benefits cuts. These cuts can be applied either immediately a deficit occurs, or over a smoothing period of a maximum of 10 years. This makes the system akin to (collective) defined contribution. Furthermore, there is a greater probability that deficits occur, as the valuation already incorporates future excess returns and risk premia. As we have witnessed, there can be prolonged periods where risk premia do not materialise. Logically, these changes have led to consternation. We expect that in the final version of FTK2 a renewed link to market interest rates (possibly smoothed) will be restored.
Furthermore, the new pension agreement contains some elements for making the system more futureproof. This includes a retirement age that moves with life expectancy and the stabilisation of contribution rates.
Under the current ‘FTK0' regime, regulations state that pension liabilities have to be marked to market interest rates, specifically the euro swap curve. As a consequence of the continuing credit crisis, this swap curve is currently reaching record lows. This leads to low coverage ratios for many Dutch pension funds, which under current regulations, have to be remedied within three to five years. This has led a large number of pension funds to announce benefit cuts for 2013 and beyond. This is certainly not true for all funds, however, as investment policy, and especially hedging policies, have diverged widely during the past few years.
The choice between FTK1 and FTK2 will have consequences for the strategic investment policy of Dutch pension funds. Let us start with funds that apply FTK1. As said, this regime is comparable to the current situation. However, because of the sharp contrast with the soft, conditional situation of FTK2, the perception is created that choosing FTK1 implies a ‘guarantee' of accrued rights for participants. We expect funds to increase their hedging policy under this regime. All balance sheet risks, like interest rates, currencies and equities will be largely hedged in order to limit downside risks. The size of matching portfolios will grow to the detriment of return portfolios.
Under the FTK2 regime, changes would be even greater. First of all, the composition of the investment portfolio will determine the level of the discount rate, creating an incentive to take on more risk. Secondly, if a fixed-discount rate is indeed applied, hedging interest rate risk will lead to higher volatility in the funding position - so exactly the opposite of what the hedge was initially developed for. Clearly, this would mean that the demand from Dutch pension funds for long-dated bonds, interest rate swaps and swaptions could diminish. It also means, however, that difficulties can be expected in the transition phase from the current to the new regime. When will funds decide to unwind (part of) their interest rate hedge and will there be a first-mover advantage? We believe that - even with a fixed-discount rate - economic reasons remain to hedge a substantial part of interest rate risk, as a long-term investor. Sooner or later, decreasing interest rates will hurt (re)investment returns. As interest-rate risk will continue to represent a large part of a pension fund's risk budget, elements of hedging should remain in place.
Inflation hedging could become more common under FTK2 as funds pursue an inflation-adjusted ambition. The use of inflation swaps will probably be preferred by many funds over funded inflation hedging through inflation-linked bonds, as the latter exposes the fund to either sovereign-credit risk, or a duration mismatch. We envisage increased interest in ‘inflation related but funded' assets, like infrastructure, real estate and commodities.
Over the last few years, we have witnessed a substantial increase in the level of trustee professionalism and support for them via so-called pension bureaux. This has resulted in better risk management and reporting. However, still more needs to be done, and the new Pension Agreement will further stretch trustees' capabilities.
It is difficult to predict how many funds will operate under each framework in the future. One of the legal uncertainties is whether, or not, currently accrued ‘hard' pension benefits can be transferred to the ‘soft', conditional FTK2 regime. That is a legal battle that has to be settled. It could even be the case that current pension funds will be closed and that future accrual will take place in new funds operating under FTK2. This will be another challenge that tests employers' patience with their pensions matters. These open-ended outcomes are becoming hard for them to swallow and the trend towards DC is on many boards' minds. In early 2011, the law to run DC-schemes in separate entities, the so-called Premium Pension Institutions (PPIs), was enacted. Since then, a few parties have, or are about to, set up such entities. It would seem that the trend towards DC is unstoppable.
So what can we conclude?
Recent research from Towers Watson shows that pension assets in the Netherlands amount to no less than 133% of Dutch GDP, the highest ratio of all major pension markets. Pension developments now receive more attention in the media. At first glance, it appears that the Dutch pension market is moving back in time, away from the well-established trend towards market valuation and transparency. The new FTK2 regime is complex and holds a significant risk to the efficient transfer of wealth between generations. It could also bring about a reluctance from younger employees to participate in a pension scheme and could boost the (currently limited) number of defined contribution schemes in the country.
The proposed new PPI structure, in effect running a DC scheme, is better designed for future developments and the ageing population. It does provide a solution to the growing problem that current pension schemes are too generous and can no longer be afforded. If the system can be adjusted somewhat, especially to increase transparency and ensuring that it remains attractive for younger members, it could be that the Dutch pension market is still considered a positive trend setter.
Michel Iglesias del Sol is head of strategy, continental Europe and Gerard Roelofs is head of investment, continental Europe, both at Towers Watson in Amsterdam