The Netherlands: Regime change
Uncertainty is unsettling the Dutch pension fund industry as a new pension framework takes shape, finds Nina Röhrbein
Regulatory changes in the Netherlands have been anticipated for a number of years. But with a new government elected in 2012, the reforms are now truly underway.
In the second pillar, one of the most wide-reaching changes to the pension regime for decades is the revision of the 2006 financial assessment framework (FTK). The revised framework was originally meant to come into force in January 2014 but was postponed by a year last autumn.
The new framework will create two systems – a ‘nominal’ system with a high degree of certainty of pension income and a ‘real’ system with a greater degree of risk sharing between the pension fund and beneficiary.
Gerard Riemen, director at the Federation of Dutch Pension Funds says the industry now finds itself in an interim period. “There are proposals for changing the regulatory framework on 1 January 2015 but it is still unclear what all those changes will entail. This year will mainly see temporary changes such as the UFR and the calculation of liabilities on a three-month average basis.” The secretary of state for social affairs and employment, Jetta Klijnsma, announced that she would have proposals for consultation by the summer and that the legal draft would be sent to parliament in December, Riemen points out.
FTK causes uncertainty
Bram van Els, spokesman at pension fund provider MN, adds: “For the industry and the legislator, the delay to the new FTK framework means one additional year of preparation.
However, it also means ongoing uncertainty for pension fund participants, which increases the number of years worked on the new pension contracts to almost six. This is not good for the confidence in the collective pension system, which is already under severe pressure.”
The two main problems with the new FTK are uncertainties surrounding the discount rate and accrued pension rights in the real contract.
A pilot scheme by the Dutch regulator, the DNB, and pension fund Pensioenfonds Zorg en Welzijn (PFZW), which has opted for a real contract, is underway to try and solve these issues, with results expected in this summer.
The delay means that cuts to benefits for underfunded pension funds will kick in when the five-year recovery period set out by the regulator comes to an end in January 2014.
“Some of the cuts could have been avoided with earlier implementation of the new FTK framework,” points out Marc Heemskerk, retirement principal at Mercer.
But the benefit cuts have already started independently of the delay to the regulatory framework. In April 2013, for example, 70 pension funds will cut their pension benefits by 0.5% to 7%, affecting more than one million pensioners and more than two million active members.
The pensioner representatives group KNVG expects plenty of lobbying in the meantime, which may result in changes to previous proposals. It believes that recent fiscal proposals of the government discriminate against pensioners compared to the workers. In addition to the cuts, retirees suffer from a stagnation of their income as indexation has been withheld for five years, meaning retirees will loose a quarter of their purchasing power between 2008 and 2017.
“With the nominal framework still in place and funding ratios remaining low, pension fund boards are bound to focus on nominal pensions for the time being,” adds Eva Wüstefeld, senior client relationship manager, institutional clients Netherlands, BNP Paribas Investment Partners.
The choice is yours
Although PFZW has agreed to move to a real contract, views are still mixed. “Some pension funds are seriously investigating the possibilities of a real contract and are in a hurry, while others are curious but worry about their existing pension rights,” says Riemen.
“The majority is less eager and awaiting the results of the pilot and the regulatory framework before making up their mind.”
Riemen believes the regulator should facilitate a January 2014 start-date for pension funds that have decided on their new contract.
“Regardless of the choice that social partners and pension fund boards will make on which contract to use, adequate pension provision is about what your pension is worth in the grocery shop,” says Van Els. “Unfortunately, the current discussion about the benefits of purchasing power protection versus nominal guarantees is complicated by strong risk aversion, induced by the financial crisis,” he adds.
Heemskerk expects larger funds to choose real contracts, as their investment strategies are suited to them. Smaller and more mature schemes are more likely to stay in nominal contracts. “Nominal pensions contracts with a guarantee require a risk-averse investment strategy,” he says. ”But some of the large industry-wide pension funds run strategies that include commodities, real estate and equities, which would be considered too high risk for a nominal contract but lower risk for a real pension.”
“The rules that apply to the nominal contract will be stricter but if the fund is healthy, there are no overriding reasons to move to a real contract,” says Bart Oldenkamp, director and co-CEO at risk manager Cardano Netherlands.
“On the other hand, if a pension fund is underfunded and facing cuts, many elements of the real contract may be appealing. A real contract might mean having to periodically announce rights cuts, albeit inflation-adjusted. Promising inflation adjustment will be difficult, since there are not sufficient real assets to invest in. For both contracts, pension funds have to manage the expectations of members.”
A new discount rate
Part of the new FTK is the new discount rate, for which the original methodology has already been revised.
“The first UFR methodology, Smith-Wilson, which is still active for the insurance industry, was revised because it created very complex hedging around the 20-year maturity,” says Geert-Jan Troost, investment consultant at Towers Watson in the Netherlands. “Under the revised UFR methodology, the sensitivities, particularly the longer-dated liabilities, are much lower than under market valuation.”
According to MSCI, for the average defined contribution pension plan, the UFR rule increases funding status and decreases regulatory market risk because the long end of the curve is tied to the UFR. Three-month smoothing, introduced in late 2011, further reduces regulatory risk. The UFR rule also creates incentives to unwind hedges because shocks to the euro swap curve have a muted effect on the UFR curve, while introducing unhedgeable political risk.
“If inflation and interest rates were to go up, there could be a political decision to change the UFR, and this risk cannot be hedged,” says Neil Gilfedder, managing director and head of analytic applied research group at MSCI.
“Hedges are generally created to counterweight the effect of interest rate changes on the funding level, so if the effect of shocks is lower for the UFR curve it creates incentives to unwind hedges,” he says.
Troost says: “For a pension fund that hedges nearly all of its liability risks, the switch to UFR is confusing. A 90% hedge on the sensitivity of the interest rate of the liabilities will jump to over 100% under UFR.”
It is almost impossible for pension funds to come up with a hedging strategy against the UFR, believes Mike Pernot, pensions consultant with Aon Hewitt in the Netherlands.
“There are no products available in the financial markets,” Pernot says. “Funds also cannot reduce their hedging positions as long as they are underfunded, which the majority are.
Therefore, all the funds we advise have continued hedging on a market interest rate-based approach. Some clients only changed the curve risk of their hedging strategy because the curve risk changed based on UFR. Others have transferred the higher duration bonds/swaps into lower durations bonds/swaps.”
The DNB has attributed more than three percentage points in coverage ratios to the introduction of the UFR.
“Some people argue that with the UFR, the balance sheet looks healthier than it is under market valuation,” says Troost. “But this also creates redistribution effects between existing pensioners and younger workers. Furthermore, a higher balance sheet as a result of the UFR also creates the obligation to meet that yield over the long-term because if liabilities are yielding at a higher level so should the assets.”
Pension funds are legally required to use the UFR methodology in combination with a three-month average interest rate to determine the value of their liabilities and report this balance to the DNB. But most pension funds use the UFR for this purpose only.
“The implementation of the UFR has led to two parallel worlds; the UFR world and the market pricing world,” says Van Els. “Pension funds have to use the UFR for supervisory purposes, but at the same time they look at their financial position based on market prices.
Which one of the two parallel worlds a pension fund bases its policy decisions on is entirely up to it, as long as it does not violate the supervisory rules.”
Oldenkamp adds: “When the government introduced the UFR, it was not sure what the UFR methodology would be at the introduction of the new pension contract. In addition, because economic exposure is still important, most pension funds have not adjusted their hedge strategy. The regulator also insisted that pension funds that decided to fully adjust towards a UFR liability hedge needed to have buffers, implying that funds still needed to worry about their economic exposure.
“If the fund is well-funded, measuring the funding level in UFR terms while managing in economic terms is a viable option. It may only harm the fund if it faces rights cuts.
Therefore, many pension funds treat the UFR as a constraint in their management. But many funds find living in two worlds difficult. Another issue is that the UFR is determined by discretion. People cannot anticipate an adjustment from 4.2% to 3.2%, for example, in other words the UFR is a huge basis risk for pension plans.”
Meanwhile, a commission aims to fine-tune the existing UFR and implement its proposals in 2014 – so the current UFR of 4.2% could change next year.