Anyone who has attempted to serve two masters knows that the risk of conflicts is enormous. Real success is only possible in two cases: where the two masters have no overlapping interests or when they have completely aligned interests.
Dutch pension funds have a long history of serving multiple masters, with large areas of overlap and not always fully aligned interests. However, they have succeeded in getting through difficult times due to the intensive collaboration between all interested parties.
But the situation changes when regulations and legislation stipulate contradicting goals that give opposite incentives. This is especially the case when a pension fund faces sanctions if one of the goals is not achieved.
This is the dilemma that will face Dutch industry-wide pension funds if current legislation is not changed before new Financial Assessment Framework (nFTK) requirements will come into effect.
What are the reasons for possible conflicts? Let us first consider the two regulations concerned.
One set of rules will be specified by the nFTK, which is expected to come into effect on 1 January 2007. Much about the nFTK has been written recently. Loosely speaking, under nFTK a pension fund’s investment strategy must assure that the risk of underfunding due to market fluctuations will be limited. The main risk factors and the necessary calculations of the pension fund risk tolerance will be specified in detail. Two characteristics of the nFTK are important in this discussion:
o It specifies how a pension fund should address investment strategy (not the tactical implementation) in order to fall within nFTK risk boundaries;
o A pension fund can adapt its investment strategy to changing market conditions at any time to assure continuing adherence to the boundaries.
A pension fund with high quality procedures is a pension fund that is able to measure the prescribed risks and that will change its investment strategy if necessary.
For example, a pension fund may have chosen not to fully match the duration of its liabilities if its risk budget under the nFTK is sufficient (ie, if the coverage ratio, as a function of the asset mix, is high enough). This can be a proper strategy if interest rates are expected to rise. However, if at any time during the year interest rates fall, the pension fund will see its liabilities increase more than its investment portfolio, which in turn means that the risk budget will decrease.
The pension fund may respond by deciding that it should increase the duration of its portfolio. In the most extreme case, it may choose to fully match its liabilities. This strategic decision will be reflected in a new investment mandate (a new strategic benchmark). Under the nFTK, a pension fund reacting to the market in this way is deemed to be behaving very well.
Note that the nFTK only involves the investment strategy. The actual investment portfolio may be actively managed, trying to outperform this new strategic benchmark. It can also be an index portfolio designed to track the new strategy.
But a completely different set of rules is specified by the exemption scheme (Vrijstellingsbesluit) for compulsory participation in industry-wide pension funds. For more than half a century already, Dutch law has made it possible to declare participation in an industry-wide pension scheme compulsory for all employers (and thus all employees) operating in the same industry.
This means, for example, that all civil servants have their pensions with ABP, all health workers are with PGGM and all bakery workers are with the industry-wide pension fund for bakeries. And while under the exemption scheme there are some possibilities for companies to operate their own pension scheme outside of the industry-wide fund, such a company scheme must satisfy strict exemption rules.
In 1998 a new law introduced an exemption rule with regard to the investment performance. This rule – which was motivated by insurance companies’ allegations that compulsory schemes did not have an incentive to set up operations in order to maximise returns, minimise cost and optimise client satisfaction – requires a pension fund to achieve a minimum rolling five-year tactical performance.
Loosely stated, the five-year underperformance with respect to the strategic benchmark - a benchmark determined by the pension fund itself - should not be too large. A statistical measure, the so-called z-score, is used to determine whether a fund is said to be a “significantly below-average” investor. If the fund passes the test, it is either an average or above average investor. Industry-wide funds must be verified as having passed the test every year.
All participating companies in a fund that fails are free to leave it and set up their own pension arrangements on the condition that they are at least of an equivalent quality to that of the industry-wide fund. Consequently, under the z-score exemption law, a pension fund passing the z-score test is deemed to be a sufficiently good investor.
So where is the contradiction between the requirements of the nFTK and the z-score? It seems that a pension fund can be doing the right things for both, setting an investment strategy (benchmark) within nFTK boundaries and achieving a sufficient performance on the portfolio compared to that benchmark.
The main problem is that under the z-score methodology the strategic benchmark must be determined only once, prior to the start of the calendar year and the z-score is calculated after the calendar year by comparing the actual return with the return of the benchmark. A pension fund can change the benchmark only once during the year in case of extreme situations, and only under strict conditions.
But it may happen that to adhere to nFTK regulations a pension fund changes its strategy (for example, where a continuing decline in interest rate forces the fund to more closely match assets and liabilities) but at the same time it is not allowed to change the benchmark that is used for the z-score calculations.
After the calendar year, it may turn out that the pension fund did a very good job under the nFTK. However, the z-score may have any value depending, essentially, on what interest rates did after the change in strategy. If interest rates rose, the fund will have to show an extremely negative z-score: the actual portfolio return, with longer duration, underperformed the original benchmark. This will happen even if the fund managers actually outperformed the new benchmark. If interest rates fell further, the z-score will be very high even if actual active management did not add value.
The problem is clear: industry-wide pension funds that do a good job under the nFTK regulations have a large risk of failing the z-score test, even if they actually outperformed their strategic benchmarks. The solution is also clear: the z-score regulations should be made more flexible. This will allow the pension funds to comply with both regulations and show their actual skills on both the strategic and the implementation level.
Hans Braker is an independent consultant and a specialist in performance analysis