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In this instalment of our series of discussion papers on defined benefit pensions, Klaas Knot argues why the Dutch FTK pension solvency system is robust and can cope with future developments and goals

For the second time in just five years, Dutch pension funds are having to contend with a sharp fall in their solvency levels. The first crisis was a consequence of the bursting of the internet bubble and the aftermath of the terrorist attacks of 11 September 2001. This time, the culprit is a combination of the credit crisis and a looming recession. Both developments show that it is important for pension funds to maintain a satisfactory solvency level. After all, sufficient solvency levels are intended to protect the interests of pensioners and employees.

Without an adequate solvency position, disturbances in financial markets can lead to funding shortages and members see their claims evaporate. This article examines the particular characteristics of solvency for a pension fund, mark-to-market valuation, the stabilisation of policy reactions and the sufficiency of the existing options for risk sharing. Finally, we look at the future of the pensions system and alternative approaches to risk sharing. The article concludes with an answer to the question of whether the Financial Supervisory Framework (FTK) is prepared for these possible changes to the pensions system.

The classic Dutch pension fund is in many respects an unusual beast. First, the institutional framework is unusual. Unlike a bank or an insurer, the pension fund has no external shareholders who take on residual risk. All risks are borne by the scheme participants collectively. They are providers of both external and own capital. If risk sharing does take place, it comes from the sponsor company making additional contributions or receiving occasional restitutions. A pension fund has in effect no share capital with clear ownership or voting rights, unlike a bank or a commercial insurer. The solvency of the pension fund surplus is ‘only' the difference between the mark-to-market value of its assets and unconditional liabilities.

Another peculiarity is that the pension fund can be analysed in several different ways. We can regard it as a risk management issue or as an investment issue. If we focus on risk management then the primary concern is to secure the (unconditional) liabilities. From this perspective, the pension fund can decide to limit mismatch risks, for example by hedging interest rate or inflation risks using bonds and derivatives. If pension provision is regarded as an investment problem, then other considerations play a role. From the perspective of an integrated life cycle model it can be more attractive to take investment risk in the pension fund portfolio. This holds true especially for younger participants who have substantial human capital with a limited risk; older people benefit more from security regarding their old-age incomes.

The above implies that pension fund trustees face a complex problem involving weighing the interests of all stakeholders against each other. In some cases these interests run counter to each other. Consider security for older members versus higher returns for younger members. Or consider the interests of participants versus those of the company's shareholders.  To give all these interests fair consideration, in my opinion, requires the application of ‘fair value'. Mark-to-market valuation minimises the opportunity for manipulation. Applying a different valuation rule would, for instance, be disadvantageous for one interest group and thus automatically advantageous for another. After all, in value terms, a pension fund represents a collection of ‘communicating vessels'. If the water level in one vessel declines, the level in the other vessels automatically rises.

Mark-to-market valuation shows that cover ratios vary sharply according to the observed mismatch risks. Fortunately, this does not mean that all policy decisions have to follow each and every fluctuation in market valuation. A pension fund can choose to stabilise its contribution and indexation decisions. The law even defines preconditions for stabilising contribution levels, and there is no rule of law mandating that conditional indexation must be based on the funding level at any one particular moment.

The above does not detract from the fact that we must critically consider the question of whether our pensions system offers sufficient opportunities for risk sharing. Let us list the existing options. First, the sponsor can make extra contributions. This is not without consequences from the accounting point of view. Using this approach will substantially increase volatility on the sponsor's balance sheet.

Second, the pension fund can raise the contribution level (by limiting premium discounts, for example). If a deterioration in a pension fund's financial position means it no longer meets the requirements for premium discounts, then it must at the least charge a premium that covers costs. Premium hikes are not particularly effective over the short term. A 10% increase in the pension premium on a macro level leads to a 0.5% improvement in the cover ratio.

This is because funds' invested assets stand at about 25 times the annual premium volume. Over the long term, premium hikes are more effective but they still have disadvantages, particularly due to the pro-cyclical effect that results. In the previous crisis there was still room to increase premiums because they were well below the cost-covering level at the time. At the moment, premiums are at roughly the cost-covering level, even though it can be argued that in cases where the cost-covering premium is calculated on the basis of optimistic return assumptions there is still some room to manoeuvre.

Third, a fund can cut back on indexation. In a conditionally indexed average wage scheme, index cutting is an effective instrument because it affects both the rights of the pensioners and the claims of the active members. The significance of indexation cuts is mainly that a decline in funding level will be slowed down as compared to a situation of full indexation. On the other hand, the indexation cut leads to a loss in purchasing power, which directly affects pensioners. Long-lasting indexation cuts are impractical for this reason. This is even more the case for the final management approach: cutting back on accrued benefits. If none of the previous approaches have helped, then the pension fund can cut back on nominal entitlements. Socially, this is a most unacceptable measure that should only be taken in extreme cases of structural funding shortages.

All this leads to the conclusion that pension funds in a long term balanced situation will possibly have to aim for higher solvency buffers than presently required by law. Solvency buffers are the most effective instrument to protect against risks. If adopting more substantial capital buffers doesn't seem like an attractive option - perhaps because it takes years and considerable effort to build up such buffers or because pension fund buffers, by their nature, involve uncomfortably vague ownership rights - the only alternative is to make changes to the pension system. For instance, an increase to the pensionable age can ease the burden as a one-off measure, but if the structurally lower pension costs trickle down to result in structurally lower premium contributions, then the matter of higher buffers inevitably crops up again down the line. These choices are anything but simple.

For this reason, we may have to consider a redesign of our old age provision. Such a redesign might take advantage of the fact that old and young people have different preferences. For older participants, a risky investment strategy is not optimal. For a younger participant, investment risk can be a sensible diversification, especially if there is a low correlation between human capital and equity returns. These young participants will not get an optimal investment portfolio in the future if the pension fund continues to base its investment strategy on the average - steadily ageing - participant. This discrepancy between the interests of younger and older participants can be accounted for by adopting a policy that differentiates between age cohorts. The younger members get a defined contribution contract while older members get more security in the form of an (indexed) defined benefit contract.

The defined contribution claim is progressively converted into a defined benefit claim as the participant grows older. This can range from 100% to 0% DC (and thus from 0% to 100% DB), but also from 80% to 20% DC (and thus from 20% to 80% DB). The advantage is that this leads to lower defined benefit obligations overall while creating lower buffer conditions on the macro level.

The Financial Assessment Framework (FTK) is already equipped to deal with a new form of pension provision of this type. After all, the FTK does not deal with the content of the pension contracts but takes them as a starting point. In the alternative system, the defined contribution claims of the young participants form a kind of buffer allowing the defined benefit entitlements of the older members to be met with a greater level of security. And this without requiring unnecessarily large solvency buffers whose ownership status is unspecified.

Klaas Knot is director of the division for regulatory policy at De Nederlandsche Bank, the Dutch central bank, where he is responsible for developing prudential regulatory standards and instruments for banks, insurers, pension funds and investment companies

This series of articles, published in conjunction with our Netherlands sister title IPN, seeks to create a platform where various authors, academics and practitioners discuss possible solutions to solvency and risk sharing issues that have the common objective of making the DB pensions system more robust

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