Z-score's wider ramifications
The Dutch public debate has been dominated the last decade by the theme of the effectiveness of market forces. Applied to the pensions sector the debate has been about whether or not membership of an industry-wide pension fund should be compulsory. If the employer and employee representatives in a sector opt for compulsory industry-wide pension fund, the business and organisations in the sector are obliged to have their pension commitments managed by the industry-wide pension fund.
After years of discussions, the Occupational Pension Scheme Act came into effect in 1998. It is based on the assumption that that employers should be able to request exemption from compulsory membership of the industry-wide pension fund on objective grounds. These objective grounds are the investment performance, administration costs and quality of service. In finding grounds for exemption, the focus has gone more and more to the issue of investment performance.
The so-called z-score published by industry-wide pension funds measures the performance of the investment policy of the pension fund. Prior to each new investment year the fund’s board of management specifies a standard portfolio. This standard portfolio takes account of the level of risk the board is willing and able to accept. The level of risk is based upon an asset liability study in which the expected developments of the liabilities are related to the development of the assets.
At the end of each investment year, the yield effectively achieved on investments is compared with the yield on the standard portfolio. The comparison makes allowance for administration costs. Alongside the annual z-score an average score is also calculated over a longer period. The performance test is the sum of successive annual z-scores divided by the root of the number of years. If the test result over a period is lower than –1.28, the employer in question can be granted exemption from mandatory participation on request. The first official performance test took place in 2002.
So the question whether employers do in the end go for exemption depends on issues like administration costs, the average yield, the contribution level, the service level and the satisfaction of the participants.
In this year’s results, the VB as the umbrella organisation of the industry-wide pension funds, reported that two of its 65 members underperformed the –1.28 level. The two member funds are the Agrarische en Voedselvoorzieningshandel (agricutural and food provision trades) and the Banden- en Wielerbranche (tyres and wheels trades). These results refer to the performance in the period 2000 – 2004. Taken only the year 2004 into account, three industry-wide pension funds have shown underperformance: Bakkersbedrijf , Natuursteenbedrijf and Bedrijfspensioenfonds Vlees -, Vleeswaren- en Gemaksvoedingsindustrie, which scored below the –1.28 level.
According to the VB the overall result is positive given the main focus of adapting investment policy to the solvency requirements. Pension funds paid more attention on their coverage ratio than on successfully passing the performance test.
This raises the question if in the end pension funds are able to combine the achievement of two goals. On the one hand to keep up the z-score in order to prevent employers exercising exemption and on the other hand meeting the increasing requirements of supervision expressed in a short-term focus on coverage ratio.
Achievement of both goals do have their influence on the investment policy of pension funds. This is clearly stated by PGGM, the pension fund for the health and care sector. According to PGGM, the effect of the z-score test is to reduce the scope available to pension funds to pursue active investment policies. It will force pension funds to adopt a more cautious stance on active investment policies since the scope to diverge from the norm performance is limited. In many cases it would be unwise for a pension fund to pursue an active investment policy to any substantial degree as there is a significant risk of not meeting the criteria measured by the z-score.
As a result a trend can be seen of sector pension funds adopting more passive investment policies (more index tracking and lower exposure to equities) and tailoring their investment specially to avoid a return lower than the norm portfolio. Instead of assessing the market for themselves, the pension funds simply track the indices as to avoid the risk of a low z-score.
The trend towards risk avoiding investment policy is reinforced by the requirements of supervision. The sharp focus of the supervisory authority on the short-term coverage ratio forces pensions funds to avoid short-term risks as these risks may result not reaching the requirements of the supervisers.
Simply tracking the index loses the opportunity for a pension fund to improve the balance of risk and return in its portfolio by acting on short-term expectations and views. Another disadvantage of both the z-score and the short-term requirements of supervision is the trend towards herd-like investment policy as all pension funds will tend to track the same indices. This reinforces the sentiment on the financial markets. Index-tracking investments also result in demand for equities included in the index being very high, while demands for other equities falls irrespective of their asset value. By focusing on index equities pension funds will miss out the higher returns available from other equities. This would result in substantial effects in the financial markets.
As a result of risk avoidance pension fund may lose their role to stimulate economic development. Pension funds may decide not to invest any longer in areas not directly leading to the required performance as a result of pressures by coming from the z-score system and the supervisory authority. So the society misses the necessary input for economic stimulation. Also as a result of the short-term focus the financing of liabilities is becoming more expensive than necessary. By not leaving room for pension funds to restore short-term loss by a long-term investment policy the contribution level becomes more and more important in the direct coverage of the pension costs.
As a result, the pension contribution demands a higher portion of salaries and puts an upward pressure upon costs. This pressure from an economic viewpoint is seen not always being desirable. Another undesirable consequence of both the z-score and the requirements of supervision is the undermining of certainty. For decades the Dutch society could have strong confidence on pension funds. But now this climate has been changed. It seems uncertain that a significant number of people will get their defined benefit pension in the end. Dutch pension funds should aware that a crisis in confidence may occur in the near future.
With the Financial Assessment Framework coming into power the question raises if the z-score will survive. According to the VB, one may wonder if the z-score still serve their intended purpose given the many changes of recent years in the pensions industry.
Later this year the z-score will be evaluated by the Ministry of Social Affairs and Employment in the context of the exemption regulation. As a result of the evaluation, in which the z-score certainly will be related to the Financial Assessment Framework, the conclusion may well be that an entirely new assessment tool is needed.
Kees Verhagen is a freelance journalist based in the Netherlands