Dutch solvency framework costing pension funds billions

​The current solvency framework – the Financieel toetsingskader (FTK), adversely affects Dutch pension funds' returns. Time to consider a different design and other risk models, writes Eloy Lindeijer.

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Good supervision is important

A robust solvency framework  and good supervision contribute to better pensions for millions of Dutch citizens. The current FTK framework has led to more attention on pension funds' risk management. That risk management is now far more professional than prior to the introduction of this framework.

The FTK prescribes that liabilities be valued on the basis of risk-free market rates, the so-called swap curve. While not wishing to call this into question, I would contend that this approach means that only swaps and government bonds from countries such as Germany and the Netherlands can be deemed 'risk-free' investments in line with the FTK.

All other investments which in terms of market value have the potential for short-term fluctuations relative to the swap curve are deemed 'higher-risk', even where they provide a good match with the cash flows of the liabilities in the long term.

Billions in foregone returns

In order to ensure they have enough of these matching assets in portfolio, therefore, pension funds need to be heavily invested in 'risk-free bonds' and swaps which, at the current negative rates, are purchased at a loss. In real terms that also applies to 30-year risk-free rates, which are significantly lower than inflation.

With assets under management totalling almost EUR 1400 billion, of which roughly half is invested in fixed-income securities, Dutch pension funds are set to miss out on billions of euros in returns each year in the coming years.

This is linked to the ECB policy of Quantitative Easing (QE). Due to QE, swap rates may now be as much as a full percentage point below their equilibrium level; ECB research also indicates that interest rates are artificially low. While the ECB has no plans to extend QE further, there is still no expectation that the policy will be fully unwound in the coming years.

As a result, pension funds not only face the prospect of missing out on returns in the short term, they also lack the structural scope for achieving their index ambition in the long term.

Higher yielding matching assets

It is possible to identify multiple investments that provide a good long-term match with the cash flows of the liabilities. They include housing with indexed rents in the Netherlands and other eurozone countries, mortgages and safe (core) infrastructure investments, such as toll roads and water utilities.

These investments can be expected to perform significantly better and, even in adverse scenarios, still provide a reasonable return in the long term. The problem, however, is that the FTK does not consider matching in the long term, focusing instead on day-to-day market value. As the aforementioned investments may perform worse in the short term than swaps and government bonds, the FTK labels them high-risk. That discourages funds from investing in them to a larger amount, since doing so would require them to keep larger financial reserves.

Solution: take a long-term perspective

The necessity to invest in expensive swaps and government bonds and the resulting billions in foregone returns are a consequence of the current method of risk measurement in the FTK. This has its origin in banks (Value-at-Risk), which employ a short horizon.

This fails to address the pension funds' long-term liabilities, however. If the FTK were to measure the risks differently, that would allow pension funds to retain their commitment to good risk management while at the same time boosting returns in the long term.

I am therefore not arguing here specifically in favour of a different methodology for discounting liabilities, nor advocating that more risk be taken in the long term. Instead, this is an urgent call, in the interest of millions of pension participants, for a debate on how best to measure our pension risks in the long term and allow greater scope for investments that make a better contribution to the desired pension income.

In a future blog, I will look at another set of regulations which lead to sub-optimal investment policy: EMIR.

Chief Investment Management

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