Dutch reform to tread lightly on investment mix

When the Netherlands pension reforms were announced in 2011, many experts argued they were likely to substantially increase the risk appetites at the funds guarding the country’s $1-trillion pension assets.

Recent developments to the reform proposals make the overall impact far from clear, however, suggesting there will be no bonanza for Dutch investment managers. The pension funds themselves are not indicating any major changes to their investment mix, although the possibility of future changes resulting from the reform measures remain. Any impact on investment is intended as a by-product by the Dutch ministry of social affairs, which regulates pensions.

Helping pension funds cut benefits without the burden falling too greatly on any age group and keeping contributions at current levels were the driving motives.

The reforms are nonetheless set to relax some key restrictions on pension funds that have helped cement a conservative investment approach in the Netherlands.

Centrally set guarantees on members’ pension entitlements are to go, even though these are only nominal. In their place will come the freedom for funds to set their own pension promises. Granting more freedom for funds to chase returns and acknowledging the inherent risk in pensions via longer recovery plans both give the green light for funds to acquire more risk. At least that is what many argued.

Risky ambition

The state secretary for social affairs, Jellejetta Klijnsma, acknowledged the complexity of the reform project when she announced the new rules would be delayed until 2015.

“The development of the new legislation is taking more time than was anticipated. The issue is highly complex and is an important topic which I wish to approach cautiously,” she said, adding there will be a pilot introduction starting in January.

The reforms are set to allow nominally defined-benefit (DB) funds to share investment risk with members, by becoming hybrid defined-ambition (DA) schemes. That also promises to take Dutch funds away from their cautious investing stances – a choice that rests very much with the fund, explains Aegon’s David van Bragt.

He confirms that “if a fund chooses the ‘soft DA contract’, there will be more room for long-term investing”, adding though that there is plenty of uncertainty as to whether existing rights can legally be transferred from a DB to a DA contract.

Van Bragt says that “jurisprudence and practical experience will probably first have to develop further before many funds will switch to DA and redefine their investment policy”.

Another potential snag is that while many pension funds might welcome the long-term benefits of moving more into equity markets and alternatives via a DA arrangement, they might need to impose short-term benefit cuts to do so.

This is a result of the poor funding status at many Dutch funds, van Bragt explains.

The average Dutch pension fund was 3 per cent underfunded at the end of September 2012.

“This will be hard to explain to existing members as they are used to the hard benefit promises,” Van Bragt says, “so I expect there to be plenty of debate if funds are to press on with this.”

Bart Oldenkamp, managing director of fiduciary managers Cardano, says that pension funds should also tread carefully in gauging the risk appetite of members before passing the risk of an altered investment mix onto them.

If you add to that the probability of DA pensions having inflation-linked return targets, then a sea change in investment strategy looks unlikely.

To further muddy the water, those pension funds deciding to remain DB (with the Dutch provision of being able to cut benefits to match liabilities with assets) look set to face stricter capital requirements that may temper any demand from them for high risk assets.

Van Bragt has done a detailed analysis of the capital requirements for funds that chose to remain defined benefit. He reckons there may even be “some degree of de-risking” with bond allocations actually rising further.

In everybody’s interest

Some of the initial expectation that the new legislation would push funds into riskier assets was based on proposals for a new discount rate for the Netherlands.

Intense debate since the reforms were first outlined in 2011 resulted in a compromise discount rate being temporarily adopted in September 2012.

The initial proposals for use of the ‘ultimate forward rate’ common for Dutch insurers raised fears of a drive-out of long-term bonds.

These fears arose because the formula, as was first proposed, discounts any cash-flow maturities with a duration of more than 20 years.

A modified ultimate forward rate was adopted, which van Bragt says has largely eliminated these concerns.

Trimming the hedge?

Van Bragt thinks that the use of the modified ultimate forward rate could lead to a reduction in interest-rate hedges by pension funds.

“We have not seen very large movements so far – although some long-maturity swaps were rolled back to shorter maturities,” he says.

According to a 2011 Dutch central bank analysis, the level of interest-rate risk hedged at the largest funds ranges by 35 to 40 per cent. The analysis found that short-term interest-rate changes (for the next five years) were fully hedged.

While an accounting basis now shows many Dutch pension funds to be over-hedged, there is plenty of sentiment in the industry that most funds will appreciate that the fundamentals that led funds to hedge at the current levels has not changed.

A side effect of the modified discount rate has been an overnight increase in the funding status of Dutch pension funds, from around two to as much as 10 percentage points.

That has led to some new worries that investors will be lulled into a false sense of security and fail to moderate risk.

Waiting game

Investors emphasise that they will not judge the impact of the reforms until all the crucial details are hammered out. The €124.9-billion ($159-billion) PFZW fund said it is close to gaining clarity on the reforms’ consequences.

Another giant fund, the $340-billion ABP, is also waiting to see what the reform package will bring exactly. A spokesperson said that the fund expects any significant change to come in its interest-rate hedging rather than investment strategy.

ABP had around $935 million invested in interest-rate and currency-hedge overlays in 2011.

The spokesperson admitted that ABP was under-hedged in comparison to other funds as it was seeking to avoid locking in low market interest rates and not being able to absorb unexpected future inflation.

ABP regularly reviews its interest-rate hedging, and any movements in the wake of the pension reform will be sure to draw the attention of analysts.

The $16.6-billion Phillips Pension Fund has said it won’t change its investment strategy in the wake of the reforms.

The reforms still need to be approved by the Dutch parliament in The Hague, but are now set to be introduced in 2015 after a pilot program beginning in January 2013.

Some funds are already exploring the chance to move to the new DA status by opening up a dialogue with members, says Oldenkamp.


If it ain’t broke, don’t fix it

Dutch funds currently invest an average of 67 per cent in bonds as opposed to just 24 per cent in equities, according to Mercer.

Only pension funds in Portugal, Denmark and Norway have lower equity exposure, according to the consultants’ 2012 European Asset Allocation Survey.

A conservative discount rate based on long-term interest rates has led Dutch funds into strong positions on government bonds in particular, which make up 54 per cent of the average Dutch fund.

Alternatives are another relatively small asset class in the Netherlands, occupying 7 per cent of Dutch funds on average. In both the UK and Germany, the asset class accounts for 12 per cent of pension assets, according to the Mercer survey.

The reforms might do little to change this relative disinterest in the riskier asset classes.

Given that the Dutch pension system continues to be rated in various studies as the most dependable in the world and that Dutch funds returned 8.2 per cent in 2011 compared to an OECD average of -1.7 per cent, that might prove to be no bad thing.