The role of emerging markets debt is evolving from a return-enhancer to providing some buffer against volatile markets.

Emerging markets debt has been one of the best performing asset classes in the last decade but experts say those spectacular returns may be a thing of the past.

There are signs emerging markets debt is becoming more robust in volatile markets – investors are closely following the development of the asset class – but they are cautious about its pro-cyclical nature compared with other fixed income opportunities.

As emerging markets debt moves increasingly from a tactical play to a long-term strategic allocation for investors, others warn that the past spectacular double-digit returns are a misleading indicator of what may lie ahead.

Cambridge Associates Singapore-based managing director Aaron Costello notes that since the late 1990s investors have been riding down high yields.

“A key risk that needs to be understood is that future returns will be much less than past performance, given the current level of yields. So, historical analysis of the asset class will overstate the case,” he says.

“For instance, US-dollar emerging markets debt has been one of the best performing assets classes over the past 10 to 15 years, simply because in the late 1990s yields were near 15 per cent to 20 per cent.

Today yields are 6 per cent. Local-currency emerging-markets-debt yields are also around 6 per cent, while emerging markets currencies have rallied strongly. So while we see 6 per cent yields as attractive in today’s environment (especially given lower volatility), this is a far cry from historical performance.”

Long way to a safe haven
T. Rowe Price emerging-markets-debt portfolio manager Mike Conelius says emerging markets sovereign and corporate debt is supported by strong fundamental and technical aspects but it is still at the start of a long journey to becoming a potential safe haven.

During more than 20 years investing in both emerging and frontier markets, Conelius has seen his fair share of crises. He is careful to separate the well known story of the underlying strength of emerging markets from the reality for the asset class.

“I would never call an emerging market a safe haven. I have done this too long. But I would say that if one definition of a safe haven would be strong fundamentals and a strong technical base, than yes, a lot of emerging markets have those qualifications,” Conelius says.

“But in the end, emerging markets debt trades more or less like a risky asset. Liquidity can dry up. The Wall Street structure doesn’t work the way it used to. Banks don’t carry risk any more. We are trading among ourselves… The street does not provide that buffer of liquidity.”

Altered structure changes play
Conelius says that an emerging-markets-debt manager must play defence in a world where the trading structure has changed so much after the financial crisis.

Cash now typically makes up 4 per cent to 5 per cent of assets under management when it would have been around 1 per cent in the past.

There is also a solid buffer of dollar-denominated sovereigns, so-called hard currency debt as well as quasi sovereigns, usually high quality corporate debt from government-backed companies, according to Conelius.

However, there have been some nascent signs that emerging markets debt is moving from just a return-enhancing risk asset to something that can provide a measure of stability during times of market stress.

JP Morgan reports that its Emerging Markets Bond Index (EMBI) Global gained 7.2 per cent in 2011, making this segment of emerging markets debt the best performing asset class in the fixed-income universe.

The EMBI covers US-dollar-denominated or hard-currency sovereign debt. T. Rowe Price’s Emerging Markets Bond strategy returned 7.09 per cent over the first three months of the year compared to its benchmark, the JP Morgan EMBI Global of 4.86 per cent. Over the past 10 years the strategy has achieved average annual returns of more than 12 per cent.

Investors are still showing strong interest in emerging markets debt despite concerns over the euro-debt crisis and slowing global growth, according to James Mitchell, a London-based fixed-income portfolio manager for asset consultancy Russell Investments.

Mitchell says that against a backdrop of risk-off selling, long-term investors are seeing an opportunity to take advantage of discounted prices, particularly in local and corporate segments of the emerging-markets-debt market.

“People see the yield as attractive and see emerging markets growth outpacing the developed world for many years to come, so that should also boost those currencies,” Mitchell says.

“We are seeing money flowing there even during that big sell-off in the third quarter of 2011. People who hadn’t got in saw that as an opportunity to get in and maybe we will see that again in the coming months.”

Away from home
The market for locally denominated debt has not fared as well in the current environment as hard-currency debt, but both Conelius and Mitchell see buying opportunities for investors.

Conelius notes that investors have in the past chased local-debt opportunities as they have tried to diversify their emerging-markets-debt holdings beyond hard-currency exposure.

Estimates from consultants who spoke with top1000funds.com put the average exposure to emerging markets debt at between 3 and 7 per cent of total fixed-income allocations.

Conelius notes that flows into the asset class have really only just begun, as investors seek to both diversify their portfolios away from longstanding home biases as well as take advantage of the long-term relatively strong economic fundamentals in emerging markets.

While this provides a strong foundation of demand for emerging markets debt, Conelius warns that prices can quickly become expensive when investors’ risk appetite improves.

“That flow of funds is coming from a very wealthy western world into a much smaller emerging markets world and that flow can pretty quickly adjust asset prices,” he says.

At a time of increasing risk and diminishing returns from traditional government bond investments, a growing number of large investors are beginning to cast their eyes toward emerging markets as a way to broaden their fixed-income portfolios.

Paul O’Brien, head of fixed-income strategy at The Abu Dhabi Investment Authority (ADIA), considered by many to be the world’s biggest sovereign wealth fund, points to a concentration of a so-called safe assets in a small number of large fixed-income markets as raising difficult questions for investors.

“To get a large, liquid bond portfolio you are really now limited to a small number of countries with fairly expensive securities,” says O’Brien. “It may be fine for now, but it could ultimately challenge the diversification role of fixed income.”

The fund uses fixed income for its diversification, store of value, liquidity and return characteristics, according to O’Brien.

The drive to diversify fixed-income portfolios has seen big investors look beyond the record low yields on offer in some developed-market-debt securities to take advantage of the long-term growth outlook and strong fiscal position of emerging markets countries.

Norway’s sovereign wealth fund has made a high profile pivot across its portfolio to emerging markets. As part of this push, up to 7 per cent of its overall portfolio will be dedicated to emerging markets debt.

While declining to comment directly on the investment strategy and holdings of ADIA, O’Brien says there was a need to balance the requirements of liquidity with the need to preserve capital in real terms.

 

Broadening the basket
JP Morgan estimates that emerging markets public debt now tops $7.3 trillion, more than tripling in size since 2000. Emerging markets debt denominated in local currency is put at $5.9 trillion, while corporate debt is about $1 trillion. By comparison, the US bond market exceeds $35 trillion.

O’Brien indicates the negative real yields on offer to investors in developed market bonds – such as 10-year US treasuries or similar UK gilts – as a driver for long-term focused investors to look to broaden their basket of bonds over time.

“It is making the decision a lot more interesting because the securities you look to for overnight liquidity are not necessarily the securities that will give you the best comfort in terms of the long-term preservation of capital or purchasing power.”

“It does lead one to thinking about a broader menu of countries in your portfolio and the possible trade-off between the need for capital preservation versus the need for overnight liquidity.”

 

Capitalise on evolving opportunities
Diversification is a key driver for large institutional investors who are looking to build out exposures to emerging markets fixed income, according to Mike Conelius, the Baltimore-based portfolio manager of T. Rowe Price’s emerging-markets bond strategy.

A 23-year veteran of the emerging-markets-debt landscape, Conelius says that funds are increasingly looking to gain exposures that capture the broad spectrum of the emerging markets universe.

This encompasses a blend of so-called hard-currency or US-dollar-denominated, sovereign debt issued in local currency and US-dollar emerging markets corporate debt.

T. Rowe Price first launched a hard-currency sovereign-bond strategy in 1994, and has since diversified to launch a local currency-focused fund and last year a dedicated corporate-bond fund.

Conelius says investors are increasingly demanding a one-stop shop where they can gain exposure through either pooled products or a tailored special account to local, hard and corporate bonds.

“We encourage the investor to allow us to use the whole opportunity set as much as possible, along with ensuring appropriate risk guidelines that place a limit country or sector exposure, but having broad flexibility is key because this environment is ever-changing,” Conelius says.

“So, the ideal mandate allows us to capitalise on the evolving opportunities.”

Conelius notes the importance of an emerging-markets manager keeping a close eye on the relative value of various debt opportunities both between countries and also within countries where hard, local or corporate debt may vary in attractiveness.

 

Maintain flexibility
Francois Otieno, senior fixed-income consultant at Hewitt EnnisKnupp’s Chicago office, says the asset consultant is advising clients take a diversified approach that is reflective of the opportunity set as well as where it is headed.

“For entry into the asset class, we recommend 50 per cent local, 40 per cent hard and 10 per cent corporate, but this might vary depending on a client’s specific circumstance and this isn’t a hard-and-fast rule but a general guide,” Otieno says.

While foreign investors entering into the market have in the past typically made a first foray into hard-currency debt instruments, fixed-income analysts have noted this segment of emerging markets debt has changed rapidly in recent years.

The hard-currency debt market is shrinking relative to the growing market for debt of countries issuing in their local currencies.

These countries, being able to issue debt in their own currency, typically have stronger underlying economic fundamentals, which improves the credit quality of the local index. Meanwhile, the hard-currency basket has seen diminishing quality as smaller emerging countries such as Ghana and Gabon have recently joined the index.

Conelius says that the increasing allocations to emerging markets debt has also led to very strong technical environment for the hard-currency market, with spreads over treasuries narrowing to as little as 200 basis points for countries such as Brazil.

Investors, according to Conelius, have looked to local-currency debt to improve yield, and are increasingly looking to corporate debt.

“In hard currency we are finding individual countries of value and for other countries we just move into their local or corporate market.”

Maintaining a flexible approach is leading to a burgeoning trend for investors to award open mandates to emerging-markets-debt managers who can achieve absolute return-style objectives.

Advocating this approach is asset consultant Cambridge, with Singapore-based managing director Aaron Costello saying that taking an unconstrained approach with an experienced manager can not only lead to better returns but a more holistic approach to risk control.

“We are advocating investors adopt an “open mandate” approach to emerging markets debt (EMD), whereby active managers allocate across EMD debt and currency exposures,” he says.

“Rather than investors seeking to allocate across the spectrum, allow managers to make the relative valuation decisions and risk control to create a basket of EMD with attractive risk-return characteristics.”

Emerging markets corporate debt is taking on a bigger role in fixed-income portfolios with attractive yields and strong underlying fundamentals relative to both sovereign and developed-market high-yield debt attracting investors.

While still beholden to sell-offs in risk assets, emerging markets corporate debt has seen strong inflows from institutional investors driven by returns that have outperformed global high yield over three- and five-year periods.

Historically, emerging markets corporate bonds have been viewed cautiously by investors, with concerns about illiquidity and credit risk both at a corporate and sovereign level.

However, there seems to be a long-term structural shift in investor allocations on the back of low interest rates in developed markets.

JP Morgan reported in April that assets under management benchmarked to its Corporate Emerging Markets Bond Index (CEMBI) group of indexes grew 72 per cent in 2011 to just under US$30 billion by year’s end. This is on the back of a doubling in these same assets in 2010.

 

Credit quality and liquidity up
T. Rowe Price portfolio manager for emerging markets debt, Mike Conelius, says that not only are investors allocating more on a long-term basis but also emerging markets corporate debt is demonstrating long-term improvements in underlying credit quality and liquidity.

Conelius points to the long-term increase in market capitalisation in emerging markets debt as evidence of a trend of improving liquidity.

In 2011 the market capitalisation of the JP Morgan’s CEMBI Broad increased by 22 per cent to $419 billion. This is an increase from $344 billion in 2010 and comes despite diminished issuance during the third quarter of 2011.

Several factors are driving this long-term growth trend, including reduced external debt issuance, benchmark development, financial and economic reforms, and a broadening stable investor base, according to Conelius.

US-dollar emerging-markets-corporate-debt issuances have outstripped external sovereign debt since the end of 2005. The new-issue market topped $211 billion last year.

Francois Otieno, a senior fixed-income consultant at Hewitt EnnisKnupp’s Chicago office, points to the growing improvement in the credit quality of emerging markets debt as also providing further confidence to investors.

“From a fundamentals standpoint, emerging market corporates look considerably better than a comparable credit in the US,” Otieno says.

“So, from a relative-value perspective, an emerging market corporate looks far more attractive from a yield standpoint.”

JP Morgan notes that default rates for high-yield emerging markets debt has fallen below US yield in 2011. In investment-grade debt, emerging market companies also carry less leverage than their developed market counterparts.

Conelius notes that the credit quality of emerging markets debt has steadily improved in recent years. Emerging markets corporate debt has a higher average credit quality rating of BBB relative to emerging market external debt (BBB-) and high yield debt (BB/B).

 

Rising middle classes and steely resolve
Emerging markets corporate debt also represents a way for investors to fine-tune exposure to the long-term theme of the growing middle class in developing countries that investors may already have in the emerging-market-equity portfolio.

“You can express the same theme [growing middle class in emerging markets] but at a senior level of the capital structure and in dollars as opposed to taking the local-currency risk,” Conelius says.

In an example of how emerging markets corporate debt can provide more granular exposures, Conelius says while T. Rowe Price’s team of  five dedicated emerging-market-corporate analysts likes steel producers, it is selective about where it gains exposure.

The team focuses on Russian steel companies because they are vertically integrated and diversified rather than the more challenged Korean and Chinese steel companies, according to Conelius.

This approach is informed by input from T. Rowe Price’s emerging-market-equity team, which provides perspective on the relative strength of companies and their management.

Corporate debt also allows investors to switch strategies in countries where sovereign debt has become expensive.

In Brazil, spreads on hard-currency debt have narrowed to about 200 basis points over treasuries. Local-currency debt leaves investors exposed to the Brazilian Real, which has dropped by almost 20 per cent against dollar since February.

Corporate debt, however, provides exposure to strong fast-growing Brazilian companies that are global leaders in their sectors.

“We are underweight external Brazil but we find many companies at the corporate level that are very interesting,” Conelius says. “So, we will own them in both our broad strategy and certainly in our dedicated corporate product.”

From a sector perspective, while banks remain the largest sector in the overall emerging-market-bond market, energy companies have expanded their market share in recent years.

An indication of the growing demand, T. Rowe Price launched a dedicated emerging markets corporate strategy in May 2011.

 

Figure 1: Annualised returns in USD (as of 31 March, 2012)

1 Year (%) 3 Year (%) 5 Year (%)
EM Corporate Hard Currency 5.75 16.49 7.04
Annualised Risk 7.29 11.33
Global Corporate (USD hedged) 7.61 11.26 5.52
Annualised Risk   4.43 5.61
EM Sovereign Hard Currency 12.59 16.48 8.60
Annualised Risk 6.81 10.43
EM Corporate High Yield 1.33 26.24 8.37
Annualised Risk   14.23 19.30
EM Corporate Investment Grade 8.10 13.79 6.62
Annualised Risk   5.10 9.09
Global High Yield 7.41 24.49 8.38
Annualised Risk 10.00 13.52
U.S. Investment Grade Corporate Bonds 9.45 13.34 6.94
Annualised Risk 4.98 7.40
Representative indices include: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified (EM Corporate Hard Currency), J.P. Morgan Emerging Markets Bond Index Global (EM Sovereign), J.P. Morgan Global High Yield, Barclays Global Aggregate Corporate Index – USD Hedged (Global Corporate Bonds) and Barclays U.S. Investment Grade Corporate Index (U.S. Investment Grade Corporate Bonds).  U.S. Treasuries are represented by the U.S. Treasury component of the Barclays U.S. Government Index. Sources: J.P. Morgan, Barclays Capital

Figure 2: EM Corporate Bonds: Index Characteristics (as of 31 March, 2012)

  Yield (%) Duration (Years) Spread (bps) Average Credit Quality Average Maturity Total Market Value ($mm)
EM Corporate 5.59 5.28 385 BBB 7.8 2,070 bn
EM Sovereign 5.61 6.95 342 BBB- 11.6 4,175 bn
High Yield 7.47 3.80 644 BB/B 6.48 763 bn
Global Corporate  Bonds 3.38 5.78 194 A/A- 8.20 6,232 bn
U.S. Investment Grade Corporate  Bonds 3.40 6.84 176 A/A- 10.36 3,175 bn
Representative indices include: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified (EM Corporate Hard Currency), J.P. Morgan Emerging Markets Bond Index Global (EM Sovereign), J.P. Morgan Global High Yield, Barclays Global Aggregate Corporate Index – USD Hedged (Global Corporate Bonds) and Barclays U.S. Investment Grade Corporate Index (U.S. Investment Grade Corporate Bonds).
Sources: J.P. Morgan, Barclays Capital

Recent legal changes governing how US corporate pension plans calculate their funding liabilities could increase moves to de-risk pension plans, particularly through lump sum payments to participants, says Matt Herrmann a retirement risk expert at asset consultant Towers Watson.

Herrmann, leader of Towers Watson’s retirement-risk-management group, says the legislative changes that passed through both houses of Congress in late June will improve the funded status of many corporate plans, allowing more de-risking options to plan sponsors.

“Historically, being under-80-per-cent funded limited your ability to pay lump sums, but one of the things that folks have realised is that holding down rates has led to an arguably unnatural environment of low interest rates and an unnatural environment for pension contributions,” he says.

“The recent act aims to stabilise pension contributions and it gives plans a little bit more flexibility in the use of lump sums.”

The push to de-risk corporate defined benefit pension funds and ultimately transfer risk to external parties is not limited to the US, with fellow pension consultant Mercer identifying a global de-risking push from plan sponsors.

Frank Oldham, Mercer’s global head of defined-benefit risk, says that the volatility of equity markets, persistently low interest rates and increased life expectancy of members have seen pension deficits increase and pension risk become a focus for plan sponsors.

“The thing that is really changing at the moment is organisations’ recognition of pension risk. More organisations now understand the need to manage that risk more proactively,” he says.

“For some organisations that will mean getting their arms around the issue and making sure the scheme is well run. For other organisations it will mean more proactively taking steps to de-risk the scheme.”

 

Asset shifts, lump sums and bulk annuities
Oldham says that funds typically look at a number of fronts when it comes to de-risking their pension plans.

On the asset side this often involves a gradual move into fixed income or bonds as funding levels improve – so-called dynamic de-risking.

A recent study by actuarial and consultancy firm Milliman into funding levels among the 100 biggest defined-benefit plans in the US found that for the first time fixed-income allocations are now larger than equity allocations.

Overall, the 100 companies Milliman studied allocated 38 per cent of their pension fund assets to equities last year, down from 44 per cent in 2010. This compares to 41 per cent for fixed income instruments, up from 36 per cent the previous year.

On the liability side of the balance sheet, plan sponsors can consider one or both of offering a lump sum to plan participants and/or annuitising remaining liabilities with an insurer. The plan typically pays a premium to an insurer, which then assumes full responsibility for paying future benefits.

Mercer’s UK figures show that for the last five years there has been a significant increase in the size of bulk annuity and longevity swap deals, with almost 100 over £50 million. The combined value of these deals now stands at £33 billion.

Last year high profile deals involving FTSE 100 companies included ITV and Rolls Royce, and Oldham also points to growing interest in Ireland and the Netherlands for these types of deals.

Oldham thinks that the push to annuitise liabilities will also add further momentum to the move by corporate pension funds to allocate more to fixed income.

For large deals, the asset mix of the fund will also play a part in the pricing of the premium a plan pays to an insurer, Oldham explains.

“You would expect in the lead up to a buyout that a pension plan would likely have more money in matching assets. So, it would seem to involve a more conservative investment approach over time,” he says.

 

Ford and GM driven to it
In the US, the push to de-risk was given further momentum by the decisions of car manufacturing giants Ford and General Motors to tackle their future and current pension liabilities through an annuity purchase and/or offering lump sum payments.

Mercer acted as an adviser on the GM deal, which saw the car manufacturer discharge around $26 billion of defined-pension liabilities to individual plan members through lump sum payments and through an annuity purchase by The Prudential Insurance Company of America.

Oldham says the deal, which Mercer claims as the largest pension buyout of its type in the US, has encouraged other funds to look at de-risking, given the move by GM was well received by the market.

“Up until now in the US, deals have been relatively small. However, there has been evidence of an active buyout market, with smaller deals often associated with plans that are terminating,” he says.

“We would expect there to be further transactions down the line and I would be surprised if GM was the last that we hear of these types of deals this year.”

The GM deal closely follows on from Ford announcing it would make lump sum pension payout offers to more than 98,000 white-collar retirees and former employees in a bid to address its $49-billion pension liability.

Since 2000, Ford’s US pension liability has increased by 50 per cent and the voluntary lump sum cash-outs are part of a plan to cut this liability by a third.

Herrmann says that he sees stronger demand from plan sponsors to use lump sum payouts because it typically can be done at lower funding levels than annuatisation. Lower funding levels, while not being a deal-breaker, will be built into the price of a potential premium paid by the plan.

“A large number of our clients are aggressively looking at the expanded use of lump sums for certain. A lot of it will depend on funded status and, with the median-funded status hovering around 80 per cent, that would have limited the probability of a certain segment of the market taking action,” he says.

 

De-risking strategies
The recent changes in the law governing how US corporate pension plans calculate their liabilities is also set to provide some relief on funding levels.

The changes, which form part of a highway reauthorisation bill, alter the way funds calculate liabilities, increasing the interest rates used to calculate these liabilities.

The Society of Actuaries says that more than 92 per cent of large corporate plans will be more than 80-per-cent funded after the changes comes into effect. Currently, just over 62 per cent of these large plans have achieved this funding threshold.

There are a number of plan sponsors who have de-risking strategies ready to activate and may act decisively given the right impetus, says Herrmann.

“You will also see more plan sponsors execute against annuity purchases in 2012. It is hard to imagine someone else doing the size and scale of GM, but this has been an opportunity that plan sponsors have been looking at for quite some time,” he says.

“Funded status has held them back, but I do think if we see any improvement in the capital market environment – and if you see any movement in interest rates – then there are many plan sponsors looking to take action.”

Herrmann warns that de-risking of corporate pension plans is a “multi-year project”, with funds having to take a holistic view of not just the asset make-up of the plan and its funded status, but also how this fits into what is happening to the company at a business level.

 

Matt Herrmann’s top four considerations when de-risking

1. Funded status of plan

2. The financial position of the business:  where is the company in its the business cycle? What is its view of future business conditions?

3. The broader market place views of management: Is there a view on where interest rates will go? How will thinking about these issues influence the operation of the business and how is the company aligning the pension strategy around this broader view of the capital market environment?

4. Operational readiness: does the company have good benefit information, can it locate beneficiaries and is the business set up to handle the processing of lump sum pension payments.

 

Both Oldham and Herrmann say that the reverberations from the GM deal and the fast-developing market for transferring pension risk away from plan sponsors in the UK could see more insurers looking to enter into similar-type deals with plans.

The resulting competitive pressures may mean more attractive terms for plans looking to enter into bulk annuity and longevity swap deals, Herrmann explains.

“As you see more and bigger deals come to market, there is the question of whether other insurers enter the market and what it does to those pricing yields in the marketplace. I do think we will see other insurers enter the market.”

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As the well-respected Dutch pension system sits in a state of reform limbo, long-time trustee and MKB-Nederland representative in the recent round of negotiations on pension reform, Benne van Popta, has particular ideas on how to improve the system.

The combination of low interest rates, an ageing population and increasing life expectancy has prompted a discussion, and protracted negotiations among the social partners, about the structure of the pension system in the Netherlands.

The likely result is a move away from defined benefit to a defined-ambition pension system, which will mean a revolutionary shift in the system via a transfer of risks to the employee.

In the Netherlands this is a big deal, according to Dutch insurance industry figures (Verzekerd van Cijfers 2011) about 78 per cent of Dutch pension plans were defined benefit in 2010.

Benne van Popta, a former Ministry of Finance employee, has been a trustee in the Netherlands since 2000 and also sits on the European Federation of Retirement Provisions on behalf of the Dutch Pension Federation and is vice chair of the European Insurance and Occupational Pensions Authority.

He has some observations about the implications of the new regime and ideas of his own on how to link pensions and longevity for a more sustainable system.

“Under the proposed reform each fund can choose between the two types of contracts: a nominal contract with a nominal risk-free discount rate and some flexibility; and a real contract with a real, somewhat return-related discount rate and more flexibility. At the moment all Dutch funds have the same contract and the same nominal risk-free discount rate. The impact of the new second contract is a transfer of risks to employees.”

He says there is a fiduciary duty attached to shifting the responsibility to the member, which will mean providing a more transparent story about the risks and promises in the system.

The Melbourne Mercer Global Pension Index, which compares retirement-income systems around the world and rates them based on their adequacy, sustainability and integrity, has consistently rated the Dutch system as number one (see tables).

Melbourne Mercer Global Pension Index ratings system:

Grade Index value Description
 A  >80  A first class and robust retirement income system that delivers good benefits, is sustainable and has a high level of integrity.
 B  65–80   A system that has a sound structure, with many good features, but has some areas for improvement that differentiate it from an A-grade system.
 C  50–65   A system that has some good features, but also has major risks and/or shortcomings that should be addressed. Without these improvements, its efficacy and/or long-term sustainability can be questioned.
 D  35–50   A system that has some desirable features, but also has major weaknesses and/or omissions that need to be addressed. Without these improvements, its efficacy and sustainability are in doubt.
 E  <35   A poor system that may be in the early stages of development or a non-existent system.

 

The Dutch pension system’s ratings as of 2011

Score Ranking
 Overall Index  77.9  1st
 Sub-indices
 Adequacy  75.9  1st
 Sustainability  70.8  3rd
 Integrity  91.4  1st

 

Beautiful building, bad furniture
How is it then that the Dutch pension system, revered as the best in the world, is in trouble?

“I have a metaphor for that,” van Popta says. “You can build a beautiful building but the furniture is terribly bad. With regard to the Dutch pension system, the organisational and economic design is good, but if you don’t make good decisions it doesn’t work.”

He points to two pieces of “bad furniture”: the retirement age and the liability of the fund, which has increased by 12 per cent in the last five years because of longevity.

“We haven’t had the contributions or returns to fund the system,” he says. “Changing the retirement age is a political debate but it is also sartorial. People are working longer, it is a mental change, and important for social partners, if you don’t link them, there’s a problem for the pension. If you don’t meet return expectations, you don’t reach the pension ambition.”

The current level of contributions in the Netherlands is about 13 per cent of total wages, and there is a proposal that this will now be capped, but the Netherlands Bureau for Economic Policy Analysis (CPB) has said this will need to increase to more than 17 per cent of gross salary by 2025 to maintain the current benefit levels.

 

The van Popta proposition
Van Popta believes two fundamental changes need occur in the system. The first is to link the retirement age to longevity, and the second is a faster link between the return on assets and the pension ambition.

The current retirement age in the Netherlands is now 65, and the outgoing government proposed increasing that to 66 in 2020 and 67 in 2025.

“My view is that is 10 years too late,” says van Popta, who is also the vice chair of the occupational pension stakeholder group of the European Insurance and Occupational Pension Authority.

It is a difficult time in the Netherlands, with a temporary political platform in place following the resignation of Mark Rutte’s government in April and an election scheduled for September.

In the meantime the “in between platform” is proposing to increase the retirement age in 2013 by one month and gradually increase it.

“They are starting earlier with small steps,” he says. “Change is difficult in the Netherlands right now, confidence is low, there has been a fall of a cabinet, we’re in the middle of the euro crisis, there’s a recession, and a polarisation in public debate.”

Van Popta’s view of how a proposed flexible defined-benefit, or a “collective defined-contribution” system should work means the defined-benefit expectation would be adjusted to certain changes in longevity and the market. It won’t be quite as individual as defined contribution.

“The proposition includes a change every five years to the official retirement age based on longevity research and then a subsequent change in pension,” he says. “There is a difficulty because on the one hand changes are necessary to make, but making change happen is more difficult.”