Fit for Purpose

For two years, Dutch pension funds have seen their financial status, which is principally determined by the so-called funding ratio, deteriorate, requiring around half of them to present recovery plans to the regulatory authorities. Many pension funds indicate that pensioners will not be compensated for inflation for years, while others made it clear that they cannot fulfil their long-term nominal liabilities. Even worse, nearly all pension funds sold risky assets and bought long-term bonds or derivatives during the period of low equity and high bond prices, induced by the low funding ratio they had to report. The implication is that funds realised billions of losses and pursued a pro-cyclical policy of selling low and buying high.

In short, the renowned Dutch pension system has come under severe pressure and has seen its standing deteriorate rapidly.

However, it is possible to demonstrate that the condition of Dutch pension funds is less severe than has been suggested. Some commentators are claiming the opposite, arguing that liabilities are calculated using the wrong discount factor and that the static funding ratio is incorrectly viewed as the correct indicator of long-term health. Replacing the funding ratio with better indicators should ease people’s uncertainty and prevent an undesired, pro-cyclical investment policy by pension funds.

Pivotal to the Dutch regulatory framework is the funding ratio, the value of the investment portfolio divided by the discounted value of the liabilities. With the introduction of new legislation in 2007, the Dutch regulator arranged that, in calculating this ratio, the fixed discount factor was to be replaced by the market interest rate at the moment of calculation.

With this change, a devastating disturbance crept into the system. In case of a decline in interest rates, a decline of the funding ratio occurs. Due to a lax monetary policy and strong deflation caused by worldwide division of labour, relevant However, it is possible to demonstrate that the condition of Dutch pension funds is less severe than has been suggested. Some commentators are claiming the opposite, arguing that liabilities are calculated using the wrong discount factor and interest rates did decline. Within the regulatory framework, this tendency created its own momentum. Lower interest rates decreased funding ratios, which induced pension funds to hedge their interest exposure, causing rates to go even lower.

Even more important is the fact that the Dutch regulator stated that pension liabilities should be valued using a credit risk-free discount factor and opted, arbitrarily, for the zero swap rate. There is no market for determining the actual price of pension contracts so models must be used, but the approach of funding ratios, based on swap rates, does not deliver consistent fair value.

Moreover, this rate appears to be very sensitive to supply and demand conditions. This situation cannot come as a surprise as in October 2006 the Organisation for Economic Cooperation and Development warned that ‘new accounting standards may have set up a vicious circle of bond demand from pension funds’.

This problematic mechanism was already apparent in 2004-05, although it did not produce the dire consequences of 2008-09 when the credit crisis lowered the asset value of all pension funds. It seems, then, that an arbitrary choice can disastrously wound a healthy pension system. However, it cannot have been the intention of regulators to create such a flawed mechanism.

Time to change

The Dutch regulator prescribed a risk-free discount rate to indicate that cuts in pension rights can never be viewed as a regular steering mechanism. But pensions are always uncertain and pension liabilities are not without risk, although this inconvenient truth was hardly ever communicated to the public. Because of this uncertainty, a discount factor incorporating a modest spread over variable government yield is much more appropriate than a risk-free rate.

Condemning the swap rate as unfit for purpose is not due to the negative effects it has on present funding ratios. It is based on two sound and fundamental reasons: theory (its risk premium is too low) and practice (the rate is too dependent on the behaviour of the pension funds themselves). A buying frenzy has led to a situation where the swap rate is lower than sovereign rates. The time has come for the regulator to enter into consultations with the industry about present-day views and experiences.

Pension fund liabilities are more comparable to AA corporate bonds. When pension funds experience weak investment results, and extra contributions are not to be expected, pensions may be cut, implying that debts are not redeemed fully. Therefore, the implicit yield on pension funds’ ‘quasi’ bonds should be considered higher than the swap rate as the risk profile of a fund is higher than suggested by the swap rate.

Swap rates and spreads are determined in a distinct market that is not comparable to the AA corporate bond market. Prices reflect essential differences in risk while supply and demand are also different. To put it another way, when the swap rate has its own determining factors it should not be used as a discount factor to simulate yields on corporate bonds.

However, another rate is better suited to provide that simulation: the yield index of an AA corporate bond portfolio. This would dramatically ease the financial status of pension funds, where a positive spread would replace the negative one and where less volatility would occur.

Re-visiting the funding ratio

Our second issue is whether funding ratios should have a place in pension fund supervision. The funding ratio is calculated on the basis of a balance sheet, the outcome of which determines whether a recovery plan is necessary. It is defined as the ratio of assets to pension debts, the market value of pension provisions.

However, this one-dimensional approach does not pay enough attention to the long-term goals of the funds. That is why it should be supplemented by information on solvency, which approach also is advocated by both finance theory and practice.

Banks, other creditors and investors have reviewed corporations using figures relating to liquidity and solvency. Both characteristics are important for pension funds because there is not so much difference between the financial institutions. Both are engaged in financial contracts with a balance between assets and liabilities and both have to invest to make returns.

Summary

Regulation and supervision based only on the funding ratio does not give enough insight into the balance sheets of pension funds. The liquidity of a fund is not recognised at all and the solvency is not judged adequately. The Dutch regulator, aiming to improve the stability and integrity of the financial system, should therefore restructure regulation by replacing the swap rate by a state-plus yield and by taking into consideration the set of alternative definitions in an extended supervision of pension funds.