This has dramatic implications. For example, PME, the €16.2bn giant fund for mechanical and electrical engineers, saw its funding ratio rise 7 per cent to 116 per cent from end 2003 to end 2004 under the current legislation. Under FTK, PME’s funding ratio would have dropped from 125 per cent to 119 per cent, although, it is still above the 103 per cent minimum, according to Roland van den Brink, head of investments at PME.
A recent Rabobank report picked out nine key consequences of the legislation for Dutch pension funds. As always, the biggest funds are expected to lead the way, with some, such as Philips, having already overhauled their investment structure.
Rabobank’s first prediction is that liability valuations will become more volatile. Experts at two of the biggest Dutch funds, PME and PGGM, the €64bn fund for the healthcare and social work sector, agree. Gerlof de Vrij, head of strategy and research at PGGM, explains that valuations “will fluctuate in line with bond market volatility if not hedged”.
Secondly, says Rabobank, there will be a shift from equities into bonds. However, Mr de Vrij qualifies the prediction, pointing out that so far most pension funds have held onto their equity weightings. “Also, a solution can be that instead of increasing bond holdings the route is chosen to reduce the duration mismatch through the use of derivatives, like swaps,” he adds.
PGGM has a strategic investment of 45 per cent to equities for 2005, with 30 per cent in fixed income, 5 per cent in commodities, 12 per cent in real estate, 5 per cent in private equity and 3 per cent in a strategic portfolio. PME has an allocation of 22 per cent to European, US and Japanese equities, 10 per cent to other equities, 42 per cent to fixed income, 8 per cent to direct property, 13 per cent to high yield fixed income and 5 per cent to commodities.
Like Rabobank, Mssrs de Vrij and van den Brink expect growing demand for long-dated fixed income securities and inflation-linked bonds. However, Mr van den Brink expects demand for long-dated bonds to increase only slowly, while, according to Mr de Vrij, supply of inflation-linked bonds is very limited, “so most pension funds see this as an unrealistic option.”.
According to Johan Cras, director for Benelux and the Nordic region at Frank Russell Consultants, the first priority for pension funds coming to terms with the new law will be lengthening of duration, although they are more likely to buy the opportunity, using derivatives and swaps, than go for an all-out sell of five-year in favour of longer duration bonds. “Flexibility,” he adds, “is the key word at the moment.”
This is apparently at odds with the experience of the Philips Pension Fund, which has already made changes to comply with FTK, going straight for longer-dated bonds. However, Jan Snippe, head of corporate pensions at Philips, concedes that other funds may take a different approach.
PME reduced its interest rate risk by about 30 per cent in 2004, but this was by no means a universal move. Mr van den Brink adds: “Company plans did this. Large, industry-wide pension funds did not, except for PME.”
According to Mr de Vrij, the timing of a duration hedge is very unfavourable, as yields have recorded historical laws.
The other key asset allocation shift will be towards diversification, and demand for alternative investments such as hedge funds, private equity and property. Once pension funds have addressed duration concerns, Mr Cras predicts that they will “look for more diversified sources of beta and alpha and, within this, room for alternatives as well”.
Mr de Vrij adds: “As short-term stability of the portfolio return has become a more important issue, and as future returns are assumed to be lower than past returns, diversification into alternatives makes perfect sense.”
A changed system
Rabobank’s next conclusion is that there will be relative flattening at the very long end of the yield curve. This, according to Mr van den Brink, is “probable but not certain”; according to Mr de Vrij, it is “likely”, as a result of higher demand.
The report also anticipates higher contributions to pension funds. “Most Dutch pension funds do not have enough reserves,” says Mr de Vrij, “and are trying to rebuild them through higher contributions and conditional indexation in the context of a recovery plan.”
Finally, Rabobank anticipates a shift from defined benefits (DB) to defined contribution (DC) schemes, but this may not sit too easily with the pensions culture in the Netherlands.
Such a shift, warns Mr Cras, would not “fit immediately with the idea within pensions in the Netherlands that DB spreads risk among many members”. Mr de Vrij adds that there is a tendency towards DC, “but also a lot of resistance. In general, there is a lot of consensus about the idea that DB is superior to DC as it allows having a longer-term investment horizon, translating into higher returns.”
On balance, Mr Cras thinks, DC will become bigger, but will not develop in the immediate future at the same rate as in the UK or the US. It is, he says, already a “huge step” that many funds have adjusted their promises on inflation-linking. Mr van den Brink foresees a shift to DC, but only for company, not for industry-wide, pension funds.
Getting acquainted
For now, most funds are still in a phase of contemplation – “still getting acquainted with the consequences of FTK”, as Mr Cras puts it. PGGM, according to Mr de Vrij, “is still studying the subject and feels uncomfortable with the shift to short-termism as long-term investment results have been very good.”
He adds that the fund has already shifted towards higher diversification, through adding alternative strategies, “and is still making further progress in this area”. PME, Mr van den Brink adds, plans further diversification, in particular to commodities, and reduction of interest rate risk. And where the giants lead, the rest of the Netherlands institutional market can surely be expected to follow.
CASE STUDY: PHILIPS PENSIONS FUND
Philips Pensions Fund has been one of the first to get to grips with the forthcoming Dutch legislation, Financieel Toetsingskader (FTK). It has overhauled its investment strategy completely, shifted from a final to an average wage system and made explicit a conditional indexation policy.
The €13.7bn fund slashed its equity allocation from 38 per cent to 28 per cent, from end 2003 to end 2004, while the allocation to fixed income rose from 46 per cent to 60 per cent. However, these changes were within the context of a major structural and strategic change, which saw the fund divided into two portfolios: a matching portfolio to account for at least 75 per cent of the fund’s nominal liabilities, and a return portfolio intended to cover the remaining liabilities and generate the means to finance indexation.
According to Jan Snippe, chief executive of the Philips Pensions Competence Centre and head of corporate pensions at Philips, FTK makes risks more visible and so makes it more likely that pension funds will manage them. In particular, it brings out the interest rate mismatch risk.
“We had that risk like any other,” Mr Snippe says, although he added that the maturity of the fund (it has an average duration of liabilities of 11 years) means that the risk is less for Philips than for many of its counterparts. The two portfolios were developed as a response, with the matching portfolio devoted to fixed income and the return portfolio incorporating equities, real estate and some alternatives.
Currently, both portfolios are internally managed. However, this will change thanks to April’s deal to sell the administration and asset management activities to Hewitt and Merrill Lynch, respectively.
Mr Snippe adds: “What we did through these changes [conditional indexation, average salary and the new investment strategy] was basically to reduce the risk profile of the fund but keep a significant probability of being able to realise decent indexation.”
Philips, “one of the very first in the Dutch market to do this”, has also applied for the new regulatory rating before it becomes mandatory. Mr Snippe expects some other funds to follow in Philips’ footsteps, but others to take a different approach to dealing with FTK.
In particular, he says, it was an important part of Philips’ policy to reduce interest rate risk by investing the bulk of the portfolio in long-dated bonds, rather than by using swaps. Moreover, he says: “Some may consider reducing interest rate risk without reducing exposure to equities. We did reduce equity exposure to make way for increased investment in fixed income.”
