Any amendments to European pension funding rules are generally well received by issuers and lead managers. Regulation changes designed to increase protection for pensioners and reduce their exposure to market risk have typically forced schemes to cut into their equity holdings and heap more of their assets into bonds – and the new Dutch pension requirements, set to kick in at the start of 2006, look like lining issuers’ pockets further.
Keen to prevent a repeat of 2002 when falling equity prices and high wage costs led to a spate of pension scheme underfunding in the Netherlands, the Dutch parliament has approved a number of new solvency rules to make sure funds’ assets and liabilities move in tandem.
As a part of the new regulations, called Financieel Toetsingskader (FTK), schemes have to pass three interrelated tests: a minimum funding test in which plans must maintain a funding level of at least 105%; a solvency test to ensure schemes have a 97.5% probability of remaining above that level for a one-year period; and a continuity test to prove they are able to withstand adverse market conditions.
But key to these new requirements is that in all three tests schemes must – as they do with their assets – calculate their liabilities at current market rates instead of the fixed 4% rate set by the current supervisory regime. Consequently, the discounted value of pension schemes’ liabilities will fluctuate as capital market rates change and their present value will become more volatile.
The good news for the sell side, however, is that analysts expect funds to move significant chunks of their equity holdings into the fixed-income market as a result of this change, while at the same time rearranging their bond portfolios to include more long-dated instruments and inflation-linked notes.
“Matching the interest rate risk of assets and liabilities will become more relevant due to the introduction of marked-to-market valuations and because the solvency test clearly relates the risks of the assets to that of the liabilities,” says Jitzes Noorman, fixed-income analyst at Rabobank in Amsterdam. “This, combined with the fact that interest rate risk is currently much higher on the liability side, means that Dutch funds will have to raise the interest rate sensitivity of their holdings. Therefore one might expect a shift out of equities into ultra-long bonds.”
Marko van Bergen, managing director at Barclays Global Investors, agrees. Although he is not sure there will be a wholesale switch from equities to bonds, he has little doubt that any new money flowing into the hands of pension fund managers will be passed straight into the fixed-income arena.
“People will definitely move more of their assets into bond-like territory because of the FTK,” he says. “Funds will lengthen out the duration of their bondholdings to bring them more in line with liabilities and will buy real-return bonds for inflation protection. I am not convinced schemes will cut into their existing equity portfolio to buy these instruments but I do think that any new money funds get to invest will be pushed exclusively into this sector.”
Frank de Waart, director of the €1.5 billion Heineken pension fund, is one such manager looking at this option. Over the last five years the fund has reduced its strategic allocation to equities from 60% to 40%, and carved up its 40% allocation to bonds to allow 25% of that total to be invested in inflation-linked paper. But, despite being currently underweight equities and overweight inflation-linked bonds, de Waart is not totally happy with the present asset mix and says that he and the board of directors will meet over the next few months to discuss further modifications.
“The forthcoming government legislation is very important for everyone in the industry and we have seen funds buying more long-term and inflation-linked bonds already,” says de Waart. “We have not as yet initiated changes ourselves but we expect liabilities to fluctuate much more as a result of the FTK, and in the coming months we will sanction a smaller asset and liability study to look at our portfolio mix. Like others we may opt for a greater exposure to bonds in order to better match our liabilities but as yet we are undecided.”
But market conditions are not ideal for a switch into long-term paper and managers are worried about lengthening the maturity of their fixed-income holdings at a time of rising interest rates. The fact is, over the last 12 months the US Federal Reserve has increased rates three times to 1.75%, while the Bank of England has upped the cost of borrowing four times to 4.75%. At the same time, inflationary pressures have been amplified by the protracted rise in the price of US oil, which is now close to $54 a barrel.
“A lot of schemes are adopting a wait-and-see policy,” says Jan Luuk Roelfsema, a consultant at Towers Perrin in Amsterdam. “I do expect most funds to reinvest in bonds that reach out much further than the ones they currently invest in as a result of the FTK, but timing is not good for them right now. Interest rates are at historic lows and the overwhelming feeling in the marketplace is that they will only go up. To move now could be a mistake.”
Noorman at Rabobank is in agreement: “It is our house view that rates will most certainly rise over the coming months and that is why I do not think we will see much activity from funds until next year. It is better for them to play the waiting game.”
But while pension funds may be prevaricating over what action to take, the large majority of Dutch analysts and consultants have reached a conclusion on the FTK’s impact. And if their conservative estimates are to be trusted, the amount of money Dutch pension funds invest in bonds is set to increase by €50 billion to €400 billion before 2006. And for them, because of the backdrop of rising interest rates, it is not a question of if funds make this move but when.
“Funds will shift more of their assets into bonds because the new requirements simply leave them little other choice,” says one analyst. “Their liabilities are set to become a lot more sensitive and, given their long-term character, funds will invest no more of their assets in equities than is absolutely necessary. But any move that is made now is a tricky one and I suspect that, because funds do not have to apply the new rules to their balance sheet calculations until 2006, they are just waiting for the right moment.”
The prime movers
Two of the Netherlands’ largest funds, ABP and PGGM, which manage some €200 billion of assets between them, have yet to announce what changes – if any – they will make to their investment strategies because of the FTK. The two funds, which make up 25% of the entire Dutch pensions market and currently invest roughly €80 billion worth of assets in the fixed-income market, say that it is too early to say what they intend to do about the new government requirements.