Dutch funding levels battered by low discount rates

Dutch pension experts question whether the interbank swap yield curve is the best rate to discount liabilities against, as Giovanni Legorano and Raquel Pichardo-Allison report

Funding levels of Dutch pension funds have been heavily hampered by low discount rates with funding levels particularly taking a beating in May. Data from the Organisation for Economic Co-Operation and Development released in mid-June showed a whopping 40% of the decline in funding levels from mid-2008 through to the end of the crisis, could be attributed to lower interbank swap rates used to discount liabilities.  The result has been the spurring of a debate surrounding the use of the interbank swap yield curve as the discount rate.

Mercer principal Dennis van Ek said at the end of last year the coverage ratio was an average of 104%. He explained: "This year the coverage ratio dropped particularly for funds with no interest rate hedge. Long-term interest rates declined to an average of 3.15% at the end of May, from an average of 3.87% at the end of 2009."

"It can make a difference if you're trying to recover, because every percentage point matters," he said.

Long term interest rates are the parameters used to discount pension funds' liabilities. Their decrease makes liabilities larger and their increase makes them smaller.

He added: "Until the end of April interest rates were still around 3.5% therefore it has been really the month of May that has seen this sharp decline of the funding level of funds."

Unusual choice

The Netherlands uses a "somewhat unusual choice of discount rates", the interbank swap yield curve, according to the OECD's report, Economic Survey of the Netherlands 2010. This is a result of a change in legislation in the mid-2000's "when the adoption of fair value accounting principles led to the replacement of the fixed rate of 4%", the OECD said in its report.

Coverage ratios for many schemes have again dipped below 105%, the threshold above which the De Nederlandsche Bank (DNB) - the Dutch central bank and pension regulator - requires the funding level to be. If it falls below this watermark, schemes are forced to develop a recovery plan which the DNB then needs to approve.

Aon Consulting executive director Rajish Sagoenie summarised the evolution this way: "The funding of pension funds is going through what looks like a W trend."

During the crisis the coverage ratio went down, then it increased and lately it has decreased again. This is an exceptional situation. Eighty percent of pension funds - and most of the large pension funds - had at the end of May a coverage ratio which is below 100%."

Figures from the DNB showed pension funds were only 98% funded at the end of May.

This is a stark difference from pre-crisis funding levels. According to the OECD report, the average coverage ratio of Dutch pension funds was 144% at the end of 2007 but dropped to 92% by early 2009.

Funding deterioration

Experts agree that at the beginning of the crisis the deterioration of the coverage ratio was mainly due to the losses incurred in the value of scheme assets. But now the downward movement on the swap rate is seen to be the main cause of the underfunding on the scheme's balance sheets.

Lodewijk Meijer Group principal Erik van Dijk said: "This is an issue the DNB has to solve. At the moment you use current interest rates to calculate funding ratios but when we have highly volatile interest rates as we have at the moment, it would be much better to use interest rate averages, for example, over a period of three years. This would make things more stable."

Van Dijk said the use of the interbank swap rate, in and of itself, is not detrimental. The problem is basing liabilities on what the rate is at a specific point in time.

"People do have a behavioral tendency to move from ‘way too enthusiastic' in good times to ‘far too depressed at other times' based on what the prevailing economic climate is. By taking an average of these climate-sensitive point estimates over some longer period of time you can polish away the excesses. Especially in a period of structural change in the world and relatively low interest rates, we believe that this approach will lead to more accurate long term valuations; and avoid the pitfall of having liability valuations that are too volatile," he said.

The OECD in its report acknowledged using a weighted average of swap rates could dampen volatility, but also said it reduces the "forward looking value" of using market rates.

Instead, the OECD suggested using less volatile long-term interest rates. "These can be obtained from investment in high-grade bonds, such as AA-rated corporate bonds," the report said.

The DNB disagrees. "We find that smoothing, as suggested by the OECD, hampers efficient risk management and blurs an objective view on the financial position of a pension fund," said DNB spokesman Tobias Oudejans.

In its quarterly bulletin release in mid-June, the DNB addressed the discount rate issue.
In a translated excerpt provided by the DNB, the central bank said: "DNB promotes the principle that defined benefit pension liabilities should be discounted at a risk-free interest rate.

The true risk free rate does not exist, but the government curve and the swap curve come quite close. The swap interest rate curve has the advantage over the government curve that it has sufficient liquidity even for very long maturities. Furthermore, it is possible that DNB applies a correction to the swap curve when there are clear biases in the swap market."

Hedging the risk

There are differences with the funds which have full interest rate hedging. Those are the ones, which - industry figures pointed out - suffered much less this year. Data supplied by Towers Watson head of investment consulting for continental Europe Gerard Roelofs shows, on average, pension funds hedge only 50% to 60% of their liabilities against the interest rate risk.

As a result, the outlook for the industry remains difficult to predict.

ING Investment Management head of institutional clients Benelux Arthur van der Wal said the evolution of funding levels depends mainly on the duration of assets matching pension funds have implemented in their portfolio.

He said: "Some pension funds are fully matched, so the sensitivity to interest rates movements is very low. But if they have a duration gap, which is happening with a lot of pension funds, then the whole dynamic is very different. What we see is that many pension funds are caught in a trap. Fully matched pension funds need higher returns to recover. Partly matched pension funds also need higher interest rates. But the outlook for both conditions is very modest at the moment. Therefore we don't see a short-term recovery of funding ratios, right away."

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