Down but not out

 

Well over a year into the credit crisis, the global pensions landscape looks very different, with virtually no territory left unscathed from the turmoil. 

The Netherlands, once seen as a shining example of good pensions practice in Europe, is hurting. Falling coverage ratios and increased regulatory requirements have come together to create the most difficult and demanding pensions environment in decades, with caution the order of the day. 

It was not without a degree of trepidation that John Smolenaers, senior consultant with Watson Wyatt called the situation facing the Dutch market “the most severe crisis we’ve seen”. 

Frans van der Horst, managing director, Aegon Global Pensions agreed: “The size, the scale and the speed with which this financial crisis happened is just amazing. The whole environment has changed. The financial community is largely in uncharted territory now.”

The grim sentiment was echoed by all the industry professionals Global Pensions spoke to, with almost universal agreement that the single most important issue facing the industry at the moment was that of coverage ratios. 

No place to hide

Unlike in the previous crisis of the early 2000s, after the dotcom-bubble burst, the effects of the credit crisis have hit every asset class. As Arthur van der Wal, head of institutional clients Benelux, at ING Investment Management noted: “There has been no place to hide.” 

Charles Janssen head of institutional clients with Fortis Investments went further: “The biggest disappointment for the whole industry is that diversification has not paid off – it did not work in this crisis. That is not to say we don’t believe in it any more, but it shows that in this case, diversification is not working.” 

Part of the problem, as Erik van Dijk, CEO and CIO of boutique financial consultancy Compendeon explained, was that over the past few years, many pension funds looked to mitigate volatility through using absolute return and hedge fund strategies, with an insufficient appreciation of the wider risks: “At the end of the day it’s just an asset class. You cannot do without the old, traditional real estate, bonds, equities and so on.” 

Exacerbating the problem of low coverage ratios was the fact that over the past few years, many funds had de-risked their portfolios using long term government bonds. 

Smolenaers commented: “At the moment, the spread on swap-rates is negative, which is really bad for pension funds.” 

A very real and present danger facing the Dutch system at the moment therefore is the need for funds to forego indexation and possibly raise premiums.

In the Dutch system, indexation or inflation-linked increases (usually 2% to 3%) are discretionary, dependent on the coverage ratio and annual returns generated by the fund. 

Eric Pouwels, senior vice president and managing director of Northern Trust Global Services in the Netherlands explained: “A lot of funds will skip or cancel indexation this year. That’s a decision that has to be made.” 

Tim Burggraaf, a European partner with Mercer said he thought it would also be likely there would be “more years without an inflation adjustment for pensioners”, the knock-on effects of which could be severe.

“If we get say three years in a row, that’s [an effective cut of] about 10%, which is quite a lot,” he added. 

Indeed, as Watson Wyatt’s Smolenaers added, the effects of a widespread and prolonged cancellation of indexation payments would be dire: “With funding ratios of around 85% to 95% it’s realistic that payments will be cut in the future. When one pension fund does that, on a micro level, it’s bad for members, but at the moment many funds  face the treath of cutting entitlements, and then it becomes a macro economic issue.” 

However, Pouwels said: “We’re in a crisis – we shouldn’t sweep that under the carpet – but at least we have the tools available to help us solve this crisis.”

Framework

Under the FTK (Financial Toetsing Kader) – the regulatory framework for Dutch pension schemes – funds with a coverage ratio of less than 105% must submit a recovery plan to the Dutch central bank, De Nederlandsche Bank (DNB), outlining how and when they expected to return to the minimum solvency level. 

Part of the FTK framework is a risk model known as the ‘S Toets’ (a Chi-squared test, for the statistically-minded) which separates market risk into six broad categories. These are: interest rate risk; equity risk; credit risk; currency risk; insurance risk; and commodity risk. 

Somewhat counter-intuitively, as Anna Parlevliet, European sales director, Scandinavia and The Netherlands, Investec AM, explained, strict risk controls for under-performing funds meant the schemes which needed to generate the highest returns – usually through higher risk investments – were prevented from doing so. 

“When coverage ratios start to deteriorate, risk management requirements lead them to increase the allocation to bonds and liability matching strategies and take risk off the table. This is quite opposite in some other regions, where under-funded schemes are increasing the risk (however well diversified) in order to get back up,” she said. 

Reinoud van den Broek, managing director Robeco Institutional Benelux said in terms of which funds had fallen below the 105% threshold, it was “a mixed bag”.

“We’ve seen some of the largest funds go under 105%, but then there are also some large funds which still have healthy funding ratios.”

In normal circumstances, funds which fall below the minimum 105% ratio have two months to draft and submit their recovery plan, but due to the severity of the situation, the DNB has extended this deadline to April 2009. 

Leonique van Houwelingen, senior vice president and head of relationship management, Continental Europe, BNY Mellon Asset Servicing, commented: “Longer recovery plan periods are a good thing – the pension funds need the flexibility and the time to be able to assess the situation and to decide on appropriate measures.” 

Van Dijk said: “The regulator felt that they forced pension plans to come up with their recovery plan immediately, in the middle of this turmoil, it might lead to them taking the wrong decision so the regulator decided to give them some breathing space. The extension allows them to sit, to think about what to do and not act hastily.”

Ard de Wit, head of institutional risk management, KAS Bank, and vice chairman of the board of trustees of the KAS Bank pension fund, said there were also very simple, practical reasons for extending the planning period: “Most funds use a consultant but if everybody goes to their consultant for support, they don’t have the people to help everyone at once.”

Van der Wal added: “In general, the government and regulator have acted very positively. The risks of doing nothing are much greater. The important thing for pension funds right now is not to panic. 

“We should not forget pension funds have a long term outlook and investment perspective but we don’t think there are many funds with liquidity problems. Keeping the long term perspective in mind is very important – we need to get some confidence back into the market.” 

Van der Horst said the FTK law had also required a higher level of regulatory awareness and ability: “From a regulatory point of view, the requirements for managing pension funds are increasing, and it’s simply not possible for many funds and plan sponsors to have the necessary level of professionalism in place.”

As an example of the increased regulatory burden, Ard de Wit explained that the KAS Bank pension fund, which by no means was one of the largest in the country, had no fewer than three oversight committees in addition to the board of trustees, with 19 members. 

He said: “That’s 19 people who sit on committees for our corporate pension fund, for a company that employs 800 people, and a fund of only €120m. You have to have the same structure for €120m as you would for €5bn – so for small funds it’s really hard to do this.” 

Smolenaers agreed; Over the past few years, the burden of governance for pension trustees has become more and more [onerous]. Pension funds have to be aware they’re professional institutes having responsibility of a lot of money.”

Van Houwelingen underlined the fact many smaller funds are struggling to cope.

“It’s a burden on a lot of the smaller pension funds to comply with the regulatory requirements. Complexity of the investment products is also a challenge – you need to have the skill-sets to be able to understand the different models of the complex products.” 

Despite this, Charles Janssen, head of institutional clients, Fortis Investments said the overall level of professionalism had increased: “If this situation had happened three or four years ago, it could have been a lot worse. The level of expertise and knowledge is better already, but it’s still not as high as it should be.” 

The increased regulatory burden on funds has also spurred the growth of outsourced pension management solutions such as fiduciary management and insurance-based products, designed to cut through the complexity of scheme management. 

Pouwels said: “The majority of pension funds are struggling to meet the coverage ratio. Outsourcing is triggered by the quantity of new legislation from the regulators, lack of expertise to support different investment strategies and the current market circumstances.” 

van Dijk agreed: “Outsourcing makes sense. There are a lot of schemes where the pension plan – even up to the size of €600 to €700m – is nothing more than two or three people working part time together with the CFO. The problem with that is the CFO should concentrate on what the firm is about, not the pension fund.” 

Parlevliet said: “More and more providers are entering the market and a whole new business concept around finding the right fiduciary manager has emerged. Pension funds are even splitting the mandate over a number of fiduciary managers in some cases, which in my view may defeat the objective somewhat.” 

Janssen added there had been reports of insurance companies receiving requests from smaller pension funds about buyouts or reinsurance contracts. “For a lot of smaller pension funds it’s quite difficult to survive unless you have a big sponsor behind you,” he said. 

In-sourcing

While there was a trend for smaller funds to outsource, there was also a counter-trend of the larger funds ‘in-sourcing’ and setting up what can be essentially viewed as asset management operations. 

Spurred by changes in the law which have required the separation of the pension fund and asset management concerns, several of the largest Dutch schemes had embarked upon what van der Wal called “blurring frontiers”. 

Van Houwelingen noted: “A few larger funds are moving to commercialise themselves – moving into a multi-client model and  offering their investment management and investment information services to other pension funds and potentially insurance companies on a third-party basis.”

Van Dijk added: “More and more, they are no longer just a DB plan, but instead a dedicated financial services firm. They’re niche players, but very big niche players. That will be the way a lot of the big plan sponsors will go. In terms of size, some of the biggest funds are so large it would take them into the top of the Dutch stock market.” 

However, some were concerned about the level of service smaller funds which opted for the pension-scheme-as-asset-manager approach might experience. Although possibly baseless, some said they had worries that smaller funds would not represent as much of a priority within the framework of the larger schemes, and could risk being subsumed into the overall fund. 

One of the most far reaching changes in the FTK law was the move from a fixed discount rate of 4% to a discount rate determined by the swap rate of the DNB. The rationale behind this was to measure risk against fair values, although in light of recent developments, this has had a wider impact than was previously expected. 

Van der Wal explained: “The single biggest consequence of the measuring assets and liabilities at market value is seeing far bigger volatilities on the liability side. These circumstances are extreme.” 

Ard de Wit added: “Recently, the swap curve has been below the Euro government curve – it’s normally 30bp higher than the overall curve but it’s been 20bp below. That’s 50bps. It’s really impacted liabilities.” 

Janssen said the situation was the “biggest test” of the FTK framework so far. 

“The fact that valuing liabilities against the swap curve should be so volatile has been a big shock for many of the funds.” 

Van Houwelingen said this proved that regulation did not, and indeed could not, prevent situations such as this from arising: “Even though you can write as many rules and regulations as you like, I don’t think anyone could have foreseen this situation.”

Reinoud van den Broek, managing director Robeco Institutional Benelux, said falling asset values and rising liabilities had caught Dutch funds in a “pincer movement”.

“They’ve been hit on both sides,” he said.

Investment priorities

With such market chaos, many funds have found their investment priorities radically altered. Burggraaf summed up the aims of pension funds in 2009: “At the moment it’s all about recovery pans and trying to stay alive. It seems that innovation has come to almost a complete stop. New product creation has come to a complete standstill, so the market has slowed down quite considerably.” 

Janssen agreed: The focus will be much more on the solvency rate than on the benchmark – the only benchmark that should matter is the solvency rate. 

Van Houwelingen added: “There will be greater emphasis on managing towards the coverage ratio. If you’re above the coverage ratio you’d be more comfortable taking risks – going towards alpha-type investments – whereas if you need to reach the coverage ratio you’d probably be more conservative.” 

Despite this, many noted a lack of changes in asset allocations – it seems there had not been large scale restructuring of assets and movements in terms. 

Van der Wal said: “The regulator has not forced pension funds to de-risk – we haven’t seen huge sell offs in equities, but we have seen a flight to quality, such as government bonds. There is far less risk appetite [than before], because funds are all focused on their recovery plans.” 

Van den Broek said he had seen demand for beta investments, such as index-based products, although in the main, there had been little movement.

“There hasn’t been a flight from equities, pension funds are still holding firm in their allocations. They’re actually not doing much – possibly because there isn’t too much liquidity and room to manoeuvre at the moment. We have however seen some demand from cheap beta.” 

Janssen noted: “The whole industry is also focusing much more on risk management – what is your counterparty risk? On your bonds? On your security lending? Oversight is much more important. It’s very easy to look at your bond or equity portfolios, but that’s not the whole picture of the risk. 

He continued: “We don’t believe funds will leave the alternative space permanently, but it will be a case of decreasing complexity. I think for the next three to five years it’s going to be over for complex products.” 

Van der Horst said: “The market has been playing with instruments which, with hindsight, have had knock-on effects that no-one wanted to see. I’m not sure it’s the case that nobody could have foreseen them, but the financial industry simply didn’t want to foresee them.” 

He added he thought there would be a trend to less complex investments. 

Mark van Weezenbeek, head of sales and business developement at KAS Bank, said: “We haven’t seen a big shift in the way their portfolios are structured but it depends on each individual fund. Some have been de-risking under the FTK regulations, possibly because the sponsor hasn’t been able to make large amounts of money available to support the fund.”

While socially responsible investment (SRI) and environmental, social and governance (ESG) concerns may not be the highest priority at the moment, it would be wrong to say they have completely slipped off the radar. 

Smolenaers said SRI strategies were on the agenda at the beginning of 2008, but for many funds, there were more important considerations to be taken into account in the current operating environment. 

However, van Weezenbeek, associate director, institutional investors, Europe, added there was a legal requirement for funds to have some sort of ESG policy. 

“The policy can be ‘well, we don’t have a policy’,” he said, “but everybody has to think about it. There has been a slowdown because of the recession, but it’s part of the long term issues.” 

Aegon Global Pensions’ van der Horst added: “It used to be that when there were good times, companies could afford to be responsible; when times were bad they couldn’t. But now I think it’s different – certainly with the larger pension funds, responsible investment has become completely entrenched in the way they think and behave and run their portfolios. It won’t be killed by what’s going on now.”

Pouwels agreed: “ESG is partially integrated in mainstream investments. In the short term, we should focus more on empirical analysis because it’s difficult to defend the performance of sustainable investments without empirical data to back it up.” 

A defined benefit system

In some ways, the Dutch market is unique in Europe in so far as it remains a resolutely defined benefit (DB) system. For cultural and historical reasons, the DB system seems to be well embedded in the Dutch social model, although the current funding crisis poses a threat to this. 

van Dijk said: “Things are really at a crossroads right now – in the Netherlands and continental Europe where we have a more or less DB structure, it’s a challenge to face the low coverage ratios at the moment.”

Smolenaers noted: “DC growth hasn’t been what we expected because of Dutch history – it’s really in the nerves of the Dutch people that pensions are DB.”

He continued: “We need to think about what is happening and how we can make regulations and a solvency framework which keeps pensions affordable. The worst thing that could happen is it makes employers scrap their DB schemes and then move over to DC.” 

Van der Horst was rather pessimistic: “What’s happened could be another nail in the coffin of DB schemes in the Netherlands.” 

For better or worse, and based to some extent on the prevalence of DB schemes, the Dutch industry also enjoys a reputation as being at the forefront of investment practices and one of the most ‘mature’ markets in Europe, if not the world. 

For van Dijk, this was down to two broad trends: “It’s definitely true that the top funds are some of the most sophisticated in Europe. There’s not much of this ‘us-versus-them’ mentality, compared with other countries. There’s less scepticism. We’re all colleagues first and foremost.”

He added: “The level of education here is high – not just the theory but also the practice – and the relative wage difference between what you can earn in a pension plan and in the industry is much smaller than in other countries.” 

Pouwels agreed: “It has always been difficult to attract and retain the right people on the investment side as a pension fund. However after the split between the traditional pension fund and its administration and investment arms, this is changing.” 

Despite the doom and gloom, Parlevliet remained upbeat: “The Dutch pensions market is one of the strongest in Europe – even worldwide – and no pension fund has ever gone broke before.” 

Van Houwelingen concluded: “On more the positive side, if you look at pensions in the Netherlands, they’re probably better off than pension plans in other countries where they don’t have those buffers and reserves.” 

 

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