THE CONTEXT. Dutch pension funds’ health—their ability to pay pensions and link them to inflation—is determined by their coverage ratio, a measurement of the value of their assets against their liabilities. The liabilities are calculated using euro swap rates, although from maturities of 20 years and higher, an ultimate forward rate (UFR) is used that ensures long-term interest rates are somewhat higher than market rates.
THE BASICS. 2014 was a bad year for Dutch pension funds because:
(1) Long-term interest rates fell significantly.
(2) They will have to cope with stricter regulations that further lower the interest rates they use to calculate their liabilities, whereas the solvency requirements will be stricter as from 2015.
(3) All this comes at a time of a ‘societal dialogue’ about the future of the pension system.
THE DETAIL. The fall in long-term interest rates means that the volume of pension liabilities has increased significantly, exerting strong downward pressure on coverage ratios, despite positive returns from most asset classes. Lower interest rates also mean that the cost price of pensions has risen strongly. The fall in long-term interest rates is the result of continued efforts by central banks—for us, the European Central Bank—to ease monetary conditions. In theory, lower interest rates should lead to higher asset prices, and the resulting rise in financial wealth should trigger higher spending.
But this is not working.
As debt-laden governments and households are unwilling to borrow and the households that have room to take on debt are apprehensive about their income and jobs outlook, central banks’ efforts resemble pushing on a string. Although the total value of assets on the balance sheets of Dutch pension funds have risen, the stronger pace of liability growth (and hence the lower coverage ratios) means that many have been unable to meet their inflation pegs.
The lack of final demand—clearly one of the most pressing problems in the European economy—is also holding back cash-rich companies from spending their money on new investments.
It is hard to see how Europe can break out of this vicious circle.
From 2015, the UFR will be a 120-month moving average of the one-year forward rate of a maturity of 59 years, instead of the fixed rate of 4.2%. In practice this means that liabilities will be calculated using lower interest rates. Given the past decade’s history of interest rates, this new UFR method will put downward pressure on coverage ratios for the next 10 years. At the same time, solvency requirements for Dutch pension funds will become stricter as they will have to keep more reserves against their (listed and unlisted) equity and credit bond investments, in particular. Pension funds face stricter rules for inflation indexation and cuts in entitlements. This will not help consumer spending in the Netherlands and thus will not help the Dutch and European economies grow again.
THE RESULT. Households have significantly lower confidence in pension funds now than prior to the global financial crisis. Of course, pension knowledge and awareness are broadly low among the public. Nevertheless, the rude awakening that pensions were not safe at all times, of cuts in entitlements at some pension funds, the inability to give inflation indexation by many more funds, and the increase in the pension age are undermining confidence in the system.
Starting next year, the tax-allowed level of pension premia will be lower. Politicians and the media expect lower pension premia as a result, thereby forgetting that the cost price of pensions has risen and that coverage ratios are in need of repair. People have to work longer and face the risk of lower pension income. At the same time, the employers’ federations and the trade unions—together the organisers of the pension system in the Netherlands—are unwilling or unable to act as ‘champions’ to defend their system. Thus, the collective assets of Dutch pension funds run the risk of falling prey to the ever-present hunger of politicians for money. It is against this background that a ‘societal dialogue’ takes place about the future of the Dutch pension system.
To be sure, changes are necessary to make the system sustainable. However, the risk is clearly there that changes will be forced upon it that serve interests other than of those who aspire to maintain a good, healthy pension system.
Bernard Walschots is the CIO of Rabobank Pension Fund.