Smoothing Framework Hits Dutch Coverage Ratios

A fall in the three-month average in interest rates has resulted in higher liabilities for Dutch schemes, putting them in the firing line of the regulator.

(June 4, 2013) – Smoothing strikes again: The average coverage ratio of Dutch pension funds at the end of May was 104%, despite market rates increasing last month, according to consultant Aon Hewitt.

The coverage ratio drop has been caused by a surge in liabilities, driven by a lower average interest rate over a three-month period and the Dutch smoothing mechanism.

In order to discount liabilities, Dutch pension funds are made to use the three-month average of the interest-rate curve. However, assets are calculated using mark-to-market valuations.

Interest rates rose in May, which would normally be a good thing. However, the three-month average no longer includes February, which had a higher rate than March, April and May.

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This means the new three-month average uses lower rates to calculate what the Dutch call their Ultimate Forward Rate, resulting in an increase in liabilities and a worse coverage ratio.

If the May market rate alone had been used to calculate the UFR instead, the value of the liabilities would have actually declined (and therefore the coverage ratio would have increased), but the forced use of a three-month average actually saw it increase (and the coverage ratio decrease).

The fall in average interest rate resulted in an increase in the value of the liabilities, of approximately 1.5%.

The 104% reported by Aon Hewitt’s Pensioenthermometer is worrying as by law, Dutch pension funds are required to have a minimum coverage ratio of 105%.

The rise in market interest rates in May also resulted in a drop in the value of the fixed income portfolio of 3.5%, although this was partly offset by good results in the US and European exchanges.

ABP, Europe’s largest pure-play pension, admitted earlier this week that despite an investment return of 13.7% in 2012, its overall funding ratio only improved from 94% to 97%, because of liabilities increasing by 10.7% and persistently low interest rates.

The pension giant was one of several big-name Dutch funds forced to reduce the payments made to pensioners in order to shore up its balance sheet this year.

ABP Chairman Hennk Brouer warned further pensioner payment cuts may be necessary if conditions don’t improve.

For an up-close-and-personal look at what is happening in the Dutch pensions sector, read about aiCIO‘s recent visit in the next edition, which is published later this month.

Rising rates would hit the end people nearest retirement disproportionally hard, according to a Casey Quirk paper, as glide paths derisk approaching their target date.

(June 3, 2013) - It may be now or never for defined contribution (DC) plans to shift out long-duration fixed income, consultancy Casey Quirk warned in its latest whitepaper.

The Connecticut-based firm projected a $1 trillion shift out of treasury bills and other traditional bonds, based on growing unease over interest rates. Defined contribution retirement accounts hold roughly a quarter of their total assets ($1.2 trillion) in fixed income. If rates rise to half of their historical average, or 4.1% for 10-year treasury bonds, the paper's author Yariv Itah estimated DC plan losses to top $180 billion.

In the event of a rate hike, target-date fund strategies would exacerbate losses for DC plan members nearest retirement. Glide paths derisk over time, largely by swapping equities for "safe haven" long bonds, despite the historically low rates of the past five years.

Short duration credit and high yield were the real safe havens in Itah's model, showing the most moderate value swings from changing interest rates.

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On the opposite end of the spectrum, a portfolio of long duration, high-grade fixed income would gain 24% with a zero rate environment, according to the analysis. But, the paper pointed out, with rate volatility, downside potential far outweighs upside. That same portfolio would lose 40% of its value if interest rates climbed to 4.1%.

Traditional fixed income managers have grown complacent (and often rich) over three decades of fairly steady and downward-trending rates, he argued, leaving the market unprepared to manage rate instability.