The Dutch supervisory authority for pension funds and insurance companies is introducing a fair-valuation framework similar to the Swedish and Danish traffic light system. This regulatory change probably marks the start of a new liability-driven investment era with pension funds eager to mitigate their cash flow risks.

The potential effects on European interest rates are of major importance to Swedish fixed income investors from both an asset-only and an asset-liability perspective.

What is the possible impact of Dutch regulatory changes for Sweden?

In September 2001, the Dutch supervisor launched its first version of risk-based solvency requirements for pension funds. These guidelines took many pension funds by surprise and created heavy resistance. Early in 2003, the first consultative document for the new regulation was presented by the supervisor and has been further refined over the past couple of years. It was expected that all Dutch pension funds would have to adopt the new rules on 1 January 2006, but a recent announcement from the Dutch National Bank has confirmed that implementation will be postponed by one year. Even so, many pension funds are planning to eliminate their interest rate risk over the short term and this might cause the long end of the euro interest rate curve to flatten, as the entire Dutch pension market accounts for roughly E650bn. Pension funds are allowed to adopt the new rules on a voluntary basis, but only a handful have decided to do so.

Although the Dutch and Swedish systems are quite comparable in nature, some differences are noteworthy. First of all, unlike the Danish and Swedish system, there is no traffic light but the outcome is either a ‘pass’ or ‘fail’. In case of a ‘fail’, the pension fund must submit a recovery plan that shows how the fund can reach appropriate reserves within 15 years. When the funding ratio drops below 105 per cent, the pension fund has to find a solution within one year to regain minimum solvency. This latter part of the law is being debated heavily in parliament as one year is considered too short a time period by some. Pension funds are more likely to reduce short-term risks if the recovery period remains as short as originally proposed. This means that the Dutch demand for long-dated euro bonds or swaps might partially depend on the outcome of this ongoing debate.

What are the differences between international supervision?

Some market risks are treated differently in Sweden than in the Netherlands, which might give different incentives to certain asset classes in the two countries. For example, pension funds have to calculate with 40 per cent credit spread widening in the Netherlands, while it is 50 percent in the red light scenario (80 per cent in the yellow) in Sweden. On the other hand, pension funds have to take into account a 20 per cent devaluation of foreign currencies in the Netherlands, against only 13 per cent in a red (or 17 per cent in the yellow) situation in Sweden. We expect convergence in the regulatory parameters over time, so that pension funds throughout Europe will have the same incentives, for example, to hedge currency risks.

Figure one: Swedish and German 10-year interest rates

Table one: advantages and disavantages of different investment solutions

One of the challenges in the Swedish situation is the limited amount of government bonds that match pension funds’ liabilities. Denmark and the Netherlands are able to use the euro market to hedge interest rate risks, which reduces the possible market impact of a move towards longer duration. Although the euro market is not a perfect hedge for pension fund liabilities, the figure shows that Swedish and euro interest rates are largely moving together. In our opinion, liability hedging is also a trade-off between costs and rewards and when long-dated Swedish bonds become expensive, the opportunity of hedging with euro bonds becomes attractive.

Most promising investment solutions

We have been using our Center of Knowledge to inform our clients about the regulatory changes and its possible impact on pension funds’ investment policies, and all information is tailored to clients’ needs. Over the past couple of years, we have been working with pension fund boards and investment committees to develop professional investment solutions that can be explained to the members of the pension scheme. Next to traditional bonds with a long maturity, three ingredients form the basis for many solutions that are attractive to various clients: interest rate swaps, liability-driven investment funds, and swaptions. In table one we summarise the advantages and disadvantages of these solutions.

Some larger pension funds are considering an interest rate swap overlay. A couple of funds, such as the Hoogovens pension fund in the Netherlands and ATP in Denmark, have such an overlay already up and running. This solution can be tailored exactly to the pension fund’s liability structure. However, it does require hiring a specialised lawyer and setting up and managing a collateral account. This usually takes at least a couple of months.

For pension funds that prefer not to spend any time on legal and collateral management tasks, it makes sense to participate in a liability-driven investment fund with a built-in swap-overlay structure. As a consequence, the swap overlay is standardised to the average pension fund. The direct swap overlay and liability-driven investment funds are preferable to investments in traditional long-dated bonds, as the latter are illiquid and less suitable for active management.

The current low interest rate environment makes many funds reluctant to increase the duration of their assets. For these funds, swaptions can be attractive, as they protect a fund against interest rate declines while allowing it to benefit from interest rate increases as well. The downside is that the pension fund has to buy the option, which might easily cost up to 3 per cent of the fund’s assets for one year’s protection. We would therefore advise that only funds with low funding ratios and strong views about a short-term interest rate increase choose swaptions. To reduce the cost of swaptions, we advise pension funds to write a swaption at a higher interest rate and receive the option premium. Economically, this means that the pension fund is protected against a decline in interest rates, and may profit from an interest rate increase, albeit up to a maximum level.

How have Dutch pension funds adapted?

So far, the majority of the 800 pension funds in the Netherlands have not yet implemented new liability-driven investment policies. Some larger funds are using interest rate swaps and several medium-sized pension funds have opted for liability-driven investment funds. Since the new Dutch regulations will remain voluntary until 2007, we expect that pension funds will slowly start moving into long-duration solutions during the next year. In Sweden, the new regulations start early 2006, which gives the Swedish pension fund industry a strong incentive to switch to liability-driven investment solutions more quickly.

Fixed income capabilities

To help pension funds match assets and liabilities in the new regulatory framework, we have developed two liability-driven funds. These funds consist of two parts: a bond fund – investing in either government bonds or credits – and interest rate swaps, increasing the duration to 20 years. This investment product is cost-efficient and at the same time offers the flexibility to meet individual pension funds’ needs. After all, the desired duration can easily be obtained by combining the traditional bond fund and the long-duration product in the right proportions. In addition, the

bond investments are actively managed to enhance returns.

New pension fund regulations in Sweden, Denmark, and the Netherlands are remarkably similar. They give incentives to better match pension assets with liabilities by extending interest rate sensitivity. As opposed to Denmark and the Netherlands, Swedish pension funds cannot yet make use of euro fixed income markets to perfectly hedge their liabilities. In practice, the hedge might be acceptable since euro-zone and Swedish interest rates tend to move in the same direction.

In the Dutch pension fund market, we see larger pension funds setting up interest rate swaps themselves, whereas medium to smaller-sized pension funds tend to choose a more standardised solution with liability-driven investment funds. Funds with a strong view on an interest rate increase and a relatively weak financial position can choose interest rate swaptions and we expect similar solutions to help the Swedish pension fund industry.

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