The Price of Certainty

Dealing with low coverage ratios in Dutch pension funds.

September 13, 2010

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1280495_tulipsIn the Melbourne Mercer Global Pension Index, Canada stood out amongst most of its peers for the adequacy, sustainability and integrity of its pension system – that three-legged stool of universal state benefits (OAS/GIS), compulsory contributions to a state pension (CPP/QPP) and voluntary workplace coverage (RPPs/RRSPs).

But Australia and the Netherlands ranked higher (so did Sweden), in part because of mandatory workplace pension schemes.

The Netherlands ranked first. Its mandatory workplace coverage, which could be defined contribution or defined benefit, comes with a target income replacement rate.

That target income replacement rate has caused a bit of a kerfuffle, according to a post at Pension Pulse. But it’s one familiar to DB pension sponsors. How do you maintain pension promises when liabilities are aging faster than assets can grow to match them?

Notes Martin van Dalen, a portfolio manager in the investment department of the Dutch Social Security Organization: “Pension funds have to report on their coverage ratio on a quarterly basis. And this is where the problems start.”

De Nederlandsche Bank publishes the discount factor monthly. Imagine a quarterly mark-to-market valuation of a plan, and no three-year smoothing cycle, nor any legislative permission to make good a plan deficit on a five or 10-year basis. Among the strictures:

“• Less than 100%: you’ve got a problem, you have to submit a recovery plan outlining how you are going to get back to at least 100%.

• 100% – 105%: no indexation of pensions and accrued pension rights allowed.

• 105% – 125%: only partial indexation allowed.
• 125% – 145%: full indexation allowed.
• Over 145%: compensation of previous missed indexation allowed.”

Now, van Dalen reports, “DNB issued a statement to the effect that 12 to 14 pension funds had such a low coverage ratio that they should cut their current pensions and their accrued pension rights by, depending on the fund in question, 1% to as much as 14%, starting as soon as January 1, 2011.” That covers 700,000 pensioners and employees.

Of course, falling stock prices have contributed. But so has the flight to quality, which affects Dutch bonds no less than other top-drawer debt instruments. Yet, there are odd kinks, van Dalen argues:

“There is something funny about the DNB yield curve. It currently tops at about 20 years at 3.60%, but is significantly lower for later years: 3.10% at the end of the curve.”

In any case, the route to full funding may lead to some unpleasant surprises. “Let’s assume that the duration of the liabilities of a typical pension funds is 15 to 20 years…. Theoretically, the ALM manager could tell the asset manager to invest in a first-rate bond portfolio with the same duration: 100% Dutch government bonds. You’d have a lovely hedge: both liabilities and assets would bob up and down on the waves of the Dutch yield curve. But at this moment that would entail accepting a hideously low YTM: less than 3% on average, across the entire length of the curve. The price such a pension fund would pay for (a lot of) certainty as to its coverage ratio, would be an annual contribution that neither the employed participants nor the sponsor would want to find out.”

Yet, if they were to find out, it might contribute to a better understanding of the pension promise – for the promisers and the promised.

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