REFORMING DUTCH PENSIONS – HIGHER CAPITAL REQUIREMENTS          UNDER “FTK1” FOR EXISTING PENSION RIGHTS?          David v...
required levels of capital. In addition, the solvency position of many Dutch pension funds wasalready weakened before the ...
Table 2: Overview of current and new FTK1 correlations (source: DNB).       risk scenario        risk scenario     current...
observed correlations during a period of market stress and not on the observed maximum values ofcorrelations.Refinement of...
Figure 2: Impact of the new FTK1 guidelines on the required capital for Dutch pension funds. Each     blue dot represents ...
would be very happy to reach the minimum required funding ratio of 105% at the end of 2013. This is      very far removed ...
AEGON’s Derisking and FTK solutionsAEGON Global Pensions has developed pension derisking solutions for companies looking t...
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Reforming Dutch Pensions - New Capital Requirements for Existing Pension Rights

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Reforming Dutch Pensions - New Capital Requirements for Existing Pension Rights

  1. 1. REFORMING DUTCH PENSIONS – HIGHER CAPITAL REQUIREMENTS UNDER “FTK1” FOR EXISTING PENSION RIGHTS? David van Bragt, senior specialist investment solutions, AEGON Asset Management The Dutch pension agreement of 2011 has been the cause of heated – and ongoing – debates. The agreement will lead to a major transition from today‟s „harder‟ pension rights towards conditional or „soft‟ pension rights, and should take effect as of 1 January 2013 or, if more time is needed, as of 1 January 2014. The agreement of 2011 will be specified in detail in 2012 in a new regulatory framework, commonly referred to as the Financial Assessment Framework 2 (Financieel Toetsingskader 2) or “FTK2”. However, with the introduction of FTK2, it is still very unclear, and controversial, whether „hard‟ pension rights built up under the old system can be transformed into „soft‟ rights under the new framework. The existing FTK rules (“FTK1”) may therefore continue to apply to all existing pension rights. Although much attention has been paid to the consequences of FTK2, the changes to FTK1 that have been proposed by the Dutch regulator are also likely to have a profound and ongoing effect on pension funds, as the revised approach to risk will lead to stricter capital requirements. A new FTK1 – changing capital requirements In June 2011, the Dutch Central Bank (DNB) issued a proposal to revise the required solvency capital for pension funds as laid down in the current FTK1 rules.[1] On 14 September 2011, the proposal was sent to the Dutch Parliament for consideration. It is currently not known when these new FTK rules will come into force. Although the proposed changes to the FTK1 are significant, the underlying principle remains the same – that the solvency capital of a pension fund should be sufficient to avoid a nominal funding ratio of less than 100% with a probability of 97.5% over a one-year horizon. However, the required capital calculation within today‟s FTK1 is now considered to be insufficiently prudent to meet this criterion. For example, DNB estimates that the average funding ratio of Dutch pension funds at the end of 2011 was 98%, and approximately 125 funds are expected to announce a reduction (of as much as 7%) in pension rights in May 2012 in order to be able to reach the minimum required funding ratio (105%) by the end of 2013. The recent financial and economic crisis easily qualifies as a 2.5% event (in other words, such an event can only be expected to occur once every 40 years on average) so it may be argued that the current low funding levels are not necessarily the result of any inadequacy in the present FTK‟s[1] This document (‘‘Uitwerking herziening berekeningssystematiek Vereist Eigen Vermogen”), is available in Dutch athttp://www.rijksoverheid.nl/documenten-en-publicaties/notas/2011/09/14/berekeningssystematiek.html. 1 March 2012
  2. 2. required levels of capital. In addition, the solvency position of many Dutch pension funds wasalready weakened before the recent financial crisis by the collapse of the dot-com bubble between2000 and 2002.Nevertheless, DNB has established, on the basis of updated time series, that the stress tests appliedto pension funds were insufficient in some areas. For example, the new DNB analysis led to anequity stress test for developed markets of −30% (rather than −25%) and a much higher correlationbetween credit risk and equity risk than previously supposed. In addition, the new proposals alsoinclude a solvency buffer for active equity risk. This risk factor is not included in the current FTKrules, which can lead to an underestimation of the required capital. For example, several pensionfunds incurred significant additional losses during the financial crisis due to the underperformance oftheir active equity portfolios.FTK1 – a summary of proposed changesThe main changes to FTK1, as proposed by DNB, are summarised in the table below. The tableshows the current and new stress test parameters for each risk factor. It should be noted that thereis no prescribed „recipe‟ to determine the required capital for insurance technical risk (S 6) (forexample longevity, mortality, disability and lapse risk). Pension funds should therefore determinetheir own capital requirement for insurance technical risk, using their own models. Table 1: Overview of current and new FTK1 stress test parameters (source: DNB). risk scenario risk factor sub factor current new S1 interest rate risk factor 15-year interest decrease 0.77 0.75 equity developed markets 25% 30% equity emerging markets 35% 40% S2 equity risk private equity 30% 40% real estate 15% 15% S3 currency risk 20% 15% S4 commodities risk 30% 35% AAA 40% 60 bps AA 40% 80 bps S5 credit risk A 40% 130 bps BBB 40% 180 bps <=BB 40% 530 bps S6 insurance risk no prescribed rules no prescribed rules based on tracking S7 active risk N.A. error and TERThe current and new correlations between the different risk scenarios are also shown in the tablebelow. These correlations are used to aggregate the capital requirements for the different riskscenarios (S1 through S7) and determine the overall capital requirement. 2 March 2012
  3. 3. Table 2: Overview of current and new FTK1 correlations (source: DNB). risk scenario risk scenario current correlation new correlation remark when S1 is based on S1 (interest rate risk) S1 (equity risk) 0.5 0.4 an interest rate decrease when S1 is based on S1 (interest rate risk) S5 (credit risk) 0 0.4 an interest rate decrease S1 (equity risk) S5 (credit risk) 0 0.5Larger capital charges for listed and private equityOne of the most significant changes under the proposed rules is to the magnitude of the „S2 shock.‟In the equity risk scenario, this shock is increased by 5 percent. DNB argues that this accounts forthe relatively large downside risk and the high volatility of this asset class. Large losses also occurmore frequently than may be expected based on a normal distribution. The shock parameter forprivate equity is also increased substantially (by 10 percent) in order to account for the leveragingeffect of debt, which is frequently used to finance these assets.Different rating classes for credit bondsFor the credit risk scenario (the „S5 shock‟), DNB proposes to use different rating classes in order torefine the applied capital charges. A separate shock for high yield investments (credit bonds with arating lower than BBB) has also been added. The credit bond stress scenario will be defined in termsof an increase of the credit spread by a fixed number of basis points instead of as a relative increaseof credit spreads. DNB argues that this approach will reduce the pro-cyclical nature of the currentapproach. Currently, the applied shock would increase (in an absolute sense) for stress situationswith high credit spreads. This would lead to very high capital charges for pension funds in alreadydifficult situations. In the new setup, this undesirable effect is mitigated by using a fixed increase ofthe credit spread (per rating class). DNB, however, indicates that the required capital for credit riskwill on average increase under the new rules.A new risk scenario for active equity riskA new risk scenario („S7‟) for actively managed funds is also added in the DNB proposal. In thecurrent situation, there is no additional capital charge for active risk. DNB research has shown,however, that in several cases the losses of pension funds during the recent financial crisis werelarger than to be expected based on the development of market indices. In the new proposal, therequired capital for active risk is based on the annual loss due to active management (correspondingto a probability of 2.5%). This loss is linked to the (ex ante) tracking error of the fund and the costs ofactive management in terms of the total expense ratio (TER). To limit the impact on reportingrequirements, active risk only applies for listed equity and can be ignored if the tracking error issmaller than 1%.Adjustment of correlation parametersA correlation factor between credit risk and interest rate risk as well as a correlation factor betweencredit risk and equity risk has also been added. The correlation between equity risk and interest raterisk has also been set to a slightly lower value. DNB analyses show that a peak in the correlationdoes not necessarily coincide with a peak in risk factors. The correlations are now based on the 3 March 2012
  4. 4. observed correlations during a period of market stress and not on the observed maximum values ofcorrelations.Refinement of the calculation of currency risk and real estate riskThe calculations for currency risk („S3‟) and real estate risk (part of the „S2‟ module) will also berefined. The current FTK1 rules use a single risk scenario of -20% (a depreciation of all foreigncurrency positions by 20%). DNB argues that this underestimates the currency risk for assets inemerging markets and overestimates the risk for a diversified portfolio in developed markets. For thisreason, the currency stress scenario will be refined according to the true risks. For portfolios withwell-diversified currency exposure, a shock of −15% can be used. In this case, the exposure toemerging market currencies should be at most one third of the total currency exposure. If theexposure to emerging market currencies is larger, the shock can increase (in an absolute sense) upto −30%.The calculation of the required capital for real estate will also become more detailed for non-listedreal estate. In the new setup, the applied stress test can become larger than the current shock (of−15%), depending on the amount of debt financing.Impact analysis by DNBDNB has carried out an extensive impact analysis of these modifications, based on the reportedinformation of pension funds to DNB. As a result of the modifications, the required capital will onaverage increase from 21.7% to 26.6% (relative to the market value of the liabilities). The averageincrease is thus equal to 4.9%, which is approximately equal to €34bn (in total) for all Dutch pensionfunds. The figure below gives an impression of the impact of these changes on the required fundinglevel of the average Dutch pension fund. Figure 1: Impact of the new FTK1 guidelines on the required funding level for an average Dutch pension fund. A comparison is made with the estimated actual funding ratio at the end of 2011 (source: DNB, AEGON). 140% 130% +4.9% 120% (see Table 3) 110% 100% 90% 80% actual funding ratio required funding ratio required funding ratio (end of 2011) (current FTK1 rules) (new FTK1 rules)It should be noted, however, that there are major differences between individual pension funds,depending on their particular characteristics and their investment and hedging policies. For example,for some funds the required capital will hardly change under the new FTK1 rules, whereas for a fewfunds the required capital may double. The figure below provides an example of the differencesbetween individual funds, with each blue dot representing an individual pension fund. 4 March 2012
  5. 5. Figure 2: Impact of the new FTK1 guidelines on the required capital for Dutch pension funds. Each blue dot represents one pension fund (source: DNB). The required capital is denoted as a percentage of the market value of the liabilities. A required capital of 0% corresponds to a funding ratio of 100%. Solvency required capital(new FTK1 proposal) Solvency required capital (at the end of 2010)DNB also provides a break-down analysis on the level of individual risk scenarios. See the tablebelow, which shows the impact of the new rules in more detail. We should stress, however, that thistable gives results for the average pension fund. Results for individual pension funds can (and willbe) very different, depending on their investment policy and specific liabilities. Table 3: Impact of the new FTK1 guidelines for the individual risk scenarios for an average Dutchpension fund (source: DNB). The required capital is denoted as a percentage of the market value of the liabilities. S4 (commodities risk) (with diversification) diversification effect S1 (interest rate risk) S6 (insurance risk) S3 (currency risk) diversification) S2 (equity risk) S5 (credit risk) S7 (active risk) (without total total current 8.9% 14.9% 2.3% 1.1% 1.1% 3.5% 0.0% 31.9% -10.2% 21.7% new 10.0% 18.6% 1.8% 1.3% 2.6% 3.5% 1.5% 39.3% -12.7% 26.6%difference 1.0% 3.6% -0.5% 0.2% 1.5% 0.0% 1.5% 7.4% -2.5% 4.9%The largest differences (measured in percentage points) occur for equity risk, followed by credit riskand active risk. Note however that, in a relative sense, the effect for credit risk is very large: therequired capital for this component more than doubles from 1.1% to 2.6%. Differences are moremodest for interest rate risk and commodities risk. On average, the capital requirements for currencyrisk decrease slightly.What will be the impact of these changes?The proposed changes do not consist of a complete overhaul of the existing FTK1 rules, but aremainly a recalibration and refinement of the applied stress tests. Nevertheless, the impact of theproposed changes on the capital requirements for pension funds will be very substantial. A largenumber of Dutch pension funds are currently underfunded and are not even able to meet the currentminimum requirements with respect to the required capital. Stated differently: many pension funds 5 March 2012
  6. 6. would be very happy to reach the minimum required funding ratio of 105% at the end of 2013. This is very far removed from the average required funding level of 121.7% under the current FTK1 rules or 126.6% under the recalibrated FTK1 rules. These stricter capital requirements may thus have a large impact in the medium to long term on sponsors of distressed pension funds and the participants of these funds. If pension funds do not meet their solvency required capital, they are obliged to submit a long-term recovery plan to DNB.1 The plan contains specific measures to ensure that the fund meets the required solvency capital within 15 years. The plan is based on a recent continuity analysis and must at least contain: An explanation of why the solvency requirement has been (or will be) violated; The expected development of the technical provisions and investments; and Specific measures to improve the solvency position of the fund within a maximum of fifteen years to the required level, taking into account all liabilities of the fund. How to proceed? It is important to note that a pension fund is not allowed to increase its risk profile relative to the situation before the solvency requirement was violated. The only „way out‟ is thus to make better use of one‟s available risk budget. It therefore becomes even more important to carefully balance the expected return and the required capital for individual assets and to exploit positive diversification benefits on the portfolio level. It may also be attractive to apply a hedging strategy to reduce the required capital. In order to assess the overall effect of different investment and hedging policies, it is advisable for pension funds to perform an Asset Liability Management (ALM) analysis. Once an ALM study has been completed, it is also important to consider the current market situation and to allow for any other tactical considerations. For example, the outcome of an ALM analysis may be that hedging interest risk is strategically attractive. In order to implement this strategic aim, tactical considerations need to be taken into account so that a choice can be made with respect to the optimal hedging instruments. For example, when the market expectation is that interest rate levels are on the rise, the hedging strategy may consist partly of swaptions instead of only swaps. This choice would limit the downside interest rate risk, while allowing pension funds to benefit from the upside potential when interest rate levels rise.2 Given the fact that FTK1 looks likely to continue to play a role in the regulation of pensions in the Netherlands for some time into the future, it is important that pension funds are aware of the proposed changes to the framework. Risk looks set to become more expensive, which in turn may make derisking a more attractive option.1 If the fund also does not meet the minimum required capital (a funding ratio of 105%) a short-term discovery planshould be filed to DNB. This plan should outline how the fund reaches the minimum requirements within 3 years.2 An example of this approach was discussed in a previous AEGON Global Pensions Newsletter (Protecting TNT’s pensions– the benefits of swaptions). 6 March 2012
  7. 7. AEGON’s Derisking and FTK solutionsAEGON Global Pensions has developed pension derisking solutions for companies looking tocontrol or remove investment risk, interest rate risk, inflation risk and longevity risks.Longevity insurance – Longevity insurance enables pension funds to protect themselves againstthe risk that their employees will live longer than previously predicted. It allows companies to reducethe volatility of their pension plans.Pension buyouts and buy-ins in the Netherlands – By transferring all or part of your company‟spension liabilities to AEGON, you can remove the risks associated with your defined benefit plans,protecting your company from both short-term volatility and long-term uncertainty.Liability-Driven Investing (LDI) – LDI allows a pension fund to remove unrewarded interest andinflation risk by matching its liabilities with assets.FTK Reporting Services – AEGON provides various FTK Reporting Services to its clients in theNetherlands. We continuously monitor all regulatory developments around FTK1 and FTK2. AEGONAsset Management can advise pension funds in this area by re-assessing the fund‟s investment orhedging policy in the light of upcoming changes. For example, AEGON Asset Management providesALM advice for pension funds using the ALM Scan and Stress Test service. Using these tools, theevolution of the balance sheet and solvency position of a pension fund can be evaluated for a varietyof economic scenarios. With such an in-depth analysis, a robust investment and hedging policy canbe developed in collaboration with the pension fund.To find out more about our derisking capabilities, please contact AEGON Global Pensions.Tel: +31 (0)70 344 8931 | aegonglobalpensions@aegon.com | www.aegonglobalpensions.com 7 March 2012

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