In the two previous blogs we looked at the two new contract forms in the new pension agreement. An important conclusion is that the certainty as it exists in the current contract will lapse. In short, this means that the funding ratio and the Required Funding Ratio (VEV in Dutch) no longer play a role. But what do these changes mean for a Dutch pension fund?
12 Oct 2020
From legislation and regulations to investment theory
In the current contract, pension funds have the necessary restrictions when it comes to formalizing their investment policy. As an example, a Dutch pension fund may not increase the level of risk - in terms of VEV - when it is in a solvency shortage. This is the case when the policy funding ratio is below the level of 100% + VEV. In addition, the VEV methodology may in some cases lead to rather arbitrary outcomes. An example of this is the current underestimation of the interest rate risk at the current low interest rate levels.
Within the new contract, the projection return will be introduced. This is going to be an expected return which will be used to determine the pension fund’s ambition. If the pension fund decides to have an ambition of 80%, it needs (for example) 2% projection return throughout the build-up phase. In that case, the pension fund will construct a portfolio in which the projection return will be achieved with a certain confidence interval.
Expected returns in a low interest rate environment
Historically, interest rates are extremely low right now. As a result, expected returns are low as well for most instruments. For bonds, the (maximum) return can be calculated by discounting the future coupons and the final payment to today. This is what we call a yield. For many government and corporate bonds, the yield is currently negative. If the interest rate remains at the same low level in the coming years, it will therefore be quite a challenge to seek for sufficient (expected) returns to realize the defined ambition of the pension fund.
Shift to other investment categories
Investment theory is therefore expected to play a more pronounced role in formalizing pension funds’ portfolios. For many return-driven instruments there has been an (average) over-return relative to the interest rate historically. Furthermore, pension funds might move towards instruments that historically had a stable return with a low-volatility profile. When constructing investment mixes, explicit attention will therefore be paid to economic criteria, such as the risk/return ratios.
In the next blog we will look at the lifecycles and what will change in terms of hedging interest rate risk. Curious about the CACEIS solution? Read the story about the CACEIS Center of Excellence for pensions: a one-stop shop for the European pension fund industry, which will offer fully internal front-to-back functionality and support services.