| FTK 101 |
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| 19/03/2006 | |
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Dr Laurens Swinkels is senior researcher at the Quantitative Strategies Department of Robeco Asset Management. He is also assistant professor at Erasmus University Rotterdam and member of the board of the Stichting Pensioenfonds Robeco. He answers this week's 101 on the new Dutch Financial assessment framework, the FTK. 1-Could you briefly describe the FTK legislation and explain how it was first brought forward? Where does it currently stand with respect to its final implementation? FTK determines whether pension funds and insurance companies are financially healthy. The main change compared to the old regulatory regime is that for the valuation of pension liabilities the fixed actuarial discount rate of 4% will be replaced by the market interest rate. Basically, FTK consists of three parts: a minimum funding requirement of 105%, a risk-based solvency requirement for investment risks, and a long-term continuity analysis. Violating the minimum requirement implies that a solution has to be found within one year. This means additional pension payments from the sponsor companies into the pension fund, or, in the most extreme case a reduction of pension rights. In addition to these minimum requirements, pension funds should aim for a solvency margin that gives them no more than a 2.5% probability of violating the minimum funding requirement. The amount of risk a pension fund takes determines the required solvency ratio. If these risk-based solvency requirements are not met, the pension fund has to find a solution within 15 years. This often involves suspension of inflation compensation and increasing pension contributions. The continuity analysis is only a slight modification of a traditional ALM-study, which most pension funds already used before the introduction of FTK. The new regulation for pension funds will be implemented on 1 January 2007, while for insurance companies the introduction has been postponed until international agreement on Solvency II regulations. 2-What will most Dutch pension funds have to do to meet the requirements of this legislation? Have they done anything so far? Moving from a fixed actuarial discount rate to a market-based interest rate increases the interest rate sensitivity of the pension liabilities enormously. On average the duration, a measure of the interest rate sensitivity, is 16, while the duration of the assets is generally about 3. This leads to large reductions in the pension funds solvency when interest rates decline. In order to reduce this interest rate risk, many pension funds are considering extending the duration of their fixed income assets substantially. The most popular solutions to increase the duration are buying long-dated bonds, interest rate swaps, or liability driven funds from asset managers. The disadvantage of buying long-dated bonds is that active portfolio management is virtually impossible. The disadvantage of interest rate swaps is the legal and operational complexity. Therefore, we see a huge demand for liability driven investment funds with active returns and a high interest rate sensitivity. Nowadays, most pension funds are aware of the duration mismatch between their assets and pension liabilities and are familiar with the three instruments mentioned above to reduce this risk. However, they find it generally unattractive to enter the long-dated bond market at the current historically low interest rates. Especially pension funds that are not constrained by the solvency requirements are waiting for higher interest rates before increasing the portfolio duration. Nevertheless, pension funds with currently low solvency margins have started using these fixed-income instruments to protect their funding ratio. Thus far they have had no reason to regret that decision. 3-Do you expect the impact of the FTK-induced investment decisions on the Dutch bond market to be substantial? Dutch pension liabilities will be valued using the euro-swap-curve when FTK comes into place. This means that the entire European bond and swap market can be used to hedge interest rate risk, instead of just Dutch bonds. This is different from other countries, such as the U.K., Denmark and Sweden, who moved from fixed discount rates to market interest rates before. Considering the size of the European bond market, one might expect that the Dutch pension liabilities would easily be absorbed. This is, however, not necessarily true. On 12 September 2005, the Dutch regulator unexpectedly announced that FTK would be postponed by one year. The 10-year interest rate reacted with a 6 basis points increase within 15 minutes after this announcement. This suggests that the total of € 650 billion of Dutch pension assets could move interest rates down at the long end in the last quarter of 2006, when all pension funds want to extend their duration in order to be ready for the new regulation to come into effect. |
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Articles of the same Serie : 101 |
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Articles of the same Topic : Pension funds Western Europe
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