Pension liabilities in safe-haven European countries below '08-'09 levels
By Thao Hua | July 9, 2012
Defined benefit pension funds based in safe-haven European countries are being punished by spikes in their liabilities as investors seeking stability amid the eurozone crisis continue to drive down government bond yields in those nations.
Both in the U.K. and the Netherlands, which are the two largest pension fund markets in Europe by assets, deficit levels have fallen to below what they were in the 2008-2009 financial crisis, according to estimates calculated by investment consultants Mercer LLC and Aon Hewitt.
As of June 30, the average funding ratio for FTSE 350 corporate plans was about 87%, down from 89% at the end of 2011. For the broader PPF 7800 index, which tracks about 84% of all U.K. defined benefit pension funds, the average funding ratio was even lower - 76.8% as of May 31, the latest date for which figures are available.
The average funding ratio among Dutch pension funds was 94% at the end of June. The average funding ratio in the U.S. is below that of the U.K. and the Netherlands, at 74% as of the end of June, according to Mercer LLC.
“The main impact on the liabilities side arises from investors in Europe looking for safe havens, and the U.K. is considered better off than many other European economies, so (investors) are plowing into U.K. gilts as a safe haven from the rest of Europe,” said Marcus Hurd, principal and actuary at Aon Hewitt in London.
In addition, the U.K. government “had decided (to implement) quantitative easing to stimulate the economy, pushing down yields, which in turn pushed up liabilities,” Mr. Hurd said. “Everything seems to have gone against pension funds in the past five years.”
Britain's Pensions Regulator has largely stuck by its regulatory framework for pension fund deficits. However, in the Netherlands, Denmark, Sweden and Finland, government bond yields generally used to discount future liabilities fell to such low levels that regulatory intervention was needed.
The challenging environment has also pushed some pension funds to seek bond-like returns outside of the typical asset classes available to institutional investors.
For example, executives at the 125 billion Danish kroner ($21 billion) PensionDanmark, Copenhagen, are in the process of shifting about 10 billion kroner from government bonds to a program that makes direct state-guaranteed export loans.
“The risk profile is the same as state-guaranteed (securities), but with about an additional 150 basis points of return on top of government bonds,” said Torben Moeger Pedersen, CEO of PensionDanmark.
The export financing initiative was part of a broader asset reallocation launched three years ago “in order to cope with two great challenges,” Mr. Pedersen said. “Firstly, bond yields were falling to such low levels that it was actually destroying people's purchasing power by investing pension assets in government bonds. On the other hand, the outlook for equity was very risky, very volatile.”
In the U.K., pension fund executives who substantially reduced risk in their investment portfolios in 2011 also benefited, sources said. Charles Marandu, London-based director of European advice at SEI Investments (SEIC), said one of his clients had increased the bond allocation to 85% from 45% and implemented it by mid-2011. “The nature and term of those bonds were selected to provide a nearer match to the long-dated inflation-linked liability cash flows,” Mr. Marandu said.
“The scheme was largely immunized against the sharp drop in interest rates that occurred from July 2011.”
The 20-year U.K. government bond yield was 4.18% at end of 2010, and investors “were thinking at the time that yields were too low then,” Aon Hewitt's Mr. Hurd said. As of June 30, the same 20-year rate had fallen to 2.7%. Each percentage-point drop translates to an aggregate rise of more than £100 billion ($155 billion) in deficits for FTSE 350 companies, according to estimates from Aon Hewitt. “You see why we're in trouble,” Mr. Hurd added.
Despite many U.K. corporate funds having made cash contributions since the 2008-2009 crisis, the aggregate deficit for FTSE 350 companies has more than doubled to £76 billion as of June 30, from £34 billion at the end of 2008, according to Aon Hewitt data.
“In 2008, assets largely fell,” Mr. Hurd said. “Ironically, during the credit crisis, pension funds' liabilities looked artificially favorable because credit spreads had jumped. ... What happened since is that credit spreads are more normal, and pension funds were no longer benefiting from that artificial boost.”
In the Netherlands — the second largest pension market in Europe by assets behind the U.K. — many pension funds are facing funding ratios below those reported during the 2008-2009 financial crisis, several sources said.
“At the end of 2008, the average funding ratio was about 95%,” said Dennis van Ek, principal at Mercer, Amsterdam. Now, “the average funding ratio is 94%,” he said.
The solvency problems faced by pension funds led Henk Kamp, Dutch minister of social affairs and employment, to announce changes in how pension liabilities are calculated to help mitigate funding ratio volatility as bond yields continued to fall amid the eurozone crisis. Since the end of 2011, pension funds have been allowed to use a discount rate based on a three-month average, rather than the year-end rate.
Furthermore, a proposal to allow the funding ratio to be based on a one-year average is likely to be implemented as early as the end of this year.
But the three-month average fell about 15 basis points at the end of June, resulting in a 2.5% average decrease in funding ratios. At the same time, market bond yields have risen during the month, resulting in a decline of the average funding ratio by another 2.5%.
Raise the rate
In June, Denmark's Business and Growth Ministry announced pension funds can raise the discount rate used to value long-term pension liabilities to better reflect normal market conditions and in line with long-term projections for growth and inflation.
The rate to be used for liabilities of 20 years or more will be extrapolated from an “ultimate forward rate” of 4.2%.
The move followed a similar one in Sweden, where regulators proposed a temporary, one-year floor on the discount rate used to value liabilities.
In Finland, authorities introduced new rules aimed at preventing pension funds from having to sell risky assets in order to comply with funding regulations.
In the U.K., however, the Pensions Regulator has not budged on its pension liabilities policy, despite calls by the country's National Association of Pension Funds to do so.
A main consideration is that in the Netherlands and Denmark, pension liabilities are calculated using a discount rate set by the regulatory authorities, and there are strict time limits to plug deficits, said John Ralfe, a pension consultant at his eponymous consulting firm in London. Therefore, increasing the discount rate automatically reduces liabilities and cash contributions.
“But there is no such prescribed rate in the U.K. to try to manipulate,” he said. The Pensions Regulator “is much weaker than in the Netherlands or Denmark, and operates with a "scheme-specific funding target' and no time limits for deficit contribution.”
This article originally appeared in the July 9, 2012 print issue as, "Pension liabilities in safe-haven countries below '08-'09 levels".