BRUSSELS - The Belgian Pension Fund for Doctors, Dentists and Pharmacists has an unusual goal for a defined contribution plan: full funding at all times.
Using a combination of a reserve account and reinsurance, officials at the Brussels-based fund aim to ensure the fund can withstand a 12.4% market drop one year followed by a zero return the next, while continuing to give participants their regular 7.75% annual return.
The result is a pension fund that closely resembles an insurance company -- not surprising given the dominant role of continental Europe's insurance industry in both providing pensions and influencing regulation.
The key difference, however, is officials at the 13.5 billion Belgian franc (U.S.$380 million) Voorzorgskas voor Geneesheren, Tandartsen & Apothekers VZW can maintain their relatively high 62% allocation to equities, designed to provide superior benefits over the long term.
In fact, the approach by the Belgian industrywide pension could set a model for European defined contribution plans, which often are more akin to hybrids between defined benefit and defined contribution plans.
Unlike U.S. defined contribution plans where participants are completely at risk in bear markets, many European pension funds provide guaranteed-return benefits. For example, Swiss and Danish defined contribution plans face minimum return requirements under law.
The VKG fund itself is unusual. It was converted to an advance-funded scheme from a pay-as-you-go system Jan. 1, 1995. Because many retirees took lump-sum payments at that time, 91.5% of the plan's 11,592 members now are active employees, meaning the fund will have positive cash flow for years to come.
The VKG fund provides a guaranteed annual return of 4.75%. As a result, the Office de Controle des Assurances, the Belgian regulator, requires the VKG plan to be fully funded, or solvent, at all times.
But fund officials believe they need to exceed the legal guarantee, especially because participants are free to switch to life insurance policies.
In addition to the guaranteed return of 4.75%, officials have a "moral obligation" to deliver an additional three-percentage-point annual profit distribution to participants, Karel Stroobants, deputy general manager for the fund, said at a recent conference sponsored by IIR Ltd.
Value at risk
With the help of Koen de Ryck, president of Pragma Consulting N.V., Brussels, fund officials have adopted a number of risk control techniques, such as value at risk, to ensure they have proper protection in the event of a bear market.
Value at risk quantifies the maximum amount the fund can lose, over a set time period, with a given confidence level. The VKG fund's value at risk is -6.86%. That is, given historical market returns and the fund's asset mix of 62% equities, 30% bonds and 8% real estate, officials have a 95% confidence level the fund can survive a -6.86% loss in a given year. However, there is a 5% chance losses could exceed VAR.
In order to make good on the 7.75% return on an after-tax basis and meet the fund's operating costs, fund officials calculate they must earn a minimum acceptable return of 7.5%.
Fund officials then calculated what level of volatility buffer was required to deal with poor markets while still delivering the same level of benefits to participants.
VKG officials determined a volatility buffer equal to 20.8% of assets, or 2.8 billion Belgian francs, was needed to withstand a one-year drop equal to the value at risk, followed by a second year with a zero rate of return.
The volatility buffer contains two non-allocated provisions: a legal solvency margin equal to 4% of liabilities that cannot be drawn down without triggering a reorganization under government supervision; and a larger, more flexible portion, known as the solvency provision.
VKG officials had two objectives in their risk management program: lowering the legal solvency margin, and putting in place a risk management program that would provide a reasonable level of protection at a tolerable cost.
The first part was simple: VKG officials reinsured 20% of liabilities for active participants with insurers SCOR SA, Paris, and Munchen Reinsurance Co., Munich.
The second part -- building up a volatility buffer -- was trickier. But luck was in hand: Net returns of 16.3% and 19.7% in 1995 and 1996, respectively, helped create the buffer of 1.7 billion Belgian francs. Future excess returns will be diverted to help reach the 2.8 billion target.
But VKG officials wanted greater assurance the fund could survive more severe losses.
By reinsuring a portion of the fund to cover losses between -6.86% and -12.4%, they will have a 99.5% confidence of withstanding a market drop. Only if the fund plunged more than 12.4% -- a 1-200 probability -- would the fund not be able to improve benefits by 7.75%.
If the reinsurance policy -- provided by SCOR and Munich Re -- is used, the fund would repay the reinsurer over five years through higher premiums. Now, the fund pays an annual premium of 11.3 million Belgian francs, or only 0.001% of total assets.
Currency hedging review
VKG officials also explored whether to provide full protection to the fund. But a one-year put option equal to 90% of assets would cost 2.8% of assets, while an option designed to protect 80% of assets would cost 2.04%. Both options were rejected as too expensive.
Mr. Stroobants, the deputy general manager, said officials are studying whether the fund's value at risk can be reduced by using currency hedging to cover the fund's dollar and yen exposure, equal to about 30% of assets.
Preliminary figures provided by State Street Banque S.A., Brussels, the fund's custodian, suggest the value at risk would be reduced to -4.03% from -6.86%. That in turn means the solvency provision could be reduced to 2.45 billion Belgian francs from 2.8 billion francs, or a decrease of 14.4%, he said.