Stress test shows cracks in European pension funds

Awareness of the impact of low interest rates and volatile markets on pension funds is nothing new, but the results of the first stress test on these investors by a European supervisory authority has made clear how acute the problem is.

The low-interest-rate environment has continued to take its toll on the liabilities side of pension fund balance sheets, and sources with knowledge of these institutional investors said no amount of investment would bring the assets up to a level necessary to tackle existing deficits.

The European Insurance and Occupational Pensions Authority's stress test looked at a number of different scenarios for pension funds in European Union countries. But even before applying these stresses, it found that in the 17 tested countries, total liabilities outweigh assets by e428 billion ($477.8 billion) under its common methodology. With a severe stress — an abrupt drop in interest rates and an increase in inflation rates — this shortfall would hit e773 billion under EIOPA's model.

It's a problem evident across the globe: The latest report from Wilshire Consulting showed the aggregate funded status of U.S. corporate pension plans fell to 78.3% at the end of February, down 1.1 percentage points. That was largely driven by an increase in liabilities coupled with flat asset growth.

Falling gilt and equity markets have also hit U.K. pension funds, although the situation improved in February. The latest update from JLT Employee Benefits showed the total deficit of all U.K. corporate defined benefit funds fell 17.1% to £209 billion ($301 billion) in February, and fell 17.4% in the year ended Feb. 29. As of the same date, the funded ratio of these funds was 85%, vs. 83% at the end of January.

But the problem is particularly acute in the Netherlands. Aon Hewitt said the average funding ratio of Dutch pension funds in January decreased five percentage points, to 97%. Pension funds in the Netherlands are considered solvent only at a 105% funded level.

The stress test covered 140 defined benefit or hybrid institutions for occupational retirement plans, across 17 countries in the European Union. Dutch pension funds accounted for 44% of the total defined benefit funds sample analyzed by EIOPA in its stress test, which applied certain financial shocks to test the effect on funded shortfalls. It investigated the shock resistance of pension funds, and the systemic risk that they might pose for the stability of financial markets. While the conclusion was that the links were limited — which sources in the industry accepted — EIOPA's stress test was criticized for its narrow sample and its failure to reflect the impact of a crisis on member benefits.

The EIOPA concluded: “The results of the severe stress scenarios applied show a significant increase in the deficits of assets over liabilities, revealing a number of risks and vulnerabilities that deserve proper attention from IORPS and supervisors. At the same time it is important to realize that the absorption of these shocks depends heavily on the time element for realizing liabilities and the mitigation and recovery mechanisms in place.” The authority added that further work is needed to gain deeper understanding on the effects of stress scenarios, “especially concerning the consequences of the extra pressure put on sponsors to increase their future contributions.”

Nevertheless, the test did highlight one important issue: the Dutch central bank, De Nederlandsche Bank, issued a statement in January on the topic detailing its concern that the Dutch pensions sector is “vulnerable to financial market shocks, as pension funds have hardly any buffers left to absorb shocks amid the current low-interest environment.”

“It is true what DNB says — but it is also no surprise,” said Gerard Riemen, managing director of Pensioenfederatie, the Federation of the Dutch Pension Funds, in The Hague, Netherlands. Mr. Riemen said while the assets of pension funds in the Netherlands have fluctuated since the financial crisis of 2008, the overall picture is that assets have about doubled, but at the same time as liabilities have suffered from low interest rates and regulatory intervention.

“We have to calculate at a risk-free discount rate, which is going down and down all the time. That means that our liabilities are sky high at the moment — and means our funding ratios at the moment are below 100. So there are no buffers,” he said.

In a statement related to the findings of the stress test, Pensioenfederatie said: “The existing pension legislation in the Netherlands ensures that pension funds are able to spread financial shocks over a long period of time, for example through long recovery periods and the long-term character of their liabilities. As a consequence, they do have a stabilizing influence on financial markets, a conclusion that EIOPA draws as well. However, financial market shocks can have an impact on pension beneficiaries and employers,” which it said could, in certain situations, “lead to measures such as limiting or ending indexation or even the cutting of pension rights.”

Mr. Riemen said the only thing really left to do is to wait for interest rates to go up — “we cannot invest against this. On the assets side you never will be able to compensate (for) what's happening on the liability side.”

But there is an ongoing debate around shifting to another kind of structure midway between defined benefit and defined contribution. “But the main characteristic should be that you are not dependent anymore on this interest rate — this is a system where you don't need a discount rate to calculate these liabilities,” said Mr. Riemen.

While the debate has been ongoing, Mr. Riemen thinks it is now crunch time.

“We have a little stress — we think we have to hurry up and come to conclusions before the end of this year, (as there is an) election in spring 2017.” Decisions over changes are not the domain of politicians, he said. “We want to come forward with solutions ourselves before the new politicians think they have to decide. We are in very bad shape — it is very difficult to explain that although since the financial crisis our assets have doubled, still we are very poor, are not able to index benefits, and there is a high risk that we have to cut benefits. Members simply don't understand. And if you cannot explain that to the people — if they don't understand about discount rates and liabilities — then they lose trust,” said Mr. Riemen.

The U.K.'s Pensions Regulator also issued a statement after the publication of results, endorsing the conclusion that “the flexibilities within the U.K. pensions sector mean there is only a limited link between pension schemes and financial stability. Alongside these flexibilities, high-quality risk management and strong employer covenants are key for the resilience of U.K. schemes.”

However, U.K. pension funds are still under pressure. “In the U.K., it is undoubtedly the case that we are vulnerable to shocks — our U.K. pension funding levels are simply inadequate to provide the guaranteed level of benefits,” said Charles Cowling, director at JLT Employee Benefits, based in Manchester, England. “The security that attaches to members' benefits is heavily dependent on the employers that are standing behind those pension schemes.”

But the setup of U.K. pension funds allows them to ride out the storms, Mr. Cowling said. Similarly, the U.K. is not subject to mortality stress in the same way as the rest of Europe, he said. “We are pretty good at factoring in allowance for mortality improvement,” he said. “It is more the financial markets stress problems that could tip a significant number of companies over the edge.” n