“Interest rate risk - and protection against it - will not vanish in the renewed Dutch pension system”.

Published on: 13 May 2024

When interest rates fall, the cost of our pension increases, or in other words, we need more money for the same pension. A fund can choose to protect its participants against this so-called interest rate risk through an interest rate hedge. What exactly does such a hedge look like? What role does it play in stabilizing the funding ratio with respect to a fund's transition to the new system? We asked Cees Harm van den Berg, Expert Strategist at APG Asset Management.

In a nutshell:

  • Pension funds are now protecting themselves against the risk that a drop in interest rates will lead to a lower funding ratio, particularly through government bonds and interest rate swaps.
  • Even in the renewed system, without a funding ratio, such protection will still be important, since the cost of the pension will continue to depend on interest rates.
  • Under the current system, interest rate protection cannot be differentiated by age. In the renewed system, this will change and it will be determined for each age group what is favorable for that group and what fits in with its attitude to risk. This often means high protection against the interest rate risk for older participants and low protection for younger participants.

Both under the Financial Assessment Framework (the part of the Pension Act that sets out the current legal financial requirements for pension funds) and in the renewed pension contract (Future of Pensions Act), funds and their participants are exposed to interest rate risk. This occurs when interest rates fall and a fund must therefore hold more capital to pay out the same pension. A fund can be protected against this risk to a greater or lesser extent.

What tools are available to a pension fund to protect against interest rate risk?
“To protect against interest rate risk, a fund can buy investment products that are interest rate sensitive and increase in value when interest rates fall. This is the case with products such as government bonds and interest rate swaps. With these investments, there are fewer other components that determine returns than, for example, with corporate bonds. After all, with corporate bonds, the company's results largely determine the return. We do assume some interest rate sensitivity here - as with mortgages - and we therefore include them in the protective investments. But that interest rate sensitivity is lower.”

The new pension contract will not eliminate funds’ need for an interest rate hedge. Does something change in the way it is deployed?

“Actually, under the current contract, we apply high interest rate protection for all participants - young and old - through the funding ratio, where we do not (cannot) differentiate by age. That will change under the new system. Under the new system, funds will opt for a graduated scale to allocate the protection return (the return used in the new system to maintain benefits as far as possible, ed.), and we will apply a higher level of protection for older participants - at PPF APG, for example, this is 100 percent - and a lower level of protection for younger participants. After all, young people still have a longer horizon and therefore more opportunity to absorb blows. In addition, future earning assets can be seen as the safe investment and pension assets can carry a bit more risk. Therefore, younger people benefit more from a portfolio that grows, while retirees, for example, benefit more from a portfolio that protects, since they are already receiving benefits. For the total participant population, you still use a certain amount of protection against interest rate risk, in the form of government bonds and interest rate swaps. But in the renewed system, we are therefore explicitly going to do for each age group what is beneficial for that group.”

Doesn’t a pension fund also use its asset mix to manage the risk of participant setbacks?
“It does to some extent, but the advantage of interest rate swaps is that you don’t have to put up capital for them. It is a derivative that has no market value at the time of conclusion, but it does have interest rate sensitivity. That allows a fund to approach the choice of interest rate hedging and the choice of how much to invest in equities separately. It does need to hold some cash and government bonds, because if those interest rate swaps do gain value, you should be able to transfer that.”  

Pension funds also use the interest rate hedge to secure their funding levels ahead of the time when they transition to the renewed system. Can you explain why and how this works?
“Let me use our own pension fund as an example again. PPF APG used an interest rate hedge of 60 percent under the Financial Assessment Framework. In September 2023, the fund found that it had a favorable funding ratio, about 120 percent, and that decisions on the new contract were as good as done. With such a financial position, it could achieve many of the transition goals that social partners have given the fund. It could provide a buffer, hold some money to absorb any future shocks, compensate for the elimination of the average premium system, etc. But there was also a chance that the funding ratio would fall, putting those goals out of reach. PPF APG then examined what the biggest risks in the portfolio were and how it could protect itself against them. It was then decided, among other things, to increase the interest rate hedge towards the transition date to eighty percent, thus reducing the risk of the funding ratio falling as a result of a drop in interest rates. Once PPF APG has made the transition to the renewed system, we will switch back to the hedging policy for the new contract, with the different allocation of protection returns to both young and older people. The total interest rate hedge will then shift again somewhat.”

Is this a common strategy for pension funds?
“It does play more broadly in the market. Some funds have already implemented this, because they want a bit of peace or comfort leading up to the transition date, others are considering it. Whether this is chosen also depends partly on the horizon that the fund in question has up until that time, of course. Incidentally, a number of steps are required from the regulator De Nederlandsche Bank (DNB, Dutch Central Bank, ed.) before a fund can protect its funding ratio in this way.”

Can you give an idea of what the cost will be for such protection against interest rate risk costs, for example in funding ratio points?
“In terms of funding ratio points, interest rate hedging doesn’t actually cost anything because there is no expected return on interest rate risk - unlike equity risk, where a reduction also involves some return loss. Interest rate swaps do incur some transaction costs, but those are a few basis points on the total. In any case, it bears no relation to the millions of euros ‘earned’ because a drop in interest rates did not cause the funding ratio to fall. If interest rates had risen, it would have cost millions, but PPF APG made a conscious decision to protect itself against much of the interest rate risk because an interest rate rise would only result in a somewhat higher buffer under the new contract. That is not necessarily needed, so the risk for the fund was mainly in a downward movement of the funding ratio.”

What is the best way for a fund to time that interest rate hedge?

“The moment you know, as a fund, what your dot on the horizon is, and have chosen protection, you actually have to implement interest rate hedging as soon as possible. In other words, as soon as you know when you’ll be making the transition to the renewed system and what your pension contract looks like - the financial set-up, i.e. all the rules you’ve drawn up for that contract. That’s the time, and don’t start speculating on a possible interest rate increase, because then you’ll always find that interest rates are going to fall before you’ve even raised the hedge. In addition, the timing also depends on how long it will be before a fund makes the transition, although that applies more to equity risk than to interest rate risk. If, as a fund, you already have a clear idea of what your contract will look like, but you are not switching to the new system for five years, you won’t spend five years reducing the equity risk. Then you’d miss out on too much expected return.”

To what extent is the average pension fund participant going to understand all this?
“This is definitely a concern. In the renewed system, participants will receive a return on their personal pension assets on a monthly or quarterly basis. That return can be broken down into a protection return and an excess return (the return from which the growth of the personal pension capital and thus a participant’s purchasing power must come, ed.), which is allocated on the basis of agreed rules. But if interest rates rise, you need less assets for the same pension, so the protection return can be negative. For example, there was a sharp rise in interest rates in 2022. Such an increase would result in a sharp drop in personal assets due to the hedging of interest rate risk in the new contract, while the expected pension remains the same. This will undoubtedly raise questions among participants, and we can explain it, of course, but it is a challenge.”