1 March 2012

REFORMING DUTCH PENSIONS – HIGHER CAPITAL REQUIREMENTS

UNDER “FTK1” FOR EXISTING PENSION RIGHTS?

David van Bragt, senior specialist investment solutions, AEGON Asset Management

The Dutch pension agreement of 2011 has been the cause of heated –

and ongoing – debates. The agreement will lead to a major transition

from today‟s „harder‟ pension rights towards conditional or „soft‟ pension

rights, and should take effect as of 1 January 2013 or, if more time is

needed, as of 1 January 2014. The agreement of 2011 will be specified

in detail in 2012 in a new regulatory framework, commonly referred to

as the Financial Assessment Framework 2 (Financieel Toetsingskader 2) or “FTK2”.

However, with the introduction of FTK2, it is still very unclear, and controversial,

whether „hard‟ pension rights built up under the old system can be transformed into „soft‟

rights under the new framework. The existing FTK rules (“FTK1”) may therefore

continue to apply to all existing pension rights. Although much attention has been paid

to the consequences of FTK2, the changes to FTK1 that have been proposed by the

Dutch regulator are also likely to have a profound and ongoing effect on pension funds,

as the revised approach to risk will lead to stricter capital requirements.

A new FTK1 – changing capital requirements

In June 2011, the Dutch Central Bank (DNB) issued a proposal to revise the required solvency

capital for pension funds as laid down in the current FTK1 rules.[1] On 14 September 2011, the

proposal was sent to the Dutch Parliament for consideration. It is currently not known when these

new FTK rules will come into force.

Although the proposed changes to the FTK1 are significant, the underlying principle remains the

same – that the solvency capital of a pension fund should be sufficient to avoid a nominal funding

ratio of less than 100% with a probability of 97.5% over a one-year horizon. However, the required

capital calculation within today‟s FTK1 is now considered to be insufficiently prudent to meet this

criterion. For example, DNB estimates that the average funding ratio of Dutch pension funds at the

end of 2011 was 98%, and approximately 125 funds are expected to announce a reduction (of as

much as 7%) in pension rights in May 2012 in order to be able to reach the minimum required

funding ratio (105%) by the end of 2013.

The recent financial and economic crisis easily qualifies as a 2.5% event (in other words, such an

event can only be expected to occur once every 40 years on average) so it may be argued that the

current low funding levels are not necessarily the result of any inadequacy in the present FTK‟s

[1]

This document (‘‘Uitwerking herziening berekeningssystematiek Vereist Eigen Vermogen”), is available in Dutch at http://www.rijksoverheid.nl/documenten-en-publicaties/notas/2011/09/14/berekeningssystematiek.html.

2 March 2012

required levels of capital. In addition, the solvency position of many Dutch pension funds was

already weakened before the recent financial crisis by the collapse of the dot-com bubble between

2000 and 2002.

Nevertheless, DNB has established, on the basis of updated time series, that the stress tests applied

to pension funds were insufficient in some areas. For example, the new DNB analysis led to an

equity stress test for developed markets of −30% (rather than −25%) and a much higher correlation

between credit risk and equity risk than previously supposed. In addition, the new proposals also

include a solvency buffer for active equity risk. This risk factor is not included in the current FTK

rules, which can lead to an underestimation of the required capital. For example, several pension

funds incurred significant additional losses during the financial crisis due to the underperformance of

their active equity portfolios.

FTK1 – a summary of proposed changes

The main changes to FTK1, as proposed by DNB, are summarised in the table below. The table

shows the current and new stress test parameters for each risk factor. It should be noted that there

is no prescribed „recipe‟ to determine the required capital for insurance technical risk (S6) (for

example longevity, mortality, disability and lapse risk). Pension funds should therefore determine

their own capital requirement for insurance technical risk, using their own models.

Table 1: Overview of current and new FTK1 stress test parameters (source: DNB).

The current and new correlations between the different risk scenarios are also shown in the table

below. These correlations are used to aggregate the capital requirements for the different risk

scenarios (S1 through S7) and determine the overall capital requirement.

risk scenario risk factor sub factor current new

S1 interest rate risk factor 15-year interest decrease 0.77 0.75

S2 equity risk

equity developed markets

equity emerging markets

private equity

real estate

25%

35%

30%

15%

30%

40%

40%

15%

S3 currency risk 20% 15%

S4 commodities risk 30% 35%

S5 credit risk

AAA

AA

A

BBB

<=BB

40%

40%

40%

40%

40%

60 bps

80 bps

130 bps

180 bps

530 bps

S6 insurance risk no prescribed rules no prescribed rules

S7 active risk N.A.based on tracking

error and TER

3 March 2012

Table 2: Overview of current and new FTK1 correlations (source: DNB).

Larger capital charges for listed and private equity

One of the most significant changes under the proposed rules is to the magnitude of the „S2 shock.‟

In the equity risk scenario, this shock is increased by 5 percent. DNB argues that this accounts for

the relatively large downside risk and the high volatility of this asset class. Large losses also occur

more frequently than may be expected based on a normal distribution. The shock parameter for

private equity is also increased substantially (by 10 percent) in order to account for the leveraging

effect of debt, which is frequently used to finance these assets.

Different rating classes for credit bonds

For the credit risk scenario (the „S5 shock‟), DNB proposes to use different rating classes in order to

refine the applied capital charges. A separate shock for high yield investments (credit bonds with a

rating lower than BBB) has also been added. The credit bond stress scenario will be defined in terms

of an increase of the credit spread by a fixed number of basis points instead of as a relative increase

of credit spreads. DNB argues that this approach will reduce the pro-cyclical nature of the current

approach. Currently, the applied shock would increase (in an absolute sense) for stress situations

with high credit spreads. This would lead to very high capital charges for pension funds in already

difficult situations. In the new setup, this undesirable effect is mitigated by using a fixed increase of

the credit spread (per rating class). DNB, however, indicates that the required capital for credit risk

will on average increase under the new rules.

A new risk scenario for active equity risk

A new risk scenario („S7‟) for actively managed funds is also added in the DNB proposal. In the

current situation, there is no additional capital charge for active risk. DNB research has shown,

however, that in several cases the losses of pension funds during the recent financial crisis were

larger than to be expected based on the development of market indices. In the new proposal, the

required capital for active risk is based on the annual loss due to active management (corresponding

to a probability of 2.5%). This loss is linked to the (ex ante) tracking error of the fund and the costs of

active management in terms of the total expense ratio (TER). To limit the impact on reporting

requirements, active risk only applies for listed equity and can be ignored if the tracking error is

smaller than 1%.

Adjustment of correlation parameters

A correlation factor between credit risk and interest rate risk as well as a correlation factor between

credit risk and equity risk has also been added. The correlation between equity risk and interest rate

risk has also been set to a slightly lower value. DNB analyses show that a peak in the correlation

does not necessarily coincide with a peak in risk factors. The correlations are now based on the

risk scenario risk scenario current correlation new correlation remark

S1 (interest rate risk) S1 (equity risk) 0.5 0.4when S1 is based on

an interest rate decrease

S1 (interest rate risk) S5 (credit risk) 0 0.4when S1 is based on

an interest rate decrease

S1 (equity risk) S5 (credit risk) 0 0.5

4 March 2012

observed correlations during a period of market stress and not on the observed maximum values of

correlations.

Refinement of the calculation of currency risk and real estate risk

The calculations for currency risk („S3‟) and real estate risk (part of the „S2‟ module) will also be

refined. The current FTK1 rules use a single risk scenario of -20% (a depreciation of all foreign

currency positions by 20%). DNB argues that this underestimates the currency risk for assets in

emerging markets and overestimates the risk for a diversified portfolio in developed markets. For this

reason, the currency stress scenario will be refined according to the true risks. For portfolios with

well-diversified currency exposure, a shock of −15% can be used. In this case, the exposure to

emerging market currencies should be at most one third of the total currency exposure. If the

exposure to emerging market currencies is larger, the shock can increase (in an absolute sense) up

to −30%.

The calculation of the required capital for real estate will also become more detailed for non-listed

real estate. In the new setup, the applied stress test can become larger than the current shock (of

−15%), depending on the amount of debt financing.

Impact analysis by DNB

DNB has carried out an extensive impact analysis of these modifications, based on the reported

information of pension funds to DNB. As a result of the modifications, the required capital will on

average increase from 21.7% to 26.6% (relative to the market value of the liabilities). The average

increase is thus equal to 4.9%, which is approximately equal to €34bn (in total) for all Dutch pension

funds. The figure below gives an impression of the impact of these changes on the required funding

level of the average Dutch pension fund.

Figure 1: Impact of the new FTK1 guidelines on the required funding level for an average Dutch

pension fund. A comparison is made with the estimated actual funding ratio at the end of 2011

(source: DNB, AEGON).

It should be noted, however, that there are major differences between individual pension funds,

depending on their particular characteristics and their investment and hedging policies. For example,

for some funds the required capital will hardly change under the new FTK1 rules, whereas for a few

funds the required capital may double. The figure below provides an example of the differences

between individual funds, with each blue dot representing an individual pension fund.

80%

90%

100%

110%

120%

130%

140%

actual funding ratio (end of 2011)

required funding ratio (current FTK1 rules)

required funding ratio (new FTK1 rules)

+4.9%

(see Table 3)

5 March 2012

Figure 2: Impact of the new FTK1 guidelines on the required capital for Dutch pension funds. Each

blue dot represents one pension fund (source: DNB). The required capital is denoted as a

percentage of the market value of the liabilities. A required capital of 0% corresponds to a funding

ratio of 100%.

DNB also provides a break-down analysis on the level of individual risk scenarios. See the table

below, which shows the impact of the new rules in more detail. We should stress, however, that this

table gives results for the average pension fund. Results for individual pension funds can (and will

be) very different, depending on their investment policy and specific liabilities.

Table 3: Impact of the new FTK1 guidelines for the individual risk scenarios for an average Dutch

pension fund (source: DNB). The required capital is denoted as a percentage of the market value of

the liabilities.

The largest differences (measured in percentage points) occur for equity risk, followed by credit risk

and active risk. Note however that, in a relative sense, the effect for credit risk is very large: the

required capital for this component more than doubles from 1.1% to 2.6%. Differences are more

modest for interest rate risk and commodities risk. On average, the capital requirements for currency

risk decrease slightly.

What will be the impact of these changes?

The proposed changes do not consist of a complete overhaul of the existing FTK1 rules, but are

mainly a recalibration and refinement of the applied stress tests. Nevertheless, the impact of the

proposed changes on the capital requirements for pension funds will be very substantial. A large

number of Dutch pension funds are currently underfunded and are not even able to meet the current

minimum requirements with respect to the required capital. Stated differently: many pension funds

S1 (in

terest rate risk)

S2 (eq

uity risk)

S3 (cu

rrency risk)

S4 (co

mm

od

ities risk)

S5 (cred

it risk)

S6 (in

suran

ce risk)

S7 (active risk)

total

(with

ou

t

diversificatio

n)

diversificatio

n effect

total

(with

diversificatio

n)

current 8.9% 14.9% 2.3% 1.1% 1.1% 3.5% 0.0% 31.9% -10.2% 21.7%

new 10.0% 18.6% 1.8% 1.3% 2.6% 3.5% 1.5% 39.3% -12.7% 26.6%

difference 1.0% 3.6% -0.5% 0.2% 1.5% 0.0% 1.5% 7.4% -2.5% 4.9%

Solvency required capital (at the end of 2010)

Solvency required

capital

(new FTK1 proposal)

6 March 2012

would be very happy to reach the minimum required funding ratio of 105% at the end of 2013. This is

very far removed from the average required funding level of 121.7% under the current FTK1 rules or

126.6% under the recalibrated FTK1 rules. These stricter capital requirements may thus have a

large impact in the medium to long term on sponsors of distressed pension funds and the

participants of these funds.

If pension funds do not meet their solvency required capital, they are obliged to submit a long-term

recovery plan to DNB.1 The plan contains specific measures to ensure that the fund meets the

required solvency capital within 15 years. The plan is based on a recent continuity analysis and must

at least contain:

An explanation of why the solvency requirement has been (or will be) violated;

The expected development of the technical provisions and investments; and

Specific measures to improve the solvency position of the fund within a maximum of fifteen

years to the required level, taking into account all liabilities of the fund.

How to proceed?

It is important to note that a pension fund is not allowed to increase its risk profile relative to the

situation before the solvency requirement was violated. The only „way out‟ is thus to make better use

of one‟s available risk budget. It therefore becomes even more important to carefully balance the

expected return and the required capital for individual assets and to exploit positive diversification

benefits on the portfolio level. It may also be attractive to apply a hedging strategy to reduce the

required capital.

In order to assess the overall effect of different investment and hedging policies, it is advisable for

pension funds to perform an Asset Liability Management (ALM) analysis. Once an ALM study has

been completed, it is also important to consider the current market situation and to allow for any

other tactical considerations. For example, the outcome of an ALM analysis may be that hedging

interest risk is strategically attractive. In order to implement this strategic aim, tactical considerations

need to be taken into account so that a choice can be made with respect to the optimal hedging

instruments. For example, when the market expectation is that interest rate levels are on the rise,

the hedging strategy may consist partly of swaptions instead of only swaps. This choice would limit

the downside interest rate risk, while allowing pension funds to benefit from the upside potential

when interest rate levels rise.2

Given the fact that FTK1 looks likely to continue to play a role in the regulation of pensions in the

Netherlands for some time into the future, it is important that pension funds are aware of the

proposed changes to the framework. Risk looks set to become more expensive, which in turn may

make derisking a more attractive option.

1 If the fund also does not meet the minimum required capital (a funding ratio of 105%) a short-term discovery plan

should be filed to DNB. This plan should outline how the fund reaches the minimum requirements within 3 years. 2 An example of this approach was discussed in a previous AEGON Global Pensions Newsletter (Protecting TNT’s pensions

– the benefits of swaptions).

7 March 2012

AEGON’s Derisking and FTK solutions

AEGON Global Pensions has developed pension derisking solutions for companies looking to

control or remove investment risk, interest rate risk, inflation risk and longevity risks.

Longevity insurance – Longevity insurance enables pension funds to protect themselves against

the risk that their employees will live longer than previously predicted. It allows companies to reduce

the volatility of their pension plans.

Pension buyouts and buy-ins in the Netherlands – By transferring all or part of your company‟s

pension liabilities to AEGON, you can remove the risks associated with your defined benefit plans,

protecting your company from both short-term volatility and long-term uncertainty.

Liability-Driven Investing (LDI) – LDI allows a pension fund to remove unrewarded interest and

inflation risk by matching its liabilities with assets.

FTK Reporting Services – AEGON provides various FTK Reporting Services to its clients in the

Netherlands. We continuously monitor all regulatory developments around FTK1 and FTK2. AEGON

Asset Management can advise pension funds in this area by re-assessing the fund‟s investment or

hedging policy in the light of upcoming changes. For example, AEGON Asset Management provides

ALM advice for pension funds using the ALM Scan and Stress Test service. Using these tools, the

evolution of the balance sheet and solvency position of a pension fund can be evaluated for a variety

of economic scenarios. With such an in-depth analysis, a robust investment and hedging policy can

be developed in collaboration with the pension fund.

To find out more about our derisking capabilities, please contact AEGON Global Pensions.

Tel: +31 (0)70 344 8931 | aegonglobalpensions@aegon.com | www.aegonglobalpensions.com