The reality is that any investment that seemed risk-free yesterday may be a systemic risk tomorrow. A pension fund has to invest in accordance with the prudent person rule. This rule is based on the “efficient market hypothesis”: investors are rational people. Under the prudent person rule, diversification of investments is key. But the legislator does not consider this diversification necessary in the case of government bonds. These have been declared “risk-free” by decree.
Pension funds and insurance companies are now facing the question whether they should invest in negative interest rate debt. The English call it “burning cash”, destruction of money. It is difficult to explain that this is how a rational investor should behave. Is there any reason to maintain that a government bond is ‘risk-free’? The government should not decide whether an investment is safe.
Escape is a tempting alternative: moving away from government bonds with negative interest rates and investing everything in equity and listed real estate funds. Their positive cash returns and increasing value look very attractive. But they mainly have the European Central Bank (ECB) to thank for this. These returns are probably unsustainable, even though the downward risk is slightly smaller than in the case of ‘safe’ government bonds.
Dutch pension funds become underfunded because they have to value their liabilities at an artificially low interest. And precisely because they are underfunded, they are not allowed to extend their equity and real estate allocation, as this “would increase their risk profile”. As a consequence, even more money gets invested in “risk-free” assets, debt instruments with negative interest rates. So is it prudent to save your money in an old sock after all?
The financial assessment framework, in force as of 1 January 2015, makes a choice for a long-term horizon. The idea is that, measured over a ten-year ‘roll-over’ recovery period, the results are on average acceptable. But is this also true if the investment portfolio has been concentrated in “risk-free” government bonds from the outset? If the interest rates return to normal levels in the medium term, this will cause considerable capital loss. The effect on the cover ratio of pension funds might be limited because of the simultaneous decrease in the pension obligations, but the overall result is a poverty trap: the assets evaporate. In addition, there may be systemic risks. We are living in a highly uncertain world. Negative interest rates increase this uncertainty.
In line with the prudent person rule, investment strategies should be considered which yield reasonable returns, independent from market scenarios. These are certainly not the kind of strategies where investments are concentrated in government bonds that yield a negative return. So what does this mean for the supervisory framework? A first step would be a departure from the rule that certain assets are deemed risk-free, immediately followed by the removal of the differentiated solvency buffers in investment categories.
This kind of tailor-made work is based on pseudo-science. The reality is that any investment that seemed risk-free yesterday may be a systemic risk tomorrow. As an alternative, a fixed-risk buffer could be introduced. This would free pension funds and insurance companies from the straitjacket of the existing solvency framework. This new freedom would undoubtedly have consequences for investments in government bonds issued by “safe” countries. Investing at a negative interest rate cannot reasonably be in accordance with the prudent person rule.
This will benefit the effectivity of the ECB’s policy, as it contributes to spending in other areas of the capital market. We believe that clinging to the current solvency framework amounts to reckless behaviour. A policy change is urgently required.
Jean Frijns is emeritus professor of Investments at VU University Amsterdam and chairman of the supervisory board at Delta Lloyd.