A bill amending the financial assessment framework for pension funds has been submitted to the Dutch parliament. The bill introduces a new type of pension contract characterised by a method for smoothing out financial shocks, clear regulation on indexation, and a stable premium.
The bill also sets out the new solvency requirements that pension funds must fulfil. An additional aim is to clarify the application of the prudent person rule. The governm ent has based the bill on five "policy conclusions". In our Legal alert we discuss the issues highlighted in the policy conclusions and summarise how the governm ent intends to resolve them. We also mention a few other notable changes of law proposed in the bill.
Policy conclusion 1
Abrupt and extensive cuts [in pensions] should be prevented where possible. It is preferable to spread windfalls and setback s over time. But at the same time, the delay of necessary measures should be prevented.
The background for this is that in the case of a funding shortfall, the current financial assessment framework compels pension funds to draw up and carry out recovery plans within a narrow time frame. A short-term recovery plan has to take the funding ratio to around 105% within three years. The long-term recovery plan has to achieve an average
funding ratio of 120% within 15 years. If a financial shock occurs shortly before these deadlines expire – as a result of developm ents in the financial markets or life expectancy
- this has to be absorbed within the original recovery plan deadline. This means that the possibility of a considerable cut increases as the end of the three-year period approaches.
The solution for this possibility is the introduction of a 'rolling' recovery plan that does not include a deadline. For each year that the pension fund fails to achieve the requisite own capital, a new recovery plan would have to be made, with a new ten-year deadline. This means that pension funds facing a shortfall at the reference date would always have to eliminate one-tenth of the shortfall during the first consecutive year. If the fund is unable to achieve this based on its projections, it will have to take additional measures ex ante. These measures should lead to a recovery that is proportional over time. An example would be increasing pension contributions and limiting or removing indexation. If those measures are insufficient as well, the fund may reduce pension claims and entitlement. We understand through the Explanatory Memorandum that this potential contribution increase, indexation freeze and entitlement reduction would be smoothed out over the following ten years and that – due to the rolling method - those measures would be recalibrated every year.
The rolling recovery plan could cause a pension fund never to come out of a recovery. To prevent this, the bill proposes two additional measures. A pension fund must never experience a funding shortfall for more than five consecutive years. If the shortfall continues after this period, a one-off top-up payment would have to take place, or a
direct one-off cut would have to be applied, in order to achieve the 105% own capital minimum. This cut may be a single reduction, but may also be spread over a number of instalments (ten at the most). The decision to apply a cut must be unconditional and may be processed in the financial administration, and therefore also included in the funding ratio. This cut would therefore not be subject to an annual recalibration. The decision to apply the cut must be carried out in the subsequent years. After this, a subsequent ten- year period would apply in an effort to take the minimum own capital to the requisite level.
Policy conclusion 2
The investment policy that is aimed at realising an index-link ed pension should not be jeopardised by the fixed duration of the long-term recovery plan.
Pension funds have to take risks in their investment policy to achieve the return needed to offer an index-linked pension. This means that they have to allocate a considerable part of their assets to equity. This leads to an investment dilemma. If the funding ratio of a pension fund is moving towards the critical 105% boundary, it may not apply any cuts yet. The fund has to remove risks from its portfolio in an attempt to steer clear of that 105% boundary (investment in equity will be liquidated and re-invested in bonds), as an ultimate measure to stabilise the fund's funding ratio. But if the markets subsequently bounce back, the pension fund will have insufficient equity in its portfolio to profit from this market recovery and will be several steps behind the market. In the current situation, this means that it takes much effort to take the funding ratio back to a mandatory minimum capital level; complete indexation is only possible after that.
The solution to this dilemma is the introduction of the rolling recovery plan. As long as the minimum own capital is too low, a pension fund has ten years to resolve that
problem, in proportion to time. All financial shocks – irrespective of whether they are caused by financial market developm ents, life expectancy or other factors – may be absorbed during a maximum ten-year period. The recovery measures are recalibrated annually.
Policy conclusion 3
It is desirable to prevent the effect of current rates in the financial assessment framework , so that more stability can be achieved in the financial control of pension funds.
The pension commitments must be discounted at the risk-free interest on the capital markets. Every pension commitment is calculated at present value at an interest rate that corresponds with a point on the interest swap curve representing the current interest structure. This means that the discount rate highly depends on current market
developm ents, which makes the scope of the pension commitments volatile. This is caused by the long average duration of pension commitments, which lies for most pension funds between 15 and 25 years. A change in the discount rate by one percentage point leads to a change in the funding ratio by 15 to 25 percentage points. This lever is mitigated in the bill by working with averages. First, the bill introduces a recommended funding ratio. That is the progressive average of the real funding ratios over 12 months. In addition, the discount becomes less volatile by the application of the ultimate forward rate ("UFR"). From the 20-year duration in the interest rate structure, the discount rate grows towards the UFR. The UFR is equal to the realised average 20-year forward rates in the preceding ten years. At the end of July 2013, this comes down to a UFR of 3.9%.
Policy conclusion 4
The financial assessment framework should not increase volatility in contributions. In other words: the requirement that the pension premium should pay towards recovery should be removed.
The premium charged by the pension fund may be softened. The calculation of the premium amount may be based on estimated investment return on the premium. There is an exception to this rule where a pension fund is facing a funding shortfall. If the funding ratio is lower than 105%, the amount of the premium should be set at such a level that it will contribute towards recovery. This causes undesirable macro-economic effects: in a difficult economic climate, the contribution has to be raised considerably, which is detrimental to spending.
The bill proposed abolishing the rule that the pension premium should contribute to recovery in a shortfall situation.
Policy conclusion 5
The statutory security criterion of 97.5% requires a higher buffer.
The Pensions Act includes a 'security criterion'. The mandatory own capital must be such that there is a 2.5% chance that it would experience a shortfall within one year.
The evaluati on of the existing financial assessment framework has shown that this objective is not achieved by the current solvency requirements. For that reason, the pension fund will have to maintain higher buffers. The mandatory own capital requirement will increase by 5%, on average from 21.7% to 26.6%. In addition, stricter
requirements will be imposed on the levels at which a pension fund may grant indexation. An indexation threshold will be introduced, whereby the governm ent wants to determine that a pension fund may not apply indexation until the funding ratio is at least 110%. In addition, an indexation rule will be introduced to the effect that indexation may only take place if permanent increases can be expected at the same level in the future. This means, in practical terms, that around 1% indexation can be granted for each 10 funding ratio points above a recommended funding ration of 110%.
Other notable amendments proposed in the bill
- Prudent person rule
Pension funds must make investments in accordance with the prudent person rule. As follows from the bill, pension funds would be asked to implement the prudent person rule with a view to their individual circumstances. This is done by qualitative and quantitative means. In a qualitative respect, pension funds will have to lay down the ways in which it ensures that its investment policy meets 'good practices'. The quality of the organisation must be in line with the complexity of the investment portfolio, the investment process must be characterised by checks & balances, and the investment policy must be based on a strategic plan that is consistently implemented and monitored.
The quantative requirements relate to strategic and tactical weights of asset classes in the portfolios. The bill refers to making the "target levels and bandwidths within the (strategic) investment policy explicit". On that basis, the Dutch Central Bank (DNB) can assess whether the investment policy is in line with this principle: is the pension fund doing what it has said it would do?
• Supplements matrix to be abolished
The bill asks pension funds to determine their supplements (indexation) policy beforehand. According to the governm ent, this makes the existing supplements matrix obsolete. This will be further regulated in statutory provisions on how pension funds should communicate about their indexation policy.
• Catch-up indexation and undoing cuts subject to restrictions
The government wants to introduce a smoothing mechanism for both shortfalls and surpluses. If the pension fund's own capital exceeds the mandatory own capital level and the level at which full indexation is granted according to the funding ratio, the pension fund will be allowed to grant catch-up indexation. But only 10% of the amount availabl e for this may be used in any year. The same system applies to compensation for cuts that the pension fund has had to apply previously.
• Effects on contributions
New limits will be imposed as of 1 January 2015 on tax-efficient accrual of a pension. These amendments, in combination with the effects of this bill, will on the whole lead to an 11% reduction in contributions (4.4 billion) in 2017. The governm ent thereby assumes that the 16% reduction in contributions will be used to compensate for the 5% increase in contributions resulting from this bill.
• Continuity analysis
A continuity test has been added to section 95 of the Pensions Act. The desired indexation, the financing of the pension scheme, and the expectations raised by the pension provider in its communications must be in line with each other. To that effect, pension funds will have to carry out continuity analyses. The pension
provider must guarantee that its promises fit with the financial basis and with the arrangements agreed on in the pension contract.
The bill intends to regulate that the consistency test will only apply to insurance companies from now on. A viability test will be introduced for pension funds. This will have to show that there is a balance between the real expected pension yield, the risk attitude of the pension fund, and the underlying financial set-up.
• Current recovery plans to expire
All current recovery plans will expire as of 1 January 2015. Any outstanding reserve or funding shortfall might be included in the new ten-year rolling recovery plan. As the buffer requirements will simultaneously increase by 5%, pension fund will get two additional years to reach the required level of own capital. Our interpretation is that pension funds will be bound by the ten-year rolling period as of 2017.
The intended commencement date of the new law is 1 January 2015. The governm ent has indicated that pension funds may possibly start applying elements of the bill from 2015 and that it will add transitional provisions in the bill. Pension funds will determine their policy plans for 2015 on the basis of current legislation. But all decisions taken by pension funds after 1 January 2015 (including those concerning contributions and indexation) will be subject to the new statutory framework. Transitional provisions will provide that pension funds facing a shortfall will get three additional months in 2015 to submit a recovery plan based on the new solvency regime. The first recovery plans will have to be submitted to the Dutch Central Bank by 1 July 2015. Pension funds will have to comply, by 1 July 2015 at the latest, with the new requirements for the actuarial and technical business report, the viability test, the financial crisis plan, the indexation policy and the investment policy (including a specific implementation of the prudent person rule).
The government aims to get this bill through parliament and seems to place much faith on it getting passed through the spirit of cooperation, in particular with the First Chamber. We would question whether pension funds should be expected to rely on this faith as well and anticipate matters in their 2015 policy planning.