Dutch Pension Funds Send Shockwaves Through Euro Swap Market
Dutch pension funds are plowing cash into long-dated swap contracts, according to strategists, upending one of this year’s most popular trades.
The funds, by far the region’s largest with more than €1.5 trillion in assets, are likely bidding up the paper to hedge for growing liabilities, strategists at Citigroup Inc. and Barclays Plc said.
Last week, 20-year rates dropped the most relative to 10-year securities since June. For most of this year, long-dated yields rose faster than short maturities, steepening the curve as investors bet that interest rates will be kept high.
The latest moves come after the Netherlands’ second biggest fund, PFZW, announced last week a sizable increase to pension payments starting in 2024, spurring talk about others following suit with announcements due in the coming weeks.
“These hedges are likely to be positioned in long-end swaps, putting flattening pressure on the €10s20s/10s30s swap curve,” said Aman Bansal, a strategist at Citigroup Inc. in a client note.
Citi’s Bansal said the “crowded” positioning in steepeners helped exacerbate last week’s moves as investors rushed for exit due to the impact from pension fund buying.
He added the lack of supply of core cash paper also contributed to the move, with the Netherlands announcing it won’t issue more bonds this year, which limits investment options for funds.
The Netherlands’ cash bond curve also flattened in the past week, with the yield on 30-year notes falling about 12 basis points while the 10-year rate dropped seven basis points.
PFZW announced an increase of 4.8% in 2024 payments, way above the nation’s inflation rate, which has recently turned negative. It was also a big shift from 2022, when the fund underpaid pensioners relative to consumer-price growth. The fund didn’t immediately respond to a request for comment.
“Part of the expected indexation of the Dutch pension sector was priced in last week, but we think there is more room for flattening as the indexation announcements could well surprise to the upside,” Jaap Teerhuis, a senior rates strategist at ABN Amro wrote in a note on Monday.
ABN Amro estimates Dutch pension funds’ hedging need due to the indexation will range from €33 million to €65 million. The bank says liabilities of the ten biggest pension funds have a weighted average duration of around 18 years, so the hedging activity will impact swaps and cash bonds on the 20- and 30-year segment in particular.
Rohan Khanna, head of euro rates strategy at Barclays, said bids from Dutch funds have “muddied the waters” for euro swap markets in the short term.
Still, he added that PFZW is likely to be an outlier among its peers, while counterpart ABP has suggested a maximum 3% adjustment.
Pension fund demand for long-end securities is not only confined to swaps, with another fund APG announcing last month the purchase of €600 million of green government bonds maturing in 2044. That accounted for half of the allocation to pension funds and insurance companies, according to data provided by the Dutch State Treasury Agency.
Dutch pension funds are closely watched for their activity as it can impact the euro swap market.
The large decline in rates last week and the uptick in indexation is what precipitated this latest buying activity in the long end of the euro swap curve.
Keep in mind, as rates decline, pension liabilities go up and Dutch pension funds which practice mark-to-market are forced by regulators to buy more long-term paper.
Setting aside this regulatory madness (why would any pension fund with long-dated liabilities need to mark them to market??), it's important to also keep in mind that Dutch pension funds underwent recent reforms that went into effect on July 1, 2023.
Joanne Bouelhouwer of Denton explains this new Dutch Pension Act and the major reform of pension system:
On May 30, 2023 the Dutch Senate adopted the new Dutch Pension Act to reform the Dutch pension system, (the Act) which comes into effect on July 1, 2023. This change impacts every employer with a pension scheme in place. In practice, all pension arrangements with employees and contracts with pension providers will need to be renewed. In this alert we provide you with an overview of the most important reforms to the Dutch pension system and recommended steps forward for employers. For those not yet familiar with the current Dutch pension system, we begin with a brief explanation.
Please find the designed version of this content here.
Dutch pension system
The current Dutch pension system consists of three pillars that together determine the pension amount a person will receive after retirement:
- State pension (in Dutch, AOW) - a pension benefit paid to people upon reaching the current retirement age of 67 and funded by contributions paid by younger people; also known as a “pay-as-you-go” system;
- Supplementary collective pension - occupational pension, arranged through employment;
- Private individual pension products - arranged by individuals on their own.
The collective pension schemes under the second pillar are arrangements between employers and employees and are commonly administered by pension funds. These are generally funds for a specific industry - most of these have been made mandatory, company or for a group of people working in a specific sector Alternatively, insurance companies may administer the pension scheme. These schemes are funded by capital funding - the pensions are financed by contributions paid in the past as well as the investment return on those contributions.
At present, the Dutch Pension Act allows for three types of pension schemes: (1) a defined benefit scheme (either a final pay scheme or a career average scheme), (2) a defined capital scheme, or (3) a defined contribution scheme. The defined benefit schemes are being phased out of the Dutch pension system, and defined capital schemes are already quite rare. Defined contribution schemes (either in full, or combined with characteristics of other schemes) are becoming more common for employees, but the current generation of retirees mostly still have defined benefit schemes.
Purpose of the reform
The Dutch government wishes to reinvigorate the pension system since, among other reasons, low interest rates and the aging Dutch population are putting pressure on the system, resulting in higher costs and a reduction in pension benefits. The increase in self-employment and other forms of flexible labor are also having an impact on the Dutch pension market, as fewer people now participate in pension plans.
The purpose of the new system is to provide for the accrual of a pension as part of an individual pension capital, combined with the benefits of collective risk-sharing. Defined benefits are no longer possible. The Dutch government intends to abolish the system of average premiums whereby one premium is paid for each individual, regardless of age. It wants to introduce a premium tailored to the individual circumstances and allocated to the individual pension capital, which is probably the most essential element of the new pension system.
Main elements of the new Dutch pension system
There is a lot to say about this new pension system but, from the perspective of the employer and briefly stated, the main elements of Act are:
- Contribution based - Pension accrual is only possible based on a defined contribution scheme, and the pension assets are managed and invested collectively for all participants. Parties can no longer agree on a defined benefit pension scheme. This means that the new pension system will be contribution-based.
- Three new types of schemes - The Act introduces three new types of defined contribution schemes: (i) a solidarity contribution scheme, (ii) a flexible contribution scheme and (iii) a contribution-capital scheme (only for pension insurers). The main difference between the three options is the level of the participant’s involvement to the investment of the contributions and collective risk sharing by using a reserve in the event of disappointing returns on investments.
- Flat-rate contributions - Most defined benefit pension schemes have age dependent pension contributions, which are no longer allowed. The current average pension accrual will be transformed to a degressive pension accrual by adopting flat rate pension contributions only. Exceptions will apply to net pension and voluntary top-op. This may also have consequences for existing defined contribution schemes, i.e. amendment may be necessary, but again exceptions apply for existing defined contribution schemes on 30 June 203 and defined benefit plans administered by an insurance company amended to an age-based defined contribution plan prior to 1 January 2028.
- Minimum entry age - The starting age in pension schemes will be lowered from 21 to 18 as per 1 January 2024.
- 30% tax - The tax limitation will no longer be on pension accruals, but on the contributions. The proposed maximum contribution for retirement and partner’s pension is 30 percent of the pensionable base.
- Net pension - The Act treats net pensions (i.e. pension accruable on salary above €128,810 as from January 1, 2023 that can be put in private individual pension products, which people arrange for themselves) almost equal to pensionable salary (i.e. under that amount). For instance, this means that the same tax limitation (i.e. 30 percent) will apply, but it is corrected with a net factor. For net pensions, the obligation of flat rate pension contributions does not apply.
- Transition plan - When transitioning to the new pension scheme, employers should prepare a transition plan, which takes account of substantial consequences related to converting accrued pensions into the new pension scheme (in Dutch: invaren) and of adequate compensation to employees in the event the change is to their detriment. Suggestions for financing this transition include a temporary increase in contributions, using temporary financial buffers, a lump sum from the employer in the solidarity reserve, etc.
- Partner pension - Partner pensions, which are paid out upon death after retirement, will be brought in line with current market-practice: Up to a maximum of 70 percent of retirement benefits can be converted into a partner pension. Partner pensions paid out upon death before retirement will be on a risk-basis only with a maximum of 50 percent of the pensionable salary, regardless of years of service, and until three months after participation in the scheme would have ended. The definition of partner definition will be made uniform, as fewer people are choosing to marry, opting instead for a registered partnership or living together only.
What to do and when?
- Start early, preferably now, and consider this a project!
- Review your current pension arrangements with employees, the agreement with the pension provider and the renewal date of such agreement;
- Involve both your legal counsel and pension broker (if any) to start investigating renewal requirements, possibilities and implementation actions;
- Remember that implementation also comprises changing employee documentation containing the arrangements with regard to the pension and not only the agreement with the pension provider, as the employee documentation forms the basis for the pension arrangement. This may require the employees’ individual consent, and
- Involve the works council (if any) at an early stage, as the works council’s endorsement will be required over both the change in pension scheme as the establishment of the transition plan.
Please note that when your company is participating in a company or a mandatory industry-wide pension fund, whether or not (also) on the basis of a pension arrangement in a collective labor agreement, different actions may be required than those set out above. Usually social partners, i.e. the employer and employee organizations, collectively negotiate the new pension arrangement.
We would be happy to assist you in (all of the phases of) this process, and we can always provide more information to you or your HR teams about this subject.
In June, Yoruk Bahceli of Reuters reported that Dutch pension fund reform spells investment rethink:
An overhaul of the private pensions system in the Netherlands - the biggest in the European Union - is leading asset managers there to rethink how they invest 1.5 trillion euros ($1.64 trillion) of retirement savings.
Asset managers for top Dutch pension funds said the reform, which takes effect on Saturday, could spark outflows from euro zone government bonds in favour of riskier assets and change the way such funds protect themselves from swings in interest rates.
Changes approved in May mean funds which struggled to meet payouts during a decade when rates were negative will no longer promise benefits.
Instead, both future and - unprecedentedly - accrued pensions will move to a defined contribution model. Funds will divide their assets into pots for each individual and payouts will depend on contributions and market conditions.
Unlike defined contribution systems elsewhere, however, most funds are expected to choose a "solidarity" framework within the new system where they still invest collectively, then allocate returns to age cohorts and spread some risks.
"It is a complete new system that the Netherlands wants to implement", said Wim Barentsen, head of investment strategy at Achmea Investment Management, which oversees 175 billion euros in assets for pension funds. "Nowhere in the world do you have the same system."
Funds must transition to the new system by 2028, with most expected to do so in 2026.
DITCH GOVVIES?
Occupational pension funds in the Netherlands make up two-thirds of all such pensions in the euro area, according to the European Central Bank, so any shift in their investments could have a big impact.
The idea is that pension funds will allocate more risk to younger cohorts and less to those nearer retirement.
The new system also includes fewer safety buffers overall, allowing more leeway to take risks.
Frank Vinke, senior strategist at PGGM, which invests mainly on behalf of healthcare sector pension fund PFZW, the country's second-largest, said a "significant change" in portfolio holdings was likely, including fewer top-rated government bonds.
"In the new system there is scope to be less precise and still effective. And that would entitle us to make more use of products such as corporate bonds with a high rating, or mortgages," Vinke said.
An ABN AMRO model based on three Dutch defined contribution pension funds suggests an optimal asset mix would be a roughly 30% allocation to bonds overall versus 50% currently, said senior rates strategist Jaap Teerhuis.
That implies pension funds could sell some 140 billion euros of triple-A and double-A rated euro zone bonds, including German and Dutch debt, and buy more equities, Teerhuis added.
The new rules also mean pension funds can be less strict in protecting against swings in interest rates and exchange rates using derivatives like swaps.
Hedging will focus on older workers and retirees, so investors expect a shift to shorter-dated interest rate swaps. Commerzbank expects a "seismic" change to the market, where Dutch pension funds are key players.
Fewer FX hedges would also have implications for currencies.
Onno Steenbeek, managing director of strategic portfolio advice at APG Asset Management, the biggest Dutch pension investor, managing 541 billion euros of assets, saw potential to increase dollar holdings.
HOLD ON
The market impact will depend on what investment strategies are adopted.
Pension funds are surveying their members to understand how much risk different age groups are willing to take.
"If you (see) younger generations don't like volatile pension pots, there could be a case to stay put and still put quite a lot of assets in government bonds," said Steenbeek, adding that APG's research so far showed age was not the only determinant of someone's risk appetite.
Ultimately, interest rates determine how much risk pension funds need to take to generate future payments. Euro zone rates have shot up over the last year from levels below zero percent to fight a surge in inflation.
"It will be only at January 2026 that we know what our target portfolio is," PGGM's Vinke said.
ROCKET LAUNCH
Sharp falls in asset prices right before the transition date could leave some groups with less money than planned, so firms will need to keep buffers high enough to address any pitfalls - a big challenge given uncertain interest rates.
"It's basically launching a rocket ... once you have made the transition on the day, you cannot change anything anymore," said Achmea's Barentsen.
"You have to be aware of the risks that may change the outlook quite shortly before you make the transition."
Asset managers said they are talking to pension funds about how much risk they are willing to take during the transition period, which could temporarily raise demand for interest rate swaps and equity derivatives.
Proponents say the new system is fairer, better reflecting an ageing society, and will make it easier to raise payouts with inflation. Opponents worry that payments will be uncertain.
"When push comes to shove and your pension payout is cut ... will it lead to upheaval?" said Gerard Moerman, European head of fiduciary services and investment solutions at Aegon Asset Management.
"That's the biggest risk and what most pension fund board members are worried about."
If you ask my humble opinion, these reforms in the Dutch pension system are long overdue.
It will take time for them to impact asset allocation and F/X hedging decisions but the key here is this:
The new rules also mean pension funds can be less strict in protecting against swings in interest rates and exchange rates using derivatives like swaps.
It's not the only thing that struck me but it's about time!
Alright, trying to ease into daily comments slowly, we shall see how that goes but I'm exhausted and the baby's schedule always comes first.
Below, Marteen Reesink of Montae & Partners discusses what are the implications of the newly approved Dutch Pension Legislation.
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