Actualiteiten

	0
	1
	1
	1
	1

Watson Wyatt Update, November 2007
Number 10, volume 10

In this Watson Wyatt Update:

• The AFM and duty of care
• The time structure of real interest
• Compliance for pension funds

The AFM and duty of care

On 17 September 2007, the Netherlands Authority for the Financial Markets (AFM) published a consultation document, presenting detailed information about the duty of care regarding pension agreements with investment discretion as laid down in the Dutch Pensions Act (Pensioenwet). In this document, the AFM discusses matters such as the application of lifecycles. Lifecycles are investment mixes whose composition is linked to the member’s age. If the pension administrator only offers a single lifecycle, the member has no investment discretion and the duty of care as specified in the Pensions Act does not apply. However, if the member can choose from multiple lifecycles, the duty of care does apply.

If a member wishes to assume direct responsibility for the investments, the pension administrator must compile a profile, based on such factors as the member’s financial position, financial objectives, knowledge of and experience with investing, and willingness to take risks. The AFM is not in favour of offering a large number of options for, say, collective investment schemes. The underlying assumption with the investments and the advice should be that the investments are oriented toward purchase prices. The objective is not to achieve the highest possible pension, but instead to realise the highest level of security regarding periodic pension benefits. Since interest rates at the time of purchase generally determine the amount of pension rights that can purchased from the capital, this is an important factor in connection with the investments.

The AFM has asked the pension sector to present their responses to the document. We drew the AFM’s attention to the following issues:

1. it is unclear what the situation is if the returns under the premium agreement are contingent upon the returns of the pension fund itself;
2. we advocate a less strict advisory duty if all options were to be sufficient in and of themselves in a situation without investment discretion;
3. besides the interest-rate risk, the inflation risk should also be factored into advice on investment mixes;
4. openness about the manner in which purchase prices are determined;
5. an investment mix targeting the retirement date does not always provide the highest possible degree of security regarding periodical pension benefits. For example, the highest possible degree of security is not necessarily attained if the membership terminates prematurely, or if the partner pension of a deceased member is contingent upon the pension capital accruals. We feel that the information provision should address this matter at greater length.

The AFM has announced that it will issue a feedback statement.

For more information contact: Jeroen Röder.

Top of page

The time structure of real interest

In order to approximate the discounted values of index-linked pensions, Watson Wyatt uses the time structure of the risk-free real market interest.

Time structure of risk-free real interest in the euro zone (as an annual %)

Term to maturity (years)	Year-end 2004	Year-end 2005	Year-end 2006	31 October 2007
1	0.0	0.8	1.6	1.7
5	0.8	1.0	1.7	1.9
10	1.4	1.3	1.8	2.0
15	1.7	1.4	1.8	2.1
20	1.8	1.4	1.8	2.1
25	1.9	1.4	1.8	2.1
30	1.9	1.4	1.8	2.1

Further information is available (in Dutch) at www.watsonwyatt.nl. Click on ideeën en onderzoek, and go to Statistische data.

Background data
The estimate for the time structure is based on current market yields on index loans (index-linked government bonds) of the highest credit rating (AAA) issued by France and linked to the European price index (HICP excluding tobacco). The effect of coupons is eliminated to remove any differences between term to maturity and duration.

Example
At the end of October 2007, the real interest rate for a 10-year term to maturity was 2.0%. What was the current market value at that moment of a one-off amount of EUR 1000 with a guaranteed payout at the end of that period, if the amount payable is linked to the price index? The market value is calculated by discounting EUR 1000 by 2.0% per year, i.e. by 1.02010 = 1.219. The result is EUR 820. Say that the amount payable is not adjusted to follow the developments of the price index. The corresponding risk-free nominal market interest rate, derived from current market yields on non-index-linked government bonds, was 4.3%. Dividing by a factor of 1.04310 = 1.524 gives a value of EUR 656. In this situation, therefore, the market value of the future price compensation is EUR 820 less EUR 656 = EUR 164.

Breakeven inflation
The difference between nominal and real risk-free interest is called breakeven inflation, and in the example above comes to 2.3%. In theory, the breakeven inflation consists of the predicted inflation, an inflation risk premium and some other minor elements. In practice, the breakeven inflation is approximately the same as the non-variable inflation for which the variable actual inflation can be exchanged using inflation swaps. It will be apparent that the breakeven inflation is not the same as the current inflation.

Which price index?
The estimate in the table above uses indexation based on a European price index excluding tobacco. In theory, a different price index, such as the Dutch CPI, will result in a different time structure. However, since no index loans exist that are linked to the Dutch CPI, there is no way of estimating the difference. Index loans based on the French price index do exist, though, and those result in virtually the same time structure as the European price index. As long as the estimate constitutes an approximation of the market value (ex ante), it is not unreasonable to work from that European index. Nevertheless, this does not alter the fact that the actual developments in price levels per region of the euro zone may display material differences (ex post).

How to deal with wage indexes
No government bonds exist that are linked to a price index. Indexation based on wages can, theoretically, be broken down into two components:

1. the development of the price index;
2. the development of the wage index in real terms, i.e. in relation to the price index.

For the second component, a constant could be assumed, e.g. 0.5% or 1%. This is done in the absence of a better solution, since there is no data available on the financial markets or historical figures to substantiate this parameter beyond any doubt. Another option is to completely disregard the real wage developments, for example if the pension obligations have to be approximated for purposes of a hypothetical liquidation scenario, and the wage index is derived from the company’s own wage development.

For more information contact: Roland van Gaalen.

Top of page

Compliance for pension funds

The environment in which pension fund directors work is becoming more and more complex. The issue that must be addressed is ensuring that the laws and regulations are actually complied with: how does the pension fund organise its compliance? Professional literature sometimes uses a broader definition of the concept of compliance, i.e. one which also covers the internal standards and code of conduct that the pension fund itself has laid down. This article uses the strict definition, which concerns observance of laws and regulations.

Many of the requirements that pension fund boards have to meet in connection with compliance are laid down in the Dutch Pensions Act (Pensioenwet), the subordinate regulations based on it, and on the Dutch Financial Supervision Act (Wet op het financieel toezicht).

Pensions Act
One of the basic principles of the Pensions Act is that the pension fund, in administering the pension agreement, is responsible for compliance with laws and regulations. Pursuant to the Dutch Financial Assessment Framework (Pension Funds) Decree (Besluit financieel toetsingskader pensioenfondsen, ‘the Decree’), pension funds are instructed to implement the following safeguards in connection with their operations:

1. Pension funds are required to have thorough administrative and accounting procedures, and sufficient internal control mechanisms. In this connection, policies must be prepared for managing possible risks and care must be taken that these policies are carried out. The risks stem in part from failure to comply with requirements under laws and regulations.
2. Pension funds are required to ensure that systematic analyses are performed of integrity risks, and based on those analyses, must determine integrity policies and ensure that the policies are implemented. According to the explanatory memorandum to the Decree, the integrity risk can be defined as the danger of prejudice to the pension fund’s reputation, or any existing or future threat to the pension fund’s capital or results, as a result of insufficient compliance with the provisions laid down in or pursuant to any statutory requirement.
3. Pension funds must implement procedures and measures aimed at preventing private interests from becoming entangled with the fund’s interests. A code of conduct must be prepared for directors and employees working for the pension fund, laying down rules to prevent conflicts of interests and abuse or improper use of any of the pension fund's information or property. Pursuant to the Financial Supervision Act, for pension funds whose annual investment transactions equal or exceed a volume of €20 million, the code of conduct must also include internal regulations about how to deal with insider trading and about private transactions in financial instruments.

Financial Supervision Act
On the subject of securities-related market conduct supervision, the Financial Supervision Act specifies that all pension funds must:

1. lay down internal regulations about how to deal with insider trading and about private transactions in financial instruments by directors and employees;
2. manage any conflicts of interest that concern transactions in financial instruments;
3. implement sufficient control mechanisms to ensure compliance with the provisions relating to securities-related market conduct supervision;
4. appoint a compliance officer with responsibility for monitoring compliance with the regulations stemming from securities-related market conduct supervision, and establish rules to ensure this.

For further information about securities-related market conduct supervision, see our article in the May 2007 Update.

Conclusion
In connection with the requirements regarding compliance by pension funds laid down by the Pensions Act and the Financial Supervision Act, it is important for pension funds to take stock of the possible risks arising in connection with failure to comply with these laws and regulations, and formulate policies aimed at controlling those risks. For these purposes, the continuity analysis can help to identify long-term financial risks. Once that has been done, safeguards must be introduced into the fund’s accounting system and internal controls. Related to this is the preparation of a code of conduct and the appointment of a compliance officer. These are requirements that apply to all pension funds.

For more information contact: Harmen Pullen.

Top of page

Questions or Remarks?

If you have any questions or remarks concerning this issue of the Watson Wyatt Update, please let us know.

Top of page

---

Disclaimer: "Hoewel wij ernaar streven om correcte en actuele informatie te verschaffen, kunnen wij niet garanderen dat de informatie juist is op het moment waarop deze ontvangen wordt of dat de informatie na verloop van tijd nog steeds juist is. Op grond van de informatie dienen derhalve geen acties te worden ondernomen zonder voorafgaand deskundig advies."

© 2009 Watson Wyatt B.V. Alle rechten voorbehouden.

Contact

Overzicht actuele berichten

Watson Wyatt Update Nieuwsbrief overzicht  Bekijk hier uitgaven van de Watson Wyatt Update Nieuwsbrief.

Vragen & Opmerkingen

Ontvang de nieuwsbrief per e-mail