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In this Watson Wyatt Update:
Turbulence
Financial markets displayed increasing turbulence in the second half of 2007 due
to the American mortgage and credit crisis. Thus the credit and liquidity spreads
(or yield surcharges for credit risks and the lack of market liquidity) showed a
marked increase: See Table 1. This is both a direct and indirect consequence of
crumbling security. Firstly, there was a fall in real estate values in America,
which led to problems with mortgages, and then it was investments in portfolios
of these mortgages and derivative structured products that suffered.
Table 1: increase in surcharge for credit risk and liquidity in 2007, in
percentage points, according to creditworthiness (source: JP Morgan)
| Bonds in EUR | AAA | AA | A | BBB | Junk | ||
| 1. | All bonds | 0.1 | 0.4 | 0.5 | 0.7 | 1.7 | |
| 2. | Commercial bonds | 0.3 | 0.6 | 0.6 | 0.6 | 2.5 | |
| a. | Industrials | 0.5 | 0.3 | 0.5 | 0.6 | 2.0 | |
| b. | Financials | 0.2 | 0.6 | 0.9 | 1.1 | 6.1 | |
| 3. | Public sector | 0.1 | 0.1 | 0.1 | 0.7 | 0.7 | |
Systemic risk
Now, the reserve position of the monoline insurers (who cover bonds) is also seriously affected. This seems to confirm the presence of a systemic risk, and will probably make it more costly to finance commercial operations with loan capital. It is also worth mentioning in this context that credit assessor Moody’s recently issued a warning that the creditworthiness of the United States might be jeopardised by increased expenditure in the areas of medical expenses and state pensions. Apparently Moody’s perceives a risk that the American economy will provide a less solid security for the American state debt. If it transpires that America is indeed facing significant downgrade risk, this might have serious consequences for the financial world.
Dutch pension funds
The question is, what does the mortgage/credit crisis mean for Dutch pension funds, which in turn have to maintain security in order to safeguard their pensions? In the first instance, the consequences will depend on how much they have invested in the American mortgages that are making a loss, and their derivative investments. Secondly, losses might be sustained on shares and bonds issued by companies directly involved in the crisis, such as certain financial institutions. Finally, pension funds are of course vulnerable to any further expansion of the existing perils across the entire spectrum of the market, in the form of lower stock prices, increased credit risks, higher volatility, and higher inflation, to say nothing of any systemic risk.
As regards inflation, the price of hedging against inflation has increased slightly in the Eurozone (see Table 2). One possible explanation is that the anticipated inflation rate has increased by 0.2%. Increased uncertainty about future inflation may also be playing a part. In fact, inflation swap rates are lower than they were in 2004. The market does not seem to be expecting inflation much above 2%, and the inflation risk is actually diminishing.
Table 2 inflation swap: fixed rate swap for actual inflation, based on
European price index, in percentage points (Source: Lehman Brothers)
| Duration in years | Position, end 2007 | Increase in 2007 |
| 5 | 2.40 | 0.23 |
| 10 | 2.42 | 0.21 |
| 20 | 2.48 | 0.18 |
| 30 | 2.53 | 0.20 |
Dutch pension funds can cope with the odd setback. With average coverage rates in the region of 135% to 140%, nominal pensions were generally amply covered at the end of 2007. As regards full fixed value pensions, the coverage rates naturally turned out noticeably lower, at between 85% and 95%. Using this stricter measurement, most of the funds have no excess. This does not alter our assessment that the gradual improvement in coverage rates between 2002 and 2006 actually continued in 2007, despite the turbulence in the financial markets. However, general indices would tend to indicate that the increase in 2007 was more or less cancelled out by developments in the early weeks of 2008.
Pension funds are not banks, but still…
Solvency deficits of a limited nature, which are already posing acute problems for banks, need not be intrinsically fatal to a pension fund. But there are still reasons to be wary. A properly financed fixed-value pension is not an excessive luxury in a world where prices can be driven up by the increasing wealth of many hundreds of millions of consumers in countries like China and India. In contrast to the banks affected by the recent malaise, pension funds are unable to attract additional capital from markets such as the Middle East or Far East in difficult times, in order to help them put their balance sheets in order if need be. For pension funds, crumbling security in the form of the appearance of a major and chronic shortfall in indexation coverage is effectively a mortgage on the welfare of future pensioners.
For more information contact: Roland van Gaalen.
In the context of continuation of the VUT (Voluntary Early Retirement) scheme for those aged 55 and above, the introduction of the Vendrik amendment to the VPL Act has introduced an obligation for an ‘actuarial interest accrual’. The maturity charge does not then apply to the body which is obliged to withhold at source. Also, the employees’ personal contributions remain fully deductible.
In an amendment to the Sundry Fiscal Measures Bill 2008, the same Vendrik proposed a limitation on the actuarial interest accrual. The change proposed in the amendment means that the fiscal facility will also apply to VUT schemes where there is no 100% actuarial recalculation, but rather an increase of the benefits which is equal to at least 50% of the benefit that would result from a 100% actuarial revaluation. The explanation to the amendment indicates that this is a compromise. The background to this is that existing ‘flaws’ in pension plans will be adjusted in exchange for a limited accrual. These might involve the lapse of a right to VUT when the age of 65 is reached, or the loss of rights following transfer to a different employer. The amendment has been accepted by the Lower House of the Dutch parliament. The Upper House is also expected to approve.
In practice, a great deal of attention seems to have been paid to the transitional right for those aged 55 and above. This transitional right, or at least the accrual, should have been effected by 1 January 2006, and involves extra (administrative) burdens. If social partners want to change the original implementation of the scheme, this can be done exclusively by mutual agreement. After all, VUT is a term of employment.
For more information contact: Eric Heemskerk.
Some further changes in relation to the certification of pension funds have appeared with the introduction of the Pensions Act. The certifying actuary must declare whether sections 126-140 of the Act have been complied with.
While there is no intrinsic increase to the scope of the declaration as opposed to previous years, a number of elements are specified in greater detail. The verdict on the provision remains an important element of the actuarial certificate. In broad terms, this means that the provision has to be calculated using an interest period structure and the mortality probabilities on the calculation date. Mortality probabilities must also take account of anticipated future developments in mortality rates. Watson Wyatt has already been doing this in recent years using the ‘Brans Table’. In 2007, the Actuarial Association [Actuarieel Genootschap] published mortality tables which took into account anticipated developments in mortality probability, and the vast majority of the pension funds will now use it as their guiding principle. The calculation and an analysis of results will also frequently be based on the new mortality tables and interest period structure. This means that determining the results will be a different process than in previous years, at least as far as methodology is concerned.
This, along with other changes in the procedure for annual work, may result in an essential realignment of certain computerised procedures. This may involve extra work for everyone concerned. Watson Wyatt has taken every step to ensure that these changes proceed as smoothly as possible. Early on in the run-up to the season for our annual work, we consulted with a range of administrators and other parties. Nevertheless, there will inevitably be new questions to be answered in the course each of our annual work procedures. This means, even more than in previous years, that proper communication between the administrator, the pension fund and the certifying actuary will be indispensable. By 1 July 2008, Watson Wyatt expects to be able to look back on a successful first period of annual work under the new Pensions Act.
For more information contact: Edwin Schokker.
Watson Wyatt undertakes remuneration surveys (General Industry Compensation Surveys) in 17 Western European countries. Watson Wyatt also has sector-specific remuneration surveys in the pharmaceutical industry, the IT sector and elsewhere. If you are interested in taking part, please contact us via mary.cloosterman@watsonwyatt.com or call Mary Cloosterman-Hughes on +31 (0)20-5433000.
For more information contact: Mary Cloosterman.
As a result of the Securities Transactions (Supervision) Act (Wte) coming into effect, the pension industry has developed a new code of conduct for pension funds with effect from 2008. The Financial Supervision Act (Wft) has a principal-based approach (instead of rule-based), under which every pension fund is expected to make its own assessment of the risks it will run and the steps it can take to counteract these risks. A result of this approach is that the new code of conduct includes fewer conditions. Thus, pension funds have some freedom not to classify individuals associated with the pension fund as being insiders. The code of conduct contains suggestions for how this freedom should be interpreted.
In the new version, the code of conduct model contains just a single model, since the Wft no longer includes an option to provide an exemption to pension funds whose transaction volume is less than €20 million per annum.
For more information contact: Marijke Biewinga.
If you have any questions or remarks concerning this issue of the Watson Wyatt Update, please let us know.
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