Chapter 19 risk based supervision of pension funds in the netherlands

Th e main elements of this framework include mark-to-market valuation of assets and liabilities, a f ull f unding requirement, risk-based solvency requirements, and a co ntinuity analysi

19.3.1 Valuation of Defi ned Benefi t Liabilities 48519.3.2 Valuation of Contingent Liabilities 48619.3.3 Term Structure of Interest Rates 488

19.4.1.2 Equity and Real Estate Risk 493

19.4.1.7 Other Risk Categories 496

19 5.3 Diff erent Functions of the Continuity Analysis 505

References 507

Risk-based supervision is being increasingly adopted worldwide As

an example of such r isk-based supervision, this chapter reviews the Financial Assessment Framework for pension funds in the Netherlands

It operates under the Pension Act that was changed signifi cantly in 2007

Th e main elements of this framework include mark-to-market valuation

of assets and liabilities, a f ull f unding requirement, risk-based solvency requirements, and a co ntinuity analysis for assessing the pension fund’s solvency in the long run Together these building blocks off er a solid foun-dation for the incentive-compatible regulation of occupational pensions

in the Netherlands

19.1 INTRODUCTION

Th e current fi nancial crisis shows that pension funds have developed a large exposure to risks Th is exposure entails market risk, interest rate risk, and even liquidity and operational risk, besides more traditional insurance risks like mortality risk and longevity risk It has become evident that the key to managing these risks is an integrated balance sheet approach, considering assets and liabilities simultaneously Th is is particularly true for defi ned ben-efi t pension plans that usually run a mismatch between assets and liabilities

on their balance sheet Th e principal responsibility of pension fund trustees, therefore, is to control risks in order to ensure that they are kept within acceptable limits so that the entitlements of members, as agreed between social partners in employment contracts, will be respected

Being i mportant fi nancial i nstitutions, pens ion f unds a re sub ject t o government regulation Worldwide, there is an increasing adoption of

risk-based supervision As an example of such risk-based supervision, this cha pter r eviews t he F inancial A ssessment F ramework f or pens ion funds in the Netherlands Th is regulatory framework has been discussed

in, inter alia, Siegelaer (2005), Nijman (2006), and Brunner et al (2008), although th is c hapter i s th e fi rst t o r eview i t i n f ull s ince i t ha s be en adopted in the Dutch Pension Act in 2007 Th e main elements of this sol-vency regime are as follows Th e mark-to-market valuation of assets and liabilities is described in Section 19.3 Th is mark-to-market approach is needed to determine whether a pension fund is currently solvent Section 19.4 describes t he risk-based solvency requirements t hat a re in place to make sure the pension fund is still solvent on a 1-year horizon with a high probability Section 1 9.5 i ntroduces t he l ong-term co ntinuity a nalysis

Th is instrument assesses the pension fund’s solvency in the long run and the f und’s ability to eff ectively infl uence t he fi nancial p osition t hrough the available policy instruments Section 19.6 contains some concluding remarks However, we fi rst describe the key characteristics of the Dutch pension system and elaborate on the objectives of prudential pension fund supervision in the Netherlands

AND SOLVENCY REGULATION

Th e Dutch pension system may be characterized in terms of the usual three layers Th e fi rst layer is constituted by the state old-age pension, which is

fi nanced on a pay-as-you-go basis and provides for a basic income for all citizens of age 65 and over As of 2009, for singles, the gross pension ben-efi t is €1038 a month For couples, if both partners are 65 or over, the gross benefi t for each partner is €723 a month It should be noted, however, that these amounts are only paid if a person has uninterruptedly lived in the Netherlands from the age of 16 onward Skipping the second layer for a moment, the third layer consists of private saving for retirement Th is cov-ers tax-favored pension saving, such as life annuities off ered by insurance companies

Th e second layer, the main focus of this chapter, comprehends tional pensions, which are primarily fi nanced by means of contributions

occupa-by employer and employees It is therefore a capitalized or funded system

in which people save for their pensions For most employees, participation

in a pension plan is automatically linked to their contract of employment

Th e participation rate among employees is thus close to 100% Typically, the employer pays the bulk of the contributions although the employees’

part tends t o i ncrease Th e second layer ser ves to supplement t he fi rst Hence, in occupational pension accrual, account is taken of a basic benefi t, known as the pension off set Th is off set is oft en linked to the state old-age pension benefi t For that reason, the supplementary pension is built up on the basis of pensionable earnings, that is, income from labor less the off set

If, under a fi nal-pay system, we assume an annual accrual rate of 1.75%

of pensionable earnings, the result aft er 40 years of service is a pens ion equal to 70% of fi nal salary Final-pay systems are expensive because of the past service involved Nowadays, some 87% of all active members par-ticipate in a career-average scheme Under such a scheme, higher accrual rates are mostly used, of up to more than 2% Th ese schemes go without past service, the pension accrual being indexed to wage growth or infl a-tion instead Th is indexation is not guaranteed however—it is contingent, and decided upon mostly on a y early basis, on the availability of ample

fi nancial resources In over half of all cases, indexation is based on wage growth, usually those in the industry concerned For over 20% of pension plan members, pension accrual is linked to t he movements in t he gen-eral level of consumer prices Th e so-called collective defi ned contribu-tion plans are gaining popularity in the Netherlands Th ese plans combine

a career-average scheme w ith a fi xed contribution rate for a n umber of years Th is allows corporations to classify a defi ned benefi t scheme as a defi ned contribution plan I ndividual defi ned contribution schemes a re still exceptional in the Netherlands

At the end of 2008, the assets held by pension funds totalled €576 billion, while t he ma rked-to-market va lue of t he l iabilities equaled € 606 billion

Th is translates into a funding ratio of 95%, which is historically low for the Netherlands Figure 19.1 shows the long-term progress of the funding ratio

It is closely related to the development of the long-term market interest rate, showing t he i mportance of ma rket va riables for a ssessing t he fi nancial well-being of pension funds

Figure 19.2 plots the asset allocation over time Notably, in the 1990s, pension f unds i ncreased t heir equity ex posure at t he ex pense of fi xed-income securities Furthermore, within the category of fi xed-income investments, private loans have been replaced in large part by traded bonds

Th e increased share of equities and bonds refl ects a growing preference for liquid investments Th is is also refl ected in investments in real estate: the percentage invested in has remained fairly stable, but there has been a shift toward indirect real estate (traded participations) at t he expense of real estate directly held by the pension fund itself Another trend is investing

Funding ratio Long-term market interest rate (rhs)

FIGURE 19.1 Long-term development of f unding ratio a nd long-term i nterest rate (From DNB.)

in alternatives like commodities, hedge funds, and infrastructure Th er e

is also a move toward investing abroad Currently, foreign assets account for some three quarters of the balance sheet total while this was still mar-ginal in the mid-1980s Th e reason behind this shift is that international diversifi cation is the key to a funded system to fully exploit the benefi ts of risk sharing

Many pens ion f unds a im a t ma intaining a fi xed a sset a llocation i n terms o f i nvestment cla sses (strategic a sset a llocation) Th is rebalancing strategy implies that changes in the relative value of fi nancial assets give rise to off setting purchases a nd sales, so t hat t he relative weights i n t he portfolio remain fairly constant However, it is also possible to accommo-date va lue changes w ithin defi ned bandwidths (tactical asset a llocation) Pension funds’ rebalancing strategy is described in greater detail in Bikker

et al (2007) Apparently, there is some asymmetric behavior Pension funds are eager to rebalance aft er a period of relative underperformance of equi-ties but a llow t heir a sset a llocation to f ree fl oat aft er a pe riod of equity outperformance

Th e lion’s share of the accrued assets is administered by pension funds

Th ey u sually ha ve t he l egal f orm o f a f oundation a nd a re g overned b y representatives of employers and employees Being a foundation, a pension fund cannot go bankrupt As such, the ultimate measure a pension fund can t ake i s t o r educe acc rued ben efi ts t o r estore i ts fi nancial position

In fact, it is a legal requirement to incorporate this possibility in the pension fund’s statutes Pension funds may be linked to a single company or to an entire industry For the latter category, participation is usually mandatory, meaning that companies in certain industries are obliged to take part in the specifi c industry-wide pension fund At of the end of 2006, 86% of all active members took part in industry-wide pension funds, and only some 13% were members of a co mpany pension fund Less than 1% of active member are related to occupational pension funds, which act in the interest

of specifi c occupations like notaries or pharmaceutical chemists

19.2.1 Objectives of Prudential Pension Fund

Supervision in the Netherlands

Employers a re f ree t o off er a pens ion p lan t o t heir em ployees o r n ot However, if they do so, the plan must comply with government regulation

Th is regulation is laid down in a pension act that was changed signifi cantly

in 2007 A ke y element of this act is that pension funds must be l egally separated from the company off ering the pension arrangement and must

always be f ully f unded Th ese requirements prevent a co rporate default from damaging the pension benefi ts Th e rules for pension fund supervi-sion are also set in the Pension Act Th is act identifi es De Nederlandsche Bank ( DNB) a s t he r esponsible body f or t he p rudential su pervision o f pension f unds A longside t he D NB, t he N etherlands A uthority f or t he Financial Markets (AFM) supervises the conduct of the entire fi nancial market sector including pension funds Th e objective of prudential pen-sion fund supervision is to off er a high degree of safety to (future) retirees through the imposition of strict supervisory standards Pension funds are thereto required to hold a certain solvency margin of additional assets over the marked-to-market value of pension benefi ts Th is solvency margin

is intended to absorb the risks inherent in the possible changes in the value

of assets and liabilities Without a clear statutory requirement to hold such

a margin, pension fund’s trustees may be tem pted to pursue short-term objectives by, say, following a risky investment policy and shift ing the bur-den of possible negative consequences on to younger generations or, i n extreme cases, on to society at large

However, Dutch pension f unds can ex ploit t he potential of erational risk sharing; see Cui et al (2009) Th e basis for this solidarity is constituted by mandatory participation in pension schemes Older mem-bers can use the young as a safety net if need be, while the younger benefi t from t he wealth of t he older i f t here is a su ffi cient la rge su rplus i n t he pension f und Th is a llows a pens ion f und to benefi t f rom sha ring r isks across generations if necessary However, in order to safeguard the savings both at present and into the future, the trustees of the fund need to avoid excessive risk taking, since the raison d’être of pension funds (i.e., cross-generational risk sharing) holds only insofar as future workers continue to

intergen-fi nd it attractive to participate in the fund

As such, i ntergenerational risk sharing cannot be st retched infi nitely

In order to demonstrate this, let us assume that there are two generations: current members and future members Intergenerational risk sharing may

be compared to fi nancial derivatives Th e current generation, which cises discretionary power over the pension assets, has, so to speak, a long position in a put option Th at is, it has the power to sell its pension com-mitments to later generations at a g iven price Th e acceding generation

exer-of (would-be) members have, so to say, implicitly written the put option, thereby entering into the obligation to take over the pension fund’s com-mitments to the older generation should the assets managed by the fund prove insuffi cient to fund those commitments Th e crux of the matter is

that such a r isk transfer from the current to future generations carries a price tag Th is price is the surplus in the pension fund.

Th e owner of the put option, in this case the older generation, ably has the most favorable ex post pos ition If the assets in the pension fund are suffi cient to serve both the older and the younger group, the for-mer will see their entitlements (fully) honored If, however, the assets are insuffi cient to provide for both the older and the younger groups, the older group can still enforce full pension rights and leave their juniors to pick

invari-up the tab Th us the youngsters, by defi nition, fi nd themselves in a timal position, because the pension fund’s money can only be spent once

subop-Th e protection of younger and future members in the pension funds from risk-taking behavior by the older cohorts requires the supervision of the pension fund

Another r eason f or p rudential su pervision i s t he absen ce o f ma rket forces Pension funds are not-for-profi t organizations and as such do not issue equity capital Th is means the members in a pens ion fund are not only the liability holders but are in eff ect also its shareholders: the pension fund is a k ind of cooperative However, the shares are not negotiable as participation is mandatory By co nsequence, the regular control mecha-nisms found in capital markets are inoperative in the pension industry.19.2.2 Prudential Supervision

Prudential regulation is traditionally aimed at (1) defi ning, (2) overseeing, and (3) enforcing minimum requirements as to the funding and the sol-vency of the supervised institutions After all, if an institution has full coverage of the technical provisions and sufficient free capital, it is able

to absorb setbacks In the absence of adequate reserves, pension funds run t he r isk o f fa ilure a nd ben eficiaries ma y co nsequently se e t heir claims a nd r ights e vaporate i nto t hin a ir P ension f und su pervision therefore centers on the continuity of pension entitlements That raises the question as to when this continuity is endangered One could argue that, for as long as pension plans attract new members, there is a safety net g uaranteeing t he benefits for t he older members This a rgument relies on the assumption that it must be attractive for younger people

to take part in the pension system If younger generations have to pay disproportionately more than the amount required for the accrual of their own pensions, t hat is no longer automatically t he c ase I n t hat event, intergenerational solidarity is no longer assured It is, therefore,

of major importance that the distribution of pension contributions and

benefits among the generations should be kept within a certain width T his i s a sub tle eq uilibrium t hat ma y e asily be d isturbed b y large fluctuations in capital markets and, hence, needs to be carefully guarded by the supervisor Maintaining the equilibrium is underlain

band-by t he a pplication of t he a ssumption t hat a pens ion f und should be able at any point in time to distribute the claims and rights in money

to the beneficiaries, that is, to have full funding at all times This is the core of the Financial Assessment Framework Before moving toward further explaining the Financial Assessment Framework, we first elab-orate on a ke y aspect of pension fund risk management: the relation between risk and time This link is also relevant for designing incen-tive compatible regulation

19.2.3 Risk and Time

Th is relation is i mportant to u nderstand a s pension f unds u sually t ake

a long-term perspective and so oft en d isplay a st rong inclination toward investing in equities Th ere is an intense debate on the relationship between time and risk that is also relevant for the design of incentive compatible regulation We discuss the issue by looking at the characteristics of equity investments versus risk-free investments over time

Pension f unds’ la rge st ock ma rket exp osures a re exp lained b y t he assumption that, in the long run, equities are expected to perform bet-ter than government bonds Looking ahead, this seems realistic: because equities are riskier than government bonds, investors demand higher returns in co mpensation L ooking at past p erformance, however, t he picture may look different There are extended periods in the past when equities were outperformed by risk-free investments One exa mple is the period from 1902 until 1932 when T-bill investments outperformed equities o ver a 30 y ear p eriod d ue t o t he s evere ma rket b reakdown starting from 1929 Most recently a similar picture has emerged for the period 1995–2008

Due to the higher expected returns, the probability of loss on an equity portfolio relative to a risk-free investment declines as the horizon increases

Th is so-called time diversifi cation eff ect may be readily explained with the help of basic statistical knowledge Suppose the value of a well-diversifi ed

equity portfolio S follows a geometric Brownian motion with an

instanta-neous return µ and instantainstanta-neous volatility σ

= µ + σ

dS S td S W d

An amount S invested in a risk-free zero coupon bond will yield an amount

S e r(T−t) over the time period T − t Th e probability p that equities

outper-form this risk-free investment is given by

2 1

A pension fund, however, must not only consider the benefi ts attaching

to risky investments Its trustees must form an opinion both on the ability that the return on the equity portfolio may fail to keep pace with

Probability of return below

risk free return

Loss given default (rhs)

FIGURE 19.3 Probability of excess return and loss given default, using µ = 0.08,

σ = 0.18, and r = 0.04.

the annual increase of its pension liabilities and particularly on the size of the potential defi cit; see also Lukassen and Pröpper (2007).

Although the probability of loss will decline as the investment horizon increases, t he po tential l oss g iven defa ult ( LGD) i s o ft en disregarded

A long-term investment in the stock market implies the real possibility that the investor will have to absorb a stock market crash, a recession, or

a period of economic stagfl ation Th erefore, the size of the (potential) loss increases with time To explore this, defi ne

µ − σ − −

δ =

2 1 2

of the probability of a shortfall and the loss given a shortfall

Th is overall eff ect is convincingly demonstrated by using option ation theory Let us assume that in the long run equity investments are indeed l ess r isky B odie (1995) dem onstrates t hat i nsurance a gainst a n

valu-overall return below the risk-free interest rate r may be acquired by ing a put option with an exercise price equal to the initial value S accrued

buy-at rbuy-ate r over mbuy-aturity T − t Th is “forward-strike” put option aff ords the

holder the luxury of enjoying optimal asset allocation (i.e., equity versus cash) at expiry Because if the actual return on the equity portfolio turns out to have lagged behind the risk-free yield, the holder will have the right

to sell the equities at a fi xed higher price

Bodie shows that the insurance premium only depends on the option’s

maturity (T − t) and t he standard deviation of t he underlying portfolio’s

value (σ) Th e crucial insight is that the value of the put option is shown to

increase with either T − t or σ Th at means that the risk of investing in equities

increases with time Th e time diversifi cation eff ect is thus outweighed by the increasing size of a possible shortfall to the risk-free yield A long maturity and a high standard deviation on the value of the equity portfolio each make for increased insecurity, upping the premium required for the assured opti-mal asset allocation In addition, Bodie argues that this result is similar both

in a w orld with mean reversion and in one without mean reversion Th e reason is that option-pricing models, such as the Black–Scholes–Merton, are valid regardless of the process for the mean return Th ey are based on the law of one price and the absence of arbitrage profi ts Lo and Wang (1995) provide a simple adjustment for the volatility parameter in the option pric-ing formula to correct for autocorrelated asset returns Although this infl u-ences the value of the option, it does not change the relation between risk and time Th is shows that pension funds should give due consideration to equity i nvestment r isks over t ime Th ese r isks should a lso be adeq uately addressed in supervision, as argued in Section 19.2.4

19.2.4 Financial Assessment Framework

Th e Financial Assessment Framework as it is operated under the Dutch Pension Act embodies the characteristics of prudential regulation as dis-cussed earlier Assuming the full funding requirement, the framework encourages sound risk management, both in the short and long run To that end, one major condition is the mark-to-market valuation of both investments a nd l iabilities, a s d iscussed i n S ection 19.3 It i ncludes a stringent restriction w ith regard to t he g uaranteed pension l iabilities, for which technical provisions must be built and covered by assets at all times Furthermore, the contributions raised must be cost-eff ective

On top of the technical provisions, the Financial Assessment Framework imposes a number of requirements on pension funds’ capital, depending on the risks incurred by a fund Th ese are dealt with in greater detail in Section 19.4 Th e strict funding requirements contrast with the less-stringent condi-tion regarding contingent liabilities: here the pension fund does not need

to build technical provisions, but must strive for consistency between the expectations raised, the level of fi nancing achieved, and the degree to which contingent claims are awarded to members (see Sections 19.3.2 and 19.5)

19.3 MARK-TO-MARKET VALUATION

Th e core in pension fund supervision is the valuation of assets and ties Ideally, the market value of liabilities is det ermined in a liq uid and well-ordered market However, as lo ng as suc h a liq uid market does not

liabili-exit, marking-to-market is also possible on the basis of the replication principle Th us, in a world without arbitrage opportunities, the marked-to-market value of a pension liability equals the market price of that invest-ment portfolio that generates exactly the required cash fl ows under all future states of the world Th e present value is equivalent to the actual value of an investment where cash fl ows are matching in all r espects and are certain

to be realized If investments can be found that, in each realization of the actuarial stochastic process, generate funds exactly equal to the payment liabilities, the cash fl ows of liabilities and investments are said to be match-ing in all respects Note that the expected value of guaranteed liabilities is therefore not aff ected by the pension fund’s actual investments (see Section 19.3.1) Th e expected value of embedded options in the pension liabilities

is determined as t he value of a fi nancial instrument that is a r eplication

of the conditional cash fl ows (contingent claims) based on underwriting principles that are deemed to be realistic Th is realistic value is determined, for example, by option valuation techniques (see Section 19.3.2)

19.3.1 Valuation of Defi ned Benefi t Liabilities

Th e technical provisions are established as t he expected va lue of t he cash

fl ows arising from the pension liabilities as defi ned in the pension contract.*

In turn, the expected cash fl ows are based on actuarial sound underwriting principles (mortality rates, longevity risks, surrender rates, frequency of trans-fers of value, etc.) that are deemed to be realistic A pension fund must take into account expected demographic, legal, medical, technological, social, or economic developments Th is means, for example, that the foreseeable trend

in improvement in life expectancy must be refl ected in the expected value, given the fact that, on average, people tend to live longer as time goes on

Th e principle of the replicating portfolio as introduced in Section 19.3

is explained through a simple numerical example using a single cash fl ow (bullet) In reality, a pension fund of course has regular payments to make, but t he idea st ill holds For t hat matter, suppose, i n year 15, a pens ion fund will have a guaranteed nominal liability of 100 (euro) to a cohort of pension plan members To determine the best estimate, account has been taken of the mortality and survival risk for each member between now and 15 years hence In addition, the expected improvement in the survival

* It is also suggested that the marked-to-market value of pension liabilities is the sum of t he expected value and a s o-called market value margin Th is margin compensates buyers for non-hedgeable r isks u nderlying t he l iabilities I n t he Fi nancial A ssessment Fr amework, these non-hedgeable risks are not i ncorporated in technical provisions but i n the required solvency margin.

rate over the next 15 years has also been allowed for If actual mortality equals expected mortality, the pension fund will disburse an amount of exactly 100 in 15 years time If actual mortality is lower than expected, a higher amount must be disbursed Th is extra payment might for instance

be fi nanced out of the surplus in the pension fund

If we neglect the actuarial uncertainty, the pension fund can hedge its liability in capital markets by investing in a zero-coupon bond that will pay exactly 100 in 15 years time Th e zero-coupon bond is currently traded at

50, corresponding to a 15 year spot rate of 4.73% Th e relationship among the variables is as follows:

( )

=+ 100 15

50.0

1 0.0473 Following t he replication a rgument, t he ma rked-to-market va lue of t he pension liability is also 50 Th e pension fund would therefore need to estab-lish and cover technical provisions amounting to at least 50 Th e modifi ed duration of the zero-coupon and the liability is 15/1.0473 = 14.3, implying that if market interest rates were to drop from 4.73% to 3.73%, the marked-to-market value of the liability would go up by approximately 14.3%.For the purposes of the valuation of a fully guaranteed indexed pension liability, it is assumed that there is a zero-coupon index-linked bond with a maturity of 15 years, whose principal is adjusted annually to the actual rate

of infl ation Suppose such a bond trades at 66.8, corresponding to a real rate

of interest of 2.73% Th e relationship among these variables is as follows:

( )

=+ 100 15

66.8

1 0.0273 Again, following the replication principle, this is also the current value of

an infl ation-protected pension liability Th e pension fund would therefore need to establish a nd cover technical provisions a mounting to 66.8 By investing in an index-linked bond, the benefi ciaries are sure to receive an infl ation-proof payment in year 15, whose purchasing power equals cur-rent purchasing power

19.3.2 Valuation of Contingent Liabilities

In a typical Dutch pension plan, the indexation of benefi ts is not teed but depends on an annual discretionary decision by the pension fund

guaran-trustees Dutch pension funds are thus not required under FTK to value and reserve for t heir f uture, conditional i ndexation i n tech nical provi-sions In practice, the indexation is oft en contingent on the pension funds’ funding ratio If the funding ratio is suffi ciently high, the benefi ts are fully indexed to infl ation or wage growth However, if the funding ratio drops below the required solvency level (discussed later), indexation is reduced or even removed Th e marked-to-market value of these contingently indexed liabilities c an a lso be der ived u sing t he replication principle, i ncluding derivatives that mimic the contingency.

Suppose again that the unconditional nominal pension liability equals

a cash fl ow of 100 in 15 years time In addition, the pension fund seeks to index its liability, subject to a ma ximum of 1.95% per a nnum (In order

to avoid undue complication, we assume infl ation fi xed at this number.) However, the actual indexation granted each year depends on the fi nan-cial position as determined by the funding ratio in each successive year

At a funding ratio of F =133.8% ( 66.8/50*100%)= or more, the maximum indexation of 1.95% is granted At lower funding ratios, the indexation is reduced linearly down to a f unding ratio of =105%F at which no more indexation is granted Th is contingent indexation procedure can be repli-cated by a series of options on the funding ratio For each year we than have

a long position in a call option with a strike of 105% and a short position in

a call with a strike of 133.6% Th e option in each year also depends on the conditional outcome of the options in the previous years Although feasible through, for example, Monte-Carlo simulations, Dutch pension funds are not required to value their future indexation policy by this method.Instead, t hey m ust st rive f or co nsistency bet ween t he ex pectations raised, the level of fi nancing achieved, and the degree to which contingent claims are awarded to members Th e consistency needs to be grounded

by the application of a l ong-term stochastic continuity analysis, which

is described later in more detail Several means of “fi nancing” gent liabilities are then accepted under the Pension Act, among which the assumption of expected future investment returns Th is treatment of contingent liabilities has kept the Dutch pension system aff ordable and

contin-fl exible since indexation can only be granted if the funding ratio is

suf-fi ciently high However, this means that the pension fund’s benefi ciaries are exposed to stock market exposure that they cannot easily hedge Also,

it qualifi es the Dutch pension system as a nominal system since tional indexation is not truly reserved for Most pension funds in prac-tice do not guarantee real pension benefi ts, but only nominal benefi ts

condi-19.3.3 Term Structure of Interest Rates

Th erefore, valuation focuses on the accrued (nominal) benefi t obligations For that purpose, a full-term structure of interest rates is made available

to pension f unds Th is section describes t he construction of t his curve

It is based upon the interest rate swap curve and published each month on the Web site of the DNB Th e swap market does not require an exchange of principal amounts and is largely collateralized thereby eliminating essen-tially all credit risk.* Th e data source underlying the construction of the nominal interest rate term structure are European swap rates for 1–10 year maturities (yearly intervals) and 12, 15, 20, 25, 30, 40, and 50 year maturi-ties as they are listed on a daily basis by Bloomberg In such interest rate swaps, 6-month Euro Interbank Off ered Rate (EURIBOR) is exchanged for a fi xed interest rate Unavailable maturity points are interpolated on the assumption that intervening forward rates are constant

An interest rate swap is a long position in a fi xed-rate bond combined with a sh ort position i n a fl oating-rate bond, or v ice versa A n i nterest rate swap is constructed so that no initial payment takes place—in other words, its market value is equal to nil We defi ne the following annually

accrued interest rates: ft1,t2 is the forward rate between t1 and t2, rt is the swap rate at maturity t, and zt is the zero coupon swap rate at maturity t

Th e latter being the applicable discount rate for pension liabilities

Th e zero coupon swap rate is derived from the par swap rate by means of

bootstrapping, starting with the 1-year swap rate Since (1 + r1)/(1 + z1) = 1,

it follows that z1 = r1 Th e 2-year zero coupon rate is determined by ing the present value, at the 1- and 2-year zero rate, of the cash fl ows from (the fi xed rate side of) a 2-year swap, and equating the present value to 1

calculat-Th e 1-year zero rate is already known, so that this leaves an equation with a single unknown (the 2-year zero coupon swap rate):

which can be solved easily

By way of explanation, we also derive the 1-year forward over 1 y ear

(i.e., the forward interest rate accruing between t = 1 and t = 2) in the usual

way via

* Although credit risk is eliminated using margin accounts, there might be risk of a premature expiration of t he s wap c ontract Usually I SDA a nd C SA c ontracts i nclude t riggers t hat predefi ne early termination.

2 2 1,2

1

(1 ) 11

z f

25 years Th is is a reasonable assumption, because the forward rate is ally a prediction about the 1 year rate that will apply 20, 21, etc., years from now Th e market is not very likely to take substantially diff erent views on

actu-1 year interest rates 20 or 2actu-1 years forward Th is ends the valuation issues related to the liabilities We now turn to the valuation of assets

19.3.4 Valuation of Assets

A pension fund will conduct an investment policy in accordance with the prudent person rule Meaning that the assets are invested in the interest of the benefi ciaries Th ere are no quantitative investment restrictions except for investments in the sponsor that are limited to a maximum of 5% of the portfolio as a whole

Th e i nvestments a re va lued a t ma rket va lue Th is is t he a mount f or which an asset could be exchanged between knowledgeable, willing par-ties in an arm’s length transaction Th ree situations can be identifi ed First,

it i s relatively simple to va lue i nvestments t hat a re t raded on a r egular market Valuation takes place on the basis of the most recent transaction price on that market Second, if no such market value is available, but the investment can be replicated by other instruments, then the value is equal

to the sum of the market value of those instruments Th ird, if there are no comparable instruments, the pension fund must resort to a model-based valuation tech nique u sing g enerally acc epted eco nomic principles such

as replication and the non-arbitrage principle Th e assumptions and mates used must be in line with what can be derived from general market prices Furthermore, each embedded option must be valued Th is could be

esti-an option either available to the issuer or the holder of esti-an instrument

If external sources are used for the valuation process, the pension fund must have procedures to establish the degree of accuracy, promptness, and consistency of t he price a nd other i nformation received Pension f unds need to assess the extent to which valuations are being produced indepen-dently and how this independence is maintained Considerations include (the appropriateness of) the valuation methodology used, validation and

backtesting procedures surrounding pricing models, independent verifi cation and the frequency of valuations.

-19.3.5 Contribution Policy

Pension funds must determine the cost-eff ective contribution as the sum of

Th e actuarially required contribution for the pension obligations

poses of granting indexation

Although it is actuarially fair to use t he current market interest rate as the m ost relevant d iscount r ate, pens ion f unds a re a lso a llowed t o u se

a smoothed or fi xed d iscount rate to d ampen sha rp fl uctuations i n t he actuarially required contribution Th is smoothing, that can be based on a moving average of historical interest rates or the expected return on assets, only applies to the calculation of the cost-eff ective contribution Th is tech-nique may not be used for the calculation of the technical provisions.Strict conditions apply to discounts or restitutions on the cost-eff ective contributions A d iscount can only be a pplied if, based on a co ntinuity analysis (see Section 19.5) over a 1 5 year period, expected indexation is suffi cient relative to the indexation ambition of the pension fund It is up

to the supervisor to decide what level is suffi cient, although a level of 70%

of full indexation is considered to be the absolute minimum Restitution

is only possible if all indexations in relation to the preceding 10 years have been fully granted and any reduction on pension rights and entitlement

to a pension benefi t in the preceding 10 years are also fully compensated Aft er this exposition on valuation and contribution policy, we now turn to the risk-based solvency requirements

19.4 RISK-BASED SOLVENCY REQUIREMENTS

Pension funds are required to retain suffi cient additional capital over the technical provisions to be able to absorb losses in the case of adverse events

on the fi nancial markets or in the development of insurance technical risks Typical adverse events include a sharp decline in interest rates, a large fall

in stock prices and the realization of lower-than-expected mortality rates