Bond lifeline for Dutch funds

Dutch pension funds struggling to meet their 105% solvency targets set by domesticregulators are turning to the bond markets to plug their funding holes. But some market participants are highlighting the potential dangers of such a move

Moves are afoot in the Dutch market to help pension funds alleviate solvency pressures caused by the malaise in the stock markets, by allowing them to tap the bond markets. Forecasts suggest that a whopping €18 billion of bonds could flood into the debt capital markets, providing a source of much-needed funding for the pension fund community.

Dutch investment house ING Investment Management, which is in final talks with seven schemes in the Netherlands, is urging funds to tap the debt capital markets for up to 15% of their assets. Doing so will enable them to resolve their unfunded pension liability problems and meet the strict solvency targets set by the Dutch pensions and insurance regulator, the Pensioen- & Verzekeringskamer (PVK).

Gerard Bergsma, head of ING’s Dutch operations, explains that one of the problems is that funds in the Netherlands do not realise the gravity of the situation they are facing. “The solvency issue is greater than most funds think and, unless they act now, regulators will get stricter and potentially force them to sell a larger chunk of their equity holdings,” he says.

The move, which ING says is the first of its kind, will allow schemes to be more flexible in terms of their asset allocation decisions and ultimately permit them to push back into the equity markets and take advantage of the Europe-wide rally in stocks.

The seven funds, which ING was unwilling to name, must wait for formal approval from the PVK before they can proceed with the proposal. But if the Dutch bank is able to generate enough interest in its debt solution, it will issue a public bond under the ING name. It will then pass the money on to the individual schemes in the shape of a subordinated loan, on which the funds will have to return a semiannual coupon for the next eight to 10 years.

If only a handful of schemes show an interest in the proposals, the capital will be raised via the private euro medium-term note arena – boosting a market that saw 2003 issuance surpass that of 2002 a full three months before year-end.

Bergsma is recommending that funds do not borrow more than 10% to 15% of their total assets under management. “If markets go down then the burden on them will be too much. The regulatory authorities have given Dutch schemes until 2010 to get their balance sheets in order and that is why the loans will carry a maturity of at least eight years,” he says.

Brave new world
ING’s proposals come some 18 months after the PVK first set its 105% coverage ratio in the autumn of 2002 and, while some members of the pension fund community believe ING’s debt route is a positive step for schemes, others think it will generate new problems.

“I wonder if the people inside the schemes know where they are going with this,” says Frits Bosch, director of the Dutch pension consultancy, Bureau Bosch. “The capital markets are a complex business and most managers will not be used to using such sophisticated instruments. This is definitely a positive move for the pension fund industry, but managers must know what they are getting themselves into.”

The director of the Dutch corporate pension fund association (OPF), Jeroen Steenvoorden, warns of long-term risks involved with this product. He advises that, as with any leveraged solution, schemes must remember there is a downside as well as an upside. “On top of that we are also pushing the PVK for longer recovery periods for schemes as well as lower buffer limits and so I think that the demand for this type of market solution will ultimately wane,” he says.

A crucial factor that will determine the uptake of ING’s proposal is how the bond will be priced. The deals will carry a variable interest rate linked to six-month Libor and, while in principle the loans will mature after 10 years, they will carry two options that will mean their duration can be either lengthened or shortened.

According to Gerard Roelofs, head of Watson Wyatt’s Dutch investment consultancy business, the fact that the deals will include two options makes them very tricky to price and therefore makes it extremely difficult to gauge how large or small the demand for the loans will be.

If in 10 years the schemes that take out the loans are still underfunded then the instrument cannot be redeemed and the notes will have to be extended. But if, after a period of five years, the schemes have exceeded the funding requirements set by the PVK, then the loans can be redeemed at any time. “This unknown makes them very hard to value,” he says.

The rally in the equity markets, which has alleviated a significant chunk of the Dutch solvency problem, also leaves a question mark over the funds’ long-term need for the loans. When the PVK first set its 105% target in September 2002, it warned that the Dutch pensions sector as a whole was some €23 billion underfunded.

The calculation was based on the level of the country’s primary equity index, the AEX, which then stood at 300 points. The AEX has since rallied by 20% and, although the PVK has stopped making such calculations claiming that the exercise is redundant, the rise has significantly eased the pressure on funds.

Just two weeks ago, provisional data from the VB, the Dutch association of industry-wide pension funds, revealed that the cover ratios of VB-affiliated pension schemes rose to an average of 111.2% at the end of 2003 – an increase of more than five percentage points on the previous year.

And just last month ABP, the huge €150 billion civil service fund, issued results that showed its cover ratio had risen from 103% to 109% after it posted returns of 11% in 2003.

But under crude calculations and with other factors being equal, the 20% rise in the AEX index still infers that funds face a combined deficit of more than €18 billion and ING’s Bergsma is adamant that the pension shortfall problem has and will not go away any time soon.

“Interest in our proposal is still very strong,” he says. “Pension funds like our concept but it is one that will take a bit of time for them to get used to. The pensions problem in the Netherlands does not look like it is going away in the near future and what we are offering schemes is a real solution.”

Equity rally
Either way a continued surge in European equity prices could dampen demand in the bond markets. As stocks rise and the solvency problem dissipates, funds will no doubt cut into their bond holdings and increase their exposure to the better-performing stocks. At the same time a climbing equity market means that the need for schemes to make use of ING’s lending arrangement is greatly reduced.

But funds will not easily forget that across much of Europe equity indices hit their lowest level for five years in 2003 and will continue to allocate a large chunk of their portfolios to bonds for some time to come.

Recent data shows that schemes are still cutting into their equity holdings in favour of fixed-income products and, if markets do take a turn for the worse and ING is fortunate enough to convince 100% of unfunded schemes that the bond markets will cure their solvency problems, then €18 billion could make its way into the new-issuance arena. This is unlikely to occur in the very short term, however.

“ING’s debt proposal sees the asset management arena and the capital markets coming closer together,” says Roelofs at Watson Wyatt. “And this can only be a good thing, but while I am normally a proponent of people being the first into any market, on this occasion I definitely see value in schemes waiting for somebody else to jump first and then watching to see what happens.”