News & analysis
DUTCH DERIVATIVES: INSIGHTS FROM THE LDI CRUNCH IN THE NETHERLANDS
Why did two countries with the same problem face different outcomes? Mona Dohle takes a look.
Last year, the Netherlands saw a drama which might seem familiar to investors in Britain. Within the first six months of 2022, Dutch pension funds sold €88bn (£77.1bn) of assets, which amounted to nearly 5% of their total holdings, according to DNB, the central bank.
This saw the value of the assets managed by Dutch pension funds to drop to €1.4trn (£1.2trn) from €1.8trn (£1.5trn). The reason for these outflows is the growing cost of collateral calls on defined benefit (DB) schemes’ derivative positions. The resemblance between the Dutch and British crisis is uncanny. So how did Dutch investors resolve it and are there any lessons to be learnt?
Dash for cash The Dutch and British retirement systems have a lot in com- mon. Compared to other European pensions markets, the Netherlands has a significant defined benefit sector. And with €1.4trn (£1.2trn) in pensions assets, they account for more than half of all European pension assets. Just like in the UK, Dutch schemes measure the present value of their liabilities based on long-dated government yields. Dutch pension funds also use liability-driven investment (LDI) hedging strategies involving interest and inflation swaps. But this hedge turned out to be rather expensive in 2022. Just like in the UK, Dutch schemes also benefited from rising rates, which led to a dramatic reduction of the present value of their liabilities. They also faced billions in collateral calls which exceeded their cash reserves.
DNB data shows that schemes were mostly selling investment fund units, which reported €57m (£49.9m) in outflows, fol- lowed by €25m (£21.9m) for equities and €8m (£7m) with- drawn from money market funds.
The impact on their portfolios added to an already difficult year. ABP reported losses of €40bn (£35bn) on its fixed income portfolio alone with long-dated bonds losing almost a third of their value. It also reported more than €50bn (£43.8bn) in losses from its overlay management strategy, leading to a total annual loss of €91.5bn (£80.1bn). Total assets managed by the Dutch pension fund fell from €528bn (£462.6bn) to €460bn (£403bn). But the overall fund- ing position of DB schemes has improved, despite the losses. ABP’s funding ratio rose to 124%, from just under 100% last year and PFZW’s now stands at 115%.
This is due to the impact of rising interest rates on the calcula- 8 | portfolio institutional | February 2023 | Issue 120
tion of the present value of scheme liabilities. Last year, ABP’s liabilities dropped from €502bn (£439.6bn) to €370bn (£323.9bn) and the fund is due to increase payments to mem- bers by 12% next year.
This might sound familiar to UK readers. USS, for example, reported its first surplus in June, despite a sharp fall in the value of its assets.
These similarities aside, there are also significant differences. The crisis in the UK escalated rapidly due to the relatively small nature of the UK gilt market and the fact that UK schemes are predominantly invested in such assets.
In contrast, Dutch investors have diversified their portfolio across the entire European bond market. ABP’s biggest hold- ings, for example, are French, German and American govern- ment debt. As a result, they are less exposed to the whims of Dutch fiscal policy decisions.
One lesson for UK investors could be the obvious: diversifica- tion mitigates risk, even in presumable risk-free fixed income assets. The dominance of British pension funds in the gilt mar- ket added to a vicious circle, where sales further depressed the value of those assets, leading to further margin calls. Another factor was currency risk. The widespread sale of gilts added to the pressure on the pound, which dropped from 1.15 to 1.08 against the dollar throughout October. This in turn added to the scale of the LDI crisis. Dutch investors did not face this problem due to being a part of the eurozone. The LDI crunch in both countries illustrates the challenges of measuring the present value of liabilities based on long-dated gilt yields. Pension funds such as ABP have booked relatively solid profits for years but struggled with ever mounting liabilities. They are now facing a paradoxical situation where they book dramatic losses on their investment returns and still increase payments to members by nearly 12%.
Systemic risks to the banking sector In addition to causing liquidity risks, derivatives can also rep- resent a systemic risk. A European Central Bank (ECB) survey demonstrated that nearly a third of European investment funds who use derivatives do not hold enough cash reserves to meet margin calls. This raises the risk of investors selling liquid assets with detrimental effects on overall market liquidity. If pension funds fail to meet their margin calls and have to close their hedging position, the banks that have issued the derivatives would be faced with the losses.
This is arguably the main reason why the Bank of England intervened in October. Its mandate is not to protect DB schemes’ investment returns, but that of the financial sector. What is at stake is not just the health of individual pension funds, but, in an extreme case, that of the financial sector.
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