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Moving from DB to DC: Rotation in the low-risk fixed income space

Historically Dutch pension funds have a large exposure to low risk government bonds. But as the Dutch pension system transforms from DB to DC the asset allocation within the fixed income space is likely to change. Should pension funds prepare for a rotation towards higher yielding fixed income? What are the dilemmas and considerations involved, and what are some of the instruments pension funds might look at?

Pensioen Pro’s partner roundtable began by asking participants what asset allocation will look like under the new WTP regime.

For APG, asset allocation strategist Cees Harm van den Berg said that different clients have different requirements. “The financial framework is most important,” he explained. “How and how much do you hedge promised protection returns? How much excess return has been promised? That divides bonds and equities. It is the big first decision.”

So far only one APG client has decided on a strategic asset allocation under the new contract. But all of them have chosen the solidarity and indirect method for protecting returns.

When asked why, Van den Berg answered that solidarity is one of the most important factors in pensions and the SPR has benefits in terms of risk versus return. Also the SPR is the closest to the current DB arrangement.

Karin Roeloffs, head of fiduciary at Aegon Asset Management, explained that clients are starting to design the lifecycle investment strategies, with different mixes of matching and return parts through time for younger and older participants. “In general, we see that pension plans can take more risk than in the current portfolio,” she said.

“Apart from shifting partially from matching to return, this is also the moment to re-assess the composition of the return-seeking portfolio and possibly increase the risk profile there. ”Philip-Jan Looijen, vice-president fiduciary management at Goldman Sachs Asset Management, agreed that the matching part will be smaller than currently. “Duration is shorter because we are no longer hedging for the whole population,” he said. “Shorter duration opens up opportunities, for example in corporate bonds. Under FTK, the matching portfolio was more important than under the new contract.”

Hedging: direct or indirect?

Looijen suggested there are three building blocks to strategic asset allocation: hedging, return and spread. His question for the Pensioen Pro panel was whether anyone was moving to direct interest-rate hedging as part of SPR? No one was.

Reinout van Tuyll, strategist for Achmea Investment Management, said that some clients were concerned about the problems that indirect hedging might bring. The issue is that additional risk stemming from the matching portfolio will flow into the excess return, to which the young cohort is mostly exposed.

For indirect hedging, van Tuyll suggested that the risk portfolio should be fully funded and correspond to the sum of the risk exposures of the participants. The remaining part of the assets will then be allocated to the matching portfolio that uses swaps to follow the protection return as closely as possible. Without such a strict bottom-up approach, younger cohorts could possibly end up taking more risk than desired.

Marèn Klap, fixed income portfolio manager at asr, said his organisation believes the indirect method will work well. “You will want to take some risks in the matching portfolio.”

Complexity guaranteed

For Van Lanschot Kempen’s fiduciary, Marco van Rijn, the solidary contract conceptually is one portfolio where segmentation is applied for practical purposes of managing the portfolio.

This contrasts with the flexible contract where capital of participants explicitly relates to segmented portfolios. Peter Kolthof, CIO for Pensioenfonds PGB, said that asset allocation was not his organisation’s biggest struggle. With 16 industry-wide funds, of which seven are compulsory and nine voluntary, there are 450 clients with different arrangements all transitioning. Putting all those moving parts into one transition plan is PGB’s biggest challenge. “Complexity is there from the start,” said Kolthof.

Some DB arrangements under the existing FTK regime will continue after 2027. PGB is already running DC. To make sure clients’ needs are met, PGB is conducting a survey of their risk appetite.

Klap said that in spite of all the new challenges, asset allocation is already a result of risk optimisation. He said it would be strange if that changed a lot under the new regime.

Looijen reckoned there was already a significant shift to 30% bonds/70% equities by his clients that are first movers into the new pension system. He said this was driven by the unshackling of FTK constraints, including freedom to hedge inflation. He envisaged private debt becoming more interesting in the return-seeking block.

“This is a more fundamental review of asset allocation than previous years,” noted Roeloffs. “It looks more like a clean sheet of paper.” But she agreed with Klap that as most pension funds are well diversified already, it is more a eassessment of the strategic weights rather than adding new asset classes.

Van den Berg said he was interested in how the panel views allocation to more illiquid securities and plitting the portfolios. He gave credit as an example: do Investment Grade and High Yield get separated – IG into matching and HY more return?

Van Tuyll said that there was room for credit as both matching asset and diversifier. “You need to gear between both portfolios. As pensioners have far more capital, they will be exposed to having larger drawdowns.”

Covering Your Bets

The roundtable then introduced the topic of Covered Bonds. Given the very high credit quality, Van Rijn could see a place for them in the matching portfolio to offset negative spreads that would flow to the excess returns. However, the typical durations of these bonds may not allow for sizeable positions.

Interestingly, with Covered Bonds investors can in effect capture temporarily wider spreads due to supply pressure

Henrik Stille, portfolio manager at Nordea, said that Covered Bonds were a useful asset strategy source versus swaps because they were much
more correlated to swaps than government bonds. He added there was not much difference in Covered Bonds by origination because their ultimate audience is the eurozone. “That is what all these issuing countries target, regardless of the underlying.”

“The Covered Bond market has been growing outside Europe for the last ten years,” said Stille. Canada is now the ninth largest market in the world.
Australia, New Zealand and Singapore all issue, while Japan is set to grow.

Stille said that what was interesting about Covered Bonds was the relative value opportunities, not related to the credit element but technical factors on the side of the bank issuer. Because this type of debt demonstrates strong mean reversion power, those relative value opportunities came and went. In effect, investors could capture temporarily wider spreads due to supply pressure.

Van den Berg compared Covered Bonds to Dutch mortgages in terms of cashflow matching. He warned that pension funds need to limit the mismatch coming out of return. Although the Dutch Central Bank (DNB) is yet to pronounce on how big the mismatch can be, APG is looking into reporting, among others, the spread effects in the mismatch (of, for example, mortgages, covered bonds and other assets) on a month-by-month basis.

Achmea has modelled shock scenarios and estimates a double hit for equities and bonds similar to the Great Financial Crisis could result in losses in excess of 8%.

Looijen argued that is the reason for modelling and optimising risk: “There will be lots of tracking error in the matching portfolio; so optimise the total portfolio then apportion returns.”

Klap said he was not optimistic about the role of Covered Bonds in the new regime. He suggested a duration of four years for the index, with a spread over government bonds of 30 basis points (bps) is attractive as a stand-alone; but in an asset optimization, covered bonds will face a lot of competition from higher-yielding assets with similar duration and there are very few covered bonds with longer maturities. Stille replied that the spread was higher than that, although the really compelling reason to hold Covered Bonds was not their return per se but their Information Ratio. He
claimed this was higher than for mortgages, swaps or government bonds.

He added that the Covered Bonds market will grow at the long end of the curve. “The political and regulatory system has preferred them as the instrument to fund mortgages,” noted Stille. “They are well known in the Netherlands but banks elsewhere want to do the same on long-dated terms.”

Van Rijn said that for return-seeking objectives, Covered Bond returns are still too low in spite of the Information Ratio: “In the return-seeking bucket they have to compete with mortgages and Investment Grade at the short-end.”

He envisaged some investment opportunities for matching, but further out.

“You don’t pay pensions out of Information Ratios,” said Looijen. “Covered Bonds may be more efficient than swaps but there is a lot of competition, e.g. Green bonds and social bonds.”

Stille then gave the sustainability angle on Covered Bonds. Because of the mortgage-backing, they connect to a large part of housing finance. “There are big plans in Europe to renovate swathes of housing,” he noted.

But Roeloffs asked whether these instruments were explicit on use of proceeds. Stille replied that, currently, they are not but predicted that will change in a few years. “Banks will be forced to offer lower returns on mortgages that are energy-efficient,” he said. “The problem so far is that the banks don’t have the data.”

Van Rijn noted Covered Bonds offered double recourse on both the pool of assets and issuer. But he wondered whether bondholders backed with mortgages in relatively exotic geographies may indirectly be exposed to currency risk when the issuer failed.

The answer from Stille was no. He explained that the underlying mortgages are swapped in the covered pool into euros.

Communication is key

The roundtable then looked at the very important issue of communication. Roeloffs’ advice was to look at negative scenarios, even when the sun is shining. “Communicate ahead of time to younger participants, who are taking on a lot of risk,” she said.

“The messaging must be consistent,” advised Van Rijn. “If there are sources of excess returns that surprise participants, then this is not the case.”

“Communication is a huge part of the new system,” said Klap. “We must make improvements, such as making more explicit to participants that pensions are not guaranteed.”

“We need more retail than institutional communication,” agreed Kolthof.

“Best to underperform and overdeliver,” said Klap. “Participants think about what they are going to get and they know their contribution. Let us say that is 30% of the ultimate total. But they don’t think about the other 70% that comes from the sponsor contributions and investment growth.”

Cost of living

The roundtable then discussed how investments support pension plan participants when the cost of living is rising
fast. Van den Berg said that if inflation protection is required, then direct matching is the way to go. “Indirect matching via inflation-linked bonds is useless,” he claimed. “Indirect hedging is calculated on a nominal basis. All other effects flow into the excess return but young people don’t care for one year’s difference in inflation shocks.”

Because of mortgage-backing Covered Bonds are linked to housing finance – and a good deal of Europe’s housing stock is coming up for renovation

Klap said that it would be nice for older people to have some protection from sudden inflation spikes. To which, van den Berg replied that FPR or direct matching is required.

He added that APG’s intention is to set a boundary on the asset return or volatility of the return. “Constraining a return contribution helps to manage the mismatch risk,” he said. “We believe this is what the DNB wants.”


Klap then raised the importance of liquidity. “So far everyone has agreed with the need to hedge. The fewer derivatives, the better,” he said. “But we still hedge using a significant amount of swaps. If interest rates were to increase another 2% – will it constrain the moves pension funds are making? How to deal with liquidity in our asset allocation?”

Van den Berg said that under the new contract, APG can do with fewer govvies. That means fewer liquids for the swaps portfolio. But at shorter duration APG was doing a lot with replication so that it is able to make up portfolio losses.

Kolthof warned that if a pension fund’s building blocks were too specific, then it isn’t possible to adjust asset allocation if needed. “So we need liquidity,” he said.

Stille pointed out that only the sovereign debt market is more liquid than Covered Bonds.

He noted that in the two months at the global start of the Covid pandemic in March 2020, Covered Bonds markets traded well every day.

“If we can use them for collateral purposes, that would be great,” concluded van den Berg.

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