Last year, the Netherlands saw a drama which might seem familiar to UK investors. Within the first six months of 2022, Dutch pension funds sold €88bn (£77.1bn) in assets, this amounts to nearly 5% of their total assets, according to Dutch central bank DNB. Assets managed by Dutch pension funds dropped to €1.4trn (£1,2trn), from €1.8trn (£1.5trn) last year.
The reason for these outflows is the growing costs of collateral calls on DB scheme’s derivative positions. Amid rising interest rates, these derivatives turned out to be an expensive hedge to hold. The resemblance between the Dutch and British LDI 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 common. Compared to other European pensions markets, the Netherlands still has a significant defined benefit sector. And with €1.4trn in pensions assets, they account for more than half of all European pension assets. Trouble with Dutch pensions could therefore have broader ramifications for European financial markets.
Just like in the UK, Dutch schemes measure the present value of their liabilities based on long-dated government yields. This means that even marginal changes in interest rates can have significant consequences.
Dutch pension funds also use LDI-type hedging strategies involving interest and inflation swaps to mitigate the effects of changes in interest rates and inflation.
This strategy worked in a low interest environment, when schemes managed to mitigate the effects of falling investment returns on fixed income. ABP, a €460bn (£403bn) public sector pension fund, booked up to double-digit profits on its derivative positions prior to the crisis.
Dutch pension funds significantly expanded their derivative position and so accounted for around 10% of total assets last year, according to the central bank.
But this hedge turned out to be rather expensive in 2022. Just like in the UK, schemes benefited from rising interest rates which led to a dramatic reduction of the present value of their liabilities. At the same time, schemes faced billions in collateral calls which pushed them over the limit of their cash reserves. In some cases, schemes were forced to sell other liquid assets.
Central bank data shows that schemes were mostly selling investment fund units, which reported €57m (£49.9m) in outflows, followed by €25m (£21.9m) in equities and €8m (£7m) in outflows from money market funds.
The impact on their portfolios was rather dramatic and added to an already difficult year. ABP reported €40bn (£35bn) in losses on its fixed income portfolio alone with long-dated bonds loosing almost a third of their value.
In addition, ABP 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).The picture is equally gloomy for the Fonds Zorg en Welzijn (PFZW), the pension fund for the care sector. It booked losses of more than 5%, leading to a year-on-year reduction of its assets to €217bn, from €288.8bn.
But the overall funding position of defined benefit 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 entirely due to the impact of rising interest rates on the calculation of the present value of scheme’s liabilities. Last year, ABP’s liabilities dropped from €502bn (£439.6bn) to €370bn (£323.9bn) and PFZW’s from €260bn (£227.6bn) to €189.5bn (£165.9bn).
This is again might sound familiar to UK readers. USS, for example, reported its first surplus in June 2022, despite a sharp fall in the value of its assets. Members of DB schemes in the UK might follow with interest that ABP has announced that its members will receive an increase of their pension of nearly 12% this year.
Differences to the UK
These similarities aside, there are also significant differences between the LDI crunch in both countries. 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 still predominantly invested in such assets.
In contrast, Dutch investors have diversified their bond portfolio across the entire European bond market. ABP’s biggest holdings, for example, are French, German and American government debt. As a result, they are less exposed to the whims of Dutch fiscal policy decisions. Which, it should be added, are also nowhere near as dramatic as that of the UK’s mini budget.
But a lesson for UK investors could be the obvious: diversification mitigates risk, even in presumable risk-free fixed income assets. The dominance of British pension funds in the UK gilt market added to a vicious circle, where sales of gilts further depressed the value of those assets, leading to further margin calls.
Dutch investors also wreaked less havoc on their domestic stock market. While they sold €25bn (£21.8bn) in equities over a relatively short time span, these were predominantly global. As a result, the Dutch AEX sank by 6% year-on-year but this was also influenced by a global dip in stock markets. In contrast, the FTSE100 dropped from 7400 to 6800 points in October alone.
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. Their derivatives are also valued based on Euribor, rather than Libor, which tends to be somewhat more volatile.
These differences meant that the Dutch LDI crunch, while detrimental to investment returns, was overall less dangerous to the health of the financial sector and received, therefore, less media coverage.
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%.
The connection between long-dated gilt yields and liabilities would have made more sense, if the fund was entirely invested in bonds and its investment returns were, therefore, linked to bonds. But it was precisely the fixed income portfolio that acted as a main contributor to ABP’s losses last year.
Systemic risks to the banking sector
In addition to causing liquidity risks for investors, derivatives can also represent a systemic risk. A European Central Bank (ECB) report demonstrated that nearly a third of European investment funds who are using derivatives hold insufficient cash reserves to meet margin calls.
The ECB also warns that the share of liquid assets in the average European investment portfolio has dropped to 30% from 35% during the past 11 years. This raises the risk of investors selling liquid assets such as money market funds on a pro-cyclical basis in so called fire sales, with detrimental effects on overall market liquidity, the ECB warns.
The most extreme scenario could be that pension funds fail to meet their margin calls and have to close their hedging position. This would mean that the counter parties, 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 the health of DB schemes’ investment returns, but that of the financial sector.
At the height of the crisis, UK’s LDI assets were valued at £1.5trn, a measure grossly accelerated by the use of leverage. The case of Archegos Capital illustrates the risks of leverage. When the $36bn (£29.1bn) investment firm defaulted on the margin calls for its derivative positions, global banks from UBS to Deutsche and Credit Suisse were faced with billions in losses. If the Bank of England had not intervened, bank losses would have been significantly worse.
From a regulatory point of view, pension funds in the UK and the Netherlands acted as “non-bank financial intermediaries” or shadow banks. British and European regulators are now saying that they are insufficiently regulated and should hold higher capital reserves if they use leverage.
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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