Back in 2012, the world’s best-managed pension market was thrown a lifeline by the Danish government to help contain liabilities. That was when interest rates were still positive.So what is this all about? In a nutshell, the persistence of negative rates in Europe are wreaking havoc on large pensions there as they struggle to cope with inflated liabilities as regulations force them to de-risking simultaneously, exacerbating the problem.
Seven years later, with rates now well below zero, even Denmark’s $440 billion pension system says the environment has become so punishing that it may be time for a change in European rules.
Henrik Munck, a senior consultant at Insurance & Pension Denmark, an umbrella organization, says the way liabilities are currently calculated “could cause a negative spiral” that forces funds to keep buying low-risk assets, drive yields lower and the value of liabilities even higher.
The warning comes as pension firms across Europe struggle to generate the returns they need to cover their growing obligations. Profitability remains under pressure despite steps to switch customers to products with lower or no guarantees, according to supervisors. In Denmark, some funds saddled with legacy policies guaranteeing returns as high as 4.5% have had to use equity to meet their obligations.
To calculate liabilities, pension firms use a complex mathematical formula constructed by the European Insurance and Occupational Pensions Authority (EIOPA). The formula is intended to shield funds from erratic market swings that artificially inflate or hollow out balance sheets. But with negative rates more entrenched, there are signs the EIOPA curve, as it’s called, may not be working as intended.
“When pension funds across Europe de-risk simultaneously, it may actually become pro-cyclical: it increases the price movements, and it could result in yet more downward pressure on the EIOPA yield curve, exacerbating the problem,” Munck said.
The curve is comprised of several elements. Its backbone -- the euro interest-rate swap curve -- has sunk since its implementation about four years ago, driving up the value of liabilities.
Sinking Swap Rates
The European Commission has started reviewing the regulatory framework around insurers -- Solvency II -- with a view to proposing improvements by the end of next year. Insurance Europe, an industry group, is urging the commission to address the curve in its evaluations.
In the meantime, pension funds have been coping by buying up riskier assets. The Dutch, ranked with Denmark as the world’s best performing pension providers by Mercer, have complained to the European Central Bank about the fallout on the industry.
And Then...
And then there’s the headache of what’s called the volatility adjustment (VA), which is set on a country-by-country basis and is designed to cushion the impact of erratic markets. According to Bloomberg Intelligence senior analyst Charles Graham, there’s “widespread” agreement that VA is “flawed.”
“It is something that EIOPA is considering recommending changing, but the challenge is still what to replace it with, or how to fine tune it,” Graham said.
Earlier this year, EIOPA unexpectedly slashed Denmark’s VA to roughly a third its previous level, causing considerable alarm in the industry.
According to Anders Damgaard, the chief financial officer of Denmark’s biggest commercial pension fund, PFA, which has about $100 billion in assets, EIPOA’s reason for the adjustment made sense:
PFA, like many Danish pension funds, started scaling back guaranteed products for retirees many years ago. That’s given it a buffer to help absorb some of the shock of growing liabilities. But not everyone’s as well prepared. “If the discount curve is more volatile and you can’t hedge it, you can -- if you don’t have enough capital -- be forced to lower risk on the more hedgeable space, to compensate,” Damgaard said.
Olav Jones, deputy director general of Insurance Europe, says the pension industry “does not see any need to change the way the risk-free curve is generated, but there is a need to improve how the VA is generated.” Right now, it’s “generally too low and generally leads to liabilities that are inflated” and creates artificial volatility in insurers’ balance sheets, he said.
In Denmark, where interest rates have been below zero longer than anywhere else, regulators are increasingly worried that pension funds are shifting more risk over to their customers. In August, the head of the Danish financial regulator said there are signs that retail investors are being forced to accept more risk than they understand.
In Denmark, some pension funds saddled with legacy policies guaranteeing returns as high as 4.5% have had to use equity to meet their obligations.
Go back to read my recent comment on how Denmark's ATP surged 27% in the first half of 2019. In the update to that comment, I received some important feedback:
Jim Keohane, President & CEO of HOOPP, was kind enough to share this with me on ATP:I agree, ATP is a well-run organization but in that comment I also stated: "...not sure if the Danes went overboard in their pension regulations like the Dutch but it's clear that they both have great pension systems which are a bit too aggressively regulated (in my humble opinion). And quite often, more regulations aren't good for pensions, especially when they are forced to do wonky things, like buy negative-yielding bonds.""I know they had a very high return which has to do with how they manage their liability hedge portfolio. Their liabilities are different than a regular pension plan. Every Danish working citizen makes an annual contribution. They take 80% of that contribution and hedge it forward in the interest rate swap market and based on the yield they get on the swap they promise a future cash flow stream. So on the asset side of the balance sheet their entire liability hedge portfolio is long term swaps. Based on the move to negative rates in Europe they would have a huge gain on the swaps - hence the high return, but the present value of the liabilities would also go up by a similar amount so there is probably no change in their funded ratio. The asset return is only half the picture."Jim added this: "I would also add that it is a good thing that they run a liability matched portfolio otherwise they would have gotten killed. It is a very well-run organization."
Another explanation for ATP's record performance was provided to me by Marc-André Soublière, Senior VP Fixed Income and Derivatives at Air Canada Pension Fund:"Another explanation is 30 bps move they made on 30 yr swap spreads! 30 year swaps spreads not swaps. They could have bought 30 yr German bonds, or futures. The spread between both was over 50 bps in January. To tie this in with what Jim Keohane wrote. If they discount their liabilities with a swap rate then there is no mismatch. However, in Canada, most liabilities are discounted using AA corporate yield. Using swaps to get your duration creates a mismatch or a basis risk. I am not familiar with ATP's LDI strategy...."
Regulations forcing pensions to de-risk at the same time, forcing them to effectively buy more negative-yielding (SAFE!!) sovereign bonds, which in turn drives yields lower and liabilities much higher. This is how overly-tight regulations lead to negative feedback loops.
The European Insurance and Occupational Pensions Authority (EIOPA) just published its monthly published technical information for Solvency II on the relevant risk free interest rate term structures (RFR) with reference to the end of September 2019.
This RFR information has been calculated on the basis of the last updated documents published on EIOPA's website. All the documents are available here.
Earlier this year, EIOPA unexpectedly slashed Denmark’s volatility adjustment (VA) to roughly a third its previous level, causing considerable alarm in the industry.
Anders Daamgard, CFO of Denmark's PFA, is right, the new VA incorporates call options that let Danish borrowers buy back the bonds that fund their mortgages, but with interest rates at unprecedented lows, a record number of borrowers are now taking advantage of those call options to refinance their mortgages.
And Damgaard says the way EIOPA calculates the volatility adjustment means the very device that’s intended to mute market swings has itself become more volatile. Worse, because it’s “an artificial number,” pension funds can’t hedge it, he says:
“That’s really where the main challenge is for us,” Damgaard said. “We have an unhedgeable component of the yield curve -- which is actually active on the entire yield curve -- and you can’t hedge it, which means that the balance sheet posts are very volatile.”This has the makings of a structural European pension mess, one that EIOPA better make sure doesn't get worse leading to more volatile swings on liabilities and more "de-risking" at negative-yielding rates.
And keep in mind, many European pensions are keenly aware of this problem which is why they're snapping up long-dated Treasuries but what happens if those yields go negative too?
Luckily, we're not there yet but this comment serves to open our eyes to how pension regulations can exacerbate an ongoing problem with negative-yielding sovereign debt and wreak havoc on pensions.
Below, Davide Serra, chief executive officer at Algebris Investments, discusses bond market concerns amid signs of slowing growth in the US and German economies. He speaks on "Bloomberg Surveillance."
Serra thinks there are bond market bubbles arising from QE and negative interest rates. He's not alone, Louis-Vincent Gave also came out recently stating"the bond market is the biggest bubble of our lifetime."
You can read Gave's views here but I must warn you, I'm not in agreement and think all these market pundits claiming there's a bond market bubble will be proven disastrously wrong, especially if deflation strikes the United States. That's what central banks are fighting tooth and nail against but it's been a tough battle as these structural issues are not going away, they're only getting worse.