DNBulletin: Recovery of pension funds: improved outlook for index-linking
Due to solid returns, 2017 saw a marked improvement of pension funds' financial positions. This allows most pension funds to apply partial or even full indexation of pensions again. However, several pension funds, including some of the largest ones, did not manage to meet the minimum own funds requirement. This means that if these pension funds fail to recover in time, they will be forced to curtail pensions in 2020 or 2021. According to their recovery plans, the pension funds expect to eliminate their deficit through surplus returns on investment – as they did in previous years.
Assessment of recovery plans
Pension funds with a funding ratio below the minimum required funding ratio must submit a recovery plan to DNB, setting out how they expect to eliminate their deficit within a maximum period of ten years. We recently completed our assessment of the recovery plans of 157 pension funds. Similar to 2015 and 2016, pension funds expect to recover through surplus returns on investments. In general, contributions have a negative effect on recovery, since many pension funds actually impose lower contributions than required to purchase pension commitments.
Returns on investment for 2017 exceed expectations
Contrary to 2015 and 2016, the pension funds did manage to achieve their target returns for 2017, causing the value of their investments to rise and improving the funding ratio by an excess 1.8 percentage points above the target set in the recovery plans. Moreover, interest rates went up in 2017, causing the liabilities to go down and yielding an additional funding ratio rise of 1.3 percentage points. The pension funds are now partly back on track with the recovery plans they made in 2015, as can be seen in Figure 1. The figure shows the real increase of the funding ratio (red line) compared to the estimated increase from the 2015 recovery plans (blue line).
Major differences between pension funds
Thanks to the favourable results in 2017, the financial position of the pension funds improved across the line. There are large differences between individual pension funds, however. Over half of them are able to partially or fully apply index-linking. At the same time, most pension fund members do not benefit from this favourable trend, as they are connected to pension funds that cannot apply index-linking or that even face curtailments in 2020 or 2021 due to regulatory requirements.
Figure 2 shows the differences between the pension funds Every dot represents a pension fund, and the size of the dot indicates the size of the pension fund.
The green dots are the pension funds with a funding ratio that is above the threshold for applying full index-linking. As at 31 december 2017, these 25 pension funds with 300,000 members have sufficient own funds to apply full index-linking. The yellow dots represent the pension funds with a funding ratio that is above the threshold for partial index-linking but below that for full index-linking. By law, the funding ratio for partial index-linking has been set at 110%. These 87 pension funds with 3.4 million members can apply partial index-linking. The third category (orange dots) comprises pension funds with a funding ratio between the minimum funding ratio of 104.2% and the threshold for partial index-linking of 110%. These 46 pension funds with 2.8 million members cannot apply index-linking. But they do not have to curtail pension benefits either in 2020 or 2021. The final category, represented by the red dots, comprises the pension funds with a funding ratio below the minimum statutory level of 104.2%. This involves 47 pension funds with 10.1 million members.
Curtailments in 2020 and 2021
the latter category of pension funds may still have to apply curtailments in 2020 and 2021. Under the minimum own funds requirement, The requirement is meant to prevent pension funds in deficit from paying more in pension benefits than they reserved for a prolonged period. Pension funds that fail to meet the minimum own funds requirement (i.e. a minimum funding ratio of 104.2%) for five consecutive years, must apply curtailments to bring their funding ratio back to at least the minimum statutory level. While curtailments are irrevocable, they may be spread over several years, with a maximum of 10 years. In 2020 or 2021, this may therefore apply to those pension funds with a funding ratio that has been below 104.2% since 2015 or 2016.
Explaining the differences
There are several explanations why some funds are able to apply full index-linking, while others are facing curtailments. In addition to the pension scheme, a pension fund's investment policy, the types of investments, the level of hedging interest rate risk and the contribution level can all play a role. Under different scenarios, different choices may lead to different outcomes. Looking back, we observed the following outcomes.
Figure 3 provides an overview of the investments in terms of variable-yield securities, the level of hedging interest rate risk and the contribution funding ratio (i.e. the contribution level), broken down by category – green, yellow, orange and red.
