The financial position of the Dutch pension sector is vulnerable to financial market shocks. The impact on the Dutch economy is apparent from the results published today of the stress test conducted among European pension administrators by EIOPA, the European supervisory authority for insurers and pension funds. A highly adverse stress scenario, which involves sharp equity price declines and rapidly widening spreads, shows that the year-on-year impact of a financial market shock on the Dutch economy through the pension funds is limited, but will be felt for many years.
Pension benefit curtailments will slowly filter through to consumption
A new feature in the European pension stress test is a more detailed cash flow analysis, which is something we have pressed for together with the of the Dutch Pension Funds. Cash flows provide insight into annual amounts paid to individual pension fund members over the next 100 years, both under the baseline scenario and under the stress scenario, taking account of any inflation adjustments and benefit curtailments.
Under the stress scenario, pension funds suffer capital losses, forcing them to refrain from making inflation adjustments and cut pension rights. Consumers will feel the impact of these two measures at the time of payment of their pension benefits. This means the impact is not immediately reflected in full in households’ disposable income, but will be felt gradually as increasing numbers of pension fund members start receiving their lower pension benefits. Accordingly, the stress scenario features gradually diminishing cash flows from pension funds to households.
The effects of the lower cash flows were used to calculate the impact of the stress scenario on the Dutch economy through the pension sector. As lower cash flows weigh down on disposable income, households consume less, which filters through into the economy and results in a lower gross domestic product (GDP).
Figure 1 shows the outcome of this simulation. Firstly, the impact is gradually reflected in annual consumer spending and economic activity. As the years progress, the benefit curtailments spread over time make themselves felt in terms of members’ disposable income. After a number of years, this income loss results in a consumer spending level that is 4% lower relative to the baseline scenario. This depresses GDP by 0.5%.
Secondly, the impact of the stress test’s once-only shock has a lasting impact on the economy through the pension sector. This also illustrates how capital losses incurred by Dutch pension funds due to the 2008 financial crisis have acted as a drag on economic recovery in the Netherlands for many years. The Netherlands occupies a special place in Europe in this respect, due to its relatively large pension sector.
Dutch pension assets appear to be vulnerable under a major shock
The stress test subjected the institutions to a shock designed in tandem with the European Systemic Risk Board (ESRB). The test simulated a significant decline in variable-yield investments such as equities and real estate, together with slightly higher interest rates and simultaneously widening risk spreads. Investments in assets that qualify as safe haven investments, such as specific government bonds, were assumed to maintain that status under the stress scenario.
In this scenario, the capital positions of Dutch pension funds are severely hit. This impact is due to the large portfolio of variable-yield investments they maintain to fund their indexation ambition. On average, the funding ratio of participating pension funds drops by around 23 percentage points, which roughly equals their required own funds. This means that the pension funds could have absorbed the impact of the shock almost fully using their buffers, had they maintained the required own funds. With the buffer lacking and the assumed funding ratio averaging 99%, the shock forces them to apply immediate benefit curtailments.
The stress scenario sees assets of the Dutch premium pension institutions (PPIs) drop by nearly 30%, primarily due to the equity shock. PPIs tend to allocate a large proportion of their investments to variable-yield assets on account of the relatively high share of young pension scheme members they represent. The stress test also considered the impact of the stress scenario on replacement ratios (excluding state pensions). The outcomes showed a large variety because PPIs differ widely.
Stress test participants represent 60% of the Dutch pension sector
The stress test looks at the figures at year-end 2018. Combined, the Dutch pension funds that participated represent over 60% of Dutch pension scheme members and assets under management under defined benefit schemes. This sector totalled EUR 1,330 billion at year-end 2018. Unlike previous EIOPA stress tests, the identities of the participating pension funds were disclosed. In the Netherlands, they were ABP, PFZW, PME, PMT, Bouw, Detailhandel and ABN Amro. The part of stress test relating to defined contribution schemes represents almost 60% of all Dutch assets under management and pension scheme members under defined contribution schemes. This sector totalled EUR 14 billion at year-end 2018. The Dutch institutions participating in this part of the stress test were all PPIs. They are: Aegon Capital, BeFrank, ABN AMRO PPI, Brand New Day PPI, Rabo PGGM PPI, LifeSight and Zwitserleven PPI. We have discussed the test results with the participating pension funds and PPIs.
