The UFR and the other elements of the September Pension Package will be incorporated into revisions of the Pension Act and the Financial Assessment Framework, which are expected to come into force in 2014. Ultimately, these efforts should contribute to a pension system that is financially more resilient, enjoys broad popular support and helps to allay widespread concerns over the costs and adequacy of people's pension reserves.
In a more technical vein, pension funds use expected future interest rates, represented by the interest rate curve, to calculate the current value of their future commitments to their members. This is referred to as the funds' technical reserves. The so-called risk-free rate used to compile the interest rate curve, is well suited to the current pension contract, in which nominal benefits are unconditional and curtailment is a fund's measure of last resort to attain sufficient cover for its future liabilities. DNB publishes an monthly table for the risk-free rate, indicating which rates should be used to value future benefits with different maturities.
The criticism levelled against the interest rate curve used so far concentrated on the strong volatility of the current market rate and on the reliability of the market information used to determine rates at very long maturities. The UFR addresses both these core issues and is, moreover, in line with policy intentions in the context of the Solvency II framework for insurers (about which DNB made announcements on 2 July last).
How does the UFR approach work?
The UFR approach is a method whereby the interest rate for very long maturities gradually moves to a preagreed level. The UFR for the euro area has been fixed at 4.2%, in line with the UFR parameter in the Solvency II Directive for insurers, and is based on a 2% long-term inflation expectation and a 2.2% long-term expectation for the short real interest rate. Pension funds must use the UFR to derive the current value of ('to discount') their future pension commitments. At present, this derived rate is significantly below 4.2%. According to the UFR curve at end-September, for instance, the discount rate for liabilities with a 60 year maturity was 3.3%.
In sufficiently liquid markets, the risk-free interest curve can be derived from market information. Due to the current shortage of active market parties, however, market information about interest rates beyond a certain maturity is less reliable. The longest maturity at which the market is fully functional is referred to as the last liquid point (LLP). For present purposes the LLP is at 20 years.
For maturities of up to 20 years, therefore, interest rates are derived entirely from market information. For maturities exceeding 20 years, market rates play a gradually decreasing role in the calculation of the actuarial rate. In this respect, the calculation method differs from the method for insurers proposed in Solvency II, which disregards market information for maturities beyond 20 years. As maturities grow longer, the weight of the UFR increases. Meanwhile, the use of three-month average rates used by pension funds since end-2011 is continued.
In designing its UFR approach, DNB has addressed the practical problems that pension funds may face in hedging interest rate risk due to possible market disruptions around the last liquid point. Implementation and administrative costs of the pension funds for hedging the interest rate risk are limited by this adjustment.
What are the effects of this calculation method?
Application of the UFR impacts the stability and the level of the actuarial rate of interest. As the actuarial rate of interest for obligations with long maturities becomes stabler, the funding ratios become less volatile. Consequently, pension funds' policy decisions become less dependent on volatile daily rates, relaxing the debate on possible pension curtailments.
Application of the UFR also means that in present market conditions, the current discount rates for maturities beyond the last liquid point go up. While this results in a redistribution from young to old, this shift is partly offset by other elements in the September Pension Package, making it a balanced whole. Should the market rate come to exceed the UFR at some point in the future, then the actuarial rate will drop below the market rate. Consequently, we see that the UFR dampens the impact of low and high interest rates on the valuation of pension commitments.