Vulnerability is due to two-track objective
The stress test has shown that the two-track objective of Dutch pension funds' investment policies – offering certainty in nominal terms and striving to provide price indexation – may have a major impact on capital positions. This is even more the case given that pension funds have insufficient buffers to absorb shocks.
Adverse scenario in the EIOPA stress test
The purpose of the exercise is to test the resilience of pension funds under an adverse scenario and identify possible systemic risks. Unlike the first stress test in 2015, the current test also considered the degree to which shocks affecting the pensions sector feed through to the real economy. An exploratory cash flow analysis was also performed to consider how pension funds will be able to meet their commitments over time, based on projected cash flows.
The stress test looks at the figures at year-end 2016. Combined, the Dutch pension funds that participated represent over 50% of Dutch pension scheme members and assets under management. The identities of the participating pension funds are not disclosed. DNB has discussed the test results with the relevant pension funds.
The stress test subjected the pension funds to a double hit scenario 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 lower interest rates and rising risk spreads. Additionally, investments in assets that used to be qualified as safe haven investments, such as specific government bonds, were assumed to have lost part of that status.
In this stress scenario, Dutch pension funds were hit relatively severely. On average, the funding ratio of participating pension funds dropped by around 24 percentage points, which roughly equals their required risk-weighted buffer, i.e. their required own funds. This impact is due to the relatively large portfolio of variable-yield investments they maintain to fund their indexation ambition, whereas their interest risks are hedged only in part.
Stress test identifies potential systemic risks
The stress test has shown that the financial systemic risks originating in the pension sector appear to be limited and linked mainly to pension funds' investment behaviour. The Dutch pension funds indicated that, on average, they tend to make additional variable-yield investments following a shock to rebalance their investment mix. This type of investment behaviour has a stabilising effect on the financial system.
By contrast, holding risk positions due to the two-track objective when buffers are insufficient makes pension funds highly vulnerable in a stress scenario. As regards the effects feeding through to the real economy, those of benefit curtailments and mandatory sponsor (employer) support, particularly abroad, could potentially be major. Specifically in the Dutch context, they can be mitigated by spreading the required measures over time using the recovery plan mechanism.
Pension funds must communicate clearly about risks
The results of the stress test show that pension funds are sensitive to extreme but not unimaginable financial market scenarios. It is important that pension funds tell their members correctly, clearly and well-balanced about the potential consequences.
European pension schemes are difficult to compare
There are large differences between pension systems across Europe. For example, national buffer requirements differ, valuation principles such as the applicable actuarial interest rate vary, and funding deficits are handled differently. EIOPA has developed a framework of uniform valuation rules to increase the comparability of the impact of a stress scenario. It has analysed the stress test results on the basis of both national supervision frameworks and the uniform valuation framework.
Under many national frameworks – but not under the Dutch framework – risks are implied and less visible. Valuation rules are not market-based and often include a higher actuarial interest rate, while a risk-based buffer as used in the Netherlands does not apply. Based on the national frameworks, therefore, the impact of the stress test differs widely among countries and is not very large for many of them. Conversely, application of the uniform valuation framework results in a more evenly spread impact and increases that impact for many countries. For the Netherlands, however, the stress scenario has virtually the same impact under both frameworks, as Dutch valuation rules are already based on market values.