Interest hedge still 'crucial' for increasing chances of indexation – DNB

A survey by the Dutch pensions regulator (DNB) to assess the impact of the new financial assessment framework (nFTK) has concluded that hedging interest risk is still a vital way for pension funds to meet their indexation targets. 

Analysis of several scenarios showed that extensive interest cover lessened the likelihood of schemes having to make unconditional rights cuts.

“However, the potential for indexation could be increased by reducing the interest hedge,” DNB said, adding that the nFTK would enhance this effect.

The regulator launched the survey after Parliament approved a motion tabled by Roos Vermeij, an MP for the labour party PvdA, who questioned whether interest hedges under the nFTK might cause problems for Dutch schemes in the event that interest rates increased together with inflation. 

DNB acknowledged that interest cover could jeopardise indexation, as the hedge could reduce the potential for inflation compensation.

It also conceded that, in an improving economy, an extensive hedge would decrease the chance of both rights cuts and indexation.

This was also the case for the regulator’s stagflation scenario.

DNB argued that, given the current low-interest environment, considerable interest risk remained, even if the economy weakened further. 

“As a consequence,” it said, “even a limited rate decrease could impact negatively on coverage ratio and may trigger the need for rights cuts.”

The regulator went on to argue that the nFTK would have a “stabilising effect”, likely to reduce the need for addressing volatility in pension funds’ coverage through an interest hedge.

“Moreover,” it added, “the nFTK has reduced the need to take tough measures, such as large rights discounts or premium increases, over the short term.”

It said Dutch pension funds must seek a balance between their own recovery potential and the need to protect against downward risks.

During this process, schemes must consider the available “steering” mechanisms, their own financial positions and the risk approach agreed between companies and their workers.