Dutch DC frontrunners reform their interest rate hedges

Three Dutch pension funds have now moved to the new defined contribution (DC) pension system, a move that has had major consequences for the way they hedge their interest rate risk.

The funds for shipping pilots (Stichting Beroepspensioenfonds Loodsen), the sector fund for disabled workers (PWRI), and the staff pension fund of pension provider APG switched to the new pension system on 1 January. The three frontrunner funds, like most other pension funds, increased their interest rate hedging substantially prior to the transition to protect their funding ratios.

The fund for shipping pilots and APG’s staff pension fund even hedged their interest rate risk completely, while PWRI upped its hedge to 65%. In the new system, all three funds have reduced their hedges.

At APG’s staff fund, the hedge will be “more or less the same as the level used before the interest rate hedge was increased in September 2023 to protect the funding ratio,” according to the fund’s president Tinka den Arend. At the time, this hedge stood at 65% of liabilities.

The shipping pilots fund will reduce its hedge from 100% to around 55% in the new system.

At PWRI, said the fund’s president Margreet Teunissen, hedging will be reduced to “around 45%”.

Cohorts

However, a reduction of the overall hedging level is not the only thing that’s changing in the new system. In DC, interest rate risk is no longer hedged at fund level, but by age cohort.

In practice, this means that the interest rate risk of younger members of the three funds is no longer hedged at all, while the hedge for pensioners is set at 100%. In the shipping pilots fund, for example, the hedge is 0% until members reach the age of 50.

“After that, it increases in steps to 100% at 60, the fund’s retirement age,” said the fund’s director Rajesh Grobbe. “Adding everything up, you then end up with an overall hedge of about 55%, because we have a relatively large number of retired members,” he explained.

Interest rate hedging at the APG fund has a similar structure. One consequence of this is that interest rate risk will be hedged for shorter maturities than at present. Whereas the average duration of a pension fund’s liabilities in defined benefit (DB) was around 20 years, this will be a lot shorter in DC.

Before or after the transition

PWRI, APG and the shipping pilots fund all move to their new DC arrangements with their ‘old’ interest rate hedging still in place. After all, they did not want to risk a sudden drop in interest rates that would drag down their funding ratios.

The APG fund already implemented its new hedging policy in the first week of January, along with the other adjustments to its investment policy. The shipping pilots fund implemented its new policy immediately on 2 January.

“At 11:10 in the morning, I already received a confirmation from our fiduciary manager BlackRock that the interest rate hedge was now in line with our new policy,” Grobbe said.

PWRI prefers to wait for a “suitable moment” to exchange long-term swaps for short-term ones, said chair Margreet Teunissen.

Risk

However, there is a risk in delaying implementation of the new interest rate hedging policy, said Martijn Euverman of Sprenkels, a pension consultancy.

“If interest rates suddenly rise dramatically in January, there is a huge mismatch that has to eventually be paid for by younger participants. Funds can therefore also opt to adjust the hedge to the new policy before or at the latest just after 1 January,” he explained.

But this can also come at a cost, because there is little trading in the first week of January, leading to higher transaction costs.

There is also the risk of a sell-off of long-term debt securities, said Euverman. “If everyone switches at the same time, that will affect the market and long-term interest rates will go up. I do have some concerns about that,” he added.

This problem is particularly acute in 2026 and 2027, when by far the majority of pension assets will be moved.

“There is therefore a case to make for switching on, say, 1 July instead of on 1 January,” Euverman said. This year, however, the market was “normal” in the first week of January, according to Grobbe.

Euverman’s warning is not new: for years, pension funds have been urged to anticipate the fact that swaps and bonds with longer maturities will be less necessary in the new system.

This article was first published on Pensioen Pro, IPE’s Dutch sister publication.