Luis Hernandez: Implications of the Wtp in asset management

Luis Hernandez: Implications of the Wtp in asset management

Risk Management Pension system Pensionfunds
Luis Hernandez (foto archief Probability & Partners) 980x600.jpg

By Luis Hernandez, Quantitative Risk Manager at Probability & Partners

The deadline for the transition plan for pensions under the Wtp is approaching, bringing with it numerous challenges, risks, and uncertainties. Given the complexity of the implementation, it's prudent to consider several key questions. Should we commence the transition now? Should we de-risk before diving in? Are there minor issues that could escalate post-transition?

Given the size of the Dutch pension system – approximately € 1.6 trillion in assets by 2023 – a major restructuring is likely to have significant impact on financial markets. The impact will vary depending on several factors, including the scale of the transition and the investment behaviors of new defined contribution (DC) participants. This is the key aspect of the reform changing from a defined benefit (DB) to a DC system, which seeks to provide more individualized pension options, allowing people to tailor their pensions to their own career paths and life situations. Switching from one large pension fund to multiple individual funds has several implications.

SWAP curve change

Currently, the hedges are managed as a single account for all age groups. However, Wtp restructuring will reduce alignment between hedges and liabilities (liability-duration risk). Consequently, changes in the risk profile will necessitate adjustments in strategic investment policies. This shift is likely to alter the euro swap curve, with younger cohorts holding a larger proportion of return seeking assets and fewer hedges, increasing the risk of a significant long term euro swap sell-off.

Given that most transitions will take place between 2025 and 2027, if significant pension funds opt to do so at the same time or at similar intervals, we may see a large sell-off of derivatives in a short period of time, heightening liquidity risk. This scenario could lead to broader market downturns as financial institutions and other major players sell assets to meet liquidity needs.

Funding Ratio

Pension funds must maintain a sufficient funding ratio before transitioning, otherwise transitioning will not be feasible. This can add operational pressure before transition, if the funding ratio is below acceptable levels, or if the funding ratio is high, diminishing the risk appetite to protect the funding ratio which would also add more liquidity risk after the transition when the hedge levels need to diminish.

Different cohort, different exposures

The introduction of cohorts will change the structure of the assets and liabilities. With the new structure come different exposures and risk appetites between the cohorts. After the transition, the investments will vary. Younger cohorts may prefer riskier portfolios to enhance purchasing power, whereas older cohorts should prioritize hedging and risk avoidance. An early transition would benefit younger cohorts by allowing full investment in riskier portfolios, whereas older cohorts might prefer a delayed, risk-averse shift. This divergence complicates the timing of the transition.

Increase in costs

Costs are expected to increase during and potentially after the transition. Managing individual accounts is more complex than managing one pooled DB fund if the flexible scheme is chosen, requiring more administrative resources and oversight. Also, increased frequency of transactions, such as contributions, withdrawals, and investment changes, can raise administrative and transaction costs. Finally, training and infrastructure needs will increase, because DC schemes typically require more detailed reporting and compliance checks to ensure transparency and adherence to regulatory standards.

Participants’ trust

Providing education and incentives to pension participants about the new system and its implications is crucial. Miscommunication or lack of understanding can lead to dissatisfaction or inappropriate investment decisions by participants. Participants might make suboptimal choices due to lack of financial literacy or experience in managing investments, especially in a DC environment. This could increase reputational risk. Therefore, it is important to maintain good communication and transparency.

In conclusion, to take balanced and informed decisions, a strong risk framework must be in place. Addressing risks proactively and maintaining clear communication and good transparency between pension funds, asset managers, and participants will diminish future complications. Also, it is recommended to have a detailed transition plan in which the phasing for all institutions is gradual. This can be coordinated by DNB. If a considerable number of pension funds plan to transition on the same date, then market impact will become a bottle neck. Starting as soon as possible with the transition will avoid stress in financial markets and diminish systemic risk. These impacts will differ between young participants older ones, so a deeper thought into this should be made on every pension fund. A balanced consideration of the interests of the participants is key, so they feel represented in a balanced way.