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 Salomons Judgement

The Norwegian pension system faces the same big changes as the Dutch system did more than ten years ago. My message for Norwegian pensionfunds: cover interest rate risks as quickly and as much as possible and take risk where you are being rewarded to do so.

I was invited to speak in Oslo at a Pensjonskasseseminar about the Dutch pension system, as Norway is currently facing a situation that is similar to the Dutch situation over a decade ago. Looking for parallels, I decided to delve into history. My findings also shine a new light on the challenges that pension systems in the United Kingdom and the Netherlands have at the moment.

The Dutch polder model is still thinking about a new system. Simple terminology such as average contributions and actuarial interest rates conceals vested interests, a lack of freedom of choice and the use of intergenerational solidarity.

Just like in the Netherlands, solidarity is a point of discussion in the United Kingdom. Pension experts, among whom seven are Dutchmen, recently sent a letter to the academic British pension fund USS with the warning not to include any expected returns when determining contributions and obligations. Adjusting the actuarial interest lowers the financial burden, which means contributions can be reduced, but at the same time the future generation will be disappointed.

Covering the interest
In both the United Kingdom and the Netherlands promises have been made in the past that are relatively pricey considering the current low interest rates. Someone has to pay the bill. That brings us to Norway. The country is heading for a model that is similar to Solvency II, valuing liabilities at market interest rates. However, there is a serious mismatch between the terms of investments and those of liabilities. When I worked for a major insurance company in 2005, pension investors agreed that the interest rate was ridiculously low then. Covering the interest rate risk against this interest rate? Unnecessary!

For the insurer, it was too expensive to leave the risk open. The playing field for insurers and pension funds was then and still is uneven: insurers, unlike pension funds, cannot reduce or raise contributions. But there is more. It may also be better to exchange the risk for which you are not rewarded, for a risk with a higher expected return.

Closing the interest rate risk for the most part to take an extra equity risk didn’t sound too bad. When I look at the presentations on the subject at the time, I am actually quite proud, even if the timing was somewhat fortunate. Closing interest rate risk in 2005, when the German interest rate was still at 3.5%. Lovely!

Some trends in pension fund allocations are clearly visible. The investment mix has shifted: less equity, more bonds and more alternatives. The decline in funding ratios has kept pace with declining interest rates, while the weighting of bonds has increased. The result of not fully covering and not taking enough other risks. Hence, most pension funds still have too little reserves to absorb future setbacks. Then it is cutting benefits or require extra payments. Adjusting the valuation of future commitments now would mean passing the problem on to the next generation.

My message to the Norwegian pension funds was simple: cover as much interest rate risk as possible, as quickly as possible, but do not forget to take other risks. I don’t know whether they will do that or not. If they cover to the same extent as insurers have done in the United Kingdom and the Netherlands, Norwegian government bonds are a steal. If pension funds wait too long to cover and/or do not take enough other risks, I’m afraid that in a number of years the same discussion about adjusting the calculation rules will arise in Norway, as it currently does in the Netherlands and the United Kingdom.

The author

Roelof Salomons

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