Dick Kamp: Risk management and investing before and after the pension transition

January 14, 2025

_{This column was originally written in Dutch. This is an English translation.}

By Dick Kamp, Director of Pension, Investment & Risk at Milliman Pension

In the transition to the new pension system, pension funds face a dilemma. Do they focus on the desired funding level at retirement or rather on designing the investment portfolios to fit the lifecycles after retirement?

Achieving the desired funding ratio at retirement is an important goal for pension funds. After all, the funding ratio can be used to achieve the desired goals. Think of the transition for all participants without discounts, financing a solidarity reserve, financing compensation for active participants and perhaps a piece of post-indexation and/or general increase.

At the same time, the pension capital will be distributed to the various participants immediately after inflation. From that point on, returns are allocated based on the lifecycles that are established at that time. An important question is whether the investment portfolio should already be set up for those applicable lifecycles from the moment of investment.

The investment policy in the period before inflation is focused on the FTK. In a number of pension funds, we see that this investment policy involves additional management measures to protect the funding ratio as much as possible at the moment of investment. This is done by increasing the interest rate hedge and by hedging the downward risk of equity returns with derivatives.

After inflation, the desired investment policy is based on lifecycles. Therefore, there may be a mismatch between the investment portfolio before infusion and after infusion. In general,[1] we see that the size of the so-called return portfolio before reinvestment is reasonably in line with the desired size after reinvestment. A possible challenge seems to lie somewhat more with the size and duration of the matching portfolio.

In order to achieve the funding ratio and protect the reasonably favourable funding ratio of many pension funds at present, the interest rate risk is largely and in some cases largely hedged by a relatively large matching portfolio.

The first calculations of matching portfolios after inflation show that a substantial interest rate hedge is expected in the (collective) benefit phase. For the accrual phase, however, this is expected to be less significant. In the so-called glide path phase (the phase from active with maximum allocation to the return portfolio to benefit), the allocation of the matching portfolio grows to the level of the benefit phase.

If we then look at the total size of the matching portfolio, we will see that it is often smaller and that the duration will also be shorter than under the investment policy under the FTK. After all, in the collective benefit phase in particular, the duration is normally shorter than in the active phase. And for younger participants, the matching portfolio will generally be smaller in size compared to the allocation in the benefit phase, where the duration is actually longer than the matching portfolio for older (retired) participants.

The solidarity contract

Based on the foregoing, the matching portfolio in particular is expected to differ before and after inflation. From the moment of inflation, returns are allocated according to the defined life cycles to the pension capitals. In the solidarity-based contract, the theoretical protection return (indirect method) is generally allocated first and then the remaining excess returns. The excess return here is defined as total returns achieved minus the theoretical protection return. The difference in return made by the matching portfolio and the desired return on the dimensions of duration and size is thus via the excess return.

The allocation of returns from the protection return to the participants is distributed differently than the allocation to the excess return. In particular, the allocation to excess returns is higher at the younger ages and lower at the higher ages, due to the length of the investment horizon and thus the absorptive capacity of volatility. We have seen that the mismatch between the actual matching portfolio and the (theoretical) protection return is imputed to the excess return. A consequence is thus that younger participants in particular bear the mismatch risk.

The flexible contract

With the flexible contract, an actual return (the so-called direct method) is generally calculated with respect to the matching portfolio. As a result, the mismatch in the matching portfolio does get allocated via the return on the matching portfolio. The result of the mismatch is then mainly attributed to the age cohorts with exposure to the matching portfolio, i.e. the older age cohorts.

Size and control of risk

The size of this risk is difficult to estimate in advance. It depends on interest rate movements after inflation. How can this risk be managed? Basically, it is difficult. There are a number of steps to take to make this transparent.

1. Make an overview of the exposures to the matching portfolio and the return portfolio by age cohorts of (for example) 5 years before and after inflation.
2. See where the significant differences are and thus where there is potential impact on the various age cohorts.
3. See to what extent portfolio adjustment is already possible before rafting[2]. Note that the return on the investment portfolio (matching and return) is distributed proportionally across all age cohorts according to the size of the pension liability provision.
4. To the extent that an adjustment of the investment portfolio is not or only to a limited extent possible (before inflation), there will be a (larger) return effect after inflation. This return difference can be allocated to the participants in two ways. The first method is via the operational cost reserve, which is built up for this purpose at the time of investment. The second method is via excess return. A combination of both is also possible.

The challenge is determining the level of risk. This is very tricky. An interest rate shock is not predictable. Also, the shock can be positive or negative.

It is important to make the period of this (basically) undesirable return allocation as short as possible. This means that the portfolios should be adjusted to the desired allocations as soon as possible after boarding. To achieve this, the following steps can be taken.

1. Obtain an overview of the current portfolio (return portfolio and matching portfolio per age cohort of 5 years). This will be the same for each age cohort.
2. Compile an overview of the desired portfolio. This will not be the same for each age cohort.
3. Prepare an overview of necessary transactions.
4. Establish a plan for making the necessary transactions.
5. Prepare an overview of the risks resulting from having to make the necessary transactions.
6. Formulate management measures to control these risks.
7. Implement the plan.

In summary, there is relevant investment risk borne by participants through the allocation of excess returns or operating reserve. The extent of the risk is determined by the extent of the mismatch risk and the period over which the mismatch persists.

It starts with insight, overview and a plan of action, including control measures for adjustment of the investment portfolio. Tools for this have been described.

Dear manager how much insight do you have into investment risk before and after transition?

This is the thirty-fifth column in a series on risk management. The series aims to encourage readers to consider risk management as an integral part of running a pension fund.

More columns by Dick Kamp

[1] From our assignments with pension funds, we have insight into investment allocations before and after inflation

[2] In practice, we also note that the use of derivatives is being considered for this purpose.