Current issues related to economy, (responsible) investment, pension and income: every week an APG expert gives a clear answer to the question of the week. This time: Head of Treasury & Trading Jan Mark van Mill, talks about the recent problems at pension funds in the UK due to sharply rising interest rates - and the likelihood that the Dutch pension sector could find itself in a similar scenario.
For the root of the dire situation of British pension funds, we need to go back to Sept. 23, 2022. On that Friday, the Truss government in the United Kingdom announced its budget plans. In it, like other European countries, the British government set aside considerable money to compensate citizens for sharply increased gas prices. However, Prime Minister Liz Truss also wanted to make substantial tax cuts. Since there is no money for both, the UK would have to borrow the deficit, in this case from foreign investors. And the financial markets' response to that was very dismissive.
“Margin call”
Van Mill: “The financial markets didn’t like the idea of those unprecedented tax cuts at all, which caused interest rates to skyrocket. And that was the point at which problems arose for pension funds in the UK. This is because they hedge much of their interest rate risk through interest rate swaps. When interest rates rise rapidly, a pension fund must deposit collateral to the party with whom they have entered into the swap contract. This is a so-called margin call. In the UK, that interest rate movement was so big and intense that pension funds did not have enough money on hand to meet those obligations in time.”
To get that money, these funds sold UK government bonds (‘gilts’) en masse, pushing interest rates up even more. As a result, they had to deposit even more collateral, sell new assets, and a vicious cycle ensued. To break it and to calm down the financial markets, the British central bank was forced to buy up government bonds on a large scale. How likely is it that such a scenario will occur with Dutch pension funds?
Rich enough
Van Mill: “Dutch pension funds also hedge their interest rate risk through swaps and they too have to deposit collateral. But on the whole, the interest rate movement in the euro zone has fortunately not been as big and intense as in the UK. So, the question is: what exactly went wrong with the British funds; how was this allowed to happen? Their solvency is not the problem; they are rich enough to afford that collateral. But they don’t have unlimited access to liquidity. You can have a very nice house with a lot of excess value, but you can’t use it to buy a car. The problem is a mismatch between solvency and liquidity. What probably played a role in the UK is that pension funds did not have the right type of collateral in time to meet those margin calls.”
The consolidated structure of the Dutch pension fund industry also makes a scenario like the one in the UK - where there are a lot of small funds - less likely, Van Mill says.
“Dutch pension funds, which are on average bigger than British funds, typically hedge a smaller portion of interest rate risk, making them less vulnerable to a sharp rise in interest rates in a short period of time. In addition, big funds invest relatively little through external managers, allowing them to sell assets more quickly to meet any collateral obligations.”
Stress test
Anyway, for the pension funds it works for, APG has not had to sell bonds to meet collateral obligations. But it does take measures to minimize the risk of such a lack of liquidity.
Van Mill: “At least once a month we conduct stress tests, in which we see whether we can generate sufficient collateral to meet our liquidity obligations under certain interest rate scenarios. What happened in the UK is a new scenario, so we adjust the stress tests accordingly.”
So, is it less likely for Dutch pension funds to end up with a scenario like that in the UK, but certainly not impossible?
Extreme circumstances
“Exactly. And to reduce the likelihood for it to happen, we have been alerting the European Central Bank for ten years to the possibility of the conditions we have now seen in England. Pension funds that need quick liquidity to deposit collateral can now turn to banks for that, in the so-called repo market. At a certain interest rate, they then borrow cash, with bonds as collateral. But pension funds have no 100% guarantee that this market will function under all circumstances - including extreme ones. They remain dependent on the willingness of banks to accept bonds as collateral. We would therefore like to see the ECB guarantee the reliability of repo markets, just like the U.S. Fed and the Bank of Canada do.”