(Bloomberg) – Back in 2012, the world's best-managed pension market was thrown a lifeline by the Danish government to help lift obligations. That's when interest rates were still positive.
Seven years later, with interest rates now well below zero, even Denmark's $ 440 billion pension system says that the environment has become so punitive that it may be time for a change of European rules. [1
The warning comes as pension companies across Europe are struggling to generate the returns they need to meet their growing obligations. In Denmark, some funds set up with grants that guarantee returns as high as 4.5% have had to use equity to fulfill their obligations.
To calculate liabilities, pension companies use a composite mathematical formula constructed by the European Insurance and Occupational Pensions Authority (EIOPA). The formula is intended to protect funds from unpredictable market changes that artificially inflate or erode balance sheets. But with negative interest rates more rooted, there are indications that the EIOPA curve, as it is called, may not work as intended.
"When pension funds across Europe risk at the same time, it can actually become pro-cyclical: it raises price movements, and it can result in even more downward pressure on the EIOPA return curve, which exacerbates the problem," Munck said.
The basket consists of several elements. The backbone – the exchange rate curve for the euro interest rate – has dropped since it was implemented about four years ago, which increased the value of the liabilities.
Declining swap rates
The European Commission has begun reviewing the regulations on insurance companies – Solvency II – with a view to proposing improvements by the end of next year. Insurance Europe, an industry group, encourages the commission to include the curve in the evaluations.
Meanwhile, pension funds have managed to buy up risky assets. The Netherlands, which is ranked with Denmark as the world's best-performing pension provider by Mercer, has complained to the European Central Bank about the downturn in the industry.
And so …
And then there is the headache of what is called volatility adjustment (VA), set on a country-by-country basis and designed to dampen the impact of erratic markets. According to Bloomberg Intelligence senior analyst Charles Graham, there is a "widespread" agreement that the VA is "wrong."
"There is something EIOPA is considering recommending to change, but the challenge is still what to replace it with, or how to Fine tuning it, "Graham said.
Earlier this year, EIOPA unexpectedly cut Denmark's VA to about a third of its previous level, causing significant alarm in the industry.
According to Anders Damgaard, CFO of Denmark's largest Commercial pension fund, PFA, which has about $ 100 billion in assets, made EIPOA's reason for the adjustment sensible: The new VA has short sales that allow Danish borrowers to repurchase the bonds that finance their mortgage loans. The long-term covered bonds to which these call options are linked , is a cornerstone of Danish pension funds' investment portfolios.
With interest rates at exceptionally low levels, a record number of loans are now utilizing Take these call options to refinance your mortgage. Damgaard says that the way EIOPA calculates the volatility adjustment means that the unit itself intended to cushion market fluctuations in itself has become more unstable. Worse, because it is "an artificial number", pension funds cannot secure it, he says.
"That's really where the main challenge is for us," Damgaard said. "We have an interchangeable component of the yield curve – which is actually active on the entire yield curve – and you can't secure it, which means the balance sheet items are very unstable."
PFA, which many Danish pension funds started to scale back guaranteed products for pensioners many years ago. It has been given a buffer to help absorb some of the shock of growing obligations. But not everyone is equally well prepared. "If the discount curve is more unstable and you can't secure it, you – if you don't have enough capital – may be forced to reduce the risk of the more hedging space, to compensate," Damgaard said. [19659019Historycontinues
Olav Jones, Deputy Director of Insurance Europe, says the pension industry “sees no need to change the way risk-free curve is generated, but there is need to improve how VA is generated. "Right now it's" generally too low and generally causes liabilities to be inflated "and creates artificial instability in the insurance companies' balance," he said.
To contact the reporter about this story: Frances Schwartzkopff in Copenhagen at fschwartzko1 @ bloomberg.net
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