Thanks to buoyant stock markets worldwide, Dutch pension funds recorded strong price gains of almost €36 billion on their equity and investment fund shares, according to macroeconomic data from DNB. As a result, their assets rose by 2% to reach €1,687 billion, despite losses on bond and derivatives investments.
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Global stock markets recorded strong price increases in the first quarter of 2024. For example, converted into euro, the MSCI World index rose by 11% during the same period. Pension funds’ price gains on equities were €26 billion in the first quarter, while investment fund shares gained €10 billion in value (see Figure 1). The latter asset class represents the net balance for various types of investment fund, including equity funds – which increased in value – but also bond funds, whose prices fell.
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In addition to the gains on equities and investment fund shares, there were losses on investments in debt securities (€9.4 billion) and interest rate derivatives (€2.0 billion), see Figure 1. These price declines are due to the rise in interest rates (for maturities of up to 10 years). Pension funds use these instruments to hedge part of the interest rate risk they incur on their long-term liabilities to members. The present value of these liabilities depends greatly on the nominal interest rate term structure (see Box 1). When interest rates go up, the present value of liabilities goes down and vice versa.
Debt instruments and derivatives decreased in value, whereas the price effect on pension liabilities was positive in the first quarter of 2024 (albeit marginal, at €0.9 billion). In other words, losses were incurred on hedging the interest rate risk on the liabilities, whereas the liabilities themselves remained virtually unchanged. This counter-intuitive difference is due to “interest rate term structure rotation” in Q1 2024. Interest rates for maturities up to 10 years rose, while rates fell slightly for longer maturities (Figure 2).
This rotation reduced the value of interest rate hedges in the form of investments in bonds and derivative contracts, which are sensitive to the shorter-term segment of the interest rate term structure, while the value of liabilities, which are sensitive to the longer-term segment, actually increased (albeit marginally). Ideally, durations of the tools used to hedge interest rate are similar to those of the liabilities. However, there are insufficient financial instruments in the market to achieve this, which means pension funds must settle for incomplete hedging.
Pension funds and insurers use the nominal interest rate term structure (IRTS) to value liabilities and assets. A discount rate is required to determine the present value of future cash flows from liabilities or assets. The interest rate term structure forms the basis for determining this discount rate. Both the European Central Bank (ECB) and De Nederlandsche Bank (DNB) publish this monthly interest rate term structure, which indicates for each year up to a maximum of 70 years forward the percentage with which a liability can be discounted in the relevant year. This is because €1,000 today is not worth the same as €1,000 in 40 years’ time. The higher the discount rate, the lower the present value and vice versa.
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