Today Jean Frijns and Rene Maatman penned an opinion piece in the Dutch financial paper "Financieel Dagblad". Jean Frijns was the former CIO of pension giant APG and currently a professor at the Vrije Universiteit of Amsterdam. Rene Maatman is a lawyer at de Brauw Blackstone Westbroek and professor at the Radboud University. As the article is in Dutch, we took the liberty of proving a translation of the piece.
In the piece, Frijns en Maatman call upon policy makers to change the directive that pension funds need to invest in 'risk-free' assets such as government bonds as these have now have a negative yield:
Liberate the pension fund from the 'risk free' straight jacket
A pension fund must invest in accordance with the prudent person principle. This principle leans on the efficient market hypothesis: investors are rational people. An essential element of the prudent person principle is diversification of investments. With regards to government bonds however, this diversification is not necessary according to law makers. They are declared 'risk free' by decree.
Pension funds and Insures now face the question whether they should invest in debt securities with a negative interest rate. The English call this "burning cash": destruction of money. It takes effort to explain that this befits a rational investor. Can we still say that a government bond is 'risk free'? The government should not determine whether an investment is safe.
The flight forward is tempting: Get out of bonds with negative interest rates and fully go for shares and listed property. They show very desirable positive cash returns and value increases. But to a large extent this is due to the actions of the European Central Bank (ECB). Those returns are unlikely to be sustainable, though the downside risk less than 'safe' government bonds.
Pension funds are becoming underfunded as they have to value their liabilities at artificially low interest rates. And because they are in a state of underfunding, they may not increase their allocation to equities and real estate, "as that would increase their risk". Therefore even more assets flow to the so-called 'risk-free' assets, bonds with a negative interest rate. Could it then be prudent to keep money stashed in an old sock?
The financial assessment framework in force since January 1, 2015, opted for a long-term investment horizon. The hypothesis is that a rolling recovery time frame of 10 years would result in an acceptable result. However, is this still the case when the investment portfolio has been concentrated in 'risk-free' government bonds from the start? When interest rates return to normal levels in the medium term, large capital losses are incurred. The effect on the funding ratio of pension funds possibly remains limited by the simultaneous reduction of the pension liability, but the result is a poverty trap: assets vaporize. Moreover, there are systemic risks. We live in a highly uncertain world. Negative interest rates increase this uncertainty.
Reasoned from the prudent person principle, one should look at investment strategies that generate a reasonable result, regardless of market scenarios. Those are certainly not strategies where the investments are concentrated in negative-yielding bonds. What does that mean for the supervisory framework? A first step would be to repeal the decree that certain assets are risk free. Immediately followed by releasing differentiated solvency buffers in asset classes. Such customization is based on faux science. The reality is that yesterday's risk-free investment can be a systemic risk tomorrow. Instead, a fixed risk buffer can be introduced. This sets pension funds and insurers free from the straitjacket of the existing solvency framework. This liberation undoubtedly has implications for investments in government bonds of "safe" countries, as investing at a negative interest rate can not reasonably comply with the prudent person principle.
This would be beneficial to the effectiveness of ECB policy as it contributes to directing assets towards other sections of the capital markets. Adhering to the current solvency framework seems like reckless behavior from our point of view. This matter is urgent.