Double Dutch implies Triple Trouble

In a post last year (Double Dutch), I wrote about the changes being made to pension fund regulation in the Netherlands. While some people put this topic in the same category as "watching paint dry", it does have important implications for how we think about fixed income markets in Europe.

Regulations (slowly) converge to reality

 

My main point was that the rules of the game for regulated investors in Europe were being forced to adapt to the reality of ultra-low interest rates. The Dutch pensions regulator decided that the old mechanism for calculating discount rates for pension liabilities was no longer appropriate and adjusted it downwards.

 

Pension funds and insurers across the continent will soon have to face the same music. Currently, they can discount their liabilities using interest rates vastly different from those prevailing in the market. The chart below shows the discrepancy.

The blue line is the AAA European government curve provided by the ECB. That is a good proxy for the investable risk-free rate in Europe at different maturities. The red line is the risk-free curve provided by the European Insurance and Occupational Pensions Authority (EIOPA) under Solvency II. The small divergence at the short end is because this is a swap-based (rather than government bond-based) curve; but the kink in the red line at 20 years and the subsequent divergence at the long end is due to the regulatory make-believe on long-dated discount curves. 

 

Significant asset-liability mismatch

 

The difference is massive: 50-year risk-free assets yield just 1.2%, but 50-year liabilities can be discounted at 2.5%. In present value terms, £29 of asset can be used to match £55 of liabilities. European insurance companies have been using this gap to run a persistent asset-liability mismatch. Last year, Moody’s highlighted that the average duration shortfall for life insurers in Germany, Norway and Sweden is over a decade.

 

That overall system will remain in place, but EIOPA is looking to revise down the 'Ultimate Forward Rate' (UFR) by 50bp. This feels like the thin end of the wedge. Over the next couple of years, there will be constant pressure to bring this discount curve closer to reality. This has several important implications:

 

  1. Investors will continue to search for yield in Europe
  2. Ongoing bias for insurers and pension funds to buy euro duration despite low yields
  3. Anticipate constant flattening pressure whenever curves in Europe steep marginally
 
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