Dutch pension funds are caught between pressure to generate returns and greater regulatory requirements. Shayla Walmsley reports

Dutch pension funds are caught between a rock and a hard place. They are under pressure from their local regulator, the Dutch central bank (DNB), to show they can generate the investment returns needed to adequately cover their liabilities while also undergoing greater requirements regarding risk management and liquidity.

There are 103 pension funds with an inadequate cover ratio under Dutch regulations. This situation has been brought about by a combination of declining returns and rising liabilities following a period of low interest rates. By the end of the year those with a projected shortfall - on average, 93% against a required 105% - must explain how they will address it within five years, and how they plan to achieve the cover ratio of 120% within 15 years.

An additional pressure is the DNB's greater scrutiny of alternative asset classes such as infrastructure, hedge funds and private equity, which also has some implications for real estate.

The cover-ratio issue is perhaps the more fundamentally problematic: in order to improve their ratios, pension funds must seek high-yielding investments which, in turn, require higher solvency ratios.

"It will be difficult for some pension funds to define a strategy that complies with the solvency requirements and fits within the recovery plan," says Karen Huizer, investor relations manager at Bouwinvest, the asset management arm of BPF Bouw pension fund. "Pension funds that have difficulties with coverage will have to explain why they're in investing in particular asset classes."

Huizer believes pension funds could be steered away from direct investments towards open-ended funds, as the pressure to improve returns is combined with a sharper focus on liquidity following the financial crisis. An increase in the number of pension funds becoming net payers will lead to greater attention paid to the spread of fund lifespans, and especially on exits. "Ten or 20 years ago it didn't matter so much," says Huizer.

Listed real estate investments might become increasingly attractive under the current regulatory and market environment. Earlier this year, the €4.3bn HORECA pension fund, which favours passive real estate investment as potentially volatility-reducing, awarded a €200m listed mandate to Northern Trust.

Large Dutch pension funds, especially those like PGGM which have been very active recently both in direct and joint venture deals, show no signs of losing their appetite for infrastructure.

In a couple of recent transactions, APG has invested simultaneously directly in assets as well as in the operating company. Most recently, in August the pension fund manager confirmed that it had acquired interests in two Texas infrastructure development projects - its first PPP co-investments in US toll roads. It acquired 12.3% of the North Tarrant Express Facility development project and the North Tarrant Express Facility and 13.3% of the IH 635 Managed Lanes project.

Alternatives under regulatory scrutiny
In June, DNB published the results of its research into alternative investments, including infrastructure. Based on a survey of 35 Dutch funds, the letter said the institutions had accepted "unsubstantiated and unjustified" claims for the value added by alternatives, overestimating the diversification benefits while underestimating tail and liquidity risks, and failing to monitor investment performance.

"A necessary condition for risk is that the pension board and the investment committee provide timely, relevant information on strategy, positions, performance and risks fully at their disposal. This requires more adequate reporting," the DNB stated.

Although the DNB acknowledged that there had been improvements in recent years, it claimed pensions funds had yet to come up with sufficiently detailed strategic guidelines for investing in alternatives.

Although the DNB targeted what it termed "innovative assets" (infrastructure and forestry, hedge funds and private equity), some of its criticisms resonate with real estate as well - not least the contention that pension funds need asset-level insight into, and control over, the risks within their portfolios.

Even before the DNB letter, pension fund managers had noted an increase in their clients' real estate reporting requirements. The construction workers' pension fund requires of manager Bouwinvest quarterly regional, sector and management risk reports, with justifications for specific investments and geographic allocations.

"It's a lot of work but it's necessary if you want to be a good manager and for pension funds to keep control of their investments," says Huizer. "You're seeing more demands for this kind of reporting, not just from this pension fund but from all pension funds. It is a big issue to show they're in control."

Control is, in a sense, what this is all about - and not just at the portfolio or fund level. The portfolio manager at a major Dutch pension fund provider says core investors have little to worry about, but investors in value-added and opportunistic funds need to increase their scrutiny of risks in investments made with a focus exclusively on returns. "Lots of pension funds have been looking at their investments from a total-return perspective, not at the details," he says. "They need to know each asset."

Even if pension funds can improve the liquidity of their portfolios by investing in funds, they still need to address what the DNB sees as the crucial flaw in their current approaches: that they rely on fund managers' assessments of the risks within their portfolios. As the manager says: "If fund managers don't provide details, they don't have to prove that what they claim for their funds is true. That has to change."

Dutch real estate investors that have so far held off from ‘risky' infrastructure should not get too comfortable. The DNB's exhortations to implement sound evaluation procedures and monitoring apply to all asset classes. "It's generic - it could easily apply to all illiquids," says Wietse de Vries, partner at advisers Almazara.

The problem is that the plans pension funds drew up at the height of the market are no longer fit for purpose, says de Vries, claiming some are still using plans dating back to 2008.

"What the letter tells pension funds - and it will stick - is that they can't do due diligence just on the fund and its manager. They have to look at some assets very closely, perform stress tests, and understand the income and cost drivers. They need more than a feeling about the risk of the underlying assets."

The message from the regulator is: dig down deep for data on investments - and pension funds are not, overall, digging deep enough. Yet there is evidence that risk management is moving up Dutch pension funds' agendas. SPW is a case in point. The multi-employer pension fund, which outsources management to APG, said in August that it had hired an independent risk manager and redefined its risk rules after the DNB suggested its expertise was not up to the complexity of its investments.

In fact, it is a moot point whether pension funds should opt for internal or external risk management to meet the DNB's requirement that they ensure risk is "independently, adequately shaped". Unsurprisingly, an infrastructure specialist at a fiduciary manager demurred from the DNB's recommendation that pension funds should bring in a "countervailing power" to provide independent third-party advice as a counterbalance to fiduciary and external asset managers. "You can more easily hold an in-house manager responsible," he says.