Chapter 19 risk based supervision of pension funds in the netherlands

CHAPTER

19

Risk-Based Supervision
of Pension Funds in
the Netherlands
Dirk Broeders and Marc Pröpper
CONTENTS
19.1 I ntroduction
19.2 Dutch Pension System and Solvency Regulation
19.2.1 Objectives of Prudential Pension Fund Supervision
in the Netherlands
1
9.2.2 Prudential Supervision
19.2.3 Risk and Time
19.2.4 Financial Assessment Framework
19.3 Ma rk-to-Market Valuation
19.3.1 Valuation of Defined Benefit Liabilities
19.3.2 Valuation of Contingent Liabilities
19.3.3 Term Structure of Interest Rates
19.3.4 Valuation of Assets
1
9.3.5 Contribution Policy
19.4 Risk-Based Solvency Requirements
19
.4.1 Standardized Method
19.4.1.1 Interest Rate Risk
19.4.1.2 Equity and Real Estate Risk
19
.4.1.3 Currency Risk

1
9.4.1.4 Commodity Risk
19
.4.1.5 Credit Risk
1
9.4.1.6 Insurance Risk

474
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486
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474 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

19.4.1.7 Other Risk Categories
19.4.1.8 Overall Capital Charge
1
9.4.2 Internal Models
19
.4.3 Simplified Method
19.4.4 Minimum Capital Requirement
1
9.4.5 Recovery Plans
19.5 C ontinuity Analysis
19
.5.1 Parameters
19.5.2 Risk and Outcome Distributions
19
.5.3 Different Functions of the Continuity Analysis
19.5.4 Insight into Indexation
19.6 C oncluding Observations
References 507

496
496
497
498
499
500
501

502
503
505
505
507

R

isk-ba sed super v ision is being i ncreasingly adopted worldwide. As
an example of such r isk-based supervision, this chapter reviews the
Financial Assessment Framework for pension f unds in t he Netherlands.
It operates under the Pension Act that was changed significantly in 2007.
The main elements of this framework include mark-to-market va luation
of a ssets a nd l iabilities, a f ull f unding r equirement, r isk-based so lvency
requirements, a nd a co ntinuity a nalysis for assessing t he pension f und’s
solvency in the long run. Together these building blocks offer a solid foundation for t he incentive-compatible regulation of occupational pensions
in the Netherlands.

19.1 INTRODUCTION
The current financial crisis shows that pension funds have developed a large
exposure to risks. This exposure entails market risk, interest rate risk, and
even liquidity and operational risk, besides more traditional insurance risks
like mortality risk and longevity risk. It has become evident that the key to
managing these risks is an integrated balance sheet approach, considering
assets and liabilities simultaneously. This is particularly true for defined benefit pension plans that usually run a mismatch between assets and liabilities
on their balance sheet. The principal responsibility of pension fund trustees,
therefore, is to control risks in order to ensure that they are kept within
acceptable limits so that the entitlements of members, as agreed between
social partners in employment contracts, will be respected.
Being i mportant financial i nstitutions, pens ion f unds a re sub ject t o

government regulation. Worldwide, there is an increasing adoption of

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 475

risk-based supervision. As an example of such risk-based supervision,
this cha pter r eviews t he F inancial A ssessment F ramework f or pens ion
funds in the Netherlands. This regulatory framework has been discussed
in, inter alia, Siegelaer (2005), Nijman (2006), and Brunner et al. (2008),
although th is c hapter i s th e first t o r eview i t i n f ull s ince i t ha s be en
adopted in the Dutch Pension Act in 2007. The main elements of this solvency regime are as follows. The mark-to-market valuation of assets and
liabilities i s de scribed i n Section 19.3. This ma rk-to-market a pproach is
needed to determine whether a pension fund is currently solvent. Section
19.4 de scribes t he r isk-based so lvency r equirements t hat a re i n p lace t o
make sure the pension fund is still solvent on a 1-year horizon with a high
probability. Section 1 9.5 i ntroduces t he l ong-term co ntinuity a nalysis.
This instrument assesses the pension fund’s solvency in the long run and
the f und’s ab ility t o effectively influence t he financial p osition t hrough
the available policy instruments. Section 19.6 contains some concluding
remarks. However, we first describe t he key characteristics of t he Dutch
pension system and elaborate on the objectives of prudential pension fund
supervision in the Netherlands.

19.2 DUTCH PENSION SYSTEM
AND SOLVENCY REGULATION
The Dutch pension system may be characterized in terms of the usual three
layers. The first layer is constituted by the state old-age pension, which is
financed on a pay-as-you-go basis and provides for a basic income for all

citizens of age 65 and over. As of 2009, for singles, the gross pension benefit is €1038 a month. For couples, if both partners are 65 or over, the gross
benefit for each partner is €723 a month. It should be noted, however, that
these amounts are only paid if a perso n has uninterruptedly lived in the
Netherlands f rom t he age of 16 onward. Sk ipping t he second layer for a
moment, the third layer consists of private saving for retirement. This covers tax-favored pension saving, such as life annuities offered by insurance
companies.
The second layer, the main focus of this chapter, comprehends occupational pensions, which are primarily financed by means of contributions
by employer and employees. It is therefore a capitalized or funded system
in which people save for their pensions. For most employees, participation
in a pension plan is automatically linked to their contract of employment.
The participation rate among employees is thus close to 100%. Typically,
the employer pays the bulk of the contributions although the employees’

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476 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

part ten ds t o i ncrease. The seco nd la yer ser ves t o su pplement t he first.
Hence, in occupational pension accrual, account is taken of a basic benefit,
known as the pension offset. This offset is often linked to the state old-age
pension benefit. For that reason, the supplementary pension is built up on
the basis of pensionable earnings, that is, income from labor less the offset.
If, under a final-pay system, we assume an annual accrual rate of 1.75%
of pensionable e arnings, t he result a fter 4 0 years of ser vice i s a pens ion
equal to 70% of final salary. Final-pay systems a re ex pensive because of
the past service involved. Nowadays, some 87% of all active members participate in a career-average scheme. Under such a scheme, higher accrual
rates are mostly used, of up to more than 2%. These schemes go without
past service, the pension accrual being indexed to wage growth or inflation instead. This indexation is not guaranteed however—it is contingent,
and dec ided upon mostly on a y early ba sis, on t he availability of a mple

financial resources. In over half of all cases, indexation is based on wage
growth, usually those in the industry concerned. For over 20% of pension
plan m embers, pens ion acc rual i s l inked t o t he m ovements i n t he g eneral l evel of consumer prices. The so -called collective defined contribution plans are gaining popularity in the Netherlands. These plans combine
a c areer-average sch eme w ith a fi xed co ntribution r ate f or a n umber o f
years. This allows corporations to classify a defined benefit scheme a s a
defined co ntribution p lan. I ndividual defined co ntribution sch emes a re
still exceptional in the Netherlands.
At the end of 2008, the assets held by pension funds totalled €576 billion,
while t he ma rked-to-market va lue o f t he l iabilities eq ualed € 606 b illion.
This translates into a funding ratio of 95%, which is historically low for the
Netherlands. Figure 19.1 shows the long-term progress of the funding ratio.
It is closely related to the development of the long-term market interest rate,
showing t he i mportance o f ma rket va riables f or a ssessing t he financial
well-being of pension funds.
Figure 19.2 plots the asset allocation over time. Notably, in the 1990s,
pension f unds i ncreased t heir eq uity ex posure a t t he ex pense o f fixedincome securities. Furthermore, within the category of fixed-income
investments, private loans have been replaced in large part by traded bonds.
The increased share of equities and bonds reflects a growing preference for
liquid investments. This is also reflected in investments in real estate: the
percentage invested in has remained fairly stable, but there has been a shift
toward i ndirect re al e state (traded p articipations) at t he e xpense of re al
estate directly held by the pension fund itself. Another trend is investing

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 477
240%

10%

220%

9%

200%

8%

180%

7%

160%

6%

140%

5%

120%

4%

100%
80%
1988

Funding ratio

Long-term market interest rate (rhs)

1992

1996

2000

3%

2004

2%
2008

FIGURE 19.1 Long-term de velopment o f f unding r atio a nd l ong-term i nterest
rate. (From DNB.)

100%

80%

60%

Other
Real estate
Fixed-income securities
Equities

40%

20%

0%
1987

1991

1995

1999

2003

2007

FIGURE 19.2 Asset a llocation of Dutch pension f unds over time. (Courtesy of

Statistics Netherlands, The Hague, the Netherlands.)

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478 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

in alternatives like commodities, hedge funds, and infrastructure. Ther e
is also a move toward investing abroad. Currently, foreign assets account
for some three quarters of the balance sheet total while this was still marginal in the mid-1980s. The reason behind this shift is that international
diversification is the key to a funded system to fully exploit the benefits of
risk sharing.

Many pens ion f unds a im a t ma intaining a fixed a sset a llocation i n
terms o f i nvestment cla sses (strategic a sset a llocation). This rebalancing
strategy i mplies t hat cha nges i n t he relative va lue of financial assets g ive
rise t o o ffsetting p urchases a nd s ales, so t hat t he r elative w eights i n t he
portfolio remain fairly constant. However, it is also possible to accommodate va lue cha nges w ithin defined ba ndwidths (tactical a sset a llocation).
Pension funds’ rebalancing strategy is described in greater detail in Bikker
et al. (2007). Apparently, there is some asymmetric behavior. Pension funds
are eager to rebalance after a period of relative underperformance of equities b ut a llow t heir a sset a llocation t o f ree float after a pe riod o f eq uity
outperformance.
The lion’s share of the accrued assets is administered by pension funds.
They u sually ha ve t he l egal f orm o f a f oundation a nd a re g overned b y
representatives of employers and employees. Being a f oundation, a pens ion
fund cannot go bankrupt. As such, t he ultimate measure a pension fund
can t ake i s t o r educe acc rued ben efits t o r estore i ts financial position.
In fact, it is a legal requirement to incorporate this possibility in the pension
fund’s statutes. Pension funds may be linked to a single company or to an
entire industry. For the latter category, participation is usually mandatory,
meaning that companies in certain industries are obliged to take part in
the specific industry-wide pension fund. At of the end of 2006, 86% of all
active members took part in industry-wide pension funds, and only some
13% were members of a co mpany pension f und. L ess t han 1% of a ctive
member are related to occupational pension funds, which act in the interest
of specific occupations like notaries or pharmaceutical chemists.
19.2.1 Objectives of Prudential Pension Fund
Supervision in the Netherlands
Employers a re f ree t o offer a pens ion p lan t o t heir em ployees o r n ot.
However, if they do so, the plan must comply with government regulation.
This regulation is laid down in a pension act that was changed significantly
in 2 007. A ke y element of t his ac t i s t hat pension f unds must be l egally
separated from the company offering the pension arrangement and must

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 479

always be f ully f unded. These r equirements p revent a co rporate defa ult
from damaging the pension benefits. The rules for pension fund supervision are also set in the Pension Act. This act identifies De Nederlandsche
Bank ( DNB) a s t he r esponsible body f or t he p rudential su pervision o f
pension f unds. A longside t he D NB, t he N etherlands A uthority f or t he
Financial Ma rkets (AFM) supervises t he conduct of t he entire financial
market sector including pension funds. The objective of prudential pension fund supervision is to offer a high degree of safety to (future) retirees
through t he i mposition of st rict supervisory st andards. Pension f unds
are thereto required to hold a certain solvency margin of additional assets
over the marked-to-market value of pension benefits. This solvency margin
is intended to absorb the risks inherent in the possible changes in the value
of assets and liabilities. Without a clear statutory requirement to hold such
a ma rgin, pension f und’s t rustees may be tem pted to pursue short-term
objectives by, say, following a risky investment policy and shift ing the burden o f pos sible n egative co nsequences o n t o y ounger g enerations o r, i n
extreme cases, on to society at large.
However, D utch pens ion f unds c an ex ploit t he po tential o f i ntergenerational risk sharing; see Cui et al. (2009). The basis for this solidarity is
constituted by mandatory participation in pension schemes. Older members can use the young as a safety net if need be, while the younger benefit
from t he w ealth o f t he o lder i f t here i s a su fficient la rge su rplus i n t he
pension f und. This a llows a pens ion f und t o ben efit f rom sha ring r isks
across generations if necessary. However, in order to safeguard the savings
both at present and into the future, the trustees of the fund need to avoid
excessive risk taking, since the raison d’être of pension funds (i.e., crossgenerational risk sharing) holds only insofar as future workers continue to
find it attractive to participate in the fund.
As such, i ntergenerational r isk sha ring cannot be st retched i nfinitely.
In order to demonstrate this, let us assume that there are two generations:

current members and future members. Intergenerational risk sharing may
be compared to financial derivatives. The current generation, which exercises discretionary power over the pension assets, has, so to speak, a long
position in a put option. That is, it has the power to sell its pension commitments t o la ter g enerations a t a g iven p rice. The acc eding g eneration
of (would-be) members have, so t o say, implicitly written the put option,
thereby entering into the obligation to take over the pension fund’s commitments to the older generation should the assets managed by the fund
prove insufficient to fund those commitments. The crux of the matter is

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480 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

that such a r isk transfer from the current to future generations carries a
price tag. This price is the surplus in the pension fund.
The owner of t he put option, i n t his c ase t he older generation, i nvariably ha s t he most favorable ex post pos ition. I f t he a ssets i n t he pension
fund are sufficient to serve both the older and the younger group, the former will see their entitlements (fully) honored. If, however, the assets are
insufficient to provide for both the older and the younger groups, the older
group c an st ill en force f ull pension r ights a nd leave t heir juniors to pick
up the tab. Thus the youngsters, by definition, find themselves in a suboptimal position, because the pension fund’s money can only be spent once.
The protection of younger and future members in the pension funds from
risk-taking behavior by t he older cohorts requires t he supervision of t he
pension fund.
Another r eason f or p rudential su pervision i s t he absen ce o f ma rket
forces. Pension funds are not-for-profit organizations and as such do not
issue equity capital. This means t he members i n a pens ion f und a re not
only the liability holders but are in effect also its shareholders: the pension
fund is a k ind of cooperative. However, t he sha res a re not negotiable a s
participation is ma ndatory. By co nsequence, t he regular control mechanisms found in capital markets are inoperative in the pension industry.
19.2.2 Prudential Supervision
Prudential regulation is traditionally aimed at (1) defining, (2) overseeing,

and (3) enforcing minimum requirements as to the funding and the solvency of the supervised institutions. After all, if an institution has full
coverage of the technical provisions and sufficient free capital, it is able
to absorb setbacks. In the absence of adequate reserves, pension funds
run t he r isk o f fa ilure a nd ben eficiaries ma y co nsequently se e t heir
claims a nd r ights e vaporate i nto t hin a ir. P ension f und su pervision
therefore centers on the continuity of pension entitlements. That raises
the question as to when this continuity is endangered. One could argue
that, for as long as pension plans attract new members, there is a safety
net g uaranteeing t he ben efits f or t he o lder m embers. T his a rgument
relies on the assumption that it must be attractive for younger people
to take part in the pension system. If younger generations have to pay
disproportionately more t han t he a mount required for t he accrual of
their o wn pens ions, t hat i s n o l onger a utomatically t he c ase. I n t hat
event, intergenerational solidarity is no longer assured. It is, therefore,
of major importance that the distribution of pension contributions and

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 481

benefits among the generations should be kept within a certain bandwidth. T his i s a sub tle eq uilibrium t hat ma y e asily be d isturbed b y
large f luctuations in capital markets and, hence, needs to be carefully
guarded by t he supervisor. Ma intaining t he equilibrium is u nderlain
by t he a pplication o f t he a ssumption t hat a pens ion f und sh ould be
able at any point in time to distribute the claims and rights in money
to the beneficiaries, that is, to have full funding at all times. This is the
core of the Financial Assessment Framework. Before moving toward
further explaining the Financial Assessment Framework, we first elaborate on a ke y a spect of pens ion f und r isk ma nagement: t he relation
between risk and time. This link is also relevant for designing incentive compatible regulation.

19.2.3 Risk and Time
This r elation i s i mportant t o u nderstand a s pens ion f unds u sually t ake
a long-term perspective and so o ften d isplay a st rong inclination toward
investing in equities. There is an intense debate on the relationship between
time and risk that is also relevant for the design of incentive compatible
regulation. We discuss the issue by looking at the characteristics of equity
investments versus risk-free investments over time.
Pension f unds’ la rge st ock ma rket exp osures a re exp lained b y t he
assumption that, in the long run, equities are expected to perform better than government bonds. Looking ahead, this seems realistic: because
equities are r iskier t han government b onds, investors demand hig her
returns in co mpensation. L ooking a t past p erformance, ho wever, t he
picture may look different. There are extended periods in the past when
equities w ere o utperformed by r isk-free investments. One exa mple is
the period from 1902 until 1932 when T-bill investments outperformed
equities o ver a 30 y ear p eriod d ue t o t he s evere ma rket b reakdown
starting from 1929. Most recently a similar picture has emerged for the
period 1995–2008.
Due to the higher expected returns, the probability of loss on an equity
portfolio relative to a risk-free investment declines as the horizon increases.
This so-called time diversification effect may be readily explained with the
help of basic statistical knowledge. Suppose the value of a well-diversified
equity portfolio S follows a geometric Brownian motion with an instantaneous return µ and instantaneous volatility σ
dS = µS dt + σS dW

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482 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

An amount S invested in a risk-free zero coupon bond will yield an amount

S er(T−t) over the time period T − t. The probability p that equities outperform this risk-free investment is given by
P (S e

( µ− 1 σ2 )(T − t )+σ ε T − t
2

> S er (T −t ) ) = p

where ε ∼ N(0, 1). Evaluating this expression yields
⎡ (µ − 12 σ 2 − r )(T − t ) ⎤
p=N⎢
⎥
σ T −t
⎣
⎦
where N i s t he c umulative s tandard nor mal d istribution f unction. Fr om
this relation, it follows that p is an increasing function of time to maturity;
see Figure 19.3. Long-term investors use both the higher expected returns
and this time diversification effect as arguments to justify their decisions to
opt for equity investment. They often add t he assumption that returns on
equity revert to the mean in the long run. Mean reversion would imply that
periods of disappointing returns are followed by periods of above-average
performance and vice versa; see, for example, Campbell and Viceira (2005).
A pension fund, however, must not only consider the benefits attaching
to risky investments. Its trustees must form an opinion both on the probability that the return on the equity portfolio may fail to keep pace with
100%

0%

80%

–20%

60%

–40%

40%

–60%
Probability of return below
risk free return
Loss given default (rhs)

20%

–80%

Years
0%

–100%
1

8

15

22

29

36

43

50

Probability of excess return and loss given default, using µ = 0.08,
σ = 0.18, and r = 0.04.

FIGURE 19.3

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 483

the annual increase of its pension liabilities and particularly on the size of
the potential deficit; see also Lukassen and Pröpper (2007).
Although the probability of loss will decline as the investment horizon
increases, t he po tential l oss g iven defa ult ( LGD) i s o ften disregarded.
A long-term i nvestment i n t he st ock ma rket i mplies t he real pos sibility
that the investor will have to absorb a stock market crash, a recession, or
a period of economic stagflation. Therefore, the size of the (potential) loss
increases with time. To explore this, define
δ1 =

(µ − 12 σ2 − r )(T − t )
σ T −t

δ2 = δ1 − σ T − t

and X = S er (T −t )

The courageous reader may check t hat, g iven a n ormal d istribution, t he
loss given default equals

1−

∫

X

ST f ( ST )dST
E ( ST | ST < S e )
N ( −δ1 )
= 1− 0
= 1−
E ( ST )
E ( ST ) P ( S T < X )
N (−δ 2 )
rT

Figure 19.3 plots t his LGD. It shows t hat for longer maturities t he LGD
turns more severe. If the probability of a shortfall declines with time and
the LGD increases with time, the question remains as to the overall effect
of the probability of a shortfall and the loss given a shortfall.
This overall effect is convincingly demonstrated by using option valuation t heory. L et u s a ssume t hat i n t he long r un equity i nvestments a re
indeed l ess r isky. B odie (1995) dem onstrates t hat i nsurance a gainst a n

overall return below the risk-free interest rate r may be acquired by buying a put option with an exercise price equal to the initial value S accrued
at rate r over maturity T − t. This “forward-strike” put option affords the
holder the luxury of enjoying optimal asset allocation (i.e., equity versus
cash) at expiry. Because if the actual return on the equity portfolio turns
out to have lagged behind the risk-free yield, the holder will have the right
to sell the equities at a fi xed higher price.
Bodie shows that the insurance premium only depends on the option’s
maturity (T − t) a nd t he st andard de viation of t he u nderlying portfolio’s
value (σ). The crucial insight is that the value of the put option is shown to
increase with either T − t or σ. That means that the risk of investing in equities

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484 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

increases with time. The time diversification effect is thus outweighed by the
increasing size of a possible shortfall to the risk-free yield. A long maturity
and a high standard deviation on the value of the equity portfolio each make
for increased insecurity, upping the premium required for the assured optimal asset allocation. In addition, Bodie argues that this result is similar both
in a w orld w ith mean reversion a nd i n one w ithout mean reversion. The
reason is that option-pricing models, such as the Black–Scholes–Merton, are
valid regardless of the process for the mean return. They are based on the
law of one price and the absence of arbitrage profits. Lo and Wang (1995)
provide a simple adjustment for the volatility parameter in the option pricing formula to correct for autocorrelated asset returns. Although this influences the value of the option, it does not change the relation between risk
and time. This shows that pension funds should give due consideration to
equity i nvestment r isks over t ime. These r isks sh ould a lso be adeq uately
addressed in supervision, as argued in Section 19.2.4.
19.2.4 Financial Assessment Framework
The Financial Assessment Framework as it is operated under the Dutch

Pension Act embodies the characteristics of prudential regulation as discussed earlier. Assuming t he f ull f unding requirement, t he f ramework
encourages sound risk management, both in the short and long run. To
that end, one major condition is t he mark-to-market va luation of both
investments a nd l iabilities, a s d iscussed i n S ection 1 9.3. I t i ncludes a
stringent r estriction w ith r egard t o t he g uaranteed pens ion l iabilities,
for which technical provisions must be built and covered by assets at all
times. Furthermore, the contributions raised must be cost-effective.
On top of the technical provisions, the Financial Assessment Framework
imposes a number of requirements on pension funds’ capital, depending on
the risks incurred by a fund. These are dealt with in greater detail in Section
19.4. The strict funding requirements contrast with the less-stringent condition regarding contingent l iabilities: here t he pension f und does not need
to build technical provisions, but must st rive for consistency between t he
expectations raised, the level of financing achieved, and the degree to which
contingent claims are awarded to members (see Sections 19.3.2 and 19.5).

19.3 MARK-TO-MARKET VALUATION
The core in pension fund supervision is the valuation of assets and liabilities. Ideally, t he ma rket value of lia bilities is det ermined in a liq uid a nd
well-ordered market. However, as lo ng as suc h a liq uid market do es not
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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 485

exit, marking-to-market is also possible on the basis of the replication
principle. Thus, in a world without arbitrage opportunities, the marked-tomarket value of a p ension liability equals the market price of that investment portfolio that generates exactly the required cash flows under all future
states of the world. The present value is equivalent to the actual value of an
investment where cash flows are matching in all r espects and are certain
to be realized. If investments can be found that, in each realization of the
actuarial stochastic process, generate funds exactly equal to the payment
liabilities, the cash flows of liabilities and investments are said to be matching in all respects. Note that the expected value of guaranteed liabilities is

therefore not affected by the pension fund’s actual investments (see Section
19.3.1). The expected value of embedded options in the pension liabilities
is determined as t he value of a financial instrument t hat is a r eplication
of the conditional cash flows (contingent claims) based on under writing
principles that are deemed to be realistic. This realistic value is determined,
for example, by option valuation techniques (see Section 19.3.2).
19.3.1 Valuation of Defined Benefit Liabilities
The tech nical provisions a re e stablished a s t he ex pected va lue of t he c ash
flows arising from the pension liabilities as defined in the pension contract.*
In turn, the expected cash flows are based on actuarial sound underwriting
principles (mortality rates, longevity risks, surrender rates, frequency of transfers of value, etc.) that are deemed to be realistic. A pension fund must take
into account expected demographic, legal, medical, technological, social, or
economic developments. This means, for example, that the foreseeable trend
in improvement in life expectancy must be reflected in the expected value,
given the fact that, on average, people tend to live longer as time goes on.
The principle of the replicating portfolio as introduced in Section 19.3
is explained through a simple numerical example using a single cash flow
(bullet). In reality, a pension fund of course has regular payments to make,
but t he i dea st ill h olds. F or t hat ma tter, su ppose, i n y ear 1 5, a pens ion
fund will have a guaranteed nominal liability of 100 (euro) to a cohort of
pension plan members. To determine the best estimate, account has been
taken of t he mortality a nd su rvival r isk for e ach member be tween now
and 15 years hence. In addition, the expected improvement in the survival
* It is also suggested that the marked-to-market value of p ension liabilities is the sum of t he
expected value a nd a s o-called market value margin. Th is margin compensates buyers for
non-hedgeable r isks u nderlying t he l iabilities. I n t he Fi nancial A ssessment Fr amework,
these non-hedgeable risks are not i ncorporated in technical prov isions but i n t he required
solvency margin.

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486 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

rate over the next 15 years has a lso been a llowed for. If actual mortality
equals expected mortality, the pension fund will disburse an amount of
exactly 100 in 15 years time. If actual mortality is lower than expected, a
higher amount must be disbursed. This extra payment might for instance
be financed out of the surplus in the pension fund.
If we neglect the actuarial uncertainty, the pension fund can hedge its
liability in capital markets by investing in a zero-coupon bond that will pay
exactly 100 in 15 y ears time. The zero-coupon bond is currently traded at
50, corresponding to a 15 year spot rate of 4.73%. The relationship among
the variables is as follows:
50.0 =

100
(1 + 0.0473 )15

Following t he r eplication a rgument, t he ma rked-to-market va lue o f t he
pension liability is also 50. The pension fund would therefore need to establish and cover technical provisions amounting to at least 50. The modified
duration of the zero-coupon and the liability is 15/1.0473 = 14.3, implying
that if market interest rates were to drop from 4.73% to 3.73%, the markedto-market value of the liability would go up by approximately 14.3%.
For the purposes of the valuation of a fully guaranteed indexed pension
liability, it is assumed that there is a zero-coupon index-linked bond with a
maturity of 15 years, whose principal is adjusted annually to the actual rate
of inflation. Suppose such a bond trades at 66.8, corresponding to a real rate
of interest of 2.73%. The relationship among these variables is as follows:
66.8 =

100
(1 + 0.0273 )15

Again, following the replication principle, this is also the current value of
an inflation-protected pension liability. The pension fund would therefore
need t o e stablish a nd co ver tech nical p rovisions a mounting t o 6 6.8. By
investing in an index-linked bond, the beneficiaries are sure to receive an
inflation-proof payment in year 15, whose purchasing power equals current purchasing power.
19.3.2 Valuation of Contingent Liabilities
In a typical Dutch pension plan, the indexation of benefits is not guaranteed but depends on an annual discretionary decision by the pension fund

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 487

trustees. Dutch pension funds are thus not required under FTK to value
and r eserve f or t heir f uture, co nditional i ndexation i n tech nical p rovisions. In practice, the indexation is often contingent on the pension funds’
funding ratio. If the funding ratio is sufficiently high, the benefits are fully
indexed to inflation or wage growth. However, if the funding ratio drops
below the required solvency level (discussed later), indexation is reduced or
even removed. The marked-to-market value of these contingently indexed
liabilities c an a lso be der ived u sing t he r eplication p rinciple, i ncluding
derivatives that mimic the contingency.
Suppose again that the unconditional nominal pension liability equals
a cash flow of 100 in 15 years time. In addition, the pension fund seeks to
index its l iability, subject to a ma ximum of 1.95% per a nnum. (In order
to avoid u ndue complication, we a ssume i nflation fixed at t his number.)
However, the actual indexation granted each year depends on the financial position as determined by the funding ratio in each successive year.
At a funding ratio of F = 133.8% (= 66.8/50 *100%) or more, the maximum

indexation of 1.95% is granted. At lower funding ratios, the indexation is
reduced linearly down to a f unding ratio of F = 105% at which no more
indexation is granted. This contingent indexation procedure can be replicated by a series of options on the funding ratio. For each year we than have
a long position in a call option with a strike of 105% and a short position in
a call with a strike of 133.6%. The option in each year also depends on the
conditional outcome of the options in the previous years. Although feasible
through, for example, Monte-Carlo simulations, Dutch pension funds are
not required to value their future indexation policy by this method.
Instead, t hey m ust st rive f or co nsistency bet ween t he ex pectations
raised, the level of financing achieved, and the degree to which contingent
claims are awarded to members. The consistency needs to be g rounded
by t he application of a l ong-term stochastic continuity a nalysis, wh ich
is de scribed la ter i n m ore de tail. S everal m eans o f “financing” contingent l iabilities a re t hen acc epted u nder t he Pension Act, a mong wh ich
the assumption of expected future investment returns. Th is treatment of
contingent liabilities has kept the Dutch pension system affordable and
flexible since indexation can only be g ranted if the funding ratio is sufficiently high. However, this means that the pension fund’s beneficiaries
are exposed to stock market exposure that they cannot easily hedge. Also,
it qualifies the Dutch pension system as a n ominal system since conditional indexation is not truly reserved for. Most pension funds in practice do not guarantee real pension benefits, but only nominal benefits.

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488 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

19.3.3 Term Structure of Interest Rates
Therefore, valuation focuses on the accrued (nominal) benefit obligations.
For that purpose, a f ull-term structure of interest rates is made available
to pens ion f unds. This sec tion de scribes t he construction of t his c urve.
It is based upon the interest rate swap curve and published each month on
the Web site of the DNB. The swap market does not require an exchange of

principal amounts and is largely collateralized thereby eliminating essentially all credit risk.* The data source underlying the construction of the
nominal interest rate term structure are European swap rates for 1–10 year
maturities (yearly intervals) and 12, 15, 20, 25, 30, 40, and 50 year maturities as they are listed on a daily basis by Bloomberg. In such interest rate
swaps, 6 -month Euro I nterbank O ffered R ate (EURIBOR) i s exchanged
for a fi xed interest rate. Unavailable maturity points a re interpolated on
the assumption that intervening forward rates are constant.
An interest rate swap is a long position in a fi xed-rate bond combined
with a sh ort pos ition i n a floating-rate bo nd, o r v ice v ersa. A n i nterest
rate swap is constructed so that no initial payment takes place—in other
words, its market value is equal to nil. We define the following annually
accrued interest rates: f t1,t2 is t he forward rate between t1 and t2, rt is the
swap rate at maturity t, and zt is the zero coupon swap rate at maturity t.
The latter being the applicable discount rate for pension liabilities.
The zero coupon swap rate is derived from the par swap rate by means of
bootstrapping, starting with the 1-year swap rate. Since (1 + r1)/(1 + z1) = 1,
it follows that z1 = r1. The 2-year zero coupon rate is determined by calculating the present value, at the 1- and 2-year zero rate, of the cash flows from
(the fixed rate side of) a 2-year swap, and equating the present value to 1.
The 1-year zero rate is already known, so that this leaves an equation with a
single unknown (the 2-year zero coupon swap rate):
r2
1 + r2
+
=1
1 + z1 (1 + z 2 )2
which can be solved easily.
By way of ex planation, we a lso der ive t he 1-year forward over 1 y ear
(i.e., the forward interest rate accruing between t = 1 and t = 2) in the usual
way via
* Although credit risk is eliminated using margin accounts, there might be risk of a premature
expiration of t he s wap c ontract. U sually I SDA a nd C SA c ontracts i nclude t riggers t hat

predefine early termination.

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 489

f1,2 =

(1 + z 2 )2
−1
1 + z1

From ma turities o f 1 0 y ears o nward, n ot a ll Bl oomberg s wap r ates a re
used. Intervening rates are derived from the 12, 15, 20, 25, 30, 40, and 50
year maturity points. To calculate, for instance, the 21 year zero coupon
rate, we assume that the 1 year forward remains constant between 20 and
25 years. This is a reasonable assumption, because the forward rate is actually a prediction about the 1 year rate that will apply 20, 21, etc., years from
now. The market is not very likely to take substantially different views on
1 year interest rates 20 or 21 years forward. This ends the valuation issues
related to the liabilities. We now turn to the valuation of assets.
19.3.4 Valuation of Assets
A pension fund will conduct an investment policy in accordance with the
prudent person rule. Meaning that the assets are invested in the interest of
the beneficiaries. There are no quantitative investment restrictions except
for investments in the sponsor that are limited to a maximum of 5% of the
portfolio as a whole.
The i nvestments a re va lued a t ma rket va lue. This is t he a mount f or
which an asset could be ex changed between knowledgeable, willing parties in an arm’s length transaction. Three situations can be identified. First,
it i s r elatively s imple t o va lue i nvestments t hat a re t raded o n a r egular

market. Valuation takes place on the basis of the most recent transaction
price on that market. Second, if no such market value is available, but the
investment can be replicated by other instruments, then the value is equal
to the sum of the market value of those instruments. Third, if there are no
comparable instruments, the pension fund must resort to a model-based
valuation tech nique u sing g enerally acc epted eco nomic p rinciples such
as replication and the non-arbitrage principle. The assumptions and estimates used must be in line with what can be derived from general market
prices. Furthermore, each embedded option must be valued. This could be
an option either available to the issuer or the holder of an instrument.
If external sources are used for the valuation process, the pension fund
must have procedures to establish the degree of accuracy, promptness, and
consistency o f t he p rice a nd o ther i nformation r eceived. Pension f unds
need to assess the extent to which valuations are being produced independently and how this independence is maintained. Considerations include
(the appropriateness of) the valuation methodology used, validation and
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490 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

backtesting procedures surrounding pricing models, independent verification and the frequency of valuations.
19.3.5 Contribution Policy
Pension funds must determine the cost-effective contribution as the sum of
• The actuarially required contribution for the pension obligations
• An extra sum for maintaining the regulatory own funds
• An extra sum for the administration costs
• An ex tra su m r equired f rom a n ac tuarial st andpoint f or t he p urposes of granting indexation
Although it i s ac tuarially fa ir t o u se t he c urrent ma rket i nterest r ate a s
the m ost r elevant d iscount r ate, pens ion f unds a re a lso a llowed t o u se
a s moothed o r fi xed d iscount r ate t o d ampen sha rp fluctuations i n t he
actuarially required contribution. This smoothing, that can be based on a

moving average of historical interest rates or the expected return on assets,
only applies to the calculation of the cost-effective contribution. This technique may not be used for the calculation of the technical provisions.
Strict conditions apply to discounts or restitutions on the cost-effective
contributions. A d iscount c an only be a pplied i f, ba sed on a co ntinuity
analysis (see Section 19.5) over a 1 5 year per iod, ex pected i ndexation i s
sufficient relative to the indexation ambition of the pension fund. It is up
to the supervisor to decide what level is sufficient, although a level of 70%
of full indexation is considered to be the absolute minimum. Restitution
is only possible if all indexations in relation to the preceding 10 years have
been f ully granted and any reduction on pension rights and entitlement
to a pension benefit in the preceding 10 years are also fully compensated.
After this exposition on valuation and contribution policy, we now turn to
the risk-based solvency requirements.

19.4 RISK-BASED SOLVENCY REQUIREMENTS
Pension funds are required to retain sufficient additional capital over the
technical provisions to be able to absorb losses in the case of adverse events
on the financial markets or in the development of insurance technical risks.
Typical adverse events include a sharp decline in interest rates, a large fall
in stock prices and the realization of lower-than-expected mortality rates.

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 491

The c apital requirement is ba sed on t he well-known va lue-at-risk (VaR)
risk m easure o n a 1 -year h orizon a nd a co nfidence l evel o f 97.5%. This
means that, theoretically, the required buffer is at least enough to prevent
the assets from fa lling below t he level of t he technical provisions w ith a

level of probability of 97.5% in the subsequent year.
Interestingly, a co mfort l evel o f 97.5% is s ignificantly l ower th an th e
99.9% confidence level in the supervisory “Basel II” framework for banks
and t he f uture “ Solvency I I” f ramework for i nsurers wh ere a co nfidence
level of 99.5% w ill be u sed. In pa rticular, t his questions t he level-playing
field between pension f unds a nd i nsurers both w riting comparable longterm obligations. However, the difference may be ex plained by t he add itional policy instruments pension funds possess to influence the funding
ratio in the long run, like being able to raise future contributions and cutting
back on the indexation of pensions when necessary. As a rule-of-thumb,
this greater flexibility should therefore reflect more or less the difference in
confidence levels. We will encounter a pension funds’ steering mechanisms
again in the discussion on the long-term continuity analysis further on.
In t he next sections, we w ill discuss in more detail t he t hree possible
methods for determining the capital requirement, that is, the standardized
approach (Section 19.4.1), internal models (Section 19.4.2), and the simplified approach (Section 19.4.3). Subsequently, Section 19.4.4 discusses the
minimum capital requirement from the European Directive for occupational pensions and Section 19.4.5 elaborates on recovery horizons.
19.4.1 Standardized Method
It wa s cl ear f rom t he o utset t hat t he F inancial A ssessment F ramework
needed to i nclude a st andardized method for c alculating t he r isk-based
capital r equirement. A part f rom a f ew la rge a nd so phisticated o nes,
pension funds do not have the means in terms of staff and modeling capabilities to determine the required solvency level themselves. The DNB therefore developed a standardized method based on the variance–covariance
method. It is fully incorporated in regulation now.
This standardized method builds a total capital requirement by applying a prescribed correlation matrix to capital requirements for the individual risk categories. These risk categories cover interest rate risk, equity and
real estate risk, currency risk, commodity risk, credit risk, and insurance
risk. The capital required for each of these individual risk factors is determined by the impact on the pension fund’s surplus or equity of prescribed
shocks in the risk factor, all shocks being calibrated to the confidence level

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492 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

of 97.5% on a 1-year horizon. Importantly, the calibration assumes welldiversified portfolios and ignores idiosyncratic risks.
This total balance sheet approach is of particular importance for interest
rate risk as it affects both assets and liabilities. The impact of the other risk
categories mostly remains limited to one side of the balance sheet, that is,
insurance risk to the liability side and the other risk categories to the asset
side. A description of the individual risk factors, followed by the aggregation
to an overall capital requirement is given in the following text.
19.4.1.1 Interest Rate Risk
As described in Section 19.3, one of the influential changes introduced by
the Financial Assessment Framework is a ma rket-consistent valuation of
liabilities. In practice, this boils down to discounting expected cash flows
by ma rket interest rates (swap rates). For interest-rate–dependent assets,
mark-to-market va luation wa s a lready co mmon p ractice bef ore. The
required capital (S1) for interest rate risk follows logically from the largest
loss resulting from applying a prescribed downward and an upward shift
in the term structure of interest rates.
As an example, in the downward scenario, current 1, 5, and 15 year rates
decline by respectively 37%, 27%, and 23%. This is equal to multiplying
the current market rates by 0.63, 0.73, and 0.77, respectively. This approach
of m ultiplying b y fi xed fac tors i s i n l ine w ith t he o bserved beha vior o f
interest r ates; cha nges a re st ronger i n a n abso lute sense wh en t he l evel
of rates is h igher a nd v ice versa. Due to t he longer duration a nd h igher
value of liabilities relative to interest-rate–dependent assets (like government bo nds, co rporate bo nds, a nd m ortgages) m ost pens ion f unds a re
more vulnerable to declining than to increasing rates. Although unlikely,
pension funds may have a reversed risk profile making them sensitive to
increasing interest rates. The standardized method therefore also includes
a scenario of an upward shift in market rates. For other asset categories,
like equities, real estate, commodities, and currencies, it is assumed that
they a re n ot d irectly ex posed t o i nterest r ate r isk, t hat i s, a ll ha ve z ero

duration. However, credit exposures are sensitive to both interest rate risk
and spread risk.
Since the 1990s, the duration gap of a typical fund that has not hedged
its i nterest r isk ex posure, ha s w idened b y t he sh ift fr om g overnment
bonds t oward m ore r isky a ssets l ike eq uities, r eal e state, co mmodities,
and alternative investment (private equity, hedge funds). As a result, the
sensitivity to interest rate risk and the capital requirement have increased.

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 493

This risk has materialized all the more strongly because of the impact on
the funding ratios of the steep decline in interest rates during the current
credit crisis.
19.4.1.2 Equity and Real Estate Risk
Investments in equities and real estate have long been considered the traditional a lternatives (“risky assets”) to investing in risk-free government
bonds. Pension funds have turned to these asset classes for their expected
risk premium, assuming that it can be realized in the long run; see Section
19.2 for a d iscussion on pension funds and equity investments. This risk
category is decomposed into several subcategories: equities mature markets i ncluding i ndirect r eal e state, private eq uity, a nd d irect r eal e state.
The required risk capital (S2) follows from calculating the impact on the
pension f und’s su rplus o f i nstantaneous, adv erse sh ocks o f r espectively
25%, 30%, 35%, and 15%. The four individual outcomes are aggregated by
using a common correlation across the categories of 0.75, according to

S2 =

4

4

4

S22 j + 2 * 0.75 Σ Σ S2k S2l
Σ
j =1
k =1 l =1, l > k

Currently, pens ion f unds i nvest abo ut 1 0% in real estate of which 4%
in direct real estate and 6% in indirect real estate although this ratio is
changing i n fa vor o f t he la tter. G enerally spe aking, i ndirect r eal e state
investments have a more pronounced risk profi le due to leverage by debt
financing. For this reason, indirect real estate is considered equivalent to
equities in mature markets and an adverse shock of 25% is applied for calculating the required capital. Another apparent development in the search
for y ield a re p rivate eq uity a nd h edge f unds i nvestments. The required
capital charge for hedge funds, funds-of-hedge funds, and other “opaque”
investments is the same as for private equity (30% adverse shock).
Since t he 1 990s pens ion f unds ha ve g radually, b ut subst antially,
changed t heir st rategic a sset a llocation t oward m ore r isky a ssets ( see
Figure 1 9.2). They have become dependent on generating additional
return for pr oviding s ufficient indexation. Th is hold s i n p articular for
those f unds t hat determine t heir cost-effective premium level by u sing
expected asset return instead of risk-free rates. Th is inherent dependency
on high returns and the accompanying high-risk profi le may actually be
one of the more important challenges for the sustainability of the Dutch
pension s ystem. The c urrent c redit c risis ha s co nvincingly t aught t wo

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494 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

lessons. First, a h igh-risk profi le leaves f unds ex posed to severe downturns i n t he sh ort t urn. S econd, t he l ong r un o ver wh ich r isky a ssets
are expected to outperform risk-free assets may actually be much longer than that previously expected, even in relation to characteristic long
horizon of pension liabilities.
19.4.1.3 Currency Risk
Currencies e xposures emerg e a s a si de-effect o f f oreign i nvestments.
Some pension f unds may hedge t heir c urrency r isk by engaging i n c urrency swaps or in forward contracts. The capital charge for currency risk
(S3) follows from an adverse shock 20% of all currencies against the euro.
This shock is calibrated using a w eighted average of seven representative
currencies including the U.S. dollar, British pound, Japanese yen, and the
Argentinean peso as a proxy for emerging markets.
19.4.1.4 Commodity Risk
An important reason for investing in commodities, which is done through
index-futures and -options, is risk diversification with other asset classes.
In recent years, most commodities have shown an upward trend that can
be explained by the increased demand from fast-growing economies like
China a nd I ndia. This ha s ra ised i nterest a mong i nstitutional i nvestors.
Commodity investors have also witnessed short and severe dips, like the
recent downturn in oil prices. The capital charge for commodity risk (S4)
follows f rom a p rice dep reciation o f 30 %. The c alibration o f t his sh ock
is based on a ba sket of commodities representing world commodities
production over a long horizon.
19.4.1.5 Credit Risk
Credit risk is actually measured as spread risk in the Financial Assessment
Framework. The capital charge (S5) is derived from the impact on the pension fund’s equity of a general increase of credit spreads by 40%, i ndependent of the time to maturity. This formulation is cyclical in the sense
that the capital charge is low in benign periods and increases when credit
markets de teriorate. Idiosyncratic default r isk wa s abst racted u nder t he

assumption t hat m ost i nvestments i n c redits a re i n b roadly d iversified
portfolios of investment-grade corporate bonds (BBB or better in the S&P
classification). This a ssumption a nd t he absen ce o f defa ult r isk ma y n o
longer hold true. In particular, it could well be t he case that the assumption of exposure to only systematic risk does not hold either for all funds.

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 495

In the future, more emphasis will be placed on credit risk assessment as
credits have become more popular as an investment class with a risk-return
profile between risk-free governments bonds and risky equities.
19.4.1.6 Insurance Risk
The capital charge for insurance risk (S6) is the only risk category for which
the regulator has not set predefined shocks in the standardized method. The
reason is that each and every fund must have the possibility to determine
the actuarial risks corresponding to the specific characteristics of their own
population of me mbers a nd b eneficiaries. Nonetheless, sufficient demand
existed for the DNB to publish standardized tables for the most important
constituents of insurance risk: 1-year mortality risk, longevity risk, and the
so-called negative stochastic de viations. These t hree r isk t ypes a re a ggregated into a capital requirement for insurance risk by assuming full dependence (a correlation of 1) between 1-year mortality risk and the other two
categories, and by assuming independence (a correlation of 0) between longevity risks and negative stochastic deviations.
The t wo la tter r isk c ategories, t hat i s, l ongevity r isks a nd n egative
stochastic de viations, ha ve be en c entral t o ma ny d iscussions abo ut t he
affordability o f pens ions u nder t he F inancial A ssessment F ramework.
They are not 1-year risk categories, but risks spanning the whole lifetime
of t he l iabilities, a nd w ere t herefore pa rt o f tech nical p rovisions i n t he
early F inancial A ssessment F ramework p roposals. L ongevity r isk i s t he
risk that the long-term trend in the improvement of survival rates turns

out t o be st ronger t han ex pected. It i s a s ystematic r isk m eaning e very
member add s to t his r isk, a nd t here a re no d iversification effects over a
group. Negative st ochastic de viations a re a m easure o f t he u ncertainity
in t he de termination o f t he tech nical p rovisions. They a re r elevant f or
smaller pension f unds where t he “ law of la rge numbers” does not apply
in full and actuarial estimations carry a significant uncertainity. For pension f unds w ith over 1000 members t his r isk quickly decl ines, a nd it i s
almost absent for larger funds. In fact, since both the 1-year mortality risk
and negative stochastic deviations behave as 1/ n , n being the number of
members and beneficiaries, large funds are basically only exposed to the
longevity risk. The capital requirement for longevity risk depends on the
age of the members, for example, 10% for the cohort of 30 year old members and 4% for the cohort of 55 year old members. The risk of a longerthan-expected lifetime (i.e., viewed from the pension fund perspective) is
obviously higher for the young.

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496 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling

A compromise was finally found in not picking up the two long-term
risk c ategories i n a r isk ma rgin a s pa rt o f t he tech nical p rovisions, b ut
as pa rt of t he capital for i nsurance r isks (together w ith 1-year mortality
risk). The c apital f or i nsurance r isks i s o ften r elatively s mall f or t ypical
funds with an exposure to market and interest rate risks, in part due to the
assumed independence from all other risk categories.
19.4.1.7 Other Risk Categories
The liquidity risk, the concentration risk, and the operational risk are recognized as three separate risk categories. However, at the inception of the
Financial Assessment Framework they were assigned a 0% capital charge.
A lesson from the present crisis is that pension funds may be v ulnerable
to liquidity risk, for example, related to derivatives collateral management.
Pension f unds are a lso exposed to asset liquidity risk: during periods of

stress block trade prices may be well below recent market prices. This risk
becomes m ore r elevant f or ma ture pens ion f unds t hat ha ve a n et c ash
outflow than for younger pension funds that are net receivers of pension
contributions.
19.4.1.8 Overall Capital Charge
The overall capital requirement is just one step f rom t he i ndividual r isk
capitals per category and follows from applying the prescribed correlation
matrix to the individual risk capitals. This correlation matrix takes a simple form and assumes all categories are independent (i.e., zero correlation)
except for a 0.5 correlation between the capital charge for interest rate risk
(S1) on the one hand and for equity and real estate risk (S2) on the other.
The overall capital charge (S) is therefore defined as

S=

6

Si2 + 2 * 0.5 * S1S2
Σ
i =1

The calibration of the correlation between S1 and S2 has generated much
discussion; se e f or ex ample, N ijman ( 2006). S ome t ake t he l ong-term
average as the point of departure and consider a l evel of 0 a ppropriate.
Others believe that one should look at the correlation in times of stress
and argue that 0.5 is too low. In times of crisis, a plunge in stock prices
often goes hand in hand with a drop in market interest rates as investors
demonstrate a flight to quality. Also, the assumption of independence
across other categories seems to be too strong for the purpose for which

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Risk-Based Supervision of Pension Funds in the Netherlands ◾ 497

the c apital is ac tually i ntended. W hen c apital is needed t he most, t hat
is in times of stress, correlation is likely to be higher than that under
normal conditions.
19.4.2 Internal Models
Instead of using the standardized method, the possibility of developing and
employing a n i nternal model ma rked a t rue i nnovation for t he pension
fund sector. Internal risk modeling allows an independent risk-management function to align the capital requirement much closer to the factual
risk profile th an the s tandardized method. The su pervisor a lso ha s t he
power to enforce a (partial) internal model if the actual risk profile deviates too much from the assumptions underlying the standardized method,
as in the case of, say, a concentrated investment portfolio or a large exposure
to idiosyncratic risks.
The use of an internal model is subject to prior approval by the DNB.
To obtain such approval, a pension fund must demonstrate that the model
is truly embedded in the organization, and that the technical aspects of the
model and the data used are adequate. Besides being technically adequate,
the internal model should therefore also be used in risk management and
decision making (in the jargon of validation practitioners this is called the
“use test”).
The DNB can grant temporary approval for the use of an internal model
even if it needs some further improvement. However, this applies only if
those shortcomings can be fi xed within the next 2 years and are not material enough to prevent responsible use. During such a transitional period,
the pension fund can rely on prudent assumptions where necessary. Even
after full swing approval, elements of the internal model may still rely on
parts of the standardized method, provided this choice is not motivated
by opportunistic motives like regulatory arbitrage and does not harm the
spirit of the internal model. Reporting requirements for an internal model

include a n a nalysis of t he cha nge in t he f unding ratio over t he last year
and, once every 3 years, a comparison with the outcome of the standardized method.
On a m ore technical level, there are basically two requirements for an
internal model: the first is that the total capital charge needs to be set at the
97.5% confidence level at a 1-year risk horizon, the second and more challenging requirement is t hat t he model must be st ochastic i n nature. The
major advantages of this principle-based outline are that the model may be
designed along a pension fund’s own definitions of risk categories and that

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