The unwinding of interest rate hedging as Dutch pension funds modify their investment strategies as they transition to the new system involves “significant risks”, according to the Dutch Federation of Pension Funds (Pensioenfederatie).

In a discussion paper, which followed an interactive workshop on the topic, the federation noted that pension funds will need to make important decisions around investment policy towards entry under the Future Pensions Act (WTP).

“For many funds, a difference between the investment policy in the FTK and the investment policy in the WTP means that the portfolio has to be adjusted. The situation on the financial market at the time of inflation is a strong determinant of the level of the funding ratio and thus the realisation of various inflation targets,” the federation explained.

“For many pension funds, the strategic interest rate hedge under FTK is lower than under WTP and they should therefore reduce the interest rate hedge around the transition date.”

It also said that many pension funds have currently increased their hedge to manage inflation risks as they prepare to meet specific funding targets ahead of the transition – so the reduction will be even greater.

However, the federation stressed that pension funds “cannot adjust their interest rate hedging to the new strategic policy overnight” and there are several challenges to consider.

For example, for some pension funds, the amounts involved are so large that a substantial lead time is needed to trade large volumes of interest rate hedges at a reasonable price.

As most pension funds have opted to transition on 1 January 2025, 2026 or 2027, it presents an additional problem as there is usually lower liquidity in financial markets between mid-December and the first week of January. In addition, the concurrence of pension funds wishing to move from FTK to WTP at the same time – and thus adjusting their interest rate hedging at the same time – could upset the balance in interest rate markets.

The federation also added: “Unlike regular pension fund transactions, more information is now publicly available on the timing and (partly) also on size. Even if pension funds are only very limitedly active in the market, third parties (e.g. hedge funds) will try to take advantage of this and create market distortions.”

As a result of these challenges, the federation said it is “inevitable” that pension funds will take time to adjust their interest rate positions.

“However, this poses a tricky dilemma. It is undesirable to phase out interest rate sensitivity before the transition date because the funding ratio at which to redeem then becomes more volatile and the redeeming targets may not be realised. This potentially affects the balance of the transition,” the federation said.

Therefore, it stressed that it is “crucial” that pension funds integrate these risks into their decision-making process to ensure a balanced solution.

“By weighing up proposed suggestions, the impact of these risks can be identified
and minimised, thus supporting a stable transition to the new pension system,” the federation concluded.

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