Denmark Reveals Mark-to-Market Trap Amid No-Return Risks

Denmark Reveals Mark-to-Market Trap Europe Is Considering
Danish pension funds pay out a higher percentage of retirees’ working salaries than life insurers elsewhere. Photographer: Linus Hook/Bloomberg

As the European Union tells its life insurers to adopt mark-to-market rules starting in 2014, it should look north to see how the model can backfire.

A decade after Denmark’s pension funds and life insurers became Europe’s first to use daily market values for matching assets and liabilities, the country is diluting the model. The government now says mark-to-market needs adjustments to work in times of volatility.

“Instead of no-risk returns, you’ll get no-returns risk,” Peter Lindegaard, who oversees about $50 billion as chief investment officer at Danica Pension, a unit of Denmark’s biggest lender Danske Bank A/S, said in an interview. “You end up on the wrong side of the tracks all the time. In trying to protect the clients from falling interest rates, we end up pushing interest rates down further.”

Regulators broke that cycle this month after Denmark’s haven status from Europe’s debt crisis sent its yields to record lows, inflating liability burdens. As the Nordic country, together with neighboring Sweden, softens its requirement that pension assets be based on daily market moves, European regulators are busy preparing the details of mark-to-market rules for the 27-member bloc. They should think again, according to the Organization for Economic Cooperation and Development.

‘The Culprits’

Pension funds and life insurers are “supposed to be long-term investors and natural stabilizers of the financial system,” Juan Yermo, head of the Paris-based OECD’s private pensions unit, said in an interview. By enforcing strict mark-to-market, “you can put them in a situation where they have to behave like a short-term investor and a contributor to the instability of the market,” he said.

The Danish government’s intervention, which raised the discount rate used to calculate pension liabilities, sent 30-year bond yields soaring as much as 17 basis points the day after it was announced on June 13. Ten-year yields also gained, and the rate on the 3 percent 2021 bond has climbed 13 basis points this week to 1.36 percent.

Not everyone agrees the model is to blame. Pension funds and life insurers that offer guaranteed products are the real culprits, according to Anders Grosen, a finance professor at Aarhus University and a former member of the Danish Pension Market Council, who said he warned the industry 15 years ago to stop offering minimum returns.

Guaranteed payouts made up 63 percent of Denmark’s $360 billion in commercial pension assets at the end of 2010, according to a March central bank report. Funds and insurers provide guaranteed returns as high as 4.5 percent.

‘Just Cheating’

The EU’s regulatory overhaul for life insurers -- the so-called Solvency II package -- is due to be adopted in January 2014. The commission is basing new pension regulation on Solvency II.

According to Grosen, mark-to-market has underscored the risks that guaranteed products have created and that would otherwise have remained hidden.

“They should have skipped the interest guarantees years ago,” he said. Raising the discount rate that insurers use is the wrong approach, Grosen said. “They are just cheating.”

Denmark’s pension industry association has defended the government’s intervention, the third since 2008.

Mark-to-market has helped pension providers to “get a better understanding of the risks in the system,” said Peter Damgaard Jensen, chairman of the Danish Insurance Association, whose 126 members include the country’s largest life insurance and pension funds. “Pension funds are more than 105 percent funded, and you don’t find the same situation in a lot of European countries.”


Even so, Damgaard Jensen cautions that mark-to-market “can become pro-cyclical if you’re not cautious,” he said.

Denmark, which regulates pension funds and insurance companies identically, told the industry to mark its assets and liabilities to market prices after the attacks of Sept. 11, 2001, disrupted global markets. The ensuing turbulence nearly wiped out PFA A/S, now Denmark’s second-biggest pension fund, after the traded value of its assets proved too small to cover its debt obligations.

Denmark in 2002 gave the pension industry one year to mark its assets and liabilities to market, and a year later made the model mandatory, becoming the first EU country to do so. The U.K., Sweden and the Netherlands followed with similar provisions in 2005, 2006 and 2007, respectively, according to the OECD.

‘Feedback Effects’

The EU has signaled it will take into account the long-term nature of life insurers’ investment horizons. The bloc’s financial services chief Michel Barnier said in a June 1 speech that financial institutions with more long-term investments may face laxer capital requirements.

“What regulators are starting to realize -- and it stems from the crisis -- is that sometimes market values aren’t very reliable,” Yermo said. “There are a lot of hiccups and all kinds of feedback effects, so that at times of financial stress, market value could be way off fundamental values.”

Daily matching of assets to market rates can reinforce negative market trends and hamper the pension industry’s ability to act as an anchor in times of turbulence, Yermo said.

Finland and the Netherlands are already exploring ways to ease liability burdens bloated by near record-low bond yields, while Sweden’s financial regulator on June 7 proposed a temporary floor on its rate, effective for 12 months.

“Rules and guidelines shouldn’t press companies to make short-term investment decisions due to unusual conditions in the capital markets,” Danish Business and Growth Minister Ole Sohn said in a June 12 statement.

Lehman Brothers

Before the government’s intervention, Denmark’s discount rate was calculated based on the euro-swap curve, which has dropped across all maturities by as much as 4.6 percentage points since the 2008 collapse of Lehman Brothers Holdings Inc. triggered the global financial crisis.

As of June 13, pension funds and life insurers have been able to discount liabilities of more than 20 years using a curve that is extrapolated based on a forward rate of 4.2 percent. The rate reflects long-term inflation of 2 percent and growth of 2.2 percent.

Danish pension funds pay out a higher percentage of retirees’ working salaries than life insurers elsewhere. Danes on average can expect 117 percent of net pre-retirement income, compared with 52 percent in the U.K., according to a May asset allocation study by Mercer LLC, a consultancy.


The government is urging the industry to shift customers into so-called lifecycle products, which would eschew most capital requirements even under EU rules, allowing higher risk-return allocations.

Danica on May 10 reported a first-quarter return of 1.5 percent on its guaranteed pensions, versus 6.4 percent on market-based products. Pension savers usually don’t draw their funds for decades, leaving them less sensitive to day-to-day market fluctuations, according to Yermo at the OECD.

“If you have a long-term commitment to meet and little probability the policy holder will withdraw funds, why base investment strategy and key investment decisions on prices today?” he said. “That is the crux of the question.”

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