Most pension funds have (much) longer maturities for their liabilities than for their assets. This balance-sheet mismatch exposes the fund to interest rate risk: if interest rates fall, liabilities increase much more sharply than the value of assets. The standard model contains prescribed interest rate scenarios to calculate the own funds required to cover this risk. Examples of interest rate-sensitive investments are corporate bonds, inflation-linked bonds, convertibles and interest rate derivatives.
Interest rate scenarios
Section 1 of Annex 3 to the Pensions Act Supervisory Regulation and the Mandatory Occupational Pension Scheme Act provides interest rate factors to derive an increase or decline for nominal and real interest rates on the basis of the applicable yield curve. For a maturity of 16 years the following factors for example apply: 1.32 for an increase and 0.76 for a decline in nominal interest rates, and 1.16 for an increase and 0.88 for a decline in real interest rates.
The interest rate risk scenario is determined by applying the interest rate factors from the table to the yield curve published by DNB. For each maturity, the yield curve is multiplied by the interest rate factors for an interest rate increase or decline, depending on what constitutes the most adverse scenario for the fund. So, if the nominal interest rate for a 16-year maturity is 4%, an interest rate decline of 0.96 percentage points (= (0.76 -1)* 4%) or an interest rate increase of 1.28 percentage points (= (1.32 -1)* 4%) would have to be taken into account in determining the interest rate sensitivity for this maturity. Each month, the current yield curve is published on DNB's website. For interest-sensitive investments where the value depends on the real rate of interest, such as inflation-linked bonds, the real interest rate change is derived in a similar way, by applying the real interest rate factors to yield curve published by DNB.
Pension funds can calculate value changes for liabilities and assets separately after application of the derived increase or decline in interest rates, and subsequently determine the net total effect on the fund's surplus. The net loss in the worst-case scenario is used as input to determine the required own funds. In most cases this involves an interest rate decline. The absolute value of this figure is referred to as S1 in the square root formula.
Correlation with other risks
The calculation of required own funds assumes a correlation of 0.4 between downward interest rate shocks and equity risk, and a correlation of 0.4 between downward interest rate shocks and credit risk (S5). No correlation is assumed with the other risk categories.