The study is based on detailed regulatory data covering Dutch pension funds between 2012 and 2022. The dataset includes information on assets, liabilities, bond holdings and derivative positions, providing a comprehensive view of pension fund risk exposures and investment strategies.
The findings show that pension funds with lower funding ratios use interest rate swaps more extensively. While these instruments help reduce the interest rate risk of pension liabilities, they also increase exposure to so-called margin calls. When interest rates rise, swap positions lose value, requiring pension funds to post additional collateral to maintain their derivative positions.
The analysis reveals that these margin calls can be substantial. During periods of sharp increases in interest rates, they amount to roughly 3% of total fund assets on average and can exceed 6% in extreme cases. For many pension funds, these liquidity demands exceed their available cash reserves.
To meet these collateral requirements, pension funds primarily sell their most liquid assets. After reducing money market investments, they tend to sell safe medium-term government bonds, particularly German and Dutch government securities, which are among the most liquid assets in their portfolios.
A key finding of the study is that these sales have consequences beyond the individual funds themselves. Forced bond sales put downward pressure on bond prices and amplify existing market movements. As a result, decisions made by individual pension funds can affect the broader bond market.
The authors argue that this creates a largely overlooked trade-off. Regulatory requirements are designed to increase pension fund stability by encouraging the management of interest rate risk. However, the use of derivatives can simultaneously create new liquidity risks. Consequently, pension funds may be forced to sell assets procyclically during periods of rising interest rates, despite their long-term investment horizons.
Overall, the study shows that while interest rate swaps are an effective tool for managing interest rate risk, they can generate significant liquidity risks. The findings highlight that measures designed to reduce one type of risk may inadvertently create new vulnerabilities for both pension funds and financial markets.
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