Explainer-Why the Dutch pension fund reform matters for markets

LONDON, Dec 29 (Reuters) - The Dutch occupational pension system, the European Union's largest, will start transitioning to a new system from January 1 that no longer promises benefits, allowing the nearly 2-trillion-euro ($2.35 trillion) sector to buy riskier assets.

The move could add to pressure on long-term government bonds which already face reduced demand from big buyers like central banks and pension funds elsewhere, at a time of high fiscal spending.

WHY IS THE SYSTEM CHANGING?

Years of low interest rates prior to the COVID-19 pandemic and an ageing population made it harder for funds to compensate for inflation and threats loomed large of cuts to benefits.

The new pension law went into effect in 2023, allowing time for preparations ahead of a 2028 deadline.

Prior to the change, the Netherlands was a rare example of a private pension system continuing to promise a defined benefit at retirement.

HOW WILL IT WORK?

Both future and accrued pensions will no longer promise a defined retirement income. Payouts will depend, instead, on contributions and will fluctuate with market moves.

Funds will be able to hold riskier assets such as corporate debt and mortgages and can invest less in safer ones like government bonds and interest rate derivatives.

Still, they will take on relatively less risk when investing for those closer to retirement, and more for younger generations. Solidarity mechanisms will help spread risks and limit losses.

WHAT HAPPENS FROM JANUARY 1?

The transition to the new system really kicks off, with the first major group of pension funds overseeing assets worth over 500 billion euros set to transition to the new system, ABN AMRO estimates, joining a small number that moved this year.

They will then have 12 months to adjust their asset portfolios, which should help smoothen market impact. Analysts expect funds to initially focus more on unwinding some interest rate derivatives they use to hedge rates risk called swaps, and shift exposure to shorter maturities.

PMT, the third largest Dutch pension fund, estimates it can unwind the excess hedges in six months, but said market conditions will determine the pace, highlighting uncertainty.

Some funds postponed transitions earlier this year. Other delays aren't ruled out given the complexity of the transition. That could spark market volatility at the turn of the year, when liquidity is low.

A larger group of funds, including ABP, the biggest, plan to transition in January 2027.

WHAT DOES IT MEAN FOR BOND MARKETS?

Pension funds will reduce government bond and interest rate swap holdings maturing in 25 years or later by around 100 to 150 billion euros, the Dutch central bank estimates, compared to 900 billion and 300 billion euros outstanding.

Markets have priced in some of the move, with anticipation of the transition helping drive the additional cost that benchmark euro zone borrower Germany has to pay on long-dated bonds relative to medium-term ones to a six-year high.. Analysts expect yield curve steepening pressure to persist.

But that steepening has been more pronounced in the swaps market than in bonds this year.

Dutch pension funds are expected to buy less long-dated bonds just as European governments face record funding needs next year. Germany is ramping up borrowing for fiscal stimulus.

Governments are starting to adjust. Germany plans to issue a 20-year bond for the first time, citing the reform as one reason the segment is attractive. The Netherlands, where the funds have substantial holdings, has reduced the minimum target for the average maturity of its debt going forward.

Governments whose debt is viewed riskier, like Italy and Spain, may benefit.

($1 = 0.8499 euros)

(Reporting by Yoruk Bahceli, additional reporting by Rene Wagner in Berlin; editing by Dhara Ranasinghe and Bernadette Baum)