Risk sharing within pension plans in the Netherlands

Sagoenie-RajishDutch pension system
Like many other European countries, the Netherlands operates a three-pillar pension system. This consists of:

1. A government-provided pension.
2. An employer-provided pension.
3. Personal pensions purchased through individual savings.

The first pillar, government pension, provides a basic income to retired people in the Netherlands. It is financed through taxes and is based on a pay-as-you-go system. The pension provided is linked to the country’s minimum wage. An amount of 2% of the state pension benefit is accrued for each year that an individual has lived or worked in the country until the age of 67, with a maximum period of 50 years taken into account. Depending on the increase in nationwide longevity, the age of 67 will increase.

The second pillar consists of occupational pension schemes. Companies offering their employees a pension plan are obliged to administer these plans externally via a pension fund or an insurance company. Funding for these schemes is provided through employer and member contributions and is based on capitalization. A majority of employers used to bear all the risk for these schemes but, in line with globally changing attitudes, there has been a move toward risk-sharing types of schemes. This pillar is discussed in further detail below.

The third pillar consists of annuities and pensions bought from individual savings. It is the main source of postretirement income for self-employed individuals and individuals working for organizations that do not provide a pension. To encourage people to make use of this pillar, tax incentives (within limits) are provided by the government.

In 2014 and 2015 the tax incentives in the second and third pillars were further limited. The annual salary on which the pension is based is limited to EUR 100,000.

Risk sharing in the second pillar
Traditionally, the second pillar of the Dutch pension system has consisted of defined benefit (DB) schemes where the employer bore most of the investment and longevity risk of the plan. As a result of the increasing risk and earnings losses associated with these plans, there has been a move by many companies in the Netherlands toward risk-sharing defined contribution (DC) plans. Typically, these DC plans have contributions that increase by age. At retirement the accrued capital must be used at that moment to buy an annuity. By default, the investments are managed in a way that the investment and interest rate risk decreases as employees approach the retirement age. In recent years, however, a variation of the DC plan, which has elements of a DB plan, has been introduced into the country in the form of the collective defined contribution (CDC) plan.

Unlike a DC scheme where employees have individual plans, within a CDC scheme contributions are pooled for investment and longevity purposes. Contributions to the fund are normally made in the form of fixed percentage salary contributions from both the employer and the employee. On retirement, instead of purchasing an annuity for retiring members, benefits are typically paid out of the plan. These benefits are in the form of a DB type of career average benefit and are received as payments dictated by the consumer price index (CPI). CPI indexation can be reduced when the funding levels are below approximately 130%.

Unlike DB schemes, benefits in a CDC scheme are not promised. CDC funds have funding targets that determine whether or not the scheme can meet its planned obligations. Within the Netherlands, contributions are set such that the CDC funds maintain a targeted funding ratio of about 130%. In the event that the funding ratio falls to a level of about 105% or less, then scheme benefit levels could be reduced or member contribution levels increased. A reduction in benefit levels would affect both retired and non-retired members contributing to the fund. In the event that the fund performs better than expected, bonus index payments would be made to the employees (or repairs of the indexation that was missed in the past). The employer does not benefit at all in such cases.

As decisions regarding CDC plans affect both pensioners and contributors to the scheme, there is a need for an all-inclusive board of trustees representing retirees, former employees, and employers. All forms of decisions regarding investments and changes in benefit levels are made by this body. This removes the burden of making investment decisions from the scheme members and also the need to have all members involved in the fund’s decision making.

Advantages of the CDC plan
From an employee perspective, the main advantage of a CDC scheme over a DC scheme is that fund costs, and risks, are shared by all members, resulting in lower contributions per member. Given the DB nature of the payments made, it is also expected that employees would get better retirement incomes. Unions, in general favoring more solidarity, and works councils are willing to negotiate a move from DB plans to CDC while often turning down DC.

From an employer perspective, there is greater certainty with respect to the contributions to be made into the fund. Unlike in DB schemes, where employers are expected to cover fund shortfalls, employers in CDC plans have no extra liability in the event that the fund underperforms. Also, from an accounting perspective, CDC schemes get similar treatment to DC schemes. Underfunded liabilities therefore do not have to be reflected in the employer’s financial statements.

Other risk-sharing issues in the second pillar
Actuarial contribution
In order to accumulate pensions, contributions have to be paid yearly to a pension fund. The contribution depends of course on the features of the pension plan (such as the level of accumulation), but it also depends on the market conditions at the time of contribution. In case of a low interest rate, a higher contribution will have to be paid for the pension accumulation than in the case of a high interest rate. In principle, each pension fund has to charge a breakeven contribution every year. The incoming cash flows from the contribution payments should be sufficient to finance the accumulation of pension entitlement in that year, including a solvability and costs increment. The breakeven contribution for the participant will therefore consist of an actuarial contribution based on the current market circumstances (including the valuation rules), possible increments for implementing costs, required equity capital, and indexation policy. There is a difference with the valuation of obligations where a risk-free yield term structure, including ultimate forward rates (UFRs), must be used, which is published every month by the Dutch supervisor of pension funds. When determining the contribution, the pension fund is allowed to use a muted discount rate instead of the current yield term structure. This is mainly to prevent the participants from having highly volatile annual contributions. Muting can be done either by averaging the recent 10 years’ interest rates or based on expected returns. Of course, the muted discount rate must be documented and implemented for a longer time period.

With the introduction of the new financial framework on January 1, 2015, several features of the contribution policy have changed. First of all, when using expected returns, new maximum returns should also be taken into account. Second, the discount rate based on expected return will have to be renewed every five years. Stricter rules regarding the required equity capital of the solvability increment, which must be incorporated in the contribution, will also lead to an increase of approximately 4% to 5%. The choice of the discount rate affects risk sharing between young and old and active and inactive participants.

Aggregate contribution
A concept closely related to the valuation method and contribution policy is the aggregate contribution. Many Dutch pension funds charge an aggregate contribution: it is one uniform contribution that has been determined without taking into account individual differences in age and/or gender. The aggregate contribution thus implies that the younger and older participants pay the same contribution percentage although the prices for pension for older participants are higher than for younger ones. For industry-wide pension funds this contribution is compulsory. The aggregate contribution was once introduced with the purpose of providing equal opportunities to all ages. Besides, many companies were confronted with older employees who were relatively more expensive with respect to the pension costs than younger employees while having the same (mandatory for the sector) pension plan. Companies with many older employees could therefore become less competitive. Nowadays, there has been discussion about the aggregate contribution and risk sharing between young and old participants. In addition to the fact that there has been a transmission from younger to older people within companies, the aggregate contribution also leads to a transmission of people with shorter life expectancy (usually less educated, lower-income, and male) to employees with longer life expectancy (often better educated, higher-income, and female).

More and more people are convinced about abolishing the aggregate contribution, because of the above-mentioned factors, although there is no consensus on an alternative. One of the popular alternatives is the aggregate contribution with decreasing accumulation, which entails an equal contribution percentage, but the accumulated pension participants can expect to receive falls. Younger employees will now accumulate more than older employees while having the same percentage. Hence, older employees will not have (another) disadvantage related to the required actuarial contributions. This seems to be a good alternative, although we shouldn’t ignore the possible consequences related to this measure. For example, the current economic crisis with a high youth unemployment rate weighs more for one generation than before. Furthermore, abolishing the aggregate contribution may come with costly transition measures. The younger generation might want compensation for the fact that it won’t be subsidized anymore later, whereas it had to subsidize the current older generation. There are no exact numbers, but it has been estimated that it might cost EUR 25 billion (Royal Dutch Actuarial Association) to EUR 100 billion (Central Plan Bureau). Also, administration and communication will become more complicated when an individual actuarial contribution note is required.

The pension system in the Netherlands was for years one of the best in the world but is showing cracks. Nowadays, there are several different discussions going on focusing on risk sharing between different stakeholders. The national pension dialogue is now “full swing” going on and will undoubtedly contribute to a change in the pension landscape in the Netherlands. The transfer of risks from employers to employees is an “irreversible” process and will lead to pension awareness for participants and pensioners and hopefully better “financial planning.” More than ever we need another “mind-set” in which the (ex-) participant and communication are central. The most important question is: Who carries what risk at which point and to what extent?