Tag Archives: risk sharing

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.

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Three cautions when considering public pension reform

Barrett-SheilaOnce a mainstay in American society, there has been a growing trend among public and private employers over the past three decades to close or freeze defined benefit (DB) plans. More recently, public DB plans have been in the forefront of the news with dark headlines detailing bankrupt public sectors unable to make good on their pension promises to retirees. The trend to downsize pensions coupled with some notorious public pension crises has led many to question whether DB plans have any place in the public sector at all. However, focusing on the horror stories from a few states or large cities is surely taking a myopic view of the situation.

The National Institute on Retirement Security (NIRS) recently published a follow-up study comparing the expense of defined contribution (DC) and DB plans. The study, published in December 2014, follows up on the original study performed in 2008, which reported similar results. The authors, William Fornia and Nari Rhee, indicate there are several advantages to DB plans that should be considered over the long term. These authors and the NIRS study provide three specific reasons for the cost savings of DB plans:

Risk pooling: DB plans spread the risk associated with employee life expectancy across the entire participant population. An easy way to conceptualize this is a bell curve—while some employees will live an “average” life span, there will always be employees who live longer and employees who live shorter lives. Those who live longer will use more retirement income than expected, but this cost is offset by the savings from those with shorter life spans. Without risk pooling, an individual bears the entire longevity risk alone; there is no cost offset mechanism for an individual who lives beyond his or her life expectancy.
Asset pooling: DB plans have significantly larger asset pools than an individual will maintain in an individual account plan. DB plans are also able to make multigenerational investments. While an individual will shift an investment strategy to be more conservative in the years leading up to retirement, a DB pension trust has no need to behave similarly as the trust can continue to maintain an investment strategy with some degree of aggressiveness. This yields better long-term investment results.
Fee pooling: The microeconomic concept of economies of scale comes into play for investors. An individual managing a single 401(k) account will bear the burden of professional investment fees. A DB plan has two advantages in this area. The first is that professional fees are paid out of the pooled asset trust and essentially split up among all individuals in the plan. The second advantage involves “investor IQ.” The typical DC plan participant does not have the investor knowledge of a professional asset manager. While a DB plan can afford to hire a professional asset manager and glean good returns, an individual is left to navigate the murky waters of the financial economy without an educated guide (National Institute on Retirement Security, 2014).

The NIRS also published a study in September 2011 highlighting public employee perspectives on public DB versus DC plans. If public entities intend on remaining competitive in the job market, maintaining their public pension plans could be a key to successful recruitment. Private pension plans are scarcer than their public counterparts, so this can be a factor for highly talented individuals looking at stable career choices.

For these reasons, a DB plan has significant, long-term advantages. These structural factors are relevant in any employment sector, but for public pension plans there is an additional angle to consider. Because the cost of public employees’ retirement plans are ultimately laid on the taxpayer, it should be a priority of any such system to use tax-funded contributions as efficiently as possible.

Last year’s NIRS study demonstrates that DB plans are truly efficient mechanisms for generating retirement income. But recent public discourse has suggested that public employers move away from DB plans. Thus, many retirees may be at risk of having a shortfall in their retirement incomes and will need to turn to the government for means of additional financial support. Social welfare programs are already in place to provide for retirement shortfalls, but these resources are not equipped to handle the long-term risk associated with today’s retirees.

In a broad sense, taxpayers will be on the hook regardless—either by paying for government DB plans or for government-subsidized welfare programs to supplement inadequate retirement income. The factors brought to light by the NIRS study reaffirm that the taxpayer dollar is put to more efficient use in a DB plan.