Abstract
The Selected Issues paper of the Netherlands provides an overview of the Dutch pension system. It examines the strengths and weaknesses of the existing bargaining model, compares the Dutch wage bargaining in different periods, examines the past macroeconomic performance of the Netherlands, addresses the issues of wage dispersion and differentiation, and discusses future prospects and challenges for the bargaining model. It also estimates the potential growth in the Netherlands, using statistical detrending methods.
I. Second Pillar Pensions, Stock Market Returns, and Labor Demand1
A. Introduction
1. Employers compensate their workers through wages and a variety of non-wage benefits, including—importantly—retirement pensions. In the Netherlands, company pension plans (the so-called “second pillar” pensions) are a substantial fraction of retirement income. In defined benefit plans, which prevail in the Netherlands, the company guarantees a payout to the pensioner, regardless of the future value of capitalized pension contributions. This contingent liability is financed upfront by contributing to a pension fund. As in other European countries, Dutch pension funds have accumulated substantial assets over the years (see table) and have become large players in international capital markets. With population aging and less reliance on pay-as-you-go public pensions in many developed countries, pension fund assets are expected to increase even further in the future.2
Pension Fund Assets as a Percent of GDP in Selected European Countries (2000)
Pension Fund Assets as a Percent of GDP in Selected European Countries (2000)
| (In percent) | |
|---|---|
| France | 5 |
| Spain | 5 |
| Portugal | 12 |
| Belgium | 14 |
| Germany | 15 |
| Italy | 23 |
| Norway | 34 |
| Finland | 50 |
| Ireland | 54 |
| United Kingdom | 81 |
| Sweden | 96 |
| Netherlands | 110 |
| Denmark | 115 |
| Switzerland | 128 |
Pension Fund Assets as a Percent of GDP in Selected European Countries (2000)
| (In percent) | |
|---|---|
| France | 5 |
| Spain | 5 |
| Portugal | 12 |
| Belgium | 14 |
| Germany | 15 |
| Italy | 23 |
| Norway | 34 |
| Finland | 50 |
| Ireland | 54 |
| United Kingdom | 81 |
| Sweden | 96 |
| Netherlands | 110 |
| Denmark | 115 |
| Switzerland | 128 |
2. In recent years, Dutch pension funds have increasingly invested in risky assets, particularly equity, to take advantage of higher long-run expected returns. While markets boomed in the 1990s, this strategy yielded high returns, the financial position of the funds improved, and funds were able to lower contributions by giving discounts to their members. With sharp declines in stock markets worldwide since 2000, though, the situation reversed, and coverage ratios eroded.3 In defined benefit plans the employer must cover the shortfalls, so companies must raise contributions or renegotiate pension plans. The former means additional pressure on balance sheets already hurt by asset price declines and the recession. Problems are particularly acute in the Netherlands, but also in the United States, the United Kingdom, and Japan (IMF, 2003).
3. In the Netherlands, the macroeconomic consequences of the need to recapitalize second pillar pension funds have been widely debated in recent months, especially as the economy is now in the third year of a cyclical downturn and unemployment, though low by international standards, is on the rise. Will the need to cover pension fund shortfalls lead to higher contributions? Will this translate into higher labor costs and put further pressure on employment? Does this mechanism exacerbate the business cycle? Should regulators exercise forbearance and allow coverage ratios to fall below required minima to reduce pro-cyclicality?
4. The answers to these questions are not obvious. Pension benefits, just like any other form of worker compensation, are undoubtedly labor costs and thus, all else equal, increasing pension benefits lowers labor demand. The current problems at pension funds, however, do not arise from an increase in pensions benefits, but from losses on the assets set aside to finance pension obligations already incurred. These losses, therefore, are sunk costs, and, as such, should not enter the calculation of the marginal cost of labor nor affect labor demand. Similarly, it seems intuitively wrong to treat increases in pension fund contributions to meet regulatory coverage ratios as higher labor costs, unless promised pension benefits also become more generous. Yet regulation, forcing firms to finance their pension liabilities in a particular way, must have some economic cost.
5. To shed some light in these issues, this chapter develops a theoretical model of a firm with a pension plan. The model is used to study the effects of pension fund solvency regulation and negative shocks to pension fund assets on the employment and investment decision of the firm. As it turns out, in the case of large firms with individual pension plans losses on accrued liabilities do not affect the marginal cost of labor, because these losses are correctly recognized as sunk costs, unaffected by the current labor market behavior of the firm. Labor demand, however, is generally not first best, because the regulatory requirement that future pension liabilities be funded upfront introduces a distortion. The larger the difference between the internal rate of return of the firm and the expected future return on pension fund assets, the lower is labor demand. In the case of a small firm belonging to an industry-wide pension plan, on the other hand, losses on pension fund asset holdings that cause an increase in contributions indeed raise labor costs and lower labor demand, because these firms fail to internalize the budget constraint of the industry-wide fund.
6. These results suggest that empirical models that treat increases in pension fund contributions to cover losses on pre-existing obligations as increases in the marginal cost of labor may overstate the impact of the “contribution shock” on growth and employment, and thus concerns about the pro-cyclicality of defined-benefit pension schemes.
7. The Chapter is organized as follows: after a brief overview of the Dutch pension system and the debate over the “contribution shock” in the Netherlands, a benchmark model in which there is no requirement to pre-fund pension obligations is presented (Section C); the case of a company with an individual funded pension plan is in Section D; and the model of a small firm belonging to an industry-wide pension fund is in Section E. A brief discussion of the case of imperfect capital and labor markets follows (Section F). Section G concludes.
B. Second Pillar Pensions in the Netherlands4
The main features of the system
8. In the Netherlands, although employers are not obliged to offer pensions, over 90 percent of workers are covered by occupational pension plans. This is partly the result of the administrative extension of branch-level collective wage agreement between the unions and employers’ organizations to all industry members.5 Second pillar pensions account for about 40 percent of retirement income. First pillar, public pensions account for another 40 percent, while the remaining 20 percent consists of third pillar pensions (Carey, 2002).
9. Pension funds are legal entities separate from the companies that sponsor them and are often organized at the industry level. Individual private-sector company funds represent around 30 percent of the industry, industry-wide funds account for 50 percent, while the remaining 20 percent consists of the pension fund of civil servants and health care workers. This distinction is important for the issues discussed in this Chapter, because it turns out that the employment effects of higher pension contributions differ between single-employer and sectoral funds. Representatives of employers, workers, and pensioners sit on the board of directors.
10. Another important feature of Dutch second pillar pensions is that 97 percent of the plans are of the defined benefit type.6 For a majority of workers (54.5 percent), benefits are based on the wage in the final year of work, while for 31.8 percent they are based on average pay. Most workers have a replacement rate of 60–70 percent of gross wage, including what the worker receives from the first pillar, the government-sponsored universal pension. The latter is paid after the age of 65. In terms of net wage, though, the replacement rate is considerably higher, as taxation is lighter in retirement. To achieve the full pension, workers must contribute for 40 years. Pension payments are usually indexed to wages or, less often, to prices, but indexation is typically conditional on the financial health of the fund. Over the years, however, Dutch workers have come to expect full pension indexation. Pension contributions are on average 11 percent of wages, with employers typically paying two-thirds of the total.
11. Dutch employers often offer an early retirement benefit financed in a pay-as-you-go fashion. These schemes have been quite popular, as the pensioner bear hardly any financial penalty from retiring early. With the goal of raising labor market participation of older workers, these schemes are now being phased out in favor of more actuarially fair ones, in which pension benefits are reduced for workers who retire early (Carey, 2002).
Financial losses on pension fund assets and their macroeconomic consequences
12. In the Netherlands, as in other countries, during the 1990s pension funds have increasingly changed their investment strategy to take advantage of booming stock markets. At present, stocks represent almost a half of the asset portfolio (see Figure below). After years of double-digit gains, returns turned negative in 2000, and have not recovered since. As a result, the average coverage ratio declined from a peak of over 130 percent in 1999 to around 105 percent in 2002, and a number of individual funds now fall short of 100 percent coverage (van Ewijk and van de Ven, 2003).
Asset Allocation of Dutch Pension Funds, End-2000
Citation: IMF Staff Country Reports 2003, 240; 10.5089/9781451829457.002.A001
Source: UBS Asset Management.Asset Allocation of Dutch Pension Funds, End-2000
Citation: IMF Staff Country Reports 2003, 240; 10.5089/9781451829457.002.A001
Source: UBS Asset Management.Asset Allocation of Dutch Pension Funds, End-2000
Citation: IMF Staff Country Reports 2003, 240; 10.5089/9781451829457.002.A001
Source: UBS Asset Management.13. To address the problem, funds began to increase contributions and consider limiting indexation. Concerned that this process was not sufficiently fast, the Dutch insurance and pension supervisor (PVK) clarified and strengthened coverage requirements in September 2002. Coverage must remain at or above 105 percent and additional buffers must be held to ensure solvency in the case of a 40 percent decline in equity values relative to the peak in the previous 48 months, or a 10 percent decline from the lowest value in the last 12 months. A similar requirement applies to declines in bond values. To avoid abrupt increases in contributions, the PVK has given funds eight years to reach full compliance with the regulation on additional buffers. Nonetheless, employers reacted negatively to the new measures, pointing out that they would have strong adverse effects on corporate balance sheets and labor costs, resulting in a further worsening of the competitiveness of Dutch producers.
14. More generally, the macroeconomic and fiscal impact of pension fund shortfalls has featured prominently in recent discussions on the Dutch economy. A serious concern is that pension funding costs will aggravate the current economic downturn and delay recovery. The Dutch central bank recently estimated that higher employer pension contributions would increase unit labor costs in the private sector by 0.8 percentage points in both 2003 and 2004, after having increased them by 0.7 percentage points in 2002 (Nederlandsche Bank, 2002). The bank also stressed that higher employee contributions would reduce disposable income, resulting in lower consumption.
15. The CPB has pointed out that higher pension contributions would lower profits and disposable income and increase labor costs, resulting in lower economic growth. The CPB estimates that a coverage ratio of around 130 percent would be necessary to comply with the PVK regulation buffers. To reach such coverage rate in the absence of pension reform, average contributions would have to rise from the current 11 percent of gross wages to 15 percent. This would result in higher labor costs, lower employment, and lower GDP (see table). In addition, since contributions are tax exempt and, furthermore, the government needs to fund shortfalls in its own pension fund, tax revenues will be lower and fiscal outlays higher, resulting in a deterioration of the fiscal balance.
Economic Effects of the Pension Shock, 2002–07
Economic Effects of the Pension Shock, 2002–07
| Cumulative change in percentage points | |
|---|---|
| Labor costs (private sector) | 1.3 |
| Employment (private sector) | -0.8 |
| GDP | -1.2 |
| General government balance | -1.3 |
Economic Effects of the Pension Shock, 2002–07
| Cumulative change in percentage points | |
|---|---|
| Labor costs (private sector) | 1.3 |
| Employment (private sector) | -0.8 |
| GDP | -1.2 |
| General government balance | -1.3 |
16. The CPB has also raised the issue of limiting equity investment by pension funds. With the current asset structure, contributions rise in periods of falling asset prices, which often coincide with economic downturns, thereby exacerbating the cycle. This also makes the tax and contribution wedge highly variable, contrary to principles of optimal taxation.
17. The next section explores the connection between pension fund losses and labor demand in a basic model of a competitive firm facing perfect capital and labor markets.
C. The Benchmark Model
18. In the benchmark model the firm pays a portion of the worker salary as deferred compensation, i.e. after the worker retires. The firm can precommit to pay the pension even if it later goes bankrupt. Hence, with full information and rationality, there is no reason to impose regulatory constraints on funding. As in conventional models, the firm is assumed to be perfectly competitive in product and factor markets. Also, implicit in this specification is that the firm has full access to capital markets and there are no information imperfections or other distortions, so that the production decisions of the firm are separate from the financial decisions.7
19. The production technology is represented by a standard neoclassical production function f(kt, lt), where kt is capital (assumed, for simplicity, to depreciate fully after one period) and lt is labor. The firm maximizes the present discounted value of future profits by choosing capital and labor inputs. The rental rate on capital is rt, and the rate at which firms discount future profits is β <1. Employees receive a wage wt when they work and a pension λ wt when they retire, so that λ is the replacement ratio. For simplicity, it is assumed that each worker spends one year in employment and one year in retirement, so that the entire labor force turns over each period.8 The profit maximization problem is
Let V(lt−1) be the maximum profit at period t. Then, at any t, this value function must satisfy the following Bellman equation
The necessary first order conditions are
Thus, the marginal cost of labor is simply the current wage plus the (discounted) deferred compensation.
Result 1. With no regulation requiring pre-funding of pensions, labor demand depends on the wage rate and the discounted value of the benefits promised to workers.
D. Funded Company Pension Plan
20. Suppose now that the company cannot pre-commit to pay out pensions in case of bankruptcy. To protect pensioners, the regulator mandates that pension liabilities be funded upfront.9 In particular, in the Netherlands funds are autonomous and they are financed by contributions from the firm.10 The fund must abide by a regulatory solvency requirement stating that the market value of its assets At must be at least X times the present discounted value of its liabilities. The parameter x is the coverage ratio, thus x=1 correspond to a fully funded plan. The present discounted value of liabilities is computed using the actuarial discount rate q <1.11 Each period the pension fund administrators set the level of contributions ct to meet the solvency requirement.12 The fund resources are invested in a risky asset paying a gross return ρt every year, ρt is the realization of a first-order Markov stochastic process, such that ρt ε P and Pr(ρt ≤ρ | ρt−1 = ρ’) = G(ρ, ρ’). Under these assumptions, the present discounted value of the firm’s profits is
21. The dynamic of the pension fund assets is given by the following equation
while the solvency constraint for the pension fund is
Combining those two equations yields
22. Contributions are equal to the amount needed to provision against new pension liabilities plus the difference between what is paid to pensioners in the current period and the funding already set aside to cover that payment. The first term is a function of the current wage bill, while the second depends only on past hiring decision. Naturally, contributions are decreasing in the realized return on the pension fund assets. Substituting (3) into (1), the profit maximization problem of the firm becomes
and the Bellman equation is
This expression explicitly recognizes the possibility that the firm may choose to close down rather than continue at time t.13
23. Let ρr(lt−1) be the value of the shock for which the firm is exactly indifferent between staying in business or shutting down. Then Prt={ ρ | ρ ≥ ρr(lt−1)} is the set of all realization of the shock for which the firm chooses to remain in business. Denoting a Ert expectation taken over this set, the necessary first order conditions for profit maximization are14
24. These equations show that pension fund regulation and the financial performance of the fund do not affect the marginal cost of capital, but may affect the marginal cost of labor. This is reflected by the second term in (4), which represents the opportunity cost to the firm of setting aside resources in the pension fund. If the firm’s discount rate is equal to the expected return on pension fund assets (1/β = Ert ρt+1), that is the firm earns as much investing in the pension fund as hi its best alternative opportunity, then the marginal cost of labor is just (l+βλ)wt, as in the benchmark model of Section C.15 However, in the realistic case of 1/β> Ert ρt+1, hiring more workers means setting aside more funds in the pension fund, an inferior investment opportunity. This increases labor costs and reduces the demand for labor. This distortion, which could be called the “regulatory wedge” is increasing in the regulatory coverage ratio x, the actuarial discount factor q, and the replacement rate λ. On the other hand, the higher the returns on pension fund assets, the smaller is the wedge.
25. Perhaps less intuitively, comparing (4) with (3) also reveals that the marginal cost of labor is generally not equal to the wage rate plus the contribution to the pension fund (wt + ct). This is the case because the contribution reflects, besides the additional pension liability that the firm incurs by hiring one more worker, charges or discounts on liabilities related to pension rights already matured. The latter are sunk costs, and thus do not enter the labor demand decision of the firm.
Result 2. Regulation forcing firms to pre-fund pension obligations increases the marginal cost of labor if the expected returns on the pension fund assets is smaller than the internal rate of return for the firm. The marginal cost of labor is generally not the sum of the wage rate and the contribution to the pension fund.
Labor demand and shocks to asset prices
26. Another implication of equation (4) is that if asset returns are uncorrected over time, then the marginal cost of labor (and hence labor demand) is independent of ρt, the current realization of the pension fund return. This is the case even though a low asset return forces the firm to increase contributions to maintain the fund’s solvency, creating the impression that labor costs have increased. On the other hand, if the shocks are correlated over time, an adverse shock today would induce the firm to revise (presumably down) how much it expects to earn on the pension fund assets next period. This increases the regulatory wedge, and hence the marginal cost of labor. If the news also induces the firm to revise down its internal rate of return, however, the effect of a negative shock on pension fund returns may be small or nil.
Result 3. Losses on pension fund asset holdings do not affect labor demand. However, if low asset returns cause the firm to lower its expectation of future returns, then opportunity cost of pension fund regulation will increase, pushing up the marginal cost of labor.
27. Even when they do not change the marginal cost of labor and capital, financial losses or gains on pension fund assets do affect the level of profits. In terms of the model, the maximum level of profits V(lt−1, ρt) is an increasing function of the current realization of the shock ρt. Hence, for low realizations of ρt V(lt−1, ρt) may be negative, and the firm may be better off closing down. If the pension fund happens to be underfunded in that period, pensioners will lose part of their pension.16 If these firms are non-negligible segment of the market, then aggregate labor demand may be negatively affected by financial losses on pension fund investments (as would the aggregate demand for capital), even if the regulatory wedge does not change.
Result 4. Financial losses on pension funds may reduce aggregate labor demand because they may cause some firms to shut down.
The effects of higher coverage ratios
28. From (4), the effect of a higher regulatory coverage ratio on the marginal cost of labor is
which is positive in the realistic case in which the internal rate of return of the firm is higher than the expected return on pension fund assets
In the realistic case in which
29. The difference between the increase in contributions and in the marginal cost of labor can be quite substantial. Consider a case in which the firm internal rate of return is 15 percent (so β=0.87) and the expected return on the pension fund assets is 5 percent. Then 1-
Result 5. If pension fund regulation is costly to the firm, an increase in the regulatory coverage ratio increases labor cost and reduces labor demand. The associated increase in the marginal cost of labor, however, is much smaller than the increase in pension fund contributions necessary to meet the higher coverage ratio.
E. A Small Company in a Funded Industry Pension Plan
30. For small companies, setting up individual pension plans can be very expensive because of high fixed administrative costs or because the size of the workforce may be too small to diversify survival and other risks. Thus, small and even medium size firms may choose to form sector-wide pension funds, as is indeed the case in the Netherlands. To analyze this case, the extreme assumption is made that firms are atomistic. The sectoral pension fund is assumed to be subject to the same regulatory constraints as the individual company fund examined above, and to levy contributions proportional to the current wage bill of each member firm. Let the sector consist of a continuum of identical firm, indexed by i. μ(i): →I[0, 1] is the measure of firms, and lt(i) is labor demand of firm i and similarly for capital. Finally, let total employment in the sector be defined as
Then the dynamic of pension fund assets is
and the solvency constraint for the sector-wide pension fund is
The contribution rate must satisfy
while the cost of funding pension for the individual firm is
31. Now, and in contrast with the case of an individual company plan, cutting back on employment not only reduces what the firm has contributed to the fund to cover new obligations, but it also reduces the transfer that the firm must make (receive) to offset losses (gains) on past obligations. The Bellman equation for the firm becomes
The first order conditions for profit maximization are
These equations show that the labor demand decision is affected by the performance of the pension fund in a very different manner than in the case of an individual company plan.
Result 6. In the case of an atomistic firm belonging to a sector-wide pension fund, the marginal cost of labor is sum of the current wage and the (exogenous) pension contribution rate. The latter is decreasing in the return on pension fund assets.
32. With a sector-wide pension fund, the firm does not internalize the link between the deferred wages it owes to its workers and pension fund contributions. The latter depend on the hiring decisions of all the members of the fund, as well as on asset returns, and are therefore exogenous to the individual member. Through their effects on the pension plan contribution rate, then, returns on asset markets directly affect labor demand decisions. In addition, the contribution rate is influenced by the rate of growth of the total labor force belonging to the fund. In particular, if returns on the assets are low (xqpt<l), then contributions are higher in shrinking industries and lower in growing industries. This is because contributions levied on current workers must make up for losses on maturing obligations to old workers. By the same token, in periods in which fund assets are overperforming, declining industries benefit, because the “financial windfall” per worker is higher.
33. The contrast between the case of an industry plan and a company plan is entirely due to the assumption (consistent with common practice in the Netherlands) that fund members are charged by the fund in proportion to their current wage bill. A two-part pricing scheme could restore equivalence between the two cases. To see this, suppose the fund charges each participants the following contribution
34. The first term, a(wt lt), is the amount that the firm needs to contribute to cover new pension liabilities. This amount is proportional to the current wage bill, and hence should enter the current marginal cost of labor.17 The second term, b(wt−1 lt−1,ρt), is the difference between what the fund pays out to the firm pensioners and the value of the firm’s share in the fund at the beginning of the period (after current returns are realized but before new contributions are added). The share is calculated using the previous period wage bill. If the pension payment is larger than the share in the fund, then the firm must put in some more money to cover its commitments to pensioners, and vice versa. In period t this adjustment is a sunk cost to the firm, because it cannot be reduced by hiring fewer workers in the current period. Using (6) to eliminate At,
which is the same as the contributions in the case of the individual pension plan (see equation (3)).
Result 7. The labor demand decision of a small firm in a sector-wide pension fund would be the same as that of a company with an individual plan if contributions consisted of two parts, one to cover new pension liabilities and the other to reflect the capital gains or losses on accrued liabilities.
35. This two-part pricing scheme, although somewhat more complex than the standard one, allows firms to better internalize the effects of its labor market decision on pension costs. In addition, a new firm joining the fund would not have to pay contributions reflecting capital gains or losses on past obligations (since 1t−1=0 for such a firm), but would pay only what is necessary to fund the pensions of its current workers.
F. Market Imperfections
Imperfect capital markets
36. The models assume that firms have unrestricted access to capital markets. In practice, though, informational asymmetries and other contracting problems may create a wedge between the cost of internal and external finance, so that financing investment or working capital through retained earnings is cheaper than raising funds from the capital markets. This wedge, in turn, may become larger during downturns, when firms become more levered and face financial difficulties. In this case, losses on pension fund assets may increases the need to resort to costly external finance, inducing the firm to cut back on current production. An extreme case of this problem is that of a credit-constrained company. For such a company, the need to finance the pension shortfall would crowd out investment or working capital one for one. This would increase the negative impact of higher premium contributions on employment.
Imperfect labor markets
37. Another important assumption is that the firm is a price-taker in the labor market, thus the compensation it promises workers (both immediate and delayed) is not affected by the profitability of the firm. If the labor market is not perfectly competitive, perhaps because workers are unionized or hiring and firing costs are present, then the firm no longer takes the wage as given. In particular, a financial loss on pension fund assets, by reducing current profitability, may induce the firm to strike a better bargain with its workers. This could result in an increase in employee contributions to the pension fund that is not offset by a higher wage rate. Alternatively, there may be a reduction in the pension replacement ratio λ, for instance by forgoing indexation. Accordingly, with imperfect labor markets the effect of losses on pension fund assets on profitability and cash-flow is likely more limited than in the perfectly competitive model, because workers end up sharing some of the losses. On the other hand, lower wages would reduce labor supply, which might curtail economic activity. If there is disequilibrium unemployment in the short-run, however, a decline in labor supply may not have a sizable effect on growth.
G. Conclusions
38. With asset values declining around the world for three years in a row, large holders of securities have realized substantial losses. Prominent among them, are occupational pension funds in a number of industrialized countries. With defined contribution pensions, the losses are borne by employees, who face the prospect of lower retirement income. Where pensions are mainly of the defined benefit type, as in the Netherlands, employers must pay higher contributions to restore the solvency of the plan.
39. To gain insights on the possible macroeconomic repercussions of these large financial losses, this chapter has developed a theoretical framework to study how firm behavior - in particular labor demand - changes when the firm sponsors a defined-benefit pension fund and the returns on the fund assets are uncertain. The model also sheds light on the economic costs of solvency regulation for pension funds.
40. In the case of large firms with individual pension plans, the marginal cost of labor, which determines labor demand, is equal to the sum of three components: the wage, the present discounted value of the pension benefit, and a “regulatory wedge,” that captures the opportunity cost of tying up assets in the pension fund. This marginal cost generally differs from the sum of the wage and the pension fund contribution. Thus, losses on accrued pension liabilities do not directly affect the marginal cost of labor, even if they result in higher contributions. The intuition is that shortfalls in pension fund coverage depend on past labor market decisions, not on the current ones, and are therefore a sunk cost. A low rate of return on pension fund assets, however, may make labor more expensive if it signals low returns in the future, because this would increase the regulatory wedge.
41. In the case of small firms belonging to industry-wide pension plans, on the contrary, the marginal cost of labor is equal to the sum of the wage and the pension fund contribution, because small firms take contribution rates as exogenous. Accordingly, as contributions raise and fall reflecting losses or gains on pension fund assets, so does the marginal cost of labor, and labor demand from these firms tends to be more pro-cyclical.
42. Both in the case of large and small firms, losses on pension fund assets lower profits and cash-flows, which may make it more difficult for weak firms to access external capital markets, causing them to reduce activity. Firms and pension funds may also seek to negotiate concessions from workers on the level of pension benefits, for instance by increasing the retirement age or indexing the benefit to the average rather than the last wage. Reducing the pension benefit, just like a reduction in the current wage, should increase labor demand by large firms, but it may curtail labor supply in the long run.
References
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Prepared by Enrica Detragiache.
Van Ewijk and others (2000) estimate that pension fund assets will reach 195 percent of GDP in the Netherlands by 2040.
The coverage ratio is the ratio between the assets of the fund and the present discounted value of its liabilities.
For a comprehensive overview of the Dutch pension system, see Kremers (2002).
See Chapter II for a discussion of collective bargaining in the Netherlands. While this structure allows for risk-sharing within the industry, it virtually eliminates any potential competition among funds (van Ewijk and van de Ven, 2003).
By way of comparison, in the United States about half of employees with a pension plan have a defined benefit scheme. Some of these workers also have defined contribution plans as supplementary insurance (Hinz, 2000). In the United Kingdom, about 85 percent of pension plans are of a defined benefit type (Association of British Insurers, 2000). In both countries the trend has been toward defined contribution plans. For a theory of the costs and benefits of different types of company pension plans, see Bodie (1990).
This model can be easily adapted to the case of uncertain survival. If h is the probability of surviving in the second period, then the expected pension is h λ wt. Other factors that make the pension payment uncertain in practice, such as the fact that benefits depend on the wage in the last years before retirement rather than the current wage, that they may be only partially indexed to inflation, or may be indexed to wage developments over the retirement period would be more complex to integrate into the model.
The funding requirement may be enforced by making it a necessary condition for the pension plan to receive favorable tax treatment.
Workers also contribute, but this is immaterial to the extent that the firm is a price-taker in the labor market. See Section E below for a discussion of imperfect labor markets.
In the Netherlands, the regulator mandates that the actuarial interest rate must not exceed 4 percent, hence q cannot be less that 0.96.
In practice, Dutch pension funds are prohibited by their statutes from raising contributions more than a given amount in each year, so that the return to the regulatory level of coverage may be gradual over time. Also, as discussed in section E, the value of the funds has exceeded the regulatory minimum, but this possibility is ignored here for simplicity.
In the Netherlands, workers have no recourse against the assets of the sponsoring firm in the event it goes bankrupt and the plan is underfunded. This contrasts with the United States, where some benefits are guaranteed by the Pension Benefit Guarantee Corporation, and the firm is liable for up to 30 percent of unfunded guaranteed benefits (Bulow, 1982).
The boundary of ρrt+1 is a function of lt, but since V(lt, ρt+1)=0 for ρt+1 = ρr(lt) this can be ignored in computing ∂V/∂lt−.
On the interpretation of β in a general equilibrium framework, see for instance Blanchard and Fischer (1989), Chapter 6.
This is why regulators may require pension funds to be over funded (x>l). Of course, in practice shocks other than pension fund returns affect firm profitability and, hence, its decision to stay in business.
This is sometimes refereed to by practitioners as the cost-covering level of contributions.
