Kingdom of the Netherlands—Netherlands: Selected Issues
Author: International Monetary Fund. European Dept.
Publication Date:
11 Feb 2016
eISBN:
9781475557695
Language:
English
Keywords:
ISCR; CR; earnings; income; income tax; rate; investment risk profile; superannuation funds; benefit indexation; default investment option; customized investment account; Aging
Download PDF (4.3 MB)

Kingdom of the Netherlands-Netherlands: Selected Issues

Abstract

Kingdom of the Netherlands-Netherlands: Selected Issues

Reforming Occupational Pension Schemes in the Netherlands1

A. Introduction

1. The Dutch pension system has served its beneficiaries well, achieving extended coverage at reasonably low cost to the government. The combination of a flat-rate ‘first pillar’ pay-as-you-go public scheme and pre-funded, earnings-related pension funds has resulted in virtually eliminating old-age poverty while ensuring generous replacement rates. The basic old-age pension from the public scheme (AOW) is available to anyone who has reached pension age. Benefits are accrued at 2 percent per year spent in the country, providing for a full pension representing 70 percent of the minimum wage for a single person, 50 percent for each member of couples—resulting in a replacement rate of roughly 30 percent of the average wage. Most of the retirement income comes from ‘second pillar’ occupational pension plans, funded by tax-deductible employee and employer contributions of about 18 percent of earnings, and which typically guarantee the replacement about 60 percent of the average wage.

A02ufig1

Old Age Income and Poverty, 2008

(Percent)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Source: OECD.
A02ufig2

Public Expenditures on Pension, 2009

(Percent)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Source: OECD.

2. While the fiscal sustainability of the ‘first pillar’ has improved, the ‘second pillar’ pension funds have come under strain during the financial crisis. In the face of a rapidly ageing population, the fiscal sustainability of the public scheme has been recently strengthened by a stepwise increase of the retirement age to 67 years by 2021, to be adjusted to life expectancy thereafter. Meanwhile however, the solvency of most ‘second pillar’ pension funds has been undercut by the financial crisis. Funding ratios have deteriorated under the joint effects of an initial drop in investment returns and a protracted increase in accrued liabilities triggered by very low discount rates—prompting some funds to levy catch-up contributions or reduce benefit indexation in a pro-cyclical way. These financial difficulties have added to a number of structural shortcomings of the funds, notably a high degree of complexity likely to affect cost efficiency, limited flexibility in the face of changing labor market needs, and opaque redistribution channels, notably from younger to older generations.

A02ufig3

The Netherlands: Pension Fund Funding Developments

(Percent)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Source: DNB.

3. This paper aims to provide a contribution to the ongoing national debate on possible reform options of the ‘second pillar’ pension plans. The financial difficulties encountered by the pension funds have prompted the government to initiate a national consultation in 2014 on ways to improve, or possibly introduce fundamental changes to, the system. First steps have been taken, including a thorough revamping of the supervisory framework in January 2015 and government reform proposals in July. To help frame the debate, section B takes stock of the main characteristics and recent developments of the Dutch pension funds in a cross-country perspective. Section C performs single-factor stress tests on a typical pension fund, with a view to identify short- and long-term financial vulnerabilities. Section D discusses various reform options currently under consideration to address the main shortcomings of the Dutch pension schemes, drawing on the experience of other countries to highlight advantages and pitfalls associated with alternative schemes. Section E concludes by offering a few policy recommendations.

B. Overview of the Dutch Pension Funds over the Crisis

Organization and size of the collective pension schemes

4. Occupational pensions complement public benefits for about 90 percent of total employees. Set up by social partners at industry or company levels in the aftermath of WWII, the ‘second pillar’ pension plans feature quasi-mandatory participation, at the initiative of the employer, for workers covered by collective labor agreements. About 5.5 million active members participate in the schemes, a number which has recently declined along with a shrinking workforce as well as an increasing share of “self-employed” in the active population, while income-related benefits are handed out to more than 3 million retirees (Table 1). The number of institutions has steadily decreased, as the Dutch central bank (DNB), acting as supervisor, has encouraged mergers through additional regulatory requirements (e.g. related to reporting requirements and rules governing the composition of the boards of the funds), thus allowing for economies of scale. The industry is heavily concentrated, with the two main funds (ABP and PFZW) and the ten biggest funds accounting for about 45 percent and 68 percent of total assets, respectively.

Table 1.

Netherlands: Pension Fund Structure and Development, 2005–14

article image
Source: DNB.

5. Most pension funds offer pre-funded defined benefit (DB) retirement incomes, providing for generous replacement rates. Benefits are typically accrued annually at a constant rate recently reduced to at most 1.875 percent of the annual salary averaged over the career. They are generally granted in the form of real life annuities indexed to either price or industry wage developments, as cash withdrawals are prohibited. These characteristics ensure the pooling of longevity and investment risks and the provision of generous replacement rates. To promote a level playing field in the labor market, contributions are levied at a uniform rate (doorsneepremie) on wages regardless of age. This implies an ex ante transfer from younger to older generations, insofar as that the future value of the formers’ contributions is much larger due to longer time span until retirement.

A02ufig4

Gross Pension Replacement Rates, 2014

(Percent of individual earnings)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Source: OECD.

6. The investment portfolio of Dutch pension funds amounts to about 160 percent of GDP. Most pension funds are ‘mature’ investment vehicles, currently engaged in their ‘divestment’ phase after decades of asset buildup. At an aggregate level, notwithstanding intergenerational discrepancies, pension assets have come to represent the bulk of household wealth, encouraged by the tax deductibility of contributions and returns.

A02ufig5

Pension Fund Assets, 2014

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Source: OECD.1/ Estimate.

C. Developments of the Pension Funds over the Crisis

Returns and costs

7. The pension funds have offset collapsing returns by levying catch-up contributions and reducing benefit indexations, thus increasing operating as defined contribution (DC) schemes. As investment returns underwent a marked drop in 2008–2010, some funds were prompted to reduce or freeze indexation benefits and levy catch-up contributions to preserve solvency ratios, thus negatively affecting disposable income. Thus, while in principle offering defined benefits, the funds have increasingly started to operate as de facto defined contributions (DC) schemes, but in a non-transparent and unpredictable way. To limit the pro-cyclical interplay between economic downturn and household earnings, the authorities introduced a revised supervisory framework (new Financial Assessment Framework—nFTK) in January 2015, which allows funds to spread out the amortization of unfunded actuarial liabilities over longer periods of time (Box 1).

The New Financial Assessment Framework

Introduced in January 2015, the revised Financial Assessment Framework (nFTK) is aimed at helping pension funds better smooth the consequences of financial shocks, so as to limit the pro-cyclical impact of benefit curtailments or contribution increases. In case their solvency ratio falls below the minimum funding ratio of about 105 percent, pension funds are required to submit a recovery plan to restore their policy funding ratio, computed as the average funding ratio over the past twelve months, to about 120 percent of their own funds within ten years. Recovery may be achieved through catch-up contributions or reduced benefit indexation, with benefit curtailments only required as a last resort in the case of solvency ratios below 80 to 90 percent or in case the policy funding ratio cannot be restored within five years. However, such curtailments may be spread out over ten years, thus allowing for a gradual absorption of shocks. In July 2015, the central bank also changed the calculation method of the ‘ultimate forward rate’ (UFR), namely the long-term reference rate anchoring the yield curve used to discount the funds’ actuarial liabilities. The UFR was reduced from 4.2 percent to 3.3 percent, closer to market values (but still above the 30 year zero coupon bond yield) at the cost of further immediate pressure on funding ratios.

A02ufig6

The Netherlands: Cash Flow Developments

(Percent of total assets)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Sources: DNB and IMF staff calculations.

8. Overall costs have been contained, but there remains some room for efficiency gains. Over the crisis, the funds were able to contain management and investment costs at about 0.5 percent of total assets, ranging from about 0.25 percent for fixed income and equity products to more than 3 percent for private equity. While moderate by international standards, such cost levels may be deemed relatively high in light of sizeable economies of scale, with major players such as APG (ABP’s management company) commonly charging 50–70 basis points for very standardized products. Moreover, cost containment appears to have been mostly achieved by wage compression while administrative expenses were on the rise, thus pointing to pervasive sources of inefficiencies likely attributable to complex redistribution mechanisms within institutions.

A02ufig7

Pension Funds' Operating Expenses, 2011

(Percent of total investment)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Sources: OECD and DNB.Note: all data are not strictly comparable, as some funds do not report on indirect investment expenses.

Balance sheet developments

9. The rebound of profitability has been accompanied with an increasing share of equity in pension fund portfolios. In the wake of the financial crisis, Dutch pension funds have managed to bounce back to satisfactory rates of return in comparison to peers, achieving above 7 percent in real terms on average over the last few years. This rebound has taken place against the backdrop of an increasing share of equity in the funds’ portfolios. However, this shift appears mostly attributable to valuation effects, as investment flows have been evenly allocated to fixed income and equity. The quality of the fixed income assets held by the funds has deteriorated over the crisis, reflecting low credit ratings worldwide. The funds also appear to have made more use of financial derivatives, notably to actively hedge interest rate risks, along declining liquidity buffers.

A02ufig8

Pension Fund Real 5-Year Average Annual Returns, 2007-2013

(Percent)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Source: OECD Global Pension Statistics.
A02ufig9

The Netherlands: Breakdown of Assets

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Sources: DNB and IMF staff calculations.

10. The management of pension plans also underwent significant changes over the crisis. The share of investment in the domestic economy has reportedly remained constant at around 15 percent of total assets. However, the funds have started outsourcing a large part of their investment portfolios to multinational asset managers or insurance companies. Specific funds have also been set up to enter the domestic mortgage market at a rapid pace. While it is too early to draw any definite conclusions regarding the impact of such changes on the long-term investment strategy of the funds, it should be noted that recent developments featuring higher credit and, possibly, counterparty risks, lower diversification, and reduced liquidity buffers entail the risk of increased balance sheet volatility at a time of mounting demographic pressures.

D. Stress-Testing the Collective Pension Schemes

11. We construct a virtual national pension fund reflecting the features of the overall system of collective pension schemes. While existing Dutch institutions differ in terms of size, demographics and financial situations, they operate under a rather homogeneous framework with regard to benefit computations, actuarial assumptions and funding methods. This makes it possible to set up and stress test a virtual pension fund reflecting nationwide demographic and financial characteristics, with the objective of highlighting the resilience and vulnerabilities of the system as a whole. To this end, we rely on a customized version of the stress-testing framework proposed by Impavido (2011) to describe the impact of shocks affecting the solvency ratio of an aggregate fund typically offering defined, indexed benefits in the current financial environment (see the Appendix for data sources and main actuarial assumptions).

12. Financial liability stress tests indicate that the solvency of Dutch collective schemes remains sensitive to interest rate and inflation risks. Starting from a (scaled) solvency ratio of 105 percent corresponding to the regulatory minimum, we stress test the impact of a downward, parallel shift of the entire yield curve prompting a commensurate re-pricing of liabilities. Other things being equal, a protracted period of low interest rates would exert significant downward pressures on funding ratios, given the value increase in real life annuities associated with lower discount rates, in a context where no benefit curtailment is assumed to take place (see text table).

Dutch National (Model) Plan—Solvency Stress Test (Yield Curve Shift)

article image
Note: interest rates are assumed to remain at the zero lower bound instead of turning negative when the magnitude of the assumed negative shock is bigger than the actual, prevailing levels.

Wage inflation shocks turn out to exert broadly similar effects on funding ratios, reflecting both the larger build-up of accrued benefits by active members due to higher nominal income and the indexation of retirement pensions (see text table). While the likelihood of near-term inflation spike in the Euro zone is probably low on current trends, it is worth pointing out that significant effects are shown to materialize as of 3 percent wage inflation—from the 2.5 percent commonly used as a basis for calculations by pension funds in the Netherlands.

Dutch National (Model) Plan—Solvency Test (Inflation)

article image

Overall, these simulations suggest that Dutch pension funds remain vulnerable to financial developments—although estimates are to be considered upper bounds, to the extent that they do do not factor in any endogenous reaction of fund policies to shocks, whereas the revised supervisory framework (nFTK) explicitly provides for partial benefit de-indexation contingent on solvency pressures and whereas half of the funds’ liabilities is hedged against interest rate risks.

13. We seek to capture the impact on funding ratios of changes in the membership structure of the funds by simulating various patterns of contribution across age cohorts. We compute the future value of contributions paid by all active members as a constant share of their salary. Assuming that the proportion of accrued contributions in the existing asset pool of our representative fund remains constant from one generation to the next, we then test for the impact on solvency of changes in population patterns by examining the variations of total assets associated with different contribution amounts. Thus, we essentially follow a comparative-static approach to assess the effects of long-term generational changes, abstracting from transition paths. With all other factors assumed to grow at exactly the same rate, the simulation results should cautiously be interpreted as pointing to directions of change rather than assessing precise values.

14. A substantial switch of younger generations to self-employment status would put pressure on the long-term solvency of Dutch collective schemes. With these caveats in mind, membership termination by young workers is found to undermine solvency ratios in the long run, starting from a 105 percent funding ratio (Table 2). This is because the actuarial value of contributions paid by younger workers is higher than the value of their retirement benefits. As the reverse holds true for older workers, the separation of the latter category from the fund is found to actually bring about improvements in solvency ratios. In this case however, an implicit assumption is that these members would totally relinquish their accumulated pension rights, which is unrealistic in practice. Thus, the mechanical improvement generated by the model should be considered an upper bound, reflecting simplifying assumptions. While more granular investigation would be required to identify the specific income categories most likely to opt out of collective schemes and build a personal pension, these results suggest that the erosion of fund membership associated with increasing self-employment may pose structural challenges to the long-term viability of collective pension schemes, especially if it were to affect mostly younger generations. Also noteworthy is the result that across-the-board departure from the funds would (slightly) undermine their solvency ratios.

Table 2.

Dutch National (Model) Plan—Solvency Stress Tests (Change in the Membership Composition)

article image
Note: the cutoff date of 45 years has been identified in the literature as representing a turning point from a situation where members tend to contribute more than they accrue, to one where the reverse holds true.

E. Possible Reform Options

15. Recent developments point to the need for more individualization in the design of Dutch pension schemes. The occupational funds have started to combine some of the disadvantages associated with both defined contributions (DC) and defined benefits (DB) schemes. Akin to DC schemes, the funds have exhibited increasing uncertainty over the future levels of benefits, moreover in a non-transparent way. Akin to DB schemes, the collective schemes feature a range of structural weaknesses: lack of transparency allowing for opaque risk-sharing mechanisms; lack of flexibility in the face of profound labor market changes; and actuarially unfair ex ante intergenerational transfers. As it turned out over crisis years, these problems entail substantial economic costs, among which increased macroeconomic volatility associated with pro-cyclical income developments (which remained arguably limited given the existence of buffers to absorb shocks), insufficient coverage of some segments of the labor market, and uncertainties on asset allocation objectives. In turn, these may end up eroding the social consensus upon which the collective schemes were built, possibly in a non-linear way—as possibly foreshadowed by the steady increase in the share of self-employment within the active population. In a context where the ambition of most schemes has been de facto reduced and sponsors are tempted to switch to individual defined contribution (DC) plans, the challenge for Dutch policy makers is to overhaul the basic pension contract in a way that assigns more explicitly members’ pension rights and obligations at an individual level, so as develop a consensus as to the appropriate level of risk sharing and how to preserve it.

16. The government sent a proposal to Parliament in July 2015 for “personal pensions with risk sharing” (PPR). This set out general principles for pension reform, which include a proposal for “personal pensions with risk sharing” (PPR). These consist of mandatory individual, defined contribution (DC) pension contracts complemented with two provisions: (i) the compulsory conversion, upon retirement, of accrued personal assets into annuitized income streams rather than into lump sum withdrawals, so as to prevent participants to opt out of pooling longevity risk; (ii) the subscription of a complementary insurance policy possibly covering macro-longevity and investment risks, to an extent still to be determined. A few stakeholders and pension sponsors also champion the transformation of the existing defined benefit (DB) plans into collective defined contribution (CDC) schemes. These involve levying fixed contributions on members and recording them in notional accounts, while still defining benefits by means of a formula referring to accrued earnings—with the proviso that retirement incomes take the form of variable annuities, the value of which is contingent on the financial health of the fund.

17. We seek to highlight how competing reform options could address outstanding issues in Dutch ‘second pillar’ pension funds. Staying aside from equity considerations, we try to characterize the ways in which alternative schemes would likely address the financial and structural issues identified above, referring to solutions implemented in peer countries whenever deemed relevant.

Transparency and flexibility

18. Schemes featuring personal pensions guarantee the highest level of transparency on wealth accumulation. The experience of the crisis brought to the fore a high degree of opacity regarding the allocation of costs within the collective schemes, affecting both current and retirement incomes. By construction, individualized DC schemes such as PPR are meant to directly address this concern by clearly linking retirement benefits to accumulated personal assets. By contrast, CDC schemes fall short of comprehensively quantifying risk transfers among participants, because strategic investment decisions are taken with regards to the joint interests of all members but equally affect the amount of annuities perceived at an individual level. In this respect however, the experience of the Swedish ‘first pillar’ could offer relevant insights on ways to clearly allocate costs and risks among active and retired members within collective schemes featuring notional accounts, while also making room for full-fledged DC strategies in the determination of the overall retirement income (Box 2).

19. Personal pension plans also appear best suited to the needs of self-employed workers. Further to catering to the needs of those individuals that genuinely opt for the status of self-employed on account of the flexibility required by their job, the introduction of mandatory PPR would extend social security coverage to those workers pushed toward the status of self-employment for tax and contribution avoidance motives. To accommodate the specific needs or desires of participants, these could possibly feature a mix of lower contributions and lower benefit accrual in some economic sectors.

Notional DC Plan and Premium Accounts in Sweden

The Swedish pension system relies on three pillars: (i) the public pension system, which features earnings-related benefits financed for the most part on a pay-as-you-go basis, but also partly through defined contributions, and supplemented by a means-tested guarantee; (ii) mandatory occupational pension schemes for workers in industries covered by nationwide collective labor agreements; (iii) voluntary private savings through insurance companies.

The major component of the public scheme is an income-based ‘notional defined contribution’ plan, financed on a pay-as-you-go basis and combining DB and DC features. Benefits are recorded in notional accounts, but converted into real life annuities at retirement using a coefficient which depends positively on lifetime earnings and negatively on contemporaneous life expectancy, hence providing for gradually decreasing replacement rates as life expectancy improves. Employee and employer contributions of about 16 percent of the pensionable salary are paid to four autonomous national pension funds, the financial balance of which is automatically ensured by symmetric adjustments of pension benefits and returns credited to notional accounts in case of shocks.

Established in 1999, the so-called ‘Premium Pension’ accounts represent the DC components of the mandatory individual accounts. Contributions amounting to 2.5 percent of the pensionable wage are credited to individual investment accounts, offering a limited range of options to choose from about 700 independently managed mutual funds. The Premium Pension Agency (PPM) collects contributions and invests them in the individually chosen options, charging a fixed annual fee of 0.3 percent of the account balance plus the management fees of the various mutual funds. To keep costs under control, the PPM forces the funds to offer fee rebates depending on the premiums they charge and on the size of their portfolio, and pass them on evenly to all participants, thus subsidizing members opting for low-costs plans. Participants can claim benefits as of 61 years old or continue accumulating them after retirement age, either in the form of life annuities or lump sums.

In terms of insights for Dutch pension reforms, the main component of the Swedish public scheme appears to provide an interesting blueprint for CDC plans featuring clear cost allocation rules, while the Premium Pension system could be considered an interesting option to progressively educate beneficiaries to the build-up and management of their own retirement income accounts in a (potentially) cost-effective way.

Risk sharing

20. Collective DB schemes feature a large degree of risk sharing but may end up encouraging a suboptimal degree of risk taking. There is an economic case for ex post risk sharing mechanisms within DB pension schemes, as the pooling of longevity and investment risks theoretically eliminates precautionary savings. In turn, this may provide for lower contributions and/or higher benefits, and may enable greater risk taking at the aggregate level. Yet in the context of an ageing population, long-term asset allocation decisions within collective schemes could end up being increasingly biased towards the interests of older members, favoring fixed income products to the detriment of higher return instruments—thereby also diverting a substantial share of domestic savings from growth-enhancing investments. In this respect, CDC schemes do not substantially differ from DB schemes, inasmuch as they seek to limit those variability components of annuities that do not arise from ex post financial shocks. By contrast, PPR plans are explicitly geared toward smoothing the investment risk profile of individuals over their lifetime, allowing for more risk taking at a younger age, when workers still have the time and ability to make use of their human capital to offset possible downturns, and for choosing more stable returns in the years preceding retirement. As such, contributory schemes support long-term investment without the need to hedge interest rate risk to offer nominal stability. For example, the ‘superannuation accounts’ set up in Australia in have been instrumental in building up a large pool of pension equity in record time (Box 3).

Superannuation Funds in Australia

Australia features a three pillar pension system, comprising: (i) a strictly means-tested public pay-as-you-go old age pension; (ii) a network of mandatory, privately-operated ‘superannuation funds’; and (iii) private savings funded, inter alia, by voluntary contributions to the superannuation funds.

Introduced in 1992, the ‘Superannuation Guarantee’ program consists in a network of private pension plans funded by mandatory employer contributions. The plans can be operated by companies, employer associations (retail, industry), financial professionals or individuals themselves. Set at 9 percent of employee earnings (above a certain threshold, and up to a ceiling representing about 2 ½ times the average wage) since the early 2000s, mandatory contributions are in the process of being gradually increased to 12 percent by 2020. Most funds operate on a DC basis, allowing participants to either withdraw the accumulated capital as a lump sum (except if they are still working) or in the form of a real (inflation-indexed) life annuity as of 55 years old—a threshold being progressively raised to 60 years old. Employees may also defer claiming superannuation after the retirement age, currently set at 65 years. No contributions are to be made for unemployment periods.

As the ‘first pillar’ flat-rate pension fulfills redistribution objectives, ensuring a replacement ratio of just about 30 percent of the minimum wage, most of the income replacement function falls on the ‘second pillar’ superannuation funds—complemented by ‘third pillar’ private savings. The latter have been instrumental in building up a large pool of pension assets in a relatively short period of time—arguably also reflecting an unprecedented period of robust, externally-driven economic growth.

Besides underdeveloped annuity markets, the system’s main challenge has been to improve the financial literacy of members, based on the observation that participants tend to overwhelmingly choose the default investment option of the various plans and may possibly proceed to early cash withdrawals for other purposes than building their retirement income. Thus, recent reforms have focused on standardizing risk disclosures by the various funds, launching educational campaigns centered on default options, and forcing employers to direct contributions made on behalf of ‘passive’ participants to newly-created “MySuper” default products offering significant asset diversification and standardized fee reporting. In the short run, these efforts seem to have resulted in increased complexity and rising administrative costs.

Combining some strong asset build-up due to mandatory participation with the flexibility offered by individual DC schemes, the Australian system may provide valuable insights for the overhaul of Dutch occupational schemes. However, cost effectiveness is a growing concern and the decumulation phase still remains to be organized, while the financial sustainability of the plans has remained untested so far.

21. The challenge for DC options consists in cushioning individual risk taking. In practice, the main reason prompting pension sponsors, including public ones, to opt for DC type of pension schemes has been to shift risk away from their balance sheet by transferring it to individual participants. By emphasizing free choice in savings product and payout options, DC plans strive to closely align the investment strategies and risk profiles of participants. The challenge for policy makers thus consists in defining safeguards against excessive pension losses, so as to prevent old age poverty and avoid undue pressure on the sustainability of social security schemes. In this respect, in the context of a very diversified landscape of DC occupational funds, the solution implemented in Switzerland has been to force all DC plan providers to guarantee a minimum rate of return to active members, and to empower policy makers with the mandate of periodically setting the conversion rate of accumulated assets into pension annuities—at the cost of an arguably high degree of complexity, along with potential sustainability issues (Box 4). In Australia, the alternative has been to establish a strictly means-tested ‘first pillar’ as a foundation for the superannuation funds, so as to preserve fiscal sustainability while providing for a social safety net (Box 3). Results have been mixed, however, in terms of old-age poverty reduction.

Occupational Pension Plans in Switzerland

The Swiss pension system has three tiers: (i) an earnings-related, DB public scheme with redistributive features, supplemented by means-tested benefits; (ii) mandatory occupational plans; and (iii) private savings, in the form of tax-deductible supplementary contributions to those plans.

The ‘first pillar’ public scheme is financed on a pay-as-you-go basis through employer and employee contributions amounting to about 5 percent of the pensionable salary in total. Benefits are calculated using a formula linking the number of years worked and lifetime average income, and are subjected to upper and lower limits, thus ensuring some substantial redistribution, with replacement rates ranging from 16 to 32 percent of average earnings.

Occupational pension funds operate as defined contributions (about 85 percent of the total), defined benefits, or hybrid plans. Participation has been mandatory since 1985 for all workers with income above a certain threshold, and employer contributions have to at least match those of employees. Pension benefits are fully portable, with employees being required to participate in turn to the pension systems of their successive employers. In the case of funded plans, benefits are calculated through the accumulation of yearly individual credits, the value of which increase with age. Up to one quarter of the accumulated capital can be withdrawn as a lump sum. The funds all have latitude to adjust the degree of benefit indexation or to raise supplementary contributions to comply with the required 100 percent funding ratio plus a buffer, but need to guarantee a minimum rate of return on individual accounts, currently set at 1.5 percent and revisable every two years. Furthermore, accumulated savings in DC schemes are to be converted into real life annuities upon retirement using a nationwide conversion rate, which has been recently reduced to 6.8 percent in view of increasing life expectancy and falling yields. Taken together, these features introduce a strong DB component in DC schemes, with the explicit objective that the combination of ‘first pillar’ and ‘second pillar’ benefits results in an overall replacement rate of 60 percent of average income.

In terms of take-away for Dutch pension reform options, the Swiss ‘second pillar’ appears to combine a very high degree of flexibility associated with multiple DC plans with the solidarity associated with strong DB components, given also the progressivity of the ‘first pillar’. This is reportedly carried out, however, at the cost of acute complexity and associated costs. The country also came out relatively unscathed from the recent financial crisis, implicitly postponing the sustainability test of its pension system.

22. Another difficulty associated with the management of risks within DC schemes relates to the financial literacy of the population. In the longer run, the main challenge in entrusting individuals with the build-up of their own pension lies in the level of financial literacy of participants—many of whom have been shown unprepared and unwilling to make what would seem to be optimal investment decisions in various country surveys (Australia, Sweden, United States). To some extent, this problem can be circumscribed by restricting the range of possible investment options offered by DC schemes. It also requires that the pension supervisor carefully monitor the risk content of the default option, overwhelmingly chosen by members in countries operating DC schemes. Following the Australian example (Box 3), this would argue for focusing financial education efforts on the default option itself, so as to ensure a reasonable degree of understanding of it by members. An alternative option would be to have part or all of individual investment portfolios to be collectively managed by social partners, such as within the public pension fund ATP in Denmark.

Costs

23. The jury is still out on the costs associated with the operation of alternative pension schemes. Substantial economies of scale have generally been put forward as a major comparative advantage of DB schemes, owing to both lower operational costs needed to manage standardized investment products and reduced investment costs associated with large asset pools and virtually open-ended investment horizons. Yet such low hanging fruit does not seem to have been fully picked by Dutch occupational pension funds, due to the increasing complexity and administrative costs triggered by successive adjustments of the regulatory framework—not to mention the pervasive costs associated with the co-existence of multiple schemes, which could theoretically be avoided by aggregating them into a national fund. By contrast, DC schemes need not necessarily be particularly costly, depending on the degree of standardization of investment products and the use of IT technologies to manage savings accounts. From this viewpoint, the partial pooling of risks within PPR-type of schemes may add a costly layer of complexity to the challenges of managing customized investment accounts, which would require careful investigation. In Australia, the standardization of investment options seems to have helped generate savings, but a high degree of decentralization coupled with increasing complexity make it challenging to keep costs under control.

Actuarial fairness

24. Making contributions increasing with age would reduce actuarially unfair transfers within collective schemes while supporting household debt reduction. Redistribution mechanisms within pension schemes have the potential to influence the overall domestic savings rate by unequally (in an actuarial sense) burdening categories of agents with different propensities to save. In this respect, the Ministry of Social Affairs has proposed to gradually abolish the uniform contribution system (doorsneepremie) by maintaining uniform contributions but allowing for decreasing accrual rates with age—the main consideration being to avoid putting older workers at a disadvantage on the labor market. An alternative, however, could be to preserve the constant accrual rate used to compute pension benefits while making contributions progressive with age, thus backloading the contribution schedule in light of the longer accumulation of investment returns from younger generations. By freeing disposable income for the most financially-constrained agents in the economy, this would help reduce household debt and, assuming a higher propensity to consume of younger workers than older ones, help sustain domestic demand. In view of an already higher structural unemployment rate of older workers in the current system, this reform would, presumably, only entail second-order detrimental effects on the latter category of the active population. Moreover, with a view to reduce existing transfers from low skilled to higher educated workers in the current schemes, the modulation of accrual rates depending on income brackets possibly by means of differentiated tax deduction rates, could potentially improve the sustainability of ‘second pillar’ schemes while fostering the development of private savings options.

A02ufig10

Actuarially Fair and Current Accrual Rates

(percent per year)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Sources: Fund Staff calculations.
A02ufig11

Actuarially Fair and Current Contributions Rates

(percent per year)

Citation: IMF Staff Country Reports 2016, 046; 10.5089/9781475557695.002.A002

Sources: Fund Staff calculations.

F. Conclusion

25. The Dutch occupational funds have started to combine the disadvantages of DC and DB schemes. Reflecting the impact of ex post financial shocks during the crisis, the level of ambition of most collective plans has been de facto reduced by benefit curtailment or de-indexation, while contributions were raised to support funding ratios. However, ex ante, actuarially unfair redistribution mechanisms, typically from the young to the old, or from the poor to the rich, have remained unscathed. Thus, the ‘second pillar’ of the Dutch pension system has been increasingly operating as a collective defined contribution one, falling short of providing full nominal security and the degree of risk sharing expected from DB schemes while still featuring opaque transfers mechanisms that may have delayed debt deleveraging and the economic recovery. Looking forward, simulations suggest that the solvency of most funds remains highly dependent on financial conditions, while public confidence shocks have the potential to undermine the sustainability of the system as a whole.

26. These issues argue for taking up the challenge of introducing personalized pensions while preserving the benefits of longevity and investment risk pooling. The move towards a more contributory regime would simultaneously enable to better align the funding strategy of the funds with the interests of participants, and to put an end to opaque and actuarially unfair transfer mechanisms—thus strengthening the social consensus underpinning the redistributive aspects of the system. In this respect, the proposal of ‘personal pensions with risk-sharing’ (PPR) appears to address some of the major concerns that have been raised in the last few years. Yet innovative solutions are called for to fulfill the promises of longevity and investment risk pooling embedded in the proposed contract, in a context where all forms of insurance products are likely to remain under pressure in the prevailing low interest rate environment. The targeted degree of risk sharing might best be achieved by collective asset management by the social partners, articulated with the careful design of savings options to be chosen from. However, further to the challenge of attuning the pension risk management structure to social preferences, the examples of successfully operated schemes in peer countries provide insights into other issues likely to emerge in the design of DC schemes with redistributive features, mostly pertaining to cost effectiveness and the design of payout options.

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Appendix I. Data Sources and Actuarial Formulas Used to Stress Test the Dutch Collective Pension Schemes

Data sources

Mortality tables: Actuarieel Genootschap, Orlevingstafels GBM en GBV 1995-2000, Mannen (Actuarial Association, male mortality table 1995-2000) (no unisex table available)

Yield curve: DNB Statistics, Table 1.3.1 “Nominal interest rates term structure pension funds (zero coupon), updated September 2, 2015

Membership and overall demographics: DNB Statistics, Table 8.7. “Demographics of pension funds”, updated September 17, 2015

Fund portolio: DNB Statistics, Table 8.1.2 “Assets and liabilities of pension funds, by sector of counterparty”, updated September 10, 2015

Average wage by age: Central Bureau of Statistics (CBS), Table “Employment: jobs, wages, working hours; key figures, 2013”

Actuarial assumptions

Entry age, 20 years; retirement age, 65 years (no early retirement); no deferred members2; wage inflation, 2.5 percent; merit increase, 2 percent; labor productivity increase: 1 percent; investment portfolio: 40 percent fixed income, 60 percent equity; payout option: single real life annuity; (uniform) contribution rate: 18 percent; (constant) accrual rate: 1.875 percent;

Actuarial formulas

Actuarial liabilities for retired members
  • ▪ Present value of a €1 real life annuity for each cohort at age x:
    a¨xπ⁢ =Σs=0∞⁢ (1⁢ + πe)s  spx(m)νs
    with πe the expected inflation rate,  spx(m) the conditional probability of survival (m) for members aged x and v the discount factor.
  • ▪ Aggregated actuarial liabilities for all retired cohorts:
    AL(R) = Σx−r∞[(RN)(RB)(RNdx)(RBdx)a¨xπ]
    with RN the number of retirees, RB the average retirement benefit, dx denoting these variables’ respective distributions, and r the retirement age.
Actuarial liabilities for active members (projected unit credit method)
  • ▪ Projected wage at age s > x:
    Ws,x⁢ =ms,ymx,y⁢ [(1⁢ + πe)(1⁢ + pr)](s−x)
    with ms,y the cumulative merit increase at age s for an entry age y in the pension plan and pr the productivity improvement.
  • ▪ Accrued benefits at retirement for each active cohort (final average salary function):
    Br,x⁢ = b(r⁢ − y)wr,x[(AN)(AW)(ANdx)(AWdx)]
    with b the (constant) accrual rate, wr,x⁢  = (Σs=r−10rws,x)/10, AN the number of active members, AW the average wage, and dx denoting these variables’ respective distributions.
  • ▪ Total accrued benefits at retirement for all active cohorts (pro-rated projected unit credit – constant dollar benefit allocation method):
    AL(A) = Σx=yr−1(x−y)(r−y)⁢ Br,x(r−xpx(T)vr−xa¨xπ)
    with r−xpx(T) the conditional probability of termination (T) at age x.
1

Prepared by Marc Gerard (EUR).

2

We do not consider the situation of so-called ‘deferred members’, namely workers that have accumulated benefit rights but do not participate anymore in specific institutions, because they have migrated either to other schemes or to self-employment, because we assume that these transitory situations do not affect total membership.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Kingdom of the Netherlands—Netherlands: Selected Issues
Author: International Monetary Fund. European Dept.
Volume/Issue:
Volume 2016: Issue 046
Publisher:
International Monetary Fund
ISBN:
9781475557695
ISSN:
1934-7685
Pages:
45
DOI:
https://doi.org/10.5089/9781475557695.002

Old Age Income and Poverty, 2008

(Percent)

Public Expenditures on Pension, 2009

(Percent)

The Netherlands: Pension Fund Funding Developments

(Percent)

Gross Pension Replacement Rates, 2014

(Percent of individual earnings)

Pension Fund Assets, 2014

(Percent of GDP)

The Netherlands: Cash Flow Developments

(Percent of total assets)

Pension Funds' Operating Expenses, 2011

(Percent of total investment)

Pension Fund Real 5-Year Average Annual Returns, 2007-2013

(Percent)

The Netherlands: Breakdown of Assets

Actuarially Fair and Current Accrual Rates

(percent per year)

Actuarially Fair and Current Contributions Rates

(percent per year)