An Outsider s Summary of the Dutch Pension System

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1 An Outsider s Summary of the Dutch Pension System October 2017 Summary This memorandum begins with a broad overview of the Dutch pension system, and then examines in greater detail the structure of employment-based defined benefit (DB) plans. These plans may better be characterized as Target Benefit plans, as they incorporate risk-sharing, or risk-management techniques that can result in benefit reductions. To date, employment-based plans have relied on the concept of solidarity -- a system of uniform contributions and benefit accruals for all employees. However, recent interest rate and labor market conditions have triggered risk-management features of the system that have resulted in increased contributions, benefit cuts, and insecurities about future retirement security. In addition, intergenerational inequity has emerged as a significant concern for younger workers, who feel they disproportionally bear the cost of risk-sharing. The Dutch Three-Pillar Retirement System The Dutch retirement system is a three-pillar system: the first is a minimum wage-based, governmentprovided flat benefit; the second is a system of employment-based pensions; and the third is comprised of commercially-available individual retirement products. Pillar one is a universal benefit provided to residents of the Netherlands. The benefit amount is fixed at a percentage of the minimum wage, and reduced to account for years spent living outside the Netherlands. Pillar two employment-based pensions are provided by individual corporations, entire sectors, and professional associations. Sector-based plans account for the vast majority of assets, as well as enrollees. Finally, pillar three plans make up a relatively small percentage of retirement assets, and as a result do not factor into this memo. The pension system overall is governed by the Dutch National Bank, the national regulatory framework known as the Financial Assessment Framework, or Financieel Toezichtskader (FTK), and a variety of EU regulations. Pillar One: Government Flat-Benefit Pension Residents of the Netherlands earn rights (or eligibility) toward an old age pension for every year up to 50 years spent living in the Netherlands prior to retiring. Residents accrue pension rights at a rate of 2% per year. For example, a person retiring at age 66 would receive 2% of eligibility toward their state pension for every year in residency in the Netherlands between ages 16 and 66. However, during any time spent living outside of the Netherlands, pension rights are not accrued.

2 The amount of the pension varies by domestic living status, but for a single person the benefit is 70% of the minimum wage, and for residents living together the benefit is 50% per person 1. The benefit is not contingent on taxes paid during working years, or income. Finally, pillar one is pay-as-you-go financed by a payroll tax. Pillar Two: Employment-Based Pensions Overview According to the Dutch National Bank, nearly 80% of employment-based pensions are a form of DB plan, and 60% are career average-salary DB plans. However, it is important to note that while characterized as DB plans, employment-based pensions in the Netherlands only provide expected, indexed benefit payments to retirees if they successfully meet strict and in an international context - very conservative solvency rules, as discussed further below. Dutch pillar two pension plans are essentially collective, or cooperative, structures owned by their members active employees and retirees -- and are operated independently of employers or the government, although they are regulated by the FTK. As such, the risk of shortfalls is entirely borne by the members, who, in the face of projected insolvency, must ultimately either raise active members contributions, lower retired members benefits, or implement a combination of the two. Collectivity is one of two defining characteristics of these pension schemes; solidarity is the other. Although the definition of solidarity is open to some interpretation, it can reasonably be defined as a positive sense of shared fate between individuals or groups. That is, a situation where social relationships center on the stronger helping the weaker or on promoting the communal interest. 2 These two defining principles can be seen most prominently in the uniform contribution and accrual system in which each member receives the same rights for the same price. At the maximum accrual rate of 1.875% per year, a worker will earn 65% over a 35 years career (1.875% * 35 years) of his career average notional salary as a benefit. Employee contributions are uniform across each employmentbased pension and are calculated annually by pension funds to meet new expenses. 3 All members of the pension fund are eligible to get annual cost of living adjustments (COLAs) for price and wage indexation if, and only if, the funding level of the fund meet certain thresholds set in the FTK. This method of providing COLAs is known as conditional indexation. In times of extreme financial stress pension benefits can forgo providing conditional indexation, and even reduce base benefit levels. The uniform accrual rate is characteristic of employer-sponsored DB-plans in, say, North America, and the reason why the Dutch system is often referred to as a DB-system. 4 But the benefit stream of a Dutch 1 As of July 1 st, 2017 these monthly amounts are approximately 1,200 for single residents, and 800 per person for married couples or those living with a partner. See for more information regarding pillar one. 2 van der Lecq and Steenbeek, Costs and Benefits of Collective Pension Systems,2007, p A 2015 Melbourne Mercer Global Pension Index study found the average mandatory contribution rate to be approximately 8%. 4 In the United States, many recent reform efforts have led pensions to develop tiers for newly hired employees and alternative plan designs. As a result, although employees may belong to the same pension system, they could have different accrual rates. 2

3 pension plan will only be truly real if the pension fund remains funded above 130 pct. during the entire life span of the member. The below chart illustrates the concept of solidarity in the uniform contribution and accrual system, and shows that younger workers temporarily pay a greater contribution rate than is actuarially required and older people pay less. This system of intergenerational transfer relies on the belief that when the younger worker is older, new workers will be there to in turn subsidize them. 5 In economic terms, workers in their mid-forties have built up a substantial implicit claim on the system after contributing about 20 years on (economically) unfavorable terms they can look forward to 20 years with better terms. Over an entire career deficits and surpluses will average out but workers moving in and out of regular employment will sample the curve randomly and will eventually get very dispersed pension outcomes. Volatile Benefits: Risk Sharing Features & Recovery Plans Pillar two pension plans have been expressly designed to protect fund solvency via a combination of risk-sharing features that have, in recent years, proved troublesome for workers and retirees. Plan members bear all of the risk of financial insolvency while employers, who are completely independent of the pension scheme, bear neither fiduciary responsibility nor financial risks should insolvency occur. And, in the event that employers did increase contributions on behalf of employees, the increased funding should properly be viewed as part of employee total compensation. In other words, employees 5 Boejen, Jansen, Kortleve, and Tamerus, Intergenerational solidarity in the uniform contribution and accrual system, Chapter 7 of Steenbeek and van der Lecq s Costs and Benefits of Collective Pension Systems, 2007, p

4 would receive less take-home wages in exchange for the increased employer contribution on their behalf. Ultimately, risk-sharing features reveal pillar two pensions to more accurately be described as what in North America is known as Target Benefit plans than as traditional DB plans. Specifically, in a traditional DB plan participants accrue a guaranteed benefit amount over the course of their employment. However, Dutch pillar two pensions only guarantee access to an income stream, and not a specific income level. In practice, this means that retirees receive a variable benefit, which can change based on conditional indexation and potential benefit reductions. The risk-sharing components of these plans are executed via a series of regulatory requirements, including funded-level thresholds and a mix of permissible discretionary and mandatory recovery actions for funds that reach these thresholds. Accounting standards and regulatory rules prescribe assets as well as liabilities to be appraised at market value. Consequently, liabilities are discounted at a modified term structure of interest rates set by the Dutch Central Bank. Interest rates have remained low around one percent - since the financial crisis and in recent years been negative for shorter-dated maturities. Resulting funded ratios are thus markedly lower than they would be under methods employed in many other countries. As recovery plans are more likely to make use of contribution increases than benefit cuts, this method may exacerbate perceptions of intergenerational transfers from younger to older workers and from active to retired members. In response to the market downturns in the 2000 s, reforms to the FTK regulations governing fundedlevels and risk-sharing features were enacted in 2015 to bolster solvency. Today, the funded-level thresholds plans must meet include: 6 < 90% funded level for six consecutive years: funds are required to cut benefits > 90% < 105% funded level for six consecutive years: funds must implement a recovery plan < 110% funded level: no indexation for benefits > 110% < 130% funded level: partial indexation can be granted > 130% funded level: indexation can be made permanent Recovery plans, if activated, may span a fixed ten-year period, and can incorporate a variety of elements to achieve recovery above 105%, including employee contributions and/or benefit reductions. Finally, if funds do not achieve recovery to a 105% funded level within five years, benefit reductions become a mandatory component of the recovery plan. These mandatory cuts can be smoothed out over a period of ten years. 6 It should also be noted that insurance and non-insurance pension funds have slightly different rules regarding assumed discount rates, requirements which are based on the European Solvency II framework. 4

5 Recent FTK Reforms & Remaining Challenges After benefit cuts became necessary following the global financial crisis, the FTK amendments above were incorporated into pillar two pensions. Initially the reforms were enacted with the goal of stabilizing pension fund finances while recognizing the need to address participant concerns regarding intergenerational fairness and eroding retirement security. The reforms that were made in 2015 (summarize above) affected both recovery plans rules, as well as benefit payment rules. Recovery plan timeframes were extended from three years to ten (with mandatory benefit cuts enacted at the five year point if necessary). At the same time, stronger restrictions were enacted to limit the granting of conditional indexation below a 110% funded-level, calculated as the twelve-month average funded level. However, despite the most recent round of reforms there continues to be growing concern about the sustainability of the system both in terms of the fiscal health of the funds as currently structured, and, increasingly, the equity and security of resulting retiree benefits. Part of these long-term concerns stems from recent years of low interest rate market conditions. The prolonged low rate market conditions of recent years have exposed vulnerabilities in the design of pillar two pensions, leading to increased costs associated with maintaining high funded levels. And, although reforms to the FTK were enacted in 2015, the general consensus is that they do not address long-term challenges in the Dutch pillar two pension system. Among these challenges is the tension between solidarity and intergenerational fairness, evident in the debate around the uniform contribution and accrual system. This tension has been exacerbated in recent years by erosion of public confidence in the long-term stability of the pension system. Younger workers in today s labor market are more transient, and are less likely to spend their entire career in one sector or one company, let alone as employees at all. Currently, workers moving from regular employment to self-employment can continue contributions to their pension plan on a voluntary basis in 3 to 10 years. After that, they are out of options in pillar 2 neither mandatory nor voluntary. A growing number of workers therefore do no longer save systematically for retirement resulting in a growing white spot on the Dutch welfare map. 5

6 ICPM Working Group This memo is prepared for the ICPM Discussion Forum in Amsterdam October 15-17, 2017 by a group of international pension experts under the Research Committee of ICPM, the international Centre for Pension Management. Michael Preisel (chairman), Danish Labour Market Supplementary Pension (ATP). Denmark. Susan Banta, the Pew Charitable Trusts. United States. Derek Dobson, CAAT Pension Plan. Canada. Bernard Morency, Caisse de dépôt et placement du Québec. Canada. David Richardson, TIAA Institute. United States. Will Sandbrook, NEST. United Kingdom. Benne van Popta (advisor), PMT. Holland. The group received valuable input and support from David Frazier, the Pew Charitable Trusts, in the preparation of this document. Glossary 7 Uniform accrual rate: employees build up for each year of service around 2% of their (pensionable) wage as new pension rights. A career of 40 years gives a pension income of 80% of the average wage over the career that is, on average, around 70% of final pay for most workers. Uniform contribution rate: all employees pay the same contribution rate over their pensionable wage. The contribution rate is set yearly such that the yearly contributions match the present value of new accrued liabilities by employees due to an additional year of service, plus buffer requirements and indexation ambition. 7 Dutch Pension Funds in Underfunding: Solving Generational Dilemmas, Kortleve and Ponds, November