Law of unintended consequences
It is one of those unwritten rules that whenever governments try to introduce more protection for one group of people someone somewhere suffers and sometimes it turns out to be the very group you tried to protect in the first place.
The ‘law of unintended consequence’ has been well illustrated over the years in the UK but I had not, until recently, appreciated the universality of this rule. The Netherlands in the form of the Government and their Pensioen- & Verzekeringskamer (PVK) seem doomed to follow this practice with the PVK’s guidelines compelling underfunded pension funds to develop a detailed recovery plan.
In the Netherlands the downturn in the equity market coupled with high wage costs which sharply reduced the average funding level of Dutch pension funds coincided in 2002 with the publication of a National Strategy Report on Pensions in The Netherlands published by the Dutch Ministry of Social Affairs and Employment.
This resulted in the PVK (the Dutch Pension and Insurance Supervisory Authority) issuing new guidelines. As a result, nearly a half of all Dutch pension funds acted to improve their funding level by adopting various measures. Whereas is the past a few changes to investment policy would have sufficed together with the realisation that markets are volatile in the short term but it is really patience and the long term that matter.
This time however we saw some fast moves towards new, leaner pension systems with lower benefits especially indexation as well as, in many cases, higher pension contributions.
The position was desperate for many funds. Even ABP the Dutch nation’s largest pension fund was briefly unable to meet the PVK requirements. We saw some very interesting quotes. Rene Bastian, director of the VVB, the Dutch Occupational Pension Funds Organisation, said the regulations are disastrous for the Dutch economy. He went on record to say “It’s not just difficult for the Dutch pension funds, the impact on the Dutch economy will be enormous and it won’t be positive.”
Although the PVK eased its guidelines, following the heavy criticism, and last year’s equity market rally provided help for the many underfunded plans, we are far from being back to where we started. The solidarity principle underlying the whole benefits edifice is under attack as never before. Indeed the expectation is now that we will see companies move towards defined contribution plans passing more of the funding burden and general uncertainty onto employees. At the very least we will see many companies switching from final salary based pension arrangements to average pay systems.
The real reason for many of these changes or the final straw for many Dutch pension funds is the expected introduction of a new framework (Financieel Toetsingskader or FTK) for the financial supervision of pension funds. The FTK will not become fully effective until 2006, but its key principles have already been published. Chief among these is a so-called ‘toereikendheids’ test, that will measure first the funding level in the longer run (the continuity test), its development over one year (the solvency test) and lastly the current funding position - the minimum test. Another key change is that liabilities will be calculated on market values and current interest rates rather than a fixed 4% discount rate.
The PVK’s initial work on a new framework started as early as July 1999 under the name NAP or New Actuarial Principles but this name was soon dropped and the current rethink follows EU initiatives to harmonise pension supervision and the PVK’s attempt to adhere to IASB (International Accounting Standards Board) guidelines and satisfy its own need for better insight into funds’ risk profile.
But still in question is the amount of security that will be needed. High security in the form of high funding levels on all three tests will lead to far higher pension contributions in the future. But will it lead it to anything else?
In the end I suspect it will lead to less, rather than more, financial security for employees as we see companies willing to make fewer commitments especially to Cost-of-living adjustment increases or COLAs. If they promise less, companies will be able to put less aside.
Under the new framework, funds will have to reserve fully for all sorts of things. Reserve are required for “general risks”, risks that cannot be quantified as well as those that can such as unconditional COLAs. Reserves are also required for any conditional COLAs, subject to the financial position of the fund if this condition has not been explicitly disclosed to fund members. In effect promises and risks have to be reserved and reserved in full. So will companies in future want to make any sort of promise? In addition pension funds are going to be afraid of high risk, high volatile assets so even lower levels of benefits could well end up costing more to provide.
Is this really what we want?