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Reality check

Anton van Nunen argues that instead of focusing on an undeliverable level of security, the Dutch regulator should recognise that 100% certainty is not attainable for pensions

 

Dutch newspapers and weekly journals continually report on the bad shape of the Dutch pension system and on the dramatic consequences of that situation. It is remarkable that most articles do not pinpoint the real cause of the problems. Because of this, the solutions put forward do not hit the core and, consequently, do not really solve the problems. This odd situation is a result of the lack of distinction between occasion and real cause.

A cause can only be identified after defining the problem. The problem at hand is not that pension funds have become so poor that full entitlements cannot be paid anymore. The real problem is that pension funds have become far less rich than many had hoped for, although far richer than the regulator would like the public to believe.

The beginning of the problem can be traced back to the 1990s when the then prime minister Ruud Lubbers suggested that pension fund ‘surpluses’ should be taxed. Triggered by this flawed intention, employers took the lead in trimming the funds’ financial position themselves and started paying in contributions that were far too low for as long as a decade.

This policy, of course, reduced the buffers that would be needed for the lean years that always follow the fat years. The after-effects of the internet bubble bursting were manageable, but the credit crisis was a call too far. The buffers were gone and, on top of that, the credit crisis turned out to be a heavy one. The perception that funds have become so poor that they can no longer pay decent pensions is created by the fact that the regulator miscalculates the wrong instrument. In normal circumstances, such a revelation would immediately supply the solution (in other words, remove that regulation), but in the regulatory setting things are much more complicated.

The present debate is a reaction to the regulator’s statements that pension funds did not invest in the way they should and that, therefore, it had to intervene with the most rigorous measure there is - reducing provisions. The area focused on is the funding ratio, which is far below the critical level of 105%. About this focus we can be sure: it is the wrong one.

The funding ratio is an empty concept (when calculated right, it is always 100% or higher), while the prescribed calculation is wrong. The idea behind it is rather technical, but it boils down to the fact that the liabilities’ discount factor, the most important determinant of the funding ratio, has been chosen arbitrarily. Academics recognise this and, perhaps more important, so does the OECD, which proposed to change the discount rate in its July 2010 survey.

The swap rate used has decreased enormously, thanks to the credit crisis and massive government intervention. Under these circumstances, the so-called funding ratio can only be saved by investing exclusively in government bonds or derivatives based on them. That would be unproductive because their returns are too low to build up decent pension provision s, since they are not as riskless as is suggested - all governments have dramatic deficits and, outside of the Netherlands, Germany and a few other strong countries, few government bonds can be trusted - and because this paper very probably will drop in value when the recent artificial buying frenzy subsides.

How, therefore, should the pension system proceed? The start point is the notion that the Dutch system of pension provision is far better than the systems in almost all other countries. Next to the basic provision for all elderly people financed by present taxes, a large body of capital has been saved by the pension funds to provide additional income. In the other countries almost all pension income has to be provided through current taxes, which does not sound safe looking at the current government deficits.

My opinion is that two major changes are required to keep the Dutch pension system afloat. First, there should be a change in the criteria by which the financial situation of pension funds is assessed, along with better communication to members. We must get rid of the funding ratio because this concept is senseless, and the swap rate as the liabilities’ discount factor should be abolished because it is theoretically wrong and it ignites a self-impoverishing mechanism.

Pension funds should be regarded as corporations that manage investment risks in order to be able to meet certain liabilities and, as all other corporations, should be assessed financially by criteria that have been in use for decades. The regulator could comply with this change after the second desired change has taken place - the removal of the insurance idea. Reality should be faced; pensions have never been 100% safe, and never will be.

These two changes require a revision of pension contracts. They are agreements between social parties, in which companies underwrite a large part of the risk in cases where pensions are related to wages. In the past, this risk was regarded as negligible because investment returns were favourable and reserves were plentiful. After two crises and a long period of insufficient contributions, this risk has grown. That is a painful confirmation of a reality that has always been there. When the going gets tough, the fund can only rely on itself. In other words, the pension fund is nothing more or less than a mutual insurance company that can provide money as long as there is cash or marketable investments.

This implies that we should abolish the system of a defined end target (x% of average salary, indexed or not) and recognise the fact that we have a defined contribution system. By the way, such a system is clearly distinct from an individual savings account because of economies of scale in execution and because investment policy is decided on at an aggregated level, enabling risk diversification and avoiding notoriously bad individual investment decisions. The rules of the game have to be prescribed by the social partners as they also provide contributions.

Of course, the regulator should monitor that rules are respected, but it should not intervene with any objective of its own making, such as an unproductive insurance regulation, to add superficial certainty.

This is at the core of the present problems: the regulator, almost literally, states that pensions are sacred to it and issues senseless directives requiring pension funds to invest in risk-free assets only. No economist has likely been consulted in arriving at this regulation because economists, as professionals, work with uncertainty in daily life in general and in financial markets in particular. For them it is clear that nothing can be 100% certain and, more importantly, they advocate taking certain risk to a certain degree because that uncertainty itself delivers the returns required for pension funds to provide decent pensions, maybe not every year but, on average, in the longer term.

Current regulation implies more certainty of totally insufficient payments without indexation, as too much safety in investments, by definition, yields too low returns. Recognition of uncertainty leads to the attainment of higher ambitions. With good regulation, on average, much higher pensions can be provided, most of the time with yearly indexation.

Pension funds are called upon to communicate this message to their members better than they did in the past. Members should receive a contract with clear risk allocation and accompanying indications of prospective returns and ultimate pay levels. One can compare this with public transport. To a certain level, the system can live up to the promises of providing sufficient material for reasonably punctual transport, but 100% certainty that all trains will run exactly on time all of the time is simply too costly.

An additional problem was partly created by the regulator. After stressing pension certainty and because incorrect calculations “indicate” that pension funds do not have enough investments to deliver the promised pension payments in due course, the solidarity of youngsters is threatened. Why would they participate in a scheme that uses part of their contributions for pensions to be paid to elderly members who obviously did not pay sufficient contributions?

When this wrong perception leads to a dichotomy between the younger and the older generations, intergenerational solidarity, as old as the pensions system itself, will vanish. If this regulation were changed and a decent discount rate specified, this problem would have been solved as all funds would show a substantial improvement in their financial condition. The amended contracts would indicate clearly that risks are present and how they are distributed between the different age cohorts.

With some cynicism one could hold the opinion that the current artificial pension fund deficit turmoil has a silver lining. Pensions have become a priority topic for everyone and this is the ideal time to come to a good contract to deal with how the inherent uncertainty should be distributed - and how to communicate this properly. This would serve an important goal - that is, avoiding politics to take the lead in modelling the pension system of the future. The system has been created by the social partners and they should remain in charge.

Anton van Nunen is principal of Van Nunen & Partners and the author of ‘Fiduciary Management: Blueprint for Pension Fund Excellence’

 

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