Ortec Finance co-founder Guus Boender takes a closer look at the Netherlands' new pensions deal.

The unions of employers and employees and the Dutch government have agreed upon a new pension deal. The new deal awaits legislation, and amendments could be expected. Put simply, the national pension agreement hinges on seven pillars.

In 2020, the pension age is increased from 65 to 66. Every five years, it is decided whether a further increase in the pension age is considered necessary.

In contrast with the previous financial assessment framework - which was based on nominal pension rights, i.e. not taking into account compensation for price or wage inflation - pension trustees can choose to define new pension contracts completely in real terms.

The pension contribution is fixed in the sense that future pension deficits resulting from a future financial crisis or further improvement in longevity will no longer automatically lead to additional payments. If changes in the contribution are deemed necessary, these have to be decided on at the negotiating tables where employers and employees negotiate labour conditions.

Pension promises become 'soft' in the sense that pensions and pension entitlements will in the future move together with the dynamic of longevity and with the value of the pension assets. Thus, 'defined benefit' is replaced by a system that is referred to as 'defined ambition'.

The new system is complete, meaning that, for each situation, it is decided in advance which policy measure will be adopted. Simply put, for each change in the situation of the fund, it is decided beforehand who pays the bill or who gets the revenue.

The system is intended to be more 'closed'. A fully closed system implies that deficits and surpluses are, in principle, completely allocated, without any smoothing or delay, to the current plan members. Hence, in a completely closed system, new members will never enter a plan with a deficit or a surplus.

Last, but not least, in soft real pension contracts, fair value marked-to-market valuation of the liabilities is replaced by a fixed discount rate based on a prudent estimate of future expected real portfolio returns.

The reasons for these changes are clear and intuitive.        
First, life expectancy has improved impressively. The remaining lifetime expectancy at retirement of a Dutch male in the 1950s had been 14 years - this has now increased to 23 years. It is widely accepted that the working population cannot afford the enormous accompanying cost, and that an increase of the risk of the strategic asset allocation cannot solve the issue. In other words, to maintain a sustainable ratio of working time to pension time the pension age must increase.

The second reason concerns maturity. Suppose the standard deviation of the growth of the funded ratio of a typical Dutch pension fund is 10%, implying that, with 2.5% probability, the funded ratio in any year could drop by 20%. This amounts to approximately €160bn, whereas the national wages are around €250bn. Thus, clearly such a 2.5% event cannot be remedied by additional contributions, whereas this ratio between pension assets and national wages deteriorates even further by at least a factor 2. Contributions have lost the power to compensate for financial shocks.

Third, the current system is based on nominal guarantees and an ambition to grant indexation. This brings pension trustees in a complicated investment dilemma. On the one hand, the nominal guarantees necessitate a long duration of fixed income. On the other hand, if inflation would increase and this would be accompanied by higher interest rates, the long position would, of course, hurt the fund.  Hence, the nominal protection could hurt the fund, especially in situations of increasing inflation, possibly even becoming fatal for the real goal. The new pension deal eliminates this dilemma.

Fourth, in the current system, pension funds are to a large extent pro-cyclic investors. If funded ratios drop, there is less room for investment risk. This often means equity has to be sold at their lowest rates or that the duration of fixed income has to be increased when interest rates are at their lowest. Of course, this could hurt the pension targets of the scheme and make markets unstable.

The literature shows that, in particular, equity, real estate, and commodities provide poor short-term inflation hedges, but rather strong long-term inflation hedges. In the new pension contract, pension funds, having a typical duration of 15 to 20 years, can exploit these positive long characteristics of several asset classes much better.

Thus, there are many good reasons for the agreed pension deal. But, of course, there are issues to be discussed and improvements to be made.

For example, would participants understand that, in the new system, there will explicitly be no guarantees and that the pension entitlements will move in tandem with the developments of financial markets and longevity? The communication of the message is at the very least a formidable challenge, where the initial signals are not encouraging. A new system is unavoidable, as both costs and risks have become less and less controllable. This phenomenon should be the main argument to convince the people a fundamental pension policy change is necessary. But, the new system is presented too heavily as an improvement for everyone, whereas every pension policy change is always nothing else other than a redistribution of risks, costs and revenues over the participants in the system. The actual pension risks should be communicated, as well as the impact of risk reducing measures such as additional saving and deferred retirement.

Is it wise and efficient that pension funds reduce or eliminate buffers, and allocate surpluses and deficits more quickly or immediately to their participants? The answer is, of course, a definite 'no'. In 2001-02, the funded ratio of pension funds dropped from 150% to about 100% and more recently from 140% to about 90% due to the credit crisis. If we would have started a system without buffers in the 1990s, the pension funds would have suffered two landslides of 40-50%. In hindsight, these buffers were so large not because they contained future pensions but because they absorbed bubbles. Thus, instead of complaining we lost our buffers, we should be pleased we put the exceptionally high portfolio returns in buffers, rather than immediately converting them into pensions. We should without any doubt continue to do so. The fundamentals of behavioural finance substantiate this view. It teaches us that the loss of satisfaction that people experience when high returns are not converted into pensions is half the pain they feel when bad returns lead to a fall in their pensions. It is well known that the unions of employers and employees and the Dutch government are working on the issue of adequate buffers.

Last, but not least, is it responsible for pension funds that opt for a soft new pension contract to return to a fixed discount rate? In theory, this is justified, but if and only if the participants are agree, with the result that their pensions and pension promises directly reflect the developments on the financial markets and of longevity. If not, a fixed discount rate would imply possible problems between generations, where the younger people suffer if the fixed discount rate is determined too high, and older people a fortiori receive too high pensions, and where older people mutatis mutandis suffer if the fixed discount rate is determined too low.

Guus Boender is professor of asset liability management studies at the Free University of Amsterdam (VU) and co-founder and board member of Ortec Finance.