Contrasting evolution

In both the Netherlands and Switzerland, substantial shares of retirement income come from the state and well established occupational pension schemes (figures 1 and 2).
Pension schemes in the Netherlands have generally been defined benefit (DB) in structure, with members receiving their benefits from this source as well as from the state scheme in annuitised form. Larger company and industry-wide schemes have tended to carry their own survival risk, and the use of annuities has been largely confined to insured schemes for smaller companies as well as providing retirement income for individual pension savings plans.
However, the markets for the latter are relatively mature and the volumes of annuities written are substantial (more than e4bn of premiums per year). Insured pension schemes and pension savings plans require all proceeds to be taken in annuity form rather than as lump sums or phased withdrawals.
Group deferred annuity contracts for insured schemes operate various forms of profit share above threshold assumptions for interest rates (currently 3% annually) and for mortality based on a standard published table. Competition largely relates to charges and to profit sharing. The forms of profit sharing reflect the extent to which future profit shares are anticipated or taken into account as they emerge.
Annuities for pension savings plans are purchased on terms available at retirement and may be either temporary (subject to meeting certain legislative requirements) or paid for life. The contracts are mainly profit sharing but a significant minority of contracts are unit-linked. Profit-sharing annuities operate with a long-term rate guarantee, but a higher rate of guarantee is typically applied for an initial period, usually 15 years. Unit-linked contracts may make an assumption about future investment returns and mortality in setting an initial income rate and then reset the income level at regular intervals to take account of variations between actual and assumed experience.
The structures described above mean that providers are less vulnerable to unanticipated improvements in longevity than their counterparts operating in other markets, where rates are fixed at outset.
The increased restrictions on tax deductibility of contributions introduced in 2001 appears to have reduced the volumes of pension savings plans, and this reduction will perhaps, over a time horizon of 10 years or more, reduce demand for annuities. However, this effect may be somewhat offset by a shift towards defined contribution plans .

By contrast with the Netherlands, the fairly mature second-pillar schemes in Switzerland are mainly defined contribution (DC), or cash balance, and provide the funds for conversion to pension payments (larger schemes) or annuities (typically smaller schemes) to complement the annuitised income from the state scheme.
Retirement benefits may be drawn as annuity or lump sum if the rules of the pension fund allow this and a portion of retirement benefits may be pledged for house purchase. If annuity is taken – and it usually is – the rate is typically independent of gender, marital or family status, with all the cross subsidies implied by such pooling. Furthermore, the rate for minimum BVG plans is prescribed by the Swiss Federal Council (the supervisory body for occupational pension institutions) and was 7.2% until the end of 2004. This conversion rate was based on a 4% interest rate compared with a 20-year bond yield at the end of 2004 of some 2.7%.
Financial pressures have emerged most clearly in Switzerland given the relatively transparent nature of guarantees, including the retirement income conversion factor. The conversion factor of 7.2% in the context
of recent interest rates and mortality tables appeared, for most categories of annuitant(s), sub-economic. Following previous review, the rate is being reduced from 7.2% to 6.8% over a period of 10 years, effective from
1 January 2005.
The Netherlands appears at first glance to have escaped the shift to DC plans observable in other countries. However, there is an emerging ‘breed’ of pension plan where contributions by the employer are fixed and benefits are targeted, and then adjusted to reflect plan performance. These are effectively DC plans dressed up as DB, and growth in their numbers may well stimulate demand for annuities at the point of retirement.

Although the Netherlands and Switzerland have rather different structures for retirement income, the underlying pressures of increasing longevity and long-term investment guarantees are common.
Switzerland appears to face a more difficult process for change because it has made the parameters for retirement income explicit and the proposed pace of change described above appears, given some international forecasts for future rates of improvement of two or more years per decade, to be too slow.
Life companies already in the market or pension schemes may be stuck with having to offer overly attractive conversion rates for the foreseeable future. It seems unlikely that further life companies will enter the market unless the mandatory conversion factors converge with economic reality or they can ‘cherry pick’ more favourable market segments such as single male lives.
The Netherlands, having taken a rather more pragmatic and market-related approach to determining retirement income, may produce outcomes that adapt more readily and that are more affordable. The Netherlands also appears to offer a more favourable environment for innovative retirement income products.
Mike Wadsworth is a partner at Watson Wyatt in the UK

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