The Netherlands: Panic football or a long game?
Dutch opinion is divided over the regulatory reaction to the recent financial shocks, find Liam Kennedy and Mariska van der Westen. Whatever the outcome of the planned overhaul to the FTK, good communication will be essential
Willem Vermeend, former Dutch social affairs minister, called the regulatory response to the financial situation of Dutch pension funds "panic football" in an interview with our sister publication IPNederland last summer. The threat of benefit cuts in 2010 - which has so far proved to be more illusory than real - dented public confidence in a pension system that was once thought both to work well and to serve as an example to the rest of the world.
The spectre of a pension system in crisis also led to cracks in the intergenerational compact that has supported the Dutch second pillar. There is open admission that previous generations have paid too little for their defined benefit pension, and younger workers are increasingly less willing to pay more to support the privileged old. While the threat of benefits cuts was meant to spread the pain of an underfunded system across generations, the announcement was chaotic and served in the end as a blunt instrument.
No-one can deny the severe effects of both the financial shocks of 2008 and other external factors, such as longevity, on the long-term health of the Dutch pension system. But the country seems split between the regulatory purists, who demand strict capital buffers to maintain the long-term solvency of the pension system, and dissenters, like Vermeend, who maintain that many of the problems stem from using the euro swap curve to discount liabilities.
That group sees the Dutch supervisor as a sort of modern day Don Quixote tilting at the windmills of problems that are to a great extent illusory, a mirage created by the current low interest rates. They also see a regulator which does not recognise that the financial game has changed: the capital adequacy concepts that underlie a pensions supervisory framework like the Dutch FTK look increasingly irrelevant. In the end, large buffers proved to be no help against the spring tide of financial crisis and the credit crisis and the idea of risk-free assets seems increasingly irrelevant in the modern world. Risk, the dissenters argue, is part of any funded-based pension system: this should be recognised and embraced.
Vermeend pointed to a solution that is increasing in traction in the Netherlands - a dual-risk system whereby those requiring greater security would pay more or receive a lower pension and those willing to take on risk over their lifetime would not. The former minister also joined the growing chorus of voices calling for an overhaul of the liability discount rate in recognition of the artificially low interest rates that have bedeviled Dutch pension funds since 2008.
In early September 2010, the €200bn-plus ABP public employees pension fund called for an overhaul of the metric used to calculate the liability discount rate, arguing that mandatory use of the euro swap curve rate was itself leading to benefit cuts. The regulator re-affirmed its intention to stay the course. The week before, Piet Hein Donner, then minister for social affairs, rejected the possibility of changing the discount rate metric, arguing that a change would merely "define away" pension funds' problems.
ABP's intervention came just a few days before it announced that its coverage ratio had fallen to just 88% as the swap rate benchmark fell to 2.51%. PFZW, the €90bn-plus healthcare pension fund saw its coverage ratio fall to an eye-watering 85.2% at the end of the third quarter. Both those pension funds are especially at risk as their sheer volume of assets accounts for some 40% of the €750bn in total in the system.
While the effect of ultra low interest rates can be described as temporary - albeit one that has persisted now for more than two years - increasing life expectancy has a secular long-term effect on coverage ratios. Correspondingly, at the end of August, the consultancy Hewitt predicted additional coverage ratio costs of 2.5%, in addition to Statistics Netherlands' predicted 4.5%, as result of increased longevity.
Fast forward to February 2011, and the situation is markedly different, providing a respite for the funds. ABP reached a coverage ratio of 106.8% thanks to an easing of the euro sovereign credit crisis that saw the 10-year swap rate edge back up to around 3.5%, and not least thanks to the fair wind that sent developed and emerging market equities back on an upward trajectory. ABP recorded healthy 2010 performance of 13.5%, against 12.6% for PFZW, although PFZW's coverage ratio still languishes at an anaemic 104%.
Benefit cuts have been averted, markets have taken pension funds back out of the danger zone and the issue of the discount rate metric has gone into abeyance. But proposed changes to the pension contract itself will once again put the pension funds to the test.
Moves that could introduce retrospective conditionality into pensions promises are likely to prove much more contentious. While the UK has maintained a generous degree of inflation proofing in its defined benefit pension system, the Netherlands introduced conditionality into the pension deal from 2007. This has provided a crucial pressure valve, as funds have formalised their ambition to uprate pensions and accrued pension rights in line with inflation, but have been able to withhold indexation in tough years to protect overall coverage ratios.
So far so good, but the report of the Frijns Committee of early 2010 - which was authored by the former ABP CIO Jean Frijns - recommended that the FTK be amended to take into account the real nature of the pension promise. Even if the pension promise is formally a nominal one, the committee reasoned, an essential part of a pension fund's mission is to provide inflation protection, and this should be a formal part of the system.
Then there was the Goudswaard report, submitted alongside the Frijns paper and, like the Frijns report, commissioned by former minister Donner. Authored by professor of applied economics and social security Kees -Goudswaard, the report suggested conditional indexation alone is not enough to future proof the system and pension rights should be made conditional on life expectancy and financial returns.
A new pension deal implementing the suggested changes is now in the making and is supposed to take effect as early as next year.
Maarten Camps, director-general for labour at the ministry of social affairs and labour, outlined the government's vision for a new version of the pension contract that should be formalised in regulation by 2012 (see page 43). This will involve a twin-track FTK - a first version that will gold plate entitlements but makes them more expensive, and a second version, akin to the current arrangement, under which entitlements will be less expensive but also less secure. Under the proposal, employers and unions in each sector would negotiate an agreement that suits them.
Not surprisingly, negotiations on the exact nature of the new pension arrangement - including the tricky issue of migrating existing pension rights to a new system offering fewer guarantees - are still ongoing. Although an agreement on principle was reached late in the spring of 2010, trade unions, employer representatives and ministry officials have yet to work out a definitive deal.
Meanwhile, the pension crisis - whether real or imagined - has drawn rapt attention from the media. Pension funds, long tucked away in a quiet corner of the business world suddenly find themselves in the spotlights of public attention. This point was once again driven home when two competing news shows ran episodes lambasting the pensions system on national television - including a February show, accusing the pensions sector of structural underperformance and trustee boards of being clueless, which resulted in MPs calling for a hearing in Parliament.
Caught between bad press and endless negotiations, pension funds focus on shoring up their funding ratios and preparing for the changes ahead.
While the Netherlands moved, some 10 years ago, from a final salary to an average salary system with virtually no controversy, any move that would retrospectively place pension benefits on a conditional footing is likely to prove highly controversial. All parties are agreed on one thing, however: effective communication to all stakeholders in the pension deal - employers, active members, deferreds and pensioners - will be essential.