The Dutch pension sector is working on new pension contracts, with softer benefits as the expected outcome. Meanwhile, the European Commission has planned to revise the IORP Directive and European supervision of pension funds. Dick Boeijen, Niels Kortleve and Jan-Willem Wijckmans ask if these processes are compatible
Increasing longevity, the ageing of society and sponsors’ withdrawal from risk bearing have all made clear that DB systems are increasingly difficult to meet through full reliance on sponsor support and future generations. These problems have been exacerbated by the financial crisis, where negative equity returns and low interest rate levels have put pressure on the guarantees written implicitly by future generations. The willingness and ability of sponsors to bail out funding shortages is shrinking and the impact of extra contributions is diminishing rapidly due to the retirement of the cohorts of baby boomers.
Defined ambition best for collective contracts
To tackle the challenges, the Dutch social partners are working on pension contracts that are more flexible. In the new contracts benefit steering will become a regular security mechanism. We call this defined ambition (DA): the partners still steer towards the same level of pensions as under a defined benefit contract, but are able to adjust benefits after financial or longevity shocks. The benefits are no longer guaranteed. This allowance for benefit adjustment does not mean that the pension outcome for the pension population as a whole becomes any more uncertain than under a defined benefit contract that lacks strong backing from a sponsor. Faced with the same drawdowns, the result should be the same, only the (re)distribution of the shortfalls will arguably be more fair. DA is a hybrid form between DB and DC, with DB elements - such as collectivity and risk sharing (also between generations) - and DC elements like adjustable benefits. DA offers the possibility to profit as much as possible from risk sharing and is the way out of unsustainable guarantees without needing to revert to individual contracts.
It seems that benefit steering will become a more regular instrument for Dutch pension funds. Supervisory rules have to change along with these changes in order to ensure proper supervision on the right pension issues. The Dutch regulator is closely involved in all new plans. Although the exact details of new contracts and the supervisory needs of such contracts are still under construction, the regulator is already working on new supervisory rules.
A point of attention and possibly concern however, is that European regulation is currently also being reviewed. Moreover, this review has not been initiated in order to allow a better fit with any changing contracts, but from the wish to harmonise supervision in European member states. This raises the question whether any plans to harmonise a very diverse field of European pension contracts, will still be tailored to developments within Dutch pension plans.
The European plans for the revision of the IORP Directive are currently under discussion. Assessing the appropriateness of the plans at this moment would still be very premature. We can however assess part of the plans if we divide up any new IORP Directive into the functional framework on the one hand, and the prudential framework on the other hand.
Holistic balance sheet
The functional framework being proposed by EIOPA is the so-called holistic balance sheet (HBS). This HBS reflects traditional assets and liabilities but also conditional elements that are available to the pension fund to steer the solvency position. The elements often mentioned are sponsor guarantees, pension protection schemes and contribution increases for the asset side of the balance sheet. On the liability side benefit steering or conditional indexation should be accounted for. It seems therefore that such a functional framework would be well suited to incorporate both DB and softer DA schemes. For DB, the HBS reflects the value of any unconditional benefit, properly secured with physical investments on the one hand and future sponsor and member payments on the other hand. For DA schemes, the possibility to lower entitlements in case of certain circumstances can be reflected by subtracting the value of this option from the existing value of the liabilities. This leads to one single framework for different types of pension agreements. It is encouraging to see that this initiative in theory offers the possibility to account for the single most defining characteristic of DA schemes - solidarity between generations but with lowering of pension benefits as a regular steering instrument.
Prudential framework and sustainability
If we look at the prudential framework, we notice that much less is known. Many issues still have to be tackled and there are many decisions ahead that can still frustrate the desire of social partners and member states to maintain or set up adequate funded retirement systems. The security level of the benefits provides a good example to illustrate possible negative consequences within the prudential framework. The European Commission has indicated the desire to work with a harmonised security level. This is at odds with the benefit steering within DA schemes. The severity of the steering and the waiting periods concluded are expected to be fund specific and will not necessarily comply - even within the HBS framework - with one single security level. Also, possible tiering rules regarding the extent to which a security level can be met with conditional steering mechanisms instead of cash assets can be a true game-changer for DA schemes. Only the greatest care and impact analyses can prevent that the wrong prudential choices will lead to a massive abandonment of collective pensions towards individual contracts.
By switching from DB to DA with flexible benefits, Dutch pension contracts will be made more sustainable for the future by making the pension system more robust for financial and longevity shocks. The Dutch regulatory framework will be changed accordingly, to facilitate this transition. Any revised European supervisory framework should not frustrate this transition, but should instead encourage the fact that such a transition attempts to retain the advantages of collective rather than individual savings. The functional framework of a holistic balance sheet does not seem to be a hurdle for DA since it should be able to recognise the possibility of cutting benefits. Within the prudential framework however, the wrong choices can lead to severe unwanted incentives to abandon collectively funded pensions - whether DB or DA - altogether.
Dick Boeijen is an actuary, Niels Kortleve is innovation manager and Jan-Willem Wijckmans is strategic risk manager at PGGM