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IPE special report May 2018

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Giving generations their due

The concept of intergenerational solidarity, whereby one generation pays for the pensions of another, is coming under severe strain in the Netherlands.
Pressure on the system has been mounting since the collapse in the equity market between 2000 and 2002 which led to substantial losses of pension asset values. The collapse posed the question - who should pay for the losses? Pensioners, employees or future generations?
Coen Teulings, director of the SEO Economic Research at Amsterdam University and the new director of the Central Planning Bureau of the Netherlands, argues that the political tensions between generations that have grown mainly because of the poor definition of property rights regarding pension fund assets. No-one is quite sure who owns what in a pension fund.
In a research paper ‘Generational Accounting, Solidarity and Pensions Losses,’ published by the Tinbergen Institute, Teulings and his colleague Casper de Vries suggest that the problem of poorly defined pension fund property rights could be resolved by the introduction of a new pension system of ‘generational accounts’. With generational accounts, each generation would know precisely what it was entitled to.
The starting points for this idea are modern portfolio theory and consumption planning theory. Modern portfolio theory says that the young should have a higher exposure to equities because they have a higher stock of human capital. The young have a longer productive life ahead of them than the old.
Consumption planning theory says that that capital losses should be distributed smoothly over lifetime consumption. When stock markets are depressed, equity should be bought, savings and consumption should be scaled down in equal proportions and retirement should be postponed.
Teulings and de Vries say that two elements are necessary to enable pension funds to achieve these optimal lifetime consumption saving patterns:
First, the pension system should be funded. Second the pension system should define clearly the property rights of each generation over the pension fund’s wealth, to avoid political decision making on the distribution of losses.
In a system of generational accounts all the contributions paid by one generation would be administered in a separate account, so that each generation’s property rights on the investment returns are clearly defined. A separate account is kept of each generation’s investment, since the risk profile of optimal investment policies will differ between generations.
Teulings and De Vries say that, by definition, generational accounts exploit intra-generational solidarity - in the manner of insurance companies - rather than relying on inter-generational solidarity:
“Intergenerational solidarity is equivalent to spreading the stock market risk over a longer time period than just a generation’s lifetime. The longer the time period over which the risk can be spread, the better it can be diversified, and hence, the lower is standard deviation.
“Yet the opportunities for this diversification are asymmetric. Including uncertainty on future stock prices in a generation’s portfolio is theoretically impossible.
“Generational accounts avoid distribution conflict between generations that might otherwise arise when the stock market goes down. The implications are equitable since all generations share in the fortunes of the economy.
Generational accounts also dispense with the inefficient holding of buffers or surplus funds, and prevent disputes over their ownership, they say. “Buffers are analogous to precautionary saving. We save more than is required. This makes sense only for uninsurable hazards. For insurable risk, the market provides the cheapest insurance. Since bonds provide insurance against stock market volatility, precautionary saving is an inefficient way to insure these risks.”
Teulings and De Vries believe the introduction of generational accounts would have important implications for the governance of pension funds. In particular, it would resolve some of the problems faced by many European companies with defined benefit pension plans, which are now required by the International Accounting Standard 19 (and its Dutch equivalent RJ 271) to include their pensions liabilities on their balance sheets.
In a system of generational accounts, a pension fund's liabilities to a generation would have to be paid from the wealth that is available in that generation’s account. So there Is a clear separation between the responsibility of the employer and of the pension fund. The employer has neither a responsibility nor a say in the pension policies, Teulings and De Vries suggest, and therefore pension liabilities should never appear on the balance sheet.
Generational accounts would remove the potential for conflict between employer and employee, Teulings said at a conference on Dutch pensions organised by KAS Bank earlier this year: “It is no longer acceptable that we are unclear about the contributions the sponsor makes. This has to be clear immediately and if it is not clear then there has to be something on the balance sheet which represents future obligations from unclear agreements.
“In this respect generational accounts will be an improvement. It is not desirable to be dependent on the way companies operate. A clear division between pension fund and company will contribute to trust and confidence in the pension system.”
Generational accounts would also remove the need for protracted negotiations about pension rights, he said. “The main advantage of generational account is that you have very clear property rights, what belongs to which generation. And if there is any setback financially, you don’t have long discussions where pension fund administrators have to talk with unions of pensions people and other organisations. There is a clear rule, there is transparency and there is risk management. You make agreements in advance and then you carry them out later on.”
This would protect pensioners as well as active members of pension schemes, he said. “It means that pensioners are protected against politics. Transparency and good contracts will prevent a lot of problems you might have later on.
“Generational accounts also protect against sponsors in a sense. In the 1990s there were periods when companies didn’t pay pension premiums. Because the economy was flourishing this seemed justified at the time, but in this respect a clear division of tasks is a good idea in my view,” said Teulings
Pension funds and their asset managers can play a key part in the operation of generational accounts, he said. “Various risk profiles need to be set up for the different generations. One generation will need to be more invested in bonds, another more in equities. This will mean transfers of different asset classes between the various generations .
“Pension funds can do this by trading on the stockmarket. But they can also do this within their own pension fund, because there will be one generation that holds lots of equities and wants to lose them because it is growing older, and another younger generation that wants to buy these stocks because. So parts of these transactions will be transactions inside the pension funds, between the schemes of various generations.”
Yet the main appeal of generational accounts is that they could restore some of the trust in pension fund saving that has been lost in recent years, he said.
“The younger generation is thinking it no longer wants to belong to a pension because it is not going to get anything at the end of it. They see that the pension capital is being used to pay people who are retiring now, and think that when it’s their turn there won’t be any more money .
“A clear definition of the claims of young people would provide a lifeline for the continuation of pension funds. Some pension funds are now seeking ways to make transparent what belongs to who, and reassure people that later on there will be money for everybody. A system of generational accounts can be of great help in this,” said Teulings.

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