How the indexation label works
Pension contributions that are paid in today often generate benefits to be received in the far future only. This makes them vulnerable to erosion through cumulative inflation. The purchasing power of annuity payments is often hard to judge for individual scheme participants.
The degree to which the purchasing power of pension payments is protected against inflation is known as the indexation quality of the entitlement.
Transparency on the future purchasing power of individual pension rights is crucial to enable participants to take adequate decisions on the options that almost all pension schemes worldwide offer to their participants.
Most Dutch schemes can be characterised as defined benefit (DB) from the perspective of the participant. However, the benefit is generally defined in nominal terms only.
Whether or not indexation will be given depends on the investments returns and premium inflow through an explicit or implicit rule that relates the indexation of an individual’s rights to the pension fund’s funding ratio. The participants in these schemes usually have a number of important choices to take. Once and for all, participants can decide to build up additional pension rights in the voluntary third pillar if they judge the purchasing power of the entitlements in the first and second pillar to be insufficient. This can be due to the fact that part of someone’s working life was spent outside of the Dutch DB system, because they were self-employed, because they worked part-time or worked abroad, and for many other reasons.
Participants who change jobs have to decide whether or not to transfer the pension entitlements to the pension fund of the new employer. Here as well, the purchasing power of old and new entitlements will be a crucial ingredient in this decision. Likewise the purchasing power is important in decisions whether or not to transfer pension rights to a partner, or whether or not to retire early. The indexation quality of the entitlements reflects their purchasing power relative to the nominal promise.
Transparency on the real value of pension payments is equally important in pension schemes that do not offer nominally protected payments.
In defined contribution (DC) schemes the payments will often be converted into some form of annuity payments. There, as well as the purchasing power of the cash flow during retirement, is the relevant variable. Even in draw-down plans (where conversion to annuities is avoided altogether) the participants will have to judge the potential impact of inflation on the income to be generated.
The draft law that was discussed in Dutch Parliament last September contained a so-called indexation matrix which was intended to enhance the transparency on indexation quality. This matrix classified Dutch schemes in a large number of categories, dependent on the indexation ambition as stated by the trustees of a fund.
In the Netherlands some funds explicitly state that they strive for indexation of their sector-wide wage inflation, while others target for price inflation, and others do not specify indexation targets at all.
The indexation matrix was initially developed to verify whether the schemes realistically lived up to their stated ambitions.
Subsequently the same matrix was proposed to explain indexation quality to individual participants. Lengthy inaccessible expressions were proposed to be used in communication with the participants. The accessibility of the information was further reduced because the wording of the expressions to be used depended on the type of indexation ambition stated by the fund. Parliament decided that a much simpler alternative measure of indexation quality, the so-called indexation label, is to be preferred.
This new indexation label, which is to be developed further within a year and will be introduced shortly thereafter, will classify the indexation quality of pension entitlements per fund into five categories only.
The indexation label is inspired by the Dutch information leaflet that has to be provided to retail investors when they are offered financial products. In the new information leaflet (introduced as of October 2006) investment risks are classified as well into five categories, based on guarantees provided and expected loss above Value-at-Risk.
Based on that measure, we have already developed a draft version of the indexation label. The indexation label will both reflect average purchasing power relative to fully indexed rights and the average relative purchasing power in the 10% worst cases.
The indexation label builds on the continuity analysis (a new element of the Dutch Financial Assessment Framework, FTK) which requires all funds to develop stochastic scenarios for their funding ratio, contribution level, degree of indexation given, and so on. Dynamic policy reactions such as changes in the asset mix in bad scenarios, in indexation, and/or in contributions are to be taken into account in this continuity analysis.
The indexation level is merely a graphical illustration of the main characteristics of the distribution of indexation cuts (and catch-up indexation) generated in the continuity analysis. Extensions to DC or drawndown plans are straightforward.
Since many important pension decisions are left to the participants in many countries, improved transparency for participants is high on the policy agenda worldwide. The Dutch indexation label is a step in this direction.
Theo E Nijman, Bas JM Werker and Peter C de Goeij are at Tilburg University and Netspar
DNB and AFM commend label matrix
Both supervisors, De Nederlandsche Bank (DNB) and the Authority Financial Markets (AFM) have commended the indexation matrix for pension funds as the best basis for an indexation label for pension fund participants.
“The text in the two last columns safeguard that the information is consistent with the ambition, the behaviour and the financial situation of the pensions provider,” they say in a letter to social affairs minister Aart Jan de Geus.
DNB and AFM suggest that some changes and improvements could increase the effectiveness of the existing text. “The core of the text should however remain unchanged,” they say.
The regulators also propose to offer participants an insight in the uncertainty of the expected realisation of the promised indexation. Participants should be told the minimal percentage of indexation they can expect, they say
The also suggest adding a graphic account of the calculations to the different categories in the indexation matrix to enhance the clarity of the communication.
“The indexation matrix is an important instrument for shaping the indexation policy of pension providers, the regulators emphasise.. “It warrants a consistency between a scheme’s ambition, its financing and granting of indexation, and its information policy on the subject.”
The proposed text is still subject to testing by a panel.