Looking over the horizon
Jan Nijssen, former global head pensions and CEO insurance central Europe at ING predicts “that within three to five years the lifetime guarantees that we see in the pension beneficiary area will be gone. When Bismark introduced the pensions structure very few people reached the age of 65 so it was a cheap system. But now the cohort of beneficiaries is growing rapidly and putting an increasing strain on the whole system.”
Just as demographic and longevity pressures have forced most European governments to encourage the development of second pillar funds to make up the difference between people’s expectations of post-retirement income and future budgetary ability to pay a reasonable amount, so second pillar funds will place constraints on their payment promise, Nijssen forecasts.
“In the UK, for example, there are around 200 providers of lifetime annuities but when people reach retirement age and must convert their lump sum into a lifetime annuity they find that there are only two or three providers that want to provide this,” he notes. “Then usually the retiree is disappointed that such a large lump sum produces such a small income and the providers are very dissatisfied as they have to give such a high annuity given the longevity factor. So the system has an in-built tension.”
Consequently, the rollover payout market is becoming a competitive arena that is posing a challenge for providers, including ING.
“I hope and expect that the obligation of future pension beneficiaries to buy annuities will continue,” he says. “I am very much in favour of mandatory participation in the second pillar with an obligation to convert its proceeds into a lifetime annuity. But the terms and conditions of the lifetime annuity will vary. So, if the assumptions taken at the time when the annuity was established have altered because of such major factors as changes in longevity, the terms will be renegotiated – say every five or 10 years.”
But won’t that undermine faith in the system?
“For such changes to be triggered would suggest that there had been one or two real medical breakthroughs to give a real jump in longevity but I don’t think it would have an impact on the three-pillar system and would even dare to argue the contrary,” says Nijssen, who is an active member of the Netspar network for pensions, aging and retirement research and has acted an adviser on pensions policy to a number of governments.
“Going back to basic principles: in mature economies, the first pillar is there to provide a minimal acceptable standard of living, and while a dramatic increase in life expectancy would have a real impact on the state budget, a solution would have to be found within society as a whole.
“But for the second pillar the maintenance of the generally accepted ambition level of two-to-three times the first pillar income in the face of a dramatic increase in life expectancy would make a hardly acceptable solidarity call on the younger generation.”
One impact of this would be that the indexed second pillar pension benefits – which people until now have seen as guaranteed – might not be guaranteed under all conditions, Nijssen says. If something dramatic occurred that made a 100% paper guarantee unsustainable a fund would be faced with the choice of either going broke or adjusting.
“In the Netherlands, as elsewhere, we see a desire for certainty,” he adds. “But only one thing is certain, if you impose on a need for 100% certainty on a pension system in all cases then people will either receive a very sober pension or it will be extremely expensive.
“However, if you move to a system that has a highest likelihood of a long-term sustainable income on the basis of an adequate supervision rather than a 100% guarantee of one, the average benefit to the average pension beneficiary will be a lot higher.”
What would such a system look like?
“The market is hardly there yet but the more focus that is put on the payout phase, the more it will generate all sorts of new concepts,” says Nijssen. But should life expectancy not increase sharply but even reduce, it could mean higher benefits for the then pension beneficiaries. While if life expectancy drastically increased, there initially would be a decision on how the system could compensate itself in terms of higher contributions or better investments. And beyond that it would have to reduce the benefit payments.
“Better to have 90% and a sustainable system than 100% of a much lower outcome.”
And what are the implications for the Dutch pensions system?
“The Netherlands may be the country with the highest likelihood of keeping a long-term sustainable defined benefit system,” says Nijssen. “But it depends on the size of the cohort of pension beneficiaries within the total system and requires that in parallel we introduce a long-term sustainable second pillar ambition level. We may have to reduce it in total from two to three times the first pillar level to 1.8 or 2.7 times.”
Nijssen is critical of some of the other responses to perceived pensions problems. The shift to DC from DB has it gone too far, he says
“CFOs got scared in 2004. They assessed the implications of the IFRS, saw volatility in the balance sheet and in the P&L, some saw that the pension fund was larger than their company balance sheet, and they wanted to get rid of the risk. The answer appeared to be a move to DC, and they wanted to implement it immediately. So we seemed set for a lemming-style migration from DB to DC and that would have been irreversible; once you move to individual DC there’s no way back to DB.
“Fortunately, it did not happen, but instead people recognisd that nothing is forever. The popular attitude changed from ‘we have what we have and because it is the best it should always remain’ to a recognition that ‘we have a good balanced system but in order to keep it sustainable over the long term we need to dare to change, and to adjust what needs to be adjusted to make it long-term sustainable’.”
What was needed was a system that retains mandatory participation, a collective approach and the professional involvement of asset managers with the right kind of long-term view, and combines it with an ability to adjust with a countervailing force if the system comes under too much pressure, Nijssen says.
“That’s where hybrid systems come in,” he adds. “While you can’t continue with the 100% DB, you can have DB to a certain level and then have DC on top of that. And even better, there is collective DC where in a period of high capital coverage ratio due to of a period of extremely high investment proceeds, the system works to increase the benefits, but when the capital coverage ratio becomes too low after a period of bad investment performance the system allows a reduction in the benefits so that the capital coverage ratio improves.”
This approach came out of the industry, not from government or regulatory pressure, Nijssen says, with Ortec co-founder and fellow Netspar member Guus Boender among those who realised that while the old ‘we-will-never-change DB’ attitude would not work, a rush to DC was a mistake.
“I perceive this as a much more appropriate ‘head cool, feet warm’ answer than a move to DC,” he says. “And while it is indicative of the fact that when needed people can be innovative, I don’t see it as the ultimate answer. Nevertheless, hybrid systems and this kind of collective DC are meaningful.”