Netherlands: Save our system
The Dutch pension system is decaying due to legislation, accounting practices and the economic climate, writes Anton van Nunen
The Dutch pension system is regarded as one of the most comprehensive and sophisticated in the world and other countries often benchmark their activities to developments in Holland. Until recently it was justified to regard the system as a worldwide example of a well-organised, highly future-proof system providing decent pensions at reasonable prices. However, this is under severe threat and Dutch pension funds find themselves in an awkward situation. In this article I will put forward a two-fold thesis: I do think the system, as such, is still one of the best in the world, it can survive as such and damage to its reputation is not called for. Second, this reputational damage is largely due to non-optimal regulation by the Dutch authorities. This article is mainly directed at DB and collective DC schemes.
History: four blows to the system
The first blow - the beginning of the degeneration process of the Dutch pension sector - was dealt in 1991. On 23 January, Prime Minister Lubbers expressed his wish to "confiscate" NLG50bn (€22.7bn) in pension assets. His reasoning was that pension funds were "too rich" and that their so-called over-reserves were a luxury, facilitated by the government's tax code when in fact there is a (future) tax claim on pension reserves. The announcement never became reality yet it caused severe harm to the Dutch pension industry.
The second blow to the pension system was the inauguration of IFRS. Ignoring all the details surrounding this major worldwide accounting change, the essential impact of this overhaul on corporate pension funds was that their balance of assets and liabilities had to be reported as part of the corporate balance sheet. Every CEO wants to control his balance sheet and hates the idea that he cannot manage part of it. But it is not necessary to be a BA, British Steel or General Motors, to experience that a reduction in interest rates, and a rise in pension liabilities, frequently with huge leverage, has more impact on balance sheets than major investment decisions relating to aircraft purchase, reorganising steel mills or reducing car sizes.
The third blow was the new Dutch financial framework for pension funds, taking effect from 2001-02. Core to the new legislation was the marking to market of assets and liabilities. The sector itself had for a long time already advocated changes in this direction, exiting the out-dated accounting rule which prescribed liabilities to be discounted by a fixed 4%. It was agreed (at the advice of the sector itself) that the swap rate should be used as a discounting factor for those liabilities.
There are several arguments to be made against the use of this tool(1), but the most important consequence was that liabilities had become more unpredictable. This created the following scene: pension funds were already inclined to reduce risk; standing on their own feet now they are confronted with more volatility of liabilities and thus with more risk, even though these risks were artificially created. This situation is detrimental to risk appetite on the investment side with lower pensions and higher contributions as a consequence.
The most poisonous part of the framework is the legal requirement that funding ratios should always be above 105% of liabilities.(2) The unproductive consequences are clear: buffers are a good thing because they reduce uncertainty, but in order to fulfill this function they have to be created when times are good and they should be allowed to deflate in bad times. Restoring them in tough times as is required in so-called recovery plans will aggravate the macroeconomic situation as wage costs increase in a declining economy. Since it is impossible to raise premiums in an economic downturn, the deflated buffers will not bring more certainty to pension fund members and liabilities will have to be redefined.
The fourth blow was again financial disruption and funds, hurt by the previous three events found themselves in a deteriorating situation. Acting according to legislation, funds contributed to a self-reinforcing process of impoverishment. Following the rules, low funding ratios were ‘countered' by selling equities and other real assets, causing even lower prices and the buying of long term bonds and their derivatives caused interest rates to decline further, thus lowering already dwindling funding ratios so that pension funds that were until then above 105% had to follow and lock in losses as well. This flywheel of selling real assets in empty markets and buying government bonds in an overcrowded market, raged through the pension system and caused havoc to an unprecedented level.
After this farce of enforced impoverishment became clear to everybody, and as recently as the beginning of December 2009 the Dutch regulator (DNB) said pension funds were to be blamed for investing in risky assets. The sad conclusion is that the regulator was totally right - within the existing legislative framework - and yet expressed the wrong verdict. The road to hell is indeed paved with good intentions.
It is also pitiful having to see that institutions, by nature able to invest anti-cyclically, were forced to do the opposite. In order to avoid the false conclusion that the regulator wants to get rid of most (corporate) pension funds, it has to be stated that the DNB had the best intentions possible in drafting legislation under fire. The new framework was put together in order to secure future pension payments as well as it could and a lot of the elements contribute to that aim. Underlining pension boards' responsibilities, encouraging study and expertise, stressing risk management are important items the new legislation has rightfully put forward. However, as indicated, these advantages have their counterparts in severe disadvantages. The regulator should address these defects in consultation with the sector.
The preceding historical sketch hints at the necessity to improve Dutch pension legislation. If legislation stays the way it is now and the pension sector does not pull its weight and expertise to change this unholy process of national impoverishment, the future will be bleak and not only for pension funds themselves. If institutional investors' economic function to provide risk capital to entrepreneurs is hollowed out, macroeconomic growth will also be hurt.
There is no better picture in sight given the circumstances of the credit crisis and strangulating legislation. But without a better functioning legislative framework, uncertainty will only become more obvious, although not greater. If recovery plans are not due immediately when wrongly calculated funding ratios hit an arbitrary threshold and if pension funds are allowed to regenerate funding over a longer horizon, pension fund members will experience higher pensions on average. Replacing the funding ratio with a better yardstick would enhance this process.
The deal is clear: taking well-balanced investment risk is to be preferred above certainty. If the regulator wants complete certainty then that can be arranged. But it would entail the return of a zero-coupon government bond with the required maturity. Pensioners would have to be satisfied with the lowest interest rates available and imagine what could happen to those interest rates if all pension funds were to flock to these safe havens.
Any insurance company can deliver that kind of product, and even a private pension saver could do the same at lower cost. Even a pension fund, of course, can offer this kind of secure but low pension provision, but should strive for more. Pension funds, through keen risk taking, diversification, economies of scale and intergenerational risk sharing, should be able to generate higher returns and at least try to index future pensions. Without this objective we might as well eliminate the pension industry and let employees do their own investing or send the money to insurance companies. This would result in certainty at the cost of fairly priced pensions.
Note that nowhere in this article is inflation protection is mentioned. It seems to be hard enough to safeguard decent nominal pensions. The looming spectre of inflation, following huge budget deficits, ballooning government debt and a massive money overhang worldwide, strengthens the arguments for better use of investment risk taking capability. If this inflation scenario does unfold, pensioners under present regulation are certain to receive low nominal pensions, eaten away by inflation. Long live certainty of that.
(1) Duffhues and Van Nunen, Dutch pensions: the big funding debate, European Pensions, September/October 2009, pages 24-27.
(2) The fact that the calculation of the funding ratio is wrong is dealt with elsewhere, see for instance Duffhues and Van Nunen, Fit for purpose, Finance Director Europe, Issue 3 2009, pages 54-55
Anton van Nunen is principal of Van Nunen & Partners, an adviser to institutional investors