Solidarity buffer to absorb inflation shocks in new Dutch pension system

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Pension funds can use the solidarity buffer in the new pension system to absorb inflation shocks, according to the new version of the Dutch pension law that was presented last week.

In the new defined contribution (DC) pension system, pension funds will have more freedom to invest in inflation-hedging assets such as real estate or inflation-linked bonds. However, since the European market for liquid products with an explicit inflation hedge is limited in size, the government wants to facilitate additional inflation protection in the new pension law.

Under the new rule, pension funds will have the possibility to use the so-called solidarity buffer to this end, although the exact rules governing this still have to be worked out.

“This buffer can be used to absorb unexpected inflation shocks,” the Dutch ministry for social affairs said in a document accompanying the revised text of the new pension law.

The ministry had not previously explicitly indicated the solidarity buffer could provide for this form of risk-sharing.

According to senior consultant Chantal de Groot at Ortec Finance, the option to use the solidarity buffer to absorb inflation shocks is “a good thing”. She said: “A pension fund will not be required to use it, but it gives them an additional tool if inflation suddenly rises.”

Netspar, a think tank, has noted that an inflation shock that turns out not to be a one-off has the potential to consume the solidarity buffer very quickly, especially if it is used to compensate the whole population of a fund instead of just the pensioners.

Ortec’s De Groot agreed, noting that the solidarity buffer can be used to many other ends, such as sharing of longevity risk and investment risk and “the prevention of good luck and bad luck generations”.

The maximum size of the buffer will be 15% of a fund’s assets, which can be built up over time using pension contributions and excess returns.

According to De Groot, the new DC pension system is much less explicit about inflation protection than the current defined benefit (DB) arrangement.

She said: “At this moment, pension funds are allowed to compensate for inflation once they reach a certain funding level. In the solidarity DC arrangement, this is being made much less explicit. Instead, indexation will be provided through excess returns which can vary year by year.”