Dutch Pensions Reform: Full speed ahead
Lans Bovenberg contends that the Dutch government should move fast to implement personal pensions with risk sharing
The Dutch government has recently published its views on the future of the pension system.
It supports the innovation of personal pensions with risk sharing (PPR). I welcome this and argue that a rapid transition to PPR is feasible under two conditions. First, the introduction of PPR should be unbundled from the government proposal to eliminate backloading of pension accumulation over the lifecycle, whereby most pension fund members accumulate the bulk of their pension income in the latter part of their working life. Second, pension rights that have been accumulated in the past can be grandfathered in the new general pension fund (algemeen pensioenfonds; APF).
Why pension innovation?
Private pension provision is in transition and needs innovation. Employers and insurance companies are withdrawing as risk-sponsors of occupational defined-benefit (DB) schemes. With participants rather than employers bearing the investment and longevity risks, these schemes have become collective defined distribution (CDC) plans. These feature a collective asset pool distributed to policyholders with complex profit-sharing rules. Hence, they provide variable rather than guaranteed annuities. Variable annuities are complex and difficult to value. Moreover, these plans do not offer much scope for customising risk profiles and adapting to macroeconomic developments. They thus give rise to conflicts among policyholders not only about the distribution, but also about the investment of the collective assets.
What is a PPR?
PPR offers advantages compared with CDC plans in terms of simplicity, transparency and property rights, on the one hand, and customisation to heterogeneous individual circumstances and scope for adapting to unexpected developments on the other. In particular, PPRs unbundle the three main functions of variable annuities – investment, accumulation, decumulation and risk sharing. Just as in individual defined contribution (DC) schemes, an individual holds a personal claim on financial assets in a PPR. These assets are the property of the individual; a PPR is a personal account shielded from the investments, accumulation and decumulation of others. Yet, an individual cannot dispose of the funds because the personal assets are earmarked for retirement income and not for consumption before that. Accordingly, a PPR is a personal pension. As a third element, a PPR includes insurance against longevity risk through pooling within a collective solidarity pool. A PPR is thus a personal pension with risk sharing.
Advantages of a collective approach
Personalising investment risk protects advantages of collective approach to pensions. The PPR combines the strengths of collective DB schemes and individual DC schemes, and avoids the opacity of variable annuities; in fact, the individualisation of financial risks protects collective risk sharing of non-financial risks. In particular, similar to DB schemes, PPRs engage in asset-liability risk management by defining ambitions for retirement income already in the accumulation phase. Moreover, longevity risk is pooled and investment risk can be smoothed in consumption. PPRs allow each collective to tailor the extent of risk sharing to specific needs and circumstances. Personalising investment risk does not necessarily mean that individual policyholders should conduct risk management. Fiduciaries can still design the optimal choice architecture, including defaults for investment policy.
Simple and transparent
Compared with CDC plans, a PPR makes the administration of pension plans less complex and increases transparency. In particular, a PPR features transparent accounting illustrating the link between individual contributions, financial returns and individual benefits. Moreover, to avoid volatility in retirement income, PPRs can smooth shocks over the lifetime of an individual in a way that is transparent. Hence, the PPR allows investment risks to be combined with longevity insurance without volatility in consumption streams or the opaque and rigid valuation rules of CDC plans.
Removing backloading is complex….
Whereas its support for the PPR concept is welcome, the government is linking the model to its reform proposal to eliminate the backloading of pension accumulation. This is unfortunate because it is controversial and may take considerable effort to implement, thereby delaying the introduction of the PPR. The backloading of pension accumulation during the lifecycle is a legacy of DB. Moving more accumulation to the first half of the working life gives rise to a major transition issue. In particular, without supplementary compensation, the active generations that are alive at the time of the reform end up with lower pension benefits. In the first part of their working life, these generations lived under the old regime and thus benefited from low accumulation. However, at the end of their working life they can no longer compensate for this because they then fall under the new regime without backloading.
By decoupling the PPR from a change in the way pensions are accumulated over the lifecycle, the PPR can be introduced immediately. The current solidarity between young and old workers in compulsory sector schemes (the so-called ‘doorsneesystematiek’) can be maintained for the meantime. All workers pay the same premium as a percentage of their pensionable wage but older (younger) workers benefit from more (less) additional pension accumulation in their personal pension accounts. This maintains the current solidarity in these schemes. At a later stage, the tax authorities can tilt the age profile for tax-privileged pension accumulation away from older to younger ages. At the same time, sector schemes can phase out solidarity between the old and young.
Grandfathering rights in an APF
The government recently created a new pension vehicle: the general pension fund (APF). This pension vehicle is meant to administer several ‘solidarity’ pools instead of just one.
The APF reconciles economies of scale in administration, asset management and governance with tailor-made solidarity. This unbundling fits well into the PPR concept. It also facilitates the transition to a PPR. In particular, a separate solidarity pool can grandfather the pension rights accumulated in previous CDC plans. These old rights thus do not necessarily have to be converted into personal pension capital. At the same time, they can be governed by the same fiduciaries who select the choice architecture for the PPRs from new accumulations.
Lans Bovenberg is a professor of economics at Tilburg University