Policy ladder manages risks and helps funding
In July 2003, ABP introduced a new system of management of pension fund risk, the so-called ‘policy ladder’ (in Dutch ‘beleidsstaffel’). The initiation of the ladder led to two important adjustments in the pension plan:
q The introduction of a set of explicit rules regarding the allocation of funding risks to the plan members;
q A move from a final-pay scheme to an average-wage scheme with conditional indexation applied to all participants, retirees as well as active workers.
The ABP policy ladder aims to improve the management of pension fund risks. At the same time, the ladder offers a way out of the current difficult funding position. The introduction of the ‘policy ladder’ has a number of advantages that ABP believes will contribute to a fair and more sustainable pension plan. Firstly, it implies a firm move from an implicit to an explicit pension deal because the set of explicit rules prescribes who has to pay, when and to what extent in a deficit situation. These rules also set down who will benefit, when, and to what extent in a surplus situation. The ladder also implies a movement away from a ‘pure DB’ towards a ‘hybrid DB/DC’ pension scheme.
Towards an explicit pension deal
With the term ‘pension deal’, ABP refers to the contract between employees and the employer that sets out the nature of the pension promise (final pay or average wage, indexation policy), the funding of this promise and how the risks in the funding process are allocated (implicit or explicit) amongst the stakeholders. Many plans in the Netherlands traditionally have been more or less implicit as to the key aspect of risk-bearing. Usually there have been no rules regarding how, by whom and to what extent the funding risks of the plan ought to be borne. In the 1990s pension funds experienced huge surpluses that were used for cuts in contributions and improvements of the pension benefits of the active employees. After the dramatic fall in stock prices in the last three years, Dutch pension funds struggled with funding deficits. The supervisor (de Pensioen en Verzekeringskamer - PVK) is insisting on a recovery in funding levels in the short term, however stakeholders argue about who has to pay. ABP believes that the introduction of an explicit pension deal will overcome the prevailing state of apathy.
Fair value principles have been in use since the end of the 1990s improving transparency in accounting issues and the measurement of pension fund risks. The ABP policy ladder aims to improve the management of pension fund risks while at the same time offering a way out of the current difficult funding position through explicit use of the fair value framework.
Two points are crucial here. The first is the value of the nominal liabilities (with valuation based on the nominal yield curve) and the second is the value of indexed liabilities (based on the real yield curve). When the value of the assets matches the value of the indexed liabilities, the contribution rate is set equal to the cost price of new accrued liabilities whereas the indexation matches the wage inflation. There will be cuts and charges regarding the base contribution rate and indexation when the value of the assets deviates from the value of the indexed liabilities.
Indexation policy: The size of the indexation is related proportionally to the size of the available indexation reserve, which is the difference between assets and nominal liabilities. There is room for full indexation when the value of the assets equals the value of the indexed liabilities. In this case, the actual indexation reserve matches the required indexation reserve. The indexation rate will be zero when the assets are equal to or even below the nominal liabilities. The indexation reserve then is actually zero or even negative. Between these points there will be a cut in the indexation where the cut depends on the actual deficit in indexation reserve. Whenever the assets exceed the value of indexed liabilities, there is room to provide extra indexation until there is a full catching-up of previously missed indexation.
Contribution rate: The contribution rate is set equal to the cost price of the new accrued liabilities of one year of service when the assets are equal to or exceed the value of indexed liabilities. A contribution charge is levied when assets fall short of the indexed liabilities. Analogous with the indexation cut, the charge will increase when the deficit is increasing.
Discussion with the stakeholders and the PVK regulator led ABP to a number of modifications, although these changes have had little impact on the core principles behind the policy ladder.
From a ‘pure DB’ towards a ‘hybrid DB/DC scheme’
The introduction of the ‘policy ladder’ has a number of advantages that ABP believes will contribute to a fair and more sustainable pension plan:
Firstly, the indexation policy and contribution rates are related explicitly and unequivocally to the actual indexation reserve position; this will prevent the re-occurrence of the recent situation of policy-apathy. Using the ladder it is always clear who, when and to what extent takes part in the funding risks.
Secondly, the ladder maintains the DB character of the plan. It still aims to realise a target pension income according to the preferred level related to final-pay or average-wage. However, this target income now has to be seen as an expected income surrounded by uncertainties as implied by risk-allocation rules of the ladder.
Thirdly, the ladder leads to a broadening of the risk-sharing capacity of the fund as retirees, workers and future participants are involved in the risk-sharing process. Finally, the ladder checks for fairness as the participants take part in the risk by accepting indexation risk proportionally to their accrued rights.
By introducing the ladder, the pension plan is moving away from a ‘pure DB’ plan towards a ‘hybrid DB/DC’ scheme. In a pure DB plan, indexation is always given and the contribution rate absorbs the funding risks. By introducing the ladder, the scheme has the characteristics of a DC plan because funding risks are primarily absorbed by adjusting the indexation rate. Hence, the value of accrued rights and benefits of all participants are volatile, as in a DC scheme. At the same time, the ladder still maintains the DB character of the fund because the risks regarding future inflation and rates of return are borne by the collectivity of active, retired and future participants. Also it still aims to realise a target pension income according to the preferred level related to final-pay or average-wage.