The dominant reaction of Dutch pension funds to the fall in funding ratios at the beginning of this century has been a switch from final-pay schemes to average-wage schemes. Official statistics classify these schemes as DB.

This contrasts sharply with the experience in the US and the UK, where the perfect storm accelerated the switch from DB to DC. In 2004, DC plan assets amounted to 22% of total occupational plan assets in the UK and to 35% in the US. The corresponding figure in the Netherlands is 9%

The switch away from final-salary schemes in the Netherlands has been more pronounced in industry funds (see table opposite). In 1998, 70% of active participants had a final salary pension plan. In 2005, this number had fallen to 9%. The corresponding figures for company funds are 56% and 19%. Particularly decisive regarding the developments in industry funds was the switch of both of the largest pension funds, ABP and PGGM, to average salary schemes in 2004.

Industry funds have almost exclusively switched from final-wage plans to average-wage plans. The switch to combination plans or DC plans has been small. In contrast, company funds have switched more to combination plans and DC plans.

Combination plans are grouped in this table as DB plans. However, a typical combination plan in company funds combines a DB-type plan up to a certain ceiling, and a DC-type plan for the remainder of the salary. Consequently, the table probably underreports the shift to DC-type plans in company funds.

As a result of the switch from final-pay to average-wage-type entitlements, almost three-quarters of participants in Dutch pension funds now have an average-wage entitlement.

However, a typical characteristic of the Dutch average-salary schemes is that indexation of all accrued liabilities is made dependent on the solvency position of the pension fund through a so-called policy ladder. The pension funds introduced flexible indexations as the primary method to enhance solvency risk management.

A policy ladder enlarges the funds' risk-bearing capacity, and is part of the pension deal agreed upon by the social partners within the board of trustees. A typical policy ladder relates the contribution policy and indexation policies explicitly one-to-one to the financial position of the pension fund. The broadening of solvency-contingent indexation implies that the final pension result will be partly dependent on investment returns. The current typical average wage scheme can therefore better be described as a hybrid DB-DC plan, keeping a midway position between a traditional DB plan, with flexible contributions and well-defined indexed pensions, and a DC plan, with uncertainty as to the final pension result because of uncertainty on the rate of return on investments.

The hybrid plan is partly DB by nature because the yearly accrual of pension rights is specified in the same way as a traditional DB plan, and because contributions are flexible, depending on the financial position of the pension fund. The hybrid plan is partly DC by nature, as the yearly indexation is related to the financial position of the fund and therefore is related to the investment returns.A number of pension funds have gone one step further than the hybrid plan by abolishing the use of the contribution rate as a risk-steering instrument. This type of plan can be characterised as a collective DC plan with fixed contributions but flexible benefits, depending on the financial situation of the pension fund.

The hybrid plan makes use of two steering instruments to control solvency risk: adjustments in contributions and indexation. As a result, the probability of under-funding almost vanishes. The collective DC variant has fixed contribution but flexible indexation. The probability of under-funding slightly increases vis-à-vis the hybrid plan, reflecting the fact that the contributions are no longer part of the risk-bearing process.

Pension plan design is decisive with regard to how risk taken by the pension fund is allocated among stakeholders. Full indexation in the traditional DB plan comes at the cost of high volatility of contribution rates. Fixed contribution rates in collective DC plans come mainly at the cost of high indexation risk.

The current hybrid plan takes a midway position in these trade-offs. There is still volatility in contribution rates and there is less than full indexation. What is gained in hybrid plans is a low probability of nominal under-funding in comparison to both traditional DB plans and collective DC plans. However, changes in the policy setup of a pension fund may easily lead to redistribution of value and risk among the members. A key characteristic of a pension fund is that it can be seen as a zero-sum game. The total value to be distributed within the pension fund at a specific point in time is given, and is equal to the value of assets under management. The content of the pension deal is decisive with regard to how the total value is distributed among members.

As shown by Hoevenaars and Ponds, the step from the traditional DB plan to either the hybrid DB-DC plan or the collective DC plan leads to redistribution from old to young. The elderly members lose value, as they have to accept that de facto unconditional indexation policy is replaced by flexible benefits, depending on the financial soundness of the fund. The younger members win, since part of the risk bearing and funding burden can be shared with the elderly members.

The current hybrid DB/DC pension-plan structure uses adjustments in both contributions and indexation as steering instruments to control solvency risk. The fact that pensions plans rely on both instruments and not on one of the instruments exclusively seems to be a reflection of a compromise between the various stakeholders.

In this perspective, the governance structure and the need to compromise in the Dutch situation are central in explaining the evolution of pension funds.

Traditionally, risk management by Dutch pension funds in the postwar period was done primarily by adjustments in the contribution rate. A high funding ratio gives rise to contribution cuts, whereas a funding ratio that is perceived as too low leads to an increase in the contribution rate.

After the millennium, awareness grew that risk management through contribution rates exclusively was no longer appropriate. First, since most Dutch pension funds stem from the 1950s and 1960s, they have now, after 40 years, a high degree of maturity - as a large group of members has reached the retirement age. In a typical mature pension fund the ratio of pensioners over workers and the ratio of the value of pension-fund liabilities over wages is high. The ratio between liabilities and total wages is expected to rise from approximately 2.5 now to 4.5 in 2030.

This sharp increase has severely undermined the effectiveness of the contribution rate as a steering instrument. To improve the funding ratio by 1% would require an additional contribution of 4.5% of salary in the future, instead of the 2.5% in the present.

It was important for employers to address this declining effectiveness of the contribution rate as a steering mechanism, and to spread risks more evenly over participants and sponsors. But this also was a concern for unions. Unions in the Netherlands have to strike an internal compromise between the interests of younger workers, on the one hand, and the interests of older workers and pensioners on the other. In most cases, moreover, union representatives in pension boards are often closely involved in wage negotiations.

This explains why unions have been willing to spread risks more broadly between active members and pensioners. An exclusive reliance on contribution rates to absorb risks would run the risk of alienation of younger workers and put a heavy burden on wage negotiations, as employers would try to shift pension costs to workers.

In most final-wage pension plans, indexation of pension benefits was, at least on paper, dependent on the solvency position of the pension fund. Thus, in principle, pension funds could have invoked this possibility and shifted investment risk to pensioners. Given the maturity of most funds, this would have presented an effective instrument for restoring solvency. This would have been difficult, however, as the conditional indexation of pension benefits had been poorly communicated to participants.

As a consequence, strong resistance from pensioners might have been expected. Pensioners might have felt that they were the victim of contribution holidays in the roaring 1990s, when they threatened to go to court in case pension funds decided to shift risk their way only. As many pensioners remain union members after retiring, unions could not neglect their concerns.

One way out was to broaden solvency-contingent indexation to all liabilities - including accrued rights of active members. Technically, this implied a switch from final-wage plans to solvency-contingent average-wage plans.

Pension funds in the Netherlands are independent financial institutions with their own governance and administrative structure separate from that of the employers. Employers and unions are equally represented on Dutch pension fund boards. Thus, in contrast to the Anglo-Saxon defined benefit plans in the private sector, employers in continental Europe are less able to dominate and to direct pension fund management and policy, and therefore must compromise more with unions. The other side of the coin, however, is that they also are not regarded as exclusively responsible for correcting situations related to under-funding and risk-bearing. This contrast is accentuated by the dominance in the Netherlands of industry pension funds, which are largely absent in the Anglo-Saxon world, in particular in the private sector. Individual DC elements in pension plans are virtually absent within industry pension funds, and risk-sharing is still predominantly done collectively through policy ladders. Especially in the US, the shift from DB plans to individual DC plans has been related to the decline of unionism. Teresa Ghilarducci has noted that unions operate on the principle of solidarity - a context of shared interests, responsibilities, and fellowship that helps to explain why they prefer DB plans to individualistic DC plans. The decline in unionism, defined benefit plans and pension funding is related to the employment shift from large hierarchic manufacturing firms and industries to the more diverse service sector.

In terms of membership, Dutch unions are not particularly strong. They organise around 25% of employees. Also in the Netherlands union membership has declined. However, the institutional set-up of labour relations gives unions a much stronger position than their true power permits. As an example, the coverage rate of collective bargaining is high (over 80%).

This has to do with both the high organisation rate of employers and the mandatory extension of collective contracts. The institutional set-up of the pension system also gives unions a stronger position than is justified by the unions' membership ratio. The mandatory extension of collective contracts is historically intertwined with the mandatory extension of industry pension funds, which predominantly explains the high pension coverage rate in the Netherlands.

The shift to individualistic DC plans in the US and the UK has a strong ideological and political dimension. In the 1980s, the conservative government of Margaret Thatcher aggressively promoted the opt-out of collective pension schemes to individual pensions. In the US, personal pension provision is high on the political agenda of the Bush administration.

In the Netherlands, in contrast, a shift to individual pension provision is not on the political agenda. Surveys show that most people prefer collective risk-sharing over individual DC plans with greater investor autonomy, and that there is a high degree of household confidence in the current pension system. This preference for collective risk-sharing is supported by economic analysis. The willingness to share risk collectively and to accept its possible distributional consequences presupposes a certain degree of societal trust. The European and World Value studies show a relatively high degree of social trust in the Netherlands. Such a high level of trust is also found in the Scandinavian countries. These surveys also indicate that social trust seems to be relatively low in the US and the UK.

A number of pension funds have already gone one step further than the hybrid plan by abolishing the use of the contribution rate as a risk-steering instrument. We characterise this type of plan as collective DC, and expect more pensions funds to follow.

The main reason for this is that the volatility in contribution rates remains relatively high in hybrid pension plans. This will be magnified by the effect of ageing, which will severely undermine the effectiveness of the contribution rate as a steering instrument.

However, a further step towards a collective DC will lead to even more redistribution from old to young. This might be both undesirable (in view of the risk-bearing capacity of the old) and unacceptable for the old. We therefore expect this shift to a collective DC to be accompanied by a rethinking of the intergenerational contract, leading to more differentiation in risk exposure between younger and older members.

Pension funds in the Netherlands typically administer a uniform pension plan for heterogeneous groups of plan members. The funding process has a collective base: one asset mix, a uniform contribution rate and risk-sharing. In the coming decades, the degree of maturity of many pension funds in the Netherlands will increase. For example, within the largest pension fund ABP, the relative share of non-active members (primarily retirees) in the total liabilities will rise from less than 40% in 2004 towards 70% within 20 years. This increase will inevitably affect the asset mix.

The investment policy will necessarily become more conservative in order to ensure that the indexation promise can be met to the greatest extent possible.

A conservative mix will not be attractive for younger workers, as the low return on assets implies higher contributions to fund the accrual of their new liabilities. Young workers, moreover, regard a conservative asset mix for their retirement savings as far from optimal, from the optimal lifecycle planning perspective.

We foresee that pension funds will evolve in their ability to differentiate more in risk exposure between younger and older members. This risk differentiation should particularly be orientated towards realizing more certainty for the elderly regarding the indexation of their benefits and allowing the younger members to have more risk exposure so that they have the prospect of higher returns.

A challenging question in such a redesign of the pension plan is whether or not it is possible to combine risk differentiation regarding ages with a safeguarding of the benefits of collective funding and intergenerational risk-sharing.

At least two choices in the design of an age-dependent policy can be discerned. Both enable risk differentiation to ages, and both are in line with the recommended risk strategy of the theory of optimal individual lifecycle planning.

One way to achieve an age-dependent risk policy is to adjust the indexation rule to ages. The current indexation rule for a typical pension plan is that accrued benefits are indexed yearly for the growth of wages in the industry. A policy ladder may be operative, so that the actual indexation rate depends on the financial position of the pension fund. This indexation rule can be adjusted easily to arrive at an age-dependent indexation policy.

The indexation consists of two parts. The first is related to wage growth, as in the current setup. The second part is related to the excess return over the discount rate of real liabilities. For a wage-indexed defined-benefit plan, this discount rate has to be equal to the difference between the (expected) nominal rate of interest and the (expected) wage growth.

With the introduction of such an indexation rule, it may also be possible to split up the asset mix in two parts: a conservative asset mix (underlying the part of the liabilities where the indexation is related to wage growth) and a more risky asset mix (underlying the liabilities of which the indexation is related to the excess return).

An open question is what the impact may be of a situation of under-funding or over-funding on the overall indexation. A policy ladder may still be operative in correcting the actual indexation for the funding position.

A main advantage of this indexation rule is that an age-dependent policy of risk differentiation can be implemented, with safeguards for the institutional structure of pension-fund plans in operation, as plan members continue to build up new liabilities for each year of service. The only thing that has been changed is the nature of the indexation policy for the workers.

A more radical idea is to allow workers to keep their contributions in an individual DC plan. Upon retirement, the end value of the DC account is converted in indexed DB liabilities.

The asset management for the DC accounts is carried out by professionals who aim to establish an investment strategy in line with the recommendations of modern theory on individual optimal lifecycle planning. The management of the assets relating to the DB liabilities is also a responsibility of professionals.

In the future, we expect that the current hybrid schemes will evolve toward stand-alone multimember collective DC pension plans. This will be accompanied by more differentiation in risk exposure between younger and older members. Risk differentiation will help elderly members to obtain more certainty regarding the indexation of their benefits and younger members to have more risk exposure so that they have the prospect of higher returns.

Collective risk-sharing will thus remain an important element in Dutch pension funds.

Eduard Ponds is head of strategy in the finance department of the ABP pension fund and an affiliated researcher at Netspar. Bart van Riel is a senior policy officer at the Netherlands Social-Economic Council (SER) and a researcher at Leiden University. This is an edited version of a paper prepared for the research department of the French Ministry of Employment, Social Cohesion and Housing and the French Ministry of Health Solidarities. The findings and conclusions are solely those of the authors and do not represent the views of the ABP Pension Fund, Netspar, SER or Leiden University.