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Impact Investing

IPE special report May 2018

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Putting pensions back on track

For a pension system to be durable, all players must abide by the rules. At the heart of the rules in the Netherlands lies a funding system, where commitments are sufficiently covered by provisions and risks by appropriate reserves.
We need to beware of slackening discipline and refrain from allowing deviations from the rules out of short-term considerations. That was true yesterday, it is true today and it will be true tomorrow.
In the 1990s, discipline came under pressure. Contributions were less than cost-effective, pension rights were made more generous and pension funds’ risk profiles were tightened. All this against the background of a falling cover ratio, at current prices.
From 1999 on, the average nominal cover ratio at market value dropped sharply, from nearly 200% at the end-1999 to 120% in 2002. The real cover ratio - the nominal cover ratio, adjusted for actual price inflation – fell from nearly 150% at end-1999 to around 80% in 2002.
As a result, full protection of nominal pension rights against inflation was no longer within reach, let alone inflation-proof pensions. Since 2002, both the nominal and the real cover ratio have stabilised. Today, the nominal cover ratio has been hovering somewhere between 120% and 130% for some time, while the real cover ratio is still well below 100%.
The fall in the cover ratio since 1999 was due to the trend-based decline in long-term interest rates, the sharp drop in share prices and the relatively low pension contributions. By 2001, when the economic tide had turned, pension contributions became subject to upward pressure. The average annual contribution as a percentage of remuneration went up markedly, from less than 8% in 2000 to nearly twice that figure in recent years.
Since 2004, however, this rise has levelled off, and contributions have now stabilised at around a level which is cost-effective. Estimates for 2006 even indicate a slight decline in the average contribution.
This is why buffers are essential to a durable pension system. The trouble with the discussion about buffers is that it generally makes allowance for the risk of under-funding, but fails to take into consideration the degree of under-funding.
The importance of buffers for durable pensions and stability shows up in probability calculations, which take into account both the chance and the measure of under-funding. An average pension fund, which invests half its capital in corporate equities, with a duration gap of around 10 years, and a cover ratio of 130%, has a likelihood of about 2.5% of facing under-funding within the next year.
This degree of risk, one in 40, is considered acceptable by politicians. However, when the cover ratio falls to 105%, the likelihood rises to about one in three.

I t is therefore important to look at both the likelihood and the measure of under-funding. As soon as the average pension fund’s cover ratio falls below the required 130%, not just the risk of under-funding goes up, but so does the measure of under-funding.
If the Dutch pension system is to be durable, such a situation needs to be avoided. Prevention is better than cure. Low cover ratios necessitate much higher contributions, as well as lower indexation. Low cover ratios also hamper value transfers and labour mobility, and create uncertainty when the sponsor goes bankrupt.
Adequate buffers, on the other hand, allow for stable contributions and lasting indexation. They also offer protection against downward risks, as well as the advantage of extra return, which can be used to realise indexation ambitions.
Back in 2002, there was no question of sustainability. Today, much has changed for the better. Far-reaching measures have been taken to put the Dutch pension system back on track again. The number of pension funds with a funding problem has fallen drastically, contributions are practically cost-effective again and the average cover ratio has all but recovered to the minimum desired level.
Sustainability goes hand in hand with transparency. Pension funds need to be sufficiently transparent about what their participants can expect to get. Transparency rules out surprises and thus enhances confidence among participants. This is a major principle of our pension system.
People trust that pension entitlements, accumulated during their active life, are paid out upon retirement. A recent survey by the Nederlandsche Bank shows just how much they value pension security. Nearly half the respondents are prepared to pay a higher pension contribution for more certainty about their eventual pension benefit. Only one in five participants opts for an arrangement without guarantees.
In the Dutch system, transparency also means being open about the pros and cons shared with future generations. Future generations are stakeholders because they, too, will join the pension system at some point in time.
With a view to the continuity of the system, access should be and remain attractive. In other words, sustainability also means that the needs of the current generation are not met disproportionately at the expense of future generations.

Risk-sharing within and between generations forms an essential element in the collective Dutch pension system and offers many advantages. It makes the pension system more stable and more durable. Pension arrangements are about spreading risks - longevity risk, inflation risk and investment risk. When these risks are spread widely and over time, all participants stand to gain in terms of prosperity.
The prosperity gains of our collective system should not be taken for granted. Spreading risks among generations works so long as future generations are not saddled with an unduly heavy burden; if they are, a funding system will be confronted with an unsustainable situation sooner or later.
New entrants facing a situation where they are required to pay disproportionately more for their own pensions over a long period of time will vote with their feet.

To prevent this from happening, discipline is needed so as not to overburden future generations, and transparency to keep up support for the distribution of the advantages and the disadvantages. A sustainable pension system stands to benefit from a durable distribution of the pluses and the minuses.
Apart from discipline and transparency, a durable pension system calls for a strong pension industry, with healthy pension funds, which flourish in a dynamic environment characterised by lasting expertise in managing pension risks.
Legislator, regulator and the sector have a common interest in maintaining and propagating the comparative advantages of the Netherlands in terms of pension provision.
By exercising supervision, the Nederlandsche Bank contributes to both durable old age pensions and a strong pension industry. Supervision contributes to three principles: identifying risks, preventing rising deficits, and should these occur, applying a customised approach to the resolution of the problems as soon as possible.
These principles form the foundations of the Financial Assessment Framework. The Framework contains standards for overseeing compliance with the pension contract. Basically, financial supervision addresses the question whether a pension fund’s assets are proportionate to its liabilities and prevailing risks. In other words, it seeks to prevent under-funding.
This is the foundation of the funding system; in combination with adequate buffers, cost-effective contributions and sufficiently inflation-proof pensions, it makes for a durable pension system.
This article is an edited version of a speech Nout Wellink made at the Fortis Pension Fund Seminar in Utrecht in February

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