The Netherlands: A plan for pensions

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At the invitation of IPE's Dutch sister publication IPN in June, writes Mariska van der Westen, over 80 pension funds and consultants joined experts to discuss the challenges facing the Dutch pension sector. Attendees included:

Jean Frijns, former head of ABP Investments, professor of investment theory at the VU Amsterdam and author of the recent Frijns Report on the Dutch pension system; Guus Boender, professor of ALM at the VU Amsterdam and founder of Ortec Finance; and Theo Kocken, partner and CEO of the Cardano Group.

This unique conference, held on the eve of parliamentary elections, culminated in a set of six recommendations for the new government, which were formally accepted by Frans Prins as a representative of the three pension fund associations, OPF, VB and UvB.

Three of the main topics discussed included ‘real' versus nominal pensions - presented by Frijns; strategic risk allocation and management, presented by Boender; and ‘defined ambition' pension schemes, presented by Kocken.

Frijns: The real stuff
Frijns focused on the need to measure solvability in real terms.

There is no doubt in Frijns' mind that pension schemes are essentially real contracts. "The objective of retirement pensions is to preserve a person's standard of living after retirement. This objective is real by definition," he said. Consequently, inflation is one of the biggest risks to adequate pension accrual. "If a pension fund does not compensate inflation, supposing an inflation rate of 2.5% annually, over a period of thirty years this would cut pensions in half."

Frijns praised the Dutch supervisory framework, FTK, for the way it enforces discipline and focuses on solvency risk, but he warned that the framework only considers nominal pension liabilities and so tends to create a false sense of security by leaving inflation risk out of the picture.

Monitoring solvency ratios is a great idea - but only if solvency is defined in proper terms and in a way that takes all relevant risks into account.

"First of all, the short term solvency norm should not be at odds with the long term. Secondly, the benchmark must serve as a signal to scheme participants: if chances of achieving a fully indexed pension deteriorate, the solvency ratio should reflect this. Next, the solvency benchmark should promote fair distribution across generations and prevent one generation squandering money intended for the next generation," Frijns explained. "Moreover, all relevant risks - including market risk, interest rate risk and inflation risk - should be taken into account."

That may seem like a lot to ask. But in fact it is not, said Frijns. "There is one simple measure we can use to monitor and manage solvency: the real solvency ratio."

"This definition takes the market value of assets as its numerator, while the denominator consists of benefits (u) plus accrued interest by a factor P - the latter preferably being price inflation, although it is possible to opt for other alternatives. The denominator includes the interest rate. This should preferably be a nominal rate, as a real rate isn't of much use," Frijns continued. "This solvency ratio definition takes all relevant risks into account while also including the main control, being accrued interest: when times are good, we all get a little more and when times are bad, we all get a little less."

Boender: Securing risk
Guus Boender, nicknamed the father of asset-liability management, argued that pension funds must ensure that the risks they take are clearly allocated and consented to by the various stakeholders.

"If a scheme runs risks that its stakeholders haven't consented to, the pension fund will get into trouble when the time comes to actually take those risks," he said. According to Boender, risks must be firmly ‘secured' - that is, it must be clear which stakeholders have agreed to take on which risks. "This is one improvement we need to make to our pensions system: pension arrangements need to be fleshed out to clarify just how risks are being secured by the various stakeholder groups," he said.

Asset liability management (ALM) may be used as a tool to determine strategic limits to solvency, premium contribution and indexation risks as well as to help dynamically manage strategic risks.

One of the main responsibilities of any board of trustees is to determine the amount of risk that can be justified. In other words, the board must determine the amount and type of risk that each group of stakeholders - active workers, deferred members, sponsoring companies and future generations - is willing to take on. "As a pension fund, first you need to figure out how much risk you can actually pass on to your stakeholders. This determines your strategic risk limits: the amount of risk you can actually take," he explained. "The amount of risk secured by the stakeholders should agree with the risk in the asset mix. So the amount of investment risk is not an ALM study's input, but its output."

Once strategic risk limits have been determined, dynamic risk management becomes the next priority. The main job strategic risk management needs to accomplish is to determine whether the assumptions underpinning the pension arrangement - both economic assumptions and assumptions with regard to risk limits - are still valid and haven't been compromised. "Do my assumptions still hold water? That is the main question. Changes and challenges must be tabled without delay, so that the board of trustees has the necessary input to be able to control the dynamic. We're not seeing enough of that at present," said Boender.

Kocken: Sinking giants
Risk management expert Theo Kocken in his presentation focused on the challenges of a rapidly ageing population - challenges that will become abundantly clear once pension funds enter the payout phase.

"Over the next twenty years, the dynamic for pension funds is about to change dramatically as they enter the payment phase," said Kocken.

"This thoroughly changes funds' ability to recover from deficits. A ‘green' pension scheme will, given average expected returns, eventually recover. But a pension fund in the payment phase is facing a whole different ball game. If such a fund continues to honour the existing pension arrangement by paying full benefits even in the case of a deficit, any chance of recovery will evaporate and the funds will be frittered away until there is nothing left for the last generation of participants."

Such a pension scheme will turn into what Kocken has dubbed a ‘sinking giant', sinking beneath the waves like the Titanic despite its size and seeming might.

To prevent this, he proposes a two-pronged solution. "First, pension arrangements need to be retooled so that future pension rights fluctuate along with the financial health of the pension fund. This can be achieved by making pension liabilities in large part conditional on the scheme's funding situation. That way, when times are bad the pain is distributed much more evenly among various groups of stakeholders."

Secondly, a non-conditional bottom line can be agreed upon, appealing to all stakeholders. "Once this bottom line has been determined, measures should be taken to derisk and ensure that the fund never dips under this unconditional bottom," he said.

This proposal would effectively replace existing pension arrangements with a ‘target pension arrangement' combining a hard bottom and a ‘soft', conditional upside. "This means a move from DB or DC to DA, or defined ambition," said Kocken.

Sea change
Pension academics have warned for some time that the traditional Dutch pension arrangement is in need of a makeover, but so far the pensions sector has resisted change. At the IPN conference, a majority declared themselves in favour of ‘defined ambition' or DA schemes, "but they don't necessarily represent the opinion of trustees and social partners at large," cautioned Guus Boender.

This persistent resistance can sometimes be frustrating, said Jean Frijns: "You keep coming up with beautiful models and great implementation, only to have them shot down time and time again."

Even so, there is a sea change underway, according to Theo Kocken. "Trustees increasingly understand that the situation is not sustainable and that the pension contract is in need of redesign."

Frijns agreed. "The present situation offers trustees a terrific opportunity to redefine pension provision and thus to avoid getting caught in a trap from which they can't escape." However, he notes that there is still a lot of resistance to the concept of switching to a real solvency ratio. "The prospect of having to communicate in real terms remains a difficult issue."

On the other hand, Kocken added, "a large majority now agrees that accrued rights, including nominal rights, should ‘breathe' along with pension funds' health".

As a matter of fact this is already the case - after all, the present system provides for benefits to be cut in times of severe trouble.

"But the way this happens at present is chaotic and unpredictable, and has not been clearly communicated," said Boender.

Consequently the generational conflict implicit in existing pension arrangements will become an issue, Frijns fears, "and this will come as a blow". A blow that is much more imminent than is generally believed, Kocken added: "If the market were to go down by ten or twenty percent, this could easily lead to falling solvency ratios within the next five years, leading to a lot of tension."

Pension fund trustees need to be aware of the possible consequences, warned Frijns. Social partners - employers and employees - are in charge of second pillar pensions, but if the current situations blows up into a conflict, "this would provide politicians with a reason to get involved and social partners might lose control. So managing the generational conflict is actually also a governance issue."

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