The Dutch pension debate is continuing, with most in the industry in agreement on the shortcomings of the current system but not on a new contract to replace it. The cabinet has decided to adopt an interim solution to ease the transition to a more structural answer to the current problems. The decision offers an opportunity to take scheme participants’ expectations and preferences into account.
Over the past few years, it has become clear that pension benefits are anything but certain. Pension scheme funding ratios have declined and many schemes have cut benefits. This situation has stirred a great deal of unrest among participants. If one compares the response of a plan’s participants to last year’s limited benefit cuts to the response to missing several years of inflation compensation, the former seems disproportionate by comparison. Psychological research into the way people experience uncertainty may explain this.
Starting in the 1970s, the psychologists Amos Tversky and Daniel Kahneman developed the so-called ‘prospect theory’ which earned Kahneman the 2002 Nobel Prize in economic sciences(1). Their research provides insight into the way people deal with uncertain outcomes, such as pensions. They list three important aspects in this regard. The first is that uncertain outcomes are valued relative to what we (think we) have.
If a pension scheme promises its participant a payout of €500 per month and the actual payout turns out to be €510 or €490, according to the prospect theory the first, higher payout will be considered as a gain, while the second will be experienced as a loss. In itself that may not be surprising, but the implications become more significant once we take the second aspect into account, which goes to risk aversion: people experience the pain of a loss twice as strongly as they experience the joy of a gain. Consequently the loss of €10 is met with twice as much resistance as the pleasure with which a gain of €10 is welcomed. In other words, the negative emotional impact of a loss of €10 equals the positive impact of a gain of €20.
Exactly what is experienced as a loss or a gain depends on a third aspect, ‘framing’, or the way an uncertain situation is presented. In the above example the gain and loss are described relative to a €500 payout promise. Precisely because pension promises are uncertain, perception can be manipulated. Instead of a €500 promise, we might have promised a lower pension benefit of €490, with the possibility of the actual payout being €510. By the same token, the pension promise could have been higher, say, €510. The promised amount changes the experienced loss or gain; differences in framing will change the perception of scheme participants. The various outcomes and their emotional impact are illustrated in figure 1.
The way in which uncertain situations are framed affects the way these are perceived. As pension promises affect pension outcome perception it makes sense to take the way participants handle uncertainty into account when designing a new pension contract.
The current pension contract starts from a nominal pension promise. According to prospect theory, inflation compensation and benefit cuts will be experienced as gains and losses, respectively. A 1% benefit cut in an economy in which inflation is near zero will be experienced as a severe loss by plan participants. Indexation of one percentage point to compensate for inflation in a situation where actual price inflation stands at 2% will, however, be experienced as a gain. Because the pension promise is based on a nominal pension, this provides the reference point to which plan participants will relate their gains and losses.
As the loss in terms of spending power is the same in both situations, based on the facts participants should not distinguish between loss of spending power by incomplete indexation, or loss of spending power by means of benefit cuts. However, history shows that the public response to benefit cuts is many times stronger than the response to receiving no inflation compensation – even in cases where the benefit cuts did not exceed 0.5 of a percentage point. This may seem strange from a spending power perspective, but prospect theory offers a simple explanation for this response through the pain of a loss.
One reason why the current pension system is running into trouble is because participants are unhappy about recent nominal benefit cuts. This unhappiness seems related to a deviation from the promise of a guaranteed nominal pension.
Last July, the Dutch Cabinet presented the so-called defined ambition contract. Although this proposal has since been taken off the table, it is a case in point, illustrating the resistance predicted by prospect theory. While the nominal contract takes a nominal pension promise with optional indexation as its starting point, the ambition contract was based on a fully indexed, but wholly uncertain pension promise. If the pension outcome under this contract would be less than the stated ambition (full indexation) participants would perceive this as a loss. As mentioned, the pain of a loss hurts a good deal more than the pain of a missed gain. As the reference point in the ambition contract is set higher, participants are confronted with greater and more frequent losses.
Referring back to figure 1, the nominal contract corresponds to the ‘median’ promise while the ambition contract corresponds to the pension promise labelled as ‘high’. Moving the reference point from ‘a nominal pension’ to ‘a nominal pension plus full indexation’ leads to an optical gain: people expect to receive more. When that ambition is not met, this will be experienced as a loss, resulting in participants’ unhappiness.
The ambition contract widened the gap between expectations and realised pension outcomes. Yet there are many valid objections to be made against a nominal contract, which still allows for losses as related to the pension promise while leaving insufficient room for the ambition to realise a decent real pension outcome.
Prospect theory offers an explanation of why participants of a real scheme will be unhappy more frequently than members of a nominal plan. The science of psychology also points the way to a possible alternative which combines the ambition to realise a decent real pension with a viable but lower pension promise than the one offered in the nominal contract. The adagio of this alternative is: ‘under-promise and over-deliver’. This hybrid or ‘combination contract’ combines a lower guarantee than offered in the nominal contract with the possibility to invest in risky assets. In figure 1, this contract corresponds to the promise labelled ‘low’.
This offers two advantages in comparison to both the current contract and the ambition contract. First, it offers a realistic guarantee, thus narrowing the gap between expectation and outcome and avoiding the psychological pain associated with loss. In the combination contract, any outcome exceeding the guarantee will be a gain and both prospect theory and experience with the current contract show that the negative response to not being granted indexation (missing out on a gain) is far less severe than the negative response to benefit cuts (suffering a direct loss). Secondly, this approach allows pension schemes sufficient room to pursue their ‘real’ ambition because annual inflation compensation is conditional.
Pension perception is crucial to creating a pension system that is sustainable in the long term. We believe that the combination contract represents a step in the right direction.
Thomas van Galen is a behavioural economist and Noortje van der Vorst is a strategic risk adviser. Both are employed at Cardano Risk Management
1. If Tversky had not died in 1996, he would have been a co-recipient of the Nobel prize in 2002 together with Kahneman.