Pension guarantees have been the hottest topic in the Danish pension debate in recent years. Another issue high on the agenda is the planned transition from book value to fair value in the accounts.
The Danish pension system first pillar
The ‘Folkepension’ is administered by the state and is financed on a pay-as-you-go basis out of general tax revenue. A person is eligible for the flat-rate pension when reaching the age of 67 (65 from the 1 July 2004). In addition to this pension, all employees are statutorily contributors to ATP, the Danish Labour Market Supplementary Pension. Furthermore, the unemployed and self-employed can to a certain extent choose to contribute to this scheme too. The ATP is managed by a separate fund administered by the unions and the employers’ federation.
A partly contributory system pays out an early retirement benefit to persons who retire between the age of 60 and 67. As this system has become too popular at a time when the political goal is to postpone retirement, the rules for eligibility have been tightened, making it more advantageous to postpone retirement until 62 instead of 60.
The second pillar
The second pillar in Denmark is very well developed as 80–90% of the workforce is covered by a supplementary second pillar pension scheme. These schemes are almost all pre-funded defined contribution schemes. The schemes typically include at least a guaranteed minimum old age pension, a disability pension and a (sometimes optional) spouse’s pension. The schemes are typically financed one third by the employee and two thirds by the employer. The total contribution typically amounts to between 9% and 15% of salary: 9% being the norm for blue collar workers and 15% the norm for academics. The contributions are tax deductible.
No matter the size of the contribution the aim is to reach a compensation rate of 60–70%, including the pension benefits from the first pillar.
The second pillar schemes are either agreed between the social partners or the individual company. The schemes can either be administered by a company pension fund, an industry-wide pension fund or by an insurance company. Some of the more recent schemes set up by the social partners are administered by insurance companies that were established by and are owned by the social partners for that purpose.
As a Danish peculiarity, industry-wide pension funds are subject to the life insurance directives. Hence, the regulation of the pension institution is the same no matter whether the institution is an insurance company or an industry-wide pension fund.
Company pension funds are not subject to the life insurance directives, but the Danish regulation of these funds has so far been almost identical to the regulation stipulated in the life directives.
Between the three types of institutions mentioned the market is shared, with two thirds to insurance companies, almost 30% to the industry-wide pension funds and a little less than 5% to company pension funds. This market structure reflects the Danish industrial structure with a vast majority of small and medium-sized companies.
Regulation and tax treatment of pensions contributions is identical in the second and third pillar.
Also, quite extraordinarily in a European comparison, Denmark has an ETT-tax regime, instead of the EET-system that – among others – the European Commission recommends. Since 1982 the real interest rate tax was levied on especially the return on bonds. The aim was to limit the real return on pension savings to 3.5%. The way the tax rate was fixed on an annual basis low interest rates combined with low inflation would lead to a low tax rate.
With effect from 2000 the capital gains taxation was changed. A new nominal tax rate of 26% on gains on bonds were introduced, and capital gains on shares, which had so far not been taxed, were now taxed at 5%. This increased taxation combined with the low interest rate level started to threaten the after-tax guarantees issued by the life insurance companies and industry-wide pension funds. These guarantees were issued on the basis of a technical interest rate of 4.5% after tax.
Despite warnings from the association, the politicians failed to recognise the risks they imposed on the pension institutions and thereby on the members of the pension schemes. However, the legal adviser to the government analysed the situation. His conclusion was that, since the guarantees were issued with the approval of a public supervisory body, the members of the pension schemes could sue the government for condemning their pension rights in case the institutions failed to fulfil the guarantees due to the changed taxation.
The risk of pension institutions not being able to fulfil the guarantees was most urgent for the less solid institutions. These institutions were typically characterised by a low proportion of shares and a high proportion of bonds in their portfolio. The government therefore in December 2000 chose to alleviate the situation by once again changing the taxation of capital gains. This time a uniform nominal tax rate of 15% was introduced applying equally to capital gains on all assets. The pronounced ambition was to sustain the tax revenue by making the more solid companies with a high proportion of shares pay a bigger part of the total tax and thereby ease the tax burden on the less wealthy companies and funds.
Furthermore, the changed taxation had an indirect but very important impact on the problem. In the formula for the maximum calculation rate the pension institutions can use for calculating the size of the reserves only the tax rate on the capital gain on bonds is included. And that rate was decreased from 26% to 15%, reducing the size of the necessary reserves.
Transition to fair value in accounts
For a couple of years the association has, together with the Danish Financial Supervisory Authority, worked on amending the accounting rules for life insurance companies and pension funds in order to implement fair valuation. The work is expected to be
finished this year, making it possible to use the new method from next accounting year with an expected transition period of a
couple of years.