Biggest isn't always best
The global pensions market has assets of around $56 trillion, of which the Netherlands, the world’s sixth largest pensions system by assets, accounts for around $1.9 trillion (3.6%).¹ However, big in pensions doesn’t always translate into best. Although considerably smaller than the US market
(62% of global pensions assets) and noticeably smaller than the Japanese (6.9%), UK (6.8%), Canadian (5.9%) and Australian (4.4%) markets,² the Netherlands has a trump card – it consistently tops the authoritative Mercer CFA Institute Global Pension Index Report (MCFAGPI),³ with a much coveted A-grade based on its robust integrity (or security), adequacy and sustainability credentials. While Canada and the – fast-growing – Australian pensions market, with their B-grades, can realistically aspire to achieving an upgrade by building greater levels of adequacy and sustainability into their systems, the US and UK, both rated C+, and Japan, with its lowly D, each have some way to go before an A-grade becomes a tangible possibility.
Pension systems are under pressure
However, while pensions systems across the world may be as disparate as the people they serve, without exception they all have one thing in common: they are under pressure. Globally, people
are living longer, while fertility rates decline. To compound these demographic headwinds, most developed economies are now seeing their second wave baby boomer generation, of the early to mid-1960s, beginning to retire. Moreover, recent sub-par global economic conditions, which will likely result in a further prolonged period of historically low, even negative, interest rates and modest real investment returns, has added further complexity to the conundrum.
Alongside this, is the global shift from collective passivity to individual responsibility, as State and employer paternalism cedes to savers increasingly taking a great deal more personal responsibility for their retirement and financial futures and so shouldering more investment, longevity and decision-making risk. Taking all of this together, you have a situation where governments worldwide are grappling with the problem of how to engineer pension systems that are both sustainable and equitable for current and future generations of retirees.
A uniquely generous pension system
While some countries, like the Netherlands, have better prepared for these seismic demographic, economic and choice architecture shifts than others, many of these others continue to buckle under the strain. Indeed, even against this backdrop, the Dutch pension system remains uniquely generous in many respects.
As in most other developed pension markets, the first two pillars are supplemented by a third pillar representing individual voluntary pension saving. In the Netherlands, this is mainly for those who
do not, or have not been able to, accrue a pension in the second pillar, whether because their employer is not affiliated to a pension fund, they are not in permanent employment or they are self-employed. This saving is principally directly through banking and insurance products, such as annuities, single premium policies and life insurance policies. Rather disconcertingly, and while not limited to the Netherlands, with the rise of the gig economy there are now increasing numbers of
freelancers and contractors who accrue little or no pension in the second or third pillars and who
will therefore rely heavily on the AOW in retirement.
RISK SHARING – STILL THE SECOND PILLAR PANACEA?
Defined benefit (DB)
As noted above, the collective sharing of risk, to ensure fairness between all stakeholders (comprising employer, employees and pensioners) though principally within and between all generations of member, is central to the second pillar of the Dutch pension system. However, even in a defined benefit (DB) context, this risk sharing isn’t applied in a totally equitable and symmetrical manner in either the good or bad times. For instance in the bad times, some stakeholders take a greater hit than others in restoring the financial viability of the fund, whether by:
- The employee and/or employer being required to increase their pension contributions;
- Limited or no indexation being applied to member benefits;
- No catch up indexation for past missed indexation being applied;
- Reducing pension entitlements (as a last resort).
Moreover, combining a uniform contribution rate with a uniform accrual rate isn’t the equitable panacea it appears to be, in that it leads to an inequitable value transfer from low to high earners, from the short lived to the long lived and from those early in their careers to those later in their careers – where the value of each pension accrual increases significantly with age.
Defined contribution (DC)
DC is popular mainly with small and medium-sized companies and start-ups, because the costs of the pension plan and the amount of individual contributions are easy both to ascertain and considerably lower than for DB, while the framework is flexible. That said, individual DC schemes are relatively rare in the Netherlands. Rather, DC is often combined with DB. An individual may, for example, accrue DB benefits up to a certain income level, beyond which DC benefits are accrued.
Collective defined contribution (CDC)
Preserving sustainability and risk sharing
Reshaping the second pillar
Of course, the next really big challenge for the Netherlands is to further reshape the second pillar to take into account not only unrelenting demographic headwinds, changing lifecycle and career patterns but also ultra-low/negative interest and, more latterly, the economic devastation wreaked by the Covid pandemic. Consequently, this reform will not simply be an evolution of the system, that has existed since the 1950s, but a genuine revolution in pension design aimed at making the system future-proof, with the collective sharing of risk remaining central to the system’s ethos.
After almost a decade of debate, the end game, which will see all DB pension schemes move to a CDC-like system, will centre around two new contract options: the new pension contract (NPC) and the improved defined contribution plus (improved DC+) scheme.
The former by far represents the biggest philosophical shift from the accepted norm, in that the long-held central principles of combining a uniform contribution rate with a uniform accrual rate for all and guaranteeing the level of member benefits will disappear. Rather, the NPC will convert all DB member accruals to an individual capital entitlement, or a notional account, within a single collective investment pool. Of course, the question of who will absorb the existing deficits of those DB schemes that remain underfunded must be addressed.
Capped at 15% of total fund assets, this solidarity reserve will be funded by up to 10% of total contributions and 10% of “excess” investment returns, i.e. those generated above a defined threshold return. Of course, the rules of exactly how and when this reserve could be distributed among the membership would have to be transparently determined in advance. Indeed, from 2026, as part of a very transparent process, members should be able to compare projected returns by age cohort.
Additionally, those older pension members disadvantaged by the move to degressive accrual will need to be compensated, either by the pension plan or by the employer. This will take the form of either a payment or an additional, tax-incentivised, pension contribution, albeit capped at 3% of the employee’s pensionable earnings, for a 10-year period, ending in 2036 latest or when the employee changes jobs (with the new employer compensating them on the basis applied to its own workforce). Depending on who funds this compensation and how, this could result in a substantial cost to employers and may see employers revising their salary structures accordingly.
More evolution than revolution is the design of the improved DC+ scheme which will replace the current age-dependent DC contribution structure with a flat-rate contribution (though age-related contributions in existing DC schemes will continue) and the default of annuitisation at retirement
with the continued investment of capital (though members can opt out of the latter if annuitisation is preferred). Of course, given the lower costs and governance requirements associated with DC, the improved DC+ scheme may well be an attractive alternative to the NPC for many corporate and smaller sector DB funds.
WHAT ARE THE LIKELY ASSET ALLOCATION SHIFTS FROM TRANSITIONING TO THE NPC?
The implications of moving to the NPC structure on pension fund investment will, undoubtedly, be acute, given the shift in focus from coverage ratios to investment returns and from managing regulatory capital to managing economic capital.
While diversification will remain integral to investment strategy, in all likelihood asset allocation will be shaped by three fundamental factors:
- Given the age-specific allocation of returns, the emphasis will shift to creating investment strategies that take into account the risks associated with each age cohort.
- Cash flow driven investment (CDI) is likely to take precedence over liability driven investment (LDI), resulting in some traditional hedging assets being sold in favour of shorter-dated credit, though interest rate hedging will remain a cornerstone of investment policy.
- A longer investment timeframe should favour a greater allocation to risk assets and perhaps more illiquid investments, not least to private markets.
Although the exact size and timing of the resulting asset shifts are difficult to call at this early stage, especially against the backdrop of an ever greater focus on integrating ESG and climate risks into investment decision making, one thing is for sure, they will be seismic.21 Indeed, anecdotal evidence suggests that these asset allocation shifts have already begun.
So can the Dutch pension system retain its pre-eminent position?
As we know, pre-eminence in pension system design derives from three broad factors: adequacy, sustainability and integrity (or security). As noted earlier, these are the metrics upon which the influential annual Mercer CFA Institute Global Pension Index Report (MCFAGPI) is based. Pre-eminence also derives from equity through risk sharing – a mainstay of the Dutch pension system since its inception.
By moving from DB to a CDC-like system, while the sustainability box is almost certainly ticked, adequacy and integrity could potentially be called into question. However, in making this assessment, there are three crucial factors to bear in mind:
- Adequacy: The current pension benefits formula of seeking to achieve an income replacement ratio of 75% of the median wage for 40 years contributions and 80% for 42 years will remain unchanged.
- Integrity: Applying investment returns adjusted for interest rate movements and transfers to or from a solidarity reserve to individual notional capital accounts should ensure each member receives a fair asset share throughout the accruals and decumulation phases.
- Adequacy and integrity: Members disadvantaged by the new arrangements should be adequately compensated.
The last two points additionally address the intergenerational fairness question of sharing the burden of paying pensions across the generations.
Of course, given the complexity associated with agreeing the most favourable terms for employers and employees, the transitioning of accruals and the terms of the compensation, much of the detail has yet to be determined. Indeed, employers will be required to publish a transition plan that includes information on the available choices, the scheme’s rationale and supporting calculations. Not only will the social partners have to agree with the proposed pension scheme arrangements put forward by the employer, but they and the pension scheme board of trustees can demand alternative provisions if the transfer is considered detrimental to particular member cohorts. In short, none of this will be easy.
When evaluated within this frame, and taking on board the generationally fair outcomes that should result from the reforms, the Dutch pension system should retain its pre-eminence, though agreeing the terms and the transition process, as already noted, won’t be without its challenges. In fact, those other pension systems facing exactly the same headwinds as the Netherlands, albeit with bigger adequacy and sustainability issues to resolve, would do well to observe the structure of these reforms and the process that’s lead to where the Dutch pension system is today. Indeed, all eyes will now be the implementation of these reforms and the resultant outcomes. However, even before these reforms have fully played out, it would seem that once again, the Dutch pension system is about to become the poster child for sustainability, adequacy and integrity.
The contributions of Rob Schreur, Martijn Vos, Anita Joosten and Prosper van Zanten are gratefully acknowledged.