Pensions: actuarial interest rate

Pension funds use the actuarial interest rate to determine the amount of reserves they must hold to be able to pay out current and future pension benefits.

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Pension funds must make long-term commitments to their members to pay out pension benefits. They use the actuarial interest rate to calculate the reserves required to pay out all pensions in 20, 30 and 40 years’ time.

Example

Say, you promise to pay out €100 to someone in 10 years’ time. You can keep this money in a safe, or you can put it in a savings account and receive interest from the bank. This means you do not need to put in the full amount in order to receive €100 in 10 years’ time. If the interest rate is 1%, you only need to put in €90.53. The higher the interest, the less money you need to reach €100. If the interest rate is 2%, you only need €82.05.

The same applies to pension funds’ liabilities. They use the actuarial interest rate to determine how much they need to invest now to be able to pay out their pension commitments at a later date. So, the higher the actuarial interest rate, the less reserves they need to hold to pay out future pension benefits. The lower the actuarial interest rate, the more reserves they are required to hold.

Risk-free and objective

The actuarial interest rate is risk-free, which means you will receive this rate with near-certainty. De Nederlandsche Bank (DNB) sets the actuarial interest rate based on the interest rates on the financial markets. The market is the most objective measure, since this is where demand and supply meet. Pension funds base their long-term commitments to pay out benefits on the actuarial interest rate, so it is essential that this is risk-free.

Comparing apples and apples

There is another reason to take the financial market rates as a standard.  The actuarial interest rate is about liabilities and commitments, but pension funds also hold assets such as equity and bonds. To determine the value of a pension fund's assets we also look to the market and the price of equity and bonds at the time. It is important that the value of assets and liabilities is calculated in the same way, otherwise you would be comparing apples and oranges. That is why pension funds are required by law to calculate the value of their assets and liabilities on the basis of market value.

All interest rates are low

Today's actuarial interest rate is low compared to that of a few years ago. The same applies to other types of interest rates: Financial market rates have been falling since the 1970s, and the rates on savings accounts and mortgages have reached historical lows. The actuarial interest rate is low because it is based on these market rates.

Setting a higher actuarial interest rate: not a good idea

Setting a higher actuarial interest rate would allow pension funds to reduce their provisions for future pension commitments, and increase their funding ratio. They would then have more funds available to pay out more pension benefits. However, setting a higher actuarial interest rate would not increase pension funds’ assets: they would remain the same. Spending these assets now would mean there is not enough left for future generations.

FAQs

Who set the actuarial interest rate?

That is why pension funds are required by law to calculate the value of their assets and liabilities on the basis of market value. Based on this provision, DNB has the power to set an actuarial interest rate. However, DNB does not decide this on its own. Every five years the Parameters Committee, consisting of independent specialists, issues an advice on the Ultimate Forward Rate (UFR), a component of the actuarial interest rate. The most recent advice dates from June 2019, and we have adopted this advice.

The Parameters Committee, headed by Jeroen Dijsselbloem, has issued its advice on the Ultimate Forward Rate (UFR). What are the consequences for the actuarial interest rate and the financial situation of pension funds?

In June 2019, the Parameters Committee proposed a different calculation methodology for the UFR, a component of the actuarial interest rate. DNB has adopted this advice. The new methodology will be introduced in 2021 at the earliest. The consequences for the financial position of the Dutch pension funds are not yet clear, since this depend on their financial position and interest rates at the moment of introduction.