Pensions: actuarial interest rate

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 rate, the less money you need to reach €100. If the interest rate is 2%, you only need €82.05. That is almost €10 less.

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

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. It is important that the actuarial interest rate is risk-free. After all, pension funds have made commitments that they need to meet.

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.

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. Some rates are even negative at the moment. The actuarial interest rate is low because it is based on these market rates.

Some people say that setting an actuarial interest that is higher that the market rate would allow pension funds to reduce their provisions for future pension commitments. They would then have more funds available to pay out more pension benefits. In reality however, setting a higher actuarial interest rate would not improve a pension fund's financial position. Their assets – their investments – would remain the same. Spending these assets now on the basis of a higher actuarial interest rate would mean there is not enough left for future generations.