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. Now and in the future. In the current system, pension funds make long-term commitments to their members to pay out pension benefits in the future. They use the actuarial interest rate to calculate the reserves required to pay out all pensions in 20, 30 and 40 years’ time.
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.
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. It is important that the actuarial interest rate is risk-free. After all, pension funds have made commitments that they need to meet.
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. Some rates are even negative at the moment. The actuarial interest rate is low because it is based on these market rates.
An actuarial interest rate that is higher than the market rate? Not a good idea.
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.
Actuarial interest rate
Pension funds are required by law to calculate the value of their liabilities on the basis of market value. Based on this provision, De Nederlandsche Bank has the power to set an actuarial interest rate. However, we do not decide this on our own. Every five years the Parameters Committee, consisting of independent specialists, issues advice on the ultimate forward rate (UFR), which is a specific component of the actuarial interest rate. The most recent advice dates from June 2019.
The government concluded a Pension Accord with the social partners (employers' organisations and trade unions) in the summer of 2020. In the new pension system, pension funds will no longer make promises to their members about the amount of benefits they intend to pay out in the future. Instead, it is contribution-based and everyone will build up their personal share of pension assets. The pension funds keep records of these personal pension assets. The actuarial interest rate is no longer needed to determine how much reserves a pension fund needs to hold. Of course, financial market developments will still have an impact on the build-up of people's pensions in the new system: it is the returns on invested pension assets that determine the eventual amount of pension benefits that can be paid out.
In June 2019, the Parameters Committee proposed a different calculation method for the UFR component of the actuarial interest rate. We have adopted this advice. The new method will be implemented in four equal steps in four years’ time, starting on 1 January 2021. It will follow market rate movements more closely. If the market rate goes up, the funding ratios will rise more quickly under the new method. And if it goes down, the funding ratios will also follow more quickly.