Five years in the pensions sector: curtailment and indexation in perspective

Since 2008¹, 276 of the 381² current pension funds have index-linked accrued pension rights, 64 funds have index-linked as well as curtailed, 11 funds have only curtailed, and 30 funds have done neither. The scale of indexation exceeds the scale of curtailment; the weighted average³ indexation since 2008 has amounted to 3.5% and the weighted average curtailment to 1.0%. Translated into numbers of pension fund members, curtailment affected 0.3 million people, index-linking had an effect on 11 million people, 0.3 million people were unaffected and 5.3 million people saw the value of their pensions both increase as a result of indexation and decrease as a result of curtailment.

Curtailment

The decision to curtail accrued pension rights was taken at the start of the recovery programme at the end of 2008. At that time, the funding ratio of more than 200 pension funds had dropped below the required minimum level of approximately 105%. The funds involved were then given five years to recover. Ultimately 68 pension funds are compelled to apply cuts this year, i.e. 35 funds fewer than anticipated last year.

Indexation

In the past five years, most pensions only partially kept pace with price inflation. Only a limited number of funds were able to provide full indexation. On average, the pensions sector lagged behind price inflation by some 6.3%.⁴ In the 2008 calendar year, indexation was granted in a relatively large number of cases. The reason for this is that the indexation granted at the beginning of 2008 was based on the financial situation in the fourth quarter of 2007. At that time, the pensions sector was still in a relatively sound position.⁵

Average annual indexation and curtailment (weighted by technical reserves)

*indexation in 2012 is based on estimates
*curtailment in 2012 is based on funding ratio at year-end 2012,but will be applied in April 2013

Notably, some pension funds applied indexation as well as curtailment. The reason is that they granted indexation as soon as their financial position allowed for it. This mainly occurred early in 2010, following the upswing in the stock markets in 2009. However, this recovery proved to be only temporary. As a result, and due to the granted indexation, the funding ratio once again dropped below the required minimum level. When the September Pension Package was prepared last year, it was decided to introduce a higher bottom line for indexation for pension funds that use customised solutions or phased curtailment.⁶ Consideration might be given to maintaining this bottom line in the new financial assessment framework for nominal contracts, with a view to avoiding the pursuit of a zig-zag policy with respect to indexation and curtailment.

Same circumstances, different outcomes

Whereas the pensions sector reveals a highly diverse picture with respect to curtailment and indexation, the question arises as to why funds differ so widely in the degree to which they apply these measures, given that all pension funds have to contend with the same worsened conditions, including low interest rates, increased life expectancy and the weakening effectiveness of the contribution instrument. After analysing the data, DNB has identified three causes that largely explain the differences between pension funds. First, a pension fund’s position at the start of the crisis obviously is a major factor. A pension fund with larger buffers is able to absorb adversities more easily. Second, the nature of the pension scheme is important. Some pension funds (in particular company pension funds) provide higher indexation because employers make additional contributions to prevent accrued benefits from being curtailed or not being index-linked. The third factor is related to pension funds’ investment policy and degree of interest rate hedging. Funds that managed to hedge their interest rate risks fully or significantly in good times suffered less from the decline in interest rates. This is also illustrated by the following graph, which sets out the factors causing the changes in the funding ratio in the period 2009-2012 for the funds applying curtailment.⁷

Change in funding ratio 2009-2012, broken down by cause  

The interest rate decline was a significant factor causing the funding ratio decrease. It was counterbalanced by a sharp increase in the funding ratios as a result of higher returns. However, more than half of these high returns are attributable to that same interest rate decline. This is related to pension funds’ investments in fixed-income securities and the degree of interest rate hedging. When the interest rates drop, not only the value of liabilities but also the value of bonds and swap contracts increases (see also the letter to Dutch Parliament concerning the actuarial interest rate and costs of administering pension schemes, pages 4 and 5). Pension funds that managed to hedge their interest rate risks in full were able to fully absorb the rising liabilities caused by the interest rate decline. Incidentally, this is said with hindsight. The current pension contract effectively serves two purposes, safeguarding the accrued rights and seeking to have these rights increase in the future in keeping with prices or wages. Interest rate hedging contributes towards the first objective but not necessarily to the second. Quite the contrary. In particular in the event of high inflation, interest rate hedging may be disastrous for the development of the real funding ratio.

In the period 2009-2012 the average funding ratio increased by 2.2 percentage points, mainly as a result of the introduction of the ultimate forward rate. Overall, the high returns did not suffice to counterbalance the interest rate decline, the increase in life expectancy and the indexation granted in this period.

Note 1: January 2008 up to and including December 2012.
Note 2: This is the number of supervised pension funds at year-end 2012, disregarding pension funds that are in the process of being wound up and have already transferred their pension liabilities.
Note 3: This is a weighted average on the basis of the pension funds’ technical reserves.
Note 4: This percentage excludes curtailment. Incidentally, this percentage need not be consistent with a fund’s ambition, given that the basis for indexation (wage inflation, price inflation or a combination of those two) is different for each fund and may vary over time.
Note 5:Even when disregarding the 2008 calendar year, the scale of indexation (1.3%) exceeds the scale of curtailment (1%).
Note 6: SeeQ&A on September Pension Package, conditions.
Note 7: Based on an unweighted average for the 103 funds that announced cuts last year.