Pension funds' weakened position reveals fundamental vulnerabilities
The past few years have seen the vulnerabilities of the present Dutch pension system exposed. For example, pension scheme members' expectations about guaranteed benefits that safeguard their purchasing power have proved impossible to realise. Pensioners are not adequately protected against the risk of curtailments, whereas insufficient investment risks are sometimes taken for younger pension scheme members, thus resulting in bleaker pension prospects. The pension system also results in opaque and difficult to justify intergenerational transfers that undermine support. These transfers result from the Dutch uniform contribution and accrual rates and the present system's lack of transparent distribution rules. The weakened financial positions of today's pension funds testify to the need to do away with pension contracts in their present form.
DNB believes new-style pension contracts must be based on two building blocks, which are personal pension accounts and individual life-cycle investment policies.
Building block 1: Personal pension accounts without uniform contribution and accrual rates
Personal pension assets are held in a personal pension account, to which contributions and investment gains are credited and from which investment losses and benefits are debited. In addition, pension scheme members share a number of risks, such as the likelihood of members living longer or shorter than expected or of a member becoming incapacitated for work. If a member lives shorter than expected, surviving dependents are paid a surviving dependent's benefits. If a member becomes incapacitated for work, he or she may continue to accumulate pension rights. Resulting gains or losses are also credited or debited. Members can always see how many assets accumulate which gives them certainty and obviates the need for debates between generations about who is entitled to what. Moreover, if pension scheme members change employers, their accumulated pension assets are easier to transfer.
Furthermore, personal pension accounts eliminate the need for intergenerational transfers, with younger members contributing too much and older members contributing too little because the younger members' contributions generate returns during a longer period. Doing away with uniform contribution and accrual rates will also make it easier in the long run to offer pension scheme members freedom of choice in terms of their pension accumulation, should politicians decide to introduce that freedom. However, to ensure that the changeover to a new system is not made more complex than needed, offering tailor-made solutions would seem more logical. This could be done, for example, by gradually lowering pension accrual targets as income goes up. This will give pension scheme members on higher incomes more flexibility and greater responsibility for making their own old-age arrangements.
The point of departure for today's pension accrual system is achieving a set amount in pension benefits payable to members upon retirement. While this creates the notion of a guaranteed pension upon retirement, this increasingly appears to be unfeasible in reality, or only at a substantial cost. If investment returns are lower than foreseen, pension funds are forced to raise contributions, which is an unsustainable approach, given that population ageing causes pension assets to rise as a proportion of total wages. The only remaining option is to no longer, or only partially, index-link pension benefits or curtail them. In an attempt to avoid this, pension funds may tend to take higher investment risks, which, however, makes benefits even riskier, thereby creating uncertainties that affect pensioners in particular. Another tempting approach might be to change the rules to present a rosier picture of pension funds' financial positions. Again, this is an undesirable course of action, given that it causes deficits to be passed on to future generations. Pension contracts based on personal pension assets are less prone to such temptations. Furthermore, it will be easier to stabilise contributions at a level commensurate with pension benefits targets agreed between the social partners.
In sum, personal pension accounts will overcome the fundamental vulnerabilities inherent in the current system. That said, it will not change the economic environment or generate additional resources to finance the present funding deficits. What it does do is make the uncertainties more visible that are also a fact of life in our current pension system. It is crucial that pension fund members are provided with adequate information on assets accumulated and concomitant downside risks to help them plan for their financial future.
Building block 2: individual life-cycle investment policy
Personal pension accounts are subject to individual life-cycle investment policies, under which investment risks are reduced as a pension scheme member gets older. This protects pensioners better against benefit curtailments while offering young people the prospect of higher expected future benefits. Pension schemes can still be administered on a collective basis to maintain economies of scale.
In today's pension system, pension funds pursue collective investment policies that are uniform across all age groups, with limited options for allocating risks between older and younger members. This means that a "green" pension fund, whose member base is largely young, will take risks that are too high for older members. Conversely, a "grey" pension fund, with a largely older member base, will tend to take insufficient risk for younger members.
If desirable, a small buffer may supplement personal pension accounts, putting aside investment returns realised on members' and pensioners' assets in good times to build a stash to be drawn on in bad times. Rules must be laid down on building up and drawing on the buffer, with drawdowns never exceeding the amount built up. This will stabilise pension benefits when returns or longevity expectancy fluctuate, without passing the bill to future generations. Importantly, the buffer must be limited in size, as large buffers will reduce the benefit of age-related investment policies and give rise to debates about who is entitled to which part of the buffer. The latter aspect may be avoided if a buffer can be transferred when a pension scheme member changes schemes.