The Dutch pension system is being completely overhauled. The Mercer Global Pension Index ranked the Dutch pension system as the best in the world in its October report this year. Nevertheless, the system will be completely overhauled. The Parliament passed a resolution on the new pension system structure last summer. The goal is to increase transparency and resolve the much-criticised intergenerational dispute over the pension system.
Background to the reform
The debate on reforming the Dutch pension system intensified after the financial crisis. Many pension funds posted poor returns and funding ratios fell substantially. Some pensions had to be reduced due to weak returns and increased pension liabilities. Low interest rates increased the current value of the pension liability. Although the funding ratio of the system as a whole remains high at over 100% of the pension liabilities, some decisions to reduce pensions have created concern and uncertainty.
Elements of the new system
The existing system in the Netherlands is largely a defined benefit one. It is also referred to as a hybrid system, as the scheme and benefits may need to be changed. This new system is a defined contribution system.
The burden of risk of the pension system will be shifted to pensioners, which will introduce automatic stabilising elements. As a result of the individual components added to the scheme, the existing pension assets will be allocated to individual accounts by the end of 2027. The Netherlands has over €1,500 billion in pension funds under management and around 180 pension funds.
The objective of the reform is to increase the transparency of the system. This is achieved with individual accounts. Every citizen will be aware of the amount of their pension funds. This will also improve intergenerational confidence in the system, as generations will no longer subsidise each other's pensions. Pensions need to be earned through contributions and returns on investments.
Even so, the system will remain basically collective, as the Dutch pension assets will continue to be managed by large collective pension funds. Pension funds have an obligation to find out their clients' preferences. The funds will presumably use questionnaires for this purpose. Additionally, the funds will manage the assets collectively by age group, creating different risk profiles for investment portfolios. These are used to determine the pension assets in the individual accounts, most of which will be converted into annuities upon retirement. In this way, the pensioner will eventually receive a monthly pension. The success of the reform will depend on how well it is implemented.
In the future, the threat of constantly fluctuating market interest rates will no longer determine the portfolio structure. The previous system was based on a risk-free interest rate discount factor, as the pension promise was secure. The new system gets around this by introducing a variable component into the pension promise.
Effects on the markets
The discount factor for pension liabilities in the existing Dutch system is the risk-free interest rate on government debt. Already years ago, this led to a huge demand for long-term debt securities in the European bond markets. Aside from the already low interest rates, additional demand was created by the purchases made by pension investors.
The structure of investment portfolios can change depending on demography and wage-earners’ risk appetite. Presumably, demand for risk-laden investments may increase. As a result, the foreseen returns may exceed the current level.
In conclusion
The Dutch pension system is undergoing a profound change. The reform is expected to restore the citizens’ confidence in pensions and the system. Individual accounts may help build confidence, as the level of pension will be determined by contributions and the returns earned on the market. Money does not grow on trees. Pensioners will have to assume more risks, which will add stabilising elements to the system. Future pensions may increase if the investment portfolios manage to improve returns. One of the lessons to be drawn from the Netherlands is that confidence and communication also make a difference when it comes to pension systems.
The writer is VER's CEO Timo Löyttyniemi.
