Towards sustainable Dutch occupational pensions Ilja Boelaars, Lans Bovenberg, Dirk Broeders, Peter Gortzak, Sacha van Hoogdalem, Theo Kocken, Marcel Lever, Theo Nijman and Jan Tamerus1 November, 14, 2014 With an ageing population, changing social views and shifting employment patterns, occupational pensions have become a timely and controversial policy issue. Indeed, the Dutch government has started a national dialogue on the future of pensions. At the same time, it is exploring ways to improve occupational defined‐contribution schemes— for example, by allowing collective risk sharing in these schemes. Netspar – the Network for Studies on Pensions, Ageing and Retirement – brought together nine pension experts in order to contribute to those initiatives by formulating policy options and trade‐offs. This paper summarizes the analysis of these pension experts as well as their policy positions on the trade‐offs. Many of the authors' positions overlap, but sometimes they differ. The reasons behind diverging positions are explained. The key messages are as follows: 1. A sustainable occupational pension system requires three objectives to be met: a) Achieving stable and satisfactory pension benefits at affordable contribution levels  The pension system's principal objective is to smooth consumption over time and across various circumstances in members' lifetimes. b) Reinforcing trust by providing transparency about the values of members' individual pension wealth  Beneficiaries must be given insight into the value of the pension wealth set aside for them, as well as the factors that cause this wealth to change over time. This helps to eliminate the perception that ‘there will be nothing left for me by the time I retire.’ c) Providing more tailor‐made and flexible solutions  Tailor‐made solutions ensure that risk profiles are appropriate during the various phases of a member's life cycle. In particular, such solutions prevent retirees from being excessively exposed to interest‐rate and investment risks or the biometric risk of higher life expectancies among active participants. Conversely, tailor‐made solutions allow young participants to benefit from risk premia by bearing enough investment risk. Tailor‐
made solutions may go together with, but do not require, more individual freedom of choice. Flexibility means that risk and benefit profiles can be adjusted if macroeconomic developments warrant this. Tailor‐made solutions also allow each collective to set the desired scope of risk sharing based on its own specific preferences and circumstances. 2. A sustainable occupational pension system is based on a collective approach. A collective system featuring compulsory insurance pools offers professional management, economies of scale and access to risk sharing. Regarding the extent to which risks are shared within a collective, a trade‐off exists between the larger degree of risk sharing that a collective system provides, on the one hand, and the drawbacks of collective decision‐making, on the other. The 1
The views expressed in this paper are those of the authors. Participating in a personal capacity, the working group members do not represent the organisations they are affiliated with. 1 authors differ in their positions on this trade‐off. Some authors advocate extensive risk sharing, arguing that this yields more stable and higher pension benefits (objective A). These authors prefer future generations to share in current investment and interest‐rate risks by means of recovery contributions and buffers. In addition, solidarity groups should be allowed to share risks that cannot be traded in financial markets, such as longevity and inflation risks. Finally, discretionary adjustments in pension contracts can accommodate unforeseen circumstances. Other authors, in contrast, favor tight limits on risk sharing in order to contain governance and discontinuity risks. They argue, for example, that safeguarding the interests of future generations is difficult if these generations are involved in the pension deal. All authors, however, agree that micro longevity risk should be shared in compulsory insurance pools. 3. All authors call for registration of accrued personal pension wealth. Pension providers should report personal pension wealth of members and how personal pension wealth develops over time as a result of contributions, realized investment returns, and solidarity agreements, including any discretionary adjustments to those agreements. This transparency strengthens members' trust (objective B). 4. Solutions can be more tailor‐made to personal circumstances (objective C) by defining individual ownership in terms of financial assets (i.e. capital) with supplementary insurance and other solidarity agreements. This applies in particular to the accumulation phase, but possibly also to the decumulation phase. This variant can in fact be viewed as a defined‐
contribution scheme augmented with collective risk sharing. Defining individual ownership in terms of personal financial assets allows the board of a pension fund to tailor financial risk, the time pattern of benefits and the risks that are shared to members' diverging characteristics. Moreover, it either eliminates complex and politically sensitive valuation issues involving the choice of the discount rate or defers these controversial issues to the decumulation phase, when the impact of these choices is smaller. Last but not least, it offers each insurance pool discretion in setting the extent of collective risk sharing in accordance with its own specific preferences. 5. The authors advocate that contributions should not depend on age, once defined‐benefit schemes have been converted into defined‐contribution schemes with collective risk sharing. Hence, compared with current age‐related contributions under defined‐contribution schemes, higher contributions are paid at a young age. This lengthens investment horizons so that members benefit longer from risk premia. Compared with the current uniform accrual of variable annuities under defined‐benefit schemes in compulsory sectoral schemes, contributions of young workers accrue fully to their own pension wealth rather than raising the pension wealth of older workers. 6. The transition from defined‐benefit schemes (in which individual property rights are defined in terms of variable annuities) towards defined‐contribution schemes (in which individual property rights are defined in terms of personal investment accounts) involves two major transition issues. Firstly, phasing out uniform pension accrual under defined‐benefit schemes and age‐related contributions under defined‐contribution schemes generates adverse impacts on the transitional generations in the absence of additional compensation measures. The transitional impact can be more evenly spread across generations in alternative ways— for example, by gradually phasing out the age‐related nature of pension contributions in defined‐
2 contribution schemes and the uniform pension accruals in defined‐benefit schemes. Alternatively, the generations in transition could accrue additional publicly‐funded pension rights to supplement AOW state benefits. A second transition issue is that accrued pension rights (in terms of variable annuities) need to be converted into financial assets. The authors prefer current pension rights to be converted into personal pension wealth by establishing the economic value of these variable annuities in the best possible manner. Detailed discussion The key messages outlined above will be discussed in more detail below. First, we summarize the underlying problems and the framework for analysis, and highlight a number of shared principles. We then discuss potential improvements to the system and address the transition issues. (i) Summary of the analysis Problem analysis The current pension system poses several challenges. As a tool for mitigating a pension fund's risks, contributions are becoming less and less effective. This means that members end up bearing the risks themselves. Hence, intergenerational conflicts loom. Moreover, the way in which risks are managed to ensure satisfactory pension benefits at an acceptable risk is changing. In particular, to accommodate differences in the preferred trade‐off between risk and return across members, pension funds should tailor risk profiles to the specific preferences and circumstances of members. Furthermore, if trust in a pension system is to be maintained, transparency and accountability are prerequisites. Likewise, a more flexible labor market calls for a closer link between contributions paid and the value of accrued pension rights. Given these developments, the present institutional framework for defined‐contribution schemes and defined‐benefit schemes is not future‐proof. Existing rules governing defined‐contribution schemes force members to purchase nominal benefits on their retirement date. This implies that collective risk sharing is not exploited. At the same time, defined‐benefit schemes may give rise to intergenerational conflicts because risk sharing is based on a single collective funding ratio. Furthermore, the link between contributions and benefits is unclear. Government regulation, aimed at alleviating these conflicts, constrains pension funds to tailor risk and benefit profiles to the macroeconomic environment and the individual circumstances of members. In particular, the goal of mitigating risks for retirees conflicts with the need to take investment risk for active members. Pension system's functions A pension system involves various functions. Three main categories may be distinguished: functions related to choice, purchase functions and risk sharing functions. There are both pros and cons associated with performing a function more collectively. Trade‐offs originate in market failures, members' limited ability to take adequate long‐term financial choices, and the drawbacks of collective decision‐making. The first function involves the quality of decision making. Pensions are complex. They involve important choices: how much premium to contribute or how benefits are paid out, how to invest, 3 which risks are shared and which risks are insured? Individuals often find it hard to make sensible long‐term financial decisions. The authors therefore agree that collective decision‐making should play an important role in designing the choice architecture in order to assist individual members in making appropriate choices. Employers and unions have an important say in the size of the contributions (i.e. the share of wages earmarked for pension accrual). Pension fund trustees and pension providers subsequently help design appropriate investment and benefit profiles. The second function is creating purchasing power. Services that are purchased involve administration, risk management (e.g., ALM), asset management and insurance services. Employers and unions define the scope of collectives that buy these services together. Collectives pool risks by purchasing insurance services together. This creates value because the individual insurance market suffers from asymmetric information giving rise to selection and screening. In this connection, homogeneous insurance pools limit redistribution. Accordingly, some authors argue that insurance pools should be homogeneous in terms of income profile and life expectancy. The third function is risk sharing. This function relates to allocating risks to the various members, as well as valuing those risks for determining contributions and conversion rates. This function is especially relevant for risks that cannot be traded in liquid financial markets, such as longevity and inflation risks, or if future generations share in current risks through recovery contributions and collective buffers. Finally, discretionary contract adjustments may accommodate unforeseen circumstances. (ii) Shared principles All authors concur that unbundling a pension scheme's different functions is useful. Separating the various functions and combining them in new ways allows for pension innovation, offering better opportunities for tailor‐made risk profiles, without resulting in complexity and conflicting interests. Unbundling functions provides better insight into the value of the financial risks that members face. The authors identify a large number of shared principles undergirding sustainable occupational pensions. An important principle is that pension fund trustees have sufficient discretion to tailor risk profiles to members' specific circumstances. A further key principle is transparency about possible redistributive effects. Another one is some form of mandatory membership with respect to paying contributions and pooling risks to protect members against unwise decisions and to facilitate risk sharing. All authors want to maintain the Dutch tradition of sharing longevity risk within solidarity groups to facilitate life‐long benefits. All authors subscribe to the importance of objective market‐consistent valuation of pension rights and stable, adequate pension benefits. An important trade‐off exists between objective market‐
consistent valuation and the benefits of sharing risks that cannot be traded in financial markets. A similar trade‐off exists between objective valuation and sharing financial shocks with future generations through recovery contributions and collective buffers. These types of risk sharing lead to subjective valuation. The authors attach various degrees of importance to objective valuation, on the one hand, and risk sharing, on the other. They are unanimous, however, in their view that longevity risk must be shared. As a direct consequence, a certain degree of subjectivity cannot be 4 avoided. They also agree that if subjective valuation and distribution rules are applied, this must be done in a transparent way for all members. (iii) Potential improvements All authors call for registration of the value of personal pension wealth. Pension providers must report members’ personal pension wealth and how this wealth is affected by contributions paid, realized investment and insurance returns, and solidarity agreements, including any discretionary adjustments to such agreements. This provides transparency, thereby boosting members’ trust in the system. The authors agree that allowing a limited amount of investment risk during the decumulation phase in defined‐contribution schemes strengthens the pension system. By taking investment risk during the benefit phase of defined‐contribution schemes, one can expect higher pension benefits with only limited risks. Some authors argue that sharing market risks collectively may play an important supplementary role. The authors advocate defining individual ownership in terms of financial assets (capital) with supplementary insurance policies and solidarity agreements. This implies pension schemes with capital accrual in individual investment accounts, similar to the defined‐contribution schemes. Indeed, the proposed scheme is closely related to improved defined‐contribution schemes with collective risk sharing that the Dutch government is currently exploring. Capital accrual in individual accounts allows investment risks to be tailored to the age (and possibly other individual characteristics) of members. Risks no longer need to be shared on the basis of a single nominal funding ratio, as is the case in current defined‐benefit schemes. This prevents older members from being overexposed and younger members from being underexposed to investment and interest‐rate risks. Separate solidarity agreements allow collectives to engage only in types of risk sharing that create value. Moreover, individual property rights in terms of personal investment accounts allow for more flexibility to adjust risk profiles when expectations about the future change, without at the same time leading to intergenerational conflicts. Indeed, complex valuations of financial risks are avoided if personal ownership is defined in terms of financial assets. For example, new estimates of future expected returns do not automatically redistribute value across members. The pension landscape The pension landscape of the future features two main pension schemes: (i) improved defined‐
benefit schemes with personal ownership rights in terms of (variable) annuities and (iii) defined‐
contribution schemes with personal ownership rights in terms of financial assets (capital) with supplementary insurance policies and solidarity agreements. Defined‐benefit schemes with indexation based on a collective funding ratio could also provide more tailor‐made solutions. However, this is complex and creates less room for tailor‐made solutions than in the case of alternative schemes. Another major disadvantage is that changes in policy rules (e.g. indexation rules and recovery plans) and in subjective assumptions (about expected returns and expected inflation) redistribute value across generations. This may easily cause intergenerational conflicts. The authors therefore do not advocate these schemes, and instead call 5 for a simplification of the pension landscape: all occupational pension schemes should become defined‐contribution schemes with personal investment accounts. Pension schemes differ only in whether—and if so, when—capital is converted into annuities later in life. These personal accounts (with supplementary agreements on risk sharing) allow investment risk, insurance and risk sharing to be freely tailored to individual circumstances and preferences without giving rise to intergenerational conflicts and additional complexity. Capital may be converted later in life in defined‐benefit schemes in which personal ownership is defined in terms of variable annuities. This limits complex and politically sensitive valuation issues to the decumulation phase. A key advantage is that the collectives in which financial risks are shared on the basis of funding rates become more homogeneous than in defined‐benefit schemes that include also younger members. This reduces potential conflicts between generations about investment and benefit policies. A further advantage of this set‐up is that it more closely resembles current defined‐benefit schemes, thereby limiting transitional problems. This explains why this policy option is already featuring prominently in current policy debates. An alternative option is to define individual property rights in terms of personal investment accounts (with supplementary insurance policies and solidarity agreements) during the entire life— including the decumulation phase. In this case, life‐long benefits are still provided but without converting capital into variable annuities provided by a defined‐benefit scheme in which a collective funding rate governs the sharing of financial risk. Property rights in terms of personal investment accounts minimize intergenerational conflicts about the valuation of financial risks, while maximizing the scope to flexibly adjust risk profiles and benefit profiles to individual circumstances and macro‐
economic developments. At the same time, this option maintains the traditional strengths of the Dutch pension system, such as life‐long benefits based on sharing longevity risk within insurance pools. This is because the assets of the members who pass away do not accrue to their heirs but to the insurance pool. As a result, members who reach a very old age enjoy substantial so‐called mortality credits. These supplementary agreements about risk sharing thus insure individuals against longevity risk. We refer to this variant in which individual property rights are defined in terms of personal financial assets also in the decumulation phase as a personal pension account (PPA). A PPA resembles a defined‐contribution scheme in the sense that financial ownership is defined in terms of assets in a personal investment account. However, it resembles a defined‐benefit scheme in terms of the benefit function and the risk‐sharing and insurance functions. Indeed, members cannot dispose of their capital at will: the investment account is earmarked for life‐long benefits following retirement. This prevents myopic behavior and protects the insurance function. During the decumulation phase, the PPA is paid out in a sustainable way. This means that the benefit level is expected to be maintained during the member's remaining lifetime, taking into account desired increases in benefits (e.g., in line with price or wage increases) and expected investment returns and mortality credits. The collective can decide which risks (in addition to idiosyncratic longevity risks) are shared between personal investment accounts. 6 (iv) Transition issues Defining individual ownership in terms of financial assets raises two important transition issues. Although these transition issues are complex, the authors maintain that these issues should not be allowed to block the move to more sustainable occupational pensions based on capital. The first issue relates to age‐independent contributions and accruals in defined‐benefit schemes provided by industry‐wide pension funds and contributions that rise with age in defined‐
contribution schemes. The solidarity implied by uniform contributions and accruals in defined‐
benefit schemes provided by sectoral funds is unattractive for members whose pension rights mainly accrue at a young age, distorts the labor market and is difficult to reconcile with the proposed system of defining pension rights in terms of capital. In defined‐contribution schemes, contributions that rise with age imply that members pay only small contributions at a young age. Hence, capital does not benefit much from risk premia due to the short investment horizon. The authors observe that transitional issues can be addressed by gradually phasing out age‐
dependent contributions in defined‐benefit schemes and uniform accrual in defined‐benefit schemes. The transitional generations will suffer adverse impacts in the absence of compensation measures, especially those who are in the middle of their working career at the time of the reform. They have had little room for tax‐facilitated pension accrual at a young age and will be unable to compensate this in the second half of their working lives. The burden of the transition may be spread more evenly across generations by phasing out only gradually the room for tax‐facilitated accrual at higher ages. In parallel, industry‐wide pension funds may phase out the solidarity inherent in uniform pension accruals in a similar gradual fashion. Following the transition to capital accrual in sectoral pension funds, wage costs of elderly employees may be kept within bounds by incorporating the cost of temporarily higher contributions for elderly employees into a uniform contribution rate for all workers in the sector concerned. As an alternative, the transitional generations could accrue additional public pension rights entitling them to an income‐related supplement on top of the AOW state benefits. The second transition issue relates to converting accrued defined‐benefit pension rights into financial assets. The authors concur that, ideally, pension rights are converted into capital by establishing the value of the variable annuities in the best possible manner. Should this appear impossible, an alternative option involves young members opting for conversion of their rights on a voluntary basis. The choice architecture is then essential, including a sound default option for members who are unwilling or unable to choose. Another alternative is to leave unaffected the rights that have been accumulated before the reform and change to a new system based on capital only for new accruals. If the funding rate of the defined‐benefit fund is low at the time it is closed, current defined‐benefit rights could be protected from dropping in value (due to the fund's closure) by levying temporary recovery contributions or requiring the employer to pay a dowry of sorts. 7