Probability & Partners: Is the NPS the solution to all pension problems?

September 26, 2023

^{This column was originally written in Dutch. This is an English translation.}

By Maurits van den Oever and Ronald Sijsenaar, respectively Quantatative Consultant and Sector Lead Pensions at Probability & Partners

Even before the financial crisis of 2008, there was a desire to reform the Dutch pension system. The crisis then made it clear that the pension funds could not guarantee entitlements, which further fueled the discussion about a new solution. Now that the transition to a new pension system has been politically ratified, the question is whether the new pension scheme will actually solve the current problems. What has become of the intended improvements in the new system?

Aging has long been seen as the major threat to the costs of the pension system. In a system where wealth was redistributed between generations, this proved increasingly less feasible as the ratio between pension builders and pension beneficiaries became lower. A second problem mentioned was that people had more variable careers by changing jobs, not working for a longer period of time, or starting their own business. In a fully inclusive pension system, it is expensive and administratively difficult to transfer wealth from one fund to another.

However, the negotiations on this change in the law took so long that the motivation for this transition was nuanced with a third motive: the level of interest rates. In the aftermath of the European sovereign debt crisis, interest rates were so low that indexation could not take place for an extended period of time. This led to criticism of the current system, as a lot of wealth ended up in the reserves of pension funds that were ultimately not distributed among the pension participants.

The new pension system was positioned as a solution to all these problems. But the creation of the law was a lengthy and erratic political process in which advocates had to make compromises. After the largely unimplemented pension agreement of 2012, a pension agreement was concluded in 2019, which itself also went through a very difficult process to be finalized as a bill.

Ultimately, the law was passed without a two-thirds majority in the Senate. Because the adoption of the law by the Senate was handled quickly before the Senate elections started, the aftertaste was bitter for some people. This raises the question of whether the new pension scheme actually solves the current problems effectively, or whether the solution to the problems has been watered down.

Aging

Aging is a threat to the current pension system, which involves redistribution between generations. The capacity of paying pension participants is decreasing compared to the expected pension obligations. Not only are people having fewer children on average, life expectancy is also increasing. A system where there is no redistribution between generations could be a way out of this. This is certainly the case in the flexible premium scheme, because an investment mix is ​​determined per age cohort where the returns actually go to the relevant age cohort.

This is much less the case in the solidarity premium scheme. Due to the mechanism of protection and excess returns, the redistribution between generations is evident. This is even clearer in the event that negative excess returns are achieved in the portfolio, after which the pension pots of younger generations are reduced more to protect the benefits of the older generation. The assumption is that young people have time to catch up. This is compensated by the fact that young people with positive excess returns also receive more of this than older people.

However, the redistribution mechanism, in which setbacks for a large group of elderly people are redistributed to a smaller group of young people, will not disappear everywhere with the introduction of the new system if a solidarity-based premium scheme is chosen. The solidarity reserve is in principle separate from this, as its use should be balanced.

Low interest rates

Another motivation for the new system is that there is now no indexation over a longer period. Interest rates were low for a long time after the European sovereign debt crisis, which put pension funds in a worse financial position due to the higher valuation of pension liabilities. A defined contribution system makes this easier. No promises about the amount of your pension eliminates the need for large reserves.

Since the low interest rates lasted for so long, this was also not a bad idea. But because the negotiations on the law change took so long, this problem has now disappeared. Interest rates have risen so much after increases by the ECB that coverage ratios are also skyrocketing. Naturally, the new system also means that pensions are no longer only variable upwards, but also downwards. The question is whether the average pension participant agrees with this in terms of risk and whether this outweighs the disadvantages of not being able to index. For now, the indexation problem has already been solved without the new pension system.

More variable career

The fact that people change jobs more often and then end up in a new fund has been partly improved in the Wtp. Under the old system, a participant's accumulated wealth can only be transferred to another fund if the coverage ratio is high enough. This can have a negative effect on the participant. This is especially true if the pension scheme is more favorable in the new fund, but also because compound returns are higher on a larger pot. In the new system there is no longer a coverage ratio, so this condition no longer applies. In theory, transfer is easier since the pension pots are already divided in advance into individual pieces.

Yet there remains a limitation. In the solidarity premium scheme it is not possible to include the share in the solidarity reserve in the individual value transfer. If the reserve of the new fund is less well filled than that of the old fund, this is disadvantageous upon transfer. This can of course also have a positive outcome if the reserve of the new fund is in better shape.

A risk sharing reserve can also be maintained in the flexible premium scheme, but this is not mandatory and therefore differs per fund. Whether the transfer is beneficial or not for the participant therefore depends on the specific features of the arrangements at the funds involved in the transfer. This does not make the consequences of the transfer more transparent and therefore does not make the transfer easier for the participant.

In conclusion, the choice of the flexible premium scheme would solve the problems that gave rise to the call for a new system to a greater extent than the solidarity scheme. But also when choosing the flexible premium scheme, it depends on how funds handle the risk sharing reserve.

The process of approving the Wtp has been a long and difficult process in which advocates have made compromises and old ideals and new ideals have been weighed against each other. Now that the battle has been fought, the problems that prompted such drastic changes to the system have not necessarily been resolved with the new system.

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