Dick Kamp: Risk management and real cash flows under the new pension system

August 20, 2024

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

By Dick Kamp, Director Pension, Investment & Risk at Milliman Pensioen

The transition to the new pension system is, among other things, intended to enable more indexation. In other words, it should enable pension funds to better keep up with inflation. Indexation no longer takes place under the new pension system, but pensioners' benefits can be increased nonetheless.

In a defined benefit scheme, the benefits are raised through indexation. Behind the scenes, the associated provision is being increased. The capital available in a buffer for this purpose is allocated to individual claims. This applies to active participants as well as former participants and pensioners.

In the new pension scheme, almost all resources are already allocated to the participants, whether they are active participants, former participants or pensioners. The return that is made is also directly attributed to the participants. A distribution of resources is not necessary, as that is inherent in the system. For the sake of convenience, I abstract the possibility of allocating additional resources via a solidarity reserve or risk-sharing reserve.

The objective of the new pension system to better keep up with inflation must be included in the social partners' assignment to the pension fund. We are talking here about the formulated ambition. This ambition must be realized by depositing and investing premiums.

Under the new pension system, there is no longer a coverage ratio that is maintained. There is no longer any focus on the nominal objective. There is therefore room to manage based on real cash flows. This means that cash flows try to achieve the formulated ambition goals. The ambition can be formulated in terms of x% of the average salary over the accrual period, adjusted for inflation.

Almost all pension funds opt for the collective payment phase. In this phase, purchasing power maintenance must be earned through the return portfolio. Based on the currently known elaborations in published transition plans, these amount to between 30% and 45% of the investments. With a risk premium of 4%, between 1.2% and 1.8% excess return is achieved. This is lower than the long-term expected inflation of 2% on average. In short, the payment phase will most likely not keep up with inflation. It is expected that purchasing power will be lost in this way. After all, the average expected lifespan of a participant in the benefit phase is approximately 20 years.

This does not have to be a problem, if more returns are made in the phase up to retirement. Then there can still be an achieved ambition over the entire duration of the pension (from the start of accrual until death). In other words, there is a higher realized ambition in the first years of retirement and a (too) low realized ambition in the latter part of retirement because inflation has not been sufficiently kept up with. However, I don't see it being worded this way yet.

This is important, because if it is not expressed properly, the social partners will get the impression that 'too much' is built up in the phase up to retirement. The conclusion could be drawn that the premium can be reduced. This is undesirable when considering the pension scheme over its entire duration.

The foregoing shows that with the current choice for a collective payment phase there is an inherent problem with generating a real cash flow. A solution will have to be found for this. We will have to think outside the existing framework.

The solution lies in increasing the allocation to return assets in the distribution phase, while also increasing the options to absorb the greater volatility. That sounds like higher buffers[1], and that is precisely what we wanted to get rid of in the new pension system.

The solution can be found in having the younger generations absorb the volatility. That may be possible, but there should be a reward in return. This still requires some thinking.

The new pension system is a step forward, but given the desire to also keep up with inflation in the payment phase, it currently has limited options. Improvement is desirable, but this will require thinking and development time. The entire ecosystem is needed for this and must be ready for it. In the Netherlands we actually use the organic growth model for further development of the pension system. That makes sense, because it concerns a large, diverse, highly educated group of people in the sector who are working on building this new pension system.

It would be nice if a dot could be put on the horizon, the dot of real cash flows. The various parties within the sector (pension fund, asset manager, advisor, supervisor, social partner, etc.) can then take this into account in their strategic plan, each with their own role in the actual development of that area. The sector as a whole is slowly growing towards this.

Sector, are you considering enabling real cash flows when developing post-employment solutions for the pension sector? And beyond the use of the solidarity reserve, do you see efficient and balanced opportunities to share volatility between young and old?

This is the thirtieth column in a series on risk management. The series aims to encourage the reader to view risk management as an integral part of running a pension fund.

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