Introduction to Pensions

Servaas van Bilsen(S.vanBilsen@uva.nl)

University of Amsterdam and NETSPAR

March 29, 2019

March 29, 2019 1 / 40

Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 2 / 40

Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 3 / 40

Pillar I: Public (or State) PensionsMain objective: prevent old-age poverty

I In principle, for everyone (subject to some conditions)I In a number of countries, the main objective is to maintain the

standard of living.Redistribution across generations

I Pay-as-you-go (PAYG): redistribution from young to oldI Age-specific taxes and transfers

Redistribution within generationsI Income solidarity: redistribution from rich to poorI Income-specific taxes and transfers

DB (contributors bear risks) but shift to DC elementsI Contribution rather than benefit is fixedI Benefits linked to macro longevity and growth rate tax base

Mandatory participation of workers and paid out as annuity

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Pillar I: Poverty Among the ElderlyPercentage with incomes less than 50% of median household income

Source: OECD (2015)March 29, 2019 5 / 40

Pillar I: Bismarck (earnings-related pension)versus Beveridge (flat pension)

Source: Disney (2004)March 29, 2019 6 / 40

Pillar I: Public Spending (% of GDP)

Source: OECD (2019)March 29, 2019 7 / 40

Pillar II: Occupational PensionsMain objective: maintain standard of livingPension entitlements backed by financial assets (funded)Providers in the Netherlands (no free choice of provider):

I pension fund (5.5 million active participants)I insurer (1 million active participants)

Often collectiveActuarially fair

I Closer link benefit and contributions on individual levelI Linked to labor history

Shift from DB (fixed benefit) to DC (fixed contribution rates)The Netherlands: Mandatory saving

I Focus on old-age insurance and consumption smoothingI Prevent behavioral mistakes by individualsI Annuities (DB) but trend toward more DC elements

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Pillar II: Assets in Pension Funds (% of GDP)

Source: OECD (2015)March 29, 2019 9 / 40

Pillar II: DB versus DC ContractsDutch Pension Funds

% of active participants

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Other

DC

DB  (Average  Pay)

DB  (Final  Pay)

Source: Dutch Central Bank (2017)March 29, 2019 10 / 40

Pillar II: DB versus DC ContractsDutch Insurers% of active participants

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1995 2002 2009 2013 2014

Other

DC

DB

Source: Dutch Central Bank (2017)March 29, 2019 11 / 40

Pillar III: Private, Personal Pensions

Main objective: taylor pensions to specific individualcircumstancesNeither redistribution across (funded) nor within generations(actuarially fair)Important for the self-employedIndividual DC products: no sponsors (no link employer)Voluntary but often tax favored (up to a ceiling)

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Other Pillars

Individual savingI Non-annuitized wealth; no insurance against longevity

Human capitalI Part-time retirement

Welfare/government (social assistance)I E.g., healthcare allowance, rent benefits

Housing wealthHealth and care insurance

I Old-age risksI Spending rather than income support

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Pension Systems in some other Countries

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PAYG (Pillar I) versusFunded (Pillars II and III)

Source: Lever et al. (2015)March 29, 2019 15 / 40

Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 16 / 40

Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 17 / 40

Features of Dutch Collective DB Contracts

Pension funds are independent non-profit entitiesIndustry-wide pension funds, company pension funds andprofessional group pension fundsNo public guarantees, i.e., no Pension Benefit GuaranteeCooperation (PBGC).Pension rights in terms of nominal annuitiesPension funds aim to index pensions rightsBonus payments are conditional on financial performanceNominal pension can be cutUniform contribution rate and uniform accrual rate

I Benefits are backloaded, i.e., young people accrue too little andold people accrue too much

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Policy LadderLN = value of nominal liabilities, LR = value of real liabilities, A = assets

Source: Ponds and van Riel (2007)March 29, 2019 19 / 40

Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 20 / 40

New DC Legislation as of September 1, 2016DC capital is invested according to life-cycle principle: share ofcapital invested in risky assets decreases with age.Before introduction of legislation, all DC capital had to bedecumulated as a fixed guaranteed nominal income stream.Nominal fixed annuity is still the default.The Dutch law allows

I to take investment risk in the retirement phase;I to buffer financial shocks;I to share macro longevity risk (among the participants) in the

retirement phase;I choice options how much to decumulate in a given year.

Providers should inform participants roughly 15 years beforeretirement about the possibility of taking investment risk duringthe retirement phase.If they choose to take investment risk during retirement, thenproviders will increase future investments in risky assets.

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How to Decumulate DC Capital?

The annuity payout is determined by the so-called AssumedInterest Rate (AIR):

Annuity Payout =DC Capital∫

hexp{−AIR · h} dh

. (1)

The maximum payout that can be withdrawn is determined suchthat the expected payout does not decline during the rest of life.The AIR is thus restricted to be less than the expected return onthe actual investment portfolio.Furthermore, in order to protect myopic individuals, theallocation to risky assets that can be used to calculate the AIR iscapped at 35%.

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Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 23 / 40

Strengths of Dutch Collective DB ContractsIncome frame (advanced risk management)

I Focus on providing a stable life-long income stream rather thanaccumulating wealth

I Interest rate risk and inflation risk are actively being managedI Pooling of micro longevity risk

Protection against agency issues and behavioral biasesI Strengthening of buying power in the financial marketI Economies of scaleI Workers are automatically enrolledI Delegation of complex decisions to professionals

Pooling of micro longevity risk and completion of marketsI Forced pooling of micro longevity risk to combat adverse

selectionI Trading of systematic risks that are not (yet) traded on financial

markets (e.g., inflation risk)

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Major Weakness: Mismatch betweenAssets and Liabilities

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Who Bears Mismatch Risk?Balance Sheet Risks are Large

Source: Central Planning Bureau (2014)March 29, 2019 26 / 40

Payroll Tax Base is not Growing QuicklyContributions can no longer be used to absorb mismatch risk

Source: Bovenberg and Gradus (2008)

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Employer Contribution Rate is RisingDramatically

Source: Lever (2013)March 29, 2019 28 / 40

Unexpected Nominal Benefit Cuts

Source: Dutch Central Bank (2014)March 29, 2019 29 / 40

Trust in Pension Funds Has Been Eroded

Source: Dutch Central Bank (2014)March 29, 2019 30 / 40

Addressing Mismatch betweenAssets and Liabilities

1 Reduce risk-bearing assets (i.e., match fixed annuities)I Expected return goes down (contributions increase)I Nominal constant guarantees: more exposure to inflation risk

(no indexation)2 Restructure liabilities (i.e., no nominal guarantees)

I Complete contracts: participants supply risk-bearing capital(e.g., personal pensions with risk sharing)

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Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

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Degree of Annuitization in Funded Systems

Source: Lever, Ponds, Cox, and Garcia-Huitron (2015)March 29, 2019 33 / 40

Freedom of Choice in Funded Systems

Source: Lever, Ponds, Cox, and Garcia-Huitron (2015)

March 29, 2019 34 / 40

Outline

1 The Three Pension Pillars

2 Dutch Pension ContractsCollective DB ContractsIndividual DC Contracts

3 Strengths and Weakness of Dutch Collective DB Contracts

4 International Comparison of Funded Pension Systems

5 Challenges and Policy Reforms

March 29, 2019 35 / 40

Declining Interest RatesChallenge for funded systems

0%#

1%#

2%#

3%#

4%#

5%#

6%#

1*04# 1*05# 1*06# 1*07# 1*08# 1*09# 1*10# 1*11# 1*12# 1*13# 1*14#

Ontwikkeling*van*de*Rente*

1*jaars#rente# 10*jaars#rente# 30*jaars#rente#

Source: Dutch Central Bank (2015)

March 29, 2019 36 / 40

Less hours working and more hours retirementComparison of life-cycle 1950 with life-cycle 2013Challenge for both funded and PAYG systems

Source: Kalshoven (2014)March 29, 2019 37 / 40

Age StructureChallenge for PAYG systems

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Recent Policy Reform (Netherlands)Linking of state pension retirement age to development in lifeexpectancyThe following formula will be applied:

V = (L− 18, 26)− (P − 65), (2)

with V being the increase in state retirement age, L being thelife expectancy at age 65 and P being the last determined stateretirement age.The new state retirement age will be P + V . It is not allowed tobe smaller than P .Government should inform people 5 years in advance aboutincrease in state retirement age.One year increase in L implies one year increase in V .

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Possible Future Policy Reforms (Netherlands)Dutch Collective DB Contracts

I Abolishment of system of uniform accrual and uniformcontribution rates.

I Reform of pension system.F Main critique: indexation has not been provided for more than

10 years.F Should we change the way liabilities are discounted?F Should we apply different regulatory rules?F Should we no longer provide nominal guarantees?

Government is going to investigate the possibility of taking alump sum payment.Should self-employed be forced to participate in a pensioncontract?Should we change the way the state retirement age is linked tothe development in life expectancy?

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