The switch to a defined contribution (DC) system in the Netherlands should lead to a 10-20% increase in pension benefits, according to consultants. This is because the new system allows pension funds to use higher expected returns when making pension projections.
The new ‘projected return’ metric is a combination of the risk-free rate and expected returns on equities. Under the new draft pension law, the ‘projected return’ varies between 0.5% and 1.5% at current interest rates levels.
This can be compared to the actuarial interest rate for an average pension fund, which is currently around 0.4%, according to consultancy Sprenkels & Verschuren.
“From calculations we have made for a couple of pension funds, we conclude that the level of benefits in the new system can go up between 10% and 20%,” said Aon’s Corine van Reedijk.
“The increase is mostly due to the higher level of the projected return,” she said, compared to the actuarial interest rate metric, which is used to define funding ratios in a defined benefit system.
“The remainder can be attributed to some funds having funding ratios that comfortably exceed 100%. These funds can pay out a part of their buffer to members, leading to initially higher retirement benefits,” she added.
Equity exposure
The level of the projected return depends on a fund’s equity exposure: the more a fund invests in equities, the higher the projected return it can use.
“However, when calculating the projected return a pension fund can only use a 35% allocation to equities at pension age as a maximum. A fund that has a higher equity allocation must still use this 35% figure,” said Cardano’s Pim van Diepen.
“But take note, in the new system the allocation of an 68-year old at retirement will probably be different than the investment mix of a younger member,” he added.
For funds that have a conservative investment mix at retirement, the projected return will be 0.5% and as such retirement benefits will only increase slightly. A projected return that is 1 percentage point higher than the current actuarial interest rate can lead to a 15% increase in pension benefits.
“However, it’s important to note that the opposite will happen if investment returns disappoint,” Reedijk said, adding that “in the current system pensioners are more insulate against equity market volatility.”
It is, however, possible to cushion the impact of negative returns over a longer time period.
As a result, retirement benefits would only come down slightly initially, as illustrated by this imaginary example: if a pension fund that has a 40% allocation to equities a pension age sees the value of its equity portfolio crash by 50%, the value of the portfolio of a member at pension age comes down by 20%.
The fund can spread out this shock over a period of 10 years, resulting in benefit reductions of 2% a year. If equities recover, benefits will do so accordingly.
Cautious pension funds
The positive expected effects of the introduction of the projected return metric on retirement benefits prompts the question of why pension funds do not actively convey this message to their members in order to shore up support for the pension changes. Especially among retirees, the planned change to a DC system is met with resistance.
“Pension funds have become cautious in making promises,” noted Reedijk.
“They look at the entire picture, including at compensating members for changes in the system that governs contributions and risk attitudes of their members. Besides, retirement benefits do not increase automatically with inflation in the new system anymore, as is [supposedly] the case in the old system.”
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