what's happening in... the netherlands?

…the Netherlands ?Fiscal pressure and the current low yield environment drive changes in the Dutch retirement system.

The Netherlands are commonly depicted as having a role model of a modern pension system. As 90% of the working population is covered by a quasi-mandatory occupational pension system, and pension assets amount to 138% of GDP (Organisation for Economic Co-operation and Development (OECD), 2011), the Dutch pension system is perceived as being well prepared for future demographic challenges.

Yet the ramifications of the 2008 financial crisis and the ensuing sovereign debt crisis in Europe will be felt

in the Dutch pension system. Dutch pension funds and their funding levels were hit hard by the asset price slump after the Lehman collapse. While assets quickly recovered to reach pre-crisis levels, Dutch pension funds are still struggling with the burden of rising liabilities which are triggered by current low yields. Furthermore, the Dutch government is faced with pronounced fiscal deficits (cf. Figure 1). In order to curb these shortfalls, the discussed austerity packages also call for social security reform. ▶

Retirement entry age will be increased to 67 in 2021 and afterwards pegged to life expectancy.

Changes in tax advantageous pension saving will lower accrual rates drastically in occupational pensions.

Current low yield environment decreases funding levels of pension funds, calling for emergency recovery plans.

Emergency recovery plans for pension funds arrive at benefit cuts.

Pension fund regulation: Moving from a market- consistent, risk-based approach to a regulatory engineered market framework by applying the ultimate forward rate (UFR).

Allianz International Pensions

What’s happening in…December 2012

Figure 1: Dutch GDP growth and budget deficit

Source: International Monetary Fund (IMF), World Economic Outlook, October 2012

Government budget deficit (in % of GDP) GDP growth

6%

0%

4%

–2%

2%

–4%

–6%2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e 2016e 2017e

Pension & Retirement Update

Impact of fiscal pressure on future retirement

The fiscal deficit of the Netherlands has amounted to more than 4% each year since 2009 (cf. Figure 1) and, according to estimates by the International Monetary Fund (IMF), the Netherlands will not balance its budget any time soon. In order to comply with Maastricht criteria and secure the nation’s AAA-rating, the government is eager to reduce the structural deficit. This year, several austerity packages were discussed, aimed at containing government expenditure. These discussions ultimately led to a split in the Dutch minority coalition government of liberals (VVD) and Christian democrats (CDA), and resulted in snap elections in September.

The new Dutch government, consisting of the liberal (VVD) and social democratic parties (PvdA), agreed on a €16 billion austerity package through 2017 to potentially cut the country’s deficit to 1.5%. Together with the formerly agreed measures, the total restructuring amounts to € 45 billion.

Changes in the first pillar

The austerity measures will have an impact on first pillar pensions (AOW). One of the major concerns of Dutch politicians is the rising life expectancy of retirees. In the past decade, the life expectancy of the Dutch population has increased more than was formerly expected – in the case of 65-year old men, by almost 2.5 years.1 To alleviate the budgetary consequences of this faster rise in life expectancy in the future, several changes to the retirement entry age have been discussed.

The Pensioenakkoord, which was approved in 2011, envisaged a gradual rise in the retirement age to 68 in the time period from 2020 to 2040. At the beginning of this year, when it became clear that the Nether-lands would not reach the 3%-deficit target in 2013, pressure arose to cut social spending even further. The former government negotiated the so-called “spring agreement”, which included a faster rise in the state pension entry age to 67 and a peg to life expectancy. But the implementation stalled due to the split in the government.

Nevertheless, the new government is following the idea of the spring agreement to increase the retire-ment entry age faster. The VVD and PvdA both agreed in their coalition talks to gradually raise the pension

entry age to 67 in 2021. The escalation will start next year with an increase of one month per year to start with, followed by yearly steps of two, three and four months. Subsequently the pension entry age will be linked to life expectancy. The Netherlands will join a group of countries including Denmark, Finland, Italy and Portugal, which have already introduced life expectancy indexation to their statutory pension age.

Impact on the occupational pillar

The austerity measures that were negotiated by the new ruling coalition also have an impact on occupational pensions. As was already discussed in the spring agreement, the tax relief for pension savings will be reduced. The changes to the regulatory framework governing tax-advantageous pension savings, the so-called Witteveen Framework, will lead to a drop of 0.4% in the accrual percentage point. Prior to that, a decrease of accrual of 0.1% point was announced. So the maximum accrual goes from a yearly 2.25% on average pay to 1.75%. Furthermore, the preferred tax treatment of pension savings will be limited to incomes below €100,000. These reforms within the Witteveen Framework have been strongly criticized by the pensions industry. According to the Netherlands’ largest pension fund, the Algemeen Burgerlijk Pensioenfonds (ABP), the measures endanger the goal of achieving a pension amounting to 70% of the average wage. Younger generations in particular would suffer from this change, which could reduce future pensions by as much as 20%.2 Pressure on pension funds comes not only from austerity-induced changes in the legal tax framework: The biggest challenges for pension funds and their plan participants lies in the current low-yield environment that reduces funding levels and might ultimately lead to cuts in pension rights and benefits.

The challenges of a low-yield environment

Over the past five years, pension funds in the Netherlands have been in a financially vulnerable position. With the beginning of the financial crisis, funding levels dropped significantly and mostly remained below the minimum funding requirement (cf. Figure 2). The short-falls of the funding requirements only partly refer to the asset price slump during the 2008 market turmoil. Meanwhile, pension funds are contending most of all with the current low-yield environment, as they have to value their liabilities on a mark-to-market basis. This refers to the ▶

2

1 Cf. Statistics Netherlands (CBS), as of 09/07/2012

2 Cf. IPE 11/01/2012

Allianz What’s happening in the Netherlands? | December 2012

risk-based regulation framework that was introduced in 2007 (cf. Figure 3). Since then, future liabilities of Dutch pension funds have to be discounted by a risk-free market rate which has been defined as the Euro swap rate. With falling yields, especially at the long end of the curve, the present value of future liabilities has risen steadily, resulting in today’s low funding levels. In order to mitigate the liability burden of the pension funds and avoid severe

pension benefit cuts, several ad-hoc measures have been implemented as part of the regulatory framework in the last few years.

It began shortly after the financial crisis, in the spring of 2009, when it became clear that pension funds would not meet minimum funding levels (cf. Box) in the requested one-year period, and the emergency ▶

3

T h e R eg U l ATo Ry F R A m e wo R k o F D U TC h Pe n s I o n F U n D s

The regulatory framework of pension funds Financiele Toetsingskader (FTK) was introduced in 2007. It represented a major shift as the Netherlands was one of the first countries to adopt a risk-based regulation for pension funds. Key features of the framework which is supervized by the Dutch central bank (DNB) were:

1. The minimum assets of pension funds must be sufficient to cover 105% of accrued benefits (minimum funding requirement)

2. Within a confidence interval of 97.5%, pension funds are required to remain above the minimum funding level. This translates into a target funding ratio of 130% for pension funds

3. The liabilities of the pension funds are valued on a mark-to-market basis by discounting them at the market interest rate (Euro swap rate)

If a pension scheme fails to meet the minimum or target funding requirements, sanctions are introduced by the regulator. If the pension fund does not fulfill the target funding requirement, it has to introduce a recovery plan with a maximum time period of 15 years to close the funding gap. Should the pension fund not meet the minimum funding level, an emergency recovery plan has to be implemented within one year. This plan includes measures such as the intermission of indexation of pension benefits, increase in pension contributions and, in a worst-case scenario, the curtailment of pension benefits.

Figure 2: Funding levels of Dutch pension funds

Source: De Nederlansche Bank (DNB), October 2012


Target funding level Minimum funding level Funding ratio

2007Q1 Q2 Q3 Q4

2008Q1 Q2 Q3 Q4

2009Q1 Q2 Q3 Q4

2010Q1 Q2 Q3 Q4

2011Q1 Q2 Q3 Q4

2012Q1 Q2

160%

130%

150%

120%

140%

110%

100%

90%

80%

160%

130%

150%

120%

140%

110%

100%

90%

80%

recovery plan period was first extended from one to three and later to five years. Within the same time frame, pension funds started to raise the average contribution rate from 16.9% to 17.5%, although the DNB allowed pension funds to apply for a contribution respite.3 Despite the new rules and a higher contribution rate, pension funds were not able to significantly raise their funding levels. Although the indexation of pension benefits was removed for the vast majority of pension funds during 2011, more severe measures had to be taken: Benefit cuts of up to 7% were announced in order to comply with the minimum funding level in the fall of 2011.4

To avoid such drastic effects, the DNB introduced a new methodology of how to value the liabilities of the pension fund in December 2011: Instead of using end-of-period swap rates, pension funds could use a three-month average to discount their liabilities. Again, this measure did not bring the expected relief, as yields continued to fall. Based on the situation in June 2012, 154 pension funds were expected to conduct curtailments in April 2013 to comply with the funding requirements after the end of the emergency recovery plan time period which had started in late 2008 for most of the funds. More than half of these curtailments would amount to more than 7%.5 In order to comply with the current “abnormal”

market conditions, the regulator decided to introduce comprehensive reforms to the regulatory framework of Dutch pension funds, known as the September pension package.

The september pension package

The September pension package was designed by the Social Ministry and the DNB to mitigate the effects of the possibly severe benefit cuts that pension funds would be obliged to make if the current regulatory framework should persist. It institutionalizes some of the implemented ad-hoc measures and furthermore aims to make the pension schemes more “future proof.” The newly implemented measures are widely regarded as a transitional stage for the new financial assessment framework which is announced for 2014 but will probably be delayed until 2015.

One option that is again offered to pension funds is the contribution respite for pension plans that do not comply with the minimum funding requirement. This option is conditional on not having applied for a respite in earlier periods. Furthermore, given that a pension fund has to cut pension benefits and rights, it is offered the option to spread necessary curtailment: The cuts which have to be carried out next year can be limited to the extent ▶

4

3 In case of the 25 largest funds, source: DNB 08/02/2012

4 Cf. DNB, February 2012

5 Cf. Ministry of Social Affairs, AV/PB/2012/14554

Figure 3: Liabilities of pension funds vs. long-term swap rate (20 years)

Source: DNB, October 2012


20-year swap rate Pension liabilities

20-y

ear E

uro

swap

rate

in %

Liab

ilitie

s of p

ensi

on fu

nds i

n EU

R bi

llion

s

800

1000

700

900

600

500

400

300

31.12.2006

30.09.2008

31.03.2012

30.06.2010

31.07.2007

31.01.2011

30.04.2009

29.02.2008

31.08.2011

30.11.2009

5

4

6

3

2

1

0Introduction of risk based FTK framework

Extension of recovery plan period

Change in discounting methodology

Collapse of the government coalition

Introduction of UFR, September pension package

Pension funds subsequently start to raise contributions ↗

Several funds announce benefits cuts for the following years

of those already announced at the beginning of 2012. In case the year-end assessments of the funding status should require deeper cuts, they can be deferred until 2014. Moreover, if the funding situation of pension funds deteriorates further, curtailments that would occur for 2014 can be limited to 7%, on the condition that additional cuts are undertaken in 2015. The future cuts should be accounted for in the balance sheet end of 2013.

Should a pension fund want to make use of either the contribution respite or the curtailment spread option, the regulators will ask the pension fund to raise the retirement age of their plans from 65 to 67 in 2013. This is one year earlier than required, as a general increase in the retirement age is required in 2014. In addition, the minimum funding requirement for granting indexation of pensions is raised to 110% instead of 105%.

The most frequently discussed change in the regulatory framework which also has a direct influence on funding levels is the introduction of the so-called ultimate forward rate (UFR). The UFR is an adjustment of the long end of the yield curve. The idea behind the UFR is that due to liquidity constraints, there is no reliable market data for rates beyond a maturity of 20 years (last liquid point). Therefore, the discount rates beyond a 20-year maturity are gradually adjusted over a 40-year horizon to the UFR, which is set at 4.2%. This particular rate consists of two components: The long-term expectation of inflation and short-term rates which are assumed to be at 2%, respectively 2.2%.6 The implementation of the UFR methodology follows the Solvency II insurance regulation, which might also be applicable with some meanderings in the future for pension funds. The introduction of the UFR leads within current market conditions to a divergence between the market rate and the discount rate that pension funds use to value their liabilities.7 As the discount rates obtained via the UFR method are higher than the prevailing market rates at the long end of the yield curve, the present value of the pension funds liability decreases while the funding ratio increases. According to PIMCO, the application of the UFR method as introduced in the Netherlands will lower the current value of liabilities by roughly 4%.8 The Dutch regulatory authorities expect that with the introduction of the September pension package the number of funds with curtailments for 2013 will almost halve to 81 funds, with only seven of them cutting benefits by more than 7%.9

The respite and curtailment spread options aim at limiting the direct financial effect of already announced

cuts for current retirees in an attempt to buy time for a potential improvement of the financial position of pensions funds. On the other hand, the introduction of the UFR can be seen as a shift within the regulatory paradigm: Moving from a market-consistent, risk-based approach to a regulatory engineered market framework. This has major implications for pension providers and future retirees. The pensions of younger generations are valued at a different level than the pensions of older generations, because the longer the liability is away in the future, the higher the interest rate on the UFR-curve will be. Possibly this move will put the solidarity between generations under pressure.

Back for good?

Even before the introduction of the FTK framework, Dutch pension funds used an actuarial discount rate to value their liabilities, which was set at 4%. From the view of the regulator and the pension funds, the major advantage of the use of an actuarial discount rate such as the UFR is the lowered volatility of the funding position, leading to a higher predictability of future contributions and benefits. With the UFR, movements at the long end of the yield curve do not have an effect on the valuation of the liabilities and the funding level. On the other hand, by directing the discount rate, the actual economic reality is disguised. Whereas the 4% pre-FTK rate was implemented when long-term yields were way above this level and the 4% discount rate served as a measure of prudence, the UFR which has now been introduced aims at preventing cuts for current retirees and does not account for economic low-yield reality.

A pension fund seeks to meet the current and future obligations of retirees. Changes in the regulatory framework do not have an influence on the capability of the pension fund to meet these promised pay- ments. Although Dutch pension funds might improve their disclosed funding levels and therefore obviate curtailments, by just changing the valuation method of liabilities, the actual financial position of the fund does not change. If the current low-yield environment prevails for longer, the cuts are simply postponed to future generations.

Furthermore, if the yield curve is regulated by politicians, pensions funds are increasingly exposed to political risk. The absolute value of the UFR and the extrapolation method are at the discretion of the regulator. Whereas interest rate risk is in general hedgeable for pension ▶

5

6 Cf. Technical specification QIS 5

7 The three-month average will be maintained when valuing liabilities.

8 PIMCO: The Ultimate Forward Rate: Implications for LDI Strategies, July 2012

9 These funds already announced that they will not opt for the curtailment phasing; cf. AV/PB/2012/14554


funds in a market-consistent framework, political risk is not. Pension funds are therefore confronted with the problem of how to mitigate between the regulatory framework and economic reality.

outlook

As of the end of October 2012, the implementation of the new regulatory measures has not shown the desired effect of the regulators. Only one out of the five biggest pension funds could rule out the possibility of rights cuts.10 Although the measures which have been introduced should decrease the size of expected benefit cuts for 2013 and 2014, with regard to the currently low funding positions and the new indexation threshold of 110%, Dutch pensioners can expect that the real value of their rights and benefits will shrink in the coming years. In order somewhat to alleviate the effect of the new legal changes and the current low-yield environment, young Dutch people in particular should consider investing in private pension schemes. Although the Dutch occupational pension system is better equipped for future challenges, the latest reforms, and current pressure from both the fiscal and capital market sides, put into question whether it will be able to sustain its formerly targeted 70% replacement rate in the future.

6

10 Cf. IPE 10/19/2012

Richard wolf Economist International Pensions

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Richard Wolf, Economist

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International Pensions

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Closing Date

November 19, 2012

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what's happening in... the netherlands?

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