Saturday, September 4, 2010

Recent Problems in the Dutch Pension Sector

Below is a guest commentary by Martin van Dalen, a portfolio manager in the investment department of the Dutch Social Security Organization:

Recent problems in the Dutch pension sector

I’m very grateful to Leo Kolivakis’ invitation to write this guest post.

Over here, in the Netherlands, the pension sector has a bit of a problem.

First, the structure of the Dutch pension system. There’s a nationwide (compulsory) retirement system, paid on a pay-as-you-go basis (out of the first two income tax brackets), providing a pension at 65 at the same level as the national minimum wage (that is, for a married or non-married couple, single persons get about 70%), calculated over a period of 50 years. (For every year you haven’t been a resident, 2% is deducted.) The starting age of 65 is likely to be moved to 66 (from 2020) and 67 (from 2025), but those plans were temporarily shelved when the Dutch government collapsed. Whether the next government will manage to get this done is uncertain; we’re still trying to form a government.

The second pillar is quite large: about 600 pension funds, (theoretically) fully funded, providing pensions to probably over 90% of non-self-employed workers. Mostly defined benefit, although the share of defined contribution is rising. By now generally based on the average wage during the period of employment, hopefully indexed for inflation. Pension rights are accrued, and contributions paid, on the income over the income provided by the first pillar pension. If all goes well, and one doesn’t have too many breaks in one’s career, one might expect a total of 60% to 70% of one’s average income. Since the income tax rates for retired persons are much lower, the net income might be about 80% of one’s average income (again, hopefully indexed). The total assets of the second-pillar pension schemes at the end of 2009 were € 741 billion.

The third pillar (for self-employed persons and for others who have gaps in their pension career) is run by insurance companies.

The pension sector is regulated by De Nederlandsche Bank, the Dutch central bank. Further on, referred to as “DNB”.

By international standards, the Dutch system is considered to be quite good. (See Ambachtsheer, K.P., Pension revolution: A Solution to the Pensions Crisis, 2007, and the Melbourne Mercer Global Pension Index, updated 14 October 2009, at .)

So everybody thought their pension was quite safe. One typically gets an annual statement from one’s pension fund (“Uniform Pensioenoverzicht”), consisting of several pages filled with numbers. I expect that most people didn’t spend more than five minutes in studying it. However, the next statement might be scrutinised more closely, as I will try to explain.

Pension funds have to report on their coverage ratio on a quarterly basis. And this is where the problems start. As I need not explain to the reader, it’s basically a simple matter: you have the current value of the investments on the one hand, and the present value of the expected outflows, based on actuarial assumptions, on the other hand. Divide the first number by the second number.

The big question is of course which discount rate should be used. DNB has prescribed a yieldcurve, period. I understand it’s a zero-coupon curve derived from the Dutch government bond yieldcurve. But whatever it is, it’s the one that pension funds are required to use when reporting their coverage ratio. It’s published monthly on DNB’s website at .

Their policy on the resulting coverage ratios is quite clear:
• Less than 100%: you’ve got a problem, you have to submit a recovery plan outlining how you are going to get back to at least 100%.
• 100% - 105%: no indexation of pensions and accrued pension rights allowed.
• 105% - 125%: only partial indexation allowed.
• 125% - 145%: full indexation allowed.
• Over 145%: compensation of previous missed indexation allowed.

(These percentages apply to the average pension fund, in term of asset mix and demographic composition.)

I need hardly point out to the reader that coverage ratios have fallen dramatically over the last few years. See for a graph, made from data found on the DNB website. (The data for 2010Q2 have not yet been released.)

Neither do I have to explain to the reader that this drop is to a large extent the result of the drop on yields on Dutch government bonds. (The other part is of course the not-too-spectacular yield on investments during the last years.) Of course, this is to a large extent the result of the crisis in Euroland public finance: yields of Greek, Portuguese and Spanish government bonds have risen dramatically, yields of Bunds have dropped to historically low levels. And the Netherlands are seen, by the international investor community, as a sort of province of Germany, economically speaking. To a fairly large extent, they have a point: Germany is our largest trading partner, for instance. Dutch government bonds move, well, not exactly in lockstep, but in a fairly narrow band: about 20 to 30 basis points above Bunds, give or take a few basis points.

For Dutch public finances, this is obviously a blessing: we’re not the safe haven that Bunds are perceived to be, but pretty nearly so. Dutch pension funds, however, are now faced with the opposite effect: these low yields work against them.

A week or two ago, DNB issued a statement to the effect that 12 to 14 pension funds had such a low coverage ratio that they should cut their current pensions and their accrued pension rights by, depending on the fund in question, 1% to as much as 14%, starting as soon as January 1, 2011. DNB was barred by law from saying which pension funds were involved, but since then, the names of all of them have surfaced. All in all, about 700.000 people would be facing cuts (total of current pension recipients, current contributors and past contributors), on a nationwide total of about 8 million people who are involved in a pension scheme (plus their dependants). (The number of 8 million people is a back-of-the-envelope calculation by a senior official of a large Dutch social security organisation who I asked for a guesstimate.)

Some of these funds are quite small (in some cases I don’t understand why they haven’t merged with a larger one), but one of them, PME, is a fairly large one. One of the largest, in fact, right behind the “big boys” ABP (public sector and education) and PZW (healthcare). 700.000 people out of 8 million means that nearly 10% of the Dutch should brace themselves for bad news. It’s understandable that this has caused a pretty big row.

Cutting nominal entitlements has never happened before, at least, not since World War II. (Not getting your pensions or future pensions indexed is, obviously, also a way of cutting them, but it attracts less attention that way.)

As was to be expected, the pension funds have shown little inclination to do as they have been told. Some of the things they have said, thus far:

• DNB made this demand out of the blue, without first telling us that they would do so, and informed the press at the same time. They should have been more polite. We’re not going to accede to their demand until they repeat their request in a polite way. (The Dutch, whatever their social status or position, do not take kindly to being told what to do. Ask any Dutch police officer for examples.)
• We have agreed with the trade unions and employers’ associations to wait until 2012 before taking any steps, so DNB has to accept this agreement. (The fact that DNB, or for that matter the Minister of Social Affairs, has legal powers of itself is not seen as being relevant in any way. This is entirely normal in the Netherlands. It is impossible to exercise authority without the consent of the governed, especially in matters pertaining to labour.)
• This is the result of something beyond our control, i.e. the behaviour of international financial markets, so we cannot be held responsible in any way.
• This is the result of DNB prescribing this yieldcurve, so it’s entirely DNB’s fault.
• The mere fact that DNB has said this, means that a lot of people are very upset, for which DNB is wholly to blame. The only way to restore confidence in the Dutch pension system is for DNB to retract its statement immediately.
• As this problem has been created by the government yield curve, it’s up to the government to solve it: please send us the required umpteen billion euro’s immediately.
• The present yield curve is historically low, which means it will rise in the future. Using a historically low rate means being too pessimistic. It would be desirable to use an average over a number of years. (This position has been taken by ABP pension fund in articles in several Dutch newspapers.)
• This is not simply a matter of cutting everybody’s claims by x%. We have to decide on whose claims to cut by which percentage, to spread the pain in a just manner. If we have to cut at all. This will take time.
• This is a very complex problem, whichever way you look at it. Let’s not start cutting claims in undue haste, but let’s make an in-depth study of the entire matter.

Please excuse the levity. I have allowed myself some leeway in paraphrasing the arguments put forward, as, I think, befits a blogger.;) I hasten to add that I am well aware that the boards of the pension funds concerned will be extremely uncomfortable. Their position is not to be envied…

In the meantime, the yields on Dutch government bonds are reaching new lows almost every day. This means that a favourite way of handling complex problems – hoping they will disappear in some mysterious way without any painful steps having been necessary- is unlikely to work.

The Dutch parliament is currently debating the matter, along the familiar lines of “how could this happen” and “who is to be blamed”.

My two cents:

On the one hand:

There is something funny about the DNB yield curve. It currently tops at about 20 years at 3.60%, but is significantly lower for later years: 3.10% at the end of the curve. That’s counterintuitive, to say the least. Furthermore, I’ve told that the observations used in construing this curve stop at the end of the Dutch government yield curve, i.e., at this moment 32 years, the NETHER 3.75 01/14/42 being the longest Dutch government bond, not counting a number of completely illiquid perpetual loans. Anything beyond that, up to 2070, is done by just extending the last set of observations. Now, this means that any fluctuations or distortions at the end are compounded in the calculations. A difference few basis points might not seem much, but raised to the power of 60…

On the other hand:

The purpose of this present-value calculation is to arrive at an answer to the question “how much should we invest today in order to be able to pay this stream of outgoing cashflows?”. This means that realistic assumptions as to future yields on this investments should be used, or the whole exercise is pointless. (I have read that U.S. pension funds are allowed to use yields of 8% or more in their calculations. If this is correct, I think this is a disaster waiting to happen, but that is another matter.)

Assuming one wants pension funds to invest in a safe way, without too much downside risk, this means, in my humble opinion, that one should use a yield curve that contains a large component of government bond yields, so to speak. (DNB does not tell pension funds which asset-mix they should use, but does apply “buffer requirements” for assets other than government bonds. The 125% mentioned above applies to a “standard asset mix” containing, roughly, 60% bonds, 30% equities and 10% anything else. Or thereabouts.)

If this means that in the present situation one arrives at an uncomfortably high number (of the present value of the future claims), that’s only a reflection of the reality.

If this means that current pensions and current claims have to be cut, so be it. (And I am quite aware that cutting someone’s pension by, say, 20 to 50 euro’s per month will be quite painful in a large number of cases.)

But if we don’t do that now, we are in effect spending money we don’t have. Which means that future generations will have to foot the bill, one way or another.

(Would it have been possible to hedge this risk? Up to a point, Lord Copper. Let’s assume that the duration of the liabilities of a typical pension funds is 15 to 20 years. Of course this depends on the demographics of the participants, but this seems not too far off the mark. Theoretically, the ALM manager could tell the asset manager to invest in a first-rate bond portfolio with the same duration: 100% Dutch government bonds. You’d have a lovely hedge: both liabilities and assets would bob up and down on the waves of the Dutch yieldcurve. But at this moment that would entail accepting a hideously low YTM: less than 3% on average, across the entire length of the curve. The price such a pension fund would pay for (a lot of) certainty as to its coverage ratio, would be an annual contribution that neither the employed participants nor the sponsor would want to find out. On the other hand, a pension fund with such an investment portfolio would not be required to have the “buffer requirements” that DNB require of other funds. The 125% coverage ratio mentioned above would be set at a much lower level. I don’t know what level, probably as low as 105%. But it’s a purely theoretical question. There just isn’t enough very long-dated Dutch government debt around to satisfy the needs of even a minority of Dutch pension funds if they would choose to structure their assets this way.)

It’s quite impossible so say what will happen. Clearly, the Dutch trade unions have a large say in the matter, and their members are generally older. (The typical trade union member is over 40, I understand.) Dutch employers’ unions, I would expect, probably care less as long as their members, in their role of pension fund sponsors, aren’t going to have to fill the gap.

Whether DNB will be able to assert itself, and force the funds to cut the nominal pensions and accrued claims, is to bee seen. DNB has had some bad publicity recently, especially over the collapse of DSB Bank. (The committee that investigated the way DNB handled this reported that DSB Bank should not have been given a bank licence in the first place…) DNB has announced far-reaching changes, among them setting up an “intervention unit” that should be authorised to take steps before things go wrong. (In my capacity as a citizen and a taxpayer I was a bit surprised to read this… I would have thought that a regulator would be able to take steps before things go wrong.)

I think this would be an excellent time for DNB to show that they do mean business. Let me put it this way.;)

A few links (in Dutch, I’m afraid, but I trust Google Translate will be able to give the reader a rough idea of the contents):

• DNB, FAQ about this issue:
• Interview with Ms. Kellermann, DNB board member:
• Statement of PME pension fund:,5824987&_dad=portal&_schema=PORTAL&p_item_id=6343632
• A collection of articles on pensions in NRC Handelsblad newspaper:
• List of pension funds that are involved:
• Joint statement of pension fund associations:

Martin van Dalen is a portfolio manager in the investments department of a Dutch social security organisation. The above has been written in a purely private capacity, and does not reflect in any way the position or opinions of either his employer or the board of the fund whose assets he helps to manage.

I thank Martin for this insightful contribution on the current state of the Dutch pension system which has long been the envy of the world. But as we can see from reading this comment, even the Dutch pension system is going through its share of problems.

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