The Bureau for Economic Policy Analysis (CPB) recently published several reports that provide greater insight into the potential consequences of the Pension Accord for DC (defined contribution) schemes. The Framework Memorandum has now been published. This also covers one of the more controversial issues, i.e. the necessary compensation for the transition to a constant premium. What does this mean for the average DC participant?
Consider an employee aged 45 who currently has a graduated contribution scale. He has an increasing premium because, as he ages, the pension contribution (for a defined contribution scheme) can generate returns for one year less. This employee currently receives a premium of 16.4% on his pensionable salary of €45,000, whereby the current contribution for his pension is €7,335. This contribution would continually increase in the future, according to the blue line of his current defined contribution graduated scale shown in the graph below. In reality, his contribution will now follow the grey line: a constant premium of 16.7%, for example, as proposed by the CPB. At presents, this equates to a practically constant premium of €7,515.
Losses could be as high as two annual salaries
When the change takes effect, the premium will be more or less continuous. But, after that, the employee will lose a significant part of his future contribution. This is much lower each year than in the old situation. In his case, the defined contribution will rise to the annual €13,770 from 65 years of age. In the old situation, this participant would receive a defined contribution of €230,535 until retirement. In the new situation, this is €172,845 – a difference of around €57,690. For him, this means a 25% lower pension contribution, equivalent to more than an annual salary. The same calculation for a 35 year-old provides a 15% lower future premium and 30% lower for a 50 year-old. There is a very real chance that the constant premium percentage in the new scheme will be set lower than the 16.7%, which the CPB assumes. This is because the new scheme enables more to be contributed earlier in order to generate returns. In theory, you can achieve the same result with a lower premium. According to our calculations, the premium could therefore be adjusted from 16.7% to 14.7%. The loss in future contributions for this employee would then increase to €78,390, almost two annual salaries. We realise that this is a simplified example on the basis of an average scale and does not include any returns. However, it provides a realistic overview of the potential consequences of abolishing the scale.
Major losses in future pension accrual
When we consider the fact that the future premiums for the average 45 year-old will be reduced by around 25%, his remaining pension accrual will also be reduced by around 25%. But has the CPB not indicated that the expected pension decline will be a maximum of 12%? The CPB considers the overall pension, including pensions already accrued. There is no shortfall on the already accrued pension, so the future loss of premium averages out with the past. If we consider the future as an employee would, we see that the impact would indeed be of this order.
What is the solution?
The conclusion from the Framework Memorandum is that an ‘adequate’ solution in the form of compensation for abolishing the defined contribution scale is not possible. The solution that has been agreed is that employees, as per our example, can retain the current graduated contribution scale. It is only employees who are newly recruited that are subject to the new, constant premium percentage. Current employees therefore do not lose any of the promised future premium increases and no one will see their pensions decline. The compensation issue is thus resolved.
This solution, of course, has met with a great deal of resistance and is not entirely elaborated in the accord, with the note that further elaboration is necessary. This is vital, as this solution would create a substantial pension ‘gap’ for hundreds of thousands of Dutch workers – something that the new system must now prevent.
What is wrong with the solution?
Employees retain their increasing contributions as long as they continue to work for the same company. But if they leave for whatever reason (voluntarily or otherwise), they become a new participant elsewhere and immediately switch to the lower, constant defined contribution. At that moment, they lose their entire, future premium increase. Any employee who fails to keep an eye on this could end up with a contribution shortfall of, for example, 25%. Employees who do keep an eye on this type of issue may choose to stay with their current employers (and become relatively expensive for the employer) or try to demand a higher salary from the new employer to keep their pension accrual at the same level. This can quickly amount to 10%.
In our files, we see that around 6.5% of employees change jobs each year. With around 1.2 million employees with a defined contribution scheme, a significant pension gap will be created annually for around 80,000 participants over the coming years. Over the course of five years, this will increase to around 400,000 participants. It is sometimes argued that, in the current situation, the transition to another employer will also result in a pension gap. This, however, is not the case; the transition to another scheme with a pension fund does not currently lead to degressive accrual and, with the transition to a defined contribution scheme, there is also an increasing defined contribution scale.
With this solution, employers are also left with two types of pension scheme: one with an increasing premium and one with a constant premium. It is unprecedented for the contributions received by a new, young employee to be higher than a young employee who was already working for the company. With the aforementioned solution, we wonder how the employer will explain to existing young employees that it is a good idea that they receive a lower defined contribution for 15 years than their new colleagues? In the world of pensions, there has never been a transition scheme in which existing employees have been disadvantaged compared to new employees. This is not something you would want to have to explain.
The employer who does not want to end up in this situation but wishes to abolish the scheme with increasing premium percentages may be faced with a substantial bill because the loss of future premiums will have to be compensated. According to the CPB, this will equate to an approximately 35% higher pension contribution for ten years. On a national level, with a DC premium of €4.5 billion for ten years, this will result in a €1.5 billion compensation premium. To avoid this situation, employers are looking for other solutions that involve austerity in terms of the (future) pension scheme and compensation in the form of the salary. This ultimately results in higher salaries and lower pensions.
Compensation also required for pension funds
Pension funds will also have to be compensated. In this context, other ‘sources’ will be used instead of the extra premium. The minister states the following in the Framework Memorandum: “Calculations by the CPB and 13 different pension funds show that, given the current circumstances, there is in fact an advantage rather than a disadvantage in many cases. The negative effects as a result of the abolition of the average system are often offset by the (positive) effects of other distribution rules in the new contract.” What this means is that the transition to an investment method in line with a lifecycle offers better results and no compensation is therefore needed. Guarantees, risk-free interest and funding ratios disappear. There will be personal pension capital with age-dependent investment, i.e. a lifecycle. This offers better results and compensation is therefore not required. In fact, this indicates that the current inefficiencies in the contract will be removed, allowing politicians and employees to finance the transition to a lower average premium in the longer term. The participant, however, will pay for it out of pocket. The participant will be deprived of the advantages of the new system (a few at least) in switching to an average premium. If there is no transition to the average premium, the employee will have to move forward with (more) lifecycles.
Redistributed once again
In addition, pension funds must once again redistribute the available capital in order to enable the transition to the new system with transparent equity pension capital. The memorandum states: “Under certain conditions, the government will allow the fund capital to be used in a prudent way to provide compensation.” The difference with current DC participants, however, is that these will already have personal capital and an efficient lifecycle investment without guarantee. This source cannot therefore be used.
Transition to a new employer with a DC scheme
Lastly, we note two small sentences in the draft letter. “When transitioning from one employer to another employer, the compensation for the pension scheme from the old employer for the corresponding participant will cease. With the new employer, the employee will receive the appropriate compensation scheme for this employer.” With a pension fund, if you switch to another employer, you retain the compensation but, with a DC scheme, you will not. Here, we see a form of inequality between pension funds and defined contribution schemes – solely for the purpose of finalising the accord.
Will we now achieve the goals of the pension accord?
When it comes to simplicity, transparency and confidence in the pensions system, we applaud the fact that the entire Dutch pensions system will be 90% DC. However, the interests of current employers and employees in DC should not be overlooked. One of the most important goals behind the pension accord is a better connection with the flexible labour market. We see that there will be a significant issue that limits labour mobility in the 40+ group, which currently has DC schemes. This involves hundreds of thousands of employees. The goal will not be achieved for them. If it does not stop employees from changing jobs, we will see a substantial decline in pension contributions. This will lead to considerably lower pensions, even though the goal of the pension accord was an improvement in prospects for the future. What should be done? Don’t leave a huge group of employers and employees behind with this problem. Facilitate good solutions and ensure open and honest communication.
This article is written by Oscar van Zadelhoff (Product manager) & Marcus Haverman (Actuary).