Dutch pension transition not yet in the pocket

Prof. Hans van Meerten and mr. Jorik van Zanden about Dutch pension system

The 2 trillion Euro pension system in the Netherlands – routinely cited as among the world’s “best” – is undergoing an historically unprecedented re-invention.  Consistent with a 2020 agreement between Dutch social partners, the system is converting from guaranteed-outcome defined benefit pension schemes (DB) into defined contribution savings plans (DC).

 

A wordwide transition to DC schemes

The world’s other great funded DB pension powers – the UK, United States and Canada – are undertaking a  transition by enrolling nearly all new workers in DC plans and letting DB plans dwindle as aging beneficiaries leave the workforce.  In Netherlands, these systems will not run in tandem; the DB system will be converted into a DC system. A similar conversion has never been undertaken in any pension market and many details are unclear. 

The drivers of this DB to DC transition are consistent worldwide. Aging demographics, declining support ratios (roughly the worker-to-retiree ratio), more mobile workforces that change jobs more frequently and flattening interest rates that seem to have eroded the ability of pension funds to guarantee benefits. 

 

Potential burdens for a smooth transition

Dutch policy makers appear to underestimate the potentially problematic nature pension rights

In The Netherlands, the reputational success of the system almost certainly led to policy complacency – a notorious enemy of progress.  In our view this complacency has left fundamental legal questions unanswered.  The guaranteed returns of DB pension funds are considered “pension rights” under European law.  And the replacement of these guarantees with market-based investment returns may be considered a breach of property rights, which in turn may lead pensioners to initiate court cases that could impede the transition.

In putting forward the conversion plan, Dutch policy makers appear to underestimate the potentially problematic nature of these pension rights.  The issue turns on the 1999 decision of the European Court of Justice, in the case of Albany, in which plaintiffs alleged that mandatory participation in multiemployer pension plans was anti-competitive.  The Court held, however, that obligatory participation was permissible under competition law because of the high degree of solidarity of these funds.

The reform appears to fail to address the issues that should have been addressed most.

But in the intervening 21 years since the Albany case, the financial and economic crises have wreaked havoc on pension fund returns, bond yields have continued to decline and the non-indexation of plan benefits to inflation has become the norm.  The new DC scheme has several elements designed to ensure maintain mandatory participation.  For example, the plans will include a “solidarity buffer” designed to smooth out market fluctuations.  In high return markets, a certain percentage of assets would be set aside to dampen the blow when markets fall.  But how would this work, exactly? And will it hold up in court? We doubt anyone fully understands. 

Another concern for Dutch workers who are obliged to divert around a fifth of their paychecks to retirement provision, is that minimal care has been taken to ensure that assets aren’t allocated to unsustainable or unwanted investments – for example, petroleum production, or weapons.  Even though the transition aims to “personalize” retirement finance, savers seem to have little control over the allocation of their assets.

To conclude: The reform appears to fail to address the issues that should have been addressed most.

Defined-Benefit (DB) versus Defined-Contribution (DC) schemes

There are various types of pension scheme. The most common is the benefit scheme, or defined benefit (DB) scheme. In this scheme, the amount of pension depends on the number of years worked and the contribution paid. Virtually all these schemes are based on average pay, with the pension accrued always related to the income in a particular year. Average pay schemes usually feature conditional indexation. This means that the pension entitlements of both those in work and pensioners will, in principle, be adjusted each year in line with inflation or the wage increase in the sector.

In addition to defined benefit schemes there are contribution schemes, known as defined contribution (DC) schemes. In these schemes the amount of pension depends on the contributions paid in during the accrual phase and the return on these contributions. The capital has to be converted into a periodic benefit on retirement. In principle, the employee bears both the investment risk and the interest-rate risk (the risk that the rate for the purchase of an annuity will change).

Source: Pensioen Federatie (2021)