Daan Kleinloog: 'New Pension System is Not Getting Any Simpler'

What is your assessment of the Future Pensions Act (WTP)? What do you like about the new law, where did it go wrong?
‘It was under discussion over a considerable period and compromises were made so fortunately there is now something with support for it. At the same time, there are things at the detail level that may not all be logical but given the time constraint there seems to be no room now to rectify this before the law is introduced. So, you can expect that adjustments will be needed in the future, and that remedial legislation will be introduced to further optimize the law.’

Where are the major flaws as far as you are concerned?
‘I think it is mainly in the details. What I find very strange, for example: in the current system, if you have defined benefit (DB) entitlements with your pension fund, you may also purchase additional DB entitlements on retirement date from any accrued defined contribution (DC) capital. Under the new system, you will not be allowed to buy back accrued DC capital (in a flexible contribution scheme) into a variable pension, also including solidarity reserve in a solidarity contribution scheme at retirement date. While I think this demand will occur in practice. That there is, for example, a solidarity-based basic scheme, with a flexible top-up scheme (a supplementary pension scheme for members who earn more than the set maximum salary, ed.). What is the reasoning against a flexible top-up scheme also becoming part of the solidarity package on a voluntary basis at the time of retirement?’

That is all very technical ... Can you explain what the difference between the flexible and solidarity-based scheme is and what it means for employers and participants?
‘In a solidarity-based premium scheme, there is a single age-dependent investment policy and employees share the risks. There are fewer individual choices, but there are more opportunities to keep the pension stable. In a flexible contribution plan, the individual is more central: the individual employee has more freedom of choice regarding the investment risk and can decide how much certainty he or she wants about the amount of the pension. On the other hand, in the flexible contribution scheme there is less risk sharing, so the possibility of keeping the pension stable is more limited.

Do you think that the introduction of the WTP will bring all the intended objectives closer?
‘One of the objectives was for the pension system to become more transparent and simpler. It is still complicated, so that goal does not seem to be any closer to being achieved. I notice that many employers find it complicated, that it demands a huge investment of time to figure out how these schemes are put together and which scheme would suit a company best. Subsequently they must also get the works council or other employee representatives on board. That also demands a fair amount of time.’

Another objective of the law is to become less dependent on the interest rate. Because it was so low, the system risked becoming unaffordable. Will the new system be that much more robust?
‘It is not so much more robust, it is just different. It will soon be possible to disregard the interest rate, whether you work with a flexible or a solidarity-based scheme. You can then work with a projected return that is higher than the risk-free interest rate.  The projected yield determines how quickly you can empty the pension pot. A higher projected yield means that participants will run more risk and that their benefits may eventually be lower than expected. With a higher projected return, you are ultimately no better off, because there is no more or less money coming into the pension pot. Only the distribution key, which determines when how much pension is paid out, is different. If the projected return is higher, the pension participant will receive a higher benefit at the beginning of retirement and a lower benefit at the end.
I notice in practice that many parties still prefer this risk-free interest rate. Understandable: they want to do what is best for their employees. Many people want to know where they stand when their pension benefits start. Not always rightly so, but people are inherently loss averse - they would rather have the certainty that their pension benefit will not decrease rather than the possibility of the benefit increasing, and they would rather have a pension that remains the same over time than a benefit which is a bit higher at the beginning and decreases in later years. Although there is a stark difference between people with high and low incomes. Higher-income people often prefer to have somewhat more to spend at the beginning, and do not mind that it becomes a little less later on - they can tolerate this, and they have the assumption that in old age they will be less healthy and thus spend less. People with a lower income, however, want to retain what they have when retirement rolls around. This all makes it difficult to choose one projected return for the entire population. This is also why many funds are careful and still use the risk-free interest rate. And then perhaps additionally offer so-called high-low constructions to individual employees, so that they can opt for a high pension in, say, the first ten years and a somewhat lower pension in the years that follow.’

Does that not mean that the implementation problem increases exponentially? All those variants will need to be facilitated.
‘Indeed. Although within solidarity-based premium schemes, the projected return is made at the collective level and applies to all participants. Within a flexible contribution plan, people can choose for themselves what that projected return will be and that is much more complicated in the implementation. Not only with the pension administrator, by the way. A flexible contribution scheme with many choices also means extra pressure on companies’ HR departments. More choice guidance is needed, and the HR staff will need to address more questions. Employers can factor that into their choice of a solidarity-based or a flexible plan and ask first and foremost what best fits the profile of employees and their level of education, income level, type of work and affinity for personal financial planning. Do employees want everything to be taken care of and not have to look after it like with the solidarity plan? Or would they prefer to be able to make the decisions themselves, as with a flexible plan? In addition, the employer must look at what best suits his own organization: to what extent can he guide employees in pensions?
It is, however, within a solidarity-based premium scheme, possible to opt for a collective payment phase, in which all pensioners face the same increase or decrease in their pension. That makes it much easier to explain to people why their benefits fluctuate, since the explanation is the same for all those involved and it reduces the need to inform everyone separately. It also focuses more on benefit fluctuations and less on capital - that is, on what is in the pension pot. That may counter the widespread but misplaced fear that the capital pot will run dry. I expect that almost all pension funds that choose the solidarity premium scheme would also choose for the collective benefit phase.’

The question then is, what is about to change if many pension funds would opt for a risk-free interest rate and a collective benefit phase? What does the WTP solve which was not regulated in the current Pension Act with the Financial Assessment Framework (FTK), which sets out the legal financial requirements for pension funds?
‘Pension funds need to hold lower buffers and can take more risks to pay out more in pensions. Pension funds will soon no longer be required by law to maintain such high financial buffers. Under the current system, those required buffers are between 15 and 25 percent of the balance sheet total, depending on the investment risk a fund takes.
Under the new system, they can suffice with a buffer of 5 to 7.5 percent if that buffer only needs to be called upon if a drop in benefits occurs. The new system allows for investment at a higher risk profile and for more money to be spent on benefits. Although the claims members can make on their pensions are reduced.’

Did you have a look at the old and new schemes under the microscope to see how big the compensation space is for participants in funds that move into the new system?
‘Yes, and that is a complicated issue. You can, of course, calculate what someone has accrued in pension and what they get added per year in the current situation. Soon, especially older workers, from about 45 years of age, will lose out when a pension fund moves in and starts complying with the new scheme. You can monetize all that, too. But the new system has just as many advantages, even for older workers. Because the buffer that the pension fund will no longer have to maintain will also benefit him or her; the older worker also benefits from entering the new system. You would then be allowed to net those benefits against the disadvantages. Those are complex calculations.
The situation is slightly different for employers with an age-dependent premium tier in a DC scheme, or who do not join: they cannot distribute a buffer. In practice, we see that many employers with a DC plan maintain the current age-related graduated scale. They then do not have to set up a separate compensation scheme, but they can still compensate their employees with the increasing premiums - because of course that is also a way of compensating, since more is paid out as people get older.’

What does the decision ‘to join or not’ ultimately depend on? How do you as employer or CFO decide what is best?
‘It is a requirement to join to be able to use the pension fund’s assets to finance the abolition of the averages system. So, if you do not join, you still need to adequately compensate for the abolition of your averages system, but you must do that from the contributions you pay. The costs then go up substantially or the pension accrual diminishes.
The pension costs may then rise significantly, although the costs can be spread over 10 years. A cost increase of five to ten percent is entirely possible, I once calculated. As mentioned, not joining is also indirectly expensive. It brings with it all kinds of extra administrative burdens, as everything needs to be dealt with partly under the old rules and partly under the new rules. All in all, in most cases I would advise an employer to join the new system.’

This article was published in Management Scope 05 2023.