Opinion Pieces

An Almost Healthy Patient

All over the world the Dutch retirement system is considered one of the best but at home it has come under fire. Serious questions are being raised about the stability and sustainability of the pension scheme. Are the concerns justified?

The Dutch pension system consists of three pillars: a basic state old–age pension on a pay-as-you-go basis for all citizens, a mandatory funded occupational pension for employed workers and voluntary pension insurance, mainly used by self-employed. The main components are the first two mandatory systems, each providing about 45 percent of the pensions, with private insurance covering about 10 percent. Together the state pension and the occupational pension provide about 70 percent of average lifetime earnings. There are, of course, many individual differences due to differences in earnings and duration of employment over life).

Although international observers assess the Dutch system as good and sound, the majority of Dutch policy-makers stamp it as being in a crisis and unsustaintainable in the long run. The country report of Bertelsmann Stiftung’s Sustainable Governance Indicators (SGI) states in this respect: “While the pension system is generally strong, a comprehensive reform is underway.” However, it is rather questionable whether there is a crisis in the making and whether a “comprehensive reform” is to be desired.

The public discussion centers on the viability of occupational pensions. There are pension funds for civil servants, for workers in the health sector, and so on; some funds are not industry-wide but tied to a specific employer. Since their beginning six or more decades ago they promised a defined real benefit in terms of an inflation-indexed fixed percentage of wages earned. Since 2010 doubts were raised about the solidity of these pension funds.

Are pension funds underfinanced?

In 2007 the Pensions Act came into effect to safeguard the financial security of pension entitlements. Under this legislation, the Dutch Central Bank (DNB) has to survey and control the pension funds. The main test is to confront the fund’s reserves with the current value of standing future obligations. The inherent problem is the question of how to estimate that current value. More precisely, which discount rate should be used? The DNB, along with the Dutch Cabinet and Parliament, opted for the so-called risk-free market rate, that is, the interest rate on a mix of German and Dutch public debt. Through ECB monetary policy this rate has fallen in the past decade from 5 to about 1 percent.  As a result, the present value of future pension obligations increased tremendously, and funds that had, according to this definition of the coverage ratio, a coverage of 150 percent or more in 2010 had one of about 100 percent or less in 2017.

The DNB requires for a solvent fund that the coverage ratio should be more than 120 percent. Thus, DNB deems many funds to be underfinanced. Repair measures are prescribed, such as no indexation for inflation, cuts in pensions paid out and reduction in the pension rights of still active workers and increases in premiums. As a result, many pensioners have incurred a loss of about 15 percent in real income since 2010 and a further loss of about 6 percent until 2021 is predicted, adding up to about 25 percent over the decade.

There is no real crisis

The ironic fact is that most pension funds have been making an average net return on their investments (including public debt) of about 7 percent during the last twenty years or more. Since 2008 the wealth of the pension funds has doubled from about €650 billion to more than €1300 billion. This being the case, it follows that the severe discount rate prescribed by the DNB is rather absurd and the main reason for the apparent ‘pension crisis ’ in the Netherlands. In fact, the discount rate prescribed by the central bank is lower than that prescribed by any other pension supervisor in Europe except Malta and Cyprus. Given that the crisis is an artifact caused by an unrealistic discount rate, the obvious solution is to re-define the applied rate. If raised from the present 1.5 to 3 percent the general coverage ratio would increase on average by about 20 percent, yielding a comfortable ratio of about 125 to 130 percent.

A second popular reason for the so-called lack of sustainability is the ageing of the Dutch population where the old-age dependency ratio fell from 8 in 1950 to about 3.5 nowadays and is tending to about 2 in 2040. However, this demographic rationale makes no sense either for the Dutch occupational pension system as it is not run on a pay-as-you-go-basis. In essence each participant saves during his working years for his own pension, although at a micro-level there may be transfers between generations or individuals, for instance, because some retirees live shorter than average and some longer.

The real problems of the Dutch retirement system

The main risk for the Dutch pension system emerges from a completely different direction. The number of workers with fixed employment who therefore take part in the occupational pension system is falling dramatically, shifting to part-time and temporary jobs or free-lancers and so-called ‘flex–work’. Those workers, now about 15 percent of the labor force, pay no mandatory pension insurance except to the state pension AOW. Most are more or less squeezed by their employers and unable and sometimes unwilling to enlist in a voluntary pension scheme. This makes them also cheap for employers. They will merely have social security as their income when they retire. A dramatic development is looming. Very recently, this has been realized by policy-makers who have begun a debate on how to counteract this tendency.

The second real problem of the Dutch pension system, still avoided in any public discussion, is that social security, the basic state old-age pension, is to a very large extent run on a pay-as-you–go basis. Here the ageing of Dutch society becomes a serious issue, because . The most likely solutions are that the basic state pension will be financed increasingly from general tax revenues and by making the benefit depending on total income of the retiree, where retirees with a large income or wealth will get a benefit reduction or even no benefit at all in spite of the fact they have made a contribution during their working life. To a certain extent an increase of the legal retirement age may mitigate the ageing problem.

Overall, however, the Dutch problems appear to be much smaller than the problems with the financial sustainability of the pension system in many other wealthy states. In Germany, for example, occupational pensions are mostly run on a pay-as-you-go basis and ageing is much more severe than in the Netherlands.