Integrating Pension Solidarity And Sustainability: Lessons From The Netherlands And Canada

“Since 2006, the Plan has had a Funding Policy designated to protect promised benefits, while managing through periods of volatility. The Policy prescribes the use of reserves, stability contributions, and          conditional benefits at each of six levels of the Plan’s financial health. The use of reserves and stability contributions supports the desire to treat each generation of members equitably.”

From the 2015 Annual ReportOf the CAAT Pension Plan of Ontario

Dutch Pension Turmoil

The recent IPE article headline “Dutch funding shortfall rises despite asset growth” captures the current turmoil in the Dutch workplace (i.e., Pillar 2) pension system in seven words. The article noted that 2016 had seen a fall of the average workplace pension plan funded ratio from 104% to 97%. That was the bad news. The good news was that it had ticked back up to 99% in the first two months of 2017, marginally reducing the fear of more pension cuts to come.

Stating the obvious, watching funding ratios bounce up and down on a monthly basis and constantly worrying about pension cuts is no way to run a pension system. By continuing to operate in this environment, the Dutch legislative/ regulatory regime worsens three mutually-re-enforcing problems: 1. An unhealthy over-emphasis on the short-term in investing, 2. An unnecessarily high asset coverage of accrued future pension payments, and 3. A catastrophic decline of participant trust in the often-praised Dutch pension system through recent pension cuts.   

With the formation of a new government now underway, this is an ideal time for the Dutch to liberate their Pillar 2 pension system from these three serious problems. This Letter offers two perspectives on addressing this challenge.    

Perspective #1

I wrote an invited paper in 2014 for the Royal Economics Society of the Netherlands (KVS) titled: “Taking the Dutch Pension System to the Next Level: A View from the Outside”. A key argument in the paper was that pension plan design should reflect the logic that the number of economic goals should be matched by the number of instruments designed to achieve them. Given the dual pension plan goals of affordability and payment safety, the logic suggests Pillar 2 pension plans should have separate affordability and payment safety pools. The former focuses on long-term return generation to achieve the affordability goal; the latter on generating predictable pension payments for life to achieve the payment safety goal.

The Life-Cycle Model of personal finance shows how these return-generation and payment safety pools are best employed. As affordability is the primary participant concern during the ‘work’ phase of the life-cycle, retirement savings should at first be fully allocated to the return-generation pool, with assets  gradually shifting to the payment safety pool as the post-work phase of life comes into view. A ‘default’ transition path would help plan participants with this transition. Importantly, the return-generation pool would not be subject to any balance sheet restrictions, leaving its managers free to roam the world, seeking out the most attractive long-term return generation opportunities. Other design benefits include clear property rights, intergenerational fairness, full transparency, and some important choice options for plan participants.  

There is of course the practical challenge of how to unscramble the existing Dutch single-pool designs which place all plan participants (i.e., from young workers to aging retirees) on the same balance sheet with the same investment policy. Successful transition to the new pension requires three steps: 1. Design an equitable ‘old-to-new’ transition protocol, 2. Engage plan participants on the merits of moving to this model, and 3. Rewrite pension law and regulations to be consistent with the model. Almost three years after the KVS paper, the Dutch debate on modernizing its Pillar 2 pension system continues, with a move to the two-pool model an option under consideration.

Perspective #2

Meanwhile, a growing number of Canadian Pillar 2 pension plans have transitioned from the traditional hard-core DB model to softer versions. These softer versions continue to maintain elements of collective risk-sharing, but have become more adaptive to changing circumstances through (a) taking a ‘going-concern’ rather than solvency view of funding, (b) establishing an explicit response protocol to changes in plan funded status over time, and (c) regularly measuring intergenerational plan fairness and communicating the findings to plan participants and sponsors.    

In contrast to the Dutch situation, this transition has allowed many Canadian pension plans to: 1. Maintain a long-term investment focus, 2. Operate with lower asset coverage of accrued future pension payments, and 3. Maintain high levels of trust in plan sustainability. As a specific example, the front page quote comes from the Annual Report of the Colleges of Applied Arts and Technology (CAAT) Pension Plan of Ontario. It states that achieving the Plan’s long-term investment return goals is tempered by explicit balance sheet risk controls and intergenerational fairness constraints. CAAT is not the only Canadian plan expressing confidence in the design and implementation of its balance sheet risk management framework. I could have picked any one of a dozen other examples.   

Why are the Dutch fearful and the Canadians confident today? The answer has direct relevance for the pension legislation and regulation changes being debated in the Netherlands, Canada, and other countries.  

The Essential Difference

The essential difference lies in the approaches to the funding and risk management. The Dutch have adopted a solvency mindset towards pension regulation, while the Canadians have adopted a ‘going-concern’ approach in the cases where the ‘going-concern’ assumption is reasonable. The focus of solvency valuations is “if the plan were to wind up tomorrow, are plan assets sufficient to make all plan members whole?” Arguably, this is only an academic question in situations where it is highly implausible that employers will announce their collective bankruptcy sometime in the future (e.g., in the government, education, and health-care sectors). In the CAAT case for example, it is highly implausible that the 38 educational organizations co-sponsoring the Plan will suddenly cease to operate five, ten, or even twenty years from now.

As a result, CAAT’s funding and investment policies do not focus on the solvency question, which would require them to use a liability discount rate of 2.6% today (i.e., approximately what Dutch plans are currently required to use). Instead, CAAT uses ‘best estimate’ projections for asset returns and for wage and price inflation (5.6%, 3.8%, and 2.0% in 2016), as well as for member longevity (89 years average lifespan). The implied real return projection of 3.6% is based on an investment policy of approximately 70% invested in return-seeking and inflation-sensitive assets and 30% in fixed income assets.

Given CAAT’s target benefits, these projections lead to a best-estimate contribution rate of 18% of pay and a 113% funded ratio at the start of 2017. According to the CAAT funding protocol, at a 13% surplus position (Level 4 on a scale from 1 to 6), the Plan will maintain conditional inflation protection as well as the additional 3% of pay contribution towards building up the Plan’s contingency reserve to Level 5. Simulated future projections show a high 98% probability that the plan will still be fully funded 20 years from now. Quoting from the Annual Report: “Long-term projections show the Plan’s financial health will remain strong for the future–your future”.

Comparing the Two Regulatory Regimes

What would be the implications if the CAAT Plan came under Dutch pension regulation? Approximate answer: the liability discount rate would drop from 5.6% to 2.6%, the funded ratio would drop from 113% into 80% area, and the Plan would have to consider cuts to pensions in pay. Conversely, if a ‘going-concern’ Dutch plan deemed 80% funded by Dutch rules used the Canadian ‘going-concern’ valuation assumptions as per the CAAT Plan, it would be deemed to be 113% funded and pension cuts would not be part of the conversation. What should we make of this confounding situation?

In my view, the answer lies in assessing the relative merits of the solvency and ‘going-concern’ regulatory philosophies. In its extreme Dutch form, passing annual pension plan solvency tests is deemed so important that it is worth subjecting current retirees to actual cuts in their pension payments now, to prevent possible cuts to future retirees in the decades ahead. In contrast, the Canadian ‘going-concern’ rules focus on maintaining long-term ‘no surprises’ plan sustainability with the constraint that no plan participant group is systematically disadvantaged at the expense of another group.ⁱ

A different perspective is to ask how much capital should be used to cover a set of accrued future pension payments. At one extreme, in a pure Pillar 1 ‘pay-go’ system, the answer is zero. At the other extreme, the solvency answer is ‘enough capital to ensure all accrued payment obligations can be met without any further recourse to outside capital in the future’ (i.e., the current reality for Pillar 2 pension plans in the Netherlands). With its suite of ‘sustainability’ tools, the Canadian ‘going-concern’ approach requires materially less capital per dollar of target pension than the Dutch approach (approximately 30% less in the CAAT example). At the same time, arguably, that capital can be deployed with a more entrepreneurial long-term mindset, further lowering the cost of the ‘going-concern’ component of Canada’s Pillar 2 system.    

Should the Dutch Go ‘Going-Concern?’

My short answer is ‘yes’. A longer answer is: ‘yes, ideally directly to the 2-pool model recommended in KVS paper, but after at least giving consideration to whether the Canadian soft DB model has a possible future in the Netherlands as a consensus-based (and hence quicker) road to dealing with the serious problems created by the current hard-core solvency approach’. Testing my ‘longer’ answer out of four Dutch pension experts, all four agreed with the attractiveness of the 2- pool model. However, two of the four has concerns about the relevance of the Canadian soft DB model to the current Dutch situation.

They raised three concerns:    

• Uncertainty: we have no idea what the future return on risk-taking will be, and the ‘going-concern’ assumption is questionable even for many Dutch public sector employers.
• Rent-Seeking: too-high discount rates in US public sector DB plans predictably shift wealth from future plan participants and tax payers to current plan participants. The same thing would likely happen in the Netherlands with moving to a ‘going-concern’ regulatory regime.
• Reset Problem: recalibrating the Dutch Pillar 2 system from a 2.6% to a 5.6% discount rate today would lead to large wealth transfers from the young to the old.

These concerns are not without merit. However, I offer these counterpoints: 

• Uncertainty: yes, the future is uncertain, but we are not totally clueless. For example, on the investment return front, the simple Gordon return model of E(R)=Y+G has done rather well in multi-decade timeframes. As to the ‘going-concern’ prospects of major economic sectors such as public service, education, and health, I am an optimist.
• Rent-Seeking: is a well-documented serious problem in the design and management of many public sector DB plans in the USA. Due to politicization and the absence of regulation, many of these plans are seriously underfunded despite the use of clearly too-optimistic discount rates. In contrast, the Canadian pension model featured here operates in a regulated environment with arms-length pension organizations bound by fiduciary duty to be ‘reasonable’. Is it really impossible to replicate this in the Netherlands?
• Reset Problem: any shift to a new pension model involves solving a point-in-time reset problem. A broad perception of fairness among participants is a necessary pre-condition for any shift to occur (i.e., whether to the 2-pool model recommended in the KVS paper, or to the Canadian soft DB     model).

In Conclusion

The Dutch experience with the solvency approach to pension regulation has shown it to be seriously problematical. The deductively derived best solution is to move to the referenced 2-pool model. However, this Letter offers an alternative to that model for consideration. The Canadian ‘soft DB’ model may not be perfect, but has shown itself capable of generating high participant trust, reducing funded ratio and pension payment volatility, and maintaining focus on implementing, and benefiting from long-term high-return generating strategies.

It is worth a look. 

Keith Ambachtsheer                

Endnotes:

1. For example, CAAT’s tool box to that end includes ‘reasonability’ tests for its economic and demographic experience assumptions, a target balance sheet contingency reserve, stability contributions, an asset smoothing protocol, a 6-step ‘possible/required actions’ list based on the Plan’s funded status, and regular intergenerational fairness testing.

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