Almost every person in the Dutch population will agree: The pension subject is unclear, incomprehensible and complex. Another complexity has arisen as of this year which makes it even more difficult for the average Dutch (wo)man. A new law came into effect as of September 2016: the law improved premium system (“Wet verbeterde premieregeling”, Staatsblad van het Koninkrijk der Nederlanden, jaargang 2016, 248). This law seeks to improve the pension benefits in premium systems – known as defined contribution (DC) – to a next level.
Pension capital which is available for the individual at retirement date used to be converted into a fixed pension benefit before this new law came into effect. Now the individual has the option to convert the pension capital to a variable pension benefit and can then yield extra benefits from sharing specific technical profits or may benefit from elongated returns on capital. The variable pension benefits can also decrease when profits go downhill, which make the actual benefit amounts less certain. Spreading techniques have been included for profit sharing to nuance the applicable shocks a little.
Individuals close to retirement will need to decide whether they want stable benefit payments or if they would go for changing benefits, with the possibility of increases. Since the pensions are already an enigma, it will surely be no easy task for an individual to make such a major decision. An investigation is made for a number of options to see if it can help the individual to make an educated guess.
The variable pensions have been introduced at the end of last year and a few possibilities can currently be found on the market such as advanced conversions and postponed conversions.
At age 57 a part of the available pension capital will be converted into benefits for the individual. This conversion will be performed annually until retirement date where the remaining capital will flow into the pension benefits.
An individual may decide to enter into the possibility for advanced conversions any time starting before age 57 till retirement age. When the individual would opt for advanced conversion at retirement age, only one conversion will take place: at retirement date.
When the individual does decide for the advanced conversion, he will get the opportunity to a fixed decrease or increase of the benefits on an annual basis. The individual may also opt out of these fixed indexations.
The benefits of the individual will be aggregated onto collective level where risks will be shared on an annual basis between the individuals in that specific collective level. These collective risks will not be taken into account in full immediately but will be spread over the coming 5 years. This risk sharing starts as soon as the first variable pensions have been converted and ends at the death of the individual for old age pension. For partner pension it will end at the death of the partner.
With these advanced conversions, the pension fund will be able to keep the coverage ratio at an even level, for instance at 100%. The pension system will then become self-sustaining, no money flows in or out.
This option resembles the pension cut of 2015 (“Pensioenknip”, Handreiking tijdelijke pensioenknip 2015) where the conversion of the pension capital to benefits was cut in two terms. The first term was at retirement date which yielded a temporary benefit of 2 years and the second was within 2 years after retirement, resulting in a lifelong benefit.
The postponed conversions will be split into five annual terms which start at retirement date. At retirement date a temporary pension benefit is determined for a maximum of one year which is deducted from the pension capital as well as a risk premium for partner pension. This temporary benefit is determined as the lifelong benefit which can be converted from the current pension capital. Each year a new temporary benefit will be determined from the remaining pension capital based on the current rates. The final benefit will be determined 5 years after retirement and will be a lifelong payment.
The invested pension capital will be available for five more years with this option and the life cycles for investing will need to be prolonged for the individual. This prolonged investing is known in Dutch as “Doorbeleggen” and results in variable pensions for the individual for the first five years.
With the new law the individual is given a choice to opt either for fixed or variable pension benefits. If the pension provider does not give the option for one, the individual will have the right to shop the other option at another pension provider. When the individual decides to participate in the variable pension plan of the pension provider, he or she can only follow the existing pension plan.
The options as described above are deemed to have an effect on the pension benefits. An individual will want to see the effects on the benefits to decide which option would be for his best interest. The question arises if it the effect would be that obvious to help the individual with choosing the best option.
In order to see the effects on pension benefits and to get a better understanding of the different options, the effect for a reference person for four different variants has been investigated:
- Variant 1: A regular DC scheme;
- Variant 2: Advanced conversion;
- Variant 3: Postponed conversion;
- Variant 4: Pension cut 2015.
An individual can either choose between variants 1 and 2, variants 1 and 3 or variants 1 and 4. The investigation will thus only focus on these options.
It is important to know that variant 2 is only possible for individuals which participate in a pension plan which includes advanced conversions and variant 4 is available due to legislation.
The reference person is currently 55 years young and male. The current pensionable salary is € 60,000 and a capital of € 80,000 has been transferred from a previous employment.
The most recent mortality tables as supplied by the Actuarial Society (“Actuarieel Genootschap”) have been used.
For each option, it is assumed that the offset is € 16,000 and the maximum salary is € 80,000. The premium is based on the premium percentage table for old age pension and deferred accrued partner pension with a 3% rate.
No fixed increases or decreases of pension benefits after retirement have been taken into account. Risk sharing has been taken into account using a simple method. A single lifecycle has been used which has been extended to age 72. Costs are disregarded.
1,000 scenarios have been taken into account for interest rates, returns, risk sharing and price and wage inflations. The pension benefits have been determined for the ages 67 to 72 for each scenario and each variant. The results are shown in the figure below.
Figure 1 Expected pension benefits for different ages and different variants
The benefits of the regular DC scheme, variant 1, behave as expected: they remain unchanged throughout the years.
At a first glance, the advanced conversion results in lower benefits than the regular DC scheme and the spread is much smaller. The expected indexations have an increasing effect on the benefits on the long term still. The benefits in variant 1 will always remain the same and the advanced conversion benefits might increase a lot over the years when other individuals on the same collective level pass away.
The benefits which result after the postponed conversions start with the same benefits as for variant 1 and increase over time. After the fifth year the benefits remain fixed and deliver higher amounts than the regular DC scheme. Spreads for postponed conversions are visibly increased.
Variant 4 shows an increase in benefits after two years. The spread has increased somewhat compared to the regular DC scheme. At a first glance, the difference between the two variants is not all that high.
Will the differences between the variants in figure 1 help the individual to make a wise decision on his benefits? Most likely not, since it shows little information on the benefit amounts which an individual would most likely receive.
The following figure shows the same results in a different form which might better suit the individual. This particular person could expect a benefit around € 20,000 a year for each variant. For the advanced conversions the expected benefit is sliding to the next amount at a very slow pace.
Figure 2 Number of scenarios per benefit amount range per age
These differences in figure 2 also do not show a major effect on the expected benefits. Then how would it be wise to change from a fixed benefit to a variable benefit and vice versa?
This all depends on the current situation of the individual and the anticipated situation after retirement. With this picture in mind, the individual may decide that it would make more sense to have the stability of a fixed benefit amount and opts for the regular DC scheme or he would prefer to have increasing benefits to accommodate planned future expenses such as travelling.
What would make sense?
What should an individual do to make that educated guess? First he needs to examine his expected income and expenses after retirement. Taxes will be lower after the state funded AOW takes effect so the expenses will decrease. The individual might have accrued pension during previous employments which will all have to be taken into the total financial picture, which will increase the income.
New style pension planners nowadays take these expenses and pensions insured elsewhere into account to determine best estimates, and pessimistic and optimistic scenarios. These scenarios mostly include the existing pension plans and not necessarily other plans. The individual would need to seek help from professionals to be able to understand what they can expect from either option.
For the advanced conversion the individual will need to make that educated guess at an age of 57 already, which makes it even harder since it is still 10 years before retirement. So many unforeseen things can happen in the future. Since people tend to postpone major pension decisions till the end, it will be new to have to make an early decision like this.
What did the new legislation bring?
The law improved premium system tends to bring slightly better pension benefits on the one hand and on the other hand more need for information for the individuals. The pension remains hard to understand and explain for the common Dutch (wo)man. Where people nowadays have more options for a better pension, they will need to get informed way ahead of their retirement.
This article is written by Susanne Mallmann, actuary AG at msg global solutions Benelux