Netherlands
compiled by Allianz Global Investors
Pension System Design
The Dutch pension system is designed with a public pay-as-you-go tier, as well as quasi-mandatory occupational and voluntary private pension arrangements. In addition to the PAYG element, the public pension is also partially funded by a reserve fund, the AOW Savings Fund, designed to cope with future demographic challenges. It is financed through tax revenues and expected to grow to EUR 135 billion in 2020 when assets are needed to finance increased public pension expenditures.
The Dutch pension market is the second largest in the EU with funds under management expected to grow at annual rate of 4.5% to EUR 1, 640 billion by 2020. As the Dutch pension market is one of the most mature markets in Europe, growth is mainly driven by performance.
The Dutch pension system, which was shaped to its present form mainly by the thorough pension reforms of the 1980s, is clearly one of the best suited in the world to tackle the demographic challenge. About 90% of the working population is covered by an occupational pension plan. Comprehensive pension reform was brought under way in 2006 and 2007, aiming mainly at further improving the already strong occupational pension system.
Public Pensions
The first pillar is a compulsory insurance plan financed on a pay-as-you-go basis that provides a flat-rate old age pension at the age of 65. The system does not only cover employees in the private sector, but also civil servants and the self-employed. Contributions are paid on income between EUR 13,160 and EUR 29,543 at a rate of 17.9%, which is solely employee-financed. A full old-age pension of EUR 932 is paid to those who have resided for 50 years in the Netherlands between the age 15 and 65. Benefits are adjusted according to changes in the minimum wage and are subject to income tax.
Occupational Pensions
The Dutch 2nd pillar is one the best developed occupational pension systems in Europe with a coverage of not less than 90% of the working population. The value of pension fund assets is well over 100% of GDP.
Although occupational pension provision is generally not mandatory, sector-wide pension plans often stipulate compulsory membership that can be approved by the Ministry of Social Affairs and Employment upon request. 80% of all occupational plan members are covered by mandatory sector-wide pension plans. Hence, the system could be described as quasi-mandatory. Opting-out of sector-wide pension plans is possible in case the employer establishes a company pension plan that provides benefits of at least an equivalent level.
Occupational pension schemes in the Netherlands are still almost entirely defined benefit schemes. But as companies are seeking to control costs and risk, a massive shift from final salary plans to career average plans is taking place. What’s more, the popularity of defined contribution and hybrid schemes is growing.
Employers are required to fund their pension plans externally by using one of the following funding vehicles:
1. Pension funds (company pension funds or industry-wide pension funds
2. Insurance schemes
1. Pension funds
Pension funds can be either company funds or industry-wide funds. The importance of the clearly prevailing industry-wide pension funds is still rising. By the end of 2006 there were 669 company pension funds with approximately 0.8m active participants and 103 industry-wide pension funds with 5m active members. Industry-wide pension funds account for a market share of ~70% of pension fund assets.
A new supervision framework, which is compulsory for Dutch pension funds since January 2007, seeks to make the Dutch retirement system more secure by adopting risk-based solvency requirements.
The newly installed FTK framework (Financieel Toetsingskader) frames rules for the valuation of liabilities of pension funds.
Key areas of the FTK:
- Minimum funding level
Minimum assets must be sufficient to cover 105% of accrued benefits. This risk-based approach requires pension plans to fully fund their nominal liabilities with a solvency buffer of 5%.
- Target funding level
The pension fund must hold sufficient assets to assure a 97.5% probability of remaining above the minimum funding level which requires the average pension fund to be funded at approximately 130%.
- Discount rate
The valuation of pension liabilities at a fixed actuarial discount rate of 4% was replaced by the market interest rate.
Pension schemes that fail to meet these requirements are faced with sanctions, including fines for employers. Underfunded plans have to achieve the minimum funding within one year to avoid the intervention of the DNB (De Nederlandsche Bank). In addition, a recovery plan with a maximum recovery period of 15 years has to be established if the plan fails to achieve the target funding level. According to figures from De Nederlandsche Bank, in the 3rd quarter of 2006 pension funds had an average funding ratio of 102% measured in real terms. The move towards a market-driven interest rate for the valuation of pension liabilities increases the sensitivity on interest rate movements considerably.
Insurance companies are currently exempt from these rules; new regulation will not be implemented until the international agreement on Solvency II regulations is defined.
Tax treatment of contributions and benefits
As long as a qualified pension plan meets the fiscal requirements (e.g. the overall replacement level of 70% of final salary may not be exceeded), employer contributions are not considered taxable income to the employee and employee contributions are also tax deductible.
In a defined benefit plan the level of the pension benefits is based on an annual pension accrual expressed as a percentage of the salary. Most often an accrual rate of 1.75% of the final pensionable salary is used with a maximum service period of 40 years, thus providing a retirement pension of 70-80% of the pensionable pay after a full career. Most employees contribute to a defined benefit plan on the basis of a percentage of their pensionable salary. This percentage usually varies between 4% and 8%. The employer contribution is determined by the funds actuary or the insurer, who calculates the amount that is required in excess of employee contributions and investment returns to provide the benefits promised in the pension plan. For defined contribution plans, employees tend to contribute about one-third of the overall contribution, with two-thirds coming from the employer. The level of contributions depends on a defined contribution scale, which is 2.2% to 12.3% of pensionable income depending on age and if spouses’ pension is included. Benefits are taxed as income upon receipt.
Investment regulation
The Prudent Person Principle is the prevailing investment principle in the Dutch pension market. This means that assets should be invested in a prudent manner. Risk and return should be well balanced with a sound diversification of the portfolio in order to control risks. The only quantitative regulation concerns the investment in shares of the sponsoring company, which is limited to 5%.
Investments of industry-wide pension funds are subject to the same controls as those of company pension funds described above with the exception that investment in the company’s own shares is not possible.
2. Insurance schemes
Smaller companies often provide fully insured pension plans. This can be done by individual insurance contracts or by group insurance contracts. Group annuity contracts are commonly used to fund benefits for pensioners. These contracts also often provide pre-retirement death and disability benefits.
Tax treatment of contributions and benefits
The tax treatment of contributions and benefits is the same as for pension funds.
Pre-pension schemes
On January 1, 2006 the tax treatment of pre-pension schemes has changed. The reform abolished the tax relief for schemes focusing on early retirement and aimed at phasing out pre-retirement schemes to increase the elderly participation rate. As a result of this step these schemes have largely terminated their operation. In return, the ERLC Act established life-course arrangements, offering the possibility to save money or time for paid leave later in life, which could also be used to finance early retirement without having officially been retired in terms of the social security.
Most of the existing large pension funds currently make use of the range of options the legislator provides to stimulate the accumulation of pension assets, which can be traded for an early retirement. Achieving higher retirement benefits, higher accumulated assets respectively, requires either raising accrual rates or broadening the earnings base for levying contributions. The legislator offers two instruments within certain limits. For average pay schemes the Wage Tax Act limits the annual accrual rate to a maximum of 2.25% and for final pay schemes to 2%. The part of the earnings that is not subject to contributions is called offset. A lower offset and higher accrual rates lead to higher retirement pension contributions, but it is not permitted to combine the lowest possible offset with the highest accrual rate.
Outlook
In the course of the implementation of the new financial assessment framework FTK, pension funds will revisit their investment strategy in favour of a more widespread use of asset liability management, i.e. the matching of invested assets to the cash flow of the liabilities. The demand for long-duration bonds is assumed to increase in the long term. The move towards a market-driven interest rate for the valuation of pension liabilities increases the sensitivity on interest rate movements considerably.