Costs and Benefits of Collective Pension Systems

Costs and Benefits of Collective Pension Systems O. W. Steenbeek S. G. van der Lecq (Editors) Costs and Benefits of ...

Author: Onno W. Steenbeek | S. G. Fieke van der Lecq

27 downloads 1239 Views 4MB Size Report

This content was uploaded by our users and we assume good faith they have the permission to share this book. If you own the copyright to this book and it is wrongfully on our website, we offer a simple DMCA procedure to remove your content from our site. Start by pressing the button below!
Report copyright / DMCA form

DOWNLOAD PDF

Costs and Benefits of Collective Pension Systems

O. W. Steenbeek S. G. van der Lecq (Editors)

Costs and Benefits of Collective Pension Systems

With 24 Figures and 28 Tables

123

[email protected]

[email protected]

Dr. Onno Steenbeek is financial economist Dr. Fieke van der Lecq is economist Both editors are affiliated with the Erasmus University Rotterdam, The Netherlands

Library of Congress Control Number: 2007933404

ISBN 978-3-540-74373-6 Springer Berlin Heidelberg New York This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. Springer is a part of Springer Science+Business Media springer.com © Springer-Verlag Berlin Heidelberg 2007 The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Production: LE-TEX Jelonek, Schmidt & Vöckler GbR, Leipzig Cover-design: WMX Design GmbH, Heidelberg SPIN 12111558

134/3180YL - 5 4 3 2 1 0

Printed on acid-free paper

Preface

In January 2006, the Dutch Association of Industry-wide Pension Funds (VB) told us about their plan to prepare a book on solidarity in collective pension systems. We were intrigued by this topic, both because of our interest in the pension sector and because of the connection with solidarity in a cost-benefit approach. After some discussions with VB director Peter Borgdorff, we decided to start a project with leading scholars and practitioners, which was to result in a book. We hoped that the researchers could investigate the extent of value transfers within collective pension funds, so that quantitative indications of this institutionalized solidarity would become publicly available. While the book was in progress, the discussion on solidarity and mandatory pension systems became very topical, and so were the results of the analyses. When the book was released in Dutch1, the chapter on costs differentials between pension funds and insurance companies also drew much attention. In the early months of 2007, the political and professional debates continued, with increasing attention from pension experts from abroad. This made us decide to try and arrange a translated version of the book. We were happy to find Springer Verlag, and collaborate with their enthusiastic publisher Dr. Niels Peter Thomas. We are also grateful to the Pension Science Trust (Stichting Pensioenwetenschap) for subsidizing the translation by Language Lab, and to the earlier mentioned VB for their generous collaboration in getting the international edition released. Now, the international pension sector colleagues can also profit from this assessment of the Dutch second pillar pension system. The Dutch pension sector has much to offer in terms of expertise and institutional experience, as the various distinguished authors in this volume show. The debate on collective pension funds remains fierce, both in the Netherlands and elsewhere. Nearly everyone has a stake in it, and a tremendous amount of money is involved. Those with established interests defend the 1

S.G. van der Lecq and O.W. Steenbeek, 2006, ‘Kosten en baten van collectieve pensioensystemen’, Deventer: Kluwer publishers.

VI

Preface

system, while relatively new stakeholders sometimes criticize it. Our aim is not to settle the debate, nor to present our own opinion about the matter. Instead, we set up the book as a collection of facts and arguments, so that the reader can form his/her own opinion, for instance on the dilemma’s in the concluding chapter. May evidence, solid arguments and wisdom prevail. Rotterdam, July 2007

Onno Steenbeek and Fieke van der Lecq

Executive summary

This volume takes stock of the costs and benefits of collective pension systems. The concept of solidarity between participants is key. Which groups show solidarity with which other groups, and how much money is involved? Part 1 concentrates on the question as to which aspects of solidarity are relevant with respect to collective pension funds. Several groups show solidarity with each other, such as the old and the young, men and women, healthy and ill participants, et cetera. Solidarity amongst these groups is also present in health care insurance, and this solidarity is compared to that of the second pillar collective pension systems. In part 2, several aspects of collective pension arrangements are quantitatively assessed. It turns out that the costs of execution of pension agreements differ substantially between different types of pension systems. The cost differences between the average collective pension arrangement on the one hand and executed by insurance companies on the other hand are very large, but differences among collective systems can be significant as well. Solidarity is about distribution: who receives the benefits of collective systems and who pays the costs? Costs and benefits are not shared equally and tentative calculations present an impression on these redistributive effects. They indicate that particular forms of solidarity bring about substantial ex ante value transfers between groups of participants. The value transfers between generations are largest. Part 3 discusses the mandatory participation by companies and individuals, and explores what would happen if participation would no longer be mandatory. As for individuals, experience from abroad indicates that people who are not obliged to participate in a pension scheme, tend to save too little, invest their savings poorly and cash out whenever they get the chance. The mandatory participation by companies in industry wide pension funds – whenever possible – has resulted in a reduction of ‘blank spots’. It has also prevented firms from competing on the labour market via their pension contributions. Collective pension agreements provide substantial advantages above individual pension plans. The execution costs are much lower, and risk

VIII

Executive summary

sharing within and across generations improves the average result to the participants. However, the benefits are not distributed evenly among individual participants. This brings about distortions on the labour market, which also imply costs. Still, on the macro level the benefits of collective systems exceed their costs.

Table of contents

1

Introduction ...................................................................................... 1 S.G. van der Lecq and O.W. Steenbeek

Part 1. The concept of solidarity 2

Solidarities in collective pension schemes ............................... 13 J.B. Kuné

3

Solidarity: who cares? ................................................................... 33 P.P.T. Jeurissen and F.B.M. Sanders

Part 2. Quantifying solidarity 4

Operating costs of pension schemes .......................................... 51 J.A. Bikker and J. de Dreu

5

Optimal risk-sharing in private and collective pension contracts........................................................................................... 75 C.G.E. Boender, A.L. Bovenberg, S. van Hoogdalem, and Th.E. Nijman

6

Intergenerational value transfers within an industrywide pension fund – a value-based ALM analysis ................. 95 R.P.M.M. Hoevenaars and E.H.M. Ponds

7

Intergenerational solidarity in the uniform contribution and accrual system....................................................................... 119 T.A.H. Boeijen, C. Jansen, C.E. Kortleve, and J.H. Tamerus

X

8

Table of contents

Everyone gains, but some more than others........................... 137 K. Aarssen and B.J. Kuipers

Part 3. Mandatory participation 9

Why mandatory retirement saving? .......................................... 159 P.J.A. van Els, M.C.J. van Rooij, and M.E.J. Schuit

10 Mandatory participation for companies.................................. 187 P.H. Omtzigt

Part 4. Conclusion 11 Macroeconomic aspects of intergenerational solidarity....... 205 J.P.M. Bonenkamp, M.E.A.J. van de Ven, and E.W.M.T. Westerhout

12 Summary and conclusions ......................................................... 227 S.G. van der Lecq and O.W. Steenbeek

About the authors................................................................................ 237 Subject Index........................................................................................ 243

1

Introduction

S.G. van der Lecq and O.W. Steenbeek Employee solidarity is central to the second pillar of the Dutch pension system. This solidarity is given shape in collective schemes implemented by industrywide, company and professional group pension funds. The present book sets out to explain how solidarity works within collective pension schemes and to answer the questions: what groups participate in the solidarity mechanism and what are the financial stakes for each group? After reading this book the reader will be in a better position to form his own opinion as to whether the current collective pension system is desirable or not. The concept of solidarity looms large in the public debate on pensions, particularly now that the funding of old-age provisions is under pressure. Solidarity is a complex issue, however, and gives rise to many questions. First of all: what groups are expected or required to show solidarity to what other groups? Secondly: how must that solidarity be organised? Answering these two questions is the purpose of this book. In many developed economies, solidarity in pensions is institutionalised through a state pension system in the first pillar and supplementary collective pension schemes in the second pillar. First pillar systems are often a general statutory scheme funded by contributions from the overwhelming majority of the population, so in this case mutual solidarity is virtually universal. This system of universal solidarity is not the subject of the present book, however. Our focus here is on the supplementary collective pension schemes that form part of remuneration packages. Each collective pension scheme makes its own choices, where some participants are perceived to benefit more than others. This inequality in the distribution of costs and benefits is one reason why opinions are divided as to the desirability of maintaining and/or modifying the collective pension systems. This book seeks to provide a firm foundation for that debate by putting the costs and benefits of collective pension systems into clear focus. These costs and benefits are quantified where possible.

2

1.1

S.G. van der Lecq and O.W. Steenbeek

Backgrounds to this book

This is not the first time that the costs and benefits of collective pension systems have come under scrutiny. An earlier study by the WRR (Scientific Council for Government Policy) also compared the costs of solidarity within a pension fund (i.e. the value transfers between participants and disruptive effects in the labour market) with the benefits of collectivity (risk-sharing and economies of scale). In addition, a comparison was drawn between the cost-benefit ratio of collective schemes and that of individual pension schemes (Boender et al., 2000). Both the quoted study and another WRR report calculated that collective pension funds lead to a substantial increase in wealth, benefiting the total economy (Jansweijer et al., 2001). The present book can in a certain sense be seen as an update of the WRR studies in the light of the current debate about solidarity in the Dutch pension system. It also digresses on the several subgroups within the population of active participants and pensioners, to provide an insight into the value transfers between these subgroups. Put simply: who pays and who gains? Another relevant aspect in the framework of this book is the debate surrounding the transition from defined benefit system to defined contribution schemes. This is a particularly interesting development given that the latter system is much more individualized and therefore has a much smaller solidarity component. The answer to the question as to whether the benefits of a different system outweigh its costs will thus decide the future direction of the pension sector. Leaving aside the actual design of the system, the very principle of solidarity in the field of pensions is under pressure. Two causes for this can be identified. First of all, ageing is making heavy demands on the younger generations, also in relation to supplementary pension provisions. One example of this in the Netherlands concerns the transition arrangement for the abolition of early retirement and the phasing out of the pre-retirement pension, where the younger generations of employees are expected to foot part of the bill. They are up in arms over this issue, partly because they themselves will never enjoy the benefits of such schemes (Roscam Abbing et al., 2005). This critical attitude of young people is reinforced by the advent of the transitional labour market. Lifelong salaried employment is now a thing of the past, which means that pension fund participation is also becoming intermittent – with potentially dire consequences for pension accrual rates (Muffels et al., 2004). Some initiatives are already being taken in the Netherlands to counter this threat. One such step concerns the creation of a special ‘open’ pension fund for self-employed persons by the

1 Introduction

3

AVV, a dedicated union for the self-employed and freelancers. The AVV happens to have a relatively high proportion of young members – which is precisely the group of people currently contending with the flexible labour market where there is the constant threat of losing pension rights due to changing jobs. To sum up: those who are being hit in their pockets by the changing labour landscape are simultaneously expected to show solidarity with the ageing population. A second reason as to why solidarity is under fire can be found in the growing availability of information on this issue. Pensions are now headline news. The drive for a future-proof pension system has become the subject of public debate and the widespread dissemination and sharing of information is giving people a better understanding of the pension system, including its built-in solidarity mechanisms. There is an inherent danger in this process. If, for instance, such information feeds fears of eroding solidarity and the subsequent collapse of the entire system, a self-reinforcing process may be set in motion (De Beer, 2005). Nevertheless the authors of this collection of essays believe that information is far preferable to ignorance – for only an informed debate can put the choices of the past and the choices for the future in clear perspective. The following chapters will provide examples of this through the quantitative elaboration of some central solidarity issues. Facts are the building blocks of an informed opinion. So to help the reader form, substantiate or modify an opinion on the current debate, our first step will be to provide clear definitions of the central concepts of solidarity and collectivity. Next, we will outline the design of the book and indicate the close interrelationship between the issues raised in the various chapters.

Solidarity The term “solidarity” is used widely in this book, for different aspects of collective pension arrangements. The most important distinction is between types of solidarity that are mutually beneficial and those that are not. The first type is identical to an insurance contract: when a participant in the pool suffers a damage, the other policy holders will compensate the loss. This is usually “risk sharing”, which is an important element of all collective arrangements. Less obvious is “one-sided solidarity”, which refers to elements in collective pension arrangements where it is clear ex ante who will subsidize whom. For example, in current collective pension systems, value is transferred from young participants to old participants. The term “value transfers” is usually applied to these elements of collective pension arrangements.

4


1.2

How are solidarity and collectivity related?

SOLIDARITY De Beer defines solidarity as ‘a positive sense of shared fate: the fate of one person is positively bound up with the behaviour of the other. A person shows solidarity if his behaviour benefits the other.’ (De Beer, 2005, page 56) This, however, is a very broad definition which could also cover all sorts of gifts, for instance. The same applies to his description of solidaritybased behaviour as ‘every form of behaviour that deliberately benefits the other, without immediately requiring a benefit in return.’ (De Beer, 2005, page 55). The addition of the terms ‘deliberately’ and ‘immediately’ point in the direction of a further narrowing down. The term ‘deliberately’ suggests that solidarity can be an aim in itself: the action is consciously designed to benefit the other. No immediate benefit in return is expected, which is the big difference between solidarity and a barter transaction. This is borne out by another definition of solidarity as ‘a positive sense of shared fate between individuals or groups. That is, a situation where social relationships centre on the stronger helping the weaker or on promoting the communal interest’ where the term ‘help’ is used (Van Oorschot, 1997, quoted in Beltzer and Biezeveld, 2004, page 41).

DIMENSIONS IN SOLIDARITY To classify different forms of solidarity, two dimensions are distinguished (De Beer, 2005, pp. 56-58): • obligatory and voluntary solidarity; • one-sided and two-sided solidarity. Voluntary solidarity can be informal and unorganised. This form is also known as warm solidarity. Examples are caring for family and donating to charity. Sometimes this solidarity is one-sided, e.g. towards children, and sometimes two-sided, e.g. between friends. Voluntary solidarity can also be institutionalised, and is then known as cold solidarity. Another, probably better known term for cold or voluntary solidarity is “risk sharing”, where it is not clear in advance who is the recipient and who is the payer. This then is two-sided. An example concerns private insurance. One-sided institutionalised solidarity can be found in tax-funded social security services where the payers and the beneficiaries are known in advance. The various forms of solidarity are worked out in greater detail in the first chapters of this book and return in the final conclusions.

1 Introduction

5

Empirical research shows that one-sided solidarity is retreating while two-sided solidarity is advancing (De Beer, 2005, pp. 61-70). Particularly institutionalised (cold) one-sided solidarity is decreasing in terms of the share of gross domestic product allocated to it. Informal (warm) one-sided and two-sided solidarity are more or less stable1. Remarkably, institutionalised (cold) two-sided solidarity is on the increase. This suggests that people are becoming more calculating in their behaviour and want to guarantee that their solidarity is returned in equal measure by means of formal arrangements. Solidarity thus takes on the nature of an insurance policy. With pensions, as with insurance, people want to know what the costs and benefits are.

RISK SOLIDARITY AND SUBSIDISING SOLIDARITY With pensions a distinction can be made between risk solidarity and subsidising solidarity. The latter is ex ante, i.e. it is clear in advance who shows solidarity to whom. The former is ex post, i.e. this only becomes clear retrospectively. Risk solidarity or risk sharing involves a pooling of risks, such as with fire insurance. Risks are thus effectively shared, as is the case with collectivities. As a result, the communal premiums paid are sufficient to cover the communal risk whereas the individual premium would nowhere near cover the costs of the individual risk should that risk actually materialise. In the pension system the investment risk is borne collectively, so that on balance more investment risk can be taken than if each participant were to try to optimise their investments individually. Subsidising solidarity involves value transfers, where no attempt is made to exactly match the individual premium with the individual risk. As a result, good risks offset bad risks, such as between employed and retired people, men and women and the sick and the healthy. In these cases it is clear in advance that value will flow from one group to the other. Subsidising solidarity goes beyond the sharing of risks that is inherent in collectivity-based risk solidarity. For this reason, subsidising solidarity is often seen as ‘real’ solidarity. Pension funds combine both types of solidarity, while insurers specialise in risk solidarity. 1

Note that there is no question of ‘warm’ solidarity being substituted by ‘cold’ solidarity. So there is no question of an analogy with the substitution of intrinsic motivation by extrinsic motivation (Frey, 1997). Warm solidarity remains as much in evidence as ever.

6


Different authors define and classify solidarity in different ways. So the above definition and classification need not correspond exactly with those used in the following chapters.2

DEVELOPMENTS The advantages of collectivity or risk solidarity are, by their very nature, not open to question. However, the desirable scale of such collectivity arrangements within society is currently the subject of intense study and debate, also in this book. Regarding the risk solidarity encapsulated in institutional arrangements, we noted earlier that the one-sided variant is retreating in favour of the two-sided variant. People are prepared to show solidarity to those in need, provided the favour is returned when they themselves require assistance. This can only be guaranteed through agreements that lay down clear rights and obligations. Basically, people’s deep-felt need for formal solidarity arrangements reflects uncertainty over the future rather than a fundamental lack of solidarity as such. This is consistent with the finding that warm solidarity, which manifests itself informally both in one- and two-sided relations, is not decreasing. In fact, security provided by institutional arrangements may actually serve to facilitate and encourage informal acts of solidarity: “Voluntary, spontaneous solidarity and enforced organised solidarity are therefore not substitutes but largely complementary”(De Beer, 2005).

SOLIDARITY IN PENSIONS Within the pension sector mandatory solidarity takes shape via the collectivity. Within this collectivity, value is transferred from certain groups of participants to other groups of participants, e.g.: • from employees to retirees and inactives; • from young to old;

2

In the insurance industry, the term ‘risk’ is used differently from the pension sector, for instance with respect to subsidies from ‘bad’ to ‘good’ risks. Here, the term risk refers to people who run a particular risk to a greater or lesser extent. These people with different risk profiles show solidarity towards one another, thus giving rise to the term risk solidarity. In the context of pension funds, by contrast, risk solidarity is equated with risk sharing because economists operationalise the term risk on the basis of distribution of probabilities.

1 Introduction

7

• from employees to early retirees; • from men to women; • from those who die young to those who live long • from singles to married persons (in the case of mandatory surviving dependant’s pension); • from healthy to unhealthy (in the case of non-contributory pension accrual during disability); • from employed to unemployed (if pension accrual continues during unemployment); • from businesses to businesses (different numbers of pension members). Not all forms of solidarity occur at each pension fund to the same degree. Each pension scheme has its own solidarity profile. This book deals with solidarity between some of the groups mentioned above. Intergenerational solidarity is currently one of the central issues and is therefore particularly highlighted, drawing on recent data and new computational models.

1.3

Structure of the book

The first part of this book explores the concepts of solidarity and collectivity. Chapter 2 elaborates these in the context of the pension sector, while chapter 3 compares solidarity and collectivity in the pension sector with the health sector. The second part of the book looks at the costs and benefits of solidarity in collective pension systems on the basis of qualitative and quantitative analysis. Chapter 4 dissects the costs of pension funds and pension insurers, thus highlighting the efficiency differences between collective systems mutually as well as between collective and individual pension schemes. Chapter 5 answers the same question for the investment policy of the pension funds, revealing that collective schemes also yield better investment returns than individually tailored schemes. Chapter 6 views the generations separately, making it clear to what extent solidarity exists between young and old and indicating the effects of specific policy adjustments within existing schemes. Chapter 7 centres on the use of the uniform contribution to promote solidarity and indicates the costs and benefits of this instrument. Chapter 8 homes in on solidarity from the perspective of the

8


individual. On the basis of a number of representative participants it shows in what situations an individual is a net contributor or net beneficiary of the solidarity arrangements in the current pension system. Collectivity in the pension system is assured through the mandatory participation of the individual (Chapter 9). In addition, many sectors operate mandatory industry pension schemes for affiliated employers (Chapter 10). Both types of mandatory participation are discussed in terms of costs and benefits in the third part of this collection of essays. The various analyses of the way in which solidarity is given shape in the collective pension system are evaluated in the final part of the book. This takes place in Chapter 11, where the analyses are discussed from a macro-economic perspective. Chapter 12 contains a summary as well as conclusions. The bulk of the material in this book is new. More important than that, however, is the thematic coherence between the chapters, which should allow the reader to form a well-founded opinion on the costs and benefits of solidarity in collective pension schemes.

Literature Beer, P.T. de, 'Hoe solidair is de Nederlander nog?, in: E. de Jong en M. Buijsen (ed.), Solidariteit onder druk?, Nijmegen: Valkhof Pers, 2005, pp. 54-79. Beltzer, R. and R. Biezeveld, De pensioenvoorziening als bindmiddel, Amsterdam: Aksant, 2004. Boender, C.G.E., S. van Hoogdalem, E. van Lochem and R.M.A. Jansweijer, ‘Intergenerationele solidariteit en individualiteit in de tweede pensioenpijler: Een scenario-analyse’, WRR (Scientific Council for Government Policy) report, 114, The Hague: WRR, 2000. Frey, B., Not just for the money; An economic theory of personal motivation, Cheltenham: Edward Elgar, 1997. Jansweijer, R.M.A and A.J.C.M. Winde (ed.), Intergenerationele solidariteit en individualiteit in de tweede pensioenpijler: een conferentieverslag, work document 116, The Hague: WRR (Scientific Council for Government Policy), 2001. Muffels, R., P. Eser, J. van Ours, J. Schippers and T. Wilthagen, De transitionele arbeidsmarkt. Naar een nieuwe sociale en economische dynamiek, Tilburg: OSA, December 2004.

1 Introduction

9

Roscam Abbing, M., and many others, FNV is niet solidair met jonge ambtenaren, De Volkskrant, 18 July 2005, in: G.M.M. Gelauff et al. (ed.), KVS Jaarboek 2005/2006, The Hague: Sdu uitgevers, 2006, pp. 21-22. WRR, Generatiebewust beleid, particularly chapter 6: Intergenerationele risicobeheersing in de pensioensfeer, WRR (Scientific Council for Government Policy) Report 55, The Hague, 1999.

Part 1. The concept of solidarity

2

Solidarities in collective pension schemes

J.B. Kuné1 This opening contribution to the book Costs and Benefits of Collective Pension Systems, an initiative of the Association of Industry-Wide Pension Funds and the Erasmus University of Rotterdam, first discusses a number of general solidarity aspects. Next it deals with more specific issues that have an important bearing on the pension sector. The collective pension system draws its strength and justification from collectiveity and solidarity. The conditions required to ensure broad-based consensus and acceptance must therefore be fulfilled at all times. Hence, the question arises what forms and degree of solidarity are desirable. Where does undesirable solidarity start? The outcomes will differ from one fund to the other and will also vary over time. In the past few years pension funds have made important progress in introducing pension contracts. These contracts specify the relationship between the fund’s financial position on the one hand and its contribution policy and indexation of accrued pension rights (of retirees and workers) on the other. In the coming years further arrangements will be made regarding diverse types of income and value transfers, also known as solidarities. Numerous questions arise waiting for an answer. Some tentative recommendations are made for the way forward.

2.1

Solidarity and social cohesion

The notion of solidarity is closely intertwined with the creation and evolution of the national welfare state. Solidarity appears in many guises. Where the principle of reciprocity plays an essential role, we speak of horizontal solidarity (Teulings, 1985: 48-73). This involves (homogeneous) groups of people making mutual rather than individual arrangements in order to gain cost and other efficiencies. A certain equality among the 1

This article was written in a personal capacity.

14

J.B. Kuné

participants is an important condition for realising such a contract. Solidarity with the group thus implies exclusion of others. On the opposite side of the spectrum we find vertical solidarity, which is not predominantly based on reciprocity and self-interest. The Dutch welfare state is a good example. Here, the better-off surrendered part of their wealth to assist more vulnerable groups, usually with a view to protecting society by avoiding social unrest and crime, and promoting public order, health and housing. The nation state plays a crucial role in this vertical solidarity by extracting donations from the population. Given this coercive element, one could say that the concept of enforced solidarity contains an internal contradiction. In this case too, outsiders must be excluded so that the nation can provide welfare to its vulnerable citizens. A sense of shared community, values and identity is necessary to legitimise this solidarity (Van Oorschot, 1997: 162-174). Vertical solidarity thus functions within the borders of the nation state as the moral cement of society. The AOW state pension is a prime example of this in the Netherlands. The survival of this system depends largely on sustained and stable consensus within society. Without this consensual acceptance, the state pension would lose its ‘equal rights for all’ character and, like supplementary pension schemes, become dependent on the individual’s employment and salary history (Kuné, 2004). The more extreme form of solidarity, based largely on the compassion of one human being for another, is less important in value transfer terms and is also more tenuous in nature. For instance, an immigration society characterised by increasingly heterogeneous population groups will find it also increasingly more difficult to continue allocating all conceivable rights to everyone residing within the territory of the nation (Entzinger and Engbersen, 2004: 41-55). As noted, solidarity draws its lifeblood from a shared sense of identity. It presumes affinity with an in-group whose members have a common history and heritage and are therefore worth a sacrifice. It follows that there is an out-group for whom the community is less willing, or even totally unwilling, to make a sacrifice. Solidarity thus always has its limits. It can be extended, but not infinitely. Beyond a certain level, solidarity becomes subject to various conditions. In the ethnically diverse United States, for instance, there is clearly less solidarity than in European countries with more homogeneous populations.

SOCIAL COHESION Various studies reveal a picture of fairly stable solidarity (in attitude and behaviour) in the Netherlands (Beltzer and Biezeveld, 2004; De Beer, 2006). However, western societies are set to become more heterogeneous in the

2 Solidarities in collective pension schemes

15

coming century. We therefore foresee more segregation along ethnocultural lines, with a growing number of smaller homogeneous subpopulations whose main allegiance is to their own circle. Fault lines are thus more likely to arise between socio-economic classes and ethnic groups than between generations. In a society where there is less cohesion and hence less support for all sorts of solidarity, increasingly more but smaller homogeneous groups will emerge. These, in turn, will build up their own internal solidarity structures based on common values and interests. Pensions is one area where this development will come to the fore. An additional factor is that the advent of genetic identification will provide yet another means of demarcating a larger number of small, more homogeneous groups. This may further reduce the appetite for society-wide solidarity, with individuals who do not match the group DNA simply being excluded. Thus, genetic similarity – together with more traditional criteria such as membership of a certain industry, company, professional group or social class – can also serve as a basis for defining specific groups of people who are willing to insure certain risks. These circumstances will induce a shift towards smaller collectivities (Aarts and De Jong, 1999). Income is already widely used as a differentiation criterion, where identifiable groups of people whose earnings exceed a defined threshold start their own supplementary pension schemes based on cost-price funding. Below this income threshold, everyone continues to participate in the same collective scheme. After these introductory observations, let us return to the real subject of this chapter: solidarities within supplementary pension schemes. It’s worth noting, incidentally, that the terms ‘risk-sharing’ and ‘risk-sharing arrangements’ are increasingly being used to denote situations which actually involve a transfer of funds or solidarity from one generation to the other or from one group of participants to another group. The next section describes several aspects of solidarity in the supplementary pension system. Section 2.3 then tentatively formulates some principles providing a basis for making a distinction between desirable and undesirable forms of solidarity. As will be clear, these principles are to some extent personally coloured. The appendix finally provides a summary of the different types of solidarity present in supplementary pension schemes.

2.2

Income and value transfers

This section casts light on some aspects of the types of income and value transfers occurring within the supplementary pension system. These transfers are also known as solidarities.

16

J.B. Kuné

THREEFOLD DISTRIBUTION MECHANISM A pension system realises a threefold distribution of funds: two are simultaneous and one is sequential. The pension system thus acts as a threefold distribution mechanism. At macro-level the pension system ensures a (simultaneous) distribution of funds between older and younger generations in each time period. The distribution mechanism depends on the applied method of funding: pay-asyou-go, funded or any combination of the two. With pay-as-you-go financing, the pensions are paid out of the earned income of the working population, while with a funded system the pension income is obtained from the accumulated pension assets. At a micro-level the pension system realises a (sequential) distribution of funds over the active and post-active period of a person’s life. The distribution mechanism exclusively concerns the financing via the funded system. The ownership of pension capital, accumulated during the active period, provides the individual during his post-active period with an economic claim on national product or a claim on production of foreign countries if the pension assets have been (wholly or partly) invested there. In the words of the WRR (Scientific Council for Government Policy) ‘… To slightly overstate the case, this (dissaving in the post-active phase) effectively entails that the future generations of young people dedicate themselves to labour-intensive caring for the elderly and are rewarded for this with cars, computers, video recorders and so on that are imported from Asia (and paid for with the aforementioned dissavings).’ (WRR, 2000: 109). At an intermediate or meso-level, the Dutch pension system encompasses numerous redistribution mechanisms which lead in each time period to (simultaneous) income transfers (in different directions) between all those belonging to the same age group or generation. Most of these value transfers are found in the first pillar state pension (AOW), but they are also present in the supplementary pension system. Little is known about the total amount involved in these solidarity-based value transfers; there is not much transparency. Note that the state pension was primarily developed as an income policy instrument. At an individual level there is little or no relationship between the amount and distribution of the contribution payments on the one hand and the size of the state pension payments on the other. The solidarities in the supplementary pension schemes are significantly more diffuse. It is generally observed that the Dutch pension system cannot survive without (subsidising) solidarity. But this claim rests mainly on emotional notions such as the idealistic belief that members of society should be pre-


17

pared to pay for one another. (Aalberse et al., 2004). So far there has been no rationalisation of the required solidarities in terms of e.g. circumstances and conditions, beneficiaries and contributors, and realistic limits.

NUMEROUS SOLIDARITIES We can identify numerous solidarities which lead to a frequently significant redistribution of funds between various groups of participants. These include the solidarity between actives and post-actives, between young and old (in a stable situation the young make a sacrifice now and benefit in their old age), between individual companies within an industry, between workers and the disabled (who continue accruing a non-contributory pension), between those who die young and those who become old, between employees with divergent career paths, between males and females, between participants with different marital status, between different types of pension, solidarity arising from the working of the financing system which determines how the financing of new obligations is distributed over time across the existing population of actives (particularly the complex redistribution arising from the level premium that is applicable at all times to all participants), between spouses in respect of the pension exchange option, etc. See also the appendix. Jointly all these solidarities ensure a simultaneous and sequential settlement of pension outcomes between different groups of participants. The calls for transparency throughout society as well as in the world of pensions will grow louder as society continues to become more heterogeneous. This certainly applies to such a sensitive issue as the distribution of pension costs. It is therefore inevitable that all sorts of open and (largely) hidden subsidy flows, i.e. solidarities, will eventually be made explicit and transparent. Greater transparency – more knowledge and a better understanding of how ‘it works’ – can either strengthen or erode the consensual support within society. In the latter case, the solidarity framework must be redesigned in order to put the system back on a viable basis. We can assume that a rational person who knows that collective schemes mostly yield a better pension result than individual schemes will – if he has a choice in the first place – voluntarily opt for the former, provided that undesirable ex-ante solidarities are sufficiently removed from the scheme. This raises the question: where does desirable solidarity stop and undesirable solidarity start? Research into the size of subsidising financial flows has yet to begin. The participants will want to form an opinion about the desirable and undesirable solidarities: what type of solidarity, by whom

18

J.B. Kuné

and for whom, how much, when, for how long and what are the limits? The answers to these questions will vary between pension institutions and populations and will also be subject to change over time.

RISK SHARING OR SUBSIDIES Within supplementary pension schemes, risk sharing mainly refers to solidarity regarding the duration of life. Substantial differences in life expectancy exist between men and women, between socio-economic classes and between the healthy and less healthy. Moreover, each group is characterised by individual differences in life expectancy. For risk-averse participants this type of solidarity or risk sharing usually has a significant wealth-enhancing effect as they are more likely to benefit from an indexed pension until well into old age. This risk solidarity within homogeneous groups is probably greater – because the differences in life expectancy are smaller – than between various socio-economic groups and between men and women. Gender solidarity is incorporated in European legislation, in this case the antidiscrimination legislation. Within collective pension schemes, life duration solidarity is realised by levying the same level premium on all participants. New entrants cannot be excluded, nor can they decide to withdraw from the fund. Participation, in other words, is mandatory.

VALUE TRANSFERS The justification of the aforementioned risk sharing is not widely questioned, though even here selective behaviour and moral hazard may arise. With subsidising solidarity, settlement of the pension outcome already exists ex ante in a certain manner. By far the most important category of subsidising solidarity concerns the solidarity in relation to the investment returns on assets. This form of solidarity takes the shape of income and value transfers that are triggered when actual returns undershoot expected returns, while the benefits and pension accrual rates are adjusted to a lesser degree or not at all.2 This is

2

The solidarity resulting from equity and fixed-income price movements can be mentioned in one breath with the aforementioned solidarity in respect of investment performance. The latter entails that when interest rates fall the obligations – apart from perfectly matching investments – usually increase more than the fixed-income investments. Finally we should note that no mutual redistribution exists between pension schemes in the Netherlands. Evidently there is such a close – though unspoken – cohesion and/or special bond between the partici-


19

also referred to as intergenerational solidarity. Lower-than-expected returns affect all participants. The question then is: how must the pain be distributed over the participants. What is reasonable and fair?

Protect retirees? It is widely agreed that the group of retirees must be protected against the impact of a negative investment shock as much as possible. They, after all, have no way of taking corrective action. Does the same apply to active participants who are approaching retirement? This would mean that younger participants would have to bear the entire burden of absorbing the threatening fall in retirement income. During the recovery period they will continue paying contributions, whilst accruing less or no pension rights for themselves. Asking for this sacrifice from young people is often considered justified given that they may be able to benefit from higher-than-average returns in the future. What’s more, their incomes will rise over time, giving them an opportunity to buy extra pension rights if necessary. Nevertheless, this sacrifice is greater than it seems. Contributions paid at a young age can be placed in higher-risk investments for a longer period of time. Sacrificing this time advantage means that young people will need to pay higher contributions to accrue the same amount of pension. In addition, demanding an extra contribution from the young to repair the incomes of retirees may provoke negative labour market effects and send the national economy into a downward spiral. The principle of the level premium entails only a weak relationship between the contributions paid during the active years and the pensions received upon retirement. Instead of an insurance it is really a provision for the collective group, just as the state pension (AOW) is a provision for all residents. The fact that this scheme is not a personal insurance but a collective provision is an argument in favour of charging contributions to retirees, too.3

pants in a particular scheme that a certain degree of redistribution within the scheme is considered justified. However, there is no basis for an income redistribution between different occupational groups such as between the less well-off cigar makers and rich professional groups such as notaries, (consulting) actuaries, medical specialists, pharmacists, and so forth. 3

Added to that, it can be argued that the elderly should show more solidarity to one another (WRR, 1992).

20

J.B. Kuné

Some generations may contribute substantially more than they receive during their lifetime, while the opposite applies to other generations. But is this always justified? After a fall in the value of the assets new entrants will not readily volunteer to join a pension scheme and saddle themselves with the obligation of repairing the pension incomes of the elderly. So some persuasion will be required to coax the younger participants into shouldering collective responsibility. Fortunately, strong arguments do exist for asking young people to make a sacrifice in the form of a ‘solidarity contribution’ (see section 2.3.)

RECIPROCITY Where advantages and sacrifices are distributed more or less equally within successive subperiods over the lifetime of successive generations, intergenerational solidarity is a universal good that makes everyone more prosperous. Here, there is a strong degree of reciprocity. However, where certain generations make systematic sacrifices over their entire lifetime while others benefit equally systematically – and there is consequently no reciprocity – the fairness of the system is open to question. This holds all the more so if the conditions for the respective generations are otherwise equal. One example of this situation is the pre-retirement pension. In the transition period towards a fully funded pre-retirement pension, many will make substantial contributions towards early-retirement and similar (transitional) schemes without ever being able to enjoy the fruits of these schemes themselves. In the light of the ageing population, the Dutch government had good reason to intervene in this mechanism. Unfortunately, society has shown little understanding and sympathy for this policy. The government has evidently failed to persuade the public of the fairness and necessity of these measures.

PERVERSE SOLIDARITY Some forms of solidarity are desirable, others are undesirable or unintended (inverse solidarity) and still others are unnatural (perverse solidarity).4 The (fair) – simultaneous and sequential – distribution of benefits and costs over generations is also known as ‘generational accounting’. 4

Our opinion about (a certain form of) solidarity depends on how we see society. A strict viewpoint is that solidarity cannot be taken for granted and must be earned. Only those who have done everything to avoid becoming dependent are worthy of solidarity.


21

One example of an accumulation of (partly inverse, partly perverse) solidarities concerns the transfer of income between a fictitious man and woman. The man started working at a young age, is untrained and unmarried (with a flat or even declining career path). On top of all this, he dies at a relatively young age shortly after being declared unfit for work. The woman started working at a later age, is highly educated (with an upward career path), is married to a younger man, and lives to a ripe old age. In the current system, significant ‘solidarity’ value transfers take place from the first man to the woman. Clearly the chosen rate of time preference or discount rate is crucial when comparing advantages and sacrifices over time. The rate of time preference is time-dependent and probably also group and persondependent (think e.g. of socio-economic class and age). The current tendency, for both scientific and practical purposes, is to select a discount rate of about 1% (Davidson, 2004: 290-293). A high discount rate (about 5% or higher) attaches substantially less weight to the future and to the interests of future generations.5

SOLVENCY MARGINS A pension fund obviously must determine the value its future obligations (i.e. pension payments) as accurately as possible. On top of this estimated amount, it will want to maintain a (solvency) margin or buffer to absorb setbacks. The size of the buffer depends on the severity and duration of the shock against which the fund wants to protect itself. The desirable degree of protection must be determined taking into account that the accumulation of such a buffer demands sacrifices from the current generations. An alert pension fund responds rapidly and adequately to economic shocks by changing pension benefits and accrued rights of actives. For such fund, a comparatively small solvency margin suffices. Conversely, a pension fund with a generous indexation policy will need a bigger buffer. The upside of a higher buffer is that it yields the pension fund correspondingly higher investment revenues. The resulting surplus return – i.e. the return in excess of the return required to maintain the desired buffer – can be used to apply catch-up indexation and/or reduce the contributions. Buffers give pension funds more room for manoeuvre. In the event of a shock, for instance, they can opt to raise contributions gradually rather 5

A payment of 100 by future generations 30 years hence that is transformed to today obtains a weight of 0.74 at a discount rate of 1% and a weight of 0.23 at a discount rate of 5%.

22

J.B. Kuné

than abruptly. Building, maintaining, and releasing buffers involves numerous redistributional aspects and, depending on the speed at which this takes place, has implications for several generations.

PENSION CONTRACT Scheme participants are increasingly demanding adequate information about the operation and performance of their pension fund. Openness and transparency are important to avoid alienating the critical and inquisitive participant from the fund. Participants also frequently want advice. The Pension Act deals extensively with the provision of information to participants. One new phenomenon is the ‘pension contract’, which lays down arrangements concerning the relationship between the recovery of the fund’s financial position (i.e. the funding ratio: the value of assets divided by the value of liabilities) on the one hand, and the contribution policy and indexation of accrued rights (of retirees and the active participants) on the other. This integrated contribution and indexation policy must be implemented according to a defined graduated scale (CPB, 2000). The pension contract must make clear in advance when pensions will and will not be indexed, and to what extent. In the past, contribution and indexation measures were usually taken on an ad hoc basis (incomplete contract). Within the context of the FTK (Financial Assessment Framework) the nominal funding ratio for a standard pension fund has been set at about 130% and the recovery period at a maximum of 15 years. When the real obligations are fully funded, gradual contribution reduction is permitted above a funding ratio of 130%. If the funding ratio rises even further, contribution refunds can even be considered. If the funding ratio falls below 130%, catch-up contributions are charged and the rights of actives and retirees are reduced if necessary. It should be noted, however, that even in a moderate inflation environment a funding ratio of 130% leaves little room for indexation. The exact content of the pension contract thus determines the degree of – simultaneous and sequential – solidarity between the various groups of beneficiaries.

SOCIAL SOLIDARITY This form of solidarity concerns the participants’ involvement in and responsibility for the proper working of the national economy. This commitment to society as a whole is the most abstract form of solidarity: it is


23

the furthest removed from people’s personal lives and therefore rests on the most fragile consensus. Increasing contributions has much greater macro-economic consequences than reducing the indexation of pension payments and accrued rights of the working population (CPB, 2004). However, pension funds give little or no attention to the macro-economic consequences when establishing their pension policy. Therefore, it is up to the supervisor to ensure that the funds operate in the best interests of the national economy. To this end, its likeliest course of action is to impose restrictions on the use of the contribution instrument, whilst leaving room for reducing or even stopping indexation. When serious shortfalls occur, accrued rights may even be reduced. In solidarity terms, this policy line spares younger employees, new entrants in particular, whilst demanding a greater sacrifice from retirees and older employees. Alternatively, the supervisor may opt for a policy where young people pay the level premium whilst accruing little or no pension rights. In this case, the contributions largely benefit the elderly.

2.3

Setting the standard for solidarity

This section formulates a standard for the desirable and undesirable degree of solidarity in the supplementary pension system.6 This standard leads to certain conclusions, two of which are discussed here. Some degree of personal preference is of course inevitable here.

STANDARD The basic premise is that every generation of new entrants should finance its own pension provision (including an agreed solidarity contribution) on an ex-ante basis. In other words, every generation must be self-supporting by

6

Views on solidarity also differ in the pension world. Here are two quotations of two (ex-) chairmen of the Association of Industry-Wide Pension Funds and two ex-directors of the PGGM pension fund and the Philips pension fund. The first quotation is of G. Beuker and J. Wennekus: ‘…solidarity between generations has a wealth-enhancing effect. A pension provision financed on a level premium basis that is accessible to everyone – which is what we want – is only possible in a system with solidarity between the various risk groups.’ (Aalberse et al., 2004). The second quotation is from D.J. de Beus and D. Snijders: ‘… pension funds should not bury their heads in the sand by continuing to brandish a term like solidarity. The day will come when participants simply won’t buy that any more.’ (C. Petersen, 2002).

24

J.B. Kuné

always paying the cost-price contribution in advance. But how strictly or loosely should this principle be put into practice? Or, in other words, how much solidarity between successive generations is reasonable, responsible and desirable as well as acceptable to all those involved? This is one of the key questions that must be carefully considered. The answer will provide valuable input for making clear and unambiguous ex-ante arrangements.7 Note, however, that ex-post discrepancies are inevitable: reality is inherently unpredictable and surpluses and shortfalls will always occur.

CONCLUSIONS The first conclusion is that there should be no hidden re-distributing solidarities within the supplementary pension schemes. Everyone must know what solidarities are involved and how much they cost. The participants can then form a standpoint as to which solidarities are necessary or unnecessary, and to what extent. They thus, knowingly and willingly, enter into a commitment to pay the price of the solidarities that they collectively wish to preserve. Given that pensions are basically deferred income, it is reasonable to argue that they should be redistributed in the same way as the current income. If this is combined with the premise that income policy is a matter for politics and government, then it follows that neither pension institutions nor other social partners (e.g. employers or trade unions) should have any influence in this case. Income policy is conducted through taxation, subsidies and so on. Consequently, any solidarity elements in pension schemes should not be open-ended (and therefore uncontrollable) but closed-ended with pre-determined quantitative floors and ceilings. A second conclusion is that any surpluses at a pension institution basically belong to, or are attributable to, those participants who paid for these surpluses. Therefore surpluses only benefit these participants.8 New entrants have no legal or moral claim to an existing surplus. Conversely, shortfalls are the responsibility of the participants who caused or allowed these deficits to arise during their participation and should not burden new entrants. In other words, new entrants should neither benefit from

7

You could for instance agree that a generation that has made a solidarity sacrifice over a certain period of time will be the first in line for the next solidarity bonus in a subsequent period.

8

Part of the buffers was formed by ex-participants who are no longer alive. That part can go to the benefit of the entire collectivity, including the new entrants.


25

existing surpluses nor be burdened with existing shortfalls at the time of entering the scheme. However, as they start accruing rights in the scheme, they must share in the costs and benefits of shortfalls and surpluses on a pro rata basis. Having said this, there are circumstances in which intergenerational settlement of increased or reduced contribution rates as well as surpluses and shortfalls may make sense. But this must always be based on sound arguments and consensual agreement between both parties. This agreement is codified in the pension contract. Future generations clearly have no say in the arrangements made by earlier generations. Consequently, generous promises may be made to existing participants at the expense of future participants. An independent party can protect the rights of future generations. This may be a role for the DNB (Dutch central bank) in its capacity as supervisor of the pension sector. The arrangements must obviously be reasonable and fair. But these criteria are notoriously hard to quantify. Good information, sound analysis and equitable judgement are therefore crucial to arrive at a fair deal for both current and future generations. Nothing must be left to incomplete information or chance.

AGE-RELATED PENSION ACCRUAL AND CONTRIBUTION PAYMENTS In the current system, young and old pay the same percentage of their income (say 14%) to the pension fund and they accrue pension rights that are the same percentage of their income (say 2%), in spite of the fact that the contribution of the younger participant will generate returns over a much longer period. This so-called “uniform contribution and accrual system” is in place to limit competition in the labour market between the young and old. Would differentiation in contribution levels be a good idea? In other words, is the solidarity between young and old implicit in equal contribution levels always justified? The following case is instructive. A 45-year-old participant A leaves his employer’s pension scheme (as active employee) to pursue a self-employed activity. During the previous 20 years this participant paid a relatively high pension premium. As a selfemployed person he will in the future continue saving for an individual pension by paying a cost-price contribution (which is relatively high compared to the level premium). All in all, A pays a relatively high amount of money for his pension. Compare this with participant B who, at the age of 45, decides to bid farewell to his 20-year freelance career to take a steady job and joins his employer’s pension scheme. In the previous 20 years this

26

J.B. Kuné

participant paid a cost-price pension contribution (which was relatively low compared to the level premium) and in the coming 20 years will be able to benefit from the relatively low level premium that he is required to pay. All in all, B pays relatively little for his pension. This raises the following question: is it reasonable and fair that participant A receives a certain refund on leaving the scheme while participant B starts paying more than the uniform premium on entering the scheme? The above gives rise to two issues for debate: (1) the age or intergenerational solidarity inherent in the level premium and (2) the pension accrual rate and contribution level in relation to age. The central question concerns the desirability of an age-related level premium or an age-related pension accrual rate. It looks like the current system is on a collision course with the Equal Treatment Act.9

SOLIDARITY CONTRIBUTION In a situation of severe or prolonged underfunding, younger participants may be prepared to make a sacrifice to help out older employees and retirees, but only up to a certain degree. They, after all, also have their own future to think about and want to be sure their contributions are sufficient to finance their own future pension income. Tentatively and intuitively we suggest that the younger generation might be prepared to pay an extra solidarity contribution of 3 to 5% to lend their elders a helping hand. Anything above that level would probably be stretching the system beyond its limits.

Solidarity sacrifice Assuming a negative shock on capital markets, the CPB Netherlands Bureau for Economic Policy Analysis has calculated that in an indexed average-pay scheme some 16% of this shock would impact on new participants while 84% would be absorbed by the present participants (CPB, 2004). Of the latter, the active population would pay the lion’s share of 78% and the retirees only 6%. The solidarity sacrifice of the new participants is also limited. In a DC scheme, future entrants are obviously not charged for existing shortfalls. The shortfall arising from a shock on capital markets is borne proportionally by the generations involved: 75% by the actives and 25% by the retirees.

9

The aspiration for equal treatment (gender, age, etc.) frustrates the process of eliminating undesirable forms of solidarity from pension schemes.


27

There are good arguments for persuading the younger generation to accept paying a relatively high solidarity contribution. In the first place, they too will be old one day and will then benefit from the solidarity mechanism. Secondly, they will benefit from a huge production potential and infrastructure that was created by many earlier generations. The future is being presented to them on a platter of gold. Thirdly, at least a part of the higher pension income of the elderly today will ultimately come to them in the form of gifts and inheritances. So perhaps there is no conflict of interest after all! These arguments provide a foundation for maintaining the solidarity mechanisms. Opinions may differ as to the acceptable level of the solidarity contribution and the rules to be observed in times of relative hardship or prosperity. But these issues can no doubt be resolved provided the parties are willing to engage in an open and constructive discussion.

VALUE TRANSFERS An employee changing jobs can decide to have his accrued pension rights transferred from the old to the new pension provider. The way in which the value transfer is determined has significant solidarity implications.

Dilemmas To illustrate the solidarity dilemma, let’s assume a new entrant whose pension rights (based on 20 years of service) are transferred. He joins a fund with a very large surplus, say a funding ratio of 200%. Should this high funding ratio also apply to the new entrant who will probably also benefit from a low contribution rate? And conversely, suppose he joins a fund with a funding ratio of only 50%. Will the value of his transferred pension rights be halved at one stroke? And will he also be required to pay more than the cost-price contribution into the bargain? Current practice seems to be developing in the following direction. If one of the two funds has a funding ratio lower than 105%, then no value transfer takes place. In all other cases, outgoing value transfers are based on the lower of the two funding ratios. As a result, neither incoming nor outgoing transfers affect the financial position of the ‘poorest’ fund. The financial position of the ‘richest’ fund, hence, improves with an outgoing transfer and deteriorates with an incoming transfer.

28

J.B. Kuné

2.4

Conclusion

The issue of redistributing or subsidising solidarity in supplementary pension schemes needs to be treated with great care. Valid arguments can be put forward for risk sharing. The creation of consensual support for diverse forms of subsidising solidarity within supplementary pension schemes is all the more crucial if the abolition of mandatory participation makes pension exit a real possibility. Put differently, limits must be set on the extent to which new entrants can be charged for the shortfalls that have arisen before their time. To maintain the required level of acceptance among all participants, it is advisable to check for each type of solidarity where desirable solidarity ends and undesirable solidarity starts.

Literature Aalberse, B. et al., ‘De waarde van solidariteit; spanning in de tweede pijler van het pensioengebouw’, SISWO Cahiers Sociale Wetenschappen en Beleid, no. 6, Amsterdam, 2004. Aarts, L.M.J. and P.R. de Jong, Op zoek naar nieuwe collectiviteiten; sociale zekerheid tussen prikkels en solidariteit, The Hague: Elsevier Bedrijfsinformatie, 1999. Beer, P. de, De ontwikkeling van de solidariteit in Nederland, unpublished paper UvA/AIAS, 2006. Beltzer, R. and R. Biezeveld, De pensioenvoorziening als bindmiddel, socialecohesie en de organisatie van pensioen in Nederland, Amsterdam: Aksant, 2004. Beus, D.J. de and D. Snijders, ‘Toekomstvisie pensioenfondsen’, in: Bestuur en management van pensioenen, regelingen, beleggingen en uitvoering (C. Petersen editor), The Hague: SDU, 2002. Boer, J. de et al., Impact van flexibilisering op solidariteit, Woerden: Actuarieel Genootschap/ASIP, 2002. CPB, Solidariteit, keuzevrijheid en transparantie, The Hague, 2000. CPB, Naar een schokbestendig pensioenstelsel, verkenning van enkele beleidsopties op pensioengebied, Document no. 67, The Hague, October 2004. Davidson, M.D., ‘Discontovoet voor klimaatschade behoeft politieke keuze’, Economisch-Statistische Berichten, 89, 25 June 2004.


29

Entzinger H. and G. Engbersen, ‘Immigratie en solidariteit’, in: W. Arts et al. (ed.), Verzorgingsstaat vaar wel, Van Gorcum, Assen, 2004. Kuné, J.B., Op weg naar één nationale pensioeninstelling, oration text 4 June 2004, Amsterdam: Vossiuspers UvA. Oorschot, W. van et al., Solidair of selectief, een evaluatie van toepassing van het selectieve-marktmodel in de sociale zekerheid, Deventer/Zeist: Kluwer/ Sovac, 1996. Oorschot, W. van, ‘Solidair en collectief of marktgericht en selectief?, Nederlanders over sociale zekerheid’, Beleid en Maatschappij, 24, 1997. Petersen, C., Bestuur en management van pensioenen, regelingen, beleggingen en uitvoering, The Hague: SDU, 2002. Teulings, C., ‘Solidariteit en uitsluiting, de keerzijden van een zelfde medaille’, in: Engbersen, G. and R. Gabriëls (eds.), Sferen van integratie; naar een gedifferentieerd allochtonenbeleid, Amsterdam: Boom, 1985. Vorselen, L. van, Solidariteit en pensioen, denkbeelden over een solidair ouderdomspensioen, Deventer/Zeist: Kluwer/Sovac, 1993. WRR (Scientific Council for Government Policy), Ouderen voor ouderen, The Hague: SDU, 1992. WRR (Scientific Council for Government Policy), Generatiebewust beleid, The Hague: SDU, 2000.

Appendix: Different types of solidarity within supplementary pension schemes (‘solidarities’) Many forms of real solidarity and quasi-solidarity can be identified. Some are open and visible; others hidden and rather difficult to detect. The various forms are summarised below. 1.

Risk solidarity (risk sharing): this principle underlies all insurance contracts, whether individual or collective. The participants bear one another’s burden insofar as these arise from bad risks. As opposed to this, there are numerous subsidising solidarities that typically result from level-premium financing.

2.

Solidarity between workers and retirees (in any given time period): this mainly concerns the exposure to real investment risk. The pension provision is usually determined on the basis of an actuarial interest rate of about 3%. This means that if the real return on pension capital

30

J.B. Kuné

– nominal return less the indexation of pension rights and payments – is greater than the actuarial discount rate, then the population of workers will benefit in the form of a lower contribution. The greater this differential, the more the retirees constitute a gold mine for the actives. Conversely, if the real return on assets is below the actuarial interest rate, the actives must make a sacrifice in the form of a higher contribution rate to maintain the pension payments at the desired level. 3.

Younger versus older employees: the price of a euro pension income is considerably higher for an older employee than for a younger worker, even though they all pay the same premium. The actuarially fair premium (with an actuarial interest rate of 4%) for a euro pension is on average about 1¼% of the pensionable salary for a 24-year-old. With a level premium of 9% this therefore entails an implicit additional charge of 7¾%. For a 64-year-old the actuarially fair premium is about 17½% and he therefore receives an implicit subsidy of 8½%. As with the AOW state pension scheme, this solidarity is based on a hidden or implicit social contract where the younger generation trusts that the next generation of young people will do the same for them when they are old. In the case of stable relations in terms of age distribution and income position, this social contract is not at risk. But the situation changes when the number and age of active participants is no longer stable. In a rapidly shrinking sector, the young people of yesterday have paid high premiums only to find out upon retirement age that there are no longer sufficient young people to pay the major part of the cost-price contribution for them. In this respect large collectivities are at an advantage compared to smaller collectivities.

4.

Individual companies within a certain sector: insofar as the profile of the participants differs from the (average) profile of the total collectivity, mandatory participation in the fund will lead to subsidising cash flows. This effect occurs in all industry-wide pension schemes.

5.

Actives versus disabled employees: disabled employees usually continue to accrue pension rights in the same manner as actives (on the basis of the indexed income at the time of becoming disabled or otherwise unfit for work) but no longer pay contributions. These pension accrual costs are included in the level premium paid by the actives.

6.

Divergent career paths: these result in what is frequently called perverse solidarity, i.e. those who make a relatively steep career, particularly towards the end of their working life (known as ‘pension promotions’), benefit considerably from participants with a flatter career. This income redistribution effect occurs irrespective of the level of in-


31

come. In recent years many schemes have been transformed from final pay to average pay schemes. 7.

Socio-economic class: the difference in life expectancy between persons of diverse socio-economic classes is substantial and can be as high as five years. This causes a redistribution of funds from lower to higher socio-economic classes. This too can be considered as a form of perverse solidarity.

8.

Gender solidarity: women aged 65 are expected to live 5 to 6 years longer than men, while all pay the same level premium. Women also run a higher risk of occupational disability. One special form of solidarity concerns the option of exchanging (usually towards the age of 65) the surviving dependant’s pension for a higher or earlier old-age pension. The principle of equal rights demands gender-neutral exchange factors, leading to a weighted average of male and female factors that generally work out favourably for women and less favourably for men. This means again solidarity between men and women, which is further reinforced by the selection effect.

9.

Solidarity related to marital status: participants with marital or equivalent status benefit from the participation of participants without a partner. The level premium paid by the latter also includes the risk premium of a surviving dependant’s pension in the event of death prior to retirement. The aforementioned exchange option mitigates this form of solidarity to a certain extent. Analogously there is solidarity between participants with dependant children and those without.

10.

Solidarity between the various types of pension occurring in a pension scheme: this occurs when the actual costs of the aforementioned types of pension differ from the expected costs and the difference is credited or charged to the (rest of the) collectivity. Where the pension package is indivisible (diffuse), there is by definition no advantage or disadvantage for any of the participants. However if we look at a pension package on the basis of its different components, the subsidising effect can be seen. Subsidies occur to the extent that distinct groups of participants (at sector and subsector level) make different use of the different components of the scheme without these being separately priced and charged.

11.

Solidarity between collective pension products and supplementary optional products: this occurs where supplementary optional products are not priced strictly according to the self-financing or self-supporting principle. No scheme or scheme component is ever entirely self-supporting.

32

J.B. Kuné

12.

Buffer solidarity: the presence of buffer assets of, say, 30% or more of the provision for accrued rights is a major source of financing. This makes it possible to keep the contribution relatively low and gives participants a disincentive to exit the scheme – assuming they are free to do so – and makes it very attractive for prospective participants to enter the scheme rather than make individual arrangements. Clearly, the participants (and former participants) who accumulated the buffer have made a sacrifice, even when the creation of the buffer took place almost imperceptibly (as was the case with many funds in the nineties).

13.

Solidarity resulting from the actual operation of the financing system: the financing system brings about a certain redistribution over time of the costs – and thus the costs for the participants present in any given time period – of the expected flows of future payments. Depending on the manner in which the distribution of costs over time is realised, some generations will contribute more or less than they receive during their lifetime. They benefit from or pay for others. On an ex-post basis the contributions paid over the lifetime period of a generation will usually not be exactly equal to the total amount of the payments that the generation receives. One crucial factor (with a strong influence on the outcome) is the rate of time preference, the discount rate used to calculate the present value of future cash flows. The method of financing a pension scheme strongly influences the premium differential and thus the extent of the value transfers and solidarity between the generations. It follows that contribution stabilisation over a certain period is not neutral for the extent of redistribution over generations, viewed from both a simultaneous and sequential perspective.

14.

Solidarity generated by and from a pension package with options: this basically involves a pension menu system. Financial neutrality is usually impossible when participants are able to choose ‘a bit more of the one and a bit less of the other’. Things become even more complicated with flexible reward packages that permit all sorts of exchange options without it being clear which components belong to the pensionable salary. The process of selection and moral hazard will inevitably lead to cost increases. The solidarity here will therefore often be of a perverse nature. But even an (ostensibly innocent) extension of the working week (as arranged in the Collective Labour Agreement) from e.g. 36 hours to 38 or 40 hours at the end of the employee’s working life will – assuming a corresponding increase in income – results in a considerable cost increase in a final pay system.

3

Solidarity: who cares?

P.P.T. Jeurissen and F.B.M. Sanders This contribution describes the principal forms of solidarity in the healthcare sector. We discuss the concept of solidarity and its diverse roles as well as the design of the existing solidarity framework and trends for the future. Solidarity in healthcare is under pressure: the costs are rising and the distribution of solidarity transfers is becoming increasingly uneven, socio-cultural trends are sending out mixed signals and many think it is fair to ask people with unhealthy lifestyles to pay more. However, a fully funded system is less suited to healthcare than to supplementary pensions. In healthcare, more so than in the pension sector, solidarity is nurtured by feelings of community and justice. At the same time, egalitarian outcomes are increasingly difficult to achieve due to the evermore uneven distribution of the health cost burden, the enormous supply of healthcare products and the large mutual differences in the production process.

3.1

Introduction

This chapter contains a discussion of the position of solidarity in the health sector. We show how solidarity is given shape in healthcare and why solidarity is pivotal in achieving equitable and efficient healthcare provision. The outcomes of this analysis are compared with the solidarity arrangements in the pension sector. The health sector and the pension sectors each have their own dedicated institutions with little mutual overlap. One common factor, however, is the aim to reduce ‘risk’ and ‘uncertainty’. Collective pensions mitigate our fears of insufficient income in old age, while healthcare decreases our concerns over treatment and care when sick – a situation that often coincides with old age. Healthcare and pension are thus the mainstays of existential security for the elderly: healthcare in the form of transfers in kind and pensions in the form of transfers in cash. This contribution starts with a reflection on the meaning of the term solidarity. What do we understand by the term solidarity and what is its

34

P.P.T. Jeurissen and F.B.M. Sanders

relationship with collectivity (section 3.2)? Next we consider how solidarity is given shape in the financing and implementation of healthcare (section 3.3). Section 3.4 shows which aspects of solidarity are most under fire and explains why. Most reform proposals concentrate on a combination of individual responsibility and system incentives; both of which are aimed at making business processes more efficient. In this respect healthcare (the no-claim rebate, regulated competition) is no different from the pension sector (growing trend of defined contribution schemes). We describe what issues play a role in this connection in the healthcare sector and discuss whether individual schemes also have a role to play (section 3.5). This contribution ends with a brief comparison of the most important characteristics distinguishing the insurance-based healthcare market from the collective pension sector (section 3.6).

3.2

Solidarity

Solidarity is a concept which we almost all endorse, but which is also subject to diverse interpretations. Solidarity suggests a sense of community and the willingness to bear the consequences of community membership – it implies a certain bond. The classic sociologists Durkheim and Weber saw solidarity as the social cohesion arising from a sense of shared fate between individuals and groups. In doing so, they made a distinction between culture-based solidarity which sprang from (shared) identity and utility-based solidarity (Widdershoven, 2005). Schuyt posits that: ‘Solidarity, as a social phenomenon, means sharing of feelings, interests, risks and responsibilities’ (Schuyt, 1998). He thus adopts a slightly more specific approach, with feelings and responsibility referring to the cultural or identity-based solidarity and interests and risks encompassing the utility aspect. Both definitions are descriptive rather than normative: they place solidarity in a sociocultural and economic context, but give no indication as to whether, and how much, solidarity is desirable. A tension exists between solidarity described in empirical terms and solidarity interpreted in normative terms of right and wrong (Verstraeten, 2005). This differentiation is of fairly recent date. Originally the normative approach prevailed: solidarity, quite simply, was the right thing to do (Verburg and Ter Meulen, 2005). More recently, however, this moral stance has been challenged by empirical arguments. In the current debate, the proponents of welfare retrenchment tend to come up with empirical arguments (rising costs, eroding support), while the opponents adhere to normative principles (‘you either have 100% solidarity or no solidarity at

3 Solidarity: who cares?

35

all’). After briefly discussing the most important normative views on solidarity, we will turn to the empirical views that may fundamentally alter the solidarity landscape.

HOW MUCH SOLIDARITY? The political philosopher John Rawls tried to define how much solidarity a society needs. In his book entitled ‘A theory of justice’, he describes a method for arriving at a fair distribution of goods (Rawls, 1972). In a hypothetical original position, citizens agree on a social contract through a process of negotiation. These negotiations take place behind a ‘veil of ignorance’. According to Rawls, the participants will follow rules that permit a fair distribution of resources precisely because of their lack of relevant knowledge of their position in society. In this context Rawls presumes a situation of moderate scarcity: the living conditions of the least well-off can be improved without causing any severe disadvantage to the betteroff. Conflict between different groups is thus avoided. In reality, this situation existed during the establishment of the welfare state when strong economic growth diminished scarcity and greatly increased everyone’s personal purchasing power, despite rising taxation. Rawls distils two fundamental rules of distribution from this original position. First, everyone has equal rights to the most extensive basic freedoms, provided that others enjoy equal freedom. Second, social and economic inequalities are only acceptable if these demonstrably (also) serve to benefit the least privileged and if there is an open opportunity structure: people of equal ability have an equal chance of achieving a certain position (Verburg and Ter Meulen, 2005). Though such reasoning underpins the welfare state, it does not lead to entirely egalitarian distribution as the freedom principle has the greatest priority. Inequality could, for instance, promote the prosperity of the least well-off by stimulating productivity improvements that are in everybody’s interest. The Rawlsian principles also entail that the current generation should not squander the wealth of future generations ‘and require one generation to save for the welfare of future generations’ (Kukathas and Pettit, 1990). Rawls’ theory assumes rational behaviour: uncertainty over their personal position combined with risk aversion ‘compels’ citizens to show a substantial degree of solidarity. Rawls’ approach to solidarity is thus essentially rational. By contrast, the culture- and identity-based community spirit of Durkheim and Weber and the feelings and responsibilities of Schuyt attach a more open character to solidarity. Solidarity, in their view, is not the utilitarian outcome of a

36


social contract based on a ‘veil of ignorance’ but a measure of the moral quality of interhuman relationships in society. This tradition is deeply rooted in history and resonates with the Christian concept of charity. Notions of personal or voluntary charity are combined with a religious or ideological instruction to do good, such as the Biblical duty to care for the poor, orphans and travellers (Buijsen, 2005). This form of solidarity is also referred to as ‘vertical’, ‘one-sided’ or ‘warm’ solidarity. Over the years these views on solidarity as an individual moral obligation acquired a more rational dimension as arguments such as enlightened self-interest started to gain currency. In the literature this process is frequently illustrated by the insurance world, where ‘cold’ utilitarian interests progressively displaced the ‘warm’ sense of social duty in the solidarity framework (Widdershoven, 2005). In the healthcare sector this development is evident from the fact that many now perceive health as an enshrined ‘right’ (Starr, 1982). This evolution from subjective duty to objective right has strongly influenced the way solidarity is organised in our society of today.

SOLIDARITY VERSUS COLLECTIVITY Weighing up the costs and benefits of collective pension schemes is the core theme of this book. What is the relationship between solidarity and collectivity? Insurance economics mainly perceives collectivity as a means of achieving economies of scale by spreading individual risks. In sociology, however, a collectivity is usually defined as a cohesive group with a shared culture, values and experiences. Society comprises a wide array of different collectivities: civilians, the insured, patients, professionals and pension fund members, to mention but a few. The interests of these collectivities can conflict in all sorts of institutions. Health insurers, for instance, have dealings with the insured, who want the lowest premium, and patients who want the best (read: most expensive) healthcare. In the course of their lives individuals may switch between the roles of insured and patient any number of times. In the pension sector the switch between collectivities only occurs once, namely on retirement. Consequently, collective interests here are more clear-cut and less muddled. The emotional sense of belonging to a collectivity promotes support for solidarity. But so does the rational awareness that individual risks can be shared in the collectivity. Insurance schemes where people with an equal risk pay the same premium are essentially rational. More emotional types of solidarity include helping sick relatives (informal care) or voluntary com-


37

munity work. The state, acting in its capacity as over-arching body, orchestrates these diverse collectivity mechanisms and – through its legislative monopoly – is able to enforce solidarity where appropriate: the young are obliged to contribute towards the state pension (AOW) and pre-pension, high earners pay welfare benefits for low earners and the healthy help to pay the costs of the sick. In practice, there is a considerable degree of overlap between the twin concepts of solidarity and collectivity: ‘no collectivity, no solidarity’ and ‘no solidarity, no collectivity’. In insurance economics the concepts of solidarity and collectivity are separated from each other via the equivalence principle (equal risks pay equal premiums). However, even in the commercial market, few products are entirely without value transfers (“good risks” pay for “bad risks”) and operate fully according to the equivalence principle. This is partly due to economic market imperfections, such as moral hazard, adverse selection and actuarial inaccuracies. But solidarity considerations also enter into the equation. Formerly, for instance, sickness funds rarely excluded nonpayers from their health schemes (Widdershoven, 2005) and private insurers hardly ever charged totally risk-based premiums (Schut, 1995). When these ‘spontaneous’ mechanisms enhancing solidarity came under pressure, the government took regulatory action to ensure that the system continued to be supported by a combination of economic (collectivity-based) and social (solidarity-based) motives.

3.3

Health solidarity

The most important solidarity concepts in healthcare are income solidarity and subsidising solidarity.1 When high earners make a more than proportionate contribution to the financing of health costs, we speak of income solidarity. Subsidising solidarity assumes that everyone pays the same premium, even though some predictably represent a higher risk than others (community rating). Those with a low health risk thus help to cover the costs of those with a higher health risk. This is achieved through solidarity transfers between the diverse risk groups – which obviously do not automatically come about in a free market. The old have a higher health bill than the young, so subsidising solidarity implicitly contains an intergen-

1

As mentioned in Chapter 1, footnote 2, the concept of risk is used slightly differently in the (health) insurance industry. As this book focuses on the pension sector, we prefer using the term as used in the pension industry.

38


erational solidarity component – as will become increasingly evident in our ageing society. Our main focus so far has been on the financial side of solidarity. In the healthcare sector, however, solidarity is also reflected in the actual provision of the services; a healthcare system that treats all patients according to medical urgency and need is considered to show more solidarity than a system which sets different priorities. We refer to this as solidarity in healthcare outcomes (RVZ, 2005). According to this solidarity criterion, the Dutch health system, due to need related referrals by general practitioners, compares favourably with that of other countries (Van Doorslaer and Masseria, 2004).

THREE COMPARTMENTS The health insurance system consists of three different compartments, each with its own solidarity levels and institutions. These are listed and tentatively compared with pensions in Table 1. Pension solidarity was extensively discussed in the previous chapter in this book. The Exceptional Medical Expenses Act (AWBZ) provides a national social insurance for uninsurable risks as well as residential care. This scheme, like the state pension (AOW), is funded by employees who pay income-dependent premiums up to a certain threshold. The AWBZ is a pay-as-you-go scheme in which subsidising solidarity plays a significant role, particularly in relation to the physically and mentally handicapped. In long term care the distribution of risk is more age-related. As with the state pension (AOW), ageing will put pressure on the financial robustness of pay-as-you-go schemes; intergenerational solidarity is thus also an important issue in the healthcare sector. Similarly, subsidising solidarity occurs in co-payment schemes. In the ABWZ these are income-dependent, so that the degree of subsidising solidarity is smaller towards high-earning patients than to low-income patients. In the new private obligatory health insurance scheme with publicly regulated conditions, subsidising solidarity plays a central role. The insured pay a nominal risk-independent premium; employers pay a wage related contribution that covers fifty percent of the total costs. Everyone pays virtually the same price for the basic benefit package, regardless of their health status and insurers are not allowed to reject applicants. But the principle of subsidising solidarity does not apply in full. There is a noclaim rebate of € 255 per insured adult; those who incur no health costs are refunded this amount. In addition, the insured can opt for a deductible of € 500 at maximum.


39

Table 1. Solidarity in the financing of healthcare and pensions

Collective

Risk solidarity

Subsidising solidarity

Income solidarity

Intergenerational solidarity

AWBZ (Exceptional Medical Expenses Act)

o

++

++

+++

State pension (AOW)

o

+

++

++

Mandatory Insurance

o

+++

+

++

Collective pensions

+

+

o

o

Supplementary Health Insurance

+

++

o

+

Private pensions

++

+

o

o

Regulated

Free market

Insurers are compensated for bad risks from a central fund. This takes place both ex-ante (risk adjustment) and ex-post (risk sharing), so that the premium discounts given to people with such a deductible as well as general premium differences are limited. The fund is filled with wagedependent employer premiums; lower-income earners also receive a health allowance. A certain degree of income solidarity has thus been maintained. Insurers may award collectivities a discount up to a maximum of 10% of the premium, but this is really a high-volume discount and has little bearing on the expected cost of claims. As older people are more frequently ill and generate more costs, intergenerational solidarity is also amply present in the new private health insurance scheme. In the ‘free market’ people can take out supplementary insurance. There is no income solidarity here. So insurers are allowed to apply experience based premiums and refuse applicants. Such rejections are quite common with supplementary dental insurance. Sometimes eligibility for supplementary insurance is subject to age limits. But even this segment displays a fair degree of subsidising solidarity. This is related to the large demand for supplementary policies (95%), which limits adverse selection effects and establishes an implicit ‘linkage’ between this insurance and the basic obligatory policy. Consequently, competition between insurers on these policies is limited. This is also reflected in the fact that the old supplementary health insurance schemes of the sickness funds fetched a high gross margin of 20% (RVZ, 2005).

40


3.4

Solidarity under pressure?

Though health solidarity can still rely on broad social support, it is no longer unchallenged: the no-claim rebate included in the new private obligatory health insurance scheme and plans for a radical overhaul of the Exceptional Medical Expenses Act underline this point. Pressure to make choices will no doubt continue to grow. Both financial-economic and socio-cultural aspects play a role in this respect. Within the pension sector, inflation, increased longevity and the return on investments are the main uncertainties. The first two also play a role in health insurance. Investment performance is of less significance here, though the need to meet solvency requirements remains a challenge to some of the private health insurers. One specific characteristic of the healthcare sector is the substantial uncertainty over the financial impact of advancing medical technology. In the past, technological innovation (and socio-cultural trends) accounted for almost half of health expenditure growth (Spaendonck and Douven, 2001). Medical advances drive up costs by creating treatments for new (older) target groups. In contrast with the pension sector, healthcare is entirely financed on a pay-as-you-go basis. If premiums continue to be undifferentiated by risk, ageing will lead to larger transfers between generations.

INCREASINGLY SKEWED DISTRIBUTION OF GROWING HEALTH EXPENDITURES With the number of old people continuing to grow, health expenditure is set to soar. The economic scenarios of the CPB Netherlands Bureau for Economic Policy Analysis estimate that about 20% of GDP growth will be spent on healthcare in the coming decades (RVZ, 2005). If this growth is to be entirely collectively funded, with health expenditure accounting for a constant share of the economy, this percentage will double. In this case healthcare will swallow up a large portion of the extra budget, unless society is prepared to accept higher taxation, lower purchasing power or substantial spending cuts in other policy spheres. This has never been necessary in the past. The competition for a slice of the budget will intensify; the Rawlsian assumption of moderate scarcity, which helps to ensure a fair distribution of resources, no longer holds water. Healthcare financing is now overwhelmingly based on the principle of subsidising solidarity (EIM, 2002). A combination of rising health spending and an increasingly skewed distribution of health costs has greatly increased the transfers between risk groups in the past decades; the costs of the 10% most expensive insured persons has jumped from 43% of total


41

curative expenditure in 1953 to 70% in 2002 (Cutler and Meara, 2002). In the sphere of exceptional medical expenses this distribution is even more lop-sided: the costs of residents of nursing and care homes, handicapped institutions and psychiatric care provisions (1.6% of the population) amount to about 74% of the total exceptional medical care expenses. This evermore skewed cost distribution is largely due to advancing technology (which mainly benefits limited groups), ageing and several sociocultural trends, such as unhealthy lifestyles, patient empowerment and medicalisation of inconvenience and distress. These cost-increasing factors can be easily assimilated within the general healthcare framework because the basic health package is formulated in general terms (that which is regarded as normal in professional circles) rather than restrictive terms. This trend towards subsidising solidarity is unlikely to weaken. Far from it, in fact. Due to a combination of factors, these transfers must continue to grow at an accelerating rate in the coming decades to maintain subsidising solidarity in its current unlimited form. We have already mentioned advancing technology as one reason for this process. In this context the National Institute for Public Health and the Environment (RIVM) also mentions the impact of epidemiological trends: the occurrence of expensive chronic illnesses such as depression and asthma will continue to rise rapidly until 2020. The higher incidence of age-related illnesses (e.g. dementia and stroke) compared to disorders that are more prevalent among younger age groups (e.g. as mental handicaps and pregnancy complications) means that subsidising solidarity will show a stronger correlation with intergenerational solidarity (RIVM, 2005). The ageing affluent post-war baby boom generation will become an evermore voracious net recipient of intergenerational transfers. Moreover, this generation will be more demanding in terms of quality than the current generation of retirees and that will further accelerate health expenditures. Young people, by contrast, will be confronted with wealth stagnation in the coming decades (McKinsey, 2005). So, up to what quality level is this generation willing and able to continue financing solidarity? One possible solution to this growing problem would be to maximise the collective contribution towards health treatments at a certain amount per quality adjusted life year (QUALY) (RVZ, 2006).

LESS COMMUNITY, MORE RECIPROCITY? The scope of this contribution does not permit a detailed account of the impact of socio-cultural change on health solidarity. Verburg and Ter Meulen note that the sustainability of solidarity hinges on more factors

42


than the increasingly skewed distribution between the contributions to and use of healthcare that we highlighted above. They point to an ongoing process of differentiation and individualisation that may erode our collective consciousness and sense of society. As a consequence, the limits of solidarity will be more sharply drawn and claims will be increasingly tested against criteria of equality, reciprocity and personal responsibility (Verburg and Ter Meulen, 2005). Not everyone agrees that individualisation is undermining the existing base of support for solidarity. Some challenge the view that solidarity is necessarily at odds with individualisation (De Beer, 2005). But it cannot be disputed that the financing of healthcare has increasingly become the domain of insurers. The launch in the Netherlands of private health insurance to replace the former social health insurance scheme as the dominant system corroborates this point – and suggests that reciprocity and collectivity may be in the ascendancy at the expense of solidarity. Civic acceptance Subsidising solidarity in the healthcare sector used to draw support from the notion that illness is a question of bad luck and that nobody goes to hospital or a nursing home for fun – the underlying assumption being that opportunistic (i.e. increased-risk) behaviour is rare. This also explains why, from a historical perspective, under the old mutual sickness funds monetary benefits such as sick pay (where opportunistic behaviour was assumed to exist) were paid out much more reluctantly than medical claims (Widdershoven, 2005). Scientific research has shown that a high level of health solidarity exists as long as these assumptions hold sway, particularly in highly cohesive societies where strong affinity is felt with the patient (e.g. through close social relationships). But this sympathy evaporates when unhealthy behaviour is perceived to be the cause of ill health. When asked about the right to collectively insured healthcare and the justification of co-payments, respondents tend to weigh lifestyle factors more heavily. People with an unhealthy lifestyle and high earners are deemed less eligible for collective financing of treatment for certain diseases (Hansen, Arts and Muffels, 2005). Society attaches conditions to solidarity: high earners and those with risky lifestyles should pay more. So unlimited solidarity is certainly not to be taken for granted, as is also evident from research of Bongers et al.; 50% of the insured are prepared to pay a higher contribution to maintain solidarity, but 39% are no longer prepared to do this (RVZ, 2006).


43

The end of the ‘veil of ignorance’? This trend is compounded by an entirely different phenomenon: new scientific insights into the causes of disease, including genetic factors and behaviour, and the use of healthcare increase the capacity to predict who will be net payers and who will be net recipients. Broad-based social support for a high degree of subsidising solidarity seems to derive partly from the uncertainty among net payers whether they too may be net recipients one day. The more this ‘veil of ignorance’ is lifted, the more unwilling net payers will become to endorse unlimited subsidising solidarity (Rosanvallon, 2000).

3.5

Is there a role for individual schemes?

Health policy-makers have so far opted for a policy strategy of cost control (efficiency cuts, budgeting) in combination with patient co-payments and certain reductions in statutory cover. Besides this, the reforms are concentrated on promoting greater efficiency through market forces. So far, the solidarity mechanisms have been left largely untouched. This is a sensitive issue and the media are always waiting in the wings to cry foul over any moves towards welfare retrenchment. As a result, the sparse cautious attempts undertaken to reduce subsidising solidarity either failed or were reversed (e.g. co-payment of medicines, specialist treatment, national health and IVF treatment). The recently introduced no-claim rebate has survived so far, but for how long? All things considered, the upshot is that economic, demographic and socio-cultural factors as well as growing scientific insights into the causes of disease entail that the current solidarity arrangements will not be left intact without discussion. All aspects of subsidising solidarity, income solidarity and intergenerational solidarity will be taken on board in the debate. Here, however, we will concentrate mainly on intergenerational solidarity, which provides the most interesting basis for comparison with pensions.

INTERGENERATIONAL SOLIDARITY: COLLECTIVE VERSUS INDIVIDUAL SCHEMES? When comparing the health and pension sectors, intergenerational solidarity is particularly important. This exists to a maximum degree in healthcare, but plays virtually no role in formal solidarity institutions as it effectively coincides with subsidising solidarity. The big question is: can this remain the case in the future? Many different aspects come into play here, but we will

44


focus on the accrued savings and personal assets, the way premiums are determined and, finally, the option of individual savings schemes. Today, personal wealth not only depends on income but increasingly on savings and other assets. Even so, these assets play virtually no role in the financing of collective healthcare arrangements. The current baby boom generation is affluent (RVZ, 2005). Whether younger generations will ever be in a similar position is uncertain (McKinsey, 2005). This is due to the growing costs of ageing, which diminish purchasing power growth. Future generations may enjoy increased longevity but, according to the most recent CPB analyses, will not be much richer than the current generations (Jacobs and Bovenberg, 2006). This raises the question whether the affluent elderly should be expected to make an extra (wealth-dependent) contribution to the rising cost of healthcare. This could be achieved by (partly) moving health premiums out of the social security sphere and into the tax sphere. Payable premiums could then not only be based on the individual’s income, but also on his or her assets. So far, however, reciprocity and insurance-based arguments have prevailed to create the opposite effect. One notable example is that of affluent people who pay a much lower exceptional expenses premium because they have retired to Mediterranean countries that provide less elderly care than the Netherlands. A second way of renewing intergenerational solidarity within the payas-you-go system runs via the premium levy system. If insurers are permitted to factor age into the payable premiums, the elderly will be charged a higher premium. This, incidentally, was already common practice in the old private health insurance system. Hitherto, higher premiums for the elderly were always justified on the grounds that they entailed an increased health risk. But now that the elderly are richer than ever, personal wealth could be put forward as a further reason for age-related premium differentiation. The less affluent elderly could then receive a health allowance to compensate for this higher premium. Yet another redistribution of the costs can be achieved within a pay-asyou-go system. This, in fact, is exactly what Germany did a few years ago with its Exceptional Medical Expenses Scheme (Pflegeversicherung). Intergenerational solidarity was invoked in justification of the measure, the argument being that people without children should pay a higher premium than people with children. The German Supreme Court ruled that child-rearing made a contribution to the sustainability of social insurance for elderly care based on pay-as-you-go financing (Di Fabio, 2005). The debate about making premiums more dependent on claims risk also touches on intergenerational solidarity, as a higher age entails a higher risk


45

of disease. However, with this policy option, other risk factors such as obesity can also be taken into account. People who generate extra health profits and/or cost reductions by leading a healthy lifestyle could then qualify for a premium discount or lower co-payment. Substantial wealth gains can in principle be achieved in this way (Bhattacharya and Sood, 2005). The National Institute for Public Health and the Environment (RIVM) recently concluded that higher excise on smoking is the most effective measure from a wealth perspective (Feenstra et al., 2006). The most fundamental recalibration of intergenerational solidarity in healthcare could take the form of a fully funded system. This system would involve every individual having their own health savings account (De Kam, 2001) to pay for specific health expenditures in the future. This could be done either individually or in a group context. Such a system would be best suited for smaller health expenditures and more or less fixed costs to be incurred in the more remote future, such as GP, homecare and elderly care costs. But savings schemes also have disadvantages. Amongst other things, it is unclear whether sufficient capital can be saved up before the costs arise. Also, due to the large inter-individual variation in costs (e.g. for hospital care), people may run into problems if their savings prove to be insufficient. Therefore, it will be clear that individual savings schemes can never provide a full alternative to health insurance (RVZ, 2005). NYFER has mooted pension-cum-health policies as an interesting option. By including mandatory old-age health insurance in the pension scheme, participants will already start saving for intensive old-age care from a young age. Apart from being cheaper, this also avoids the selection and acceptance problems that arise when people put off taking out old-age cover until a later age (NYFER, 2005). These are interesting options from the insurer’s perspective as an unhealthy lifestyle increases the risk of higher annual healthcare costs but also leads to decreased life expectancy and a lower pension risk.

3.6

Conclusion

This contribution set out to discuss the most relevant solidarity concepts for the healthcare sector. We showed how solidarity is categorised and explained the relationship between solidarity and collectivity. Collectivity is both a precondition for solidarity and a means of achieving economies of scale. A tentative comparison with the pensions sector shows that subsidising solidarity is the most important type of solidarity in both sectors; in the healthcare sector there is also a strong correlation between risk and intergenerational solidarity.

46


Solidarity is crucial in healthcare, much more so than in the pensions sector. Without a certain minimum solidarity, vulnerable groups can easily lose access to healthcare. For this reason, substantial redistributions of wealth are necessary between the healthy and ill, young and old, and higher and lower incomes. The argument of accessibility (no solidarity, no healthcare for some) is less relevant in the pensions sphere. After all, people save for their own supplementary pension. Consequently, solidarity is not so much positioned in terms of redistribution, but is above all relevant for achieving economies of scale (e.g. because the participants in collective pension schemes are relatively insensitive to the time horizon). The direction of redistribution in pension systems is therefore mainly the (unintended) consequence of such factors as the achieved return on investments and wage inflation (WRR, 1999). The financial sustainability of pensions is relatively strong thanks to the full funding system. The current generations are only dependent to a limited extent on the will of future generations to help cover their pension costs. Healthcare is a different story: the reduction of uncertainty about the future financing of healthcare rests primarily on the perceived solidarity of future generations. If this solidarity remains strong, a pay-as-you-go system is probably the most efficient financing method. However, this contribution has also shown that we cannot simply assume that the strong healthcare solidarity we know today will remain intact in the future. With health expenditures set to continue rising, the health sector will make a structural claim on a large portion of the available economic growth. What’s more, the rising health expenditures will be concentrated on a relatively small group. The empirical ‘veil of ignorance’, which long concealed the relationship between health and genetics, behaviour and lifestyle, is rapidly wearing thin. This is likely to influence the degree of support for solidarity arrangements in society where differentiation and individualisation are still gaining in significance. Views differ as to the exact impact of these trends, but few expect them to strengthen support within society for solidarity. From this we can distil a policy agenda that is more focused on the individualisation of (existing) arrangements, including in the healthcare sector. This is already visible in the increasing material importance of supplementary health insurance and certain recent measures, including the noclaim rebate, the optional health insurance deductible and the possibility of joining a reduced-risk collectivity. Going forward, the future could bring more fundamental reforms such as a partial abolition of the ban on risk related premiums, supplementary savings schemes, and intergenerational redistributions to make the (affluent) elderly pay more for healthcare.


47

Literature Beer, P. de, ‘Hoe solidair is de Nederlander nog?’, in E. de Jong and M. Buijsen, Solidariteit onder druk? Over de grens tussen individuele en collectieve verantwoordelijkheid, Nijmegen: Valkhof Pers, 2005. Berg, B. van den and F.T. Schut, ‘Het einde van gratis mantelzorg?’, Economisch Statistische Berichten (88) 4413: pp. 420-422, 2003. Battacharya, J. and N. Sood, Health insurance and the obesity externality, Working Paper 11 529, NBER, 2005. Buijsen, M.A.J.M., ‘Solidariteit, rechtvaardigheid en de zorg om gezondheid’, Filosofie & Praktijk (26)5, pp. 5-18, 2005. Cutler, D.M. and E. Meara, The medical costs of the young and the old: a forty year perspective, Working Paper 6114, NBER, 1997. Di Fabio, Die Kultur der Freiheit, München: Verlag C.H. Beck, 2005. Doorslaer, E. and C. Masseria, Income related inequality in the use of medical care in 21 OECD countries, Health working paper 14, OECD, 2004. EIM-onderzoek voor bedrijf en beleid, Solidariteit in het ziektekostenstelsel, inkomens- en risicosolidariteit in het tweede compartiment, Zoetermeer: EIM, 2002. Feenstra, T. L., P.H.M. van Baal, R.T. Hoogenveen, S.M.C. Vijgen, E. Stolk and W.J.E. Bemelmans, Cost-effectiveness of interventions to reduce tobacco smoking in the Netherlands, An application of the RIVM chronic disease model, Bilthoven: RIVM, 2006. Hansen, J., W. Arts and R. Muffels, ‘Wie komt eerst? Een vignetonderzoek naar de solidariteitsbeleving van Nederlanders met patiënten en cliënten in de gezondheidszorg’, Tijdschrift voor Sociale Wetenschappen (48) no. 1/2, pp. 31-59, 2005. Jacobs, B. and A.L. Bovenberg, ‘Voortschrijdend inzicht in de vergrijzing’, Tijdschrift voor Openbare Financiën (38)2, pp. 62-79, 2006. Kam, C.A. de, ‘Samen voor ons eigen’, Economisch Statistische Berichten (86) 4336, pp. D15-D16, 2001. Kukathas, C. and P. Pettit, Rawls: a theory of justice and its critics, Cambridge: Polity Press, 1990. McKinsey, The Coming Demographic Deficit: How Aging Populations Will Reduce Global Savings, McKinsey, 2005.

48


NYFER, Blijvende Zorg: economische aspecten van ouderenzorg, Zoetermeer: RVZ, 2005. RIVM (National Institute for Public Health and the Environment), Risicosolidariteit en zorgkosten, Zoetermeer: RVZ, 2005. RIVM, Kosten van ziekten in Nederland 2003, RIVM 270 751 010, Bilthoven, 2006. Rosanvallon, P., The New Social Question, Princeton: University Press, 2000. RVZ (Council for Public Health and Health Care), Houdbare Solidariteit in de Gezondheidszorg, Zoetermeer: RVZ, 2005. RVZ, Briefadvies, Houdbare solidariteit in de gezondheidszorg, Zoetermeer: RVZ, 2006. RVZ, Zinnige en Duurzame Zorg, Zoetermeer: RVZ, 2006. Schut, F.T., Competition in the Dutch Health Care Sector, thesis Erasmus University, Ridderkerk, 1995. Schuyt, K., ‘The sharing of risks and the risks of sharing. Solidarity and social justice in the welfare state’, Ethical Theory and Moral Practice (1):297-311, 1998. Spaendonck, T. and R. Douven, Uitgavenontwikkelingen in de Gezondheidszorg, Memorandum no. 16, The Hague: CPB, 2001. Starr, P. The social transformation of American medicine, The rise of a sovereign profession and the making of a vast industry, New York: Basic Books, 1982. Ter Meulen, R., R. Verburg, M. Offermans and H. Maarse, ‘Hoe verdelen we de schaarse zorg? Een vergelijkende analyse van opvattingen over criteria voor toegang tot zorgvoorzieningen in medische ethiek, beleid en surveyonderzoek’, Tijdschrift voor Sociale Wetenschappen (48) nr. 1/2, pp. 85-107, 2005. Verburg, R. and R. ter Meulen, ‘Solidariteit of rechtvaardigheid in de zorg? Een spanningsveld’, Tijdschrift voor Sociale Wetenschappen (48) nr. 1/2, pp. 11-31, 2005. Verstraeten, J., ‘Solidariteit in de katholieke traditie’, in: E. de Jong and M. Buijsen, Solidariteit onder druk? Over de grens tussen individuele en collectieve verantwoordelijkheid, Nijmegen: Valkhof Pers, 2005. WRR (Scientific Council for Government Policy), Generatiebewust beleid, The Hague: SDU-uitgevers, 1999. Widdershoven, B.E.M., Het dilemma van solidariteit. De Nederlandse onderlinge ziekenfondsen, 1890-1941, Amsterdam: Aksant, 2005.

Part 2. Quantifying solidarity

4

Operating costs of pension schemes

J.A. Bikker and J. de Dreu1 This chapter examines what type of pension scheme has the lowest operating costs. We first analyse the operating costs of Dutch pension funds, broken down by administrative and investment costs. Various cost-influencing factors are identified, including scale, pension fund type, plan type, outsourcing and reinsurance. Economies of scale are shown to be dominant in explaining differences in costs across pension schemes, leading to the conclusion that the consolidation of small pension funds could improve cost efficiency. In addition, the costs per participant of mandatory industry-wide pension funds turn out to be significantly lower than those of company pension funds. Next, the costs of pension schemes offered by pension funds and life insurers in the Netherlands are compared in an effort to distinguish between collective and private schemes. We find that the operating costs per participant of collective pension funds are many times lower than those of private schemes.

4.1

Introduction

The fall of equity prices in 2000-2002 combined with persistently low longterm interest rates and an ageing population led to a worldwide crisis in the pension industry. Since then, higher contributions and lower pension accrual rates, as well as a rebound of equity prices and interest rates con1

The Dutch central bank (DNB), Supervision Policy Division, Strategy Department, [email protected]. Jan de Dreu wrote this article when working for DNB; currently he is employed by ABN AMRO, [email protected]. Views expressed are those of the individual authors and do not necessarily reflect official positions of DNB. The authors are grateful to Dirk Broeders, Aerdt Houben and Wil Dullemond for valuable comments and suggestions. The first part of this article is based on Bikker and De Dreu (2007).

52

J.A. Bikker and J. de Dreu

tributed to the recovery of the financial position of pension funds.2 Despite the financial problems sketched above, the operating costs of pension funds as a potential source of savings received little attention. However, the cumulative effect of these costs can have a strong impact on the size of pension benefits. Figure 1 shows the impact of annual costs on pension benefits for a fictitious pension scheme (for a single person or a group of persons). Here, annual costs of 1% of total assets lead to a reduction in the pension payments of 27% in a defined contribution (DC) system or an increase in the costs or contribution of over 37% in a defined benefit (DB) system.3 Operating costs per participant vary strongly between pension funds, mainly due to scale effects and inefficiencies. In addition, operating costs differ significantly between pension funds and life insurers. In this context, one should bear in mind that the different types of pension schemes are not fully comparable. The costs of collective schemes of pension funds and collective contracts of life insurers, on the one hand, and the costs of private pension schemes at life insurers, on the other, differ in nature. As a result, the costs of private schemes as a percentage of the contribution are typically five times higher than those of collective arrangements.4 In private schemes, unutilised economies of scale is the dominant factor explaining relatively high costs. These cost differences illustrate the importance of selecting the right organisational form for pension provisions. This chapter first examines the operating costs of pension funds and the main factors that determine these costs. A distinction is made between administrative and investment costs. Key cost determinants include the size of pension funds, their organisational form, the type of pension plan and the degree of outsourcing of the administration, asset management and risks. This analysis makes it possible to determine characteristics of an ideal pension fund in terms of efficiency and to identify which policy or form of market organisation can help to improve the efficiency of existing funds. For this analysis we use data of all (one thousand) Dutch pensions funds during 1992-2004. Next we turn to the role of life insurers as pension providers, both as a service provider to pension funds and as an independent provider of collec-

2

Risks that were shifted from employers to participants also play a role here insofar as employees were not compensated for this.

3

See Bateman and Mitchell, 2004, and Bateman, Kingston and Piggot, 2001.

4

One should be careful in interpreting these figures, as the comparison is complicated.

4 Operating costs of pension schemes

53

Reduction of pension benefits

0% -10% -20% -30% -40% -50% 0%

0,5%

1%

1,5%

2,0%

Administrative and investment costs

Fig. 1. Erosion of pension benefits due to annual operating costs Note: To simulate the impact of operating costs on annual pension payments, we assume annual wage growth of 3%, annual inflation of 2%, a nominal investment return of 7%, uninterrupted contribution payments over 40 years and a pension payout period of 20 years. Source: Bikker and De Dreu, 2007.

tive and private pensions. Attention is also devoted to the cost differences between pension funds and life insurers as well as between private and collective schemes. We thus establish the characteristics of pension funds and pension schemes that are best suited to provide efficient pensions.

4.2

Operating costs of pension funds

The operating costs of pension funds consist of administrative costs and investment costs. Administrative costs relate to all operational tasks excluding asset management, such as record keeping, communication with participants, policy development and compliance with regulatory and supervisory requirements. These costs include salaries, rents and fees charged by third parties such as actuaries, accountants and lawyers. Investment costs are discussed in section 4.4. We use data of Dutch pension funds over the past thirteen years as reported to the Dutch central bank (DNB) for prudential purposes. The number of pension funds gradually decreased from 1131 in 1992 to 742 in 2004 (see also Table B.1 in the appendix). Tables 1 and 2 present key statistics on administrative costs in 2004 for, successively, different size categories, types of pension funds and types of pension plans. Size is measured

54


by the number of participants or total assets. Participants consist of contributing employees, inactive participants and pensioners. Data from earlier years (1992-2003) lead to comparable figures as shown in the tables below and are not presented separately. Though all pension funds are independent legal entities, many small and some mid-sized company pension funds utilise staff and facilities of the sponsor company. The associated costs are often not fully charged to the pension fund and consequently also not reported. About 12% of the pension funds report no administrative costs.5 These funds are therefore excluded from the statistics presented in this chapter. In addition, many (mainly small) company pension funds underreport their administrative costs. For example: 65% of these funds report no wage costs. Evidently these costs are either borne by the sponsor company or are included in ‘other costs’ (and remain part of the administrative costs). Such underreporting does not occur among industry-wide pension funds, as these are unable to shift costs to their sponsors. Later we will see that these imperfections in the data are systematic (occurring mainly at smaller company pension funds) and therefore do not significantly impair our analyses. Without this distorting effect, the observed dominant influence of economies of scale and differences in costs between the different categories of pension funds would only be greater. The upper part of Table 1 shows the average administrative costs of pension funds for different size categories in terms of participant numbers. The table indicates that the (weighted) average of administrative costs as a percentage of total assets declines sharply as the number of participants increases: from 0.59% for the smallest funds to 0.07% for the largest funds. The average administrative costs per participant fall even more sharply as the number of participants increases, namely from an average of € 927 per year for the smallest funds to about € 30 for the two largest size categories. As noted earlier, the cost differences between the size categories are actually even greater than shown in these figures. This is due to the underreporting of costs, mainly by the smallest company pension funds (see also fourth column). Almost half of the category of smallest funds consists of personal pension vehicles for director-owners and director funds for a limited number of (former) board members and members of the supervisory board. This explains why, on average, this category has much higher assets per participant than the other categories. 5

The data was collected for prudential supervision purposes, where costs only play a minor role.


55

Table 1. Annual administrative costs of pension funds by size category (2004) Size categories of pension funds based on:

Administra- Administra- Total assets Funds that Total numtive costs/ tive costs per partici- do not report ber of total assets per participant wage costs participants (%) pant (€ 1000) (%)a (1000) (€)

Number of funds

1. number of participants < 100

0.59

927

157

88

2

56

100-1000

0.46

302

66

82

104

225

1000-10 000

0.23

156

68

55

809

264

10 000-100 000

0.17

86

50

18

2 774

87

100 000-1 million

0.24

28

12

30

7 146

20

> 1 million

0.07

33

46

0

5 611

3

Average / total

0.15

48

33

61

16 446

655

2. total assets (€ million) 0-10

1.23

159

13

85

37

105

10-100

0.55

129

23

71

508

289

100-1000

0.27

51

18

45

3 532

209

1000-10 000

0.17

45

27

23

4 929

44

> 10 000

0.10

43

45

25

7 439

8

a

Note that mainly (small) company pension funds sometimes underreport wage costs.

Source: Bikker and De Dreu, 2007.

Economies of scale result from high fixed costs and other operating costs that increase less than proportionally with pension fund size. Examples include the costs arising from policy development, data management systems, reporting requirements and the hiring of experts such as actuaries, accountants, lawyers and consultants. The lower part of Table 1 presents the (weighted) average administrative costs for different size categories in terms of total assets. The table shows that administrative costs expressed as a percentage of total assets are negatively related to the size of pension funds. While the smallest funds have operating costs of 1.23% of total assets, this percentage is only 0.10% for the largest funds. Figure 1 shows the impact of a 1% difference in annual operating costs on pension benefits. In summary, Table 1 shows that the operating costs of pension funds are characterised by strong economies of scale, irrespective of whether the size of the institution is expressed in terms of participant numbers or total assets.

56


The upper part of Table 2 presents administrative costs for different types of pension funds. We distinguish three main types: company pension funds, industry-wide pension funds and professional group pension funds. Company pension funds provide pension schemes to employees of the sponsor company. They are legally independent of the sponsor company and are managed by the employer and employee representatives. Industry-wide pension funds provide pension schemes to employees in a sector based on a Collective Labour Agreement (CLA) between the employers and labour unions in this sector. There are two types of industrywide pension funds: mandatory and non-mandatory. Mandatory funds are based on a binding CLA, making participation mandatory for all employers and employees working in the respective sector. Non-mandatory funds are based on a CLA that allows employers to choose whether to participate in the collective fund or not. Professional group pension funds provide pension schemes to professional groups such as general practitioners and notaries. Apart from these three main groups, there are also other types of funds such as savings funds. The administrative costs of company pension funds average € 138 per year, which is high compared to industry-wide pension funds whose annual Table 2. Annual administrative costs by type of pension fund and type of pension plan (2004) Type:

Administrative Administrative Total assets Total number costs/total costs per per participant of participants assets participant (€ 1000) (1000)a (%) (€)

Number of fundsa

Average number of participants (1000)

Pension fund Industry-wide (all)

0.13

33

26

14 072

95

148

– mandatory

0.12

31

26

13 557

76

178

– non-mandatory

0.16

66

40

515

19

27

Company

0.19

138

71

2 167

524

4

Professional group

0.10

221

221

71

11

6

Average / total

0.15

48

33

1 446

655

25

Mainly DB

0.14

49

34

15 546

590

26

Mainly DC

0.37

25

7

672

51

13

Other

0.36

33

9

221

12

18

Pension type

a

The pension type of 21 pension funds is not known; four funds are savings funds.



57

costs average only € 33. As noted before, the actual differences are even greater due to the aforementioned underreporting of costs by company pension funds. Professional group pension funds have the highest costs per participant, namely € 221. Company pension funds and professional group pension funds usually manage more assets per participant, which leads to higher costs. This may be due to e.g. more generous pension schemes or a relatively large number of older participants (whose accrued pension assets are obviously larger than those of younger participants). Consequently, the administrative cost difference between the various types of pension funds is smaller per invested euro (or as a percentage of total assets) than per participant. Pension schemes provided by company pension funds are generally much less standardised and much more customised to the preferences of the employer and employees than schemes provided by industry-wide pension funds. In addition, the services to the participants can be of a higher quality. However, this explicit choice for customisation and extra service results in higher operating costs. Table 2 shows that most pension funds are company pension funds, but that these serve only a small number of the participants. One major advantage of industry-wide pension funds is that when employees change employers within the same sector, the accrued pension assets can often remain within the fund. As a result, lower costs are incurred than when the assets need to be transferred between company pension funds. The (mandatory) industry-wide pension funds have by far the largest number of participants. The lower part of Table 2 shows the administrative costs for different types of pension plans. We see significantly higher average costs for DB pension plans of € 49 per participant per year, as compared to € 25 for DC pension plans. However, the total assets per participant are much higher in DB pension funds than those of DC funds, presumably because the participants in the latter funds are a lot younger and have therefore accrued much less pension assets.6 In addition, the number of DC participants has been fairly limited so far. These cost differences are probably also partly determined by scale effects. Overall, scale effects appear to be the dominant explanation for cost differences between pension fund categories, whilst the organisational form possibly has some, albeit smaller, effect. In order to identify the impact of different factors that capture the various organisational forms, we need to perform a multivariate regression analysis so that all factors can be taken into account simultaneously.

6

Note that more assets also involve higher costs.

58


4.3

An empirical model for administrative costs

To establish the impact of scale, organisational structure and pension plan types on the operating costs of pension funds, we use a multivariate regression model. The left-hand column of Table 3 provides the estimates for the impact of variables that explain administrative costs in our model.7 The scale of pension funds is represented by the number of participants (in logarithms). This term is also included quadratically to account for the possible nonlinearity of scale effects. The coefficient of 0.63 indicates that a 1% increase in the number of participants leads to a cost increase of only 0.63%. This implies that there are substantial unutilised economies of scale averaging 37% per unit of extra production. This observation was also made in relation to DB and collective DC pension funds in the United States (Caswell, 1976 and Mitchell and Andrews, 1981), Australia (Bateman and Mitchell, 2004), and in relation to DC pensions in sixteen countries around the world (Whitehouse, 2000; Dobronogov and Murthi, 2005, and James, Smalhout and Vittas, 2001). The quadratic term indicates that these economies of scale are greater for small funds and smaller for large funds. In 2004, all existing funds were below the theoretical optimum size, where the economies of scale turn to diseconomies of scale. While controlling for other factors, mandatory industry-wide pension funds are found to operate at the lowest costs.8 As noted before, this can partly be explained by their generally standardised and less generous pension schemes, which are simpler to administer. An additional advantage is that when employees change employers the accrued pension assets can often remain within the fund, so that less transfer costs are incurred. Nonmandatory industry-wide pension funds and company pension funds occupy the middle ground in terms of efficiency, while professional group pension funds are the least efficient. Their costs may be higher mainly because these funds cater to lots of individual participants instead of a single employer, which, for instance, makes the collection of contributions more cumbersome. We find that pension funds with a DC plan have lower administrative costs than funds with a DB plan. This applies to Dutch DC pension funds in which participants (1) are unable to select and switch between pension funds so that no marketing costs need to be incurred and (2) have only a limited choice in terms of the investment mix so that information costs are 7

Administrative costs are expressed here in logarithms.

8

Significantly lower than company and professional group pension funds.


59

Table 3. Estimates of the administrative and investment cost models (1992-2004) Administrative costs Coefficients Number of participants (in logarithms) Total assets (in logarithms)

Investment costs

t-values

Coefficients

t-values

0.63

105.1

–

–

–

–

0.83

76.4

0.05

38.1

0.03

10.0

Mandatory industry-wide pension funds

-0.56

10.5

-0.24

3.5

Non-mandatory industry-wide pension funds

0.49

6.8

-0.25

2.6

Company pension funds

0.56

17.1

0.14

3.0

Professional group pension funds

1.24

18.1

0.05

0.5

Defined Contribution pensions (DC)

-0.20

4.7

0.05

0.8

Outsourcing of the administration

1.08

33.2

Complete reinsurance of liabilities

-0.77

19.2

-0.30

4.9

Partial reinsurance of liabilities

-0.12

2.9

-0.09

1.8

Total assets (in € 1000) per participant

0.07

3.0

Percentage of pensioners

0.62

11.5

-0.09

1.1

Reported investment costs

-0.45

17.8

Constant

-0.45

8.9

-5.17

50.3

10 119

7.4

4 986

Ditto, squared

a

Number of observations R

2

0.71

0.75

Respectively, the number of participants (in logarithms) and total assets (in logarithms). Note: Almost all coefficients are significant at the 99% level; italics indicate ‘no significance’. All variables are expressed in 2004 prices.

a

limited.9 Compared with DB funds, DC funds require no or less actuarial advice, which should imply lower costs. Outsourcing of the administration seems more expensive, but that is probably a distortion due to the aforementioned underreporting of administrative costs. With outsourcing the invoice puts the full costs on the table, whereas without outsourcing part of the costs can remain concealed, at

9

Marketing costs constitute a major part of the operating costs in countries where participants can switch between funds (Dobronogov and Murthi, 2005). In addition, since many participants have no idea how to invest their pension assets properly (e.g. see Van Rooij et al., 2007), they should be provided with information and advice if they can choose to select their own investment mix for their pension.

60


least for company pension funds. It is found that both full and partial reinsurance of insurance and investment risks, which is often accompanied by the outsourcing of administration and asset management, lead to lower operating costs. However, it is probable that part of the operating costs is included in the contributions that are paid to the insurer. We are therefore unable to conclude that reinsurance increases efficiency. Next, we look at three control variables. As expected, the costs are slightly higher if more pension assets are managed per participant. Costs also increase with a growing number of pension recipients. Finally, costs are lower if the fund also reports investment costs. Evidently, investment costs are sometimes partly stated as administrative costs. This does not distort the total operating costs, but does influence the distribution over the two cost categories. Insufficiently accurate reporting by a (small) portion of the funds has evidently not prevented clear regression results. All coefficients are significant at a very high reliability level. Also, if the regression model is estimated for different subsets (e.g. all industry-wide pension funds, all company pension funds or only the data of 2004), the results show the same signs for the coefficients and, for most variables, the same high level of significance of 99%. The first important conclusion is that substantial unutilised economies of scale occur in the management of small and medium-sized pension funds. The same applies after controlling for the option to achieve economies of scale through outsourcing at life insurers and pension providers. Size, therefore, is a crucial determinant of the efficiency of pension funds. The second important conclusion is that, on average, mandatory industry-wide pension funds have significantly lower administrative costs than company pension funds. The organisational form of pension funds is evidently also essential for efficiency purposes. Due to the systematic underreporting of administrative costs by mainly small company pension funds, both effects are actually expected to be somewhat higher than observed in this analysis.

4.4

Investment costs of pension funds

Investment costs arise from investment analysis, risk management and trading, and include salaries of analysts and portfolio managers, brokerage fees and charges for the use of electronic trading facilities.10 The reported 10

The literature on mutual funds (which have comparable investment activities) shows that higher investment costs are not (sufficiently) compensated by higher returns (e.g. Jensen, 1968, Malkiel, 1995, and Malhotra and McLeod, 1997). Large


61

investment costs amount to approximately 40% of total operating costs. Actual investment costs are probably somewhat higher because part of the investment costs is immediately deducted from the returns. About 24% of the pension funds report no investment costs. These funds do not occur in the tables and estimates used below. Sometimes these costs are included in the reinsurance premiums. In addition, the investment costs may have been deducted directly from the investment returns or included in administrative costs. The upper part of Table 4 presents the average investment costs of pension funds for different size categories, expressed in numbers of participants. Investment costs as a percentage of total assets decrease as the number of participants increases from about 0.14% for the three smallest fund classes to 0.08% for the biggest funds. The average investment costs per participant decrease even more sharply with the number of participants, namely from € 270 for the smallest funds to € 13 and € 39 for the two largest fund categories. Note that the investment costs per participant are the lowest for pension funds in the second-largest category, which contains most participants. Once again, the real cost differences between size categories are even greater than shown in Table 4, as non-reporting of investment costs is much more common among small funds than the large funds. The lower half of Table 4 shows a comparable picture for the various size categories on the basis of total assets. The analysis of the investment costs of pension funds reinforces our earlier finding that scale has a strong impact on operating costs and that industry-wide pension funds operate at significantly lower costs. This conclusion is confirmed if the earlier regression analysis is repeated with a model for investment costs, where the size of total assets is used as the scale variable (see the right-hand column of Table 3). The results show similar coefficients and comparable conclusions. On the investment side, large unutilised economies of scale are found to exist, though these are smaller than for administrative costs (17% versus 37%). For investment costs it is found that – after controlling for other factors – industry-wide pension funds again operate at significantly lower costs than company and professional group pension funds. The coefficients of the other explanatory variables are less significant.11 funds with an extensive investment apparatus generate no or insufficient excess returns to compensate for higher costs. Therefore it makes sense to reduce the costs to an optimal level. Note that bid-ask spreads are not part of the investment costs. See for this e.g. Bikker et al. (2007). 11

In an alternative specification (not shown here) with participant numbers as the scale variable, the other variables do all prove to be highly significant, with the same signs as in the administrative cost model.

62


Table 4. Annual investment costs of pension funds by size category (2004) Size category of pension funds based on:

Administrative Administrative Total assets Total num- Funds that Number of costs/total costs per per particiber of report no funds assets participant pant participants wage costs (%) (€) (€ 1000) (1000) (%)a

1. number of participants < 100

0.13

270

208

1

52

27

100-1000

0.14

101

72

75

33

151

1000-10 000

0.14

97

71

672

21

209

10 000-100 000

0.11

45

41

2 469

13

76

100 000-1 million

0.13

13

10

6 847

10

18

> 1 million

0.08

39

46

5 611

0

3

Average / total

0.10

31

31

15 676

26

484

0-10

0.15

25

17

16

53

49

10-100

0.14

31

22

418

28

209

100-1000

0.14

25

18

3 163

14

179

1000-10 000

0.10

24

24

4 809

7

41

> 10 000

0.10

39

41

7 270

25

6

2. total assets (€ million)


4.5

Life insurers as providers of pension schemes

The second part of this chapter examines the cost differences between private and collective pension schemes. The present section discusses the role of life insurers as a provider of both private and collective pension schemes. Section 4.6 then takes a closer look at the cost differences between life insurers and pension funds.

COLLECTIVE PENSION SCHEMES Companies that do not belong to an industry with a mandatory industrywide pension fund can choose to arrange their employee pension scheme through a life insurer. Forty insurers provide such ‘direct schemes’ to some 1.8 million participants working for around forty thousand companies.


63

In addition, pension funds can reinsure their insurance and investment risks at life insurance companies and outsource their administration and the management of their investments to more specialised institutions, including life insurers. A pension fund can even outsource all its activities to a life insurer, in which case it exclusively acts as a middleman. Where insurers or other institutions are better equipped to bear certain risks of pension funds or are able to perform certain activities more cost-effectively, pension funds can increase their efficiency by reinsuring risks and outsourcing activities. This actually happens on a considerable scale. In 2004 pension funds outsourced on average 36% of their activities in cost terms. Over a third of the pension funds (principally smaller institutions) outsourced more than 50% of their activities. In the same year, 20% of the (mainly smaller) funds were fully reinsured.12 In this way, pension funds seek to maximise the efficiency of their pension activities, with (mainly small) pension funds benefiting from economies of scale at life insurers and pension providers in cases where their own scale is too limited. Direct schemes and outsourcing thus mean that (at least some) market efficiencies are still achieved in providing pension schemes.13

PRIVATE PENSION SCHEMES Besides collective schemes of pension funds and collective contracts of life insurers, there are also private pension schemes. These are important for a large number of self-employed people who are not in salaried employment and are not members of an professional group pension fund. In addition, many people choose to supplement their employee pension with additional savings in the third pillar of the Dutch three-pillar system, e.g. to repair a loss of pension rights due to a change in employment or to enjoy a higher pension. Apart from privately managed assets (e.g. savings or investment accounts), this mainly concerns life insurance policies. These are either (deferred or immediate) annuities or endowment insurance policies with annuity clauses. Premiums for both types of insurance are eligible for 12

On average these funds have a balance sheet total that is only one tenth of that of the other funds.

13

Outsourcing of pension activities to insurers is accompanied by additional agency costs: the pension fund or the responsible employer needs to check whether the insurer or pension provider fulfils all its obligations.

64


income tax deduction, subject to certain conditions.14 In the case of endowment insurance, savings are built up in order to purchase an annuity: for instance, an annuity payable on death before retirement for the benefit of surviving dependants or a single lifetime annuity. Table 5 provides an overview of the administrative costs of life insurers, consisting of operational costs and acquisition costs (marketing and selling costs, including commissions for intermediaries).15 Note that these figures indicate the average costs of life insurers for their entire portfolio of products, which include both collective and private policies, insurance policies where the investment risk is borne or not borne by the policyholders, life annuities, endowment insurance, and so forth. In addition, it is important to remember that cost comparisons between pension funds and insurers are difficult to make (see section 4.6). The first point worth noting is that large unutilised scale effects also occur for life insurers. The total costs as a percentage of gross premiums (a measure we use to permit comparison with pension funds) vary from Table 5. Administrative costs of life insurers and pension funds by size category (2004) Life insurers Size category based on total assets (€ million)

Pension funds

Administrative Gross Administrative costs/gross profits/gross costs plus gross premiums premiums (%) profits/gross (%) premiums (%)

Number of insurers

Administrative Number of costs/gross pension funds premiums (%)

0-10

37.9

0.6

38.5

12

11.9

80

10-100

36.1

11.8

47.9

11

7.8

277

100-1000

17.2

13.4

30.6

26

5.0

206

1000-10 000

13.2

11.4

24.6

24

3.9

43

> 10 000

12.4

13.0

25.4

8

2.6

8

Average/ total

13.1

12.6

25.7

81

3.5

614

14

A proposal (annuity saving bill of Depla-De Vries) has been made to the Dutch Lower Chamber to extend the application of such fiscal facilities to old age savings via blocked bank accounts.

15

The data are described in Bikker and Van Leuvensteijn (2007). Investment costs are discussed later in this chapter.


65

12.4% for the largest life insurers to 37.9% for the smallest. In proportional terms therefore the costs of small insurers are three times higher than those of large insurers. On average almost half of the costs consist of acquisition costs; the percentage is somewhat higher for small insurers. For the period from 1995 to 2003, Bikker and Van Leuvensteijn (2007) calculated unutilised scale effects of on average 21%, varying from 10% for the 25% largest insurers to 42% for the 25% smallest insurance firms. These unutilised scale effects are therefore somewhat lower than those of pension funds. In addition, a portion of the contributed premiums goes to gross profits. This compensates shareholders for bearing certain risks such as the longevity and investment risk. The profit margin in 2004 seems to have been more or less equal across the size categories. It should be noted that this profit margin relates to the entire portfolio. There are indications that the margin for the new production is smaller than for older policies.16 On average, administrative costs and gross profits jointly account for a quarter of the gross premium at the larger insurers and almost half of the gross premium at the smaller insurers. Insurers are partly unable to avoid these costs while pension funds, being non-profit institutions, do not charge profit margins. It is again noted that the above analysis provides information on the average costs of all life insurance products. We lack the data required for a more refined analysis. It is plausible, however, that large cost discrepancies will occur for different types of products, such as collective versus private contracts. With collective contracts the costs will decrease relatively strongly as the size of the contract increases, e.g. in terms of number of participants. Alongside the aforementioned administrative costs, insurers also incur investment costs. In the financial figures that life insurers are required to report to the Dutch central bank (DNB), the investment costs are aggregated with interest charges. Averaging 0.31% of total assets, these costs are higher for life insurers than pension funds (0.10% of the total assets). This is probably (partly) due to interest charges. However, as the basis of comparison, i.e. total assets, is not identical at life insurers and pension funds, no further conclusions can be drawn from this.

16

This is evident from e.g. embedded value calculations where, for instance, the profit on new policies is determined over the entire term.

66


4.6

Administrative costs of life insurers and pension funds compared

Comparing the administrative costs of pension schemes provided by life insurers with those provided by pension funds gives rise to numerous complications.

DIFFERENT PRODUCTS The first question that arises is whether insurers deliver, or are able to deliver, the same products as pension funds. This is not the case. Most pension funds provide DB pension plans where the size of the pension benefits is fixed (long) in advance on the basis of the final or average salary, in a few cases with guaranteed price or wage indexation, at least until the time of retirement (see Bikker and Vlaar, 2007). Insurers do not provide such pensions (and, in fact are not allowed to, at least not at fixed contributions). They cannot distribute the investment, inflation and longevity risks over different generations by varying contributions. In general, insurers provide nominal pensions where surplus profit sharing creates the possibility – but not the certainty – of applying indexation.17 Incidentally, the aforementioned DB pensions can be offered by an insurer if the employer undertakes to pay the additional contribution required for indexation and supplements up to a certain percentage of the final salary (socalled “back service” in final pay schemes). Besides direct schemes and collective contracts that are comparable with pension fund schemes, life insurers also provide reinsurance contracts and private policies for individuals, including both pension schemes as well as other types of insurance. Such products cannot be provided by pension funds.

MANDATORY PARTICIPATION Moreover, from a cost perspective, the position of pension funds and that of life insurers is not always comparable. First of all, the mandatory participation at pension funds leads to a strong reduction in costs. Almost half of the administrative costs of life insurers consist of acquisition costs made up of marketing and selling costs, including commissions for intermediaries. Insurers need to incur these costs to acquire customers, while pension

17

Sometimes partial indexation is guaranteed.


67

funds can avoid these as a result of the mandatory participation. It is worth noting that these costs are not entirely without benefit for clients, as they are partly incurred to advise on the need for, and best method of, saving for a pension.18 Mandatory participation in pension schemes yields large social savings in terms of reduced educational and search costs. Note, incidentally, that collective contracts of life insurers also benefit from mandatory participation, as acquisition costs can then be avoided.

ADVERSE SELECTION The absence of mandatory participation with private policies of life insurers also leads to costs due to adverse selection. People with poor health and therefore a greater risk of death are, on average, more likely to take out life insurance payable on death. Similarly, people in good health are more likely – on average – to take out a lifetime annuity. In order to limit the effects of adverse selection, applications for life insurance involve a costly medical examination and selection process. Due to the mandatory participation, costs related to adverse selection play no role for pension funds. In addition, buyers of annuities tend to be more highly educated and remunerated people who, on average, are healthier and have a longer life expectancy. This will be taken into account in the pricing process.19

DIFFERENT ORGANISATIONAL FORM The difference in organisational form also leads to unequal costs. Insurers tend to be profit-oriented companies while pension funds are non-profit institutions. Gross profits averaged 12.6% of the contributions in 2004. For comparison purposes, the corporation tax on the profit and surplus profit must be included in the calculation as costs for the policyholder. Whether the net return on equity should also be included in the calculation is open to question. For pension funds a portion of the paid contributions is used to fund buffers. In a sense the participants in a pension fund must themselves contribute a kind of share capital. In the long term, however, they will eventually benefit from this capital as the returns earned on the buffer will be used for e.g. indexation (see Bikker and Vlaar, 2007). The buffer itself, however, will be shifted to the following generation.

18

The quality and reliability of such advice is sometimes disputed (CPB, 2005).

19

This does not influence the administrative costs of insurers.

68


DIFFERENT REGULATORY REGIME Finally insurers must cover the risks on insurance contracts by maintaining capital, so that costs of capital (or profits before taxation) become part of the cost price.20 Pension funds are required to cover their nominal liabilities for 105% and also to maintain a solvency buffer for investment and longevity risks. The required buffer for an average fund is approximately 30%. Until the Dutch Financial Assessment Framework took effect on 1 January 2007, pension funds were permitted to base their calculations on an actuarial interest rate of 4% at maximum,21 whereas insurers were required to use 3% for new contracts since 1997. This difference in interest rate does not lead to widely divergent pension contributions in the long term, but may do so in the short term, for instance in a recovery period when buffers need to be repaired. Different regulatory regimes can disturb the optimal allocation of pension provisions over pension funds and life insurers. Though some regulatory convergence is likely in the near future, differences between the regulation of the two sectors will continue to exist on account of the profit objective of most life insurers and the corporation tax on their profits as well as the intrinsic differences between pension funds and life insurers.

COST DIFFERENCES Table 5 shows the differences in the administrative costs of Dutch pension funds and life insurers by expressing these costs as a percentage of the gross premiums.22 The size categories are not relevant for the comparison; these only give information about the distribution of the costs. On average, administrative costs account for 3.5% of the gross contributions at pension funds in 2004,23 while the percentage at insurers is over 13% excluding profit margins and almost 26% including profit margins. These data can differ from year to year due to e.g. fluctuations in profits or changes in

20

The supervisor sets a minimum solvency requirement for life insurers, which, incidentally, is much lower than the capital that insurers maintain in connection with their own operational targets.

21

Many pension funds did not use 4% but 3.7% at year-end 2005.

22

Insurers do not report investment costs separately. These costs are included in the investment charges item.

23

This figure may be a fraction higher due to partial underreporting of costs by mainly small pension funds.


69

Table 6. Administrative costs of life insurers and pension funds (2000-2004) Life insurers

Pension funds

Year Administrative costs

Gross profits

Administrative costs and gross profits

Administrative costs

As % of gross premium 2000

12.4

14.7

27.1

5.8

2001

12.8

12.8

25.6

5.6

2002

13.1

1.7

14.8

4.2

2003

13.0

13.0

26.0

3.9

2004

13.1

12.6

25.7

3.5

Average

12.9

11.0

23.9

4.4

As % of total assets 2000

1.20

1.42

2.63

0.13

2001

1.31

1.32

2.63

0.15

2002

1.31

0.17

1.48

0.18

2003

1.26

1.26

2.52

0.17

2004

1.23

1.19

2.42

0.14

Average

1.27

1.08

2.35

0.15

the contributions. For this reason, Table 6 presents the same data for the past five years while the administrative costs are also reported as a percentage of total assets.24 The conclusions remain the same. The comparison indicates that due to (i) the frequently individual scale, (ii) the need for acquisition (promotion, distribution and advice), (iii) the costs that are caused by adverse selection and (iv) the profit objective, insurers generally incur higher costs for the provision of pension schemes than pension funds.25 Life insurers play a vital social role in offering insurance

24

Because pensions are build up over a very long time, pension funds maintain comparatively more assets, which further reduces their cost margins expressed as a percentage of total assets.

25

The annual continuing costs per policy amount to about € 50-100. The one-off costs per life insurance, including medical examination, equal about € 300-500 as opposed to € 1500-2000 per policy for endowment policies (e.g. for mortgages) and annuities (immediate annuities and endowment policies with an annuity clause). The latter include advice.

70


products and their policies can yield significant benefits for individuals, partly due to the possibility of providing customised products. However, collective pension schemes based on mandatory participation can be offered at significantly lower (administrative) costs. One area where a cost comparison could conceivably be made between life insurers and pension funds is that of collective contracts. Unfortunately, the absence of separate data on the administrative costs of these collective contracts implies that we are unable to make such a comparison. However, we do know more about one specific cost item, namely profits. Insurers report profits on both collective and private insurance products, and it turns out that both yield comparable profit margins in both market segments (see tables B.2 and B.3 in the appendix). These, however, are the profit margins on the existing portfolio, i.e. the production from the past. Another source of information consists of embedded value calculations, where the profitability of the portfolio of both existing and new collective and other contacts in the remaining term until maturity is calculated. These often turn out to be loss making in the sense that the targeted return on equity is not entirely achieved. Apparently, this part of the market, where actuarial knowledge is present on both sides of the table, has become a fiercely competitive market. Smaller and medium-sized pension funds take out reinsurance contracts on a reasonably large scale, while smaller and medium-sized companies take out collective contracts. Evidently this is more cost-effective in these cases, where economies of scale will often be a decisive factor. Finally we can make a statement about the costs of private policies. Though we do not have separate administrative cost data, we can see in Table B.2 of the appendix that more than half of the contributions and provisions relate to private policies. The number of private policies greatly exceeds the number of collective policies (by 36 million).26 Given that the costs are strongly determined by scale, we conclude that most of the insurers’ costs are allocated to private policies. Nevertheless, we prefer to use conservative estimates by assuming average costs as a percentage of the gross contributions for private policies. Finally, we assume that there is no significant difference between the administrative costs for endowment insurance and pension and annuity insurance products.

26

The number of collective arrangements is limited and comprise less than 5 million insured persons.


4.7

71

Conclusions

This chapter shows that the administrative costs of collective pension schemes offered by pension funds constitute only a fraction of the operating costs of private pension schemes offered by insurers (over the last five years an estimated 4.4% versus 12.9% of the gross contributions). The difference becomes almost twice as large when the gross profit margin of insurers is also taken into consideration: 4.4% versus 23.9%. These differences are explained by, among other things, scale effects, adverse selection, acquisition costs and institutional structure. With some provisions for cost comparison problems (averages need not apply to sub-categories), we conclude that collective schemes are much cheaper than private schemes. From a cost-efficiency perspective, collective schemes are superior to private schemes. Furthermore this study shows that the operating costs of pension funds are strongly influenced by scale. The operating costs of small funds are more than ten times higher per participant than those of very large funds. Some employers and employees may deliberately opt for a small pension fund to obtain extra service and customisation (where pension schemes are designed to accommodate non-standard choices), but whether they are sufficiently aware of the resulting higher operating costs is open to question. More transparency to stakeholders about operating costs could help in this respect. The conclusion here is that the consolidation of small pension funds would lead to efficiency gains. Lastly, the above analysis has shown that some types of pension funds are more efficient than others (after controlling for economies of scale), even though the cost differences in view of the above comparison are modest. Industry-wide pension funds, particularly the mandatory ones, have significantly lower operating costs per participant than company and professional group pension funds. Standard pension schemes that are less generous and simpler to administer yield extra efficiency gains. In this context efficiency also refers to factors that cannot be influenced, such as the lower costs of value transfers for industry-wide pension funds. In addition, more extensive services can be provided to participants. The aforementioned efficiency gains cast a different light on the recent discussion about the desirability or undesirability of mandatory industry-wide pension funds and the possible expansion of the number of participants at this type of funds.

72


Literature Bateman, H., G. Kingston and J. Piggot, Forced saving: Mandating private retirement incomes, Cambridge: Cambridge University Press, 2001. Bateman, H., O.S. Mitchell, ‘New evidence on pension plan design and administrative expenses: the Australian experience’, Journal of Pension Economics and Finance 3, 2004, pp. 63-76. Bikker, J.A., M. van Leuvensteijn, ‘Competition and efficiency in the Dutch life insurance industry’, Applied Economics, forthcoming, 2007. Bikker, J.A., P.J.G. Vlaar, ‘Conditional indexation in defined benefit pension plans’, Geneva Papers on Risk and Insurance, forthcoming, 2007. Bikker, J.A., J. de Dreu, ‘Pension Operating costs of pension funds: the impact of scale, governance and plan design’, Journal of Pension Economics and Finance, forthcoming, 2007. Bikker, J.A., L. Spierdijk, P.J. van der Sluis, ‘Market impact costs of institutional equity trades’, Journal of International Money and Finance, forthcoming, 2007. Caswell, J.W., ‘Economic efficiency in pension plan administration: A study of the construction Industry’, Journal of Risk and Insurance 4, 1976, pp. 257-273. CPB, ‘Competition in markets for life insurance’, CPB Document no. 96, The Hague: Netherlands Bureau for Economic Policy Analysis, 2005. Dobronogov, A. and M. Murthi, ‘Administrative fees and costs of mandatory private pensions in transition economies’, Journal of Pension Economics and Finance 4, 2005, pp. 31-55. James, E., J. Smalhout, D.Vittas, ‘Administrative costs and the organization of individual retirement account systems: A comparative perspective’, in: Holzmann, R. and J.E. Stiglitz (eds.) New ideas about old age security: Toward sustainable pension systems in the twenty-first century, Washington, DC: World Bank, 254-307/ Policy Research Working Paper Series no. 2554, World Bank, Washington DC, 2001. Jensen, M.C., ‘The performance of mutual funds in the period 1945-1964’, The Journal of Finance 23, 1968, pp. 389-416. Malkiel, B.G., ‘Returns from investing in equity mutual funds 1971 to 1991’, The Journal of Finance 50, 1995, pp. 549-572. Rooij, M.C.J. van, C.J.M. Kool, H.M. Prast, ‘Risk-return preferences in the pension domain: are people able to choose?’, Journal of Public Economics, forthcoming, 2007.


73

Appendix: Key data of pension funds and life insurers Table B.1. Key data of pension funds (1992-2004) Year

Number of funds, total

Number Number of Number of Total Number of Total costs/ Total costs of industry- company funds in assets, participants, total assets per particiwide penpension sample average average (%)b pant (€)a,b sion funds funds (€ million)a (1000)

1992

1131

82

1029

781

197

11

0.19

34

1993

1123

82

1021

820

209

11

0.18

34

1994

1111

82

1009

819

223

11

0.19

37

1995

1098

81

997

823

237

12

0.18

38

1996

1090

83

987

823

409

15

0.15

42

1997

1059

82

957

805

468

15

0.14

41

1998

1040

85

938

816

545

16

0.15

52

1999

1014

93

904

784

651

17

0.13

49

2000

986

92

877

791

658

17

0.14

51

2001

961

100

843

773

644

19

0.15

51

2002

924

102

804

727

613

22

0.18

51

2003

873

103

753

702

696

23

0.17

52

2004

841

104

718

655

826

25

0.15

48

a

In 2004 prices;

b

Weighted averages.

Source: DNB.

74


Table B.2. Technical provisions and gross premiums of life insurers and pension funds (2004; € billion) Private

Collective

Total

Endowment insurance - insurers

9.0

0.9

9.9

Pension and annuity insurance

0.1

3.0

3.1

Total life insurersa

9.1

3.9

13.0

– of which for pensionsb

1.2

3.9

5.1

–

22.8

22.8

101.2

7.9

109.0

21.4

84.8

106.2

122.6

92.6

215.2

–

446.9

446.9

Gross premium

Insurers

Pension funds Technical provision Endowment insurance – insurers Pension and annuity insurance Insurers Total life insurers Pension funds a

Excluding annual deposits in savings banks;

Data from Statistics Netherlands (CBS), subject to differences in definition. Distributed over private and collective, according to the authors’ own judgment. Note that a proportion of the private endowment insurance policies includes an annuity clause and is intended for pension purposes. b

Source: DNB, Financial data life insurance companies; and Statistics Netherlands (CBS), National Accounts. Table B.3. Gross profits of life insurers (2004) Gross profits (€ million) Private insurance Collective insurance Totala a

Gross profits /gross premiums (%)

Gross profits / technical provisions (%)

1 192

12.3

1.0

624

15.9

0.7

1 816

13.9

0.9

Excluding the item ‘not to be categorised’.

Source: DNB, Financial data of life insurance companies.

5

Optimal risk-sharing in private and collective pension contracts

C.G.E. Boender, A.L. Bovenberg, S. van Hoogdalem, and Th.E. Nijman Pension solidarity can no longer be taken for granted. Due to demographic changes – and hence a growing retiree/employee ratio – additional contributions offer steadily fewer opportunities for clearing pension shortfalls. Together with the growing costs of contribution volatility and the trend towards short-termism, this means that the added value of solidarity is increasingly being called into question. A carefully argued and well-substantiated answer is therefore in order. What is the added value of solidarity and what is an ‘optimal’ pension contract? This contribution seeks to provide a survey of what we can learn about these issues from the current academic literature and to identify those areas where further in-depth research is warranted. The starting point consists of the private and collective pension contracts that are perceived to be optimal in the academic literature. However, the practical questions regarding pension funds and the economic environment in which pension funds operate are considerably more complex than assumed in the literature. Additional research is necessary to answer the central questions concerning the added value of pension solidarity and the optimal form of pension contracts. This contribution analyses how the assumptions and findings of the WRR study (Boender et al., 2000) relate to the customary assumptions in the academic literature. It specifies what we can learn from this about the added value of pension solidarity as calculated in that study. The insights in this contribution do not result in a single uniform answer regarding the exact added value of pension solidarity and the precise form of optimal pension contracts. Our aim here is rather to arrive at a number of concrete research questions in order to gain a deeper understanding of the underlying considerations and to be able to build a bridge in the near future between the academic literature and complex reality.

76

C.G.E. Boender, A.L. Bovenberg, S. van Hoogdalem, and Th.E. Nijman

5.1

Introduction

Solidarity in pension systems exists in many different guises.1 Several contributions in this book discuss examples of solidarity and seek to define what form of solidarity leads to the most desirable cost-benefit distribution in pension contracts. An important aspect is that the pension contract is designed to meet the preferences and circumstances of all individuals in an optimal way. This is often referred to as risk solidarity, where the pension contract is designed to protect the vulnerable elderly against a sudden loss of pension capital due to economic shocks. Young people are better able to absorb these shocks, because of their available human capital and longer investment horizon. In return, young people must receive an adequate reward for their role as shock absorber. This reward is all the more vital now that solidarity in the pension system is under pressure. One important cause of this pressure is the growing retiree/employee ratio. In the year 2006 pension assets in the Netherlands had already grown considerably above the value of the gross domestic product (GDP) and, when ageing reaches its peak, pension assets will be more than twice as large as the Dutch GDP. Assuming there is no structural decrease in annuity rates and returns in an ageing society and no further increase in estimated longevity, the pension system will not become more expensive due to ageing and a growing retiree/employee ratio, but it will become less risk-resistant. Back in the seventies and eighties, the national wage bill and GDP were so large compared to the accrued pension capital, that a pension capital loss of e.g. 10% could be easily made up for by charging the working population limited extra contributions. In the year 2006, however, this passing of responsibility to the employed would soon cost more than 10% of GDP, rising to over 20% of GDP in the year 2030. This is an important and objective cause of the growing doubts within society regarding the sustainability of the pension system. New pension regulations have highlighted this reduced risk-resistance, which is positive in itself. But this increased awareness has also divided opinions as to who should bear responsibility for the pension system’s greater vulnerability. The debate took on an ever sharper edge in the wake of the equity and bond slump at the start of the new millennium. The upshot, in short, is that solidarity is under pressure, particularly among the young who fear their current contributions are predicated on solidarity

1

An extensive description of the many different types can be found in the appendix of Chapter 2 in this volume, by Jan Kuné.

5 Optimal risk-sharing in private and collective pension contracts

77

principles that may no longer hold sway when they reach old age. For this reason, pension solidarity can no longer be taken for granted and must be shown to offer an economic win-win proposition for young and old alike.

PREVIOUS RESEARCH The value of pension solidarity in collective pension systems is demonstrated in a study carried out on behalf of the Scientific Council for Government Policy (WRR) (Boender et al., 2000). This report provides quantitative evidence that an individual within a collective scheme achieves a significantly better pension than an identical individual who is entirely responsible for making his own pension arrangements. Within the pension solidarity debate this report is often cited as an argument against switching to defined-contribution (DC) systems where all pension risks are offloaded onto the individual participants. However, the risk-sharing assumptions made in this report do not correspond with the pension policy that is demonstrated to be optimal in simplified theoretical models that are explicitly based on individual utility functions (see e.g. Teulings and De Vries, 2005). The outcomes of the WRR report have therefore attracted strong criticism, raising doubts as to whether pension solidarity yields genuine economic benefits. Clearly therefore, there is a great practical need for a more explicit understanding of what type of pension solidarity delivers what economic benefit under what assumptions. This contribution is a first step in that direction.

STRUCTURE OF THE ARGUMENT This chapter is built up as follows. In section 5.2 we will first establish what the optimal pension contract looks like according to the recent academic literature. The central question is: what investment and contribution decisions are optimal in the event of shocks on the financial markets and given the age of an individual? This section describes what pension policy is optimal if a number of simplifying assumptions are met. The assumptions of the theoretical model are not consistent with practical reality. The extent to which this is the case and the resulting consequences for, respectively, the optimal pension policy for an individual and a collective are discussed in sections 5.3 and 5.4. The optimal pension policy given the assumptions made in the academic literature diverges significantly from the outcomes of the aforementioned WRR study. With the assumptions applied in the WRR study, it is

78


found that, notably, risk solidarity between generations delivers substantial economic benefits and that buffers have great added value. This solidarity comes about because people in the workforce – if necessary – pay extra contributions and temporarily accept underfunding in order to protect the pensions of the elderly against inflationary erosion. In return, the elderly put a buffer at the disposal of the young. However, with the assumptions made in the academic literature, the economic benefits of solidarity and of buffers is much smaller because the volatility of contributions is also included in the costs. This creates confusion over the actual importance of these two pillars within optimal pension contracts. For this reason, a number of assumptions underlying the academic literature and the WRR study are put under the microscope in section 5.5 to make a qualitative analysis of the consequences of these differences for the resulting valuation of risk solidarity. Quantification of the consequences of the differences in the applied assumptions is high on the research agenda. In section 5.6 this leads to a summary of the most important research questions. Section 5.7 outlines the principal conclusions.

5.2

Optimal risk-sharing in theory

A BENCHMARK This section describes how a pension fund, given certain simplifying assumptions, would provide an optimal pension service to its participants. An optimal pension policy for the individual consists of a combination of contribution, indexation and investment policy. To define the explicit characteristics of the optimal pension policy for the individual, it is assumed that the individual exclusively saves for retirement via the pension fund.2 The optimal pension fund policy in relation to the contribution, indexation and investments obviously depends strongly on the objective function of the individual. One common basic assumption in the literature is that an 2

For instance, the contributions to this book by Hoevenaars and Ponds (Chapter 6) as well as that by Boeijen et al. (Chapter 7) make precisely the opposite extreme assumption, namely that the individual has optimal access to the capital market and can and will trade all undesirable risks at no cost. Only the market value of the pension commitment is relevant in this case. The two approaches are complementary.


79

individual maximises the utility of the expected consumption in each future year. Apart from taxation, consumption in the working period is equal to the salary less the pension savings and after retirement the level of consumption is determined by the pension. The utility increases in each period with the consumption, but the extra utility of an extra unit of consumption decreases with the level of consumption. Another basic assumption is that the more stable the development of this consumption, the greater the positive utility awarded by the individual to the future development of consumption. Moreover, an individual also discounts future consumption. This implies that the further in the future the consumption, the less utility it carries for the individual. For this reason in this model young people attribute relatively little utility to their consumption in retirement. The absolute value of the sensitivity of the marginal utility in relation to the consumption level is known as the relative risk aversion of the individual. Other frequently used basic assumptions are: • this relative risk aversion is constant. It does not depend on the level of consumption; • the contributions can be constantly optimally adjusted to new information; • interest rates and inflation are constant and equity returns have no memory (no ‘mean reversion’).

OUTCOME With these basic assumptions the optimal investment policy of an individual is surprisingly simple. At each moment the same portion of the total assets must be invested in equities, where the total assets consist of financial capital and human capital (the discounted value of future earnings3). The share of financial capital in the total assets increases with the individual’s age. In other words, with the passage of time the individual steadily converts his human capital into financial capital. According to this theory, the portion of the financial capital that is invested in equities decreases with age. A very simple example will clarify this. Assume that, according to this theory, an individual should invest 50% of his total assets in equities; and also that this young person’s total capital consists of 10% financial capital, whereas that of an old individual consists of 100% financial capital.

3

Uncertainty about future earnings is ignored in this simplest model.

80


The young individual must then invest 500% in equities and the old individual 50%. One result of the optimal investment policy is that all cohorts (given equal risk preferences) lose the same percentage of consumption over the rest of their lives as a result of a negative shock on the financial markets. Assuming e.g. a 10% underperformance in any given year, this implies that the consumption and the pension during the active period and after retirement are reduced to such an extent that a fixed percentage is expected to be relinquished in each future year. In this pension model this reduction is the same for each age group. Young people invest more in equities, but spread lower- and higherthan-expected returns over a longer period. Elderly people invest less in equities and spread the results over a shorter period, in such a way that the pension consequences in relation to consumption are the same for everyone. The optimal investment behaviour in complete capital markets thus creates solidarity between the various age groups. Though young people suffer a larger loss in euro terms, they can also spread that loss over a longer horizon. They basically have longer to recover than the elderly. The economy’s loss of capital is spread as equally as possible over all age groups and also over each person’s remaining life. Younger generations entering the labour market do not yet have any financial capital. In this model, therefore, it is optimal for younger generations to borrow from the older generations in order to invest in risk-bearing capital. The optimal situation for the elderly is that the young do this by issuing indexed bonds to the elderly. In this way the young give the older generations the greatest possible certainty that they can enjoy an indexed pension, while the young profit at an early age from the risk premium on equities. In this theoretically optimal pension model, the young basically own an insurance company for the elderly. Put differently: they invest the pension capital of the elderly at their own risk and provide an indexed pension in return. The basis for risk-sharing can be even further expanded in this theoretical pension model by also including future generations in the risk-sharing mechanism. In this context, the term ‘future generations’ refers to generations who do not yet participate in the labour market, including generations who are not yet born when a shock on the financial markets occurs. Basically these generations are then already investing in the financial markets before they start paying contributions. This increases the opportunities for wealth-creating trading between the elderly and the young. The elderly are entirely dependent on their financial capital and therefore are more vulnerable to financial risks. The young can still use their human


81

capital to absorb risks and thus benefit from the reward for risk. In this case risk-sharing takes place between non-overlapping generations: the shocks are borne not only by the cohorts who are alive when the risks occur, but also by cohorts who must still enter the fund in the future.

EXTENSIONS OF THE BASIC MODEL We will discuss a number of well-known extensions of the basic model before turning in the subsequent sections to explore how practical, implementable private and collective pension contracts relate to the recommendations made by the simplest theoretical model. In the simplifying assumptions underlying this optimal pension policy, equity returns have no ‘memory’, i.e.: there is no question of mean reversion. Mean reversion entails that equity returns become predictable up to a certain point, because the chance of higher returns increases as the period with lower returns lengthens. In these circumstances, equities are less risky over a longer horizon, because the returns average out to a certain extent over time (see, for instance, Siegel, 2002; Steehouwer, 2006). The differences in optimal investment policy between different age groups become stronger if mean reversion is taken into account. Older people often want to maintain the standard of living they enjoyed when younger, which makes them even less inclined to take investment risk. Above all, they want to minimise the risk of sinking below their accustomed – relatively high – level of consumption in times when returns are low. Young people will take even more risks than posited in the basic assumptions if they are not only able to adjust their contribution levels, but also the number of hours they work. Basically they have a larger stock of human capital, which they can use as a buffer in the financial markets. The assumption that older people place a smaller portion of their financial capital in equities is reasonably robust to changes in other assumptions in this theoretical pension model. As for young people, however, there are certain circumstances in which they should invest relatively little in equities: e.g. where, contrary to the basic assumptions, their salaried earnings are uncertain and strongly correlated to equity returns. In such cases, the human capital of young people already has much in common with a high-risk asset such as equities. In this theoretical pension model, they will therefore invest a smaller proportion of their financial capital in equities. Liquidity restrictions can also make young people risk-averse investors. These also play no role in the basic assumptions. If young people are unable to borrow against their human capital to adjust their con-

82


sumption level to their expected future earnings, they will be inclined to take less risk - for this would have a direct adverse impact on their current consumption level and they would be unable to spread negative shocks over a longer period. The optimal portfolio for the elderly will contain a relatively large equity component if the elderly can count on a relatively high state pension that is not correlated with financial risks. Basically, the elderly then have a relatively certain pension claim via the state, so that they can afford to place a large part of their financial capital in high-risk investments. The optimal investment behaviour will vary not only across the life cycle but also between individuals. For the share of total assets placed in equities depends in part on individual risk preferences as well as on the nature of the human capital within a household. The pension income of or through a partner will also play a role, as will any assets held in addition to the pension capital.4

5.3

Private pension savings in practice

In practice private pension savings differ in several ways from the policy that is optimal given the assumptions in section 5.2. In the first place, the real economic environment confronting pension funds is much riskier and more dynamic than assumed in section 5.2. Consequently, pension contracts that are optimal in practice may diverge from the optimal pension contracts in section 5.2. In addition, more and more information is becoming available (Van Rooij et al., 2004) about how people value possible future developments concerning their pension savings and pension payments. Discrepancies may therefore be found between the utility functions assumed in section 5.2 and actual practice. This has obvious consequences for the pension contracts that are optimal in real-life conditions. Moreover, in contrast to the assumptions in section 5.2, ‘adverse selection’ and ‘moral hazard’ generally make it difficult, if not impossible, for young people to borrow against the value of their human capital. This limits their ability to benefit from the risk premium on equities.5 In addition, unborn generations are unable to trade with current generations. This basically entails the absence of a public market for trading risk, so that 4

A more extensive discussion of the basic model and the many ways in which it can be refined is provided in Bovenberg et al. (2007). This paper also presents additional empirical results on the value of risk sharing.

5

See e.g. Constantinides et al. (2002).


83

young people are unable to take over the risks of elderly people in exchange for a reward. The risk-trading capabilities of capital markets are also limited in other ways. The market for index-linked loans, for instance, is at best embryonic, particularly in relation to the indexation of Dutch inflation. The same applies to the trading of longevity risk through longevity bonds. With this type of bonds the interest paid by the issuer increases with the percentage of people of a pre-determined age group who live longer than expected. There is also fundamental uncertainty regarding not only the set of possible outcomes, but also the objective probability distribution. Certain types of macro-economic shocks (such as political uncertainties) are inconceivable to us, let alone that negotiable products exist to insure such risks. In short: by no means can all risk factors be traded. Adverse selection also results in financial markets that are inadequate or even non-existent. The market for annuities, for instance, suffers from adverse selection because providers will try to bar relatively healthy elderly people from this market. Examples of non-existent markets are: • Borrowing by younger and even unborn generations using their human capital as collateral; • Sufficient availability of index-linked loans, notably for Dutch price inflation and industry-specific wage inflation; • Sufficient availability of longevity bonds; • Insurance products to protect against macro-economic shocks, such as political risk; • Financial guarantees, such as put options on stock exchange indexes, with a very long term of several decades; • Availability of complex derivatives strategies which are available to institutional investors, but not to individuals. In practice, an individual is also unable to approximate optimal investment behaviour because constant trading leads to excessive transaction costs or because certain markets are entirely closed to individuals and only accessible to large institutional investors (e.g. complex derivatives strategies that pension funds use to optimise performance). In addition, individuals often lack the expertise to save and invest rationally. People have difficulty making complex decisions in uncertain circumstances. The re-

84


cent literature describes various ways in which individual investors make systematic errors and often do not know what is best for them.6 Buying professional knowledge is also problematic, because this market is often opaque and involves high transaction and marketing costs. Every percentage point of the invested capital that an individual loses annually as a result of these impediments and irrational behaviour translates into a decline in the pension payments of about 25% (see the contribution of Bikker and De Dreu in this volume). Suboptimal private pension management consequently implies a substantial deterioration of the pension result. In this light it is obviously of crucial importance to eliminate these impediments insofar as possible.

5.4

Collective pension funds in practice

CREATION OF HITHERTO NON-EXISTENT MARKETS Collective pension funds seek to overcome the imperfections of individual behaviour and the incomplete capital markets mentioned in the previous section. The more successful they are in achieving this objective, the closer actual practice can approximate the theoretically optimal pension contract. Pension funds can absorb these market imperfections in various ways. Through collective DB systems they organise risk-sharing between overlapping and non-overlapping generations that is not (yet) possible in capital markets. This takes the form of young people paying catch-up contributions as and when necessary. This opportunity for absorbing negative shocks enables the fund to take more risks in the investment portfolio and thus generate a higher return than would otherwise have been possible. Shocks in financial markets thus do not directly undermine the inflationproof nature of the pensions paid to pensioners. In collective DB systems, where pensions are linked to prices (wages), the young basically issue (wage-)indexed longevity bonds to older participants that are not yet for sale on the financial markets. Depending on the investment behaviour of the fund, the young invest the obtained funds at their own risk in the capital market. So here, the practical working of pension funds corresponds with the theory described in section 5.2, where the young are basically the shareholders of an insurance company for the elderly. Pension funds thus construct financial instruments (such as wage-indexed annuities with a 6

See e.g. Munnell and Sundèn (2004) and also Van Els et al. (Chapter 9) in this book.


85

long term which cover the longevity risk) that are not yet (readily) available in the financial markets. By filling these gaps in the financial markets, risk-sharing between the generations can be made more efficient: the young share in the financial risks of the elderly and the elderly share in the wage risk of the young. Mandatory participation can further reinforce the funding base for intergenerational risk-sharing, so that future generations can also be involved in intergenerational risk trading. In addition pension funds can create value which is, in itself, separate from the selected degree of risk sharing. Economies of scale dampen the management and marketing costs, thus closing the gap between their contracts and the optimal pension contracts given the assumptions in section 5.2. Moreover, the funds provide employees with access to complex investment strategies that few individuals could use if left to their own devices. In addition, they also protect employees against unwise savings and investment decisions by offering professional asset management (see Van Els et al. in this volume). Their non-profit character boosts the confidence of participants in the fund’s policy: the participants are also the owners, so there are fewer conflicts of interest between pension fund management and participants. Finally, the mandatory participation of employees prevents adverse selection in the market for life insurance and annuities. All this reduces the implementation costs. Due to their close ties with the social partners (employer and employee representatives) as managers of the human capital in a sector, pension funds are also able to make optimal use of the buffer function of human capital in undertaking financial risks – for instance by enabling employees to take out loans against their human capital. Even if the financial markets start offering more risk-sharing instruments (especially wage-indexed bonds and longevity bonds), pension funds will continue to play a vital role in offering cheap, professional management of human - and, above all, financial capital, forcing people to save for retirement and preventing adverse selection in longevity risk insurance.

COSTS OF INSTITUTIONS Collective pension funds are not able to create all non-existent markets. This is mainly due to the fact that even if participation is made mandatory, young people can still evade this obligation by choosing to work in a different sector or company or as a self-employed person. They can also decide to work less. The greater the labour mobility and wage elasticity of the labour supply, the more catch-up contributions will distort labour market behaviour and be translated into compensating wage differences. In simple terms: in a labour market where people can change jobs quickly, it

86


is more difficult to charge employees catch-up contributions as they will then simply defect to companies where no catch-up contributions are levied. This danger is smaller with larger collectives where it is less easy for participants to switch between collectives. Moreover, apart from voting with their feet, participants can also exert influence on the management of the fund. Delegating decision-making powers to a pension fund results in collective decision-making which always involves certain political risks. Older participants, for instance, are vulnerable to the risk that younger participants will refuse to pay large catch-up contributions. The greyer the fund, the greater this risk. The limited freedom of choice over the contributions and investments within collective systems protects participants against unwise decisions, but prevents these same participants from adapting individual behaviour to personal circumstances. The availability of pension benefits accrued by a partner, the nature of the human capital (is working longer an option?) or the risk attitude of the participant usually play no role in the pension contract. By offering more freedom of choice or by basing the pension on more information about the participant’s individual circumstances, collective pension funds could provide more customised pensions. This, however, has a price tag in the form of higher transaction and information costs. Most current collective systems (still) offer little in the way of customisation because they impose homogeneous contributions, investment portfolios and indexation on heterogeneous participants. Freedom of choice raises the danger of individuals making unwise choices. But, there too, delegating complex decisions to collective funds also inevitably creates extra transaction costs. These are incurred because the participants must be sure that the professional managers and investors who are acting on their behalf are genuinely working in their interest. Clear arrangements about governance, risk monitoring, and investment performance evaluation by a mandated supervisor are therefore of crucial importance.

5.5

Reconciling the WRR study and the theory

The WRR study (Boender et al., 2000) mentioned in section 5.1 quantifies the added value of solidarity that is realised by means of catch-up contributions and buffer formation. However, the added value of this solidarity and the optimal pension contracts based on this value do not correspond with the optimal pension policy, given the assumptions made in section 5.2. As a result, pension policy-makers are in the dark about one crucial point.


87

This section therefore looks in greater detail at the differences between the starting points underlying the WRR study and the assumptions of the theoretical pension model from section 5.2. In addition, we will try to establish what consequences these differences have for the resulting optimal pension policy. A future study will seek to quantify the consequences of the differences in the applied assumptions. To permit a proper analysis of the differences between the assumptions of the WRR study and those of the academic literature, we will briefly describe the design and results of the WRR study: Design of WRR study • The study simulates the life cycle of an individual who starts saving an entirely self-managed pension at the age of 25 and compares this with an identical individual in a solidarity-based collective whose participants differ in age only. In the basic policy, both the individual and the collective pay a single premium which, given a fixed actuarial interest rate, is sufficient for a nominal 70% average-pay oldage pension and 49% survivor’s pension. • If financial market volatility (inflation, interest and returns) leads to a lower-than-expected pension accrual rate, both the individual and the collective adjust the contribution. The central control variable here is the funding ratio given a 4% discount rate. This implies that an individual is stronger than the collective at a young age and weaker at a later age. Within the context of the collective, this premium mechanism means that the elderly can continue benefiting from the equity risk premium via catch-up contributions. If necessary, these are paid for by the young. • Next, a follow-up policy is analysed for the individual, who takes less investment risk as he grows older. Specific policy variants are analysed for the collective, where buffers are built up and then passed on to subsequent generations. • The results are evaluated on the basis of a large number of stochastic scenarios whose characteristics (uncertainties, correlations, memory) are based on historical figures (1966-1998) for the applied factors (inflation, interest and return). The central return expectations in the long term are determined according to the insights applicable at the time.

88


• The applied evaluation criteria are important. These concern, on the one hand, the average pension during the retirement period and, on the other hand, the downside deviation from the pension enjoyed in retirement compared to the 70% real average-pay pension with survivor’s pension. In plain language, this means that a twofold increase in the negative difference between the received and envisaged pension will be felt 2 x 2 = 4 times more severely by the individual.

RESULTS OF WRR STUDY With these starting points and evaluation criteria, it is found that an individual within a collective realises an approximately 30% better pension result than an identical individual who carries full responsibility for his own pension saving scheme. In other words: given the same average contributed pension capital and the same expected pension result, the individual within the collective fund runs 30% less pension risk during the retirement period than the identical individual outside the collective fund. It may happen (and actually does happen in the stochastic scenarios) that the collective fund takes an advance on the future by granting its participants indexation even when insufficient funds are available to continue doing this in the future. In that case the solidarity within the collective fund could start to crumble. This is not discounted in the calculation.

DIFFERENCES The first difference in the starting points applied in the WRR approach and the most common academic literature concerns the weighting of the contribution volatility. In the WRR approach this plays no role in the evaluation, while contribution fluctuations are relatively strongly penalised in the literature. As a result, the WRR approach assigns a higher expected added value to solidarity than the models in the literature. A second difference concerns the measurement of the difference between the envisaged and the realised pension. In the WRR study, the fact that the actual pension undershoots the target pension is penalised quadratically. This entails that a retiree receiving a pension that is lower than the 70% indexed average pay will feel this four times more severely if the shortfall were to double. This measure for the downside pension risks implies a specific form of aversion to loss of consumption levels during the pension (see Tversky and Kahneman, 1992). Only downside volatility is penalised where, due to the squaring operation, larger deviations carry


89

relatively more weight. If people also valued upside deviations in the pension result, as in most utility functions applied in the literature, then the added value of solidarity will obviously decrease. The WRR study shows that it is more optimal for younger employees to invest in equities than for older employees or retirees. This advantage is mainly due to the assumed ‘mean reversion’ of equity returns and the longer time horizon. By implication, the cause does not lie in the greater propensity of young people to carry risk, because even in the collective system, shocks must be absorbed within one year. The WRR study assumes a uniform investment mix for the collective fund, irrespective of the participant’s age. The added value of solidarity as calculated in the WRR study is sensitive to divergent assumptions regarding the degree of mean reversion in equity returns, the incorporation of the risk characteristics of human capital and a longer recovery term for pension shortfalls. Finally, the WRR study applies a richer description of the financial market risks by including not only equity risks but also inflation and interest rate risks. These risk factors are not taken on board in the simple theoretical models. Thanks to the solidarity within collectives, risks such as inflation risk and longevity risk, which are difficult if not impossible to trade on financial markets, can be implicitly traded within the fund by the participants. This turns out to be an important determinant of the added value of collective contracts, which is probably why the simple academic models arrive at a lower added value for solidarity than the WRR study. By contrast, the fact that longevity risks were ignored in the WRR study means that theoretical models that do incorporate longevity risk can indicate in a higher added value of solidarity than estimated in the WRR study.

ADDED VALUE OF SOLIDARITY On the basis of the above comparison there is no way of telling in advance whether the added value of pension solidarity as calculated in the WRR study will be higher or lower if the assumptions are adjusted to correspond more closely to the most common assumptions in the academic literature. This is an important reason for carrying out a follow-up study. In addition, the WRR study needs to be deepened further even though it contained a richer description of economic uncertainty. Among other things, a negative weight must be assigned to the contribution volatility during the working life as also happens in the models from the literature. In addition, products that were not yet applied in 2000 in the pension world, such as derivatives, should be added to the analysis.

90


5.6

Research agenda

The previous section showed that the WRR study must be enriched in certain areas. The relevant research questions focus on the way the added value of collective pension systems develops if 1. financial markets become more complete through the introduction of option contracts and indexed bonds or because participants can act dynamically and create certain options. In that case younger and older individuals can in principle also trade in risk via the financial markets without the intervention of a pension fund. The question remains whether individuals have the required expertise or can hire this at low costs. These new financial instruments also enable collective pension funds to control certain risks via negotiable securities in the financial markets instead of via implicit trading in non-negotiable claims within the pension funds between participants; 2. the preferences of the participants correspond more closely (or less closely) with the assumptions used in the academic literature. Recent experiences suggest that contribution volatility can be costly for the sponsor of a pension scheme. If this is the case, the optimal pension contract could shift from DB towards DC. By contrast, if participants are less concerned about contribution volatility and contribution pressure and attach more importance to keeping pensions inflation-proof, then the principle of inflation-proof pensions must be maintained insofar as possible (DNB, 2004). Further research into the preferences of participants in an ageing society is therefore of great importance; 3. the funding ratio on the basis of a 4% discount rate is replaced by a funding ratio at market value; 4. the labour market distortions caused by catch-up contributions are included in the analysis. Even in collective pension systems loans taken out by young people against the future value of their human capital are not entirely cost-free -- for young people are able to evade catch-up contributions by choosing to work less or elsewhere; 5. the possibility of a more flexible retirement age is included in the analysis. By utilising the retirement age as a risk buffer, people in the workforce can afford to take more investment risk and the optimal pension contract will thus change.


91

In this case the participants take a risk in relation to their personal health (at age 40 one doesn’t know how healthy one will be at age 65), but disability insurance can be taken out to cover this risk; 6. an estimate of the difference in costs between private and collective pension contracts is taken on board. It is clear that the costs of collective contracts are considerably lower and will therefore become relatively more attractive; 7. realistic assumptions are made concerning the actual behaviour of individual decision-makers. It is well-known that individuals often save insufficiently for the future and tend to maintain undiversified investment portfolios, which impairs the quality of the pension result; 8. heterogeneity of the participants is assumed. Collective systems are generally characterised by an identical contribution and indexation rule for all participants, irrespective of their age, risk aversion, realised pension accrual, etc. This can easily lead to wealth loss as compared to the optimal scheme for the individual participant whose characteristics deviate strongly from the average participant; 9. pension contracts (policy ladders) are determined optimally. Above, we have already looked at the optimal risk-sharing contracts given the evaluation criteria used by Boender et al. (2000); 10. longer recovery terms become possible if the pension accrual rate is lower than expected due to unfavourable developments in the financial markets. This would mean that surpluses and shortfalls can be spread more evenly over the remaining life. Collective systems can thus add even more value and become less procyclical than when shortfalls are eliminated as quickly as possible (as is also the case in the WRR study); 11. risk solidarity in relation to longevity risk is included in the analysis. In this case, collective systems can add value as there are virtually no opportunities for trading longevity risk in financial markets.

5.7

Conclusions

Collective and private pension solutions differ in many dimensions. To permit a choice between the two and, above all, to further optimise the existing pension solutions, it is important to answer the central question: under what assumptions are specific private or collective pension contracts the most suitable and efficient way of achieving risk solidarity?

92


Above all, this contribution sought to sum up the current state of affairs regarding this central research question in the literature. The adopted approach was to test the reality value of the assumptions underlying pension contracts that are assumed to be optimal in the literature. The conclusion is that reality is so much more complex and complete than the assumptions made in the literature and the WRR study, that extra research is necessary to answer the central question regarding the added value of pension solidarity. In addition we also analysed how the assumptions and findings of Boender et al. (2000) relate to the assumptions that are more common in the academic literature, and what we can learn from this regarding the added value of pension solidarity as calculated in this study. The table below compares the strengths and weaknesses of private and collective pension schemes as discussed in sections 5.3 and 5.4. Table 1. Strengths and weaknesses of private and collective pension schemes Strengths Private pension saving

Weaknesses

• Individual customisation of investment and contribution policy

• Suboptimal choices due to low pension awareness

• Competition between providers

• Suboptimal choices due to behavioural effects • Adverse selection • Not all financial products can be accessed

Collective pension savings

• Creates hitherto non-existent markets

• Continuity of solidarity not guaranteed

• Enables young people to take much more risk (elimination of restrictive conditions)

• Not geared to heterogeneous participants

• Low costs

• Ownership rights are not transparent

• Professional investors

This study does not produce full answers to the central question regarding the value of pension solidarity. This is because private and collective pension schemes both have strengths and weaknesses (see table) and because the assumptions underlying the assertions about the optimal pension contract as made in the literature may still be too far from reality. Instead, this study provides a list of concrete questions to be addressed in follow-up research. This will seek to gain a deeper understanding of the underlying considerations and thus provide a more well-founded basis for the further optimisation of pension contracts.


93

Literature Boender, C.G.E., S. van Hoogdalem, E. van Lochem and R.M.A. Jansweijer, Intergenerationele solidariteit en individualiteit in de tweede pensioenpijler: Een scenario-analyse, WRR (Scientific Council for Government Policy) report 114, The Hague: WRR, 2000. Bovenberg, A.L., R.S.J. Koijen, Th.E. Nijman and C. Teulings, ‘Saving and investing over the life cycle and the role of collective pension funds’, Netspar panel paper, Tilburg University, 2007. Constantinides, G., J. Donaldson, and R. Mehra, ‘Junior cannot borrow. A new perspective on the equity premium puzzle’, Quarterly Journal of Economics, pp. 269-296, 2002. Cui, J, F. de Jong and E. Ponds, The value of intergenerational transfers within funded pension system, Working paper presented at the 4th RTN Workshop on ‘Financing Retirement in Europe: Public Sector Reform and Financial Market Development’, Louvain, België, 2005. Munnel, A. and M. Sundèn, Coming Up Short: The Challenge of 401(k) Plans, Washington: The Brookings Institution, 2004. Rooij, M.C.J. van, C.J.M. Kool and H. Prast, Risk-return preferences in the pension domain: are people able to choose?, DNB working paper 25, Amsterdam: De Nederlandsche Bank, 2004. Siegel, J,J., Stocks for the Long Run, New York: McGraw-Hill, 2004. Steehouwer, H., Macroeconomic Scenarios and Reality, thesis, VU University Amsterdam, 2005. Teulings, C.N. and C.G. de Vries, ‘Generational Accounting, Solidarity and Pension Losses’, De Economist, 154 (1), pp. 63-83, 2006. Tversky, A. and D. Kahneman, ‘Advances in Prospect Theory: Cumulative Representation of Uncertainty’, Journal of Risk and Uncertainty, 1992, pp. 297-323.

6

Intergenerational value transfers within an industry-wide pension fund – a value-based ALM analysis

R.P.M.M. Hoevenaars and E.H.M. Ponds1 Intergenerational solidarity is an important topic in the increasing interest in collective pension schemes. How great is this solidarity? Is there a balanced sharing of costs and benefits across age cohorts? The long-term sustainability of any pension scheme stands or falls by the willingness of members to continue to participate; the attitude of younger persons is crucial in this regard. In this chapter we set out a method by which we can illustrate the way in which the value transfer between generations within an industry-wide pension fund occurs. This method – which we term value-based generational accounting – is ideally suited to investigating how far current policy itself, and changes to that policy, result in a balanced sharing of costs, benefits and risks across the generations participating in the pension fund. The method thereby also forms a good basis for justifying (in advance and in retrospect) the policy that is pursued. We begin the chapter by explaining the method of value-based generational accounting. We deduce from this that a pension fund can be characterised as a ‘zero-sum game’. A change in policy does not create extra value, but does result in a redistribution of value between the parties involved in the pension fund. We then examine the generational effects for a standard industry-wide pension fund the pension fund policy regarding investments, contribution rate setting and indexation policy. We pay no attention on transfers between members as a consequence of the operation of the uniform contribution rate. We regard this practice as a given. The contribution by Boeijen et al. in this book deals specifically with the pay-as-you-go 1

We owe a debt of gratitude to Niels Kortleve for our many discussions on this topic, to Roderick Molenaar for the construction of the deflator set and to Alexander Paulis and Jo Speck for the allocation of the actuarial cash flows to the various generations.

96

R.P.M.M. Hoevenaars and E.H.M. Ponds

element from younger to older employees, making use of the technique explained in that chapter. In addition, value transfers can also occur within a cohort. This topic is the focus of the contribution of Aarssen and Kuipers in this book. It is our view that the proposed method is a valuable addition in the evaluation of current policy and policy variations. The approach of value-based generational accounting should therefore form a part of the decision process regarding the financing policy of the fund. This can prevent undesirable and/or unintended value transfers between generations. The proposed method can assist in searching for a set of policy parameters whereby transfers do not take place, or if they do, they are of acceptable size.

6.1

Introduction

In this chapter we set out the method of value-based generational accounting. This method gives us an insight into the size and direction of value transfers between generations within the pension fund in the event of a policy change. The aim of this method is to evaluate the current financing structure or changes in this structure from the angle of a balanced sharing of costs and benefits across generations. Intergenerational value transfers are the result of risk sharing between generations within an industry-wide pension fund. Recent studies reveal that intergenerational risk sharing within a pension fund is welfare-improving for the plan members vis-à-vis an optimal indiviual pension plan, even under ideal market conditions (Cui et al. 2006, Gollier 2006, Teulings and De Vries 2006). The analysis of transfers of value between generations is based on generational accounts. A generational account can be formulated for each age cohort within a pension fund. A pension fund faces an uncertain future. Each projection of benefits and contributions is therefore shrouded in uncertainty. In formulating generational accounts we need to bear such uncertainty in mind. ABP and PGGM have worked together to develop the method of ‘value-based generational accounting’ (Kortleve, 2003, Ponds, 2003, Kortleve and Ponds, 2006). The generational accounts method is supplemental to the current ALM analysis. A classic ALM study helps to answer the question how realistic and/or desirable a policy variant is in terms of, for example, level of contribution rate, indexation allowed and the development of the financial position and the uncertainties involved. Value-based generational accounting makes clear how changes in the financing structure and the risk allocation specified in the pension contract can lead to value transfers between generations.

6 Intergenerational value transfers

97

The structure of this chapter is as follows. We first explain the method of value-based generational accounting. We then discuss various policy changes for a stylised industry-wide pension fund and examine the possible value transfers between members thereby involved.

6.2

Explanation of the ‘value-based generational accounting’ method

6.2.1 PENSION FUND AS ZERO-SUM GAME A pension fund is a structure of stakeholders with diverging interests. The content of the pension contract determines the value of the claim of each of the stakeholders on the assets of the fund. This claim is a combination of accrued rights, indexation terms, premium contributions and claims on the fund’s buffer. The sum of all claims is always equal to the value of the assets in the fund, since the total value of all claims of members at any one time can never be greater or smaller than the total assets in the fund at that time. A change in the financing structure (adjustment of the asset mix or contribution methodology) or a change in the rules of risk allocation between members (for example, a change to the rules regarding conditional indexation or a change in the tempo of catch-up indexation) will result in the claims of interested parties changing in value. As the total value of claims at the moment that a policy is altered does not change, the pension fund can therefore in this context be characterised as a zero-sum game. The assets do not increase or decrease as a result of a change in policy, but a change in policy usually will lead to a change in value of the individual claims of interested parties. Since the pension fund is a zero-sum, then what one party gains through an increase in value will be at the expense of one or more other parties suffering a loss in value. Policy changes lead to value transfers between the members. In a company pension scheme value transfers are mostly transfers between the company’s shareholders on the one hand and the plan members of the pension fund on the other hand (Chapman et al. 2006, Steenkamp 1998). In the case of an industry-wide pension fund we are dealing principally with value transfers between generations (age cohorts). These value transfers can now be analysed using the value-based generational accounting method. This method is, in fact, a combination of generational accounting and value-based ALM. We explain this in the following sections.

98


6.2.2 GENERATIONAL ACCOUNTS Generational accounting is a method developed by public finance economists as a tool for investigating the intergenerational distributional effects of fiscal policy (Auerbach et al., 1999, Kotlikoff 2002). Generational accounting is based on the government’s intertemporal budget constraint, which requires that either current or future generations pay for government spending via taxation. The government’s net wealth (including debt) plus the present value of the government’s net receipts from all current and future generations, must be sufficient to pay for the present value of the government’s current and future consumption. The generational accounting method can be employed for calculating the present value changes in net life-time income of both living and future generations that result from changes in fiscal policy. Generational accounting reveals the zero-sum feature of the intertemporal budget constraint of government finance. In other words, what some generations receive as an increase in net lifetime income must be paid for by other generations who will experience a decrease in net lifetime income. Planned increase or decrease in government debt can be used for tax smoothing over time in order to realize a sustainable fiscal policy (Auerbach et al. 1999, Van Ewijk et al., 2006). Similarly, the method of generational accounting may be of use in evaluating the policy of pension funds to cover both current and future participants. Two similarities with public finance can be discerned. Firstly, pension funds also face an intertemporal budget constraint, as the promised benefits must be backed by current and future contributions and returns on paid contributions. Secondly, as the government uses the tax instrument to close the budget over time, adjustments in contribution and indexation rates are the instruments used by pension funds to square the balance over time.

6.2.3 UNCERTAINTY Generational accounts focus on the long term. Future projections are thereby shrouded in a great deal of uncertainty. We must take this uncertainty into consideration when valuing future benefits and costs. In applying generational accounting to government finances, economists face the problem of how to deal with these uncertainties. Kotlikoff, the one of the godfathers of generational accounting, explains this problem as follows: ‘In the realistic case in which countries’ tax revenues and expenditures are uncertain, discerning the correct discount rate is even more difficult. In this case, discounting based on the term structure of risk-free rate is no longer theo-


99

retically justified. Instead, the appropriate discount rates would be those that adjust for the riskiness of the stream in question. Since the riskiness of taxes, spending and transfer payments presumably differ, the theoretically appropriate risk-adjusted rates at which to discount taxes, spending and transfer payments would also differ. (…) Unfortunately, the size of these risk adjustments remains a topic for future research. In the meantime, generational accountants have simply chosen to estimate generational accounts for a range of discount rates.’ (Kotlikoff, 2002). Virtually all studies in the field of government finances therefore in the first instance assume a world of certainty, and then analyse uncertainty based on a sensitivity analysis for alternative core parameters, including the discount rate applied to the present value calculation. The recent study by the CPB Netherlands Bureau for Economic Policy Analysis on the longer-term development of Dutch government finances is a good example of this (Van Ewijk et al. 2006). An analysis of uncertainty that is better than this sensitivity analysis of the discount rate is an analysis that uses stochastic discount rates (also termed deflators). This has recently received a lot of attention in the literature (Cochrane, 2001; De Jong, 2004; Ang and Bekaert, 2004; and Nijman and Koijen, 2006). A feature of stochastic discounting is that favourable economic variants in calculating current value are weighted less than unfavourable economic variants. Individuals and policy makers avoid risk and in a poor economic climate attach greater value to payments and revenues than they do when the economy is flourishing. Through the use of stochastic discount rates, the risk aversion is amply reflected in the valuation of uncertain cash flows, so that in valuing future cash flows there is a correction made for risk. This approach is much used in the valuation of insurance contracts and derivatives traded on the financial markets, such as options and futures. Cash flows out of and into the government, as well as pension funds, can also be valued as derivatives, since in the case of government finance, the payment out of tax revenues and government expenditure are endogenous to a number of underlying fundamental factors in the economy, such as growth and inflation. With regard to a pension fund, indexation payments in pension contracts depend on underlying variables such as investment returns and inflation. Such agreements in financial contracts can therefore be seen as derivatives that are dependant upon the underlying variables. Stochastic discounting with the help of deflators2 has found 2

Although derivatives are in general valued as risk-neutral, the deflator approach is more useful in the valuing non-tradables such as taxes and indexation. The

100


acceptance in the context of pension funds with the development of the socalled value-based ALM, which we discuss below.

6.2.4 FROM CLASSIC ALM TO VALUE-BASED ALM The usual Asset Liability Management (ALM) studies of pension funds, which we label classic ALM analysis, are intended mostly to identify the risk distribution of significant pension fund variables. The uncertainty surrounding future variables are analysed, and choices are then made with regard to the fund policy to be adopted on the basis of an evaluation of the expected values and risk for the current policy and alternative policies. An evaluation of pension fund policy on the basis of risk distribution alone provides insight into the possible value transfers between generations. An understanding of these transfers with the aid of generational accounts is important in order to prevent unintended and/or undesirable transfers. Such transfers can be the result of an imbalanced distribution of burdens (risks, contributions) and benefits (undertakings, indexation) amongst the interested parties. Partly as a result of discussions between British actuaries, we have seen the development of value-based ALM studies alongside the classic ALM studies (Chapman et al. 2001). This development means that the policy of a pension fund is valued not only on the basis of risk distributions, but also in terms of economic value. A value-based ALM applies the stochastic discount rates discussed above. The approach here is as follows: by determining all contributions, benefits and investment returns for each future variant and by calculating current value using the stochastic discount rate applicable to each variant, we arrive at the current economic value of these cash flows. ‘Economic value’ means here the cash value in euro’s at today’s date of uncertain future cash flows. The extending of the classic ALM analysis to a value-based ALM and the technique of generational accounts therefore potentially offers a solution to the problem of how to deal with uncertainty surrounding the results of generational accounts. Classic ALM and value-based ALM are therefore both extremely useful. Classic ALM allows us to calculate how a policy variant performs under significant variables such as expected values and risks concerning the level of contributions, indexation and the stochastic discount rate varies with the underlying stochastic risk factors such as investment returns and inflation. This means that the deflator is dependent on the risk in the payment out, and therefore more suitable for the valuation of risky payments than a fixed discount rate.


101

development of a financial position for the fund as a whole. Value-based ALM allows us to see the economic value in euro’s of participation in the fund by various members, and how large the possible value transfers between members of a pension fund are.

6.2.5 EXPLICT PENSION CONTRACT AS A BASIS FOR VALUE-BASED ALM In valuations applying value-based ALM techniques it is important that benefits and costs for the members are defined explicitly. Until recently, pension contracts for Dutch pension funds were characterised in practice by poorly-formulated ownership rights, especially with regard to the question of who shares in the gains and losses in the funding process, when and in what proportion, and who owns the funding surplus or shortfall (overfunding or underfunding) of the pension fund. In the nineties, this led to a lot of discussion between stakeholders regarding the allocation of what at the time was regarded as a high level of overfunding. The discussion centred on whether this surplus should be used for contribution holidays, extra indexation or the financing of early retirement. During the pensions crisis of a few years ago, it was not clear which party was responsible for making up for the underfunding. Partly as a result of this problem, pension contracts have since then been drawn up in more explicit detail. Over recent years, a large number of pension funds have implemented policy ladders with explicit rules governing indexation allowances and conditions relating to contributions. This makes it clear how the relevant parties share gains and losses. Based on such policy ladders it is possible to arrive at explicit economic values for contributions to be paid and indexation to be received. On the other hand, many funds have not yet properly regulated the allocation of the surplus. An important element of the value-based generational accounting method is that there must here be a explicit contract. It is therefore important to formulate a closure rule regarding the question to whom, when and in what proportion a surplus can be allocated. This study assumes as closure rule that at any point in time the surplus is to be allocated amongst the members in proportion to their nominal claims. Alternative closure rules are of course possible, such as allocation in proportion to the actual value of the pension commitments or in proportion to the amount of contribution. These alternatives would not lead to significantly different results. Thanks to the move to draw up explicit rules governing the allocation of risks and the funding surplus or shortfall, the pension contracts of Dutch

102


pension funds have, in fact, been transformed into financial contracts and the claims by members of these pension contracts can be valued as if they are being traded on financial markets (Kocken 2006, Frijns, 2006). As Dutch pension funds have moved to explicit pension contracts, valuebased ALM can be applied.

6.2.6 VALUE-BASED GENERATIONAL ACCOUNTING Basic variant The set up below shows how a generational account is drawn up (refer to Hoevenaars & Ponds (2007) for more details). This calculation can be applied to pension funds with intergenerational solidarity. The set up covers the period 2006-2025 for the generation born in the year ‘19xx’. Here, all terms are expressed in euro as at 2006. Using stochastic discount rates, the value of all cash flows over the period 2006-2025 is calculated back to 2006, including an adjustment for the risk that is implied in these cash flows. In general, this means: the more volatile the cash flow is expected to be, the higher the discount rate and the lower the current cash value. In fact, these terms are the current prices (option premiums) that the market would be willing to pay for risky future cash flows. Risk adjustment means that the risk aversion of the market is reflected in the valuation of the cash flows. Cash flows in poor economic climates are valued more heavily than cash flows in buoyant economic conditions.3 Generational account for age cohort 19xx (in euro as at 2006) = +

Value of accrued benefits in 2006

+

Increase in benefits due to new accrual and indexation 2006 - 2025

+

paid-out benefits 2006-2025-/- written-off accrued benefits 2006-2025

-/-

Contributions to be paid 2006-2025

+

Claim on surplus in 2025 -/- Claim on surplus in 2006

3

In this chapter we do not deal with the technique of valuing in line with market conditions with a correction for risk. We merely indicate that the ALM projections are based on a vector autoregressive model (see Hoevenaars et al. 2005) and that an economic valuation of these projects makes use of a pricing kernel (see Nijman and Koijen, 2006 and De Jong, 2005). See also Hoevenaars and Ponds (2006) for a description of the techniques underlying value-based generational accounting.


103

The generational account is the sum of a number of components. The first component is the value of accrued benefits of the relevant age cohort. Over the next 20 years, these accrued benefits increase as a result of further accrual and indexation. This increase in accrued benefits enlarges the value of the generational account. The contributions payable by the generation are a minus item in the generational account. In addition, the cohort receives benefits over the period in question. As a rule, the actual benefits will tie in with the written-off benefit obligations that can be forecast actuarially. In line with the closure rule we have assumed for the calculations that the generations have a claim upon the funding residu in proportion to the value of their nominal claims. This interpretation of the ownership right to the surplus means that the funding balance at the end of 2025 will be allocated to the cohorts in proportion to the value of their nominal claims at that time. This increases the value of the generational account. On the other hand, the funding residu at the beginning of the period is at the expense of the generational account. The right of ownership of the funding balance as at 2006 is, as it were, surrendered, in exchange for a right of ownership of the funding balance as at 2025. Policy variant We can also draw up such generational accounts for a policy variant, i.e. for an alternative pension contract. The generational accounts can then be compared with each other. This is shown in Table 1. The first column indicates the age of the cohorts in 2006. The oldest generation is 105 years. The youngest generation will be born in two years’ time and will reach the age of 18 in 20 years’ time. Members of this generation will then become pension fund members for the first time. The second column indicates the generational accounts for the basic variant, i.e. existing policy. The third column indicates the results of the generational accounts for an alternative policy variant. The fourth column shows the difference between the results of the generational accounts for the alternative, and those for the basic variant. A very important characteristic is that these differences add up to zero. This reflects the notion that in terms of economic values the pension fund is a ‘zero-sum game’: a change to policy may lead to a positive value effect for one age cohort, but has a negative value effect of the same order on at least or more age cohorts.

104


Table 1. Outline of generational accounts

Age – 2yrs.

Generational account standard variant X

Generational account alternative variant Y

Increase /decrease

X-2

Y-2

X-2 – Y-2

X30

Y30

X30 – Y30

X60

Y60

X30 – Y60

X105

Y105

X105 – Y105

Sum = 0

Sum = 0

Sum = 0

… Age 30yrs. … Age 60yrs. … Age 105yrs

6.3

Analysis using value-based generational accounting

6.3.1 BASIC VARIANT FINANCING STRUCTURE We have carried out a classic ALM study for a standard industry-wide pension fund with a conditionally index-linked average-wage scheme. We calculated over a 20-year period from 2006 to 2025. We did this for 5,000 variants. Then, based on the results, we drew up the generational account for each age cohort using the value-based generational accounting method. The pension fund’s investment portfolio consists of 40% equities, 40% bonds and 20% alternative investments (including commodities, hedge funds and private equity). Figure 1 shows the policy ladder operated by the pension fund. The contribution rate is stable and is fixed on the basis of the real return (prudently estimated) on the investment portfolio. The indexation policy is conditional. There is no indexation if the funding ratio is less than 100%. If the funding ratio is greater than 140% then there is full indexation. For a funding ratio between 100% and 140% there will be partial indexation according to the formula: (FR-100%)/140%-100%) x wage increase, where FR stands for funding ratio. Figure 2 shows the generational accounts. The horizontal axis represents the age of the relevant cohorts in 2006. The vertical axis represents the economic value of the generational accounts, expressed as a percentage of the total fund liabilities in 2006. The sum of all generational accounts is zero. The calculations all assume that the funding ratio for the pension fund at


105

Costprice contribution rate

Full indexation

indexation

0% 100%

Funding ratio

140%

Fig. 1. Policy ladder – basic variant 1.5%

% total liabilities

1.0%

0.5%

0.0%

-0.5%

-1.0%

-1.5% -2

3

8

13

18

23

28

33

38

43

48

53

58

63

68

73

78

83

88

93

98 103

age cohort

Fig. 2. Generational accounts in basic variant as % of total liabilities in 2006

the beginning of 2006 is equal to 120%. According to the ladder, therefore, there is a cut back of the indexation at the start. The results of the generational accounts are heavily determined by the use of the uniform contribution rate. All employees pay the same uniform contribution as a percentage of their pensionable salary, but the value of the rights that are acquired for any year of service depends on age. For a 48-year-old the value of the new sum accrued is virtually the same as the contribution that this member pays in. The value of rights of employees under the age of 48 is well below the amount of contribution they pay, whereas the older members accrue many more rights than the contribution

106


they pay. The contribution from Boeijen et al. in this book deals with this subject in detail. A 48-year-old has the highest positive generational account. For almost 20 years this member has profited from the fact that the value of the new sum accrued over this period is larger than the contributions paid over the same period. A 25-year-old has the largest negative generational account. For this member, the difference between the value of the contributions and the value of the sum accrued is the biggest. For a member aged 38, the generational account is approximately zero. In the first 10 years the value of the sum accrued remains less than the amount of the contributions, whilst in the second half of the period this is exactly compensated for by the accrued sum that exceeds the value of the contributions made. Those in retirement have a slightly negative generational account. This reflects the uncertainty surrounding future indexation. The question that arises is whether we can show on the basis of figure 2 whether the current pension contract is fair or not to the relevant parties. The answer is no: we are unable to make any judgment on the degree of fairness. Firstly, we are looking 20 years into the future and the history of the members’ contribution payments and indexation rates is not included in the analysis. We need this additional information to obtain a broad picture of the total contributions paid by the generations and the total benefits being received by the generations. Secondly, the approach does not include welfare aspects regarding the pension scheme in the analysis. Membership of the pension fund’s pension scheme gives the prospect of pension income being related to wage developments. This thereby provides an insurance against risks concerning future inflation and actual growth in income, whereby we have the prospect that on reaching pensionable age our standard of living is related to the standard of living we enjoyed before reaching such age. This form of insurance cannot be purchased on the financial markets. It may be that a generation has to accept a loss in value terms, but that nevertheless – in welfare terms – there is a positive-sum game (cf. Cui et al. 2006). For welfare analysis we have to apply a utilitybased ALM, but for the time being this is not useful yet for practical applications.4

4

The academic literature contains a number of initiatives for formulating an objective function for a pension fund and for utilising this in formulating an optimum policy. This approach, which we call ‘utility-based ALM’ can, however, as yet only be applied to a very stylised characterisation of an actual pension fund.


107

Value-based generational accounting is not therefore suitable for issues concerning fairness and wealth analysis. The method is primarily suited to identifying value transfers between generations resulting from changes in policy. This is the subject of the following sections.

6.3.2 POLICY ALTERNATIVES In this section we study a number of policy variants, in particular the effects in terms of generational accounts when there is a switch from the existing financing structure to these policy variants. We begin by noting the results of the classic ALM analysis for a number of core criteria. Then, we analyse the consequences of a change in the policy for the generational accounts. The effect on the generational account of a policy change can be split into the following components: Change in generational account for x through policy change = + Change in value of accrued benefits of cohort x for 2006-2025 – Change in value of contributions by cohort x for 2006-2025 +

Change in value of the claim on the surplus of cohort x in 2025

Here, the total across all the cohorts must always be zero, as we showed in section 6.2 above, since the pension fund is a zero-sum game in terms of economic value. The total value at any moment is equal to the value of assets at that moment. A change in policy does not result in more or less wealth in the pension fund. As a rule, it will, however, lead to a redistribution of risk between the members and therefore a redistribution of the value. We will examine three policy changes: 1. a change in investment policy; 2. a transfer to a DB final-salary scheme with unconditional indexation and variable contribution; 3. a switch to a collective DC scheme. Changes to investment policy We will look at two variants of investment policy: a switch to 100% bonds and a switch to 100% equities. We will first discuss the results of the classic ALM analysis, and then the effects for generations in value terms.

108


Classic ALM The following table shows the results for a number of core variables of a classic ALM analysis of the existing policy and two policy variants. Table 2. Results of classic ALM analysis for investment variants FR* 2024

FR < 105% 2005 – 2024

Median

Contribution 2005 – 2024

Indexation as % of wage 2005 – 2024

Median

Median

Costs and Benefits of Collective Pension Systems

The costs and benefits of price stability

Costs, Risks, and Benefits of Surgery

Gambling in America: Costs and Benefits

Modeling Pension Systems

Collective Dynamics of Nonlinear and Disordered Systems

The Sarbanes-Oxley Act: costs, benefits and business impacts

Solutions for the World's Biggest Problems: Costs and Benefits

The Sarbanes-Oxley Act: costs, benefits and business impacts

Greening Our Built World: Costs, Benefits, and Strategies

Economic and environmental benefits and costs of transgenic crops: ex-ante assessment

The Welfare Impact of Rural Electrification: A Reassessment of the Costs and Benefits

The Effective Measurement and Management of ICT Costs and Benefits, Third Edition

The Economic Benefits and Costs of Entrepreneurship (Foundations and Trends in Entrepreneurship)

Costs, benefits, and farmer adoption of agroforestry: project experience in Central America and the Caribbean

Valuing Health Care: Costs, Benefits, and Effectiveness of Pharmaceuticals and Other Medical Technologies

The Costs and Benefits of Price Stability (National Bureau of Economic Research Conference Report)

Balancing Environment and Development Amid Rapid Urban Growth: Costs, Revenues, and Benefits of the Western

Pension Schoeller

Pension Vanilos

Pension Systems, Demographic Change, and the Stock Market

Pension Economics

Pension Finance

The Costs and Benefits of Animal Experiments (The Palgrave Macmillan Animal Ethics Series)

Broadband Wireless Communications Business: An Introduction to the Costs and Benefits of New Technologies

Pension Systems, Demographic Change, and the Stock Market

Benefits And Wages

Pension Vanilos

Pension Vanilos

Pension Economic

Exclusief pension

Costs and Benefits of Collective Pension Systems

The costs and benefits of price stability

Costs, Risks, and Benefits of Surgery

Gambling in America: Costs and Benefits

Modeling Pension Systems

Collective Dynamics of Nonlinear and Disordered Systems

The Sarbanes-Oxley Act: costs, benefits and business impacts

Solutions for the World's Biggest Problems: Costs and Benefits

The Sarbanes-Oxley Act: costs, benefits and business impacts

Greening Our Built World: Costs, Benefits, and Strategies

Economic and environmental benefits and costs of transgenic crops: ex-ante assessment

The Welfare Impact of Rural Electrification: A Reassessment of the Costs and Benefits

The Effective Measurement and Management of ICT Costs and Benefits, Third Edition

The Economic Benefits and Costs of Entrepreneurship (Foundations and Trends in Entrepreneurship)

Costs, benefits, and farmer adoption of agroforestry: project experience in Central America and the Caribbean

Valuing Health Care: Costs, Benefits, and Effectiveness of Pharmaceuticals and Other Medical Technologies

The Costs and Benefits of Price Stability (National Bureau of Economic Research Conference Report)

Balancing Environment and Development Amid Rapid Urban Growth: Costs, Revenues, and Benefits of the Western

Pension Schoeller

Pension Vanilos

Pension Systems, Demographic Change, and the Stock Market

Pension Economics

Pension Finance

The Costs and Benefits of Animal Experiments (The Palgrave Macmillan Animal Ethics Series)

Broadband Wireless Communications Business: An Introduction to the Costs and Benefits of New Technologies

Pension Systems, Demographic Change, and the Stock Market

Benefits And Wages

Pension Vanilos

Pension Vanilos

Pension Economic

Exclusief pension

Recommend Documents