CFA Digest November 2013 Volume 43 Issue 4
The “Defined Ambition” Pension Plan: A Dutch Interpretation (Digest Summary)
Rotman International Journal of Pension Management
Traditional defined benefit (DB) plans have become quite difficult to sustain because of increasing longevity, an aging population, and sponsors withdrawing from risk. In response, the Dutch pension sector is actively working on redesigning its traditional DB system to address these challenges.
Traditional defined benefit (DB) plans have become too expensive for plan sponsors, and the financial crisis that began in 2008 has exposed many of the challenges facing DB plans today. Negative equity returns, low interest rates, and demographic shifts have put pressure on guaranteed benefits. To help alleviate this pressure, a new type of plan called “defined ambition” (DA) has been established. These plans allow for more flexibility when a financial shock or other external factors affect the plan adversely. The concept is that there is still a target benefit, but with the DA plan, the benefits can be adjusted by removing the “guarantee” that is typically found in DB plans.
How Is This Research Useful to Practitioners?
By understanding the changing demographics of their workforce and moving to a more flexible DA model, the Dutch are strengthening their pension plan system to withstand more variability in the financial markets. A reduction in pension benefits, currently seen as a last resort, has become a possibility as the Dutch change their regulatory framework to meet this new reality.
A DA plan is essentially a hybrid plan that has characteristics of both a traditional DB plan and a defined contribution (DC) plan. Similar to DB plans, DA plans accrue benefits according to years of service and salary. The primary difference between the two is that when a DA plan’s assets or longevity changes, the benefits are revised downward in poor times and conversely can be revised upward in good times. For example, if life expectancy increases, the plan can increase the retirement age and make adjustments to retirees’ benefits. Similarly, when a negative financial shock hits the plan, the benefits can be reduced.
The European Commission released a white paper in 2012 that proposed a holistic balance sheet (HBS) framework for pension plans. The HBS gives a more realistic idea of a pension fund’s true financial position. Essentially, the pension fund’s balance can be extended on both the asset side and liability side as determined by increasing or decreasing conditional assets and liabilities. The pension fund has the option to charge extra contributions when the funding ratio is low and grant benefit level indexation (increased benefits) when the funding ratio is high. This flexibility allows the balance sheet to adjust as needed to meet the needs of the plan and its obligations.
The author believes that by moving to a DA model from the more traditional DB model, the increased flexibility to change benefits will make Dutch pension contracts sustainable for the future because they will be more stable and balanced to meet the needs of all pensioners.
How Did the Author Conduct This Research?
The author identifies the need for pension reform specifically as it relates to the Netherlands. To review and describe the DA plan that is being designed in the Netherlands, he references nine recent papers dating from 2007 to 2013. He particularly focuses on a list by Kocken (Rotman International Journal of Pension Management 2011) combined with his own ideas to determine that a sustainable pension plan should include an income-related target as well as be indexed to inflation, affordable, risk sharing, adjustable to shocks, and well balanced for all stakeholders.
To address increasing longevity, an aging population, and the global financial crisis, the Dutch are taking active steps to mitigate current and future shocks by modifying their current pension system. With many industrialized nations facing similar challenges, the author’s research on the Dutch pension system raises some interesting thoughts on and provides a possible framework for how other countries might address their own pension challenges.