When one thinks of pensions crisis, the state of Illinois - with its woefully underfunded retirement system which issues bonds just to fund its existing pension benefits - usually comes to mind. Which is why it is surprising that the first state that may suffer substantial pension cuts is one that actually has one of the world's best-funded, and most generous, pension systems.
According to the FT, millions of Dutch pensioners are facing material cuts to their retirement income for the first time next year as the Dutch government scrambles to avert a crisis to the country's €1.6 trillion pension system. And while a last minute intervention by the government may avoid significant cuts to pensions next year - and a revolt by trade unions - if only temporarily, the world finds itself transfixed by the problems facing the Dutch retirement system as it provides an early indication of a wider global pensions funding shortfall, not to mention potential mass unrest once retirees across some of the world's wealthiest nations suddenly finds themselves with facing haircuts to what they previously believed were unalterable retirement incomes.
At the core of the Dutch cash crunch is the ECB's negative interest rate policy, which has sent bond yields to record negative territory across the eurozone, and crippled returns analysis while pushing up the funding requirements of Dutch pension funds.
Ahead of a parliamentary debate on Thursday on this hot topic issue, the Dutch minister for social affairs and employment, Wouter Koolmees, will write to lawmakers to outline his response to the pension industry’s problems, the FT reported.
In order to offset the ECB's NIRP policy, Shaktie Rambaran Mishre, chair of the Dutch pension federation which represents 197 pension funds and their members, said that contributions might have to rise by up to 30% over the next few years, an outcome which will lead to outrage among existing working-age employees who will suffer a surge in the pension costs. Absent a dramatic increase in benefits contributions, "as things stand, around 2 million people are facing cuts from next year,” she added.
Predictably, trade unions have already held protests and strikes this year over the potential cuts to pensions and have threatened more action if the government does not step in. “We expect some relief next week and if not we will mobilise,” said Tuur Elzinga, lead pensions negotiator at FNV, the biggest Dutch union.
The Netherlands - one of the Eurozone's richest nations - is hardly alone in this predicament, as the ongoing debate reflects broad concerns about the impact of low interest rates among the Eurozone and Japan, as ageing populations and longer life expectancy have put pension systems across the world under great strain. A report last week from the Group of Thirty, a club for current and former policymakers, warned of a $15.8tn shortfall in funding to support the ageing populations of the world’s 20 biggest countries.
And if there is one way to guarantee riots among the world's richest nations, it is to inform pensioners that their benefits are suddenly being "haircut."
In some ways, the Netherlands has one of Europe's most generous retirement systems: at its core, it represents a basic pay-as-you-go state pension as well as employer-run pension scheme which together provide workers with about 80% of their average lifetime wages when they retire. The US and UK have similar systems, but Dutch pension funds are more generous and must use a lower risk-free rate to value their liabilities, forcing them to hold more assets.
Unfortunately, the lower Dutch risk-free rate is not low enough, and as a result about 70 employer-run pension funds with 12.1m members had funding ratios below the statutory minimum at the end of September, according to the Dutch central bank. And here lies the rub: if funds have ratios below the legal minimum for five consecutive years or have no prospect of recovering to a more healthy level, they must cut their payouts. Interest rates have rebounded slightly in recent weeks, but many funds are still facing cuts.
In other words, in making a select handful of European stockholders rich courtesy of NIRP and QE, Mario Draghi is threatening the pensions of hundreds of millions of retired European workers.
So what, if any, is the solution?
Last week, Rabobank reported that the Minister of Social Affairs is supposedly willing to prevent a large part of the pension benefit cuts of 2020, as the government is reportedly willing to lower the minimum coverage ratio from 100% to 90% for one year. This temporary measure can be seen as a pause button, which buys time for:
- Pension funds to hopefully recover over the next year. For pension funds, a rise in their risk-free rate term structure which is used to discount their liabilities (EUR 6m swap rates) would be most helpful
- Continuing to work out the details of the Pension Reforms announced in June 2019. Unions, employer representatives and the opposition parties were against pension cuts because this would undermine the goals set out in the Pension Reforms.
Cutting pensions is a very sensitive and unpopular measure especially for politicians because the government has the ability to change the rules by changing the law. This is especially hard in times where there is no economic downturn, because it makes it more difficult to explain and justify the cuts. One can only imagine what will happen to Dutch pensions during the next Eurozone recession, when the ECB will be forced to cut rates even more negative in the process threatening even more pension haircuts.
While this pause would, in theory, prompt some pension funds to reduce their matching portfolio or hedge ratio in anticipation of pension cuts, not many pension funds already acted on the threat of these cuts according to Rabobank. Therefore, this temporary measure will have a limited effect on the investment behaviour of pension funds because:
- Pension funds are typically big and are long term investors, meaning they take time to react to certain events
- Most pension funds have a fixed risk budget. This risk budget is maximised by regulation and is fixed at the moment the coverage ratio drops below the required coverage ratio. This means if a pension fund would want to increase its risk toward for example equity, it often has to reduce risk somewhere else in the portfolio
- Possible pension cuts are based on the policy coverage ratio which is the 12th month average of the coverage ratio. This further reduces the incentive for a temporary risk-on or risk-off strategy.
What's next? On 21 November 2019 the official plans will be discussed in parliament, although Rabobank does not expect any additional changes that would affect investment behavior of pension funds. However, as the Dutch bank admits, "there are some challenging times ahead in the pension reform discussions" and it expects possible big changes this time next year. Chief among them: the risk free rate term structure that is used to discount the liabilities will likely change in every possible reform scenario, although it is unclear how much lower it can drop.
As the FT notes, a group of 10 academics wrote to parliament recently calling on the Dutch government not to raise the risk-free rate, arguing this would be at the expense of younger workers as “the assets pot will be a little bit more empty each year”. Others, however, think the government will intervene. “I expect that politically the cuts will not happen,” said Lex Hoogduin a professor at the University of Groningen and a former board member of the Dutch central bank, who did not sign the letter.
“But this is just kicking the can down the road as eventually they won’t be able to afford the payouts that people expect,” said Mr Hoogduin. And the people have Mario Draghi - and now Christine Lagarde - to thank for it.