Continuing the average pay scheme or switching to a pension fund.

Painful mistake or a smart move?

In this blog, I will discuss a real-life case study. It is an average pay scheme provided by an insurance company that is swapped for an average pay scheme with a better accrual percentage provided by a voluntary industry-wide pension fund. The ultimate goal is to switch to a flexible contribution scheme in the new system. For now, the transfer to a defined contribution scheme is being delayed.

Door: Berry van Sonsbeek, Product Marktmanager Zwitserleven

A client has an insured average pay scheme with an accrual percentage of 1.875%. The current contract is a five-year contract, with an actuarial rate premium based on the market rate of five years ago. The contract will be up for renewal effective 1 January 2022. The market rate has now fallen sharply. An unchanged contribution budget for the new contract period means that the accrual percentage will drop to 1.25%.

The employer and employees are not willing to put more money into the pension scheme than they did under the old contract. Alternatively, the employer can join a voluntary industry-wide pension fund that has a contribution-based funding ratio of approx. 80%. Partly because of this, an accrual percentage of about 1.6% can be applied. It is also noted, though, that under the new system the employer wants to switch to a flexible contribution scheme based on the old contribution budget.

The interests at play here

1. 1. In the negotiations the unions persist in their demand for an average pay scheme, as long as the new pension scheme has not yet been passed by the two Houses of Parliament. In the background, they may prefer the solidarity-based defined contribution scheme for the future. The unions have an interest in not yet openly accepting collective agreement arrangements in favour of an individual defined contribution scheme. After all, this would conflict with the general premise that unions prefer pension schemes with elements of solidarity.

2. The unions try to achieve the highest possible accrual percentage for their members in order to minimise the drop in pension accrual.

3. As a good employer, the employer wants to introduce a modern, flexible pension scheme for its employees with multiple options to choose from. Obviously, participants should be able to look forward to a pension providing a sound financial position in old age. The employer cannot increase the pension scheme costs that applied in previous years.

4. As a subsidiary of a multinational company, the employer may link up the pension scheme with a multinational pool that also includes the insurance company. This way, the employer will benefit from any profit sharing on underwriting risks, which in turn can be used to improve the pension scheme.

Throughout the process, comparisons have been made between average pay with the voluntary industry-wide pension fund, versus average pay with the insurance company and a defined contribution scheme with an increasing graduated scale with the insurance company. The comparisons have led to the conclusion that, in terms of expected pensions, transitioning to the defined contribution scheme is the best solution for participants.

Nevertheless, the employer decided to switch to the voluntary industry-wide pension fund while maintaining the average pay scheme with a 1.6% accrual percentage for 2022. Is this a painful mistake or a smart move in the participants’ interests?

Personally, I think the decision is not in the participants’ interests. And the unions have made a smart move from their perspective by ensuring the scheme’s transfer to a voluntary industry-wide pension fund. In doing so, they keep their goal in sight: transitioning to a solidarity-based contribution scheme for the future. A move that for now is painful for the participants.

The arguments applicable here:

Participants’ interests in the transition to the new pension system

On 1 January 2023, the pension system in the Netherlands will change. In the period until 1 January 2027, all existing average pay schemes will be converted to defined contribution schemes. This change reflects a trend that started abroad already years ago. What we see is that many multinational companies have already switched to individual defined contribution schemes.

In the Netherlands, this has taken the shape of the flexible contribution scheme under the new system. As the name suggests, it is a pension scheme that gives participants options to tailor their pensions to their personal circumstances. And where pension providers help participants make the decisions that are best for them. Knowing that we will transition to the new system, we can see sufficient arguments to justify switching to an individual defined contribution scheme even now, in the participants’ interests, instead of waiting until 1 January 2027.

Contributions are invested defensively in a continuation of the current average pay scheme. This may result in a loss of return for the participants as compared to a defined contribution scheme. This is particularly clear in the comparison we have made, comparing expected pensions under an average pay scheme with expected pensions in a defined contribution scheme.

As an employer, it is important to ask this question in every discussion: What will I deprive my employees of by continuing the average pay scheme now, knowing that it is finite? Five years from now, if someone asks me why s/he is getting a lower pension than s/he could have had if we had switched to a defined contribution scheme, will I be able to give them a satisfying answer?

Knowing, therefore, that in 5 to 6 years’ time, average pay schemes will be a thing of the past, employers would have a strong case if they were to decide to make the move now when their contract comes up for renewal. Even if that would be before 1 January 2023.

Should the employer decide for whatever sound reasons they may have to delay the implementation of a flexible contribution scheme, the following key issues would present themselves:

Continuing the current average pay scheme with an insurance company or switching to the voluntary industry-wide pension fund

If an employer were to switch to the voluntary industry-wide pension fund in order to maintain the average pay scheme for a few more years, our comparison shows that this industry-wide pension fund applies a higher accrual percentage than the insurance company. This can be explained by a number of arguments.

1. Contributions for the voluntary industry-wide pension fund are lower than the actual cost of pension purchases. This is permitted because pension funds are allowed to take the average interest rate of the past 10 years into account when setting contributions, or expected future returns. In the case of the voluntary industry-wide pension fund, there is a very real chance that every euro of contribution they receive chips away at their overall funding ratio. In essence, they are thus transferring funds between their clients and participants in order to meet the central bank’s regulatory requirements. Also, this means they offer pensions that are only 97.5% guaranteed (they may reduce benefits).

2. According to the requirements of the Dutch central bank (DNB), we as an insurance company have to apply contributions based on a risk-free interest rate, offering a guarantee of 99.5% certainty that we will be able to pay the benefits. In practice, this means that defined benefits will not be reduced.

3. The population’s age in this case study is higher than usual. This implies that, with the funding system of the voluntary industry-wide pension fund (based on average contribution), there may also be some cross-financing between generations.

Will the participants benefit from a transition to the voluntary industry-wide pension fund?

The new pension system is designed to incorporate the old entitlements into the new system during the transition. This means that in the future, the average pay entitlements in the voluntary industry-wide pension fund will again be translated into pots of money. This way, accrued pension entitlements will lapse, to be replaced by a pension pot. After the transition, this pot will then increase or decrease, depending on the return on investments.

In the case of average pay schemes with an insurance company, the accrued average pay entitlements remain guaranteed, unless a request is made for a group transfer of accrued benefits to the new flexible contribution scheme. Individual participants may always object if such a request is made, in which case the accrued average pay entitlements for that participant will be maintained. Pension funds do not offer that option.

Contributing the old average pay entitlements in the new pension system does not create free money. We are arguing here that what the participants in the voluntary industry-wide pension fund will receive in their pot based on past practices may not be different from what they will receive from the insurance company (based on the same contribution budget for the next few years).

With the voluntary industry-wide pension fund, unions have massive influence on the pension scheme. There is therefore a very real chance that the participants in the voluntary industry-wide pension fund will end up in a solidarity-based contribution scheme. This does not give them all the options that a flexible contribution scheme with an insurance company or PPI does. This way, participants will miss out on opportunities to optimally tailor their pension income to their personal circumstances. And they will miss out on the opportunity to decide entirely at their discretion at their retirement date which provider they want to receive their pensions from. There is no full “shopping right” in that case.

In addition, participants in a solidarity-based contribution scheme will have to contribute to filling and maintaining a solidarity reserve. The participants will not receive their share from that reserve if they ever transfer their accrued entitlements to a different provider when they start working for a different employer. To build this buffer, approx. 10% of contributions is used and approx. 10% of returns in the first few years. The buffer is gradually redistributed among participants over time (when it has reached the target level).

I would also note here that a 5-year rate guarantee may apply at the insurance company, whereas the voluntary industry-wide pension fund may adjust contributions or the accrual percentage where the contribution budget remains the same. In other words, with the insurance company a guarantee of accrual applies if the average pay scheme is maintained, whereas with the voluntary industry-wide pension fund it can be reduced.

The compensation issue

If the employer decides to convert the current average pay scheme with the insurance company or PPI to a defined contribution scheme with an increasing graduated scale for existing participants before 1 January 2027, no compensation needs to be granted to participants under the new legislation. Existing participants may then remain with a defined contribution scheme with an increasing graduated scale. By 1 January 2027, a flat contribution must be agreed for new participants.

A pension fund (and therefore also the voluntary industry-wide pension fund) will always switch to a flat contribution. This will always stoke debate among the older population to the effect that they should be adequately compensated. A pension fund uses a compensation period of 10 years. This means that contributions will increase during the compensation period and may afterwards level off again.

Regardless of what form of compensation is decided on, there may be IFRS consequences that are important for the employer and the organisation’s multinational parent.
The compensation can be circumvented by switching to a flexible or individual contribution scheme with an increasing graduated scale at an insurance company or PPI.

Conclusion

1. 1. A huge opportunity has been missed here for participants to switch now to an individual defined contribution scheme with an increasing graduated scale, which is expected to provide a higher pension for the same budget than the current average pay scheme. The natural moment of contract renewal would have been the perfect opportunity.
   
   2. The decision to switch to the voluntary industry-wide pension fund was made on improper grounds. Only a higher accrual percentage was leading. After the transition to a flexible or solidarity-based contribution scheme in the new system, this higher accrual will no longer have any added value, since accrued entitlements will be transferred.
   
   3. The employer will run a potential claim risk if, upon transitioning to the new system, participants discover that they have missed out on returns. After all, there is a report that shows that switching to an individual defined contribution scheme now will yield higher expected pensions.
   
   4. The switch to the voluntary industry-wide pension fund will probably strip participants of their shopping right at the retirement date, and thus of the opportunity to then choose the best pension provider.