As long as I have been working in the Dutch pension system, it has been under discussion or reform. But now it’s for real! A monumental reform law (WTP stands for Wet Toekomst Pensioenen, the Future Pensions Law) was passed in 2022, and much of the €1.5 trillion market is shifting to new arrangements in the coming years.

It involves a transition from DB (defined benefit) to DC (defined contribution, participants bear the risk), and ambitious in that existing claims will not be grandfatherd but restructured. Much has been said and written about the reform as it affects nearly everyone in the Netherlands and so is politically salient, but I will try to explain how an investor can understand the system.

To do that will involve some math. That gives me the opportunity to trot out my Latex skills. The confusing thing about the Solidarity Contract (NL: Solidaire Pensioen Regeling SPR) is that it explicitly involves risk sharing and so the returns earned on a person’s capital are not directly related to return on assets but depend on a regulatory formula. My aim is to understand this risk sharing in terms of the pension fund’s balance sheet, to ultimately inform investment decisions.

Pension arrangements classify participants into age cohorts with their risk appetite expressed as an exposure “x” to hedging return (NL: beschermingsrendement) and “y” to growth (NL: overrendement). It is not said that exposures necessarily sum to one. The return to a cohort is calculated in two steps:

1. first distribute the hedging return promised beforehand;
2. then distribute residual return in proportion to the exposure to growth.

The hedging returns hence have priority in the capital structure to the growth claims.

I will use the notation used by regulator DNB to unpack this. They specify that in first instance, a cohort is allocated its hedging return on its capital

This calculation does not depend at all on the return on the fund’s assets or Collective Fund Return CFR. That enters the second distribution, where the residual return

is distributed after all cohorts are awarded the hedge return on their capital V_i. We define a growth return R^O that is equal over all cohorts

and see that a cohort’s capital after distributions can be expressed as

Just one more step lets us express the cohort’s return as

This final formula bears pondering. Underneath all the novel concepts and notation, we can conclude that a cohort’s return comprises

1. an exposure xᵢ to an annuity with cohort-specific return R^M_i
2. an exposure yᵢ to a growth asset with return (R^O+R^c)
3. a residual exposure (1-xᵢ-yᵢ)—likely negative—to cash return R^c

It is common practice for Dutch funds to determine the “life-cycle” exposures x and y for the cohorts they have defined. However, it is possible in principle for individuals to deviate from the default life-cycle and choose their own exposures to satisfy a non-standard risk appetite.

An important observation is the role of the cohort’s leverage (1-xᵢ-yᵢ). This part of the return is often not made explicit: it can be subsumed in the returns of either class, or neither, or both! When considering different cohorts or comparing the growth claims of different funds, be aware whether reported returns are funded or unfunded as there is no consensus for how to report these.

The fund manages assets collectively and so can consider the leverage in the aggregate also. In Dutch practice outright borrowing is much less common than using derivatives to hedge interest rate risk—which explains why the DNB chose to write the formulas the way they did. The mathematics are agnostic as to where in the portfolio the leverage is taken, be it swaps or equity futures or outright borrowing or a combination of all three.

This hopefully sheds some light on how a participant will experience the new pension contract. While their return is not immediately explained by observatios in the public market, it can be separated by “securities” issued by the fund and can form the starting point of an Asset-Liability Management (ALM) analysis. This thinking further illustrates how the fund balance sheet supports risk sharing, and in what proportions participants are exposed to risks before they materialize.

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Roger will be speaking at the Pension PlayPen coffee morning at 10.30 am on Tuesday 18th November.  https://pensionplaypen.com/login

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