Many pension funds are not able to increase pensions to keep up with price increases. This means that your real pension goes down over time and you will be able to consume less when you retire. For a worry-free retirement, it is essential to get a realistic view of your financial future, such that you can plan and save accordingly.
Defined-benefit pension plans are commonplace in the Netherlands and most workplace pension plans are of this type. Yet, the way they work and the risks inherent in these plans remain often opaque.
A defined-benefit plan, as the name suggests, promises the plan holder a certain amount of retirement income in the future. You accrue pension based on the contributions you make.
Typically, contributions are made when you receive your paycheck and these are most often automatically deducted from your gross salary. Your contribution consists of two parts: an employer contribution and an employee contribution. The shares of employer and employee contributions vary depending on your pension fund.
The future retirement benefit that the fund promises, is indeed only a promise. The amount you will actually receive and the real value of your pension depends on the performance of your pension provider.
In this article, we explain in detail how the value of your retirement benefits can change over time, how the real value of your pension is often much lower than you think, and what you can do about it.
As a member of a defined benefit plan, the real value of your already earned retirement benefits decreases over time. The source of the problem is an economic phenomenon that is unrelated to pension funds: prices tend to increase over time. This is referred to as inflation and affects your ability to pay for goods and services in the future.
While these annual changes to prices appear small and almost unnoticeable, another picture emerges once we look at longer time periods. For instance, between 2000 and 2019, the average Dutch inflation rate was around 1.8% per year. This translates to a total price increase of 41% over the same period. As a result, goods and services that cost 1000 euro in the year 2000 now cost 1410 euro on average.
If prices go up, but your income remains constant, you will have to lower your standard of living and will have less financial security. Taken together, this means that for you to keep your ability to consume and maintain your lifestyle, pension funds need to increase their promises to you at the same rate as inflation.
Increasing pensions to keep up with inflation is called “indexation”. The term describes the fact that pension providers often strive to increase pensions in line with a wage or price index. If your pension increases with inflation every year, your pension maintains its purchasing power and you will able to afford the same amount of goods and services.
Instead of indexation, some pension providers refer to keeping up with inflation as pension increase (“toeslagverlening” or “verhoging” in Dutch). However, such an “increase” is in fact not an increase at all. If for instance inflation is 1.8% and the increase to your earned benefits also is 1.8%, then your fund is just maintaining your ability to pay for goods and services and not increasing your pension.
In most companies, salaries increase with inflation over time. Your salary is probably a fair bit higher today than it was in 2000. As you accumulate retirement benefits throughout your working life, the majority of these rights were calculated as a fraction of your salary many years and even decades before your actual retirement. Thus, these pension rights only maintain their value, if your pension provider increases them with inflation every year while you are working.
But the need for indexation does not stop once you stop working. Once you are retired, you depend on your monthly retirement income. If your pension fund does not index your pension during your retirement, your retirement income will allow you to purchase less and less over time.
The goal of most pension funds is to increase their promises to their plan holders in sync with inflation. When this happens, we talk of full indexation. Yet, many pension funds are not able to keep up with inflation but try to at least partially increase their promises to make up for some of your lost ability to pay for goods and services. This is known as partial indexation.
Worse yet, the financial position of a pension fund may deteriorate so much that they are not even able to partially index. They would then either not index your benefits at all or in worst case even have to cut, or curtail, them. These cuts are rare but they are possible.
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The effect of missed indexation on pensions is large. For example, ABP, the largest pension fund in the Netherlands, has failed to meet its own indexation target for an extended period of time. This has led members of this fund to lose a significant part of their future ability to pay in the last 10 years.
To be specific, the figure below shows the value of an ABP pension relative to prices. If you had a pension of 1000 euros in 2009, the same pension could buy you goods and services worth only 850 euros in 2019.
The total loss is 15% and will translate directly into a lower standard of living and less financial security during retirement for plan holders of ABP. While ABP aims to make up for the lost indexation, this is unlikely to be possible in the near future given their financial health.
A pension fund can index when their financial situation allows for it. Specifically, Dutch regulators require that the so-called regulatory funding ratio (in Dutch: "beleidsdekkingsgrad") to be above a certain threshold. The funding ratio captures the relationship between the promises a pension fund has made to current and future retirees and the funds available to pay out on these promises.
A pension fund that can pay their promises precisely, with the assets that they hold and invest, has a funding ratio of 100%. The law requires Dutch pension funds to strive for a funding ratio much higher than 100%. The precise threshold is fund specific, but ranges between 120% and 130% for most funds.
Only if a pension fund has a regulatory funding ratio above the threshold level, the fund is allowed to increase pensions fully with inflation.
Data from the Dutch Central Bank for the first quarter of 2020, shows that only three out of 201 defined benefit plans in the Netherlands have a funding ratio of more than 130% and the vast majority have a funding ratio of less than 105%. Thus, indexation is unlikely for most funds until their financial situation improves significantly.
Continuing the example from above, the regulatory funding ratio of ABP as of July 2020 is 89%, far below the required level of 128%. This is an alarming level for two reasons. First, it means that ABP cannot index and most likely will not be index at any time in the near future. Second, and even more worrisome, ABP has made promises in excess of the assets they hold. This means that it is even possible that ABP will need to curtail benefits in the future.
This is not something anyone wants to experience and unfortunately, ABP is only one example of a much bigger problem: Many defined benefit pension funds are systematically underfunded and not able to live up to their own goals.
Unfortunately, it is in general not possible to change your current pension provider. Most companies or even industry have one pension plan that every employee participates in.
Under certain conditions it is possible to move your pension from pension funds you contributed to in the past to the one you are currently contributing to (“waardeoverdracht” in Dutch). This can be a viable option if your current fund is a better financial position than your pension providers that you contributed to in the past. However, such a transfer is usually not possible for funds in a bad financial position, meaning that your pension is stuck with these underperforming funds.
The best you can do in this case is stay informed and plan your financial future accordingly. It is important to get a realistic picture of your financial future as soon as possible, such that you can plan and save accordingly. It is never too late to take action but the earlier you do so, the more time you have to make necessary adjustments and to plan for a worry-free retirement.
The numbers provided by your pension fund, and also reported on mijnpensioenoverzicht do not take the financial health of your pension funds into account when estimating your future retirement income. Therefore, their annual pension statement does not always give you a realistic picture.
If you would like to get an independent assessment of the financial health of your pension providers and your estimated retirement income, we offer a personalized Dutch pension report that includes all relevant information on your financial future. You can find more information and get your report today on our main website.