Compensation in Defined Contribution schemes?!
28 June 2019
In the future, all pension schemes will be based on an age-independent contribution rate. This amendment to the current situation was presented as part of the recently published pension agreement in principle. In this article the impact of this amendment is described for Defined Contribution (DC) schemes. For average pay schemes, administrated by pension funds and insurance companies, the same effect applies.Download PDF version
In the Netherlands, a DC scheme is based on scales with a contribution rate which rises with age. For almost all employees, the transition to an age-independent contribution results in a lower total premium compared to the current age-dependent scales. This results in a lower expected pension benefit. Is compensation appropriate here? We believe the answer is "yes".
Insight into consequences and calculation compensation
The consequences for pension costs and pension results can be determined based on data of the current workforce, the current and new contributions, and some assumptions regarding economic and demographic development. As a second step, the compensation can be calculated for each year of birth.
Below we provide insight based on a stable workforce of 50 employees (ages 18 to 67 years) and a few simple assumptions.
Cost neutral solution
The pension costs in our example is approximately 16% of the total pensionable salaries. If we grant 16% to each employee in the new system, the effect on the total pension costs per annum (left) and pension result (right) is as follows:
In this situation, the pension costs do not change (the orange line equals the pink line and is therefore not visible). The effect on the pension capital at retirement is considerable, especially when we only take future service years into account. Young employees receive a higher contribution in the new situation and therefore end up with a higher pension capital. For old employees the opposite applies. If we look at the total service time, pension benefits of the middle-aged employees show the greatest decline.
Pension neutral solution
For the pension neutral solution, we first determine the age-independent contribution that an 18-year-old employee requires to achieve the same expected pension capital as on the basis of the current scales. We use this contribution (in this example approximately 13% of the pensionable salary) as the new age-independent contribution. During the first 10 years of our projection, the pension costs are increased with a compensation premium for each employee which only depends on the year of birth. The total pension costs per annum (left) and the pension result (right) now look like this:
The pension result is 100% for all ages, since we fully compensate (the dark blue line is equal to the green line and therefore not visible). The pension costs are higher during the first 10 years (chosen compensation period) and after these 10 years lower than in the old situation. The pension costs decrease during the first 10 years because employees with high compensation rates (highest ages) retire and are replaced by new 18-year-old employees (for which no compensation applies).
Compared to the current situation, the pension costs in the first 10 years increase by an average of approximately 50% in this example.
The government will propose a transition framework within which the compensation must be determined. Within this framework, among other things, the maximum tax-deductible pension contribution will be determined.
To date, little attention has been paid to the consequences of the agreement in principle with regard to Defined Contribution schemes. As we have shown, the consequences for pension costs and / or pension results are considerable.
We emphasize that a different workforce and / or different assumptions lead to different results. These assumptions must be determined in consultation between employer and (representation of) employees.
Employer and (representation of) employees will have to answer a number of questions:
- How do we determine the new age-independent contribution?
- How do we determine compensation percentages (i.e. what are the economic and demographic assumptions, such as career, investment returns and withdrawal rates)?
- To what extent do we compensate employees for the decline in pension results? And who pays these compensation costs?
- Do new employees receive the same compensation as current employees?
- Do we make a distinction between a basic pension scheme and a (possible) top-hat scheme or net pension scheme?
We are happy to offer you, as an employer or (representation of) employees, the required insight into the consequences of the agreement in principle on your Defined Contribution scheme(s).