The Dutch have long been famous — at least to pension nerds like me — for their retirement system, which is well-funded and well-managed. Now that reputation is in jeopardy: As it turns out, providing generous, guaranteed pensions to an aging population is as expensive in the Netherlands as it is everywhere else.
Many countries, especially in Europe, are struggling with aging societies and unsustainable pension systems. In the last few years, the Dutch have been reforming their system. It used to consist of a flat, fairly modest state benefit and a more generous, employer-provided benefit. Now those defined-benefit pensions from employers are being replaced by something called a collective defined-contribution plan, known as collective DC.
It is a hybrid of a traditional defined-benefit pension and a defined-contribution plan like an American 401(k). With a collective DC plan, individuals make contributions, the pension invests the money, and whatever the asset balance is when they retire determines their benefit.
When participants retire, they might have two choices. They can pick an annuity and get a fixed benefit. Or they can opt for a higher payout that will vary each year depending on how markets perform. There is some risk-sharing, as there is with a defined-benefit plan — but instead of the plan taking on the risk, it is spread among the plan’s participants. Depending on the plan, asset returns may be “evened out” across cohorts, either with a reserve fund or increased contributions when the plan underperforms.
This transition to collective DC roiled markets this week. First, there was a big drop in demand for long-duration bonds. The defined-benefit pensions used to hedge their duration risk by buying long-term bonds that matched the duration of the benefits they owed retirees. Now younger participants invest in more equity, and older participants are also choosing a riskier portfolio with a shorter duration.
This change is not great for financial stability — or for Dutch retirees. Moving to a collective DC plan doesn’t eliminate the interest-rate risk defined-benefit plans tried to hedge; it just shifts it to individuals. Shortening the duration of their fixed-income portfolios means retirees now have to deal with market risk and rate risk. They will see their annual retirements benefits fluctuate far more than their salary did.
Another reason the transition is causing turmoil is the pension funds’ misbegotten quest to revive ESG investing, which US investors have left for dead. Both BlackRock and AQR lost their mandate with PFZW, one of the largest Dutch pension funds, because they are not “adequately focused on sustainability” (translation: They invest in fossil fuel companies). BlackRock once led the charge with ESG investing but has walked back its commitment. ESG’s popularity in the Netherlands investing community creates a quandary for US asset managers, who can’t please both their US and Dutch customers — and it’s not fair to Dutch pensioners, either.
The performance of ESG funds has been inconsistent. Initially they did well, because in 2015 moving out of fossil fuels and into technology (which appeared to be ESG compliant) was a good move. But during the pandemic bear market, ESG underperformed. And while its heavy investment in tech has redeemed ESG in the last few years, a fund should be judged on its performance in bull and bear markets. ESG’s reliance on tech suggests more risk and less consistency over the long term. That’s to be expected: By definition, an ESG fund is constrained in the investments it can make. And a constrained optimization underperforms an unconstrained one over the long term.
The definition of the term “ESG compliant” is also difficult, political and inconsistent over time. None of this matters as much when you are dealing with individual investors, who are free to define ESG in a way that comports with their values. It can even be defensible for a pension fund if it bears the risk of assets underperforming. But with collective DC, the pension fund picks the investments, and individuals bear the risk. If funds underperform because of a political choice its managers make, odds are that investors won’t be happy.
I am a pension nerd because retirement finance is a great metaphor for life. Here we have two ways to save for retirement — defined-benefit pensions and defined-contribution plans. Both are imperfect. The first is expensive, while the second requires individuals to take on a lot of risk. A hybrid that merged the best of both approaches would be ideal.
Unfortunately, that is not the way the Dutch are going about it. Sometimes when you combine two imperfect options, you get the worst of both.
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