‘By the time I retire, the pension reserves will have run out anyway’
We often hear this comment, particularly from relatively young members who are still building up a pension. I can certainly imagine that the losses that pension funds are currently suffering as a result of the corona crisis are reinforcing this belief. If you share this view, however, I have some good news, despite the difficult times: it is absolutely wrong. Read on to find out why that is.
Let me explain the situation using the concept of the ‘funding ratio’. A pension fund's funding ratio represents the pension fund's assets, divided by its pension liabilities. The pension fund's assets are the sum of the value of all its investments, but how are the pension liabilities calculated? Philips Pensioenfonds (and other pension funds too) use the following method:
Pension liabilities, step by step
First, for every member - whether aged 70 and retired, or aged 30 and working for Philips or Signify, we work out how much pension he or she has accrued.
Next, we work out how long the period is that each member will be paid a pension. This is based on our members’ projected life expectancy. For example: a 30-year-old Philips or Signify employee has accrued €5,000 in annual pension rights. This member will retire at age 68, and statistically he or she will die at the age of 88. That means that we will pay him or her a pension for 20 years. Our total payment to this member is 20 x €5,000, or €100,000.
We run the same calculation as shown at Step 2 for each of our members. Then we add all the results together, and the sum is the total amount that we will have to pay to all our members now (our retired members) and in the future (our retired members and members who will retire in the future).
Lastly, we need to establish how much money we need to have available now, i.e. what the value of the pension fund's assets needs to be at this time, for us to be able to pay all those current and future pensions. We make allowances for the fact that, for a payment of €20,000 in the year 2035, we do not need to have that sum available just now: our assets will continue to generate returns during the period between now and 2035. The rate of return that we have to use in our calculations is prescribed by the supervisory authority: we are not free to decide it for ourselves. This means that if the sum calculated in Step 3 is €20 billion, as it is in the case of Philips Pensioenfonds, we need ‘only’ to have €18 billion available. That amount, i.e. how much we need to have available right now to be able to pay out all current and future pensions that our members have accrued, represents the pension liabilities.
Funding ratio of 100%: exactly the right amount of funding
As explained above, a pension fund's funding ratio represents the pension fund's assets, divided by its pension liabilities. If Philips Pensioenfonds has a funding ratio of 100%, therefore, the pension fund has exactly the right amount of funding to pay all the pensions of all its members until the final member dies. This includes the pensions of all Philips and Signify's employees, whatever their age is. A funding ratio of 100% does not mean that the reserves have run out: they are in fact full. Even a 90% funding ratio is still enough to pay out 90% of the pensions: the reserves have not run out, but they are not entirely full either.
Of course it is important to minimise the risk that people cannot be paid their full pension. That is why Dutch law includes all manner of rules that say what buffers pension funds need to maintain. DNB, the Dutch central bank, oversees the pension funds to make sure they comply. Does that mean that we will never find ourselves in a situation where we will be forced to lower our pensions? Unfortunately, that is not a promise that we can make. Still, 'we need to cut our pensions’ is still a long way from ‘the pension reserves have run out’. We cannot rule out the possibility of being forced to cut our pensions at some point, but whether you are still building up your pension or already drawing it: do not believe anyone who tells you that the pension reserves will run out in a few years.