Lisa Pinehill

Now the big question is how to introduce more freedom of choice without sacrificing solidarity

The debate about Dutch pensions has taken a new route. A few years ago the debate centred around the question whether workers of retirees should pay for the shocks that are inherent to a funded system. Now the big question is how to introduce more freedom of choice without sacrificing solidarity. Freedom of choice is currently very limited when it comes to pensions. By signing a labour contract, it is decided whether one will participate in a pension scheme, and if so, how large the annual contribution will be, which will be the fund that will provide pensions, and how risky the investments undertaken by the fund on behalf of the worker will be. One could argue that the pension scheme leaves no freedom of choice at all, but that would be an exaggeration; it is the worker’s choice to sign a labour contract annex pension contract.

Noteworthily, not every participant of a pension scheme is in favour of more freedom of choice. In general, only a few show interest in their future pension income. For many youngsters in particular, pension income is too far away in the future to capture today’s interest. Similarly, many seem to be happy with the current situation, in which pension funds decide on pension contributions, indexation of pensions (and pension rights), and investment strategy. On the other hand, the call for more freedom of choice is getting louder. Lack of freedom is thought of as something of old times, which is not that strange considering the fact that the strong link between worker and employer has ceased to exist and has been replaced with a string of loose, often temporary worker-employer relations.

If we were to introduce more freedom of choice, we would face a problem, however. That is that freedom of choice conflicts with the principle of uniformity pricing on which current pension schemes are based. If we would allow the workers of tomorrow to choose whether to participate, there is a risk that many would not do so. Not only because they do not give their future income high priority, but also because they know they would be paying partly for the pensions of older workers. And if we would allow new participants to choose in which fund to participate, there is a risk that many would turn away from the so-called grey funds that are overpopulated with retirees, as they know they would be paying for the pensions of the retirees.

There is a third way, one that combines more freedom of choice with more solidarity

Currently, there seem to be two answers to this problem. One is to go for the current degree of solidarity and to accept the lack of freedom. The other is to go for more freedom of choice and to accept a lower degree of solidarity. But if we allow ourselves to think beyond current borders, there is a third way, one that combines more freedom of choice with more solidarity.

Assume a set of individual products that are being offered by different competing providers, and that differ in details about contributions, indexation, and investment strategies. Assume also a public transfer scheme that organises mandatory transfers between generations. The combination of individual pension products and a public transfer scheme features complete freedom of choice — as to provider, the level of contributions, and the riskiness of pension pay-outs. It also features a maximum of solidarity. The public transfer scheme allows society to preserve the solidarity between generations, which is a crucial feature of the current pension scheme. The elimination of the uniformity pricing principle means the end to the perverse solidarity between those with low life-expectancy and those with high life-expectancy. It also means the end to the perverse solidarity between young workers and old workers. Actually, this new scheme doesn’t compromise solidarity; it enlarges it! But there is more to it. The new scheme also includes the self-employed. The self-employed will have as much freedom as salaried workers. Presumably, this improves their position, as the market for pension products will be more competitive under the new scheme. Moreover, the self-employed are also covered by the public transfer scheme — just like the salaried workers. Again, this implies more rather than less solidarity.

Actually, the price might be as high as 100 billion euros

But where is the ‘but’? As economists, we know there is no such thing as a free lunch, so there must be a ‘but’ somewhere. Well, the ‘but’ is: who is going to pay for the transition from the current to the new scheme? Under the current scheme, pension contributions are front-loaded as compared to the build-up of pension rights (feature of the principle of uniformity pricing). Consequently, moving from this scheme to an actuarially fair one implies that current workers will face big opportunity costs if they are not compensated. Society can choose to compensate current workers, but this involves a high price. Actually, the price might be as high as 100 billion euros, according to a CPB report on this matter. But, again, the problem can be solved if we allow ourselves to think beyond current borders.

This is precisely what one would like to have: a reform that increases efficiency without invoking unintended redistribution

The solution lies in the observation that the elimination of the uniformity principle does not only imply opportunity costs to current workers, but also opportunity gains to future workers. The same CPB report calculates that an actuarially fair system will feature pensions that might be up to 8 percent a year higher than under the current scheme (or pension contributions 8 percent lower, which is the same). By taxing future workers and using the revenues to compensate current workers, it is possible to eliminate both the opportunity gains for future workers and the opportunity costs for current workers. Actually, such transfers remove the redistribution that the elimination of the uniformity principle brings about. This is precisely what one would like to have: a reform that increases efficiency (in the form of more freedom of choice and greater solidarity) without invoking unintended redistribution between different generations of workers.

Obviously, the compensation of current workers that is financed with future taxes means that there will be an accumulation of public debt. Debt that will be definitely paid off in the future, but still it is debt. It then requires that the EU should recognise that this new debt should receive a special treatment in order to not create problems with public debt policies. Alternatively, one could argue that the transfers from future to current generations should be organised on the level of pension schemes. In this case, we would also have an accumulation of debt, now on part of pension funds. This new debt would depress the funding ratios of pension funds. In this case it is DNB that should recognise the special nature of the new debt in order to not create problems with pension fund policies.

We can have them all:

  • freedom of choice as to participation, provider, and investment strategy;
  • solidarity between generations and between salaried workers and the self-employed;
  • the end to perverse solidarity between those with short and long life-expectancy, and between younger and older workers.

So let’s take them all.