Conditional indexation in defined benefit pension plans in the Netherlands

Abstract

In an ageing society, defined benefit (DB) pension plans are increasingly difficult to manage by means of contribution policy only, as the contribution base is likely to shrink relative to total pension provisions. This development, together with an increased emphasis on market valuation in regulatory and accounting rules, has led to a switch of DB plans to defined contribution plans throughout the world. In the Netherlands, a different solution has been sought. The typical pension contract nowadays comprises an average earnings DB pension in which only nominal benefits are guaranteed, but with the intention to provide wage or price indexation. In the new supervisory regime, the guaranteed pension rights, based on market valuation, are subject to risk-based solvency requirements. Provisioning is not required for conditional pension rights, although contributions have to be consistent with the indexation ambition. In this paper, we analyse to what extent indexation is indeed likely, given various indexation and contribution policies. Simulations show that voluntary provisioning for indexation is to be recommended. Fully guaranteed indexation is virtually unaffordable under the new supervisory regime, because the real discount rate is generally both very low and highly volatile. © 2007 The International Association for the Study of Insurance Economics.