Netspar Jaarcongres 2020: Keynote Klaas Knot

I can remember, Casper, that you were also a member of the first committee. And I myself also went back in my thoughts 15 years ago, when I had just merged the Pension and Insurance Chamber back into the Netherlands Bank in 2005. And I also remember from that time and the genesis of Netspar that there was simply a need for a knowledge center for pensions in the Netherlands. And from the Pension and Insurance Chamber and the Netherlands Bank, we wholeheartedly supported that at the time. And I am extremely happy with what it has become. Of course, other people also played a role in that, like Bovenberg et cetera. I think too many people to name now, but it is very nice that we can now speak about pensions again at this, yes, delayed congress, and also try to bring science and policy together here. Pensions affect everyone. I myself think I am about fifteen years away from my pension, but certainly for young people, the tendency to postpone it as long as possible is not very wise, because I think that ultimately everyone strives for an old age without financial worries, and that is not immediately the first association with pensions at the moment. So if you ask people now, there are still many people who worry about their retirement provision, and the first thing that comes to mind is the low interest rate. So it is very good to dwell on that today, very good what Netspar is doing for its 15th anniversary, and also tries with verve to generate some clarity in this debate by, on the second as our broker, and by translating scientific insights as much as possible into policy, into practice. We have participated a lot in Netspar. I would also like to remember my colleague Job Swank, who unfortunately cannot be here, but if he had been able to, he would certainly have been present here today and would have participated, because yes, it is a subject that fascinates many of us immensely. Good, before we discuss the consequences of the low interest rate, we will also briefly say something about the causes. We do that because there are many stories about the interest rate. As you know, since the mid-1980s in developed countries, there has been a trend decline in interest rates, and often a finger is pointed accusingly at me and my colleagues, central bankers. And of course it is also true that the monetary policy of the European Central Bank and other central banks has been very, very accommodative in recent years, and in response to corona even further. But still, if we look at that trend decline in interest rates since the 1980s, it is not only related to the decline in inflation, but also to other macroeconomic trends, factors on which monetary policy has considerably less influence. For example, the globally increased propensity to save and the decreased willingness to invest. Let me briefly explain that. First of all, why has the propensity to save increased so much? Well, that has to do primarily with increased life expectancy. That means people save more for old age, because the number of pension years also increases. And at the bottom of the pyramid, we had and have lower population growth, leading to increasing average aging. And with an increase in the average age of the working population, there is also an increase in savings, because savings are highest among older working-age people. In addition, we had a decrease in investments, and that probably also has to do with the decline of the industrial sector in the share of national income in favor of the services sector, because in many services, less is invested than in industry. And also the prices of investment goods fell, especially when we think of ICT. And as a third factor, I could also mention that governments have invested less. So it is mainly these structural factors that have led to a trend decline in interest rates worldwide. And yes, alongside these structural factors, there is also monetary policy that has further influenced interest rates, in its attempts to bring the actual interest rate below the equilibrium rate to provide additional stimulus to the economy. Good, what does this mean? Well, central banks base their policy on macroeconomic developments. The ECB aims for inflation below but close to 2% in the medium term, and inflation, as well as inflation expectations, have been below that target for quite some time. So the ECB, like all other central banks in the world, tries to promote inflation with accommodative monetary policy. This translates into a reduction in the policy rate. Since 2014, the policy rate has been negative, and because that policy rate forms the anchor for other rates, the other short-term rates, but also long-term rates, have also fallen. On top of that, the ECB and other central banks have not limited themselves to interest rate policy; they have also used new instruments such as purchase programs, which also have a direct downward effect on the longer end of the yield curve, to ensure that the accommodative monetary policy transmits to the real economy, where many citizens and companies prefer to borrow money for longer periods than just short periods. Good, in the past six months, the ECB has had to intervene further, first to stabilize financing markets, with new large-scale lending operations to banks, a new purchase program, the Pandemic Emergency Purchase Program. The goal of these interventions is all to ensure that citizens, companies, and governments maintain favorable financing conditions in a time characterized by unprecedented uncertainty. With that, the first blow of the corona crisis has been absorbed, and with that we naturally hope to prevent as much permanent damage to the growth potential of our economy as possible, and that is also relevant for the ECB's inflation target. In short, the historically low long-term interest rates in the euro area are the result of a combination of factors: long-term trends in the real economy, but also the monetary policy of the ECB. And Casper rightly indicated that the chance that this will persist for a long time is considerable, and that is also widely priced in on financial markets. Good, what does this mean for pensions and saving for old age? Well, it means a lot, because it affects both the assets and the liabilities of pension funds, and therefore also their financial position. If we first look at the assets, due to the lower interest rate, not only fixed-income investments such as bonds have increased in value, but also the value of shares has become higher, because when interest rates fall, the present value of future profits increases, which translates into higher share valuations. Recent research at the Netherlands Bank also confirms this, and shows, for example, that announcements of new rounds of quantitative easing in recent years have also been accompanied by increases in share valuations. But that was the good part of the story. At the same time, due to the lower interest rate, the liabilities of the pension fund have also increased in value, and even much more than the value of the assets. This has led to a sharp decline in the funding ratios of pension funds, from 150% before the outbreak of the financial crisis in 2008 to an average of about 95% in August last year. And if we take stock, we see that at this moment, relative to their liabilities, most pension funds have insufficient funds to meet those liabilities at this time. Indexation has actually been lagging for a long time, and the threat of nominal cuts still hangs over the market. Good, many people here, but also virtually and in the country, are rightly concerned about this. And the first thing we must realize here is that I have spoken about pension funds as a homogeneous group, but that does violence to reality. There are simply important differences between pension funds, differences related to various factors, such as investment policy, the extent to which pension funds are hedged against falling interest rates, the extent to which they have invested in shares and other equity, but also the level of the premium paid. These are the three most important factors that, in retrospect, can explain the difference in funding ratios, and therefore also the difference in possibilities to still achieve some indexation. Good, the end of an era of low interest rates does not seem in sight for the time being, and that has important consequences for the cost price of pension accumulation. Because I think the low interest rate also means that expected returns on investments will be lower. That does not necessarily have to mean that the return expectation moves one hundred percent with the lower interest rate. At the same time, we cannot assume that risk premiums will provide perfect compensation so that those lower interest rates would not affect the return. So it is plausible that low interest rates are accompanied by low returns. Yes, that simply means that building up a pension will become more expensive than in the past. Because however you organize a pension, at the end of the day it is the contribution of premiums plus the return achieved that determines the pension result. So a significant impact on the cost price of pensions. And I completely agree with Casper that actually the biggest issue at the moment of that significantly higher cost price is: are we going to set aside more money today to try to maintain the same pension, or do we accept that our future pension will be somewhat lower because we are simply not willing to pay that price today? Well, that is a difficult choice, a choice that is preferably avoided as long as possible. And that leads to a search for alternatives: is it possible to have your cake and eat it too, as the British say nicely? But none of those alternatives is actually a miracle cure. Putting in less than the cost price for building up your pension might work for a while if returns are favorable, but in the long run it comes at the expense of the financial position. It is not a sustainable solution. Taking more investment risk can lead to a higher expected pension for a while, but with that risk comes an increased chance of disappointments, and they can remain latent for a long time, but at some point they will manifest themselves again, and I don't need to explain that to this audience. Does the key lie in the reform of the pension system? Can you ask that? Well, in itself, I am satisfied, and I want to say this again, about the agreements that the cabinet and social partners made last summer on this. Because I think that with that, the necessary steps are being taken, the much-needed steps towards a future-proof pension system. For example, by no longer promising pension entitlements, there is no longer a need for a discount rate for valuing pension entitlements, and thus, I think, an important source of tension between generations disappears. And with the abolition of the average premium system, in our view, an important source of undesirable redistribution between young and old disappears. And with that, the system will also better align with a modern labor market where people change jobs more often and perhaps also want to work part of their career as self-employed. And this also makes it possible to better align investment policy with the risks to which young and old are exposed, the risks they want and can bear. So, for example, the interest rate risk of young people no longer has to inadvertently end up with the elderly. But, and this was a long lead-up to what I actually wanted to say, even the reform of this system, however necessary it may be, is simply not a solution for the high cost price of pensions. Even in a new pension system, the ultimate pension result simply depends again on the premium paid and the return achieved. And that is why it is logical that not only within that funded pension system solutions are sought, but that perhaps also outside the second pillar, the question arises: has the time come to reconsider the balance between pay-as-you-go financing and funding? And now that pay-as-you-go financing has become relatively cheaper, everything is relative, but relatively it has become cheaper. We think that every answer to this question must take a sufficiently long time horizon into account. This is not something you should optimize with high frequency. And if you not only look forward but also look back, for example, and compare the return on financial assets with the growth rate of the economy, then we know that there have been periods when one variable was above the other, as well as periods when the opposite was true. So in other words, if you had wanted to move back and forth in the past, you would have constantly moved up and down with the amount of pay-as-you-go and the amount of funding. And that actually leads to the conclusion that combining both, let's not forget, when we talk about pensions, we tend to talk about the second pillar, but for the vast majority of pension participants, the first pillar is of course much more important than the second pillar. It is precisely the combination that leads to the spreading of risks, both political and demographic risks, but also financial and productivity risks. And if we then compare the Dutch system with surrounding countries, I think that precisely that combined system has served us well. Poverty among the elderly in our country is low, lower than, for example, poverty among other age groups in the Netherlands, and also lower than poverty among the elderly in surrounding countries. So it is the diversification where I believe one of the strengths of our system lies. But good, within that you can still look at the ratio between the two pillars, and the idea of using those ratios to respond to the change in the cost price of different forms naturally looks sympathetic. But here too, I think you should not act hastily. They can lead to redistribution effects between generations. For example, a direct increase in the AOW would mainly benefit the current, current elderly generations, but the costs would have to be borne by future generations. And an adjustment of the AOW also affects the labor market, because the right to AOW is not linked to someone's work history. And also with a larger first pillar, I think a warning is in order. To the extent that the lower interest rate goes hand in hand with lower growth of the labor force, for example, the return on pay-as-you-go financing is also lower than in the past. In short, I keep coming back to my main conclusion: saving for old age, one way or another, has simply become more expensive, and there is really no escape. Good, let me conclude. To put the debate on the consequences of the low interest rate for our pensions in the right perspective, I think we first need to zoom in on the causes of the low interest rate, both structural macroeconomic factors and global policy. The consequences for our pensions are certainly not rosy. However you turn it, for any pension system that works to some extent with funding, a lower interest rate means that saving for our old age simply becomes more expensive. Yes, should we set aside more money, or should we accept that our pension may be lower in the morning? I think there is simply no easy solution to that question. It also has to do with preferences. And the new pension agreement, however important and necessary it is, cannot work miracles in this area. And so I think it also depends a lot on very careful communication about this, on information obligations, whether this pension is near or far. I think everyone benefits from a clear view of the expected level of the pension and the associated uncertainties. And that certainly applies to the youngest generations, who have of course only just started building up their pension and who also need insight into the correct starting point for that difficult trade-off of how much pension we want to build up and how much we are willing to pay for it. Well, let me conclude by saying that I am convinced that this issue will not go away in the next fifteen years, and that I am also convinced that in the next fifteen years, Netspar will continue to play as useful a role in this debate as it has played in the past fifteen years.