While the stock markets are writing deep red numbers, inflation is spiraling towards double digits and a war is raging in Europe – just as storm balls are being raised – major pension funds have announced that they will start indexing and increase pensions somewhat.
It feels crazy, counter-intuitive, which in itself doesn’t mean it’s wrong. But it does make you extra curious about the reasoning behind it.
Pension supervisor Else Bos of De Nederlandsche Bank (DNB) wrote an article about it in this newspaper about a week ago, for which thanks, because it was at my invitation. She reiterated the official position. ‘Calculating with an interest rate higher than the risk-free rate leads … to a wealth shift from young to old.’ I could have written it myself, and have often done so, but now I have serious doubts about this – which Bos has not been able to dispel.
Let’s peel it off. Bos’s statement is in itself correct. If you value pension fund liabilities at a higher interest rate, they will be worth less in today’s euros. The pension fund is then in a better financial position, and therefore has financial room to index pensions, room that would not exist if a lower interest rate was calculated. That’s hard mathematical logic.
The reverse is also true. If you calculate with an interest rate that is too low, you shift wealth from old to young. It is therefore important, both for the sake of fairness and for the sake of the stability of pension funds, to calculate with the correct ‘risk-free interest rate’.
But what exactly is that ‘risk-free rate’? DNB chooses to rely on interest rates that are established on the financial markets for, for example, government bonds of a country with a sustainable government debt, which therefore does not involve a bankruptcy risk. After all, the assets side of the balance sheet is also valued on the basis of the market prices of, for example, shares. It made sense.
But is it? I have at least two major doubts. Firstly, the system assumes that the ‘right price’ is always achieved on the financial markets. Economists call this the ‘efficient market hypothesis’, which has been undermined by all kinds of research that points to herd behavior in financial markets. In other parts of DNB, they can also complain quite a bit about financial markets that are ‘playing games’, such as with interest rates in Italy. If players in financial markets ‘gamble’ and exhibit herd behaviour, and central banks, moreover, try to steer interest rates themselves through their unorthodox monetary policy, why is the market rate still the right ‘risk-free rate’? That hurts, to put it mildly.
Second: the horizon. Pension funds have obligations that are up to eighty years in the future (the 21-year-old entry-level participant who turns 101). Nobody knows what the interest (and the yield) will do in the meantime. Then you can focus on overnight interest rates, and then the financial health of a fund swings up and down – as it does now. Or you opt for more rest, and take some moving average, with a lower and an upper limit for the interest rate.
“We should have set a lower limit for the interest at the time,” a pensioner told me last week. “But you can’t change the rules of the game during the game.” That first one is correct. The second is a view I do not share.