The math behind a pension shuffle

Thanks to some discussions on the FIRENL Slack group we have a guest post today! This post from Peter is titled: The math behind a pension shuffle. It’s a topic that is important for everyone in the Netherlands who just switched job or plans to switch jobs in the future. Looking at how your pension is arranged with you employer (past, present or future) can be crucial!

Quick introduction: Peter and his family live in the Netherlands and are on a journey to financial independence. Their story can be followed in detail on his recently launched blog dutchjourneytofi.blogspot.com. His blog (in English) will discuss low-cost index fund investing, mortgage and pension optimization strategies, as well as other fun FI facts.

Take it away Peter!

The math behind a pension shuffle

If you change jobs in the Netherlands you are allowed to transfer the pension from any previous employer to the pension fund that you participate in at your new employer. There is a six month window of opportunity in which you can request your new pension fund to ask your old pension fund(s) to provide you with a lump sum quote. After you receive this quote you can decide to do the transfer or not (“pensioenoverdracht”). Whether this is a good idea depends on the exact rules and regulations in your different pensions. For instance whether your old pension is still indexed for inflation after you have left your employer.

A new rule was implemented on January 1st 2015. Since that date, pension funds are allowed (but not obliged) to agree on transfers if your request comes in more than six months after you changed jobs. I have used the new rule in the current low interest rate environment to likely increase my future pension substantially!

The math behind a pension shuffle.
The math behind a pension shuffle.

Inflation & Indexing

Currently the pension system in the Netherlands is under pressure as indexing for inflation is lagging behind while pension ages are being increased. This raises many eyebrows, as the total net worth of the pension funds is higher than ever. In which universe does that make sense?

The answer is in the fact that the traditional Dutch pension provides you with a guaranteed amount per year. Guarantees are expensive; while pension funds perform well, they cannot use actual yields to calculate how much money they have to allocate for future payments. Instead they have to use a mathematical interest rate instead (“rekenrente”) which dipped below 1% in 2017.

This is bad news for pensioners as you can look at a pension as an inverse mortgage. The pension fund has a lump sum of your money and pays you a monthly amount. At the end (when you die) the lump sum is gone and the monthly payments stop. Lower interest rates lead to lower payments. Obviously people die at different ages but this averages out for the pension fund.

Pension Transfers

But how does a low mathematical interest rate play out for people who want to do a pension transfer? Exactly the other way around! My old pensions from multiple employers have guaranteed monthly payments (a Defined Benefits (DB) pension).  The low mathematical interest rate results in an increase of the current net value (“dagwaarde”) of my pension! So I requested a transfer quote which came in at €14.477. With that number in hand I could do the math to rationally decide whether I should transfer or not. No calculation was included as in how they got to the quoted lump sum. But let’s use my actual numbers to exemplify what a transfer could bring you.

My example

According to mijnpensioenovericht.nl my old pension fund (ABP) was predicted to pay me €973 per year from the age of 68 onwards. My life expectancy (like anyone aged 42 at the moment) is around 82 years, so 14 years of payment on average. €973x 14 = €13.622. The fact that the expected payments are even lower than the quote are caused by the fact that the lump sum includes partner pension as well. It mostly reflects that at interest rates around 0 you get roughly the full lump sum now as no yields are legally allowed to be assumed in the coming 26 years until my payments start (remember the low mathematical interest rate).

Hence, the low mathematical interest rate nicely comes my way. They pay me more or less the full sum now instead of monthly payments starting 26 years from now that add up to more or less the same number!

New Pension

Let’s assume I put the lump sum in a low cost index fund in my new pension (which I did!) and this yields a modest average 6% per year for 26 years. (Quick note, this “new pension” is of the Defined Contribution (DC) type.) The lump sum will grow to €65.552. How much monthly pension can I purchase from that? That is actually impossible to know as it depends on the mathematical interest rate that is employed in 2044.

Anyway, the lump sum grew 4.8-fold so this would simply yield 4.8x more pension under the current low (unfavorable) mathematical interest rate. The pension would be even higher if the interest rates have normalized by then to let’s say 4%. You can obviously play with the numbers as you like. E.g. assuming a lower yield of your index fund or an inflation correction still being applied to your old pension. Mijnpensioenoverzicht.nl is agreeing with the math above as my predicted pension went up substantially since I did the transfer.

Guarantees

As always, guarantees cost money. In my example above you are trading security for potential higher yields. But how big is this risk? If your index trackers yield 0% in 26 years you still get the same pension. If the mathematical interest rate would go up, you already get more pension from this same lump sum. The risk sounds more like a black swan to me.

Unfortunately, pension funds are not obliged to play along with this game, if you have not changed jobs in the last 6 months. I have a 6-fold bigger pension locked up at Avero Achmea. After first trying to talk me out of the transfer they admitted they simply refuse to go along as they are not obliged to. If anyone knows a trick, other than moving jobs, to get access to this part of my pension as well, please let me know!

Overlooked?

Taken together, I feel pension strategies and tricks are largely overlooked by the Dutch FI community. This is complex matter as there are tons of different pension types with different rules and regulations. Generalizing is impossible, but investigating the matter makes sense!

I have strong arguments why I can now include my new pension fund in the calculations for reaching our FI number.  I’ll write a post on my blog covering this aspect in the near future. If you have interest in using the strategy described above I would urge you to take swift action as I predict the loop hole might be closed at some point in the future and the mathematical interest rate might not remain this low forever. 

Thanks!

Thank you Peter, very insightful investigative work you did! This might be a wakeup call for all my Dutch readers to check on their “regular” pension, regularly 😉

Also, if you want to know more, Peter wrote a post about the topic on his blog with some additional explanations: http://dutchjourneytofi.blogspot.com/2018/09/living-american-dream.html 

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26 Comments

  1. Great article. I’ve never seen it explained in such a simple way. Your value transfer also gave me the input I needed to calculate the value of my own Dutch DB pension.

    I thought that the rules were changed in 2015 to basically say that if the difference between the book value and transfer value of the DB pension exceed some arbitrary percentage (it was pretty low, 10-15%?) then the transferring pension fund can refuse to cooperate. And this change was in response to the low interest rates.

    I also understood that the intended pension reforms of the current cabinet ( which seem to be stalled) involved converting all DB to DC-like pensions, and one of the big issues to address is how much it will cost to convert the gauranteed DB amounts into DC-like amounts. As your recent example shows, doing this on a national scale would cost many billions of EUR, which the government (debt/tax!) would need to provide.

    1. This is an excellent point which almost requires another post to explain 😉 The pension funds still use 4% interest to calculate the current value of pensions to each other, regardless of the actual mathematical interest rate. This means that with >4% the new pension fund pays the old one the difference in the calculation to the customer and between the two pension funds, while the money flows the other way when mathematical interest is 10% of the sum to be transferred. This is another reason why I think this loophole will be closed at some point.

      1. Sorry, lost half my reply it seems, another attempt:

        This is an excellent point which almost requires another post to explain The pension funds still use 4% interest to calculate the current day value of pensions to each other, regardless of the actual mathematical interest rate. This means that with >4% the new pension fund pays the old one the difference in the calculation to the customer and between the two pension funds, while the money flows the other way when mathematical interest is <4%.

        The pension funds can charge this money to the old/new employer to which the pension was connected. In the current low interest rate environment this means companies have to deal with surprise bills from employers that have left decades ago. That's why they can refuse to cooperate when the bill is above 15,000 euro AND more than 10% of the sum to be transferred.

        This is another reason why I think this "loophole" will be closed at some point.

      2. Yes! That’s it 🙂

        I thought the right to refuse means the loophole is limited (10%/15k), though not entirely closed.

        Imagine no limits! In my case it would be worth switching jobs to a company with a good DC plan just after reaching cruiseFI altitude. Because, as you say, after converting a DB to a DC, in the hands of an individual with continued risk appetite the DC is eventually likely to buy more pension down the track, than a DB which is likely to erode due to insufficient indexation.

      3. One thing that does not work is starting your own side business. You can build up a pension but the transfers don’t work to personal pension plans 🙁
        If anyone comes up with a trick, please let me know as I have one DB pension left I want to transfer. I thought about agreeing with my employer to leave for one month and start a new contract. Not sure if the pension fund will buy that I have a new job, so probably not worth the risk (new contract means no legal piss-of money in case they dump you (“transitievergoeding”). Changing jobs just before FIREing is a way out. Also be aware that your pension cannot be higher than your last salary. If your stocks do great, you should retire early or switch to bonds as you are taking risk that will not be rewarded.

      4. I had no idea that your pension can’t exceed your last salary.

        What a mine field!

        Thanks again for the article and dialogue. Cheers.

  2. I actually made a post related to this a while ago (for the dutchies https://www.thinkingbig.nl/geld/vroeger-met-pensioen-in-nederland/ ) – because I feel like a lot of Dutch people read mostly USA focussed blogs, they tend to forget that we have some great systems in place in the Netherlands for everyone.

    So while the 4% rule makes absolute sense as a sort of ‘Bible’ if you have to create your full pension for yourself completely from scratch. In the NL we all tend to have at least some company pension and we all get AOW (state pension).

    You can (and I think you should) take those into account for your forward earnings / spendings.

    1. thanks for sharing your post! Fully agree you can be a bit more loose with the 4% rule. The value of DC pensions can even be included in your FI number as far as I am concerned.

    2. I also agree, though I haven’t figured out how to model it.

      I tend to work with the idea that the approach to FI is like building a bridge to traditional retirement. How big and long the bridge is, and how much of it needs to remain intact over time depends on a bunch of factors. One factor must be the amounts you have in traditional retirement vehicles and when they can accessed.

      Regular retirees frequently do this so as to retire a few years earlier, supported by their own means, and some sporadic consulting/freelance work to ease the transition.

      What about a 10, 15 or 20-year bridge?

      I reckon you can take more risk and run a higher SWR rate during RE if you have decent pensions to rely on in case the higher SWR depleted your capital.

      So in NL the FIRE plan might look like a combination of regular and “cruise” FI.

      1. it is tricky to come up with the one best way on how to include the DC pension in your FI number, that’s why I wrote a separate post on my own blog 😉
        It depends on the ratio personal FI money to DC pension. It depends on the number of years to bridge. In my case a 4% withdrawal rate of my total stash means a 6% withdrawal rate from the personal stash. With the bridge being 15 years I will not run out of money with the 6% withdrawal from personal money before the DC pension kicks in. So effectively I am withdrawing 4%. Also a DC pension leaves you approximately 4% in hand after taxes and that withdrawal rate is safe for sure but the money will be exactly finished when you die. Complicated matter but not counting your pension at all means you work for too many years.

  3. I just got my overview from my company pension at my previous employer. Now their fund is run ok-ish with low costs (the benefits of working for a big bank that does this still “in-house”) but as a FIRE person it annoys the hell out of me I have now 17.000 euro standing there I will not be able to touch before 65 (or even 67). Honestly, I can use it a lot more now than in 20+ years. Especially taken into account I am an only child and will most likely already be a millionaire by then. And no way to cash it in early, only transfer to another fund… Sigh It is especially the one size fits all approach of our government that really annoys me.

  4. Also, if you are Dutch, it is good to check if you have ‘jaarruimte’, (can be used up until 7 years backdated) so you can add to your tax free pension savings using ‘lijfrente’.

    This is valid for people who have no or poor pension plans, or who earn large variable bonuses on which no pension is accrued.

    This is a great system, where you can invest substantial sums from your gross salary (you pay 48%, tax authorities pay the remaining 52% for you!), which you can invest in low cost index products. This is fully exempt from equity tax, and you can have it paid out as an annuity or a fixed yearly amount when you reach the retirement age, at a far lower income tax rate! The downside is that you are not allowed to withdraw before the age of 67.

    It is a useful tool especially for people who are aiming for FIRE, who earn a lot now, but do not expect to receive a big pension as they stop working and therefore contributions well before the normal pension age. Google it!

    1. Funny you mention this, because we did the opposite. Because we wanted to FIRE, we needed the money now, but also in 20-30 years. So opted out of the addition pension and invested into real estate for the cash-flow. We realize we lose some tax benefits, but it will get us to FI sooner = more choices in life what to do. Rather than having more money when we are 67-68+

      1. Seems personal finance is, well, personal! We reason the same as CF and prefer to not use the jaarruimte. It is certainly attractive from a tax point of view and can be a an option. Beats spending everything for sure! What holds us back is the fact that the age by which you can withdraw might change. Also the tax brackets for pensioners might be increased. My trust in the ten governments to run the show before it is my turn to retire is simply not big enough.

  5. Agreed that the earlier you look at this, the more impact it has in the long run.

    I advise to also look at moving Defined Contribution plans if necessary. For me personally the majority of my pension savings were with a provider which charged a total of 2.1% in ‘maintenance’ fees (for investing in index hugging products), every year! Finally this has been moved after a 2.5 year battle to my current provider which charges just 0.6% in total fees annually. Still higher than I would like, but the 1.5% extra return will compound to great sums in the coming 30 years!

    1. Certainly true not all DCs are ideal either! I’ll publish a post on my pension costs soon inspired by your comment. And a few more posts on pension stuff in the weeks to come, including one on the performance of the active, more expensive pension fund. Spoiler alert; these guys are not worth their money! You might loose even more money on them failing to outsmart the market.

  6. Hi Claudia,

    the 6 month limit is indeed abolished but be aware that this only means pension funds are allowed to transfer but are not obliged. ABP was happy to transfer for me but Avero Achmea simply sad no. The calculations behind the numbers are impossible to understand but in this post I at least try to explain how to get to the numbers and how to decide whether a transfer is a good idea or not. Happy to help if you have any concrete example in the coming months, good luck with your new job!

    cheers, Peter

  7. Hi Cheesy

    I totally agree that the Dutch FI community should talk more about the “standard” pension. The problem is that it is sooooooooo complicated!!
    For example according to the link below the 6 months limit is abolished since 2015. (But on many sites this is still given as a fact. One should always check the date of the page before believing it)
    By the way this is very useful for me since I’m going to start with a new job next week.

    https://www.fnv.nl/themas/pensioen/waardeoverdracht-pensioen/
    greetings
    Claudia (CenG)

  8. Great idea. Pensions are indeed really important to take into account. I think most of your dutch readers don’t have the possibillity to invest in a low cost ETF in a DC-pension. I have had a DC-pension and i also didn’t have.
    But comprehending their types of pension, capital, interest rates and mortality-assumptions is a good idea!

      1. good point MrPFP, you should obviously check what costs are involved in your new pension and take this into account in the calculation I propose in the post by simply lowering your yield for the years to come.

        Peter

  9. One of the reasons I left one of my pensions with my original employer is that it still includes partner pension for when I die before the pension age, even though I am no longer employed with that organisation. Most modern pensions do not cover this anymore (which can be a really nasty surprise if your partner dies).

    1. Great point, the problem is it is complicated to compare apples and pears. In my case the new DC pension includes a partner pension so this was not an issue. You could also check what the costs are for a life insurance that pays the same amount as your pension, so a linearly decreasing one that ends when you are 65 (or 71 or whatever your pension age is). Life insurance might work out cheaper when combined with a pension transfer.

      1. to make it more concrete. An after-tax partner pension of 10,000 euro/year for the coming 26 years (to my pension date to make it fit into the blog post numbers) can be covered with a linearly declining life insurance of 260.000 euro that ends in 26 years. Best quote I can find online (https://www.moneywise.nl/overlijdensrisicoverzekering/vergelijken/) is 14 euro per month (total premium over the years is 3600 euro). Not sure if that alone should be a reason not to transfer. If you do my sums in the post with the starting number lowered by 3600 it still makes a lot of sense to transfer.

        Peter

      2. But that assumes you are healthy and can get a normal life insurance. I have a chronic illness (which does not bother me the least in daily life), so life insurance is not so cheap or easy to get.

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