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!
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.
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.
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!
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.
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!
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.
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