How to adequately size a 2nd pillar DC pension plan for future retirees? An actuarial answer

The replacement ratio as a guide for your DC retirement plan 

The current idea is that a 2nd pension pillar foreseeing a premium equalling 3% of the salary would be sufficient to enable employees to save for after retirement. But how can this percentage be appropriate for each category of workers?

Given the changing economic context, we were curious to understand in more details the outcome of a couple of simulations.   

The replacement ratio can be defined as the ratio between the 1st total retirement income and the last salary before retirement. In other words, if a worker would earn a gross salary of 2,500 EUR per month just before retiring, and would benefit from a total pension income of 2,000 EUR, its replacement ratio would be 80%. 

For this article, we considered 3 illustrative profiles of employed workers with different monthly gross salaries. Each profile intends to represent a percentile of the worker population in Belgium (percentile 20, 50 and 90 for a person aged 25). Each starts his career at age 25, works at 100% and is expected to retire at the age of 67 (no pension bonus / malus will be considered). The initial salaries are respectively 2.300 EUR, 2.700 EUR and 3.700 EUR for our profile 1, 2 and 3. These salaries have been defined based on Statbel 2021 information, although mitigated by starting age and function. These 3 profiles intend to illustrate the situation of workers in Belgium, reflecting various career paths, specialties, and expertise. The life cycle of each profile has been designed to reflect a general behaviour. 

The salaries, as well as other financial charges and revenues, will evolve with an annual inflation of 2% and an annual merit increase between 0.6% and 5% depending on their career path and age. For the projections until retirement age, the longevity of the profiles is modelled by the IABE prospective mortality tables 2020 which are generational tables. According to these tables, it is expected that in average a person born in 1999 will live until 91 years old if he/she is alive at the age 67, leading to a period of 24 years after retirement age.

During their active life, the 3 workers will rent or buy a house/flat, buy a car, have children and finance their studies, etc. Their annual saving is therefore defined as the remaining budget after covering all the charges: they are expected to save at the maximum 20% of their net income. The simulation grants a return of 2% net on the savings’ investments, which is rather conservative / prudent although rather consistent with an inflation rate limited to 2%. 

After retirement, while some charges decrease, others increase, such as a retirement home or medical expenses. The workers are assumed to build up savings and rights during their working life which will afterwards finance the old age expenses. The initial costs of the assistance support (before projections) are based on the current market price of health insurance, retirement homes, medication costs, etc.  

The simulations do not reflect any change in the income taxation, the system applicable at the moment of writing this article has been kept unchanged (December 2024). Some of the specific taxes or deductions are not reflected.  

We can observe on the below graph that during the lifetime of the participant, the savings’ possibility (the green line) varies and decreases sharply as from age 80 which concurs with our assumption that one enters a retirement home or benefits from similar services. While the active career is rather an accumulation phase, the post-retirement period is more like a decumulation one. Note however that the moment of the actual decrease in the financial means depends mainly on the moment the worker’s neediness increases, triggering additional care. 

Based on this lifecycle, we originally determined the necessary replacement ratio to extinct any savings at the time of the expected death.

However, we noted that this situation is not realistic as it requires an exact alignment of the needs and expenses. Any deviation in the payment pattern as well as other unpredictable situation (such as inflation raising, pandemic, serious illness and costly (medical) treatment, financial crisis, family unforeseen events, etc.), would lead to financial difficulty directly and precarious situation.  

As, there is no possibility to face these events after retirement alone (if younger family members are asked to cover the unforeseen costs, that would directly impact their financial situation and consequently their financial stability), we defined a more down to earth situation, targeting for a single payment upon the death of the participant or to face unfortunate circumstances or financial difficulties. This lump sum is determined as approximately 6 months of the last income at the age of 91.   :

We note that the selected goal of achieving 6 times the last salary does not necessarily reflect the same behavior of the savings amount for each profile. 

For the Profile 1, the projection results in a negative annual budget during the high dependency age (>80), decreasing the remaining amount at the moment of death.

This is not the case for the other 2 profiles.

The amounts imply a replacement ratio sufficient to cover the expected costs, resulting in a neutral or slightly positive annual budget. We understand that this slightly positive income is explained by the real estate investment generating a sufficient income to cover the costs before death. 

To build up these income after retirement (replacement ratios), the worker will receive his/her state pension and possibly a 2nd pillar pension. The savings accumulated during the working period (if any) can be assimilated to 3rd/4th pillar savings. Any improvement of this rate could be reflected in the amount payable upon death of the profile.  

Simulating the replacement ratio of the state pension for each profile, we can observe that the state pension represents between 49% and 34% of the last salary - : 

As the state pension is calculated on a salary limited to a defined amount (pension ceiling), the higher the salary is, the lower the replacement ratio covered by the state pension will be.

Comparing with the state pension replacement ratio, our conclusion is that the state pension will not be sufficient to cover the needs of the 2nd and 3rd profiles while it would be around the equilibrium for the 1st one. This 1st profile represents the situation of a minority of the Belgian working population (below 20% of the working population would be in this situation).

What does a DC retirement plan represent? 

Our initial projections here below consider a pension plan offering an annual retirement premium of 3% of the salary. These coverages provide a total replacement ratio between 38% and 54% depending on the profile (under a legal minimum rate of return of 2.5% and a cost on premium of 5%).   

The replacement ratio necessary to overcome unpredicted situations is not reached for the last 2 profiles. To achieve the desired replacement ratios (or objectives), a pension plan would need to provide at least a retirement premium, payable over the whole working period, of:

We conclude that a pension plan defining an annual premium of 3% of the salary will not be sufficient for the 2 last profiles simulated.  

In addition, due to the complementary nature of the 2nd pillar pension system and considering the limited retirement replacement ratio the 1st pillar pension offers to highest earning profiles, selecting a pension plan defined as a flat rate percentage for all workers does not provide the same level of protection.

Note that this observation explains the rationale of the step rate pension plans, which define a premium as a percentage of the salary below and above a certain ceiling.  

Further conclusions and considerations 

1. One DC pension plan for all?
   
   Considering that the higher salary suffers a shortage of coverage due to the limitation embedded in the state pension calculation, a pension plan dividing the retirement premium as a percentage of the salary below the state pension ceiling (S1) and in excess of this ceiling (S2) could increase the replacement ratio while keeping the same plan design for all profiles.  
   
   To achieve 64% replacement ratio for the 3rd profile of our example (i.e. a retirement income equalling 64% of the last salary), a pension plan providing a retirement premium of more than 21% x S would be necessary. Under a step rate formula, the decrease of the percentage applied on S1 would directly lead to an increase of the percentage applied on S2. This implies that the objective to attain a similar replacement ratio while instituting the same plan for all workers is not possible. 
   
   What other parameters than the plan design would influence the retirement income?
   
   
2. The impact of cost in the pension benefit 
   
   We noted that the government agreement intends to at least monitor the costs embedded in the 2nd and 3rd pillar pension systems. In our example, the retirement premiums are decreased with a 5% cost applied to the premiums, leading to an increase in the investment balance of 95% of the actual premiums paid. Other costs such as the cost of investments are directly impacting the net return granted on the premiums and are therefore embedded in the net return discussion. 
   
   A 1% of cost reduction on the retirement premiums would lead over the full working period to an increase of the replacement ratio around 0.05%, depending on the underlying pension plan formula. This impact will vary depending on the investment return as any cost embedded in the retirement premium represents a shortage of return along the career (the part of the premium covering cost will not generate any return during the accumulation period).  
   Considering the rather limited impact of the cost on the replacement ratio, our analysis leads us to the third consideration here below. 
   
   
3. Optimizing the equilibrium risk versus return for a DC plan
   
   Since 2016, the legal minimum rate of return is defined as a formula based on the OLOs. This rate could therefore be interpreted as conservative risk profile in terms of investment strategy. In the recent past, the applied rate was at its minimum (1.75%) even if the 1.75% was indeed exceeding the result of the formula. The legal minimum rate of return has increased for the first time since 2016 reaching 2.5%.  
   
   With regards to the investment return, an increase of 1.0% would lead to an increase of the replacement ratio around the same percentage: 

This demonstrates the importance of the investment return as one of the key parameters of a pension plan. However, seeking additional return of the DC pension plan implies increasing the investment risk for the beneficiaries and/or the sponsoring company. While the sponsoring company will face the investment risk below the legal minimum rate of return, the individual will support the investment risk above that threshold. The actual exposure will depend on how that threshold is applied on the individual assets. Let’s not forget the long-term nature of the pension system, allowing to derisk an investment portfolio towards the end of the working career. 

Conclusion

In conclusion, an universal DC pension plan fulfilling identical needs for all is impossible, the relative level of coverage will depend on the individual worker age and salary (profession). This was demonstrated by our projections and simulations. 

Designing a DC plan by taking into consideration the state pension benefit would allow a certain tailoring based on the salary of the workers, in line with the 1st pillar design. 

A minimum level of coverage would not be achieved with a DC plan defining a premium equalling 3% of the salary excepted for the workers receiving a salary far below the average Belgian salary.  

Seeking additional return (on top of the legal minimum rate of return) could improve significantly the replacement ratio and allows some protection towards inflation.