# **1 BACKGROUND**

To give a better understanding of how derivatives have been used to hedge embedded options in the Danish case, this section provides a brief description of the Danish pension system, its main institutions, and its regulatory framework.<sup>1</sup>

- _1.1 THE DANISH PENSION SYSTEM_

The Danish pension system consists of three pillars. The first pillar – the social pension – ensures a minimum pension for everyone regardless of employment status and history. It is a pay-as-you-go system and is publicly funded from general tax revenues. All Danish citizens are eligible for this pension from the age of 65. There is a basic social pension that roughly corresponds to 20 percent of average earnings and a means-tested supplement that may double the social pension, effectively ensuring that all pensioners receive at least 40 percent of average earnings. Additional support is provided through housing benefits and free access to the universal healthcare system.

The second pillar – occupational pensions – is an integral part of the Danish collective bargaining system and is funded by contributions from employers and employees. Typically, the employer contributes two thirds and the employee one third. Participation for workers covered by different collective labor agreements is mandatory. The contribution rate varies with the specific plan. It has steadily grown over the past decade and the average contribution rate now exceeds 10 percent of wages. In 2002 77% of the labor force contributed more than 7% of their gross salary to pensions; up from 4% in 1998.<sup>2</sup> Most pension plans are based on defined-contribution schemes. Retirement benefits depend on contributions and investment returns. But pension plans also offer death and disability benefits. Payouts can take various forms: lump sums, phased withdrawals, or life annuities<sup>3</sup> , depending on the specific plan.

The third pillar – personal pensions – covers additional private saving. In many ways these personal pension plans resemble the occupational pension plans, but participation is entirely voluntary and the plans are funded solely by the participants, although favored by partial tax exemption. Like pillar 2 schemes, payouts can be as lump sum payments, phased withdrawals, or life annuities.

In addition to the three pillars the Danish pension system also includes a number of statutory supplementary pension schemes. The supplementary schemes could be construed as being part of pillar 1 as they cover a large part of the population – in some cases much more than the work force – but their institutional setup and funding compares better to pillar 2 plans.

> 1 A more comprehensive description and analysis is provided in Andersen and Skjodt (2006) and Van Dam and Brink Andersen (2006).

> 2 Danmarks Nationalbank (2006).

> 3 One of the differences between phased withdrawals and annuities is that annuities are strictly personal. In case of death the remaining savings will not be paid out, whereas phased withdrawals will be paid out to next of kin. This has become a disputed point in some divorce cases as annuities are seen as a way of preventing ex-spouses from getting any part of the savings.

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