March 15, 2006

Notional Pensions: Does Sweden Have the Answer?

Rick Mattoon
Senior Economist and Economic Advisor

In the 1990s, the Swedish government realized it had a pension problem. Sweden relied on two primary pension mechanisms. The first was a pay as you go, defined-benefit plan financed through a payroll tax on employers. This was supplemented with an occupational pension that was part of collective bargaining agreements between different classes of workers and their employers. Given changing demographics and generous pension benefits, the Swedish government recognized that the pension system would go bankrupt in 20 to 25 years without significant tax increases. At the heart of the problem was the linking of benefit increases to price changes rather than wage growth. This tended to make benefits rise faster than wages and contributions during periods of slow productivity growth.

To address this problem, the Swedish government wanted to restructure its pension system to respond to the increased longevity of the population and reflect economic conditions. In 1998, the Swedish Parliament abandoned the traditional defined-benefit pension plan in favor of a new notional defined contribution (NDC) plan. The new plan has two components—a notional account for each worker and a private account referred to as the premium pension. The contribution level is 18.5% of earnings with 16% going to the notional account and 2.5% to the premium account. So far this doesn’t sound all that radical. However, the notional defined contribution plan is fundamentally different from other traditional pension structures. Contributions to the NDC are recorded in each individual’s personal account and accumulate based on their earnings. However, the contributions are only “notional” in the sense that the money that is being collected today is used to finance current obligations of retirees. The individual’s fund balance grows on paper even though there is no real money in the account. The rate of growth is determined by the employee’s contribution and a defined rate of return that is tied to the national per capita real wage growth. In doing so Swedish officials wanted to stabilize pension funding and insure pension sustainability.

Workers can then choose to retire as early as age 61. When they retire annual benefits are calculated by dividing the account balance by a divisor. The divisor is set to the cohort’s age 65 life expectancy and an imputed rate of return based on the long-term real growth rate of the economy (assumed to be 1.6%). Benefits are then adjusted each year for inflation take into account the imputed rate of return.

The ability to cap total payouts and adjust benefits to reflect economic and demographic changes significantly improves the financial stability of the Swedish pension system. However, the system is still a pay as you go plan and as such the Swedes decided it was wise to build in buffer funds to protect against shortfalls. The buffer funds are critical because given the structure of notional accounts, raising contributions levels only has the effect of increasing future benefit promises. One of the clear goals of the reform was to take the politics out of pensions by making the system more transparent and making adjustments driven by formula rather than politics. In addition it encourages workers to postpone retirement since benefits continue to accrue based on annual earnings.

Individuals are also required to carry “Premium” pension accounts. These supplemental individual accounts require a mandatory contribution of 2.5% of annual earnings. The funds are then invested by the individuals in a large range of fund types including equities, balance funds, life-cycle funds, and interest-earning accounts. In addition the government established a low-risk default fund for investors who did not feel comfortable making an investment choice. A key component of the individual accounts was investor education. The government undertook a significant program of financial education.

The transition to the new structure has gone well according to most reports. Individuals will be phased in over a 16-year period based on cohorts. Only workers born in 1954 or later will fully participate in the new system In contrast, the first cohort, those born before 1938, will receive only one-fifth of their benefit from the new system while receiving four-fifths from the old defined benefit system. In the end, the biggest advantage of Sweden’s reform can be found in pension fund sustainability. While the notional accounts structure is designed to adjust future benefit levels based on economic and demographic conditions it runs the risk of providing benefit levels will be inadequate if economic conditions are sufficiently adverse. In this case the system might unravel under political pressure. What is clear is that the Swedish system now makes individuals far more responsible for planning for their own retirement and given pension pressures facing many governments, NDCs will continue to receive attention.

To find out more about NDCs:

The Economist, “More Than a Notional Improvement” Economic Focus, February 18, 2006.

Annika Sunden, “The Future of Retirement in Sweden” in Reinventing the Retirement Paradigm, Robert L. Clark and Olivia S. Mitchell, editors, Oxford University Press, 2005.

Posted by Mattoon at 07:40 PM | Comments (0)

March 09, 2006

Highlights from the State and Local Government Pension Forum

Rick Mattoon
Senior Economist and Economic Advisor

Over 150 people attended the February 28, 2006, State and Local Government Pension Forum cosponsored by the Chicago Fed, the Civic Federation, and the National Tax Association. Presenters offered a wide range of perspectives on trends affecting pension funding and solvency, as well as discussing the potential impact that recognizing future OPEB liabilities will have on government finances.

I will summarize the conference discussions in an upcoming Chicago Fed Letter. Meanwhile, here are some of my impressions. By the end of the program I think a pretty firm consensus had emerged that:

  • while not a crisis, pension funding and OPEB liabilities will be the largest fiscal challenge to many state and local governments in some time. Financial commitments for these programs are growing much faster than the rate of revenue growth.
  • these commitments cannot be avoided. Even the OPEB liabilities may be a contractual obligation that must be met.
  • the secondary impact on state and local governments will be significant. Program reductions and higher taxes are likely.
  • if somehow the state and local governments can get out of their OPEB programs, this will have a negative impact on an already overtaxed Medicare system.
  • this is a major political problem since there is little reason for any governor, mayor or legislature to fix the problem.
  • The strength of the state and municipal workers unions (as shown, for example, by the recent NYC transit strike) suggests that negotiating concessions will be difficult.
  • The rating agencies are unlikely to significantly downgrade public debt when OPEB liabilities are reported. As long as the government under analysis can demonstrate a plan for meeting OPEB liabilities, they will be held harmless.

The conference had many excellent presentations. I provide a brief description of each presentation here and a link to the relevant powerpoint or speech.

The Impending Pension and Health Plan Crisis and the Impact of an Aging Work force on Talent Management
Tim Phoenix and Lance Weiss, Deloitte Consulting

Tim Phoenix and Lance Weiss discussed the aging demographics of the government work force and stressed that any change in pension or health care plans must consider issues of talent retention and talent attraction. They also provided a comprehensive history of the Illinois pension system and recent efforts to address underfunding.

An Independent View of the Credit Risks of Pension Underfunding
Richard Ciccarone, McDonnell Investment Management
John Kenward, Standard & Poor’s
Paul Nolan, Moody’s Investors Service
Joe O’Keefe, Fitch Ratings

Richard Ciccarone moderated a panel of rating agency analysts, who examined how state and local governments are handling pension liabilities and the impact that OPEB liabilities might have on government credit ratings. The analysts stressed that a primary concern is whether state and local governments have recognized their future liabilities and have a plan for meeting them.

The Regional Perspective on Pension Issues
Michael Moskow, Federal Reserve Bank of Chicago

Michael Moskow offered his perspectives on improving pension solvency and the impact of pension underfunding in the Midwest.

Are Public Pension Funds Able to Break from the Path of Social Security and the Private Sector?
J. Fred Giertz, University of Illinois and National Tax Association

Fred contrasted the relative liability of the Social Security and Medicare system to private and state and local government pension exposure. He examined resources that each sector might have to meet future expenses.

If the Pension Bomb Stops Ticking, What Happens Next?
James Spiotto, Chapman and Cutler

James Spiotto described the legal protections surrounding pension funds as well as the limits on state and local governments to restructure pension and even health care liabilities.

The Organized Labor Perspective on Pension Issues
Hank Scheff, AFSCME Council 31

Hank Scheff described why defined benefit pension programs are often best for government workers. He noted that nearly one-quarter of state and local government workers do not receive social security benefits, making pension income that much more important. He also described recent problems in Illinois pension funding.

Best Practices for Reforming Pension Governance
Lise Valentine, The Civic Federation

Lise Valentine examined governance structure for pension fund boards and spoke of the importance of having independent and citizen member representatives. She stressed that pension boards should focus on protecting the funds assets and not lobbying for any particular stakeholder group.

Finally, if you have any questions after you look over the presentations, let me know. I’ll get in touch with the presenter and try to get you an answer.

Posted by Mattoon at 04:27 PM | Comments (0)

February 17, 2006

OPEB: The 800 Pound Gorilla in the Room

Rick Mattoon, Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

State and local governments are facing other retirement-related issues as well as the problem of funding pensions. The Government Accounting Standards Board (GASB) has established new guidelines that require governments to account for their “other post employment pension” (OPEB) obligations (GASB no.35 and no.45). Large state and local governments will be required to begin accounting for these obligations on December 15, 2006. OPEB obligations are primarily for retiree health care costs but also can include other benefits such as insurance. Currently OPEB obligations are paid for out of current revenues on a pay-as-you-go method. The annual cost of OPEB is what it costs to cover specific retirees in that year without regard to how this obligation might change as the number of retirees changes or the cost of providing the benefits changes in the future.

The new GASB regulations are intended to improve transparency in government accounts by making it easier to know what the future liability for OPEB expenses will be for a given government and to assess whether they have a strategy for meeting these requirements. The GASB regulations are patterned after similar requirements that FASB placed on private firms in 1992 (SFAS 106). As was the case for private firms, this new accounting standard for governments raises many challenges. For example:

• estimating the total OPEB liability is an accounting nightmare. Unlike pensions where actuarial estimates can be at least somewhat understood, OPEB requires making guesses about things like health care and prescription drug inflation and utilization. One estimate suggests the unfunded liability is around $700 billion, but this is a back of the envelope guess. Other estimates suggest that OPEB exposure could range from five to ten times current outlays for retiree health care.

• managing OPEB costs is tricky. In most cases, retiree health care is not a contractual responsibility like pensions. It is a voluntary benefit offered by the employer. However where it is a contractual responsibility, the ability to require retiree contributions, increase co-pays or cut benefit coverage is limited. Where retiree health insurance can be modified, a concern is that when these liabilities are reported, some governments may choose to abandon or significantly reduce coverage, forcing the federal government to serve as the health care insurer of last resort.

• There are strategies for managing OPEB costs. Efforts to contain health care costs and slow increases in health insurance premium costs can help. Shifting more costs to retirees can be an option, along with trying to limit future OPEB obligations by changing benefit packages for new employees. One strategy that is popular (and essentially required) for addressing OPEB costs is to set up a trust fund. A trust fund meets the new accounting standard requirement that an irrevocable source is identified for meeting OPEB obligations. It also has the advantage of allowing governments more flexibility in the use of investment options. Like pension funds, OPEB trust funds would permit investments in equities and other potentially higher yielding investment vehicles. A potentially attractive option that a trust fund may allow is the ability to issue OPEB bonds to cover part or even all of a government’s OPEB liability. Like pension bonds, these are essentially an arbitrage strategy, where the bond issuer anticipates that the investment yield they will receive from the bond assets will exceed the interest that will be paid to bond holders. Also like pension bonds, the OPEB bonds are not free from federal taxes so they must carry slightly higher interest rates than tax-free investments.

• The impact on credit ratings for governments is another real concern. Once this liability is recognized, some governments’ finances might appear more fragile. To date, several of the major rating agencies have indicated that they will judge the creditworthiness of these governments based on whether their plan for meeting OPEB liabilities appears prudent rather than on the size of the liability on the balance sheet when it is first recognized. Credit agencies do expect OPEB liabilities to be largest in the Northeast and Midwest, where government entities have large unionized work forces and slightly older workers on average than in other areas.

• Finally, OPEB is still a major concern for the private sector. It is estimated that for the 337 companies in the S&P 500 that have OPEB obligations, the funding ratio is around 27% (versus 88% for pensions). For the 282 companies with the most complete financial records, the unfunded liability in 2005 was estimated at $292 billion versus an unfunded pension liability of $149 billion. OPEB liability is concentrated in Ford and GM. Their unfunded liability alone is $94 billion, representing 32% of the S&P 500’s total. (These two companies also have 13% of the total pension underfunding.) Telecom is the other industry where OPEB is a significant issue.

In the end, dealing with OPEB will require considerable skill, particularly if governments are intent on trying to reduce retiree benefits or increase retiree contributions. Neither option will be politically popular, and both have the potential for reducing the appeal of public service to potential workers. OPEB will also further squeeze state and local budgets, making reductions in discretionary programs such as economic development and higher education more likely. For the U.S. economy as a whole, a concern is that any reduction in public sector health care coverage will place further burdens on the Medicare system. What is clear is that the combination of pension and OPEB liabilities will be the source of much discussion in state capitols and town halls for some time to come.

Suggested reading on OPEB:
The GASB 43 and 45 Reporting Guidelines For Other Post Employment Benefits: A Civic Federation Issue Brief

The Economist, “Clearly Unhealthy”, 7/2/2005, Vo. 376, Issue 8433, pp 65-66.

Standard & Poor’s, “Funding OPEB Liabilities: Assessing the Options”, December, 14, 2005.

Fitch Ratings, “The Not So Golden Years: Credit Implications of GASB Statement No. 45.”

Posted by Mattoon at 03:42 PM | Comments (1)