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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)