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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 March 15, 2006 7:40 PM

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