Pensions Core Course 2013: Notional Defined-contribution Schemes

Agnieszka Chłoń-Domińczak

World Bank Pension Core Course, Washington, April 9th, 2013

Individual contributions are noted on individual accounts. ◦ NDC – contributions pay for benefits of current pensioners ◦ FDC – contributions are prefunded

Accounts earn an “internal” rate of return: ◦ NDC – based on (nominal) covered per capita wage &

covered labor force growth ◦ FDC – (nominal) financial market rate of return

Retirement from any age after a minimum age. Life “annuity” based on individual’s account balance

and cohort (unisex) life expectancy at retirement. Annuity rate of return (or indexation) ◦ NDC - based on (nominal) covered per capita wage &

covered labor force growth ◦ FDC – based on the financial rate of return.

2

Individual accounts give transparency They state clearly the individual claim on aggregate liabilities.

Intra-generational fairness A unit of contributions gives the same pension increment – same transfer of consumption from the present to the future - for all.

Intergenerational fairness. Individuals in all generations pay the same rate on earned income into pensions. (The share of GDP going to pensions is the same over all generations.)

Social policy through non-contributory rights e.g., for early years of childcare (financed with general revenues).

Accounts can be shared between spouses/legal partners During the accumulation period and/or joint annuities can be created at retirement.

Basic equations

At macro level:

At individual level:

𝑃𝑒𝑛𝑠𝑖𝑜𝑛 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑒𝑛𝑠𝑖𝑜𝑛

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑤𝑎𝑔𝑒×

𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑛𝑠𝑖𝑜𝑛𝑒𝑟𝑠

𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑒𝑟𝑠

𝑃𝑒𝑛𝑠𝑖𝑜𝑛 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑝𝑒𝑛𝑠𝑖𝑜𝑛

𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑤𝑎𝑔𝑒×

𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑟𝑒𝑡𝑖𝑟𝑒𝑚𝑒𝑛𝑡

𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔

Italy, Sweden, Latvia and Poland

◦ Two western European countries with: need to keep social expenditure under control

with lower economic growth prospects

population ageing

◦ Two transition economies with: the Latvian economy was turned upside down by the

collapse of the Soviet system

Inadequate and inefficient pension system inherited from the Soviet times, with widespread special conditions and early retirement provisions

need to promote growth of the formal sector of the economy

population ageing

Italy Latvia Poland Sweden

Contribution

rate on

earnings

33% (employees)

20% (self-employed)

24% (atypical

contracts)

20% 19.52% 18.5%

NDC 33% (employees)

20% (self-employed)

24% (atypical

contracts)

14% from 2012

12.22%

From 2011:

17,22%

16.0%

FDC

Voluntary scheme 6% from 2012

7.3%

From 2012:

2,3% going up

to 3,5%

2.5%

Occupational

and voluntary

schemes 20% of labour force

in 2008

Yes, but very

low coverage

Yes, but very

low coverage

Yes,

supplement

under ceiling;

whole benefit

above

Reform Overview - Overall DC framework and contribution rates

Credits for periods outside employment ◦ Differences in disability treatment ◦ Common recognition of unemployment, maternity

and periods of care of younger children

Inheritance gains (mortality credits) ◦ Sweden distributes to remaining active accounts ◦ Indirectly used to finance transition (to FDC, to

cover for unbalanced PAYG expenditure)

Notional interest rate ◦ Per capita wage in Sweden ◦ GDP growth in Italy ◦ Wage sum growth in Poland and Latvia

Country Oldest cohort covered Recognition of acrrued rights

Italy initially mandatory for cohorts born after 1960, in 2010 expanded for older ones

Two parts of pension: from old and new schemes

Latvia all contributors covered from the beginning

Re-computation of past contributions based on work histories

Poland cohorts born after 1949 New pension calculated based on existing records, mixed old-new formula applied

Sweden cohorts born after 1941

Initial capital based on old pension formula

Source: Jabłonowski and Müller (2013) based on 1% ZUS sample

Retirement age discussion continues…

… but increase in participation rate expected.

Continuing debate on retirement age:

◦ Italy: complex changes with final equal retirement age and increases linked to life expectancy

◦ Latvia: retirement age equalized at age 62 as a part of reform package. Present discussions of increase to 65.

◦ Poland: retirement age equalization and increase to 67 from 2013 to 2040

◦ Sweden: incentives with NDC seem to help raising actual retirement age

0

5

10

15

20

25

Sweden EU27 Italy Poland

15-64 15-71 55-64

Source: Commission services, EPC.

Estimated impact of pension reform on participation rates (2020),

in percentage points

Close link between earnings and benefits – deviation at bottom and top of wage distribution

Despite different role of pillars – relatively similar outcomes

Italy Latvia Poland Sweden

0.30 0,99 1,08 0,96 1,04

0.50 0,75 0,80 0,74 0,79

0.75 0,75 0,80 0,75 0,67

1.00 0,75 0,77 0,75 0,64

1.50 0,77 0,73 0,75 0,81

2.50 0,78 0,70 0,77 0,88

Net replacement rates in the future by wage level

Based on the OECD pension models

Source: The OECD Pension Models.

-0.06

-0.04

-0.02

0.00

0.02

0.04

1 year 2 years 3 years

Italy

gross loss compensation

-0.06

-0.04

-0.02

0.00

0.02

0.04


Latvia


-0.06

-0.04

-0.02

0.00

0.02

0.04


Poland


-0.06

-0.04

-0.02

0.00

0.02

0.04


Sweden


◦ Latvia

Reduced FDC contribution

Reduced newly granted early retirement pensions

◦ Poland – good economic performance with maintained small GDP growth but high budget deficit

Social Insurance Fund deficit covered with commercial loans and state budget loan – SIF can also borrow from Demographic Reserve Fund

Demographic Reserve Fund finances part of expenditure

Reduced FDC contribution

Increase of retirement ages as a long-term change agenda

◦ Sweden

Automatic balancing mechanism initiated

Negative indexation of benefits

◦ Italy

No specific adjustment

Risk of future ad hoc measures?

Source: Jabłonowski and Müller (2013)



NDC formula uses life expectancy for the entire population

Risk of bias if the system covers only the part of workforce ◦ Deficit in the financing if actual life expectancy of

the covered group is higher than for the entire population

DC systems both nonfinancial and financial have strong link between lifetime earnings and pensions

Risk of low pensions for people with shorter working careers and low wage levels

NDC system requires maintenance of individual accounts ◦ For the entire working population ◦ For long periods of work ◦ Contributions that are not assigned and not registered and

do not increase individual’s pension rights.

This requires: ◦ Prepared social security administration ◦ Well-designed communication channels between all

stakeholders: social security institutions, employers, banks and individuals

◦ Good quality unique ID numbers Revision of existing numbers (if exist) Establishing a new one (costly and complicated)

Regularly revised life expectancy information

Indexation information: ◦ Wage growth and labour force growth

Record keeping

Quality of information must be assured

All participants are equally responsible for adequate performance of the system

Computer system is important….

…. as well as system managers

Proper identification should be ensured

Procedures should be designed to avoid errors

70%

80%

90%

100%

Sep

tem

ber 2

001

Dec

ember

200

1

Mar

ch 2

002

June

2002

Sep

tem

ber 2

002

Dec

ember

200

2

Mar

ch 2

003

June

2003

Sep

tem

ber 2

003

Dec

ember

200

3

Mar

ch 2

004

June

2004

Identification of employers Identification of employees

Formal control Identification of payments

Overall efficiency

Simple and understandable message to individuals

Annual pension statements

On-line access to the OA account

Country 2010 2020 2040 2060 Change

2010-2060

Italy 15,3 14,5 15,6 14,4 -0,9

Latvia 9,7 7,3 6,3 5,9 -3,8

Poland 11,8 10,9 10,3 9,6 -2,2

Sweden 9,6 9,6 10,2 10,2 0,6

EU27 11,3 11,3 12,9 12,9 1,5

Source: 2012 Ageing Report, European Commission.

0

100

200

300

400

500

600

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Simulation: value of OA pension for 100 000 currency unitis

for 65-year old in Poland

OA Pension Reduction due to life expectancy change

Source: own calculation based on GUS data

Source: Orange report 2011



-3

-2

-1

0

1

2

3

4

2010-2020 2020-2030 2030-2040 2040-2050 2050-2060

Italy

Dependency ratio contribution Coverage ratio contribution

Employment effect contribution Benefit ratio contribution

In the long-run the NDC pension system reaches financial balance (as expected in DC system)

Strong link between contributions and benefits in the NDC encourages participation, but requires long working lives and stable wages

NDC offers transparency and stable financing, but needs high coverage, long working lives and good administration

Chlon-Dominczak, Franco and Palmer (2012), The First Wave of NDC Countries – Taking Stock Ten Plus Years Down the Road - Sweden, Poland, Latvia and Italy in: Holzmann, R., E. Palmer and D. Robalino. 2012, eds. NDC Pension Schemes in a Changing Pension World, Volume 1: Progress, Issues, and Implementation. Washington D.C.: The World Bank & Swedish Social Insurance Agency.

Jabłonowski, J. and Müller, C. (2013), 3 sides of 1 coin – Long-term Fiscal Stability, Adequacy and Intergenerational Redistribution of the reformed Old-age Pension System in Poland , National Bank of Poland

European Commission (2012), Ageing Report 2012.

Business

Pensions Core Course 2013: Notional Defined-contribution Schemes