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A review of the Swedish Pension Reform

Strengths and Weaknesses

Contribution to the 10th International Pension Seminar in Tokyo, Japan, organised by the International Pension Research Institute,

November 22, 2005

KG Scherman

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Problems

• A normal pensionable age that had been unchanged for decades, in spite of a raising life expectancy

• The “baby boom” generation approaches retirement• Too generous a benefit formula, requiring only 30 years

for a full pension, the amount of which was based on average earnings during the 15 best years

• Many of these problems originated from the fact that the system was designed at a time when the expectations about economic growth were much more optimistic than today

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The Aim for a new Public Pension

The public pension system shall give a pension at approximately the same replacement rate (old age pension as percentage of final salary) as in today’s system, i.e. somewhere between 55% and 65%, for a person who works to “a normal extent”, provided there is a 2 % real growth in the national economy.

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The New System

• Earnings related part with two subsystems• PAYG, Notional Defined Contributions, 16%

• Premium reserve, fully funded, 2,5%

• A guarantee for those who have no or only a small pension

• Various supplements, especially for housing

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The minimum pension

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Minimum pension(reduced against public earnings related pension but not against any other earnings or income or wealth)

• Today: – Minimum pension: around 8 800 Euro for a person

without any earnings related pension at all

– Max. earnings related pension around 19 800 Euro

• Tomorrow (2% real growth, 35 years): – Minimum pension: Still 8 800 Euro for a person

without any earnings related pension at all

– Max. earnings related pension 39 600 Euro

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18, 5 % of covered earnings

• Ceiling around 33 800 Euro, indexed to average earnings

• 11% is paid by the employer, 7% by the employee• Certain periods (social security benefits, child

care, military service, higher education) give pension rights for which the individual and the state pay the contributions

• The contributions are split between PAYG-scheme (16%) and fully funded scheme (2,5%)

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The PAYG, Notional Defined Contribution (NDC) part

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The PAYG, Notional Defined contribution part : Contributions and

covered earnings• Contributions, 16 %, unchanged

indefinitely

• Benefits based on all earnings over an individual’s full working career

• it is the contributions paid to the system on behalf of each individual that constitutes the pension rights;

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The PAYG, Notional Defined contribution part: Pension calculation

• pension rights are indexed according to average wages and accumulated during the entire career;

• the retirement age for an individual is flexible after age 61;

• the pension amount is dependent upon a cohort's average life expectancy and on the individual age of retirement;

• pension benefits are indexed in relation to growth in average wages minus 1.6 per cent;

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The NDC pension is dependent on life expectancy and a

”norm”

Adjusted for the norm= Amount of old age pension

./. Life expectancy at the time for retirement

notional account

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Basic ideas behind the calculation

• Reduce pension drawn at a certain date, for later cohorts when life expectancy increases

• with the aim to maintain financial balance

• Use the ”norm” in order to – Increase first years pension– By reducing the yearly revaluation

as compared with a straight wage indexation

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The yearly revaluation is wage increases- 1,6%

  Growth = norm High growth

Low growth

% % %

Average rate of nominal wage increase

4.7 5.4 3.7

Rate of price inflation

3.1 3.1 3.1

Average rate of real wage increase

1.6 2.3 0.6

Deviation from the norm 1.6%

0 0.7 ‑1

Pension adjustment = economic adjustment index

3.1 3.8 2.1

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Pension as compared to wage for people who remain in employment

pension

earnings of people

remaining in work

replacement rate

Average wage increase:

Average wage increase:

Average wage increase:

1% 2% 1% 2% 1% 2%

at the year of retirement 100 100 167 167 50 50

10 years later 94 104 184 204 43 43

20 years later 89 108 204 248 37 37

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The Automatic Balancing Mechanism and the Buffer fund

• In spite of all restrictive measures the system can loose it’s balance– Average wages - sum of wages– Continuous increase in life expectancy even

after 65

• The baby boom generation approaches retirement and– large recourses needed to meet obligations

• A very big fund was in fact available and is a prerequisite for the reform

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The PAYG, Notional Defined contribution part :Financial stability

• there is an automatic balancing mechanism that sees to it that the financial stability is always maintained;

• there is a buffer fund to counter variations in the flow of contributions as compared to the flow of pensions.

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The Balance number

• New calculation methods for assets and liabilities

• If assets exceeds liabilities the Balance Number is above one

• If the Balance Number is below one; pension rights and pensions in payment are reduced

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0,6

0,8

1,0

1,2

1,4

2070206020502040203020202010

Balance Number( Assets/Liabilities )

The yearly revaluation of pension rights and pensions is reduced in

order to restore the financial equilibrium

Optimistic

Base

Pessimistic

Pessimistic without balancing

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-10-8

-6

-4

-2

02

4

6

8

10

2070206020502040203020202010

År

The size of the Buffer fund=Fund/yearly pension payments

The Balancing Mechanism is activated

2009

This difference is eliminated by the balancing mechanism

Optimistic

Base

Pessimistic

Pessimistic without balancing

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Basic scenario is fairly optimistic

• Growth in average wages is assumed to 2% p.a.

• Real return on investment is assumed to 3.5% p.a.

• Much higher immigration than ever before. • Fertility, 1.8 is high compared. • Assumed increase in life expectancy stops

around 2050

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Reduction of PAYG pension as a result of the automatic balansing mechanism in the pessimistic

scenario

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

1940 1950 1960 1970 1980 1990

Birth cohort year

Red

uct

ion

%

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The Premium reserve part

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The fully funded part; contributions

• contributions 2.5 per cent

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The fully funded part; administration

• a State Insurance Authority is fully responsible for all functions in the scheme, with the exception of the investment funds;

• All contacts with the funds on behalf of insured• Concludes agreements on fees, dissemination of information

etc.

• contributions are accumulated in one or several funds which the individual chooses;

• there are both private and State funds, today nearly 700 funds!

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The fully funded part; pensions

• the amount in the funds increases by the investment yield on the savings which are deposited;

• the pension is determined by conventional private insurance principles.

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Why a premium reserve subsystem?

• Many arguments

• Spread the risks between the capital market and the sum of wages

• Political compromise

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Problems• Too many funds

– Causes confusion– High costs in spite of special arrangements

• Uncertainty– What about return on investment?– Room for manipulation with forecasts for

amount of pension

• No minimum guarantee on investment yield

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The Result: Work more and up to a higher age

• Longevity effect

• Further reductions

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1940 2005 15,7 – 65 years 18 years 6 months1945 2010 16,1 –2 % + 4 months + 6 months1950 2015 16,4 –4 % + 8 months + 12 months1955 2020 16,8 –6 % + 11 months + 17 months1960 2025 17,0 –8% + 14 months + 21 months1965 2030 17,3 –9 % + 17 months + 25 months1970 2035 17,5 –10 % + 19 months + 29 months1975 2040 17,7 –12 % + 22 months + 33 months1980 2045 17,9 –12 % + 24 months + 36 months1985 2050 18,1 –13 % + 25 months + 38 months1990 2055 18,1 –13 % + 26 months + 40 months

Cohort born

...reaches 65

Life expectancy reduces the pension

Pension age to compensate for higher life expectancy

Remaining life expectancy at 65, men and women

The annuity factor is

Demography and time of retirement

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Further reductions

• Manipulations with the old system

• Work ”to a normal extent” has become ”work at a stable wage for 42 years”

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Replacement rates

Case: 2005 2050

“Model case”: Constant earnings for 40 years as an average production worker

53.0% 40.4%

2/3 of average earnings during 40 years 62.5% 40.4%

Concave earnings profile, from 75 to 105% of average earnings with retained life time earnings

49.7% 35.2%

Rising earnings from 80% to 120% of average with retained life time earnings

48.0% 33.0%

Rising earnings from 100% to 200% of average 36.1% 25.9%

Broken career (30 years of seniority at retirement at average earnings)

49.6% 30.3%

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Replacement rates

• The replacement rates are reduced significantly over the time period studied.

• The outcome falls far short of expectations and is much lower than should have followed from the objectives, formulated in 1994.

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A sustainable system?

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Core questions

• Financial stability and adequate pensions?

• Coherent old age policy and social justice?

• Are work careers expanded and employment improved?

• Can the system be understood and has it been carried out in an open and transparent manner?

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The earnings related pension system is financially stable, …

Item Present Future

Finances of earnings related pensions

Stable Stable

Contributions from the state budget for social security benefits and certain other periods

High ??

Amount of minimum pension Fairly high Successively lower in the face of economic growth

Costs of minimum pension Modest Diminishing

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….but the replacement rates are not adequate

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…and the need for a coherent old age policy is not met

Item Present Future

Availability of benefits in kind Comprehensive

??

Cost sharing for benefits in kind Low ??

Public costs of benefits in kind High ??

Availability of adequate health care Good ??

Cost sharing for health care Low ??

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…hence important changes are needed

• The automatic balancing mechanism must be rescinded

• The contributions must be increased

• Further changes are also needed in order to meet the need for social justice

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Far-reaching risks are transferred to the individual and further changes

are needed for social justice

• The minimum pension is faced out and that can not be accepted

• Risks of not being able to find a job at an advanced age is transferred to the individual, therefore the safety net must be extended to higher ages

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Expand work careers and raise the retirement age

• The generational contract is all about mutual solidarity

• The national economy need people working

• People’s behavior need to be influenced in an effective and transparent way

• The state becomes involved in providing jobs

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..and improve employment opportunities

Item Present Future

Employment opportunities for people age 55-67

Comparatively good but much to low to meet the need

Probably enhanced

Employment opportunities for people age 67-75

Non existent

??

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Transparency and democracy

• A ”paradigm shift” has occurred, but only gradually

• The information to the public is inadequate• The financial balance of the new system and the

ensuing reduction in replacement rates is poorly understood– Manipulation with the old system– 42 years of stable earnings needed to break even– Longevity effect– All this comes to the surface only gradually, due to the

effect of the transitional arrangements

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Conclusions (1)

• The request to work more and up to a higher age for a decent pension is a realistic approach

• A financially stable earnings related pension system is a valuable result

• But the new system does not offer– neither adequate pensions, – nor social justice, – nor transparency.

• And therefore it must be thoroughly revised

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Conclusions (2)• The introduction of a NDC system– that is a

system designed to keep the contribution rate unchanged –means that, with a continuously aging

population, pension levels will fall.

• Hence, a NDC system, whatever kind it is, does not offer any way out of the hard questions on how to balance pension ages, contributions and benefits, today and in the future.

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Conclusions (3)• The belief that a “paradigm shift should add

clarity and consistency to reform” is not backed by practical evidence. Instead, confusion becomes the

result.

• The deficiencies of the Swedish reform might at least to some degree depend on a lack of

understanding of the true meaning of the reform.

• In the end democracy itself is at stake .