The Political Economy of State-Based Pensions: A Focus on Innovative Reforms

2. Notional Defined Contribution Schemes: Sweden

In 1991, with the country in a deep recession, the Social Democratic Government in Sweden was defeated and replaced by a multi-party, centre-right minority coalition that placed pension reform high on the agenda. The coalition Government established a small working group to negotiate the pension reform framework that was headed by the minister of social policy. The group included representatives from each of the five political parties supporting the reform process, including the Social Democrats, the Moderates, the Liberal Party, the Centre Party, and the Christian Democrats, as well as a few selected experts.
The group’s sweeping pension reform proposal was adopted ‘in principle’ in 1994 by the Riksdag, the Swedish Parliament, shortly before elections returned the Social Democrats to power. The Parliament passed implementing legislation in June 1998, with the first benefit payments under the new rules beginning in 2001.
Many pension experts have been interested in Sweden’s move toward mandatory individual accounts for retirement savings, with workers required to contribute 2.5% of covered wages to their personally-directed retirement funds. But it is Sweden’s novel approach to financing the much larger pay-as-you-go state pension that was truly innovative. The new Swedish pension system contains features that should achieve what the architects of the new system sought — guaranteed and permanent financial solvency at a fixed contribution rate of no more than 16% of wages.
Sweden’s pension reform is built on the conversion of the main pension entitlement from a defined benefit to a ‘notional defined contribution’ (NDC) system. Under the NDC, workers’ payroll tax contributions are treated like contributions into an investment fund even though the actual tax payments are used to finance benefits for current retirees. The contributions are tracked separately and credited with a presumed rate of return equal to growth in average wages in the economy. Thus, Swedish workers build up a notional ‘fund’ from which they will draw an annuity at retirement.
The NDC approach to pension reform may have two important advantages over a traditional, defined benefit approach. First, the NDC system promotes benefit transparency, which may improve incentives for labor supply. Many defined benefit schemes inadvertently discourage work beyond a certain age, as workers who are already entitled to benefits gain little from additional pension contributions. With an NDC system, workers can see clearly that their wages translate directly into an increase in their NDC ‘account’, and all wages are treated identically in the pension benefit formula. Thus, working beyond age 65 may become more attractive for workers.
Second, the NDC system appears to strengthen budgetary control. The pension entitlement is strictly tied to pension contributions; no benefit payment is made that is not financed by a worker’s payroll tax payment. In the past, many countries made the mistake of expanding defined benefit promises without a clear means of financing the newly promised payout. Under an NDC system, the only way to provide more benefits is to increase the contribution rate into the NDC accounts, which may not be popular among workers with other priorities. In Sweden’s case, the payroll tax — 16% of wages — is widely viewed as a ceiling that should not be breached.

3. Government-Owned and Invested Pension Reserves: Canada

While other countries made substantial cuts in future benefits to offset the projected cost of population ageing, Canada chose to pursue a different strategy. Faced with its own pension crisis due to population ageing, in 1997, the Canadian parliament passed a large increase in the payroll tax rate. Between 1998 and 2003, the rate was raised in stages from 6.0% to 9.9%, well above the system’s current cost rate, to create a Government-owned investment fund to offset the costs of higher pension spending in the future.
To help ensure that the ‘partial advance funding’ results in genuine savings, the Government created a firewall between the general budget and the pension fund. Investments are managed by the Canadian Pension Plan Investment Board (CPPIB), an independent agency whose 12 members are appointed by the finance minister. The CPPIB has a legislated mandate to invest assets solely in the interest of the beneficiaries. Prior to the 1997 reform, Canada’s public pension reserves were invested primarily in low-interest loans to the provincial governments, much like US Social Security trust-fund surpluses are invested in special interest US Treasury bonds. Since the reform, pension assets have been invested primarily in marketable securities. As of 31 March 2007, the fund totalled C$116bn, nearly two thirds of which was invested in equities4.
The Canadian pension reserve fund is projected to grow rapidly over the next few decades, accumulating assets of roughly C$600bn by 2030, or the equivalent of six years of benefits. Current contributions are expected to exceed annual benefit payments until 2022, after which investment income will be needed to finance a growing portion of costs5.
Over the years, many countries, including the US, have tried to put in place reforms similar to the Canadian approach. Few, if any, of these efforts have met the most basic litmus test of success — raising national savings. Typically, the pension reserves are invested poorly, and the Government increases other spending in proportion to the pension surplus. Moreover, in many countries, the source of financing for the invested reserves is an existing revenue source, not a new tax. Investing existing government revenue in private sector securities may actually decrease national savings as it could displace existing private investment and create the false impression that further pension reform is unnecessary.
Canada has taken a more substantive approach. The firewall separating the operations of the Canada’s reserve funds from the general budget is functioning effectively. Investment decisions appear to be made by the investment board without political interference. The Federal Government, moreover, has run uninterrupted budget surpluses since the late 1990s, not counting the surpluses generated by the pension system. It also helps that Canada’s political culture is accommodating of a large government stake in the ownership of private sector companies, something which would not sit well in other countries, particularly the US.
Over the long run, even Canada is likely to find it difficult to sustain the discipline necessary to ensure the fund truly is ‘saved’ for the future, particularly when an economic crisis hits. Even so, it must be admitted that the Canadian approach shows much more promise than previous efforts at addressing the ageing challenge with direct governmental savings.

4. Mandatory Personal Retirement Savings Accounts: Australia

Unlike most other developed nations, Australia never established an earnings-related state pension system, relying instead on a means-tested state pension, voluntary employer plans, and personal retirement savings.
Over the years, as the pension law was liberalised, more and more Australians qualified for the means-tested benefit, called the Age Pension. By the mid-1980s, some 85% of the population aged 65 and over was receiving a full or partial Age Pension. Labor unions and the Labor party Government elected in 1983 became increasingly concerned that workers were relying too heavily on state benefits, leaving their retirement income vulnerable to the fiscal pressures expected as Australia ages.
During wage bargaining negotiations in 1985 and 1986, the labor unions secured, with government cooperation, a contractual agreement that all covered employers contribute 3% of total wages to a pension plan — called a ‘superannuation fund’ in Australia — on behalf of their employees. By July 1991, some 75% of Australian workers had superannuation coverage.
The non-governmental nature of the obligation, however, left gaps in coverage. At the same time, the 3% employer contribution rate was viewed as inadequate to support retirement income — and increasing it would have been difficult through voluntary employer-employee negotiations. In 1992, the Labor government successfully passed legislation imposing the ‘superannuation guarantee’ (SG), which requires all Australian employers to contribute a percentage of a worker’s earnings, up to a maximum of about 2.5 times average earnings, to an employer-sponsored superannuation fund. The SG increased this mandatory employer contribution gradually over a decade, until it reached 9% in 2002.
Adoption of the Super has substantially improved the retirement income prospects of most Australian workers. According to government projections, the overall pension system — the Age Pension and Super combined — is expected to provide a replacement rate of 82% in 2042 for an average-earning worker with 40 years of contributions, far above the typical replacement rate today for the Age Pension alone and well above the replacement rates provided by state pension schemes in most other developed countries6.
With the superannuation guarantee, Australia has a near universal, fully funded, privately administered, and, as of 2005, individually controlled and portable, retirement savings program. Today, over 90% of workers have superannuation coverage, and superannuation assets are growing rapidly, from 14% of GDP in 1983 to 75% of GDP in 2004, with the Australian Treasury projecting that they will reach 110% of GDP by 20207.
Australia still faces challenges associated with population ageing, particularly with regard to rising health care costs. But, unlike the rest of the developed world, Australia does not face a state-run pension crisis. Government spending on the Age Pension is projected to be manageable in the decades ahead and likely can be made more so as workers accumulate substantial reserves in their ‘Super’ accounts. Australia has thus reconciled better than most countries the inherent tension between a sustainable and adequate retirement system.

4 2007 Annual Report Summary, Canadian Pension Plan Investment Board, p. 4.
5 Actuarial Report (21st) on the Canadian Pension Plan, Office of the Chief Actuary, Office of the Superintendent of Financial Institutions Canada, November 18, 2004, p. 32.
6 “Inquiry into Superannuation and Standards of Living in Retirement”, Submission by the Commonwealth Treasury to the Senate Select Committee on Superannuation, July 2002, p. 4.

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