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

5. Automatic Benefit Stabilizers: Sweden, Germany, and Japan

One of the more encouraging developments in recent pension reform initiatives is the introduction ‘automatic benefit stabilizers’ into state-based pension schemes. Three countries have adopted such a mechanism — Sweden, Germany, and Japan — with Sweden again leading the way.
Automatic adjustment mechanisms are formulaic provisions which adjust retirement benefit payouts automatically — without further legislative intervention by government — to keep pension spending within available revenue or a spending target. These adjustments thus differ substantially from traditional benefit indexing for inflation in that the adjustment is aimed at budgetary control, not benefit adequacy.
In Sweden, the NDC system has two automatic stabilizers. At retirement, the NDC account balance must be converted into a monthly pension payment by way of an ‘annuity divisor’. The divisor is updated for each annual cohort of retirees to reflect the most current estimates of life spans and mortality. Thus, as retirees are projected to live longer, the monthly annuity paid out from a fixed notional balance will automatically decline with successive cohorts unless the pensioners choose to begin taking their monthly annuities later than those who retired before them. The system, therefore, is protected against most of the cost of projected increases in life spans.
Although correcting for longer life spans helps stabilize costs, it is not sufficient to assure solvency at a fixed contribution rate, as fertility and population growth, labour force participation patterns, and productivity growth all play important roles in long-term pay-as-you-go financing. As a result, in 2001, Sweden adopted what is called the ‘automatic balance mechanism’. Each year, the government creates a balance sheet, with measured ‘assets’ and ‘liabilities’, to check for balance. If the calculation reveals an unfunded liability, the interest rate applied to the notional account balances and the indexing of annuities is reduced below the presumed rate — average wage growth — to offset the deficit.
Critical to this approach is the introduction of the concept of ‘assets’ in a pay-as-you-go system. Swedish officials developed a measure of system ‘assets’ by multiplying pension contributions for the year in question by the so-called ‘expected turnover duration’. Turnover duration is a measure of the average amount of time, in years, that the pension system has until it must liquidate a pension obligation earned during the year in question. Turnover duration is calculated as the difference between the earnings-weighted average age of workers contributing to the system and the pension-weighted average age of those drawing annuities. Turnover duration thus contains within it factors that are critical to pay-as-you-go financing: fertility trends and population growth, wage patterns, labor force participation, retirement patterns, and mortality.
Currently, Sweden’s expected turnover duration is about 32 years8. This implies that the system has a flow of contributions that can finance pension liabilities equal to about 32 times the amount of annual pension contributions, as there will be 32 years of annual contributions coming into the system before, on average, the pension obligations incurred this year must be paid out as benefits. Longer measured turnover duration thus implies a system that can finance more pay-as-you-go benefits, and vice versa. If, for instance, fertility continues to trend downward, the turnover duration will eventually reflect this trend. The weighted average age of workers will creep upward, shortening the turnover duration and reducing the value of the system’s ‘assets’. As this occurs, notional balances will earn a reduced rate of return, in effect offsetting the reduction in revenue to the system from fewer workers.
The new Swedish pension system has shifted the financial risk of changing economic and demographic factors onto the pensioners themselves rather than the wage earners financing the system. Based on intermediate demographic and economic assumptions, the government projects that the life span adjustment will cut average monthly benefits for those continuing to retire at age 65 by 18% by 2055 compared to those who turned 65 in 1995 — which is equivalent to a delay in their retirement of 36 months9. With the adjustment for longevity in place, the government expects the automatic balance mechanism to be triggered only ‘a few times’ over the next 15 years, thus modestly cutting the rate of return applied to the notional accounts.
But the intermediate assumptions — slightly higher fertility and immigration rates than the country is experiencing today, as well as permanent 2% real wage growth — may prove to be too optimistic. Under more pessimistic assumptions, the automatic balance mechanism is triggered more or less continuously beginning in 2008, driving down the replacement rates for retirees for several decades. But, as intended, the system would remain financially solvent at the 16% payroll tax rate.
Unlike Sweden, Germany has opted to stay with a traditional defined benefit state pension system, perhaps due to the country’s long and generally favorable history with ‘retirement insurance’. Started by Bismarck in 1889 as the first formal pension system in the world, the German state pension has served as a model for many other countries’ social security systems. In the post-war era, German state pensions were expanded substantially, providing high wage replacement rates even by European standards, as well as generous early retirement options.
Over the last fifteen years, however, the German system has been in a period of retrenchment, as costs have soared with longer life spans and revenue has stagnated with low fertility rates. Before the system was reformed in 2001 and 2004, projections indicated that the payroll tax rate needed to finance German pensions would increase substantially, from today’s 19.5% to more than 28% of payroll in 2040.
Former Chancellor Gerhard Schröder sought to stabilize the payroll contribution rate for pensions at no more than 20% before 2020 and 22% before 2030. A first effort, in 2001, made progress toward this goal but was based on overly optimistic economic and demographic assumptions. Soon after enactment, it quickly became clear that more reform was necessary. Schröder appointed a commission in November 2002, headed by Professor Bert Rürup, to make further recommendations on stabilizing the system’s financing. The Rürup commission proposed linking annual pension indexing, in part, to changes in the ratio of pensioners to workers supporting the system — the so-called ‘sustainability factor’. All German pensions — for new retirees and those who retired in earlier years — are tied to the same basic pension value component, which, in turn, is indexed to annual wage growth. Adjusting this pension value component by the sustainability factor will have a powerful stabilizing impact on the pension system because it will automatically lower pension payouts for all German retirees as the pensioner-to-worker ratio increases over time. The German parliament passed the sustainability factor in March 2004.
State pension reform in Germany is more of an ongoing process than a completed task. Under current projections, the Rürup sustainability factor has reduced the projected payroll tax necessary to finance German pensions from 28% in 2040 to just under 24%10. Clearly, more reform will be needed to keep costs manageable, and there is on-going discussion of an increase in the retirement age. Nonetheless, the sustainability factor, now in place, will moderate any further demographic shifts which would otherwise push the system toward unaffordable levels of taxation. It is also a ready lever that can be pulled to further downsize the system if and when Germany’s political leaders are ready to again address pension reform.
Japan passed two conventional pension reform measures — in 1994 and 2000 — that scaled back promises and made some progress toward sustainability. After each effort, however, new, more realistic demographic assumptions revealed a remaining financing shortfall. In particular, plunging fertility rates have eroded the expected future tax base substantially.
When taking up a third reform effort in 2004, Japanese political leaders decided to take a different approach from the previous efforts. To avoid the need for additional ad hoc adjustments to benefits, the 2004 reform introduced an automatic stabilizer, or ‘macroeconomic slide’, that automatically adjusts benefits to compensate for changing demographics. The automatic stabilizer is modeled on the German approach. It adjusts the normal indexing formula applied to both new and current benefits by two factors — one designed to offset the decline in the number of contributing workers, the other to offset the increase in the life expectancy of beneficiaries. It is expected that the stabiliser, which is scheduled to remain in effect for twenty years, will cut annual indexation adjustments by an average of 0.9 percentage points each year between 2004 and 2023, at which point the replacement rate for an average wage earner is projected to be 50%, down from 59% today11. Automatic benefit stabilisers — as put in place by Sweden, Germany, and Japan — should be a particularly attractive reform option for other countries.
First, automatic stabilisers reduce uncertainty in the long-term viability of a pension system. Until recently, governments were forced to implement pension reforms based on the most reasonable set of point estimate assumptions. As those estimates have inevitably been proven wrong (frequently by being too optimistic), governments have been forced to revisit pension legislation before the public has had time to adjust to what was already passed. Japanese voters, for instance, have grown particularly weary of pension debates as the government has passed three major reform laws in just over a decade. With automatic adjusters, pension systems can self-correct, reducing the need for constant tinkering by the Government and boosting confidence among the public that the pension system will remain viable, come what may.
Adoption of an automatic stabiliser can also foster a healthy emphasis on financial discipline. Instead of focusing solely on benefit adequacy issues (such as the retirement age and replacement rate), an automatic stabiliser, such as the one designed by Sweden, helps to focus public attention on how much the country is willing to set aside to pay for retirement benefits. The automatic stabiliser is then calibrated to keep spending within the level of taxation the public will support. Thus, the financial burden associated with a sustainable pension system is clearer, and political leaders can move more easily to implement the necessary changes.
It may also be easier for some countries to downsize their pension systems using an automatic adjustment mechanism rather than traditional changes in the retirement age or replacement rate. Instead of designing a pension reform to hit a point estimate for solvency, political leaders can build automatic adjustment provisions into the pension system that gradually alter key program parameters based on firm, actual data in the years ahead. Using this approach, politicians can correctly claim to satisfy both the optimists who assume the input assumptions are too dire and the pessimists who worry that the projections will be worse than anticipated. Either way, if the policy adopted has the ability to adjust flexibly to whatever key demographic and economic trends actually occur, the pension system can remain perpetually solvent.

7 Rothman, G.P., Retirement Income Modelling Unit (1998): “Projections of Key Aggregates for Australia’s Aged”, Commonwealth Treasury, Paper for the Sixth Colloquium of Superannuation Researchers, University of Melbourne, Conference Paper 98/2, July, p. 24.
8 The Swedish Pension System Annual Report, National Social Insurance Board, 2005, p. 29.
9 The Swedish Pension System Annual Report, 2005, pp. 49-50.
10 Börsch-Supan, A.H., Reil-Held, A. and Wilke, C.B. (2003): “How to Make a Defined Benefit System Sustainable: The ‘Sustainability Factor’ in the German Benefit Indexation Formula”, Mannheim Institute for the Economics of Aging, October, p. 26.
11 Sakamoto, J. (2005): “Japan’s Pension Reform”, The World Bank, Social Protection Discussion Paper Series No. 0541, December, p. 40.

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