Notional Defined Contribution schemes: Old wine and a new Zeitgeist in a new bottle Michael Cichon Social Security Department Paris, 30 May 2006
Structure of presentation Point One: A reminder: What are NDCs Point Two: The identity of the NDC benefit formula and the classical DB pension formula Point Three: A new addition: Balanced NDCs an their effects Point Four: Do we need NDC reforms? Point Five: To sum up: Why NDCs? Why balanced NDCs? 2
Point One: A reminder - what are NDCs: NDCs are less than fully funded pension schemes that use: A pension formula: That mimicks an annuity calculation using a notional balance of individual contributions thus they deal with - the financial effects of increasing longevity in old-age on the financial equilibrium of pension schemes, they do not (automatically) deal with, - the effect of declining workforces NDC schemes are not in automatic financial equilibrium
Point Two:The identity of the NDC benefit formula and the classical DB pension formula Theorem: An NDC is equivalent to a DB scheme with a linear pension formula, constant contribution rate and with actuarial reductions or increments for early or late retirement and an: accrual rate in the equivalent DB scheme that is equal to = constant contribution rate/life expectancy (annuity factor) at normal retirement age
Point Two:The identity of the NDC benefit formula and the classical DB pension formula - a simplifed mathematical exercise n 1 NDCP = ( x n t= 0 t t n t W. CR(1 + w) )/ ä, x NDCP = CR/ e * n. AW x, n x
Point Two:The identity of the NDC benefit formula and the classical DB pension formula DBP x n, = r( x)* ACR* n. AW r ( x) = e / e z x ACR = CR / e z
Point Two: Conclusion I: on NDCs The NDC formula is essentially old wine in an elegant new bottle
Point Three:A new addition : Balanced NDCs Balanced NDCs seek to keep contribution rates constant by applying a reduction factor to the interest rates for notional balances and pension adjustments whenever the scheme is in actuarial disequilibrium 8
Point Three:A new addition : Balanced NDCs The PAYG basic formula: PAYG t = P t /A t * AP t /AIW t OR : The PAYG Con Rate = demographic ratio times the financial ratio 9
Point Three:A new addition : Balanced NDCs Let s start today with: 0.16 = 0.33 * 0.485 CR = DR * FR In 2050 this should be : 0.16 = 0.57 * 0.281 CR = DR * FR 10
Point Three:A new addition : Balanced NDCs About 24% of the reduction of the RR comes from increased longevity That means that 76% has to come from the balancing mechanism in a case without a buffer fund Or: the average retirement age has to increase by 8 years (from 65 to 73) Or: the income from a buffer fund in 2050 alone has to amount to 12% of total insurable earnings, that means at a 60% share of wages at GDP and an interest rate of 4%, one would need a capital stock of 1.8*GDP (Sweden today has maximum of 0.4*GDP) 11
Point three: Replacement rates for a standard recipient in a stylised balanced NDC in Europe without buffer fund Replacement rates 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 1 3 5 7 9 11 13 years 15 17 19 21 23 RR Normal RR adjusted Min. P. 12
Point three: Conclusion II on Balanced NDCs A standard beneficiary in a typical European demographic environment will face severe reductions of her/his replacement rate, of which three quarters could occur after retirement age The risk has been moved to the pensioner who can no longer adjust her/his behaviour this represents a new zeitgeist 13
Point three: Conclusion II on Balanced NDCs which has nothing to do with intergenerational equity: a person born in 1985 in Western Europe living in a standard family with standardised income still has a higher lifetime income than person born in 1950... 14
Point Four: Did we need the reforms Orig. DR
Point Four: Did we need the reforms
Point Four: Did we need the reforms Estimated old age system dependency rates in Western Europe 2004-2050 without (DR1) and with (DR2) increased retiment age Dependency rate in % 80.00 60.00 40.00 20.00 0.00 2004 2008 2012 2016 2020 2024 2028 2032 2036 2040 2044 2048 DR (1) DR(2)
Point Four: Likely systemic consequences Pension systems: Dropping replacement rates in NDC schemes may have to be compensated by higher contributions to DC second tier schemes Social transfer schemes in general: there may be behavioural (unemployment benefits, invalidity pensions ) or systemic (social assistance, min. pensions) spillovers into other benefit schemes 18
Point five:point Five: To sum up: Why NDCs? Why balanced NDCs Why NDCs: To find a way to reduce entitlements in line with declining mortality fair enough Why Balanced NDCs: To keep CR rates constant in an adverse demographic environment, through reduced benefit levels without telling people 19