1. 1 Robert Holzmann The World Bank Buenos Aires, October 6, 2010 NDC Pension Systems: Progress and New Frontiers in a Changing Pension World

2. 2 Challenges and need for reform, in particular: Population aging Socioeconomic changes Motivation for NDC approach: Promise to address reform issues and constraints better than alternatives Background and Motivation 2

3. 3 Challenges: Public pension expenditure grow with population aging 3

4. 4 Challenges: Finding reform approaches that address population aging in a credible manner  Population aging and increase in life-expectancy can be easily addressed: Requires an increase in effective retirement age as lynchpin between fiscal stability and benefit adequacy  Parametric reforms can, in principle, address all reform needs, including a legislated increase in standard retirement age. But political economy does not favor their success, as they lack credibility  Successful pension reform requires parallel reforms of financial and labor market 4

5. 5 Challenges: Aligning systems with socioeconomic changes  Increase in life-expectancy and old-age pension  Increase in life-expectancy and disability pension  Increase in female labor force participation, divorces and widow’s pensions 5

6. 6 Motivation for NDC Approach  Limited reform options for unfunded first pillar due to  inherited implicit pension debt and hence the costs of transition  absent or underdeveloped financial markets  Low credibility and limited success of parametric reforms  Promises of NDC to handle key reform pressures  Basic design is simple, transparent and credible  Capacity to handle fiscal pressure from demographic, economic and political shocks  Ability to address social-economic changes (aging, divorces, female labor force participation, etc)  Attractive features to deal with challenges and opportunities of globalization  Promising experiences with NDC reforms in Sweden, Latvia, Poland and Italy 6

7. 7 Background and Motivation I.Basic Design of NDCs II.Experience with NDCs after 10+ years III.Design and Implementation issues Concluding Remarks Road Map 7

8. 8 The Beauty of Simplicity Generic NDC – Individual Equilibrium Generic NDC – Macroeconomic Equilibrium I. Basic Design of NDCs 8

9. 9 The Beauty of Simplicity  NDC is like an illiquid life-time cash balance plan (or individual account on Pay-As-You-Go basis)  Participants (and/or their employers) pay contributions on earnings during their whole career  Contributions are noted on an individual account  Account grows with contributions and is credited with rate of return (but remains unfunded/PAYG)  At retirement, the “notional” capital is converted into an annuity which takes account of remaining life-expectancy 9

10. 10 Generic NDC – Individual Equilibrium  Individual notional capital  Converting capital into annuity 10

11. 11 Generic NDC – Macroeconomic Equilibrium  Static equilibrium condition K t + P t = L t ≤ A t = FA t + PA t K t : notional capital of all active workers P t : present value of all benefits in disbursement L t : total liabilities, A t : total assets FA t : financial assets, PA t : Pay-As-You-Go Asset  Dynamic equilibrium condition  Permissible notional interest rate 11

12. 12 NDC is simple but a few rules need to be respected, inter alia  Choice of appropriate interest rate, life expectancy  A buffer fund to handle short-term shocks  A balancing mechanism to address long- term changes  A financing mechanism to handle inherited commitments (legacy costs) when moving from existing system 12

13. 13 A sustainable rate of return on contributions exists (case of Jordan)

14. 14 Basic Principle of Solvency in the NA system… Liabilities = Assets

15. 15 … Liabilities Individual accounts Pensions in payment = Assets

16. 16 ? … Liabilities Individual accounts Pensions in payment = Assets Financial assets

17. 17 … Liabilities Individual accounts Pensions in payment = Assets PAY-AS-YOU-GO ASSET Financial assets IMPLICIT TAX

18. 18 What happens in the insolvent pay-as- you-go system? Liabilities = Financial assets PAYG Asset Unfunded Liabilities Or Tax Overhang Could be <0

19. 19 How to compute the notional interest rate? Liabilities = Assets The sustainable notional interest rate is actually the allowable growth rate of liabilities: the rate used to index pensions and revalorize individual accounts.

20. 20 … Liabilities = Assets New assets

21. 21 … Liabilities = Assets New assets New Liabilities Allowable change From changes in life expectancy

22. 22 NDC movement across the world NDC Experiences 10+ years after (Italy, Latvia. Poland, and Sweden) II. NDC Development and Experiences 22

23. 23 NDC movement across the world  Countries with NDC-reformed schemes (late 1990s)  Sweden, Latvia, Poland, Italy  Recently legislated NDC schemes  Norway (2009), Egypt (June 2010)  Countries with NDC-inspired reformed systems  Brazil, Kyrgyz Republic, Russia  Countries with NDC-type systems (point systems)  Germany and France; Croatia, Romania, Slovakia, Ukraine …  Under discussion/consideration in  Belarus, Czech Republic, France, Greece, Hungary, Spain, China, ?  All recent reforms in OECD countries mimicked elements of NDC reform (life-time earnings, decrements/increments, etc) 23

24. 24 Lessons from NDC reforms in Sweden, Poland, Latvia and Italy  Overall, reforms went well. Reform delivers adequate replacement rate for average earners and are financially sustainable for next 50 years  Reform requires extensive preparatory work at technical and political level, good communication with the public, an efficient administrative framework, and good rules to cope with economic and demographic changes  All 4 countries applied different pathways to reform, i.e. there is no single way to do, or different paths lead to the same final destination  Reforms in all countries were undertaken against the backdrop of crises and the need to adjust. 24

25. 25 Year of implementation and coverage in NDC system 25

26. 26 Contribution rates for pensions as percentage of wages 26

27. 27 Cohorts covered by NDC scheme 27

28. 28 Individual accounts build-up 28

29. 29 Pensions formulae 29

30. 30 Country lessons  Expected outcomes on labor force participation of elderly seems to have been achieved while replacement rates in line with OECD countries  NDC appears to have weathered the storm created by the deep recession of 2009, albeit it did not emerge completely unscathed  Expenditure projections suggests effectiveness of long-term fiscal balancing approach 30

31. 31 Estimated impact of pension reform on participation rates in 2020, in pp 31

32. 32 Expected replacement rate 32

33. 33 Projected pension expenditure 33 Change in expenditure (in percent of GDP) Decomposition of public pension expenditure (in percent of GDP)

34. 34 Poland: GDP and wage growth, NDC and FDC returns in comparison 34

35. 35 Design of explicit balancing mechanism Addressing the legacy costs of reform Role and size of reserve funding Estimation of remaining cohort life expectancy and mechanism of risk sharing III. Key Design and Implementation Issues 35

36. 36 Design of explicit balancing mechanism  Purpose: Assuring solvency of system  Approach: Adjusting notional interest rate and pension indexation in line with asset-liability  Issue: Direct estimation of notional interest rate or choosing proxies such as GDP, wage or contribution base growth and adjustments in case of sustained asset-liability imbalance  Approaches: Only Sweden has explicit and direct approach. Latvia and Poland underprice NIR to pay for legacy costs et al. 36

37. 37 Role and size of reserve funding  Purpose: Assuring liquidity of system  Approach: Creating reserves that are able to deal with short/medium-term macro-shocks and/or long-term temporary demographic bulges  Issues: Size depending on objectives and risk preferences (6-24 months or 60 months expenditure), and build-up (easier in inmature systems)  Approaches: Sweden inherited fund. Others have no explicit fund yet (some have wealth fund) 37

38. 38 Addressing the legacy costs of reform  Purpose: Starting new scheme with clean balance sheet; establishing credibility; avoiding distortions during transition to new equilibrium  Approach: Defining and estimating the costs and finding extra-system financing (budget, privatization assets, coverage expansion)  Issues: Size of the costs, and capability to find less distortionary ways of taxation (as wage tax)  Approaches: Reduced NIR (Latvia, Poland), or ignored (i.e. budget financed) 38

39. 39 China: Estimated legacy costs 39

40. 40 Estimation of remaining cohort life expectancy and mechanism of risk sharing  Purpose: Assuring solvency and avoiding unplanned burden shifting (via adjustment mechanism)  Approach: Searching for best method to project cohort life expectancy given current information  Issue: No best practice yet emerged (given systemic underestimation in LE) and no consensus on how best to share risk for unexpected increase in life expectancy 40

41. 41 Concluding Remarks  NDC is a very promising approach to achieve sustainable, fair, and non-distortionary PAYG scheme (as part of multi-pillar approach)  NDC is not fool proof. But done by the book offers less possibilities for political gaming.  Not all conceptual and operational issues have yet been solved. But they need to be addressed in any other system and reform. 41

42. 42 Muchas grazias 42

43. 43 Selective References 1.Holzmann, Robert, Edward Palmer and David Robalino, 2011, Non-Financial Defined Contribution (NDC) Systems: Progress and New Frontiers in a Changing Pension World, In Finalization. 2.Holzmann, Robert, David A. Robalino, and Noriyuki Takayama, editors, 2009, Closing the Coverage Gap, The World Bank. 3.Holzmann, Robert and Edward Palmer, 2006, Pension Reform: Issues and Prospect for Non-Financial Defined Contribution (NDC) Schemes, The World Bank (also available in Chinese, German and Spanish). 4.David Robalino and Andras Bodor. 2008. “On the Financial Sustainability of the Pay-as-you-go Systems and the Role of Government Indexed Bonds.” Journal of Pension Economics and Finance.