Sweden's Self-Correcting Pay-As-You-Go Pension System
Sweden has a reputation for providing expensive cradle-to-grave social welfare protection, but in 1998 the country put in place a public pension reform more conservative than most of the plans now sponsored throughout the industrialized West. The 1998 reform imposed a budget constraint on pension spending that is enforced automatically, without the need for further approval by the Swedish parliament. As a result, while other countries with advanced economies, including the U.S., are still grappling with large unfunded public pension liabilities associated with population aging, Sweden’s new system is projected to remain in balance permanently.
Paul Samuelson showed that pay-as-you-go pensions like Social Security can provide real increases in benefits over time, consistent with demographic and economic trends. In rough terms, the generosity of the system can grow with the real growth rate of the system’s aggregate level of contributions, which is a function of growth in the size of the labor force and increases in worker productivity.
In 1958, when Samuelson’s insight was published in a famous article, it was assumed that Western democracies would continue to have high fertility rates and thus also steady growth in their labor forces. Politicians felt safe voting to increase the generosity of pay-as-you-go pensions because they were told that population growth would make it affordable.
That was a mistaken assumption. Fertility rates plummeted in the 1960s and have remained below the natural steady population replacement rate in most advanced economies ever since. Furthermore, many countries, including the U.S., severely underestimated how long their retirees would live and continue to draw benefits. Social Security and other pay-as-you-go pension systems are implicitly paying rates of return to retirees that exceed what is affordable given the relevant countries’ demographic profiles.
To safeguard against this fate, the architects of Sweden’s reform built their plan around strict adherence to a refined version of the natural rate of return that is affordable within a pay-as-you-go system. Under the new system, pension benefits are calculated based on a defined contribution philosophy.
Overall spending is constrained by a fixed contribution rate of 18.5 percent of covered wages. A portion of the contributions — 2.5 percent of wages — is devoted to a straightforward defined contribution pension. Workers get fully funded individual accounts, which are invested in privately managed investment funds and owned by the workers. These accounts resemble 401(k) plans and IRAs in the U.S.
The rest of workers’ pension contributions — 16 percent of wages — finances the pay-as-you-go system, but with a twist. Sweden is phasing out the old defined benefit formula used to calculate pensions and replacing it with “notional defined contribution” (NDC) accounts. Workers’ accounts build “balances” during their years in the labor force, which are then used to calculate their annuities when they retire.
Sweden’s reformed system creates a direct link between aggregate pension liabilities and contributions, which makes it much easier to keep the system in overall balance. The system incurs future liabilities in direct proportion to workers’ current contributions. The only uncertainty is the rate of return earned on those contributions.
With the notional accounts, there are no actual invested assets. Instead, the government applies a uniform, presumed rate of return to the accounts, tied in the first instance to the growth rate of per capita wages. To keep the system in balance, this default rate of return is subject to adjustment to correct for shifts in demographic and economic factors.
To assess the financial viability of the new system, Sweden measures its assets and liabilities annually. If assets exceed liabilities, then the system is in balance, and the notional accounts and the annuities paid to retirees are credited with the default rate of return. If liabilities exceed assets, then the system is out of balance, and the rate of return is reduced as needed to eliminate the deficit.
Liabilities in the system are clear enough. They are the balances in the notional accounts plus the present value of annuities payable to current retirees. Measuring assets is trickier because most of what is contributed by current workers goes to pay for the benefits of current retirees, and thus is not available to be invested.
Sweden created a way of gauging assets in a pay-as-you-go system by multiplying current year contributions by the weighted average difference in ages of current workers and retirees. The result of this calculation provides a measure of the amount of pension liabilities that can be financed in the future based on today’s contributions and the country’s demographic profile. If a country has a high fertility rate and a pattern of long working lives and late, short retirements, then measured “assets” would be relatively high, implying that the system could afford a high rate of return on contributions. On the other hand, a country with low fertility and earlier retirements would have low measured assets and thus also a lower sustainable real rate of return.
After the financial crash of 2008, Sweden’s reformed system fell out of balance. To eliminate the deficit, workers’ notional accounts were credited with a minus 1.4 percent rate of return in 2010 and minus 2.7 percent in 2011. Retirees received similarly large reductions in their monthly pensions. In subsequent years, measured assets exceeded liabilities, which allowed the accounts to grow faster than the default rate and thus make up for the reductions that were imposed in the immediate post-crash years. The Swedish government expects the system to fully catch up this year to where it would have been had it remained in balance continuously over the past decade.
Sweden’s reformed system also automatically adjusts for longer lifespans. When a worker retires, the Swedish government converts the balance in his notional account into an annuity using an estimate of average remaining life span for all workers born in the same birth year — the so-called “annuity divisor.” Annuity divisors are used to calibrate how much can be paid on a monthly basis such that the balances in the notional accounts are depleted during the average remaining lifespan of all retirees born in the same year. Because younger retirees are expected to live longer than their older counterparts, they have larger annuity divisors, which means they will get a smaller monthly annuity than older retirees if they retire at the same age with the same balances in their notional accounts. Of course, younger retirees tend to have higher lifetime earnings than their older counterparts, which would offset the effect of their longer lifespans. Workers can also choose to retire at older ages, which would also increase their monthly pension payments.
Sweden’s system establishes a permanent and enforceable budget constraint on public pension spending. The rate of return earned on contributions is tied directly to the country’s evolving demographic and economic profile. The system’s architects also developed a system that allows needed adjustments to occur automatically, without the need for further legislation. (The Swedish parliament has enacted minor revisions to the reformed system to smooth out adjustments when there are deficits over longer periods of time.)
Every country with unfunded pay-as-you-go liabilities, including the United States, faces problems similar to those Sweden faced in the 1990s. These countries need to acknowledge, as Sweden did, that pay-as-you-go pensions must, in the end, be responsive to demographic and economic realities.
James C. Capretta is a RealClearPolicy Contributor and holds the Milton Friedman chair at the American Enterprise Institute. He is the author of “Automatic Adjustments Within Entitlement Programs: A Look at the Swedish Pension Reform Model,” published by AEI.