33382 World Bank Pension Reform Primer Notional accounts Notional defined contribution plans as a pension reform strategy N otional accounts are designed to mimic a de- (The new systems are described in boxes below.) fined contribution plan, where the pension This note assesses the arguments for notional depends on contributions and investment returns. accounts relative to alternative strategies for (For this reason, they are sometimes called `no- pension reform. tional, defined-contribution' schemes). Pension contributions are tracked in accounts which earn a rate of return. However, in notional accounts, the Pension reform strategies return that contributions earn is a notional one, set The cost of government promises to pay pensions by the government, not the product of investment has been both highlighted and exacerbated by the returns in the markets. aging of the population. The scale of these current and projected future commitments has prompted a Like traditional social insurance schemes, they are search for effective pension reforms. publicly provided. However, the pension formula differs somewhat from the `traditional' earnings- The traditional approach to making public pension related model, with the benefit based on the promises more affordable has been to adjust the accumulation in one's account at the time of pension system's parameters, such as pension eli- retirement. Pension accounts in this system are gibility age, indexation arrangements and the rate called `notional' because there is no pot of pension at which benefits accrue. However, this strategy fund money, just a series of individual claims on has often proved unsatisfactory. Benefit cuts have the future public budget. They are pay-as-you-go been insufficient to put the pension system's fi- financed--current contributions pay for current nances on a sustainable footing. And benefits--just like most defined-benefit public governments, with their eyes on the short term, schemes. have often reversed previous policy changes. When the individual reaches pension age, accu- A second strategy is to shift some provision to mulated contributions and notional returns-- mandatory, funded individual pension accounts. termed notional capital--are converted to an This model--set out in the World Bank's report, annuity. By adjusting the annuity rate, the government can adjust the pension value to take Averting the Old Age Crisis--consists of: account of life expectancy. "a publicly managed system with mandatory participation and the limited goal of reducing poverty among the old; a privately managed Recent reforms in Italy, Latvia, Poland and Swe- mandatory savings system; and voluntary den were based on the notional-accounts model. savings." This briefing is part of the World Bank's Pension Reform Primer: a comprehensive, up-to-date resource for people designing and implementing pension reforms around the world. For more information, please contact Social Protection, Human Development Network, World Bank, 1818 H Street NW, Washington, D.C. 20433; telephone +1 202 458 5267; fax +1 202 614 0471; e-mail socialprotection@worldbank.org. All Pension Reform Primer material is available on the internet at www.worldbank.org/pensions 2 Notional accounts Some 20 countries around the world have now multiplied by an accrual factor. The structure is adopted this schema. The main obstacle to re- the same. If the revaluation index is the same as forms of this type is the transition cost. In simple for notional accounts and the accrual rate is terms, one generation has to pay for pensions equivalent to the g-value multiplied by the no- twice: first, for their parents' pay-as-you-go enti- tional-accounts contribution rate, then the pension tlements and secondly, for their own funded values are the same. pensions. (See the Pension Reform Primer brief- ing note on transition.) There are, however, some differences in practice. The defined-benefit formula in many public pen- The system of notional accounts, its proponents sion systems uses the earnings only of a sub-set argue, offers a `third way' between these two pro- rather than the full lifetime average. For example, posals. By maintaining pay-as-you-go finance, pensions in two-thirds of developing countries and notional accounts avoid the transition costs in- two in five OECD countries are based on some curred by a shift to funding. By mimicking the measure of `final' pay, ranging from the last structure of defined contribution plans, they avoid month's to the last ten years' earnings. A further some of the problems of schemes with a defined fifth of countries use a limited number of `best' benefit formula. years' earnings. Notional accounts, like the benchmark defined benefit scheme, are based on Fairness in pensions lifetime average earnings. Linking individual pension benefits more closely with individual contributions is a central motiva- A second difference stems from changes in the tion for reforms based on notional accounts. This accrual rate with the duration of pension-scheme enhances the `actuarial fairness' of pay-as-you-go membership. Fifty countries' public pension plans pension systems. For example, Edward Palmer, an pay more for early years' contributions (usually the architect of the Swedish reform, argues that "a first 10 or 20 years') than for subsequent contribu- fundamental feature of the notional defined con- tions. Notional accounts, in contrast, give equal tribution system is that it is fair". To explore the weight to all years' contributions. fairness issue, we compare pension entitlements under notional accounts with a traditional defined- There are strong arguments for basing pension benefit scheme. benefits on lifetime average earnings. First, using a limited number of best or final years dispropor- Notional capital at retirement in a notional- tionately rewards people with steeply rising pay accounts scheme is the sum of earnings multiplied profiles. These tend to be better-paid careers. by the contribution rate. Earnings are revalued by Secondly, it opens the system to abuse through an index, such as the wage bill, which is the no- people manipulating their reported earnings. tional rate of return on contributions to the Thirdly, it encourages people to retire rather than scheme. This sum is then multiplied by a set con- move to part-time or lower-paid jobs. version factor, often called the `g-value'. Note that the government sets the value of all the variables: However, these gains can just as readily be the contribution rate, notional rate of return and achieved with a defined-benefit scheme based on the g-value. In fact, the contribution rate lifetime average earnings with a constant accrual attributed to the notional account may not even be rate. Indeed, Mr Palmer argues that notional ac- equal to the contribution rate paid by the counts are `fair' because two people of the same contributor, as the experience of Latvia and Italy age receive pension benefits proportional to the shows. amount they pay into the scheme. But this is equally true of many defined-benefit plans. A defined benefit formula could be similar. Individual earnings, again revalued by an index to Fiscal sustainability take account of changes in the cost or standard of Funded pension systems avoid many of the prob- living, are summed over the working life and then lems of financial sustainability by ensuring that Notional accounts 3 there are assets to match pension liabilities. In a omy's ability to pay for pensions. This was defined-contribution scheme, assets and liabilities established in 1958 by Paul Samuelson. match, by definition, at each point in time. In- creased longevity reduces individuals' pension In Poland, notional contributions are uprated by benefits directly, as annuity providers alter the growth in the wage bill (i.e., average earnings and prices they charge. But the cost of any unexpected employment growth); in Sweden, by earnings increase in life expectancy after retirement falls on growth; and in Italy, by growth in gross domestic the annuity companies. product. These indices broadly reflect the change in the economy's ability to pay for pensions. Pension liabilities in most pay-as-you-go systems are forecast to rise as a share of national income. Again, however, the same result can be achieved This results both from the aging of the population by indexing earlier years' earnings to the same vari- and from increasing generosity of public plans. able in a traditional defined-benefit scheme. Fiscal sustainability is generally a central motiva- Furthermore, Salvador Valdés-Prieto, professor of tion for pension reform. But notional accounts Economics at the Catholic University of Chile, has are neither a necessary nor a sufficient condition shown that notional accounts do not deliver finan- for improving a pension system's finances. cial stability. If the contributions available to Sustainability requires real benefit cuts (or, failing finance pensions were able to be divided among that, contribution increases) which are not deliv- the various claimants each year based on their ered by a system of notional accounts per se. previous contributions, they would be financially stable. However, the pensions in notional More subtly, the notional-accounts formulae that accounts are based on the account balance which have been adopted include some automatic stabi- comes from the notional interest rate which is lizers to help sustain the system's finances in the determined based on parameters of the past, not face of adverse demographic or economic shocks. the present, which in no way guarantees financial First, the `g-factor', the annuity rate set by the gov- solvency. ernment, adjusts the pension benefit to reflect increases in longevity. The system is therefore Retirement and notional accounts immune to this aspect of worsening demographics The declining labor-force participation of older (but not to other changes, such as declining fertil- women and older men in particular is a concern in ity). This means that the pension replacement rate many countries. The reasons for this trend are falls automatically when mortality improves. complex, but probably involve both demand ef- fect--high and persistent unemployment, However, there is no reason why these automatic especially in Europe--and supply effect--pension cuts in benefits will be any easier to achieve in a benefits and the value of other savings have in- notional-accounts system than discretionary cuts creased. (A separate Pension Reform Primer would be in a defined-benefit scheme. Nor are briefing note examines the issue of retirement.) notional accounts necessary for this kind of auto- matic stabilizer. Italy, for example, will in future Many public pension programs have explicit or adjust the replacement rate in its defined-benefit implicit early-retirement provisions that are a pow- plan every 10 years to reflect increased longevity. erful disincentive to work beyond the earliest possible retirement age. In Sweden, for example, A second kind of stabilizer comes in the choice of the effective marginal tax rate on working beyond the notional rate of return credited to individuals' 60 is 35-40 per cent. In other countries, it is notional accounts. A `fair', pay-as-you-go social- higher still. Working beyond the minimum age security contract is one giving each generation a often entails foregoing pension benefits. It can return on their contribution equal to the product mean paying pension contributions that do not of employment and productivity (wage) growth. generate any marginal increment to the benefit This fair return represents the growth in the econ- when eventually it is drawn. 4 Notional accounts Notional accounts systems in practice: Italy and Sweden Italy has one of the world's most expensive Notional accounts were first proposed in public pension systems, currently costing Sweden in 1994, but the legislation was not more than 13 per cent of GDP. And the finally passed until 1998. The new system OECD expects the cost to reach 20 per cent will combine a means-tested `guarantee of GDP by 2030. The process of reform be- pension' with notional accounts, called the gan, belatedly, in 1992, with standard, `income pension'. Contributions of 16 per `parametric' changes. But in 1995, the Dini cent of earnings between a floor and a ceil- government established a new system. ing will be credited to the notional accounts, Pension rights are linked to explicitly to with `imaginary' contributions for some peo- contributions, revalued in line with GDP ple not in paid work (for example, because growth. (A moving average is used to re- of caring responsibilities). The notional re- duce volatility.) This accumulation is turn is average, economy-wide earnings converted to an annuity with a `transforma- growth. On retirement, aggregate contribu- tion coefficient', depending on the age the tions and notional returns are converted to pension is drawn and life expectancy. The an annuity. Post-retirement indexation will pension in payment will be indexed (ulti- be to wage growth less 1.6 per cent. mately) to prices. Sweden will also introduce a small funded But these reforms are unlikely to be suffi- pension at the same time, with contributions cient to put pension financing on a firm of 2½ per cent of pay. The accumulated footing. First, the contribution rate is too low fund will be annuitized separately from the to finance current benefits. The rate will notional-accounts pension, but again by a need rise in the future to close this revenue public agency rather than a private insurer. gap. In the meantime, pension accounts will The new scheme will be phased in, although be credited with more contributions than are more quickly than in Italy. People born after actually paid. Secondly, people with 18 1953 will receive their entire pension under years' contributions will remain in the old the new rules, while people born between system and only new labor-market entrants 1938 and 1953 derive a sliding proportion will derive their entire pension under the from each of the new and old schemes. new rules. Pension financing problems will dog fiscal policy for many years to come. In notional-accounts systems, the g-value varies ment varies, but the average (6½ per cent a year) is with the choice of retirement age. Early retirement similar to the adjustment implicit in notional-ac- is possible, but only with an actuarially reduced counts systems. Again, the advantages of notional pension. Later retirement earns a pension incre- accounts can be achieved with a defined-benefit ment. For example in Poland, working an scheme. additional year beyond 65 will increase the pension by nine per cent; retiring a year earlier, at 64, will Under Poland's pre-reform pensions system, reduce it by eight per cent. The hope is that this around a quarter of the workforce were in occupa- will provide an incentive for people to remain in tions that were offered earlier retirement than the the labor force. normal pension age with full benefits. The no- tional accounts system has been used to make the Many countries have incentives of this kind in cost of such privileges more transparent: early re- their defined-benefit plans. Half of OECD coun- tirement options can be maintained, but workers tries, for example, adjust pension values for early must pay a higher contribution rate to reflect the and/or late retirement. The scale of the adjust- additional cost. Notional accounts 5 Transparency of notional accounts contribution plan can be matched exactly by a Another purported advantage of notional accounts defined-benefit plan. is transparency. One aspect of transparency is macroeconomic: that lack of knowledge of how Redistribution pension contributions generate and pay for bene- A related issue is reformers' emphasis (for exam- fits has led to excessively generous pensions, ple, in Poland) on separation of the redistributive especially those targeted on particular groups. De- component of the pension system from the `actu- fined-benefit plans, with their benefit target, arially neutral' part (the notional accounts). encourage unsustainable promises, while reconsti- tuting the system with notional accounts (where However, notional accounts, like any pension sys- contributions are defined) eliminates this tendency. tem, systematically redistribute ex ante in a number But it could equally well be argued that the prob- of ways, for example: lem is the failure of governments to provide from men to women (because annuity factors credible measures of future pension liabilities in are the same for both sexes and women live public-sector accounts. Whether pay-as-you-go longer); pensions are defined benefit or determined by a through survivors' benefits (because annuity notional-accounts formula makes no difference. factors do not take account of the number and age of dependants); and The microeconomic aspect of transparency is that through credits for periods unemployed or as a notional accounts provide a closer link between student. contributions and benefits. Workers, it is postu- lated, treat defined-benefit pension payments as a This is in addition to ex post redistribution, to peo- political promise and contributions as a tax, which ple who (actually, rather than are expected to) live reduces employment (if firms cannot pass higher a long time. Full actuarial neutrality would require costs on as higher prices) and workers' effort. If annuity rates to be differentiated by factors af- notional accounts encourage workers to treat con- fecting longevity and the length of payments--sex, tributions as savings (generating a future income income, and number and age of dependants--and stream) rather than a tax, then incentives might be the removal of credits for periods out of the labor improved. It might also encourage workers to market. move out of the informal or `shadow' economy. However, accepting that social security is intrinsi- However, this effect is likely to be of secondary cally redistributive and designing the system to importance. Joining the formal sector involves achieve distributional goals is a simpler approach. paying taxes and contributions for other benefits For example, a social-security system with a flat- and public spending which do not generate a re- rate universal benefit financed by a proportional turn to the individual. Workers are unlikely to payroll tax (with no ceilings on contributions) treat mandatory contributions as they would would decouple contributions and benefits, but voluntary saving, particularly when the return they achieve distributional goals at low cost. earn is below that on investments. (See the Pension Reform Primer briefing note on coverage Notional accounts and funded plans for a more detailed discussion.) Contributions to notional accounts `earn' a no- tional interest rate, usually set to equal earnings or Again, defined-benefit plans can be restructured to GDP growth. The rate of return on savings is un- eliminate pension privileges. By relating pensions likely to coincide with the notional rate of return. to average lifetime earnings rather than some sub- Assume, for illustration, a 15 per cent pension set of years, a defined-benefit plan can also contribution rate, two per cent earnings growth provide a reward for each year of contributions. and retirement at 60. A notional-accounts system After all, the financial flows in a notional defined- would deliver a pension worth around 30 per cent of pre-retirement earnings. If the market interest 6 Notional accounts rate were one percentage point higher, a funded This also carries important implications for the pension would generate a pension replacement long-term operation of notional accounts. These rate of around 40 per cent. With a gap of two systems make the rate of return on contributions points between the notional and the market re- transparent. In a defined-benefit scheme, the rate turns, the replacement rate from the funded plan of return in implicit. If market returns continue to would be around 50 per cent. exceed the notional return, it seems reasonable that workers will demand that the return credited Empirical evidence shows that market returns have to their account is closer to the long-run market outpaced the growth in wages. Furthermore, there return. This would undermine the stability and are theoretical economic reasons why this should fiscal sustainability of the system. be the case. We do not propose to repeat here the arguments for financing pensions through pay-as- you-go or funding. Nevertheless, it is important to Redistribution between generations note that notional accounts are pay-as-you-go fi- In addition to the notional return, two other es- nanced. They are not an adequate substitute for a sential components of the notional defined- funded system based on true defined-contribution contribution formula--the `g-value' or notional pensions. annuity rate, and the procedure for indexing bene- fits during retirement--are open to political Notional accounts systems in practice: Latvia and Poland The first country to introduce an explicit Poland has a larger funded component in system of notional accounts was Latvia in its reformed pension system than Sweden 1995-96. A small mandatory funded pen- or Latvia: seven per cent of earnings will go sion plan was introduced more recently. into individual pension accounts. A further Most of the features of the notional-ac- 12 per cent of earnings will be credited to counts component of the new system are individuals' notional accounts and another similar to Sweden and Poland. 21 per cent of pay will finance other welfare Latvia is a useful illustration of the interac- benefits. tion between notional-accounts pensions Poland initially proposed to credit notional and safety nets of social assistance benefits accounts with a return equal to the rate of or minimum pensions (such as the guaran- growth of the wage bill. But, to reduce the tee pension in Sweden). cost of the new system, the final choice of Latvia's social assistance pension is a little notional return is three-quarters of nominal over a quarter of average earnings, and is wage bill growth. paid from age 55 for women and 60 for Pension rights accrued under the old de- men. The notional accounts pension after a fined benefit system will be translated into full lifetime of contributions on average notional initial capital. Again, there is a economy-wide earnings would be 46 per guaranteed minimum pension, which will be cent of pay (for retirement at 60). Someone financed by general tax revenues, and addi- with a full lifetime at half-average pay (or, tional credits for periods of unemployment similarly, a part-time worker or with a partial or labor market absence due to caring re- contribution record) would be entitled to just sponsibilities. 23 per cent of economy-wide average pay, below the social assistance minimum. This, Pensions in payment will be price indexed, of course, mitigates many on the incentive but there is scope for variation if real wages effects of the new system. fall or when fiscal performance is particularly good. Notional accounts 7 pressure and manipulation. The difficulty, as be very accurately characterized as a `thoroughly stressed by Paul Samuelson, is that there is no way reformed pay-as-you-go defined benefit scheme'", for governments to pre-commit to a particular according to Karl Gustaf Scherman, former di- benefit structure in a pay-as-you-go system. Pen- rector of the National Social Insurance Board in sions are therefore subject to the `policy risk' that Sweden. And Olivia Mitchell, a professor at the the benefit promise might be broken. Wharton School at the University of Pennsylvania has described them as "an unfunded defined bene- Different ways of calculating the g-value give very fit plan in defined contribution `sheep's clothing". different pension entitlements. In Poland, for ex- ample, the annuity rate calculation is based on We agree. Under the following conditions, a de- average life expectancy (not the full distribution of fined-benefit plan delivers the same outcomes as possible life expectancies) and assumes a zero rate notional accounts: of return. This cuts the pension by almost 15 per benefits are based on lifetime average earnings cent for someone retiring at the normal age of 62 (not a subset of best or final years' pay); compared with calculations using a three per cent earlier years' earnings are revalued with an in- return and standard actuarial techniques. The ef- dex (such as economy-wide earnings growth) fect is complex, and varies with retirement age: for that reflects the growth in the economy's abil- someone retiring at the maximum age of 70, the ity to pay for pensions; difference in the pension value is 6½ per cent. A benefits are actuarially adjusted for early and future government might alter this complex part of late retirement; and the system, possibly with large effects on benefits. replacement rates are adjusted to reflect in- creases in life expectancy at retirement age. Indexation rules can also be manipulated. In Po- land, benefits in payment will normally be indexed Thus, as Mr Cichon concludes: "It is the packaging to prices. However, if real wages fall, then the real that differs" between notional accounts and de- value of pensions will be cut. Furthermore, the fined-benefit pay-as-you-go plans. It has been legislation permits higher indexation should eco- proposed that notional accounts might make pen- nomic performance allow. The vagueness of this sion reforms politically more palatable, particularly condition is likely to encourage pressure for faster- those that involve substantial cuts in future enti- than-inflation increases. tlements to restore fiscal sustainability. Yet, it remains to be seen if people will accept cuts in In Sweden, benefits will be uprated by the devia- their pension benefits more readily because they tion from a real wage growth `norm' of 1.6 per are packaged as notional accounts rather than cent. So if price inflation is two per cent, and real defined-benefit. Indeed, if they did, it would imply wages grow at 0.5 per cent, then benefits are that the complexities of notional accounts uprated by 2-(1.6-0.5)=0.9 per cent, i.e. rather less facilitated the reform through obfuscation, leaving than inflation. Again, it is seems unlikely, claims of greater transparency rather shallow. whatever the underlying concept of `fairness', that there would no be pressure for uprating at least in line with prices, rather than real cuts, whenever wage growth falls short of the `norm'. Pension reform strategy Michael Cichon of the International Labour Office has called notional accounts "old wine in new bot- tles". He contends that notional accounts' "potential financial and distributive effects could also be achieved by a classical, linear defined-bene- fit formula". Similarly, notional accounts "could 8 Notional accounts Further reading Conclusions and recommendations Disney, R.F. (1999), `Notional accounts as a pen- sion reform strategy: an evaluation', Pension Notional accounts constitute a well Reform Primer series, Social Protection Dis- designed PAYG defined benefit system, cussion Paper no. 9928, World Bank. which may be more appropriate when Valdés-Prieto, S. (2001), `The financial stability of the implicit pension debt is large, making notional account pensions', Pension Reform the transition to a funded system difficult. Primer series, Social Protection Discussion They may also be easier to introduce Paper, World Bank, forthcoming. than comparable PAYG defined benefit Cichon, M. (1999), `Notional defined-contribution system reforms because language that schemes: old wine in new bottles?' International clearly relates contributions to benefits Social Security Review, vol. 52, no. 4, pp. 87-105. may be appealing. On notional accounts schemes in practice: However, notional accounts do not Chlon, A., Góra, M. and Rutkowski, M. (1999), ensure long run financial sustainability `Shaping pension reform in Poland: Security and are subject to the same through Diversity', Pension Reform Primer series, demographic pressures as other PAYG Social Protection Discussion Paper no. 9923, schemes. World Bank. They also fail to diversify retirement Hamman, A.J. (1997), `Pension reform in Italy', income sources relative to funded Working Paper no. 97/18, International schemes. Monetary Fund, Washington, D.C. Moreover, when implied reduction of Palmer, E. (2000), `The Swedish pension reform benefits is understood, political -- framework and issues', Social Protection pressures to prevent these by changing Discussion Paper no. 0012, World Bank. government determined parameters Scherman, K.G. (1999), `The Swedish pension re- (e.g., notional interest rates, G-values, form', Issues in Social Protection Discussion and minimum pensions) may arise. Paper no. 7, International Labour Office, Notional accounts require increased Geneva. administrative capacity and more On redistribution and generational issues: information (e.g., life expectancy of the Disney, R.F. (1996), Can We Afford to Grow Older? covered population). In countries with A Perspective on the Economics of Aging, MIT weak capacity exists, conventional DB Press, Cambridge, Mass. schemes may be easier to administer. Samuelson, P.A. (1958), `An exact consumption- loan model of interest without the social aymployer ent contrivance of money', Journal of Political odic pr em ed age Economy, vol. 66, pp. 467-482. siongoveron abov n.1.perient oe specifi nm etc r-for´m Pension Reform Primer briefing notes: pe´np. bypers on retire madment o e es r to World Bank (2000), `Retirement: can pension re- IORNEF form reverse the trend to early retirement?' pr World Bank (2001), `Coverage: the scope of pro- tection in retirement-income systems'. of imp.e)rfections,faultsorerrors World Bank (2001), `Transition: paying for a shift PENSPRIMERORM betterby removal orabandonment from pay-as-you-go financing to funded pen- v.t. & i. 1. make (institution, procedure sions'. equip pmerson with information er n. 1. elementary book to