Friday, January 21, 2011

The Swedish Pension Model?

Naomi Powell of the Globe and mail reports, In Sweden, pension problems are so 1989:

There’s no shortage of pension woes in Europe these days.

Everywhere, it seems, governments are hiking retirement ages, cutting benefits and quelling protests from outraged workers.

Not in Sweden.

It isn’t that the Swedes escaped the troubles now facing many of their European neighbours, they were just forced to deal with them a long time ago. Still, the economic crisis presented the first real test of the country’s pension reform, one it weathered relatively well.

In the late 1980s, the government realized that without a major overhaul, the public pension system would be bankrupt in about 20 to 25 years. The reasons are familiar: a rapidly aging population and a defined benefit system that would collapse without consistently strong economic conditions.

“You had this big tanker of pensioners who were going in one direction and you had pensions that had to be paid by law,” said Edward Palmer, a professor of social insurance economics at Uppsala University who helped design the system. “But you had an economy that could do anything. We had to get a system that would be resilient to both economic and demographic shifts and we had to get people to work longer.”

In a radical change, Sweden scrapped its traditional defined benefit pension for what's called a "notional defined contribution" plan (NDC). The notional account recorded each individual's contributions and a rate of return tied to the national per capita real wage growth. There was no "real money" in the account - as in traditional pension plans, contributions fund current retiree benefits – but the system provided a way of keeping score.

Swedes contribute 18.5 per cent of their pay to the system: 16 per cent to the NDC and 2.5 per cent to a private account where money is invested in mutual funds of their choice. The public pension is a significant portion of retirement income – responsible for 75 per cent of the average monthly benefit for men at 17,000 Swedish kronor ($2,562 U.S.) and women at 12,000 kronor. The rest comes from occupational pensions negotiated between companies and unions.

When workers retire, their annual benefits are calculated by dividing the account balance by the life expectancy rate and rate of return based on the growth of the economy. Benefits are adjusted each year taking into account changing life expectancies, inflation and the rate of return.

Workers can retire as early as 61, but the longer they stay in the work force, the higher their benefit upon retirement.

The bottom line? When the economy is strong, pensioners receive more than they might have under the old structure. But when the economy is weak pension payments automatically drop to ensure the fund’s stability.

The system was designed in part to take difficult decisions regarding benefit cuts out of politicians’ hands by allowing them to refer to a formula.

That was the theory anyway. No one really knew how well the system would perform until the global economic crisis.

Pensioners, who had enjoyed years of higher payments following the changeover to the new system in 1999, suddenly faced a cut of 3 per cent in 2010 and 4.3 per cent in 2011.

The government stood behind the system, though eventually politics did get involved. Taxes for pensioners were slashed to make up for the shortfall.

“The positive side is that Sweden now has one of the few public pension schemes that is in good shape after this crisis,” said Ole Settergren, head of research and development at the Swedish Pension Agency. “But one of the points was to isolate public finances from what happens in the pension arena. That didn’t happen.”

Perhaps the most controversial aspect of the plan is that it shifts the burden of fund shortfalls onto pensioners – though there is a basement for how low benefits can fall, at 7,000 kroner a month. And as the crisis proved, that burden can be significant.

Not a perfect system then, but sustainable. And one that many countries, including Egypt, Poland and Brazil have considered as they try to fix their own pension schemes.

I'm not an expert of the Swedish pension system, but I know about the buffer funds:

Första AP-fonden’s mission is regulated by the Swedish National Pension Funds Act. The act (and preparatory work to the act) state that Första AP-fonden shall:

  • Function as a buffer in the pension system
  • Maximize long-term return with a low level of risk
  • Manage the funds without being influenced by prevailing government policies, whether industrial or economic
  • Give consideration to ethics and the environment without compromising the overall goal of attaining a high return
Första AP-fonden, also known as the First Swedish National Pension Fund or AP1, together with the Second, Third, Fourth and Sixth National Pension Funds (AP2, AP3, AP4 and AP6), is a buffer fund in the Swedish pension system. The capital of the buffer funds is used to even out temporary fluctuations during periods when pension contributions are not sufficient to cover pension disbursements from the income pension system.

According to the annual report, AP7’s investment returns in 2009 were its highest since the premium pension system launched ten years ago (2009 was a good year for everyone). AP1 also provides its 2009 annual report online and its latest semi-annual report. Both reports provide intricate details on the fund's performance, operations and cost structure.

I like the Swedish buffer funds and think they're worth looking into more closely. Even Canada should look at these buffer funds and set something similar up here (basically building on our existing defined-benefit plans). Other countries can also learn from the Swedish pension model and bolster their retirement system. At the very least, they should examine the pros and cons and see if there is anything they can adopt to improve on their existing pension system.

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