Forewarned is forearmed – automatic stabilizing mechanisms in pension financing in five countries
Our pension system is currently sailing through deep waters. The seas are likely to get rougher in the future. Reduced fertility rates and lower interest rates form dark clouds on the sky over our pension system. The most recent gust of icy winds is the corona pandemic, which has only added to the challenges pension financing faces. Yet it is possible to navigate through the rough seas – partly on automatic pilot.
Over the years, Finnish pension policy has found ways to react to challenges facing the country’s pension system. In the past decades, the system has been steered mainly through decisions made in various negotiations. Gradually, automation that reacts to changes has been increased. The life expectancy coefficient and a retirement age that is linked to life expectancy adjust the financing balance of earnings-related pensions relative to changes in life expectancy without separate decisions. However, the current automation does not react to changes in the birth rate and national economy.
The notable decline in fertility and the weaker dependency ratio in Finland has increased the need to explore whether, in case of an unfavourable development, it would be possible to find automatic stabilizing mechanisms that could stabilize the demographic and economic risks more evenly than at present. The corona pandemic has added to the challenges of financing earnings-related pensions.
In seafaring, vessels have been equipped with stabilizers for a long time. Could the course of our shared pension vessel also be increasingly stabilized by adding stabilizing mechanisms that react to the risks mentioned above?
We investigated what kinds of automatic stabilizing mechanisms are in use in other countries. In our report published in September 2020 (summary in English), we presented current models of automatic stabilizing mechanisms used in five countries: the Netherlands, Japan, Canada, Sweden and Germany.
Stabilizing mechanisms transfer risks to current and future pensions
The aim of the stabilizers is to mitigate the pressures caused by the demographic and economic developments on pension contributions, and thus stabilize the financing of pensions. At the same time, they also change how the risks are allocated between the parties to the system. In practice, automatic stabilizing mechanisms transfer the risks to current and future pensions. It means that the benefit level would react to changes in circumstances.
At their best, the stabilizing mechanisms allow for a more even distribution of risks and make the operations of the entire system more predictable. When taken to the extreme, the result may be a system in which the pension contribution level is fixed and the pension benefits are flexible and may even be cut. In the mildest scenario, the indexing of pensions is restrained but, in itself, the mechanism alone is not enough to guarantee a fixed contribution level. It’s worth noting, though, that a “positive” risk may also increase relative to the indexing of benefits.
Changes in wage sum or solvency may trigger the stabilizing mechanism
Depending on the system, the automatic stabilizing mechanism may react to different variables. In a pay-as-you-go (PAYG) system, pensions in payment are financed with the annual contributions of those working in the given year. The essential factor is the ratio between the wage sum and pension expenditure. If the development of the wage sum faces risks in the form of, for example, reduced birth rates which lead to a reduced working-age population, it makes pension financing more difficult. In a funded system, on the other hand, the essential factor may be the development of the value of pension assets relative to the benefits they finance.
The earnings-related pension system in the Netherlands offers an example of the stabilizing mechanisms in a funded system. The solvency ratio of a fund determines the limits of how pensions are indexed: are they indexed at all or are they cut? The alternative is an increase in the pension contribution, but that has a limited effect on solvency, considering the relatively small share of contribution income to pension liabilities.
The German system, on the other hand, is a PAYG system. The stabilizing mechanism pays attention to changes in the dependency ratio, that is, to changes in the ratio between contribution payers and pension recipients. In Germany, the indexing is also affected by changes in the pension contribution: if the contribution has been raised in previous years, it has a weakening effect on the index adjustments in the following years. However, it is also possible that the changes go the other way, in which case indexing is improved. This was the case during the favourable employment development before the corona pandemic.
The mechanism in Japan functions in a very similar way to that in Germany. The stabilizer reacts to changes in the number of insured persons and the life expectancy of 65-year-olds. The pension contribution is fixed and the protective mechanism prevents a nominal cut in pensions.
Negative index adjustments in Sweden
In the Swedish contribution-based earnings-related pension system, the balance between liabilities and assets are monitored annually. The liabilities consist of pensions in payment and accrued pensions. The assets consist of contribution income and buffer funds. Since the contribution level is inflexible, the index adjustment can be negative if the financing balance becomes more unfavourable. So far, pensions have been cut in 2010, 2011 and 2014. Correspondingly, if the financing balance improves, the system goes full steam ahead instead of slowing down in terms of index adjustments.
In Canada, the mechanism goes off if the estimated contribution level in long-term projections exceeds the prevailing contribution level. Under a 50/50 principle, the Canadian mechanism focuses on weakening the indexing of pensions in payment and raising the pension contribution.
Politics play a considerable role
Political decision-making plays a central role in the final risk distribution, automatic mechanisms notwithstanding.
Two extremes can be observed behind the definition of the mechanisms. At one end of the spectrum there is the Swedish model, in which the role of projections based on assumptions has been minimized. In principle, the mechanism is fully automatic and based on an already realised development. Canada is at the other end of the spectrum. The Canadian model is linked to long-term projections and assumptions used in them.
In Sweden, based on the experience of benefit cuts, the decision has been made to reduce the effect of the index slow-down and full-steam-ahead with one third from the original impact. The balance is strived for over a longer period of time, avoiding sudden slow-down and acceleration. In addition, the cuts have been compensated by tax relieves and a traditional discretionary pension reform to raise the old-age pension retirement age and pension levels.
In Canada, the mechanism is like the stern of the vessel: if the legislators do not act, the final assumed mechanism consists of freezing the index rates and raising contributions.
In Germany, as well, the measures to be taken if the stabilizing mechanism is not enough to keep the contribution level below or the benefits above an agreed limit require a political decision.
In Japan, the standard regulations regarding pension indexing have been deviated from on several occasions through political decisions. That is why the automatic macroeconomic indexing mechanism intended for 2004 was applied for the first time as late as in 2015.
Protective mechanisms applied to prevent cuts in earnings-related pensions
Nominal cuts in pensions are possible in Sweden and the Netherlands. The actual risk-bearing of pension recipients is reduced in the Netherlands by the high national pension and in Sweden by the guaranteed pension which is fully deductible from the earnings-related pension.
The other countries included in the comparison employ protective mechanisms which prevent pension cuts or negative index adjustments. In addition, in for example Germany and Japan, a minimum level for the replacement rate, also called a computational norm pension, has been introduced to protect future pensions. If the minimum level is approached, legislation has to be changed.
Skipper needed to keep the vessel on course
The needs for and aims of the stabilizing mechanism are similar in each of the five countries under review, but the mechanisms themselves deviate from each other considerably. Thus there is no single ideal model that could be applied to different national pension solutions.
Automatic mechanisms increase the predictability in pension financing. At the same time, it improves the balance and manoeuvrability of the shared pension vessel. That said, the skipper still needs to be alert and ready to react in changing circumstances. He or she needs to steer the vessel to its destination in such a way that also the passengers remain content. Pension policy determines the course and the home port – that is, the objectives of pensions. The stabilizing mechanisms are a tool that assist the skipper to stay on course.
Mielonen, Antti; Risku, Ismo; Vidlund, Mika; Väänänen, Niko (21 Sept. 2020): Automatic stabilizing mechanisms allow for a division of pension financing risks (English summary in Julkari), Finnish Centre for Pensions, Reports 10/2020