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Improving Sweden's Automatic Pension Adjustment Mechanism

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Publication Date: January 2011

Publisher(s): Center for Retirement Research at Boston College

Author(s): Nicholas Barr; Peter A. Diamond

Series:

Special Collection:

Topic: Economics (Economic conditions)
Economics (Economic theory)
Economics (Infrastructure)

Keywords: international

Type: Report

Abstract:

The public pension world has seen two innovations in recent years. One is the emergence of notional defined contribution (NDC) plans. The other is the introduction of automatic adjustment mechanisms to help keep pension systems solvent when the economy weakens. This brief looks at the Swedish system to demonstrate how NDCs work and evaluates the workings of the automatic adjustment mechanism in the wake of the 2008 financial crisis.

Sweden passed reform legislation in 1994 that introduced a partially-funded NDC plan.1 The arrangement is conceptually similar to a defined contribution plan in that contributions are accumulated in individual accounts, but different in that the accounts are not fully funded and may be financed entirely on a pay-as-you-go basis. In this setting, the rate of return credited on the account assets is based on a rule rather than on actual returns. The Swedish system uses a notional interest rate equal to the rate of growth of average earnings. However, if a calculation suggests a potential deficit, the notional interest rate is automatically reduced through a “brake” mechanism. The recent financial crisis has highlighted ways in which the brake mechanism could be improved.

This brief proceeds as follows. The first section describes Sweden’s NDC plan. The second describes the Swedish brake mechanism. The third describes two problems with the current adjustment procedure: 1) it creates the likelihood of large shocks for retirees; and 2) while disadvantaging retirees, it tends to advantage workers. The fourth section presents possible fixes for the current problems. The final section concludes that the Swedish NDC plan could function more effectively with modest changes to the brake mechanism.