One of the great dilemmas facing countries around the world is to define a pension system that is financially sustainable in the face of increasing life expectancy, falling fertility rates and the consequent lack of generational replacement. Globally, pension reforms in countries with more advanced aging processes have focused on implementing parametric reforms and incorporating automatic adjustments of the main parameters to share productivity, financial and demographic risks.
In this article we present the advantages and disadvantages of three benchmark pension models: Sweden, the Netherlands and Denmark.
With notional accounts, each worker has a fictitious account in which the contributions they make are included, as well as the theoretical yield generated by these contributions.
The case of Sweden and the challenges of notional accounts
Sweden was several decades ahead of other countries in designing a model based on notional accounts and a system of systematic risk sharing. In this way, each worker has a fictitious account in which the contributions they make are included, as well as the theoretical returns generated by these contributions. The interest rate used to calculate these returns is linked to the evolution of per capita wages and inflation.
When calculating the pension, the balance accumulated during their working life is divided by the estimated life expectancy at retirement; this has made the system relatively successful despite increased longevity, the 2008 financial crisis, market volatility and the downward trend in interest rates in recent decades.
However, it is not a perfect model. Those factors led to a reduction in the nominal value of pensions for several years. If, in addition, one takes into account the potential 20% reduction in pension amounts due to the 5-year increase in life expectancy expected for 2060, the system would not be socially sustainable. This is why the government had to compensate for the drop through tax policies, an increase in the retirement age and the establishment of a partial indexation of life expectancy in pension amounts.
The Netherlands: how the world’s best pension system led to financial unsustainability
The pension system in the Netherlands has been considered one of the best in the world due to its level of benefits and coverage, and its financial sustainability in its beginnings. It is a mixed system combining a public pay-as-you-go pension and a funded system through the private sector.
The public part guarantees a percentage of the minimum interprofessional wage, while the private part accounts for approximately 70% of the total pension. This private part has been mostly defined benefit pensions, i.e., they guarantee a fixed pension amount over time. This poses a problem for companies as they must ensure that the assets built up are sufficient to pay these fixed benefits in the future. Moreover, this is complicated in an environment of falling interest rates in recent decades and a higher-than-expected increase in life expectancy. In consequence, the purchasing power of retirees fell by 16% between 2000 and 2020 while contributions rose by 40% and the nominal pension fell by 1%. This resulted in systematic transfers between generations and an unsustainable situation.
Ultimately, this led the government to pass a reform to transform the Dutch employment system from a defined benefit system to a new collective defined contribution contract.
Denmark’s strategy: keeping the retirement period constant
Denmark is the only country in which, at present, pension expenditure will fall by 2060 and, in addition, the average replacement rate will increase. Unlike Sweden and the Netherlands, Denmark chose the path of increasing the retirement age, so that, based on mortality tables and the life expectancy of 60-year-olds, a retirement period of 14.5 years will remain constant. Thus, the normal retirement age will progressively increase from the current 65 years to 67 by 2027.
In addition, Denmark established labor market exit pathways that take into account socioeconomic differences in life expectancy. In this regard, it chose to incorporate an early retirement scheme that compensates for differences in longevity.
The country also established the payment of a bonus for every three months of full-time work after the age of 62 and, from 2008 to 2020, the employment rate among the elderly increased by 11 percentage points in the years prior to the state retirement age (55-64 years) and by 3 percentage points in the years after (65 years and older). This is a particularly important development for the elderly, as the employment rate among the population aged 16-64 has not shown the same increase.
With this system, Denmark has made progress in both financial and social sustainability (adequacy). In fact, in 2012, it received an “A” rating from the Melbourne Mercer global pension index, becoming the first pension system to obtain that evaluation, which it maintains to this day.