Statement of Edward Palmer, Professor, Social Insurance Economics,
Uppsala University in Sweden, and Chief of Research and Evaluation,
Swedish National Social Insurance Board⁽¹⁾, Stockholm, Sweden

Testimony Before the Subcommittee on Social Security
of the House Committee on Ways and Means

Hearing on Social Security and Pension Reform: Lessons From Other Countries

July 31, 2001

Sweden´s New Pension System ⁽²⁾

An Overview of Sweden's New Pension System

In a series of steps in the 1990s, Sweden converted a two-tier defined benefit scheme from 1960 into a combination of notional defined contribution (NDC) pay-as-you-go and financial defined contribution (FDC) schemes. The reform was driven by the threat of future large contribution rate increases, redistributional unfairness in the design of the old system and a goal of providing a framework that would promote mandatory saving through the pension system - but with privately managed assets.

The overall contribution rate for the two schemes together is 18.5 % of earnings, with a split of 16/2.5 between the notional and financial account schemes. The annuity in both schemes is based on lifetime account values and life expectancy at retirement. Accounts in the NDC system earn an economic rate of return, whereas accounts in the FDC scheme earn a financial rate.

About 90 per cent of the Swedish labor market is also covered by contractual pension arrangements that top off the public pension. This was also a consideration in establishing the parameters for coverage in the new public system. During the 1990s, contractual schemes for private sector blue-collar and municipal government employees (generally, persons working with health care, education, social assistance, other public services provided locally, and local public administration) have converted to financial defined contribution following the reform of the public system. Blue-collar workers have a contractual supplement of an additional 3 % on earnings, and municipal workers can have a supplement of up to 4.5 %, depending on regional arrangements. (See Palmer 2000, 2001a and b.) Consequently, the pension portfolio for over half of Swedish employees contains a large total mandatory/quasi-mandatory FDC component, in which participants choose their own investment portfolios. Presently, private white-collar workers are mostly covered by advance funded defined benefit schemes, and can also make their own fund choices within this framework. There is also discussion on converting private white-collar contractual schemes into defined contribution schemes, in line with the reform of the public system.

Appendix 2 provides an illustration of replacement rates for a person born in 1975, with the present life expectancy forecast for this cohort. This individual begins working at age 22 and the table illustrates replacement rates for different ages of retirement for ages from 61 through 70. In the illustration, the contractual benefit is based on a contribution rate of 3.5 %, on top of the 16 % (NDC) and 2.5 % (FDC) contribution rates in the public system. This means that 27 % of total contributions go to the financial account systems and that the outcome will depend on the market rate of return for this 27 % of contributions. If we look at the replacement rate for an individual retiring at age 65, a real market rate of return of 2 % would yield an overall replacement rate of 54 %, while a return of 6 % would yield a replacement rate of 70 %.

Lastly, it is important to note that the reform creates mandatory insurance without redistribution - other than over the individual's own lifetime, and the redistribution from men to women embodies in the unisexual life expectancy factor used to compute annuities. Redistribution is financed through general revenues, instead of through the insurance system, with the most important example being a new guarantee benefit for low-income pensioners. Also, all non-contributory credits are financed with general revenues, and money is transferred to the NDC and FDC schemes to support these credits. As a part of the reform, a separate deduction for pensioners was abolished putting all forms of pension income and earnings on the same tax status. (A detailed summary of the Swedish reform is provided in Appendix 1.)

The Process of Legislation and Implementation

The concept for the reform was published in the autumn of 1992. It was passed by Parliament in1994 with a majority vote of about 85 %, supported by both the governing liberal-conservative block and the Social Democratic opposition. Ownership from a broad political spectrum was viewed from the beginning as being an important condition for the long-run stability of the reform.

Since 1994, representatives of the political parties responsible for the reform have constituted an implementation group with the purpose of working through all the legislative details. Most of the necessary legislation was passed in 1998, although at the time of this writing, some legislation still remains.

The first step in implementation was to set off contributions to start individual financial accounts. Beginning in 1995, contributions were paid into a blocked, interest-bearing account at the National Debt Office. In following years, new contributions were paid in and held in the blocked account in the interim until the individual accounts and the administrative apparatus had been created. The interim account is still used to hold new contributions, with interest, until tax forms of all participants have been processed and approved through the standard tax procedures.

Sweden has had computerized individual accounts since the 1970s. Nevertheless, the systems were dated and did not satisfy the requirements of the new schemes - or for that matter those of a modern administration. In addition much new information had to be created, in some cases retroactively from 1960. As a result, it took some time to create the accounts needed for the new system.

The technical conversion of old-system accounts from 1960 into NDC accounts was completed in December 1998. At the same time, individual financial accounts were created for the contributions that had been paid since 1995. The first individual account statements were sent out in the spring of 1999, with an extensive mass medial campaign and ensuing discussion and renewed debate. Since 1999, account statements are sent out to all participants in the spring of each year. Owing to a delay in the development of IT support for fund choices and accounting, the debut for individual fund choices in the financial account scheme was postponed from the early autumn of 1999 to the same time in 2000.

Joint account statements for the NDC and FDC schemes are sent to participants in the spring of each year. In addition to general information, statements include personal "forecasts," assuming individual earnings follow the most recent outcome, 2 % real average wage growth in the future and a real rate of return in the financial market of 6 %. The former is close to the long-run (100 year) rate of growth in productivity and the latter corresponds to a bond and equity fund with real rates of return similar to those experienced over the past half century, with a bond/equity mix of around 40/60. Not surprisingly, these assumptions have been criticized as being both too optimistic and too pessimistic. On the other hand, the debate itself has served to focus public attention on the new system.

The implementation of the new pension system also provided a much-needed impetus for the National Social Insurance Board to focus on developing modern information services for participants. In addition to the yearly statements and other information available at local offices, people can access information on their accounts not only through their local offices, but using the internet. In fact, there is an internet program for calculating your own pension. The user provides his/her own assumptions about personal earnings growth, non-contributory periods, alternative rates of return, and ages for and degrees of (partial or full) retirement. The latter is especially useful for older individuals who want to examine different exit alternatives.

The PPM is the Clearing House for Fund Transactions, Keeps Individual Accounts and will be the Monopoly Annuity Provider in the FDC Scheme

The PPM (Premipensionsmyndigheten) - or Premium Pension Authority in English - is the agency within the social insurance administration that administers the financial account scheme. The focus of development of the administration has been on holding back administrative costs. The principal responsibilities of the PPM are to enter into contracts with funds applying to participate in the system, execute purchases of fund shares on behalf of the participants, collect and make available information on fund shares, keep the individual accounts of the system and provide the insurance products specified by the law.

The flow of funds and information in the administration of the financial accounts can be summarized as follows:

• Contributions for the financial account scheme are collected together with all other social insurance contributions (and taxes in general) - by the National Tax Authority. Information on payments is transferred on an individual basis to the National Social Insurance Board (NSIB), which also keeps all the social insurance accounts. Money from new contributions is transferred through the National Debt Office, which administers all the financial transactions of the Swedish State, to the participating funds, following the receipt of an order from the PPM.

• The PPM is a clearinghouse for all fund transactions. Choices for new entrants and requests to buy and sell fund shares for all other participants are grouped together and executed jointly on each transaction day by the PPM. Participating funds are required to report fund values to the PPM electronically and on a daily basis. The PPM keeps the individual accounts of fund shares and values are computed for all trading days.

• The PPM is the sole provider of annuity products. Participants can choose between single and joint life annuities. Annuities can be fixed or variable rate annuities. (Lump-sum payments or phased withdrawals over shorter periods than a life are not among the available alternatives.) A fixed annuity is "purchased" from the PPM and entails moving fund assets to the PPM. Alternatively, the participant can leave his/her money in market funds and accept a recalculated annuity on an annual basis.

FDC Fund Participation Criteria and Fund Administration Costs

All funds licensed to operate as investment funds in Sweden and/or the European Union, are allowed to participate in the system. In addition, funds must conclude an agreement with the PPM, agree to provide information to the PPM upon request, agree not to charge withdrawal fees and provide a periodic report of administration costs charged. Funds are required to compute share values and report them electronically to the PPM on a daily basis. The PPM invests assets on behalf of participants, and is the sole client for any given fund. Part of the agreement concluded with the PPM includes accepting a system of rebates established by the PPM. What this means in practice is that the fund can levy its normal charge minus a possible rebate to the PPM, depending on the normal charge and the amount of PPM assets held. (See Appendix 3.) Individuals bear the costs of their own fund choices.

As a result of individual fund choices in December 2000 about 70 % of total assets were allocated to private market funds and 30 % to the public fund for non-choosers. Private fund choices resulted in the distribution of costs shown in Table 1, with an average cost of 0.72 % of PPM assets. The publicly managed fund for non-choosers charges a fee of 0.48 % of assets.

For both systems together, the average cost for fund administration, given the distribution of individual choices in 2000, was 0.65 %. By regulation the PPM is allowed to charge up to 0.3 %, annually, of total PPM assets, to cover the costs of both its clearinghouse and insurance functions. These costs are to be distributed proportionately among the insured. This gives total administration costs of 0.95 % of total assets, based on the year 2000 distribution of choices and actual fund charges.

Table 1. Distribution of assets among market funds by fee category

FDC Fund Choices

Around 4.4 million participants were given the opportunity to make their first fund choice(s) beginning September 11, 2000. To avoid administrative overload, information was sent out to six separate regions of the country at intervals of one week, ending October 26. People were given a month to respond and after this deadline non-choosers were allocated to the public fund for non-choosers.

To help participants make informed choices, a brochure listing all registered funds, their investment profile, historical performance, degree of risk and administrative charges were sent to all participants. As it turned out, some funds had no or only a short record of operation and thus little or no performance information could be provided. The PPM spent the equivalent of around 7 million dollars on a mass media campaign. In addition, large insurance companies and other large fund managers advertised heavily especially in the radio and TV media immediately prior to and during the first choice period.

About 3 million persons - or 67 per cent of all participants - made an active choice from among the 460 funds registered with the PPM at the time. Slightly more women (68 %) than men (66%) made active choices, and this was true for all age groups and throughout most of the country. Younger persons were slightly less active: Active fund choices were made by around 58% of participants in the age group18-22 and 63% of participants age 23-27.

Participants chose on average 3.4 funds, which gave a total of over 11.5 million fund choices. The number of active fund choices was a little over 10 million. Around 1.4 million participants were "non-choosers." Over 72% of those making active choices chose funds holding only equities, and another approximate 25% chose either mixed bond-equity or generation funds that enable the individual to adjust his/her risk profile to remaining years to planned retirement.

About 30% of available funds ended up in the publicly managed non-chooser fund. This fund presently has a portfolio with a split of around 80/20 between equities and bonds. The private fund getting the largest share of total assets (of 56 billion Swedish kronor - or around 5.6 billion dollars) held 4 % of the PPM assets in December 2000. The top 10 funds together attracted 23% of all assets. Among these was only one foreign owned fund, and this fund was number 9 in terms of assets held in the ranking of the top 10 private funds.

Unless individuals actively make new fund choices, all new contributions are distributed to their existing fund choices in accordance with the portfolio shares they made at the time of their last choice. Information on fund values is available daily in major Swedish newspapers and through the internet link to the administration.

Summary Remarks

Prior to the introduction of the financial account system nearly half of all Swedes had some personal experience with financial market funds, and there was, in addition, opposition from important quarters. Most noteworthy in this respect is that, although they were initially opposed to the advance funded component of the public system, the central blue-collar union changed its mind and negotiated a shift from its own defined benefit supplement to a defined contribution supplement that closely resembled the new public FDC component! Both the blue-collar union (LO) and the Confederation of Employers (SAF) supported the move towards NDC. Blue-collar workers, who usually have long, but flat earnings profiles - compared to managers and professionals - could easily see the advantages in fairness to their members in introducing notional and financial account schemes in social insurance. For employers there was a clear advantage to a system with a contribution rate that, in principle, will be fixed forever.

How have people in general reacted? With the reform, all participants were provided the opportunity to choose the construction of their own portfolios in the public scheme, and 67% made an active choice. There was widespread mass medial coverage of the events surrounding the first opportunity to make fund choices, and the whole process appeared to go very smoothly - judging by the lack of negative press coverage. In short, it appears that the Swedish people have accepted the reform and with it a paradigm change in the provision of social security.

Appendix 1. Summary of the New Swedish Pension System

1. Individual accounts - contributions

• Persons born prior to 1938 are outside the new system. Generally, participants born 1938 and after have two accounts in the new system: one Notional Defined Contribution (NDC) and one Financial Defined Contribution (FDC).

• Contributions are paid on earnings above the minimum level at which income must be declared for tax purposes (presently about 900 dollars per year) and up to a ceiling of about 29 000 dollars, using an exchange rate of 10 kronor per dollar. (The Swedish krona has fluctuated between 5.5 and 11.0 kronor per dollar since 1995 and is presently close to its lowest level.)

• The transition rule is that persons born in 1938 will receive 4/20 of their benefit from the new system and 16/20 from the old system; persons born in 1939 5/20 and 15/20 etc. Persons born in 1954 and later are completely in the new system. (The new system proportions are also used to determine payments for the transition cohorts to the FDC scheme.)

•  The contribution rate is 18.5 % on earnings. (Eventually to be split equally between the employee and employer.)

•  A 16 % contribution rate goes to the pay-as-you-go system and is noted on the individual's NDC account.

• A 2.5 % contribution rate goes to the individual's financial account. Individuals choose one to five registered funds. Funds of non-choosers go to a publicly managed default fund. There is no limit when or how often participants can switch funds and (presently) no individual charge on switching funds.

2. Non-contributory rights and rights for periods of sickness, disability and unemployment covered by social insurance

• Non-contributory rights in conjunction with child birth, higher education and (conscripted) military service are financed by general revenues and money is transferred from the general state budget to the NDC and FDC social insurance schemes to cover these.

• Childbirth credits are given for a maximum of four years per child, although only one credit can be earned at any given time (two children born two years apart give 6 credit years in total). The credit can be claimed by either parent, but to date is usually claimed by the mother. Claimants are entitled to the most advantageous of: 1) contributions based on 75 % of average earnings for all covered persons; 2) contributions based on 80 % of the individual's own earnings the year prior to child birth: or 3) a supplement consisting of a fixed amount, indexed over time to the (covered) per capita wage.

• Periods of sickness, disability and unemployment covered by social insurance provide financed rights in both the NDC and FDC schemes. Benefits for sickness and unemployment are treated as earnings in computing contributions. An imputation of future earnings is performed for disability (the rules remain to be legislated in the autumn of 2001), and contributions are transferred from the disability scheme to finance these rights. The sickness and unemployment schemes pay for the employer share of the contribution for sickness and unemployment. A disability benefit is converted into an old-age benefit at latest at age 65.

3. Account values

Accounts in both the NDC and FDC schemes grow with:

• New contributions and transfers to the system for non-contributory rights

• A rate of return based on the growth in the average wage rate in the NDC scheme and the return on the individual's fund(s) in the FDC scheme

• Inheritance gains. Inheritance gains derive from the accounts of persons who die prior to the retirement age. They are distributed among survivors in the same birth cohort as the deceased.

4. Calculation of a benefit

• A full or partial (25%, 50%, 75%) benefit can be claimed from the NDC and/or FDC scheme separately or together at any age from age 61. There is no upper age limit. A benefit can be combined with continued work. Contributions paid on earnings from work always yield enhanced account values. A person who claims a partial benefit and/or combines a benefit with work will have the benefit recalculated, based on new account values, upon permanent retirement.

• The annuity is calculated as:

Annuity = Account value / unisexual life expectancy from retirement
and
- in the NDC scheme assuming a real annual return of 1.6% during retirement
- in the financial account system taking into account the return on the funds of annuity recipients.

• In the NDC scheme permanent life expectancy factor is determined for a cohort in the year in which its members turn 65, even for individuals who claim a benefit before or after this age.

• The annuity in the NDC system is indexed to the CPI, however a yearly adjustment (up or down) is made for trend divergence of real per capita contribution growth from the growth norm of 1.6 % used in calculating the original annuity value.

• Even benefits of pensioners born 1937 and earlier are indexed from 2002 with inflation plus the difference between 1.6 % and the actual outcome.

• In the financial account system the participant can choose either a fixed or variable life annuity. In the latter case he/she chooses the investment fund and the annuity is recalculated annually. A joint life annuity is also offered. A survivor benefit can also be subscribed to during working years.

• Although early retirement is possible for persons born in 1938 in 2001, most persons born in 1938 are expected to claim benefits in 2003, which has been a "normal" retirement age for over two and a half decades, in part owing to contractual arrangements covering about 90 per cent of employees. In addition, a guarantee supplement cannot be claimed until the age of 65, which for persons born in 1938 is in the year 2003.

5. The guarantee benefit

• The guarantee benefit is available from age 65. It is an inflation-indexed supplement (with a specified maximum) to the total benefit provided by the NDC and FDC earnings-related schemes.

• The guarantee is financed with general revenues. Together with a means-tested housing allowance, it will usually be sufficient to meet the subsistence norm established by the National Welfare Board. Since it is prorated with regard to years of residence, with 40 years needed for a full amount, it is possible that late-working-life immigrants may nevertheless fall under the subsistence norm and be in need of social assistance, provided by local authorities.

• The initial level of the guarantee was set at a high enough gross value to align it after-tax with the commensurate benefit in the old system.

6. Taxation

• Individual earnings and pension benefits have the same income tax status. The reform eliminated a separate tax deduction for pensioners.

7. Administration

• The tax authority collects contributions (together with other taxes).

• NDC accounts are kept by the National Social Insurance Board. The Board also keeps track of all contributions for and pays NDC, FDC and guarantee benefits together.

• The FDC accounts are managed by a state monopoly - the PPM. The PPM places one daily order per fund, aggregating all orders to buy and sell. The PPM is the single provider of FDC annuities.

8. Reserve funds in the NDC scheme

• The NDC system has a buffer fund that arises due to fluctuations in the sizes of birth cohorts, but which will also pick up remaining imperfections in the practical design of the scheme. Reserves, accumulated within the framework of the old system, were approximately 450 billion kronor at the end of the year 2000. (GDP was around 2100 billion kronor.) These reserves will help in financing the transition period - when the large cohorts born in the 1940s are only partially within the new system.

9. Financial stability of the NDC system

• Two main sources of potential financial instability remain. The first source of instability arises because life expectancy is calculated from the known life courses of contemporaneous cohorts at the age when the retiring cohort has reached age 65. Neither of the two more stable alternatives - continuous adjustment after retirement or basing the factor on a cohort-specific projection - was chosen. The second source of instability is the choice of using the growth in the average wage for indexation, whereas it is well known that the growth of the contribution base (which also takes into account the size of the contributing labor force) must be used to guarantee financial stability - a fixed contribution rate. To counter these a balance index has been constructed.

• The balance index: An evaluation of the present value of assets and liabilities is made, based on current information, to construct a balance index. When the valuation of assets falls short of the valuation of liabilities, the index falls under unity and both account values and benefits are deflated by the index. Positive indexation occurs in a recovery until the balance index reaches unity again. (See Settergren, 2001)
  

Appendix 2. Replacement Rates

of the new system in greater detail. Note that benefits are affected by three factors. The first is additional contributions. The second is indexation and market returns on account values not converted into benefits. The third is unisexual life expectancy from the time of retirement. For the older worker, the latter two are generally more important.

One of the advantages that can be claimed for the combination of NDC and financial account schemes is that workers can combine work (full or part-time) with a partial or full benefit from either or both of the social insurance schemes. See Palmer (1999).

Appendix 3. Fee Schedule for administrative costs for private asset manages participating in the FDC scheme

The authority administering the financial account system, the PPM, is the sole client for the system. The PPM has at most one (net of purchases and sales) transaction in fund shares per day vis á vis any specific fund manager - and normally the transaction amount will be very small relative to the amount of total assets managed on behalf of the PPM. On the other hand, a large amount of money will be transferred on an annual basis, in conjunction with the transfer of new contributions covering a whole year.

The fund manager's cost of administrating PPM assets should be very low under these circumstances. For this reason, the PPM uses a fee schedule designed to keep asset management costs low for participants, and fund managers must agree to use the fee schedule to participate in the scheme. The way it works is that managers are allowed to charge what they normally charge in the way of administration fees, but will pay a rebate to the PPM if their administration fees exceed a specified amount, determined by a formula. The following table (Palmer 2000) illustrates how the rebate schedule works in practice. Generally speaking, the larger the stock of PPM assets held by the fund, the less it is allowed to charge for administration.

Fund Manager Charges

1. Managers holding less than 70 million SEK in PPM Funds

2. Managers holding 70 to 300 million SEK in PPM Funds

3. Managers holding 300 million to 500 million SEK in PPM Funds

4. Managers holding 500 million to 3000 million SEK in PPM Funds

5. Managers holding 3000 to 7000 million SEK in PPM Funds

6. Managers holding more than 7000 million SEK in PPM Funds

References

Palmer, Edward, 1999. "Exit from the Labor Force for Older Workers: Can the NDC System Help?" The Geneva Papers on Risk and Insurance, Vol. 24(4), Geneva: Blackwell Publishers.

Palmer, Edward, 2000. "The Swedish Pension Reform-Framework and Issues," World Bank Pension Primer, Washington D.C.

Palmer, Edward, 2001a. "The Evolution of Public and Private Insurance in Sweden in the 1990s" in (ed. X. Scheil-Adlung) Building Social Security: The Challenge of Privatization, The International Social Security Association's International Social Security Series, Vol. 6, Transaction Publishers, New Brunswick (USA).

Palmer, Edward, 2001b. "Swedish Pension Reform-How Did It Evolve and What Does It mean for the Future?" in M. Feldstein and H. Siebert (eds.) Coping with the Pension Crisis: Where Does Europe Stand? Chicago: University of Chicago Press (forthcoming).

Settergren, Ole 2001. "The Automatic Balancing Mechanism of the Swedish Pension System- a non-technical introduction," Wirtschaftspolitische Blätter 4/2001.

1. E-mail: Edward.Palmer@rfv.sfa.se

2. The reader interested in learning more about the Swedish pension reform is recommended to visit the administration's web sites at www.pension.nu and www.ppm.nu.