NDC is in many ways similar to classical PAYG pension scheme. Working age individuals contribute to the system and pay for the benefits of current retirees. However, NDCs are different when it comes to determining the size of the benefits. For each individual the amount contributed to this system is added to a pot which is appreciated by a rate of return. However, this rate is only notional one – set by the government based on some formula, in reality the money collected from contributions is used to finance current pension benefits. At the end of the contribution period workers receive annuity based on final financial value of their lifetime contributions, their life expectancy and expected interest rate during the remainder of their lifetime in similar way they would in defined contribution scheme.
The most important aspect which distinguishes NDC systems from PAYG systems is the fact that both demographic and economic changes are reflected immediately. When the economy grows at a slower rate, the notional returns decrease and when life expectancy of population goes up it implicitly lowers the size of their annuity. To pay for future liabilities in more difficult times, country must usually maintain a liquidity reserve. Unlike in PAYG pension system, there is no guarantee that the worker can expect decent pension in his retirement, since it is based solely on his contributions and the notional rate of return. For this reason many countries introduced guaranteed minimal pension to their systems. While the reason why most countries introduce NDC pension reform is to improve financial sustainability of their old age retirement systems, NDC pension systems are similar to PAYG systems with regards to the demographic pension crisis. They are financed in the same way via contributions of current working generation and therefore are still heavily influenced by population ageing.
Brief History of NDC Pension Reforms
NDC pension reform was first introduced in 1992 in Sweden to replace previous system based on defined benefits. It was legislated in 1994, but was not implemented until 1999 because of “Time-out” proposed by newly elected Social Democratic Party. Italy implemented the NDC first in 1992 in so-called Amato reform with several parametric changes and calculation of benefits based on life-time income. Later in 1995 full change to NDC system was passed, although smaller changes were done to the pension system up to the year 2012. Both Italy and Sweden had similar motivation to implement the reform. They wanted to reduce their deficits and debt prospects since they were about to enter European Union and eventually European Monetary Union for which they had to fulfill the Maastricht criteria. They differed slightly in the specifics though. Sweden had recalculated the contribution history back to the year 1960 whereas in Italy the changes were applied gradually only affecting the people entering the labor market at first. Latvia introduced the reform in 1995 and implemented it in 1996. It was heavily influenced by Sweden and was also trying to improve financial sustainability. On the other hand, while in Sweden fiscal sustainability was the main objective, Latvia also wanted to motivate population to contribute to the system. It was estimated that about 30-40% of earnings were unreported at the time the reform was proposed. This was expected to decrease since in NDC pension system the pension is based on history of lifetime earnings and is much more heavily influenced by misreporting of one’s income. In Poland NDC pension scheme was introduced in 1996. The country faced serious fiscal challenges with rate of contribution into the pension system having reached 45% of gross wage. The system was implemented in 1999 after long political discussion about its various aspects and was meant as means of both reducing the future pension debt and motivating workers to prolong their careers.
