Asian Development Bank, 2012, Pension Systems in East and Southeast Asia: Promoting Fairness and Sustainability edited by Donghyun Park, Asian Development Bank: Philippines.
Gerig, Daniel S., 1960, “Automatic Cost-of-Living Adjustments in Foreign Countries,” Social Security Bulletin, March 1960. Available at: https://www.ssa.gov/policy/docs/ssb/v23n3/v23n3p13.pdf
Gillingham, Robert. 2010, “Meeting the Long-term Challenge of Old-Age Entitlement Spending: What Can We Learn from the Greenspan Commission”, Working Paper 10-25, Mercatus Center, June 2010.
OECD, 2012, “Putting Pensions on Auto-pilot: Automatic adjustment Mechanisms and Financial Sustainability of Retirement-income Systems” in OECD Pensions Outlook 2012, World Bank: Washington DC.
Soto, Mauricio, and Sanjeev Gupta, Forthcoming, “Pension Reform in China: Toward a Sustainable, Equitable, and Portable System”.
Appendix: Selected Country Cases with AAMs
Adjustment of Benefit Levels
In response to chronic cash shortages, both of the confederated entities of the country introduced a strict benefit rationing regime in the 2001. The rules (imposed by the UN-appointed high representative) stipulated that a bracket of the pension benefit roughly corresponding to the subsistence minimum is protected and should enjoy preference when allocating contribution revenue. Remaining pension obligations (corresponding to the benefit portion over and beyond the subsistence minimum) were pro-rated to the remaining revenues. The adjustments were executed on a monthly basis and unpaid pensions were not accounted as arrears. The system, while notionally operational, is cautionary tale in the over-ambitious application of the AAMs and ABMs: instead of subjecting pensioners to volatility in terms of benefit levels, both entity government went to great length to convince enterprises to pay up their contribution arrears which accrued over the preceding years – and then compensated the same enterprises through various tax easement and budget subsidies. Thus, the extremely strict AAM eventually did not help either to increase transparency or sustainability – instead, it forced the government to continue subsidizing public pension funds in an even more nontransparent manner
From 2010, new earnings-related pensions are reduced in line with improvements in life expectancy at retirement. The life expectancy coefficient is calculated at age 62, and is compared to that in 2009. The adjustment is expected to result in benefit reductions of 20 percent by 2050, keeping all other assumptions and policies unchanged. Finland also legislated an increase of the retirement age to 65 – after which further increases will be determined by improvements in life expectancy.
Japan has introduced an AAM in 2004 but has only activated in in 2015. The “macroeconomic indexing” reflects changes in the number of the insured and the average longevity. The indexing allows the pension benefits to be reduced in real terms but pension benefits cannot be cut in nominal terms. If the replacement ratio is projected to drop below 50 percent in the quinquennial re-examination of pension finances, additional reform measures are called for.
Latvia and Poland
Both Latvia and Poland reformed their social security pension schemes along the Swedish example of Notional Defined Contributions (NDC). As described in the body of the paper, NDC schemes, among other adjustment mechanisms linked to the performance of the economy as a whole and reflected in the notional returns credited to individual accounts, also adjust benefit levels to life expectancy at retirement. This mechanism is similar to that applied for commercially underwritten annuities, and is based on statistical life tables as well as the requirement to equate the present value of the expected benefit stream with the value of the notional account at retirement.
Russia replaced its NDC system with a point system as of January 2015. Points are generated by dividing covered earnings with the economy-wide average wage, while point values are calculated along an automatism: by the higher of (a) indexing the previous year’s point value to CPI or (b) dividing Pension Fund revenues (including budget subsidies) by the total points in the system. The similarity to the German system is in applying the same valorization to the point value of new and existing retirees, while a major dissimilarity is that pension fund revenues which automatically drive the indexation of point values include budget subsidies – thus, while establishing the value of points appears to follow an automatism, it can be influenced directly by the government.
The most important AAM in the Swedish NDC system is the annuity divisor which translates (notional) individual balances into monthly benefits on the basis of cohort-specific life expectancies. The mortality information is regularly updated, reflected in the divisor and communicated to members so that they can adjust their retirement decisions accordingly. In addition to the annuity divisor – which is an AAM – the system also has automatic balancing mechanism: every year, the scheme’s balance sheet is compiled and if unfunded liabilities emerge, both the notional returns credited to individual accounts and the rate of benefit indexation is automatically reduced until the funding gap is closed.
In addition to various parametric reforms and the recurring discussion of a structural reform, the US Social Security legislation also includes an AAM. Its trigger is the depletion of the US Social Security Trust Fund: Social Security is prohibited to borrow. Thus, from the time the trust fund is depleted, pension benefits will need to be adjusted downward immediately – according to some estimates by as much as 30 percent – and, in effect, be prorated to contribution revenues. This ultimate – and politically unfathomable – threat was incorporated into the legislation to make sure that it need not be applied and, instead, legislators introduce more gradual adjustments in time. Thus, the strong AAM of the law is expected to trigger a weaker, institutional-procedural AAM
Germany and Spain adjust both benefit levels and the contribution rates (Germany) or retirement ages (Spain) – see below.
Adjustment of Contribution Rates
Canada is one of only two countries (the other being Sweden) with automatic adjustments explicitly triggered by long-term sustainability considerations. Every three years, there is a review of the financial sustainability of the public, earnings-related scheme. The scheme is partially funded – in other words, the reserves are not intended to offset the scheme’s liabilities but to help smoothing the required contribution rate and to provide a buffer when baby boom cohorts retire. Canada is also unique in two more ways: on hand, the variable responding to imbalances is the contribution rate: if the legislated rate is below rate required for the scheme’s sustainability, it is the contribution rate which is expected to adjust. On the other hand, the projected imbalances first trigger a call on provincial ministers to agree on an alternative solution and the contribution rate increase only goes into effect is ministers fail to act. Canada also splits the burden of adjustments, in a manner somewhat similar to Germany: if contribution rate increases are introduced, benefit indexation is also suspended for three years (until the next actuarial study). This provision places even greater pressure on government to find a solution other than contribution rate increases.
Germany’s earnings-related public pension scheme has been operating a point system for over fifty years and has served as the model for other countries. The points earned in a year are the result of dividing the individual’s insurable earnings with the economy-wide average wage. At retirement, the points earned are multiplied by the point value established for the given year. The point value is annually indexed to wage growth but is also adjusted (downward) by a contribution factor (reflecting necessary contribution rate increases) and a sustainability factor, based on improvements in longevity. The index thus arrived at is uniformly applied to new pensions and benefits already in service (functioning as a benefit indexation rule, in effect). The contribution factor is an interesting feature of the system. If contribution rates need to be increased (to maintain the system’s short- to medium-term solvency and to honor the legally established, permanent share of budget subsidies to the scheme), the contribution factor of the formula ensures that the additional financial burden is also shared by pensioners: if contribution rates need to increase, pension benefits must decline, too, in a manner ensuring that 25 percent of the adjustment is borne by pensioners and 75 percent by contributors
Adjusting Retirement Ages and Qualifying Service Time
After the current retirement age increase is completed (at 65 for both men and women) in 2030, the retirement age will continue increasing automatically, at a rate of 2 months per year, in line with projected improvements in life expectancy at retirement.
France has taken a unique approach to tightening eligibility conditions and thereby influencing workers’ retirement decisions. In addition to gradually increasing retirement ages (although not linking it to life expectancy or making it automatic in any other way), the other major eligibility condition – the minimum qualifying service time needed for a full pension – will automatically increase in line with life expectancy. The purpose of this AAM is to keep the ratio of the period of benefit receipt to that of working and contributing constant. In addition, the “cost of a point” and point value factors in the country’s social security point system are established in accordance with time-bound agreements (as opposed to annual re-negotiations). The agreement which expired at the end of 2012, for instance, required upscaling the cost of points in line with wages and the point value in line with prices. Thus, during the applicability of that agreement, the points earned reflected relative contribution performance not only across individuals but from year to year, too.
In addition to various ad-hoc and systematic measures aiming at reducing the social security system’s imbalances, Greece also introduces life expectancy adjusted retirement age increases, commencing in 2021.
Norway introduced two measures, both automatic and both conditioned on changes in life expectancy. On one hand, from 2011 retirement ages are flexible but observe actuarial neutrality – which by definition, implies adjustments to life expectancy at retirement. On the other hand, the normal retirement age, at which pensions can be claimed without either actuarial deductions or increments will be adjusted to life expectancy.
Portugal also introduced an AAM which ensures that new pensions reflect the changes in life expectancy at 65, measured between 2006 and the year of retirement.
In order to address the long-term sustainability issues of its social security system, Spain introduced parametric reforms in 2011: retirement age increases and an extension of the wage histories counting into the pension formula. In addition, Spain also introduced, in 2013, an Automatic Balancing Mechanism. The ABM has three elements: (a) starting from 2019, new benefits will be calculated with life expectancy changes taken into consideration; (b) from 2027 on, indexation of pensions already payment will no longer be linked to prices but to prices and the financial position of the pension system; (c) a lower (-2.25 percent) and upper (+0.5 percent) limit on the sustainability adjustment of pension indexation.
We are grateful for extensive comments and suggestions from A. Corbacho, L. Everaert, C. Rhee and J. Ueda. We also benefited from very helpful suggestions from N. Arnold, D. Benedek, K. Miyachi, J. Pereira, and P. Wingender.
In 1922, Danish pensions were linked to the cost-of-living adjustment for the salaries of government employees. This was repealed in 1927. In 1933, pensions were linked to changes in the national price index (Gerig, 1960).
This is true for contribution ceilings too since insurable incomes (defining the extent of contribution liability) are usually harmonized with (or the same) as pensionable earnings (determining starting pension levels).
In Germany, the link to life expectancy is indirect and happens through the dependency ratio.
Automatic adjustment typically happens through two instruments: notional returns credited to individual accounts which reflect long-term expectations of per capita GDP growth; and adjusting the annuity factor (the operator translating notional retirement balances into periodic benefits) to life expectancy at retirement.
Finland’s 2015 pension reform increases the retirement age to 65, starting in 2017, and links subsequent increases to improvement in life expectancy.
Whether life expectancy improvements lead to adjustments in benefits or retirement ages depends on the nature of the system, too. In NDC schemes, there is statutory retirement age above the earliest permissible age: since retirees accrue a (notional) retirement balance, they are free to choose their age of retirement which will determine the monthly benefits which are commensurate with the given retirement balance. Longer life expectancies, ceteris paribus, will mean lower monthly pensions. In defined benefit schemes, it is monthly pensions which result from the pension formula – thus, it is through retirement age increases that the relationship between total contributions and retirement wealth (the sum of monthly payments) can be maintained.
In Singapore the re-employment age (the age ceiling up to which firms are legally required to offer reemployment) has been increased over time, taking into account increasing life expectancy and people’s ability to work longer. This has enabled older Singaporeans who are able and willing to work beyond the retirement age of 62 to do so. In Singapore and other defined contribution systems, members are also typically given the option to delay the start of their retirement payouts, allowing them to grow their savings further and subsequently receive permanently higher pension payouts.
The existence of the lower and upper limits on contributions makes the system somewhat regressive.
Defined as the ratio of household pension benefits of a new pensioner to the wage of a representative household.
IMF (2016) estimates that Japan’s potential growth will gradually decline from the current 0.5 percent to close to 0 in 2030.
Scenarios A to E assume TFP growth to increase to 1.8 percent in 2023 from the current 0.5 percent, while scenarios F to H to 1.0 percent
Tokuoka (2012) argues that although increasing the pension age and reducing the replacement ratio have a similar impact on the economy, the latter is fairer in terms of intergenerational equality. Kashiwase, Nozaki and Tokuoka (2012) also recommend increasing pension age in line with rising life expectancy as the most attractive reform option for Japan.
The Norwegian Pension Fund Global is not a dedicated pension fund but was created to help addressing, by accumulating savings in a sovereign wealth fund, the consequences of future population aging.
The simulation is based on the 2013 life table compiled by Statistics Korea. We used a simple regression to transform life expectancy at birth in each year to residual life expectancy (RLE) at the age of 60 for the same year. The expected duration of pension is calculated by subtracting retirement age from RLE.
Although it sounds harsh, a scheme of this sort may not necessarily be politically unpalatable because it simply follows an already-agreed phasing-in scheme for the next two decades or so, and then activate a rule that appeals to both equity and sustainability,
2060 is the point at which this gradual adjustment based on this particularly AAM makes the retirement age exceed the one scheduled under the current scheme.
The government also provides pensions to its employees, which are non-contributory. Expenditure is near 0.6 percent of GDP and benefit are roughly as generous as that in the UWR scheme.
The first component provides a 35 percent replacement rate (0.5*35*provincial wage, 0.5*35*career wage). The notional defined contribution could provide up to 24 percent—assuming returns are equal to wage growth (which might be an optimistic assumption, since current rates generally follow the one-year bank deposit rate), an 8 percent contribution would generate a balance of 2.8 the average wage after 35 years, which divided by 139 (the annuity factor currently used) and multiplied by 12 months produces a pension of 24.17.