Social Security

Notional Defined Contribution Model

Recently I came across a paper by John Williamson describing a Notional Defined Contribution Model as a replacement for state pension system. Countries who have adapted the Notional Defined Contribution (NDC) model include Sweden (1994), Italy (1995), Latvia (1996), the Kyrgyz Republic (1997), Poland (1999), and Mongolia (2000). The model is in essence a pay-as-you-go framework, but benefits are closed linked to contributions. Policymakers hope this will encourage labor force participation.

Individual have an account which details how much money (in taxes) they have paid into the system. This account, however, is entirely virtual in that individuals do not have access to the fund in these accounts. The government chooses a “virtual” rate of return usually based on economic factors such as price inflation (e.g.: in Italy and Latvia) or a mix of wage and price inflation (e.g.: in Poland and Sweden).

Those in favor of this plan claim that since benefits are mostly tied to contributions, this may encourage labor force participation during a person’s working years; on the other hand the NDC model is less redistributive than a guaranteed benefit pension program. There is no financial market risk since the accounts are contemporaneously paid out from the current labor force to current retirees, but there is demographic risk. If a country has few workers and many retirees, the “virtual” rate of return must be lowered to account for this. The NDC plan has lower administrative cost than one in which individuals have access to their accounts because of economies of scale and lower transaction costs, but there is no incentive for individuals to increase their savings.

To me, this plan sounds exactly like the current U.S. Social Security system. Every worker has an account with their Social Security Contributions to date. These funds, however, are not owned by the individual but are paid contemporaneously to retirees. Upon retirement, an individual receives a Social Security pension based on the value in the account. (This is a simplification since Social Security payments are subject to a cap, and the payments also depend on the number of working years).

A more sensible plan is the Chilean system of personal accounts. According to the Cristian Science Monitor, (“In Britain and Chile“):

“The second and main pillar is the obligatory monthly payroll deduction of 12.3 percent. Ten percent goes into the worker’s own account, administered by one of six private pension funds, while 2.3 percent covers administrative fees. Unlike in the US, the payroll tax is funded entirely by the employee. At retirement – age 60 for women, 65 for men – they take out what they put in, plus accumulated gains. Currently 3.6 million Chileans, or 65 percent of the 5.5 million-person workforce, are actively contributing under this system.”

There are a few caveats. The Cato Institute (“Empowering workers“) notes, “This percentage applies only to the first $22,000 of annual income. Therefore, as wages go up with economic growth, the ‘mandatory savings’ content of the pension system goes down.” Also, if an individual works at least twenty years, they are eligible for a state-sponsored minimum pension. Thus, individuals will not be destitute in old-age, even workers with lower wages over their lifetime.

The privatization of a portion of the state pension program was less successful in Britain, however. “Pension sellers, working on commission, frequently coaxed… [workers] into unsuitable products, often overstating the potential for returns.” Still, keeping retirement savings in the hands of individuals will lead to more savings and ensure sufficient funds at retirement for all individuals; especially when paired with a minimum state-provided benefit.