Sweden operates an expansive retirement income system

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Introduction

Sweden operates an expansive retirement income system that combines both public pension and private pension systems (Tapia 2008, pg 76). Previously the Swedish government operated a public define-benefit pension system. Faced with the increasing cost of an ageing population, Sweden has made significant reforms to ensure the long-term sustainability of its state-run pension system. These reforms represent a gradual transition from the previously state-run defined-benefit system to a defined-contribution and the Swedish invented pay-as-you-go notional defined contribution system. According to Tapia, these legislative reforms were first passed into law in 1994, but took effect in 1999(Tapia 2008, pg 76). Many private schemes have followed the governments by switching from defined-benefit to defined-contributions schemes over the past few years.

The Public Pension Scheme in Sweden

Previously Sweden operated a compulsory defined-benefit pay-as-you-go (PAYG) pension system. Selén and Ståhlberg (2007, pg 1176) stated that "In a pay-as-you-go (PAYG) pension system, the working population pays for today's pensions based on the understanding that the next generation will pay for their pensions". This points to an underlying assumption that contributions in such a system should exceed or at least be equal to the pension obligations of the system in order for it operate successfully. This type of scheme is therefore vulnerable to economic and demographic changes as it assumes inflows in the system will always exceed outflows. In Sweden's case, increases in life expectancy and decreases in the birth rates created a drastic shift in the demographic composition of the population. Over time this shift in demographics caused a severe long-term deficit to accrue as outflows began to consistently exceeded inflows. Temporary shortfalls in a PAYG system are usually covered by Government transfers; long-term deficits require increased contribution rates, usually in the form of increased taxes. Due to Sweden's ageing population, successive generations would be required to pay more in taxes to support the previous generation. In the early 1990's Sweden experienced a deep economic recession that caused the contribution rate to fall by 10 % (Palmer 2000, pg 2). The recession highlighted the fragility of the system causing many to become disillusioned and drove home the need for reform as Sweden's public pension scheme proved clearly unsustainable in the long-run.

The Swedish Reform

After the need for reform became clear to all it was important that the reformed system adequately address the concerns of all participants. The old defined-benefit PAYG system sought to provide adequate retirement support for all retired Swedes. It however was susceptible to demographic and economic shifts. It was also unsustainable and unfair as successive generations faced increased tax rates to support the previous generation. It was therefore necessary to have a set of clearly defined aims and objectives to address these issues. Sweden had four main aims fairness, transparent redistribution, financial stability and the creation of private managed financial retirement savings (Palmer 2000, pg 2-3).

Fairness in any system is very important. The previous system was a defined-benefit system that favoured white-collar workers and persons that had received significant wage increases throughout their career. This was due to the fact that it gave weight to seniority and calculated benefits using the best 15 years of the minimum 30 years required to qualify for a pension. This could potentially have led to persons who made identical contributions thorough out there working live receiving very different amounts. Conversely it was also very important that if a person contributes more he should receive more. Under the reformed Notionally Defined Contributions (NDC) model benefits are based on the contributions made by each individual.

Transparent redistribution is another objective of the new system. Under the new system this is achieved by means of special policies regarding budgetary transfers that ensure the use of funds according to their intended purpose. An example of such a policy is the minimum guarantee benefit designed to protect the lifetime poor (Palmer 2000, pg 2). The minimum guarantee is a notable example, as part of Sweden's welfare policy it tries to ensure that all Swedes have an acceptable standard of living. Funds are allocated from the general budget to cover retired persons who's earning fall below the minimum amount. If a retired person's total pension benefit is not at the minimum guaranteed level, funds are transferred into the system from the allocated funds to bring his/her benefit to this minimum level. Other notable such allocation include disabilities and child-care.

Financial stability was the major goal of the reform. The old defined-benefit public scheme had many faults but its primary fault was its financial instability. In pursuing reform the Swedish government's major goal was to create a system that was able to withstand both demographic and economic shifts. Under the old system it was the future generation that paid the bill for the previous generation, under the NDC system each individuals benefit is defined by his/her contributions thus reflecting an individuals decision on work and retirement (Palmer 2000, pg 3). Concerns about constantly increasing tax rates to support an ageing population were removed ,as the contribution rate made by workers today would be the same as those made by workers in the future under the reformed public pensions system.

The fourth goal pointed out by Palmer (2000, pg 3), was the creation of financial savings managed by private firms. This was a second-pillar in the government pension scheme, which ensures mandatory savings for retirement. Sweden again chose to be very innovative in its design of the second pillar.

Sweden's reformed public pension system comprises an earning-related scheme and a guaranteed minimum pension for people with low income levels (Tapia 2008, pg 76). The earning related scheme which replaces the old define-benefit scheme consists of a compulsory basic scheme combined with a compulsory funded individual saving scheme. The total contribution rate on earnings for the earning-related scheme is 18.5 %. This contribution is split into two parts, with 16% going to the compulsory basic scheme and 2.5% going to the compulsory funded individual saving scheme.

The compulsory basic scheme

In Sweden, "the compulsory basic scheme follows the notional defined contribution (NDC) model" (Tapia, 2008, pg 76). Designed in Sweden the NDC model is an innovative solution to a complex transitional problem. On the surface the NDC Scheme resembled a fully funded individual scheme while effectively remaining a PAYG scheme. Under the Notional Defined Contributions (NDC) Scheme all workers have individual accounts. When a worker contributes to the scheme his notional account is credit based on a defined contribution rate applied to earnings, at present 16% of gross earnings. Accounts in the NDC model do not contain money, but values representing a claim on pension at retirement. At the end of each year the accounts are indexed to the rate of growth of covered earnings, effectively calculating an investment income on funds in the accounts. As the accounts are indexed each year to match growth, it gives equal weight to contributions made in earlier years effectively offering some amount of protection against inflation.

Selén and Ståhlberg (2007, pg 1178) suggested that the use of average wage growth in the indexation of nominal account introduced potential instability. They illustrated this by pointing to the fact that in the event of a decrease in the workforce, growth in benefits and pension rights could outpace the growth of the contributions base from which benefits are paid. Other demographic factors may also influence similar shifts. The Swedish authorities recognised this when creating the framework and added an automatic balancing mechanism to protect against potential instability. The automatic balance mechanism reduces indexation of NDC accounts and outgoing benefits if the system faces a deficit. This automatic adjustment of payouts to stay within the available revenue ensures the Swedish NDC scheme is permanently solvent.

At retirement, funds in an individual's NDC account are converted into an annuity based on the unisex life expectancy of a person of that specific age. The annuities from NDC accounts are paid out from inflows from current workers, thus the system remains effectively a PAYG system. The fact that an individual's benefit is calculated based on that individual's contributions allows the system to mimic a full funded individual defined-contribution scheme. Without the need for advanced funding of accounts, the NDC model allows for the gradual transition from a define-benefit to a defined contribution type scheme.

The compulsory funded individual saving scheme

Sweden's premium pension system forms the compulsory funded individual savings scheme under the reformed model. Funds transferred into the scheme are then credited to individual accounts, where they form a part of an investment portfolio. This investment portfolio is then invested in funds and insurance products that are registered with a special social security agency called the Pensions Premium Authority (PPM). At retirement an individual's account is then converted into an annuity using a similar calculation to that of NDC accounts.

The Premium Pensions Authority (PPM) was specifically created by the Swedish government to act as a clearing house and the sole annuities provider of the public defined-contributions scheme. According to Palmer (2000, pg 33) people are allowed to invest in virtually any fund registered with the PPM but at their own risk. It was therefore important that people be allowed to move money freely without incurring excessive cost in doing so. It was for this reason that the Swedish government decided on the use of a clearing house model. In the Swedish styled clearing house model all the individual transactions on a particular fund are aggregated at the end of the day and transmitted as a net. The transaction price is based on the value of the fund at the time of the transaction. A default fund was also established by the government for persons who decided not select their own investments (Selén and Ståhlberg 2007, pg 1178). It is important to note that there is no guaranteed rate of return on the individual investment accounts unlike the NDC accounts.

The PPM is also responsible for maintenance of individual accounts, transaction history and general record keeping. The PPM aggregates transactions done by individuals on insurance products, funds and shares maintaining a single account for each investment product that is registered with it. It does not pass on any information to the funds or insurance companies. This Palmer (2000, pg 34) pointed out was to prevent solicitation of individuals by funds and insurers providing unnecessary cost to the system. The PPM also collects and makes available information on all participating funds and insurers on a daily basis.

As a part of Sweden's overall social security program the PPM works in partnership with several other branches to carry out specific functions. Palmer went on to list agencies such as the National Tax Authority, the National Debt Office, the National Social Insurance Board and Social Insurance Offices (Palmer 2000, pg 37). In creating their system Sweden aimed for efficiency throughout, by working with these agencies the PPM took advantage of existing facilities and reducing the duplication of efforts thus keeping cost down. The National Social Insurance Board for example does the reporting for both the NDC and individual investment accounts in one annual report. The collection of contributions is centralized under the National Tax Authority.

Similarly to the NDC scheme, benefits can be withdrawn from the age of 61, this is not mandatory as the retirement age in Sweden is flexible. Individuals can choose to claim both the NDC and Individual defined contribution benefits together, but this is not compulsory (Palmer 2000, pg 36). Palmer further stated that individuals have a wider choice of annuities to choose from under the premium pensions system. They can opt for a single life or joint life annuity. They are also able to include a survivor benefit if they choose. Individuals also have the option to claim partial annuities according to law but are again forbidden from taking lump-sum payments similarly to the NDC system. Work and benefit can be combined in any fashion to allow individuals to enhance benefits. It is also important to note that the minimum guarantee cannot be claimed until a person reaches 65. Benefits from annuities are taxable under Swedish law.

Guaranteed Minimum Pension

The guaranteed minimum pension in Sweden is intended for persons who earned little or no pension income before turning 65. It is financed by general taxes, not from contributions made to the Public pension scheme. Persons are entitled to the guarantee after 40 years of residence. It is still possible to claim a benefit with less than 40 years, but it will be reduced by 1/40 for each year under the 40 (Palmer 2000, pg 21). Palmer went on to state for a married pensioner the benefit would also be reduced.

Private Pensions System in Sweden

The private pension system includes both occupational pension scheme and other retirement arrangements (Tapia 2008, pg 76). Almost all employees in Sweden are a part of a private pension scheme. Tapia went on to state that the occupational pension system consists mainly of privately managed schemes formed by national collective agreements between the employers and trade unions. Palmer ( 2000, pg 4) suggested that after the governments reform of the public system, the major occupational-based groups followed suit and converted from defined-benefit to defined-contributions. Under these schemes employees private accounts are credited with contributions between 2-4.5 % of gross earning.

According to the OECD Private Pensions Outlook 2008 the occupational pension system covers approximately 90% of Sweden's labour force (OECD 2009, pg 279). It also went on to suggest that although these schemes are optional, due to the collective bargaining arrangements of the Swedish unions these schemes are effectively mandatory. It also distinguishes between blue-collar and white-collar workers, as these workers would have their negotiations done by separate unions; their typical plans differ from each other. It also suggested that pension plans for blue-collar workers are typically defined-contributions in nature. In the case of white-collar workers their occupational plans would typically be defined-benefit in nature if the employee was born before 1979 and defined-contribution if born after 1979.

Blue-collar Workers

The majority of blue-collar workers in Sweden belong to a SAF-LO plan or are apart of a similar styled plan. The OECD stated that the SAF-LO occupational pension plan was created by a collective agreement between Swedish Employers' Confederation (SAF) and the Swedish Trade Unions' Confederation (LO) (OECD 2009, pg 279). Under the SAF-LO plan employees begin to make contributions at age 25 and end typically at the usual retirement age of 65. It is possible to retire at 55 and receive a pension. It also stated that contribution rates are different for persons over the 7.5 income base amount. Each employee has the option to choose his/her plan provider, typically employee assets under the SAF-LO schemes are managed by insurance companies (Tapia 2008, pg 78). He also went on to state that the SAF-LO plan may be offered by employers that are not included in collective bargaining arrangements voluntarily.

White-collar Workers

For white-collar workers the primary plan is the ITP occupational pension plan (OECD 2009, pg 280). According to the OECD this is a two part scheme, a defined-benefit and a defined-contribution. For employees born after 1979 the scheme is defined-contributions, with employers contributing 4.5% for workers under the 7.5 income base amount and 30% for those over. Contributions to the ITP plan start at age 25 similarly to the SAF-LO plan. OECD continued by stating that for all workers born before 1979 their scheme is mainly a defined benefits scheme based on final earnings, but there are some elements of a defined-contribution. If an employee works for 30 years, at the age of 65 he is entitled to benefits in the form of a life annuity (OECD 2009, pg 280).it further stated that in 2007 adjustments where made to the ITP system, allowing employees to withdraw the entire benefit in a period as short as 5 years.

Other Retirement Arrangements

Under all the mandatory and quasi-mandatory schemes the rate of contributions are set and participants are not allowed to contribute more. If a participant wants to contribute more to his pension he would have to do so privately. In Sweden Banks, Insurance companies and other financial institutions offer such facilities to private customers allowing then to create their own private pensions plans. Tapia (2008, pg 77) noted that these private arrangements are usually defined contributions. Swedish banks provide a specialized type of account for this purpose called an individual pensions savings (IPS) account. At the end of 2007 the OECD (2009, pg 281) reported that there where 1.5 million such accounts at Swedish banks, with managed assets totalling approximately USD 9.5 billion.

Summary

The Swedish Retirement Income system incorporate public and private provisions. Through systematic reform Sweden replaced a faltering system and restored confidence in the state run pension scheme. They succeed in setting up a model that allowed for the smooth transition from a public defined benefit to a notional defined contributions scheme. Almost all Swedes enjoy private pension arrangements as 90% are covered by compulsory occupational schemes. There is also a substantial amount of private savings in pension deferred IPS accounts.

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