• According to Mercer and CFA Institute’s latest Global Pension Index report, the Netherlands and Sweden rank among the best pension systems in the world (2nd and 8th place, respectively).

• Due to their characteristics, both countries, whose pension systems include funded mechanisms, offer important lessons to the rest of the countries, including the following:

• The Netherlands and Sweden have non-contributory pension programs that provide a minimum support base to avoid poverty in old age, financed by general taxes. Modern pension systems must have such programs, and their design must be carefully thought out to avoid disincentives to formality.

• Having one of the best pension systems in the world, according to an international index, does not avert the need to introduce changes to address demographic, labor, and financial challenges. (Higher life expectancy, reductions in the birth rate, more self-employment, lower interest rate). For example, in its occupational funded system, the Netherlands has had to propose a reform to enable switching from “defined benefit” to “defined contribution,” to guarantee the solvency of the system. Sweden, on the other hand, has had to establish a mechanism for adjusting the retirement age that considers life expectancy increases, through the so-called “target retirement age.”

• A PAYGO system with high contribution rates does not necessarily lead to good results in terms of replacement rates, and this is explained by the fact that this system is affected by population aging (higher life expectancy at retirement and lower birth rates). Sweden is proof that a mostly PAYGO system with notional accounts can have relatively low replacement rates, that are projected to be even lower in the long term, despite having high contribution rates.

• There are at least two alternatives to addressing the solvency problem of pension systems with a significant PAYGO component:

• Reduce the generosity of their benefits and/or introduce stricter requirements to access them. For example, in the Swedish system, in order to achieve fiscal sustainability, pension promises have to be reduced by means of an automatic brake, increasing contributions, or progressively increasing the retirement age, with incentives. This must be seriously considered by other countries that are looking to implement PAYGO systems, starting from an initial situation where the system is fully funded.

• Link the retirement age to life expectancy increases. The Netherlands and Sweden have incorporated this feature into their PAYGO systems.

• Funded occupational pension systems and voluntary savings systems will play an increasingly important role in complementing the pensions granted by the PAYGO system. In the Netherlands, 58% of the total pension comes from occupational systems, whereas in Sweden this percentage is 22%. The reduction in the generosity of PAYGO system pensions, caused by population aging, must be compensated by mandatory occupational and voluntary savings plans, in order to maintain and/or improve workers’ pensions.

To review the full Pensions Note, click here.