Sweden´s New FDC Pension Systemby

Edward Palmer

1. Introduction - An Overview of Sweden’s New Pension System

In a series of steps in the 1990s, Sweden converted a two-tier defined benefit scheme dating from 1960 into a combination of notional defined contributi1on (NDC) pay-as-you-go and financial defined contribution (FDC) schemes2 – with a DB guarantee benefit level constituting the floor of the overall system. The reform was first articulated in a paper published by the Working Group on Pension Reform already in 1992, and was legislated in 1994.3

The reform was driven by the intergenerational unfairness deriving from expected large future contribution rate increases needed to maintain the old DB system, intra-generational (distributional) unfairness resulting from the design of the old system and a goal of providing a framework that would promote mandatory financial saving through the pension system. The first goals were achieved by transforming the old DB pay-as-you-go system into the (N)DC framework and by introducing an FDC component into the new system. The goal of creating a mandatory financial saving scheme was achieved by introducing a system with privately managed assets held in individual accounts.

The contribution rate for the two mandatory and universal schemes together is 18.5 % of earnings, with a split of 16/2.5 between the NDC and FDC schemes. Both schemes are based on individual accounts. In the NDC scheme accounts are notional. The rate of return on accounts is based on the average covered wage, and an automatic balance mechanism is employed to keep the system in financial balance. In the financial scheme participants have individual financial accounts and choose their own investment portfolios from a large number of funds. The rate of return on individual accounts is determined by the return on the funds the individual has chosen.

In both the NDC and FDC schemes an annuity is granted at retirement, based on lifetime account values and life expectancy at retirement. The earliest age at which an annuity can be claimed is 61, but the guarantee (financed with general tax revenues)

1 Edward Palmer is Professor of Social Insurance Economics at Uppsala University and Head of the Research Division at the Swedish National Social Insurance Board.2 This paper employs terminology developed and motivated in Góra and Palmer (2003). 3Palmer (2000 and 2001) and Könberg, Palmer and Sundén (2004) provide more detailed descriptions of the reform and the reform process.

cannot be claimed until age 65. People can claim either a whole or a partial annuity from age 61, while continuing to work. If persons continue to work they also continue to pay contributions on new earnings, which results in a new increment to individual accounts, and eventually to their full annuity, when it is claimed. NDC and FDC annuities (and the guarantee top-up) have the same tax status as earnings.

About 90 per cent of the Swedish labor market is also covered by contractual pension arrangements that top up the public pension. These provide a supplement to the mandatory scheme that insures earnings up to a ceiling. As a consequence of the reform of the mandatory public scheme in the direction of defined contribution, three of the four major contractual schemes, which were previously defined benefit (DB) and unfunded were converted into FDC schemes, where the individual chooses his/her investment company and within this framework can also choose among a number of market funds.

On average these schemes entail an additional contribution rate of 3.5 % on earnings, giving an overall contribution rate of 22 % (18.5 + 3.5 %) for most employees. Particularly noteworthy is that the move to FDC schemes for contractual pension arrangements involved conversion from unfunded DB schemes for municipal employees and civil servants and other employees of the state and a quasi-funded scheme for blue-collar workers in the private sector to fully funded FDC schemes. Only privately employed white-collar workers still have a DB top-up scheme.

How did the conversion work in practice? In each insurance group there is a transition rule to move to the FDC scheme. For example, under the rules of the old financial DB scheme for blue-collar workers, participation gave coverage from age 28. Employers could choose from two options in the old scheme. One was to keep book reserves during the accumulation period and transfer the balance owed to an insurance organization – set up specifically to manage the contractual schemes - when the worker retired (at earliest age 58, but usually considerably later). The other was to transfer funds to the insurance organization on a regular basis as reights were accrued. The insurance organization set up to manage this system was owned jointly by the central labor and management organizations. In addition, companies keeping book reserves were required (by agreement) to pay for reinsurance of these with a second company set up just for this purpose.

According to the transition rule, the new FDC top-up scheme for blue-collar workers, which came into effect in 1996, applies fully for all years of coverage from 1996. Hence, persons born 1968, who were 28 in 1996, are fully covered by the new scheme. The age for coverage was also lowered in steps to 21 in 2002. For persons born 1932-1967 an actuarial calculation was made of the amount a participant was entitled to on the basis of coverage prior to 1996 and is transferred from the employer (or the insurance company administering the system) at retirement and constitutes a component of the participant’s total benefit, together with the FDC component.4 The transition for state and municipal sector employees was performed in a similar manner, although in these cases there were no book reserves or actual funds to back up old (non-financial) DB commitments.

As a consequence of the reform of the public contractual pension systems in the 1990s, the overall pension portfolio of around 80 percent of Sweden’s employees consists

4 In addition, contributions going to individual FDC accounts were based on a contribution rate of 1.5 % until the year 2000, when they were increased to 3.5 %.

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of two FDC components with a total contribution rate of 6 % (2.5 + 3.5 %), which tops up the NDC scheme, once again, based on a contribution rate of 16 %. Lastly, it is important to note that the FDC and NDC schemes are pure insurance systems that distribute the participant’s own resources over the individual’s lifetime.5

What happened to social policy in Sweden, then? It still exists, but as a part of the reform, it was separated from the pure insurance systems. The most important example is the guarantee benefit level for low-income pensioners, which is financed with general tax revenues. This tops up the insurance (combined NDC and FDC) benefit if it is below a minimum level. There are also non-contributory credits (for four years of child care beginning with the birth of a child, military conscription and higher education) financed yearly with general tax revenues, and money is transferred to the NDC and FDC schemes to support these credits. As a part of the reform, a separate deduction for pensioners was abolished putting all forms of pension income and earnings on the same tax status. (A more detailed summary of the Swedish reform is provided in Appendix 1.)

Following this general overview of the Swedish reform and a brief history of the reform in the next section, the focus of this paper is on the public, mandatory financial defined contribution (FDC) system with privately managed individual accounts. The paper begins with a brief overview of the reform process and then moves into a more detailed description of the FDC scheme. This is followed by a section that analyzes the administrative costs of the system and thereafter a section discussing public awareness and information. The final section draws conclusions.

2. Brief History of the Reform

5 Note however that there is an explicit interpersonal element of distribution from men to women embodied in the application of a unisex life expectancy factor to compute annuities. Unisex life tables apply also in the occupational contractual-saving plans.

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The ideas of the reform were presented in 1992 for public discussion and legislated in June 1994. The first step in implementation was to set off contributions to start individual financial accounts in 1995. Since details of the legislation of the FDC scheme were still to be determined and the administrative apparatus had to be created, beginning in 1995, contributions were paid into a blocked, interest-bearing account at the National Debt Office.

Sweden has had computerized individual records since the early 1970s. Nevertheless, the systems were dated and did not satisfy the requirements of the new schemes – or for that matter those of a modern administration. In addition much new information had to be created for the NDC scheme, with contributions from 1960 and later being transformed into NDC capital. It took some time to create the IT framework for the account system needed for the new NDC system, which had to await the reformulation of extensive, related legislation and new NDC, guarantee and tax legislation for pensions. In addition, from the outset it had been decided that the same collection and accounting procedures vis á vis employers and the self-employed would be used for both the NDC and FDC schemes. This was seen as a way to reduce the overall cost of collection, while creating unified information and payment procedures for employers. However, in practice this meant that the introduction of the FDC scheme had to await all other legislation and the development of supporting IT for the overall reform.

The technical conversion of old-system accounts from 1960 into NDC accounts was completed in December 1998. At the same time, individual financial accounts were created for the contributions that had been paid since 1995. The first individual account statements were sent out in the spring of 1999, accompanied by an extensive mass medial campaign. Owing to a delay in the development of IT support for fund choices and accounting, the debut for individual fund choices in the financial account scheme was postponed from the early autumn of 1999 to the same time in 2000. Since 1999, individual statements containing both NDC and FDC account information are sent out to all participants in the early spring of each year.

In addition to individual information, the individual statements include personal “forecasts,” assuming individual earnings follow the most recent outcome, 2 % real average wage growth in the future and a real rate of return in the financial market of 6 %. The former is close to the long-run (100 year) rate of growth in productivity and the latter corresponds to a bond and equity fund with real rates of return similar to those experienced over the past half century, with a bond/equity mix of around 40/60. Not surprisingly, in the initial years these assumptions were criticized as being both too optimistic and too pessimistic. On the other hand, the public debate itself helped focus attention on the new system.

The implementation of the new pension system also led to a focus on developing modern information services for participants. People can access information on their own accounts through local social insurance offices, which are a part of the overall administration of social insurance.6 There is also a call center set up specifically for the new financial account scheme. Individual information on the individual’s overall standing in the combined NDC-FDC system can be accessed through a web site using the

6 About 400 persons already employed in the local social insurance offices, where NDC and other social insurance is administered on a daily basis have received special training to administer the new pension system – including providing general information and answering client questions.

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internet, using individual codes. In addition, the individual can use the specific web site for the FDC scheme to check his/her current portfolio status, retrieve standardized information on any fund in the system and for switching funds. Finally, there is also a program that can be accessed at the local insurance offices or via the internet to calculate your own expected pension. The user provides his/her own assumptions about personal earnings growth, non-contributory periods, alternative rates of return, and ages for and degrees of (partial or full) retirement. The latter is especially useful for older participants who want to examine different exit alternatives.

3. The Swedish Mandatory FDC Scheme – Organization and Operation

The goal of Swedish politicians in setting up the financial account component of the Swedish pension reform was to create a system with privately managed individual financial accounts, where the individual him/herself makes his/her own investment decisions within a broad spectrum of alternatives. In addition, the focus in the design of the administration of the individual financial account scheme was on creating a structure that minimizes the overall costs of administration. This section describes and discusses the system that emerged. Since the system has just started up, the costs of administration have been higher in the initial years than they will be once it has been running a few years. This paper also presents and discusses the likely long-term costs of the system. Sweden’s experience in designing options may provide a valuable input into the discussion of reformers in other countries. One of the main themes of this discussion is also that it is important to consider carefully the default options, and that Sweden has more to do in this respect, as will become clear from the discussion in the following sections of this paper.

3.1 The Clearinghouse Model – with the PPM

Typically, when one thinks of the insurance business, one thinks of insurance companies operating in an insurance market, where each company provides the whole package of services surrounding an insurance product. These include the collection of contributions; keeping participant accounts; providing information services; investing participant funds and providing benefits and benefit services. An useful approach is to view the provision of insurance as consisting of the provision of a bundle of services, which can be broken up and repackaged in a number of ways.

The model chosen for the Swedish reform unbundles the services of traditional insurance companies in an attempt to minimize costs and provide a high degree of freedom of investment choice. This section provides an overview of how the overall functions of insurance provision in the new public mandatory scheme have been organized.

To achieve these goals, a new public agency, the PPM (Prempensionsmyndigheten) – or Premium Pension Authority in English was established within the social insurance administration to administer the mandatory financial account

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scheme. The PPM is the clearinghouse for fund transactions, keeps individual accounts, collects and provides (daily) information on participating funds, provides information services to participants and is the monopoly annuity provider.

The Swedish clearinghouse does not collect contributions from employers, but utilizes the already existing contribution-collection infrastructure of the Swedish National Tax Authority for this purpose. This authority has tax accounts for all employers, the self-employed and all individuals in Sweden, and was already responsible for the collection of contributions for the old Swedish pension system prior to the reform. This organizational procedure has the advantage for employers that the same accounts (income definitions, audit procedures, etc.) are used for all taxes and contributions, and that there is only one audit. The tax authority also covers all public interests in judicial proceedings. Of course in another institutional environment, the clearinghouse could also include the contribution collection service. In the Swedish institutional environment this would have added a new function where the same function already existed, which would not have made sense.

The following points summarize how the Swedish financial account system is organized:

Contributions for the financial account scheme are collected together with all other social insurance contributions (and taxes in general) - by the National Tax Authority. Employers pay contributions on a monthly basis but are required to provide individual information only on a yearly basis – in spite of the fact that monthly information is required anyway to compute monthly their contribution payments.

Information on payments is collected by the Tax Authority and transferred yearly on an individual basis to the National Social Insurance Board (NSIB), which also keeps all the social insurance accounts. Money from new contributions is transferred through the National Debt Office, which administers all the financial transactions of the Swedish State. Bank transfers are made to the custodian banks of the participating funds, following the receipt of an order from the PPM.

New contributions are held on a blocked account at the National Debt Office for about 18 months, which reflects the fact that the exact value of contributions owed is not known (in principle) until after the income statements of individuals and employers have been processed by the tax authority. During this time accounts earn a bond rate of return. Note that since monthly information is available from employers (it is used to calculate monthly payments to the tax authority) it would be possible for Sweden to move into a monthly payment system, if this were the only consideration. However, since coverage is mandatory for all income, including income of self-employment, ton date the current opinion is that it is administratively easier to await the total income picture for all individuals provided by their individual income tax statements – and the information supporting these.

Fund investment services and account keeping. The PPM is the clearinghouse for all fund transactions, keeps individual accounts and provides client information

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services. Fund shares purchased with new payments of contributions, choices for new entrants and general requests from participants already in the system to buy and sell fund shares are grouped together and executed jointly on each transaction day by the PPM.

Private versus public ownership and contracts. The PPM is a publicly owned monopoly provider of services. A fund manager’s client is the PPM, not the individual worker. In principle, there are two options in setting up a mandatory financial account scheme, one is to allow individuals to have contracts directly with the funds, the other is that made by Swedish reformers. In the latter the contract is between the clearinghouse and the private fund companies. The contracts in the Swedish system are between the public monopoly, the PPM, and the individual funds. The fund managers’ function in the system is restricted solely to investing funds.

The clearinghouse could also be owned and operated privately. For example, within the framework set up in many countries, e.g. Bulgaria, Chile and Hungary, the clearinghouse could be owned jointly by the participating funds or insurance companies. Alternatively, it could be set up exactly as in Sweden, but owned and operated privately. This would make the clearinghouse a private monopoly. However, it is not clear that a private monopoly clearinghouse would have any cost advantages over creating a public monopoly.7

Participating Fund Managers. The main requirement for inclusion in the system is that the fund company is registered in Sweden, and is thereby subject to the rules, regulations and auditing procedures of the Swedish Financial Supervisory Agency. To participate in the PPM system, fund managers must also draw up a contract with the PPM. The conditions of the contract require the fund to report fund values to the PPM electronically and on a daily basis. This enables the PPM to execute trading orders daily on an electronic basis, keep individual accounts of participant fund shares, compute new individual account values on all trading days and provide current fund-value information upon request to participants.

The PPM is the sole provider of annuity products. The possible products are specified in the law regulating the PPM system. Accordingly, participants can choose between single and joint life annuities. Annuities can be fixed or variable rate annuities. (Lump-sum payments or phased withdrawals over shorter periods than a life are not among the available alternatives.) A fixed annuity is “purchased” from the PPM and entails moving fund assets to the PPM. The PPM is then responsible for investing the funds. Alternatively, the participant can leave his/her money in market funds and accept a recalculated annuity on an annual basis. This is the variable rate annuity. A participant choosing this alternative will have his/her annuity recalculated each year based on the amount of money remaining on his/her account and life expectancy for his/her birth cohort at that

7 The one advantage it might have would derive from the private sector’s freedom to offer employees market salaries, which would make it easier to compete for skilled employees. In many European countries, including Sweden, it is possible to pay competitieve (though not excessively high) wages even for public sector employees, in which case this no longer becomes an issue.

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year.8 Annuities are calculated using unisex life expectancy tables (as in the mandatory pay-as-you-go NDC scheme), which is in line with an EU court decision regarding public pension schemes. The first persons who could claim a benefit in the new system were persons born 1938 and they could do this first in 2001. On June 30, 2004 there were about 120 000 pensioners. Of these, 92 % had chosen an individual benefit and 8 % a joint life-benefit. The system’s annuity products are discussed below in a separate section.

Financial supervision. The Financial Supervisory Agency regulates and supervises the activities of the funds and the PPM as a part of its normal operations. The choice to use this already existing financial supervisory institution was clear for Sweden, just as it was clear that the existing tax and contribution collection process should be used even for the mandatory PPM system. In principle, this should be less expensive than setting up a separate institution. The logic of this choice is supported in the otherwise scant literature on this topic (e.g. Taylor and Flemming 1999).

3.2 Insurance Products

The Swedish system makes use of the possibility to separate the function of fund management during the accumulation period from the function of insurance product provision. The permissible insurance products are regulated in law There are several issues and policy options left to Sweden, however, and these are discussed here.

One of the first major decisions that had to be made was whether to invite private insurance companies into the setting to compete with annuity provision or to create an annuity monopoly provider. Of course, the insurance industry favored the former alternative and had the opportunity to present arguments favoring it, both through a representative in the expert committee set up to discuss the options for the financial account scheme, but also in the public debate on the actual proposal. Given the rapid trend towards increasing de-regulation of the financial market from the mid-1980s, both in Sweden but also in Europe in general, and the flora of new financial institutions and products that had come by the mid-1990s when the final legislation was agreed upon, it would have been logical to allow individuals to choose annuity providers freely in the market. In addition, given the political decision to allow all funds operating in Sweden to compete for the management of PPM funds, this would have provided a similar alternative on the annuity side.

The political decision was nevertheless to create a monopoly provider of the products. Why was this? This decision was driven by the principle that in the mandatory scheme there should be a life annuity and that everyone should be required to have this product. Instead, possible occupational and individual variation would be left to the occupational schemes and individual insurance contracts that all individuals are free to enter into privately. Given the political decision to restrict the choice of insurance products, available insurance companies could only compete on the cost and investment side, but not the product side.

8 This form of annuity is discussed in more detail the the following section, which is devoted to annuities.

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There is another important consideration that is easily overlooked, however. Splitting up the nascent insurance collective in a relatively small country like Sweden – birth cohorts are on average around 100 000 persons - among a large number of competing annuity providers would decrease the size of the risk pool for any single provider. Even if they knew the characteristics of their own clients and could risk differentiate, this is not permitted by law. This also comes into conflict with the principles of a mandatory scheme to keep the elderly out of poverty and provide adequate (mandatory) benefits for the normal career worker. Of course, the latter also serves to keep the normal myopic worker out of poverty.

In addition, in the initial decade or so the actual volume of money in the insurance business is very small since the older participants only have a few years in the system. In addition, since companies would not know – and are not supposed to know - the profiles of their own clients in principle all companies should offer a product that can only differ in terms of their investment portfolio success and cost profile. Assuming that portfolios and unit costs would tend to be similar, the main differences would be in marginal costs – which would depend on volume of business alone – and on the specific de facto risk profile of company specific clients. For the latter reason, companies would have to be very cautious so as not to provide overly generous annuity products that could eventually lead to losses, and to the extent that companies do this it would come at the expense of lower lifetime annuities for clients.

The country collective associated with creating a monopoly provider - the PPM - creates a larger pool of clients and at least, in principle, should allow for slightly better benefits. In the long run it is still conceivable that the management of annuity products could be turned over to a(several) private company(ies) – using a bidding process. The question then arises as to whether clients should be allowed to take their accounts to competing annuity providers once they have entered the annuity phase of their lives. This would seem to be the only way to allow them to take advantage of companies that successfully compete with better yields and/or costs. This may never prove to be cost efficient, however, and is subject to the criticism that in the long run all competing companies may have about the same returns anyway and that the only differences would be on a short-term yearly basis. It is not clear that clients should be encouraged or allowed to change on the basis of these short-term fluctuations, and switching itself creates administrate costs that the client would have to bear.

The overall Swedish mandatory system is designed to promote a gradual exit from the labor force, with flexible use of the mandatory pension system. It is possible for individuals to claim a partial or full annuity and either leave or remain in the labor force. The PPM pension component can be claimed at the same time as or at a separate time from the NDC component, and in either case, a minimum guarantee top-up for low income pensioners will not be effective until the age of 65.9 As the overall mandatory pension system is set up in Sweden, then, the scheme allows considerable freedom for 9 Recall that the guarantee top-up covers the overall NDC-FDC public system. In principle, one could argue, it should also have weighed against the top-up occupational pensions. This was the intention of the Working Group on Pensions responsible for the reform but the idea was met with vociferous opposition from organized labor, which made it impossible for the Social Democratic Party to support the idea. The option of creating a guarantee within the financial account scheme, as is common in the Latin American and some new schemes in Eastern and Central Europe, was an option considered, but did not have any strong proponents among either the experts or the politicians working on the Swedish reform.

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combining work and pension options to provide income during a gradually exit from the labor force after age 61. The normal age of exit with an old age pension is 65 in Sweden, and if one takes exit with a disability benefit into account, age 63. The goal of policy now is to encourage people who can to remain in the labor force to the age of 67-70. Here it is important to note that all pension income is now treated equally with earnings – which was another component of the overall reform legislation.

If the participant continues to work while collecting his or her pension, then contributions on earnings continue to be paid into the individual account and the amount of the annuity will be recalculated at a later date. In practice, and thanks to the defined contribution foundation, this scheme requires limited actuarial services – with adequate IT support - and these are easily provided in-house by the PPM, the latter as a part of the PPM accounting system.10 This is readily dealt with through the central clearinghouse IT system, but would create extra administration in an environment with several insurance providers.

In the discussion preceding the legislation, one of the major decisions that had to be made was whether the funds in the PPM system should be regarded as being in the private or public domain for legal purposes. In the first case, in principle, the system could have been designed to permit participants to designate heirs to their funds. In the latter case, which was the option chosen by Sweden, inheritance gains left by the deceased would be distributed within the collective of surviving participants. However, it would be possible to “purchase” a pre-retirement survivor benefit for a spouse, and/or a joint annuity from retirement. Swedish politicians chose the latter, based on the criterion that it is more in line with the principles underlying a mandatory public scheme, that is, that the money left by the deceased should be shared within the overall collective of survivors.

The issue of survivors prior to the annuity claim (or some specific age specified by contract or law) creates other issues. Sweden allows clients to purchase a survivor benefit during the accumulation phase, which at first glance appears to be a reasonable thing to do. In practice this turns out to create a problem. The choice is voluntary and the question immediately arises as to whether those (few) who choose this option do so because they have information about themselves that the insurance provider does not have. It is not possible to require health declarations within the PPM system, adverse selection can be a real problem, and the insurance provider can only know ex post whether this was the case. Because of this, the actuaries have set a high price on the purchase of this product, which is to the disadvantage of “normal” survivors. Most are agreed that it would have been better to have left this product outside the public scheme - to the private market.

Generally speaking, in setting up a mandatory public scheme it is important to consider the default options carefully. The default option chosen was a single life annuity, rather than a joint-life annuity. The change from a two to a single person household upon the death of a spouse requires more income per capita than a two person household does – among other things due to a number of consumption outlays that a family needs only one of instead of two. For these reasons alone it makes sense to specify the joint annuity as the default. In practice, a joint life annuity is a preferable default alternative because it provides better coverage for women, as has been argued by

10 Accounts can easily be convertedn into annuities and reconverted into accounts any number of times.

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Diamond (2002). In Sweden, as elsewhere, women are the likely survivors,11 although the advantage of a joint annuity would also benefit male surviving spouses. This conclusion is supported by the fact that individuals are not well informed about their options and can easily make a choice – here the choice not to have a joint annuity - that is the worst of two options for them.12

There are other issues regarding annuities in the mandatory setting. The most important issue – which can be regarded as being unresolved in the present Swedish legislation – is the management of funds during the annuity phase. The funds of retired participants could be managed by private fund managers rather than the PPM. What’s more, given the initial political goal of all political parties in the agreement to the reform to privatize all fund management, the fact that the PPM is left to manage what soon will be very substantial funds for retirees appears to be a clear flaw in the design of the overall system.

Today the volume of money managed is small and for those retiring now financial accounts constitute an insignificant portion of their overall pension. In the near future it makes little difference for the pensioner whether more conscious fund management could give a better return. However, soon this will no longer be the case. Something will have to be done about this in the future, however. With an average real rate of return on financial accounts of 5 % and an NDC real rate of return of 2 %, with retirement at age 65, around 25 percent of an individual’s life benefit in Sweden will be determined by the PPM system.13

With such a large volume of business, there is considerable room for replacing the present government bond with a fund with both equities and bonds, and, further, for creating more than one annuity investment fund manager. It would make sense to let private funds, after a bidding process based on performance quality criteria, manage this soon-to-be-large amount of money – which will continue to increase for about 40 years. - Note that the fund(s) will never have to liquidate its (their) assets, but rather will experience only normally gradual (and predictable) demographic fluctuations on the surface of a large stock of money.

There are other aspects of annuity provision that need to be revisited. Unisex life expectancy at 65 is presently over 15 years, and is projected to be around 20 years for a person born 1975. This suggests that a product (or products) could be developed that is (are) somewhere in between the option of a fixed rate contract at retirement and a variable rate product that people with no time limit. The present Swedish variable-rate product embodies a disadvantage similar to that inherent in a phased withdrawal. The problem with a phased withdrawal is that it specifies a fixed number of years for payment – leaving the participant with the risk of being uncovered in extreme old age. By choosing the variable rate annuity in the Swedish system, the participant is allowed to choose to continue to expose him/herself to the financial market risk until death, with the possibility of a dwindling and miniscule annuity resulting from one or more bad market years – of which there are many historical examples.

11 In Sweden they are expected to outlive their husbands by about seven years, since they are on average two years younger than their spouses and live almost five years longer.

12 The reason why Sweden chose the single annuity as the default option is that there is a strong political consensus in Sweden that men and women should be treated as individuals, with individual rights in all the public insurance systems, and as a consequence the single annuity should be the option.13 Based on figues presented in Palmer (2001).

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This suggests that a possible default for a retiree desiring a variable rate annuity – given the present Swedish legislative framework - could be a kind of “generation fund” for, for example, persons 65+ in the framework, with a gradual shift of fund shares from a fund with potentially greater short-term volatility to shares with potentially less volatility. This would more or less provide the same function as requiring the older participant to recontract for a fixed annuity. There are many possible candidates for the annuity products, but the greater the choice realm that is offered, the farther away from the basic principle of security in old age one wanders. Finally, if one were to retaining the “privilege” to invest freely, means testing would be a way to determine whether a participant has ample means. However, the fact that a person has ample means at present (while usually living with a spouse) is no guarantee that he/she will have ample means in 10-20 years’ time – and also runs against the grain of social security.

3.3 Fund Participation in the PPM System

All companies licensed to operate in Sweden and/or the European Union, are allowed to participate in the PPM system. Fund managers are required to follow the rules and regulations set out by the Swedish Financial Supervisory Agency (FSA). To be in the PPM system fund providers must conclude an agreement with the PPM In addition to the requirements of the FSA, signing the agreement means agreeing to provide information to the PPM upon request, agreeing not to charge withdrawal fees and to provide a periodic report of administration costs charged. Companies are required to compute fund share values and report them electronically to the PPM on a daily basis. A company registered to do business in the PPM system can provide one or more funds. In September 2004 about 75 domestic and foreign companies managing about 650 funds were registered to operate in the PPM system

Part of the agreement concluded with the PPM includes accepting a system of rebates established by the PPM (and to be discussed in greater depth below). What this means in practice is that the fund can levy its normal charge minus a a rebate that depends on the balance of PPM assets held. Since there are economies of scale in large holdings of PPM assets, the size of the rebate increases and the allowable administration charge thus decreases with the scale of PPM assets managed by the fund. The exact construction of the rebate is discussed in a separate section below.

The PPM invests assets on behalf of participants, and is the sole client for any given fund. The PPM is the legal representative of all clients vis á vis the funds. The participants can choose up to five funds, and carry the costs of their individual fund choices themselves. This means that the total price paid for all fund services together is determined by the weighted average of individual choices, and not directly by the PPM – although the PPM is nevertheless involved through the setting of the rebate schedule, which is a partial determinant of a particular fund’s price to the client. Table 1 provides an overview of asset categories chosen by participants through their choice of funds, and the share of total assets held in these. In interpreting the table it is important to recall that non-choosers have only one fund whereas choosers have over three funds per person.

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Table 1. Number of funds held by participants and total assets, September 2004  Number of funds

chosenAssets, Millions of SEK

1. Equity Funds 8 292 60 9592. Mixed Equity-Bond Funds 553 4 9363. Generation Funds 1 099 14 4034. Bond Funds 418 3 5025. Non-chooser Fund 2 265* 38 611Total 12 628 120 471     *Number of participants.

As Table 1 shows, to date about half of the individual accounts invested through the PPM system have ended up in equities – disregarding the non-chooser fund. The non-chooser fund has about one third of all assets, however, and with a portfolio with about 80 equities. Taking this into consideration, over 75 % of all funds in the system are in equities, including the money in the mixed equity-bond funds. Also, the table illustrates that those who have made a choice have for the most part chosen equity funds, and generally more than one.

The PPM provides information on fund profiles, history of returns during the past five years, and measures of risk and cost. In principle, the participants in the PPM scheme, if anyone, perform the role of the optimizing purchaser. Participants make decisions given the cost of listed funds (net of the PPM rebate) and fund returns, with the other funds as a benchmark. The names of the majority of funds indicate the profile of their portfolios. For example in September 2004, there were 31 global equity funds, 21 US equity funds, about 50 Asian portfolio funds, including country specific index funds for Japan, China and India.

Since information on daily returns for all PPM funds together is listed by major newspapers, is available along with other stock market information on bank monitors and is available from several internet sources and the PPM. Hence, the holder of, for example, one of the over 30 global equity funds can compare returns on a daily basis. Individual clients of a given fund bear the price of services charged by this fund, which is why one can claim that the clients perform the function of the optimizing purchaser.

It is probably safe to say, however, that most participants are not capable of consciously functioning as optimizing purchasers, and generally are unaware of how to do it, which is verified by client surveys (see the separate section below). It is probably safe to say that most clients determine the risk exposure they want to take first and then look for a fund with a high return relative to similar funds, but paying little attention to the price they pay for investment services. As the system works today, funds with the highest returns compared to relevant alternatives tend to attract relatively more clients, while the PPM rebate system drives down the allowable price for services as funds grow in volume. This mechanism steers clients into high return funds, while forcing down prices charged by these funds , thereby created a sort of pseudo optimizing behavior, given participant risk and portfolio choice preferences.

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A main criticism of the PPM system from the very outset has been that the choice set is too large. An model that could be used to reduce the number of funds to a more manageable number would be for the PPM to act as the optimizing purchaser at a first stage by determining which funds are allowed to enter into the system. As an optimizing purchaser, the PPM would adjust its schedule of purchasing prices with respect to quality of service. Following Goodwin (1998) fund management quality/performance could be measured with three statistics: the average difference in return with some benchmark chosen by the monopoly purchaser, the standard deviation of the difference in return with that benchmark, and the correlation between the benchmark return and the difference in return with the benchmark. The PPM would choose suppliers on the basis of commission minus this composite measure of quality. In practice, some suppliers may achieve large economies of scale by offering a standardized services (e.g. index funds), but their quality/performance value would be low. Other suppliers would offer high quality/performance that compensates for their higher commissions.

All new entrants from the beginning and thereafter have had and have the option not to make a fund choice, as has already been mentioned. To accommodate this group of participants, a publicly managed fund for non-choosers was among the funds in the system from the outset. The PPM performs the optimizing purchaser’s functions of adjusting by quality, for the non-choosers fund, and has set a low price for this fund. In December 2000, the first year in which people could choose funds, about 67 % of total assets were allocated to private market funds and 33 % to the publicly managed fund for non-choosers. The distribution has stayed close to this since then. Participants can choose up to five funds at a time with any distribution between these. Participants can switch funds at any time, and the cost of switching is born by the PPM (i.e. all participants together). In 2003 the about 5.3 million participants made about 360 000 fund switches. There is no restriction on fund choices, which means that it is possible to put all of one’s money into one sort of fund, for example, a country index fund (e.g. Sweden, Russia, China, Japan, India, the UK, the US), into a branch fund (e.g. IT, pharmaceuticals) or a bond index fund. The PPM information in brochures on how to think about making the choice, depending on the client’s age, a test designed to reveal how much risk one is willing to take, etc., but there are no restrictions. To date, there is no good study of how people diversify there risks, but it is probably safe to say that people know little about how to do this, in spite of the general information readily available from the PPM.

Finally, experiences, such as the 401(k) plans in the US that suggests that even in the “simple” 401(k) world of choice it is difficult for participants to know what to do, and in fact the evidence shows that too many make mistakes. Well thought out default options are necessary to steer participant decisions in the right direction. Munnell and Sundén (2004) summarize their study of participant behavior in 401(k) plans as follows: “The evidence indicates that, at every step along the way, a significant fraction of participants make serious mistakes (p 182).

Summing up, as it stands, the system is too open, and it is quite possible for individuals to gamble their money away – for example simply by choosing a single fund and not watching its performance for many years. This has been the major criticism of the PPM system since its conception. A way forward for the PPM system would be to let the PPM perform the role of the optimizing purchaser to eliminate the number of funds

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available for choice – dramatically compared with today’s choice set. In a second step, well thought out default options should be set. A stronger restriction would be to establish requirements on the maximum amount of allowable risk in an individual portfolio, given standard risk statistics, while allowing people to determine the composition of this portfolio, given this restriction. In principle, the default – or alternatively rule - could even include generation restrictions that allow a greater equity content for younger participants, but still allow a reasonable level of equity holdings up to an age after which most have retired. This could be set perhaps ten or so years prior to the expected end of the payout period – not the least since people are encouraged to work well past the age of 65 in the scenario of the future.

3.4 The PPM Fee Schedule for - Rebates

Since the PPM is the sole client of any fund, there is at most one net buy or sell situation per trading day. The PPM aggregates all individual switch orders and orders deriving from new money flowing into the system into a single transaction vis á vis a specific fund. As a result, individual funds do not have accounting costs for individual participants. Neither do they have recruitment costs for individual participants, since they do not have individual customers and the most relevant advertising is the information on fund returns. This is available daily in the major newspapers, on the websites of these major newspapers, and over the internet from the PPM website.

Generally speaking, there is little direct advertising by fund companies in conjunction with the PPM system, although advertising was substantial prior to the first choice in 2000. Especially the well-known Swedish companies spent considerable sums of money on advertising prior to the first choice. There are other ways of recruiting clients, however, the most important is perhaps through union affiliation, associated with the occupational schemes. This is why many of the largest PPM funds have some form of historical union connection through the occupational schemes. However, as will become clear below, with the exception of the non-chooser fund, a “large“ PPM fund nevertheless only holds 2-3 % of total PPM assets.

Table 2 shows the distribution of total assets in the PPM system at the end of December 2003 by gross fee category, that is, prior to the rebate. The fees represent what the funds charge individual participants who subscribe to them outside the PPM system, on an individual market determined basis. Of the 606 funds registered in the PPM system at the time, 2 percent charged less than 0.25 percent on assets with no PPM rebate and 50 charged 0.25-0.49 percent with no rebate. As many as 95 funds charged a half to three quarters percent with no rebate. This group includes the non-chooser fund, which charges, would like to charge 0.50 %, but is forced to lower this price to 0.15 % due to the rebate (see below) in accordance with the PPM fee schedule. We can note here that the price for all PPM fund investment services was 0.41 % in 2003, net of rebates. As will be discussed in a separate section, this price can be expected to decline considerably in the near future.

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Table 23. Gross (pre-rebate) prices for services distributed by category

Cost category No. of funds % of total assets- 0.24 % 6 2,12%0.25-0.49 % 50 23,90%0.5-0.74 % 95 44,45%0.75-0.99 % 38 1,18%1-1.24 % 35 0,91%1.25-1.49 % 82 13,13%1.5-1.74 % 118 9,61%1.75 % - 182 4,99%

606 100%Source. The PPM.

As PPM money increases in any fund, the marginal cost of managing the money falls. Following this logic, the PPM designed a fee schedule for participating funds based on the amount of PPM assets they hold. The aim of the fee schedule is to keep asset management costs low for participants, and fund managers must agree to use the fee schedule to participate in the scheme.

The way fee schedule works is that managers are allowed to charge the fees they normally charge individual participants but are required to pay a rebate to the PPM (which is accredited the account of the participant) if their administration fees exceed a specified amount, given the overall scale of the PPM accounts they manage. The rebate is determined by a formula, which has been used to construct Table A in the Appendix. The Table is designed to illustrate how the rebate schedule works in practice. Generally speaking, the larger the stock of PPM assets held by each fund manager, the less it is allowed to charge for administration.

An alternative construction would be to use the (lower) reference fee that the funds usually charge institutional clients. This would work for some (particularly many of the foreign based funds) but not all funds. It’s probably safe to say that most of the funds responsible for large shares of PPM clients are funds available within unit-link insurance schemes in Swedish private insurance companies or cash balance schemes normally available only to individual clients.

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3.5 An Overview of the Largest PPM Funds

Table 3 provides a list of the 20 largest funds in the PPM system, showing their relative share of total PPM assets, their average returns in 2003, their administrative cost and whether they are domestic or foreign based. By and far the largest fund in the system is the fund for non-choosers, which held 31.8 % of total assets at the end of December 2003. The next 19 largest funds held about the same percentage of total assets all together, that is 32.1 %. In this way the top 20 funds held 64 percent of total assets and the remaining approximately 580 funds held the remaining 36 % of total assets.

The table also shows the gross and net costs after rebates charged by these funds. By far the highest charges are for the Russian Fund (HQ Rysslandsfond), both before and after the rebate. In 2003 this fund had also by far the highest rate of return. The Swedish index funds were next best with returns of over 30 %. The two funds that performed poorly in 2003 were both medical/pharmaceutical funds.

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Table 4. Overview of the 20 largest funds participating in the PPM system. December 2003

Fund name

Share in total PPM

assets

Return on

assets 2003

Gross admin charge

Net admin charge

(estimated)

Domestic (S)or foreign (U)

Non-chooser fund (Premiesparfonden) 31,8% 18,7% 0,50% 0,15% SAMF Pensions Aktiefond Världen 3,2% 21,5% 0,40% 0,27% SRoburs Aktiefond Pension 2,8% 19,8% 0,42% 0,28% SAMF Pensions Aktiefond Sverige 2,8% 30,8% 0,40% 0,28% SDidner & Gerge Aktiefond 2,7% 33,4% 1,25% 0,36% SRoburs Aktiefond Contura 2,7% 17,9% 1,44% 0,39% SSPP Generation 50-tal 2,4% 13,5% 0,42% 0,28% SSPP Generation 60-tal 2,3% 17,2% 0,42% 0,28% SRoburs Aktiefond Medica 1,6% 0,9% 1,44% 0,44% SAMF Pensions Balansfond 1,5% 14,7% 0,40% 0,29% SSPP Generation 40-tal 1,4% 7,8% 0,42% 0,30% SCarnegie Fund Medical subfund 1,2% 16,1% 1,70% 0,52% UFolksam LO Sverige 1,1% 31,3% 0,40% 0,30% SSPP Generation 70-tal 1,1% 19,3% 0,42% 0,31% SFolksam LO Världen 1,1% 8,7% 0,40% 0,30% SPremievalsfonden 1,0% 19,6% 0,50% 0,33% SHQ Rysslandsfond 1,0% 52,6% 2,50% 0,73% SSEB Läkemedelsfond 0,8% -1,6% 1,50% 0,58% SCarnegie Fund Worldwide subfund 0,8% 6,8% 1,60% 0,62% USPP Aktieindexfond Sverige 0,7% 31,0% 0,23% 0,23% S

Source. The PPM.

Finally, it is important to say that the Swedish FDC system was implemented more-or-less as the IT stock market bubble burst in 2001-2002. As a result, account values in the PPM system lost about 40 % in value during the first little over two years of operation. Some of this loss was recaptured in 2003 with an average return of around 19 %, and the upward trend has continued in 2004. The above list contains four index funds for Sweden, all of which earned a little over 30 %. Compared with this, the non-chooser fund, which is a mixed equity-bond fund, performed relatively well, with a return of a little under 20 %.

3.6 Cost of Administration

Because the PPM system is just starting up, the costs of administration are relatively high compared with what they can be expected as the system matures. There are two reasons for this. The first is the obvious fact that the scale of accounts is much smaller in the initial years of any system just starting up, whereas there are substantial fixed costs for

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investments in IT technology and staff.14 Systems of this type reach maturity first when they include a representative life of all workers and pensioners – which takes around 60 years. When this occurs the average duration of money on accounts can be expected to be about 32 years given today’s participation patterns, income distribution and mortality rates.15

A second reason why accounts are small on average is has to do with the transition rules of the Swedish reform. Cohorts born 1938-1953 contribute only a part of the 2.5 % contribution rate due to the PPM scheme. Persons born 1938 have 4/20 of their overall pension from the new system and 16/20 from the old system; persons born 1939 have the proportions 5/20 and 15/20; etc. Thus, a person born 1944 is half in the new system and half in the old system, with a de facto contribution rate of 1.25% to the FDC scheme, and a person born 1938 contributed only with a contribution rate of 0.5 % (4/20 times 2.5 %) – and for a very few years. Although this leads to extremely low account values for older cohorts, Swedish politicians nevertheless wanted them to participate, even in this limited way, in order to stress the universal nature of the system. These transition rules will nevertheless hold down the average size of accounts for decades.

The costs for operating the PPM system are comprised of:

(1) The PPM’s total costs of operation. These include

a) Daily transactions with on average 650 funds, providing information to almost 6 million participants in 2005 and over 7 million participants by 2020. b) Provision of printed information and verbal information to participants upon request through a call center.c) Maintenance of the PPM website with daily updates.d) An individual accounting system with daily accounts. d) In-house IT support for and development of IT systems.e) Cost of general management

(2) Reimbursements to the National Social Insurance Board for

a) Individual account information on contributions transferred into the system from the Tax Authority, which collects information from employers and keeps its own individual and employer accounts.b) Partial financing of the individual statement sent jointly for the NDC and FDC schemes on a yearly basis, with individual account information and forecasts under two sets of assumptions and general information about the overall system.c) Partial financing of local insurance office personal who can also provide system information to participants upon request, and National Social Insurance Board personal costs related to the PPM scheme.

14 An idea that could be considered would be to solicit and sell services to other systems. In the outset, however, the PPM had its hands full just starting up operations, and in fact, the start was delayed owing to a dispute with a foreign IT supplier that resulted in the development of an in-house system. 15 This is based on the estimate of this time derived for the NDC scheme and published in the Annual Report of the Swedish Pension System by the Swedish National Social Insurance Board.

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(3) Charges of participating funds, after deduction for the “PPM rebate”.

As we have seen, the distribution of total PPM assets among participating funds is determined by the choices of individual participants. Future costs as a percent of total and individual capital accounts can be calculated given assumptions about the future development of fund choices, the number of participants, the age and gender distribution of income and the rate of return. Table 5 has been constructed given current individual choices of funds, the current values in the PPM rebate schedule, the Central Bureau of Statistics’ current population forecast, the current distribution of density in contributions and an assumed real rate of return on accounts of 5.5 %.

Table 4. Total Costs of Administration of the PPM SystemYear 2002 2005 2008 2011 2014 2017 2020Total Capital (Billion kronor) 78 152 260 400 574 781 1011Participants (thousands) 5 466 5 815 6 167 6 504 6 793 7 033 7 237Capital per participant (kronor) 14 293 26 129 42 233 61 475 84 477 111 121 139 660PPM charge(% of capital) 0.30 % 0.23 % 0.18% 0.15% 0.12 % 0.08 % 0.04%Fund charge*

(% of capital) 0.41 % 0.36 % 0.32 % 0.29 % 0.27 % 0.25 % 0.24 %Total charge(% of capital) 0.71 % 0.59 % 0.50 % 0.44 % 0.39 % 0.33 % 0.28 %Charge Per participant (kronor) 101 154 211 270 329 367 397Charge as a % of average yearly earnings** 0.0005 0.0007 0.0009 0.0011 0.0013 0.0014 0.0014

*Weighted average of all funds. ** Annual real earnings growth of 2 %. Note that funds and therefore charges grow at a faster real rate than earnings due to the assumed real rate of return on the average account of 5.5 %. As a result, the cost of the system increases faster than earnings.Source: The actuarial division of the PPM ands author’s calculations.

As Table 4 shows, the costs of administration are relatively high at the outset, in 2002, but become cheaper at a rapid pace, expressed as a percent of capital. However, since the real rate of return on funds (5.5 %) is greater than the real rate of growth assumed for earnings (2 %), charges will increase during the coming 15 years expressed as a percent of average individual earnings.

By 2011 the charge as a percent of capital – and also as a percent of individual account values – has declined from about 71 basis points to 44 basis points By 2020 the total charge is only 28 basis points, consisting mainly of the charge of managing funds. If the funds carrying the density of PPM money were to become so large that they fell to the lowest rebate level, which is 12 basis points (see Table 2 above) the total costs would approach 12 (for funds) plus 4 (for the PPM) basis points in total. They will never reach this level, however, as long as individuals choose at their discretion among the 600 funds

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that thus far have been available for choice within the system. In addition, it will be a challenge for the PPM to keep its costs slim.

What is not covered in Table 4 is a cost for collecting contributions. As the Swedish system is set up, the marginal cost of collecting contributions is zero. This is because the only additional cost arises in practice when the total contribution rate has to be divided between the NDC and FDC components, and this is a cost covered by the National Social Insurance Board’s (NSIB) computer system – and is also, marginally, very small there, too. From 2005 the PPM will also pay for its proportionate share of the cost of collecting contributions charged the NSIB by the tax authority, which is 40 million kronor. This will increase the total charge to 0.62 % in 2005 and to 0.29 % in 2020 in Table 4

The Swedish Tax Authority collects all forms of taxes from employers, keeps individual employer income and tax accounts and individual personal income, financial and tax accounts. These days all information on domestic and, in principle, international financial transactions of individuals and employers are also reported annually to the tax authority. The tax authority collects, thus, direct income taxes for individuals and employers, the value added tax, contributions for mandatory social insurance, customs duties, inheritance taxes, etc. The income definitions and procedures vis á vis employers are standardized so that employers keep only one set of accounts for tax purposes, have one authority to deal with, and most information is transferred electronically. An audit, a judicial process, etc. vis á vis an employer is done on behalf of all these public interests.

In sum, the system will move into a cost range under 0.30 %. It would be less than this if choices were restricted to a small number of funds. These would be so large that they would soon approach the present minimum fund charge of 0.12 % according to the PPM rebate schedule (Appendix A) - compared with the 0.24 % assumed to arise given the present distribution of individual choices. This would give an overall cost of 0.17 % (0.18 % with the additional payment to the NSIB for Tax Authority services) by 2020. As we have discussed, the system is set up to minimize overall costs in all respects.

4. Governance

As the system is set up, there are presently no governance problems vis á vis the participating private funds. The PPM has nothing to do with the investment portfolios of the funds in the system, but simply purchases their portfolio investment services. Even if the number of private funds allowed to operate in the system were to be limited to, for example 20-50 funds – through a bidding process where the PPM took on an explicit role as an optimizing purchaser - there would still be no governance problem, since there would still be no connection between the PPM management and the directors of the funds – and fund investment decisions.

Of course, by introducing a bidding process and thereby opening the process to negotiations, the question of governance becomes an issue One of the obvious conditions to set would be to require transparent criteria and the publication of negotiating proceedings for public scrutiny.

The one fund that could in principle create problems is the public default fund for non-choosers. The legislation governing this fund creates a board of directors that is

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instructed invest funds so as to optimize the results for participants covered by the fund, but prudently. The amount of money that can be invested in any given company is not restricted, however, the fund is not allowed to participate in electing board members, and hence does not even have indirect access to the decision process. The fund is required to have a stated long-run policy and to make this policy readily accessible to the public.

The Board of Directors of the non-chooser fund is appointed by the government and management of the fund comes from the private market. The legislation states that the strategy of the fund should be to maximize yields at a reasonable level of risk. The strategy of the Board and its proceedings are available on the fund’s web site. Since management has been recruited from the private market, there salaries are in line with those they would earn in the private setting. Of course, an option that is always open is to even privatize the non-chooser fund – perhaps dividing it into several funds – through a bidding process.

5. Overview of Individual Fund Choices

The first choice in 2000

Around 4.4 million participants were given the opportunity to make their first fund choice(s) beginning September 11, 2000. People were given a month to respond and after this deadline non-choosers were allocated to the public fund for non-choosers.

To help participants make informed choices, a brochure listing all registered funds, their investment profile, historical performance, degree of risk and administrative charges were sent to all participants. As it turned out, some funds had no or only a short record of operation and thus little or no performance information could be provided. The PPM spent the equivalent of around 7 million dollars at the time about 70 million SEK) on a mass media campaign, which is included in the overall PPM cost in Table 4 – spread out over a number of years along with initial IT investment costs. In addition, large insurance companies and other large fund managers advertised heavily especially in the radio and TV media immediately prior to and during the first choice period. Their willingness to invest in this advertisement is rational only if the fee schedule after rebates leaves an attractive profit margin. This is indirect proof that fund managers did not expect the PPM to perform the optimizing purchaser’s role.

About 67 per cent (3 million) of all participants – made an active choice from among the 460 funds registered at the time first choices were being made for all participants at that time. Slightly more women (68 %) than men (66%) made active choices, and this was true for all age groups and throughout most of the country. Younger persons were slightly less active: Active fund choices were made by around 58% of participants in the age group18-22 and 63% of participants age 23-27.

Participants chose on average 3.4 funds, which gave a total of over 11.5 million fund choices. The number of active fund choices was a little over 10 million. Around 1.4 million participants were “non-choosers.” Over 72% of those making active choices chose funds holding only equities. Although this may seem surprising, it is important to recall that older participants have very limited funds in the PPM system and may simply see their participation as an opportunity to take a risk. One would expect the weighting to

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change as the density of the money in the system “ages” with time About 25% chose either mixed bond-equity or generation funds that enable the individual to adjust his/her risk profile to remaining years to planned retirement.

Engström and Westerberg (2003) examined the how people chose in making the initial choices in 2000. Their findings indicate that persons with prior experience of investing, persons with higher education, persons with higher income, persons who have other pension plans, married persons and persons under 42 years of age were more likely to make a choice. The age variable employed showed that those most likely to make a choice were age 23-32. Persons with only small accounts at the time of introduction – age 58-62 showed an especially low propensity to choose.

Sundén (2004) repeated the Engström and Westerberg analysis and arrived at the same findings. In addition she examined the propensity to invest in equities, which she found first increases and then decreases with age, which corresponds to the typical u-shaped pattern found in other studies in the literature. Women invest less in equities, while persons who have private equity portfolios tend to invest more in equities.

Sundén also discusses the more general findings in the literature (Munnell and Sundén 2004) that participants’ propensity to choose many funds increases with the number of available choices, and that this appears to explain the relatively heavy propensity to choose many equity funds when Swedish participants made their initial choice. On the other hand, Sweden has a substantial pay-as-you-go floor in the overall pension system, and many participants may see the PPM funds as being a very marginal to their overall pension. This is certainly true of older workers, and especially those who due to the transition rule had almost no money in the system. Younger workers would be expected to have a large proportion of their money in equities as they initiate their lifetime saving for old age.

About 30% of available funds ended up in the publicly managed non-chooser fund. Since 2000 this fund has consistently invested close to 80 % of total assets in equities, 10 % in real interest bonds, 4 % in hedge funds and the remainder in other assets. The private fund getting the largest share of total assets (of 56 billion Swedish kronor - or around 5.6 billion dollars) held 4 % of the PPM assets in December 2000. The top 10 funds together attracted 23% of all assets. Among these was only one foreign owned fund, and this fund was number 9 in terms of assets held in the ranking of the top 10 private funds.

Unless individuals actively make new fund choices, all new contributions are distributed to their existing fund choices in accordance with the portfolio shares they made at the time of their last choice. Information on fund values is available daily in major Swedish newspapers and through the internet link to the administration.

New entrants after the initial choice 2000

There are about 100 000-130 000 new entrants per year. Although almost 70 % made an active fund choice in the first year of the system’s operation, interest in making an active choice among new entrants has been very weak. In 2003 and 2004 about 10 % of new entrants made an active choice. The contributions of the remaining ca 90 % were allocated automatically to the default non-chooser fund.

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Figure 1. Percent of New Participants Making an “Active” Investment Choice

Source: PPM .

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The relative size of the public default fund has remained practically constant since the beginning. Even though new entrants have largely ended up in this fund. However, it is important to keep in mind that a large percentage of new entrants are teenagers – and for the most part persons whose main activity is studies – with very small contribution amounts, and consequently small accounts until they become more tenured participants in the labor force. It is important to note, however, that very little money has been switched out of the non-chooser fund since the system started in 2000. Given that the profile of the fund resembles an index of all PPM funds many participants may see no reason to exit. The non-chooser fund uses a weighted average of all PPM funds as a benchmark, and to date its yield since 2000 is about 9 percent better than this weighted average. Finally, once a participant opts out of the default fund he/she is no longer allowed to opt back in This rule is intended to minimize the relative size of the public fund as time passes.

6. Information –What Do People Know and What Should They Know?

Prior to the introduction of the financial account system nearly half of all Swedes had some personal experience with directly with the stock market, with mutual funds or unit link funds through private insurance. Nevertheless, there was originally met with opposition from important quarters. Most noteworthy in this respect is that, although they were initially opposed to the advance funded component of the public system, the central blue-collar union changed its mind and negotiated a shift from its own defined benefit supplement to a defined contribution supplement that closely resembled the new public FDC component!

Both the blue-collar union (LO) and the Confederation of Employers (SAF) supported the move towards NDC. Blue-collar workers, who usually have long, but flat earnings profiles – compared to managers and professionals – could easily see the advantages in fairness to their members in introducing notional and financial account schemes in social insurance. For employers there was a clear advantage to a system with a contribution rate that, in principle, will be fixed forever.

How have people in general reacted? People’s knowledge about the essentials of the overall reform towards NDC and FDC is still weak, especially when asked about some of the essential features of the reform, such that pensions are now based on lifetime accounts with benefits being directly linked to individual contributions and life expectancy at retirement (Sundén 2003). In addition, since the PPM system gets a relatively large amount of coverage in especially the newspapers – both due to the poor performance of the stock market in 2001 and 2002 and the opposite trend in 2003 – because journalists know that righting about winners and losers always attracts attention, people typically associate the reform with the FDC component and PPM system.

Surveys of what people know and associate with the overall reform have been run on a yearly basis since 1999. One result is that only about 10 % of respondents say they have the right knowledge to invest their PPM money judiciously. The PPM has recently

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run a survey of its web site users, which gives over 50 % who feel comfortable with the PPM system. The difference between these results is probably due to the selection of persons using the web site who are generally more financially literate and financially active.

Finally, it can be mentioned that because people indicate that they need to know more to make more informed choices, the PPM has begun a program to identify target groups for information. In a second step they will tailor information to these groups with the aim of improving people’s knowledge about the system, and how to use it.

7. Conclusions

The Swedish FDC (PPM) system is now into its fourth year of operation and is well-established in Sweden, in spite of rather substantial account losses during the first two years of operation due to the deflation of the stock market in 2001-2002. Few voices are heard to abolish the system. Public discussion to date has focused on the extremely large number of funds, whether people know enough to make informed decisions and, finally, the still relatively high cost of the system.

As the volume of the system grows, calculations presented in this paper show that the system can become considerably less expensive in the next 15 years, and that the costs are high initially mainly due to the relatively small volume of investments. These will grow fairly rapidly with time, however, leading to lower prices for fund services. This paper also argues that this process would probably be helped along if the PPM were to act as an optimizing purchaser in limiting the choice set of funds to 20-50 funds at most, after which individuals would choose according to returns, but also be steered by overall fund-choice restrictions – or a default design – that would lower the average risk exposure compared with today. The PPM is working on new ways to educate clients, which should also be expected to have a positive effect on the choices of participants.

Presently, the publicly run non-chooser fund provides a kind of default design for younger participants, with a mixed portfolio including 80 % equities. Presently, older participants have very small accounts in the system, and their ultimate pensions will not depend so much on the PPM results. This will change, however, in a decade or so, and eventually around 25 % of the overall public pension may depend on the PPM component. With its present construction, the system has no good default for older workers, and there is presently no mechanism to steer them into what may be the best portfolio for them.

There is still a need to reconsider the annuity products offered in the PPM system, even if the choices remain limited. First, it would seem logical to make joint annuities for spouses the default option, rather than single annuities as at present. Second, it is not desirable in the long-run to allow the PPM to invest the account money of annuity purchasers. This is a large amount of money that can be invested in a mixed portfolio of equities and bonds, rather than just in bonds, and it could be managed by private investors. Third, the option to purchase a survivor benefit during the accumulation phase should be cancelled.

In sum, it appears that the PPM system provides a means for achieving low costs in a mandatory financial account scheme, and that costs will continue to decrease in the

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future. With some redirecting, where the PPM would exploit its possibilities to operate as an optimizing purchaser costs could be improved even further, while the number of funds in the choice set would be reduced to say 50 funds, which still allows for a broad band of choice among index-type funds. This combined with the above proposals for changes in the annuity products would improve upon the overall design of the system.

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References

Diamond, Peter, 2002. Social Security Reform. Oxford University Press.

Engström, Stefan and Anna Westerberg. 2003. “Which Individuals Make Active Investment Decisions in the New Swedish Pension System,” Journal of Pension Economics and Finance, vol. 2, pp. 225-245.

Frennberg, Per and Björn Hansson, 1995. ”An Evaluation of Alternative Models for Predicting Stock Volatility: Evidence from a Small Stock Market,” Journal of Internatinal Financial Markets, Institutions and Money. Vol 5, No 2/3, pp. 117-134.

Goodwin, Thomas, 1998. “The information ratio”, Financial Analyst Journal, July/October, Association for Investment Management and Research, New York.

Góra, Marek and Edward Palmer, 2003. Changing Perspectives in Pensions. Mimeograph. http://www.rfv.se/konferens/index.htm.

Könberg, Bo, Edward Palmer and Annika Sundén, 2005. “The Swedish NDC Reform – The Road to 1994 Legislation, the Long Implementation Phase and Remaining Loose Ends,” forthcoming in Robert Holzmann and Edward Palmer (eds.) Non-Financial Defined Contribution (NDC) Pension Schemes: Concept, Issues, Implementation, Prospects. Washington DC: The World Bank. http://www.rfv.se/konferens/index.htm.

Munnell, Alicia H. and Annika Sundén. 2004. Coming Up Short: The Challenge of 401(k) Plans, The Brookings Institution Press, Washington, DC.

Palmer, Edward, 2000. “The Swedish Pension Reform-Framework and Issues,” World Bank Pension Primer, Washington D.C.

Palmer, Edward, 2001. “Swedish Pension Reform-How Did It Evolve and What Does It mean for the Future?” in M. Feldstein and H. Siebert (eds.) Coping with the Pension Crisis: Where Does Europe Stand? Chicago: University of Chicago Press (forthcoming).

Sundén, Annika, 2004. “How Do Individual Accounts Work in the Swedish Pension System?” Paper presented at Annual Conference of Retirement Research Consortium The Future of Social Security, Washington, DC August 12-13, 2004.

Sundén, Annika, 2005. “How Much Do People Need to Know about Their Pensions and What Do They Know?” forthcoming in Robert Holzmann and Edward Palmer (eds.) Non-Financial Defined Contribution (NDC) Pension Schemes: Concept, Issues, Implementation, Prospects. Washington DC: The World Bank. http://www.rfv.se/konferens/index.htm.

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Taylor, Michael and Ian Flemming, 1999. “Integrated Financial Supervision: Lessons from Northern European Experience” World Bank Policy Research Paper 2223. Washington D.C.

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Appendix 1. TableA. Fund Manager Charges

NormalAdministrativecost, % of fund´sPPM assets

Flat rebate rate,% of fund´s PPMassets

IncrementalRebate factor

Rebate payableto PPM, % offund´s PPMassets

Administrative costafter rebate, % offund´s PPM assets

1. Managers holding less than 70 million SEK in PPM Funds

1.5 0.4 0.25 0.275 1.2251.0 0.4 0.25 0.15 0.850.5 0.4 0.25 0.025 0.4750.12 0.4 0.25 0 0.12

2. Managers holding 70 to 300 million SEK in PPM Funds

1.5 0.35 0.65 0.7475 0.75251.0 0.35 0.65 0.4225 0.57750.5 0.35 0.65 0.0975 0.40250.12 0.35 0.65 0 0.12

3. Managers holding 300 million to 500 million SEK in PPM Funds

1.5 0.3 0.85 1.02 0.481.0 0.3 0.85 0.595 0.4050.5 0.3 0.85 0.17 0.330.12 0.3 0.85 0 0.12

4. Managers holding 500 million to 3000 million SEK in PPM Funds

1.5 0.25 0.95 1.1875 0.31251.0 0.25 0.95 0.7125 0.28750.5 0.25 0.95 0.2375 0.26250.12 0.25 0.95 0 0.12

5. Managers holding 3000 to 7000 million SEK in PPM Funds

1.5 0.15 0.95 1.2825 0.21751.0 0.15 0.95 0.8075 0.19250.5 0.15 0.95 0.3325 0.16750.12 0.15 0.95 0 0.12

6. Managers holding more than 7000 million SEK in PPM Funds

1.5 0.12 0.96 1.3248 0.17521.0 0.12 0.96 0.8448 0.15520.5 0.12 0.96 0.3648 0.13520.12 0.12 0.96 0 0.12

Source. Constructed by the author using PPM the formula and first published in Palmer (2000).

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Appendix 2. Summary of the New Swedish Pension System

1. Individual accounts - contributions

Persons born prior to 1938 are outside the new system. Generally, participants born 1938 and after have two accounts in the new system: one Notional Defined Contribution (NDC) and one Financial Defined Contribution (FDC).

Contributions are paid on earnings above the minimum level at which income must be declared for tax purposes (presently about 900 dollars per year) and up to a ceiling of about 29 000 dollars, using an exchange rate of 10 kronor per dollar. (The Swedish krona has fluctuated between 5.5 and 11.0 kronor per dollar since 1995 and is presently close to its lowest level.)

The transition rule is that persons born in 1938 will receive 4/20 of their benefit from the new system and 16/20 from the old system; persons born in 1939 5/20 and 15/20 etc. Persons born in 1954 and later are completely in the new system. (The new system proportions are also used to determine payments for the transition cohorts to the FDC scheme.)

The contribution rate is 18.5 % on earnings. (Eventually to be split equally between the employee and employer.)

A 16 % contribution rate goes to the pay-as-you-go system and is noted on the individual’s NDC account.

A 2.5 % contribution rate goes to the individual’s financial account. Individuals choose one to five registered funds. Funds of non-choosers go to a publicly managed default fund. There is no limit when or how often participants can switch funds and (presently) no individual charge on switching funds.

2. Non-contributory rights and rights for periods of sickness, disability and unemployment covered by social insurance

Non-contributory rights in conjunction with child birth, higher education and (conscripted) military service are financed by general revenues and money is transferred from the general state budget to the NDC and FDC social insurance schemes to cover these.

Childbirth credits are given for a maximum of four years per child, although only one credit can be earned at any given time (two children born two years apart give 6 credit years in total). The credit can be claimed by either parent, but to date is usually claimed by the mother. Claimants are entitled to the most advantageous of: 1) contributions based on 75 % of average earnings for all covered persons; 2) contributions based on 80 % of the individual’s own earnings the year prior to child birth: or 3) a supplement consisting of a fixed amount, indexed over time to the (covered) per capita wage.

Periods of sickness, disability and unemployment covered by social insurance provide financed rights in both the NDC and FDC schemes. Benefits for sickness and unemployment are treated as earnings in computing contributions. An imputation of future earnings is performed for disability (the rules remain to be legislated in the autumn of 2001), and contributions are transferred from the disability scheme to

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finance these rights. The sickness and unemployment schemes pay for the employer share of the contribution for sickness and unemployment. A disability benefit is converted into an old-age benefit at latest at age 65.

3. Account values

Accounts in both the NDC and FDC schemes grow with: New contributions and transfers to the system for non-contributory rights A rate of return based on the growth in the average wage rate in the NDC scheme

and the return on the individual’s fund(s) in the FDC scheme Inheritance gains. Inheritance gains derive from the accounts of persons who die

prior to the retirement age. They are distributed among survivors in the same birth cohort as the deceased.

4. Calculation of a benefit

A full or partial (25%, 50%, 75%) benefit can be claimed from the NDC and/or FDC scheme separately or together at any age from age 61. There is no upper age limit. A benefit can be combined with continued work. Contributions paid on earnings from work always yield enhanced account values. A person who claims a partial benefit and/or combines a benefit with work will have the benefit recalculated, based on new account values, upon permanent retirement.

The annuity is calculated as:

Annuity = Account value / unisexual life expectancy from retirementand - in the NDC scheme assuming a real annual return of 1.6% during retirement- in the financial account system taking into account the return on the funds of annuity recipients.

In the NDC scheme permanent life expectancy factor is determined for a cohort in the year in which its members turn 65, even for individuals who claim a benefit before or after this age.

The annuity in the NDC system is indexed to the CPI, however a yearly adjustment (up or down) is made for trend divergence of real per capita contribution growth from the growth norm of 1.6 % used in calculating the original annuity value.

Even benefits of pensioners born 1937 and earlier are indexed from 2002 with inflation plus the difference between 1.6 % and the actual outcome.

In the financial account system the participant can choose either a fixed or variable life annuity. In the latter case he/she chooses the investment fund and the annuity is recalculated annually. A joint life annuity is also offered. A survivor benefit can also be subscribed to during working years.

Although early retirement is possible for persons born in 1938 in 2001, most persons born in 1938 are expected to claim benefits in 2003, which has been a “normal” retirement age for over two and a half decades, in part owing to contractual arrangements covering about 90 per cent of employees. In addition, a guarantee

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supplement cannot be claimed until the age of 65, which for persons born in 1938 is in the year 2003.

5. The guarantee benefit

The guarantee benefit is available from age 65. It is an inflation-indexed supplement (with a specified maximum) to the total benefit provided by the NDC and FDC earnings-related schemes.

The guarantee is financed with general revenues. Together with a means-tested housing allowance, it will usually be sufficient to meet the subsistence norm established by the National Welfare Board. Since it is prorated with regard to years of residence, with 40 years needed for a full amount, it is possible that late-working-life immigrants may nevertheless fall under the subsistence norm and be in need of social assistance, provided by local authorities.

The initial level of the guarantee was set at a high enough gross value to align it after-tax with the commensurate benefit in the old system.

6. Taxation

Individual earnings and pension benefits have the same income tax status. The reform eliminated a separate tax deduction for pensioners.

7. Administration

The tax authority collects contributions (together with other taxes). NDC accounts are kept by the National Social Insurance Board. The Board also

keeps track of all contributions for and pays NDC, FDC and guarantee benefits together.

The FDC accounts are managed by a state monopoly – the PPM. The PPM places one daily order per fund, aggregating all orders to buy and sell. The PPM is the single provider of FDC annuities.

8. Reserve funds in the NDC scheme

The NDC system has a buffer fund that arises due to fluctuations in the sizes of birth cohorts, but which will also pick up remaining imperfections in the practical design of the scheme. Reserves, accumulated within the framework of the old system, were approximately 450 billion kronor at the end of the year 2000. (GDP was around 2100 billion kronor.) These reserves will help in financing the transition period – when the large cohorts born in the 1940s are only partially within the new system.

9. Financial stability of the NDC system

Two main sources of potential financial instability remain. The first source of instability arises because life expectancy is calculated from the known life courses of contemporaneous cohorts at the age when the retiring cohort has reached age 65.

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Neither of the two more stable alternatives – continuous adjustment after retirement or basing the factor on a cohort-specific projection – was chosen. The second source of instability is the choice of using the growth in the average wage for indexation, whereas it is well known that the growth of the contribution base (which also takes into account the size of the contributing labor force) must be used to guarantee financial stability – a fixed contribution rate. To counter these a balance index has been constructed.

The balance index: An evaluation of the present value of assets and liabilities is made, based on current information, to construct a balance index. When the valuation of assets falls short of the valuation of liabilities, the index falls under unity and both account values and benefits are deflated by the index. Positive indexation occurs in a recovery until the balance index reaches unity again.

’

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