Notional Funding: How an Imaginary Pension Fund Can Help Steer a PAYG System
The aging population presents serious challenges for traditional pay-as-you-go pension systems. Longer life expectancies increase pension expenses while low birth rates weaken the future contribution base.
A buffer fund can help alleviate these problems. However, this raises questions about how much insured should contribute and how big the fund should be. Ideally, the contribution rate should be stable, but it also needs to be based on observable quantities and transparent rules.
Notional funding (NF) provides a coherent solution to this problem. It takes the liabilities of the PAYG system as seriously as those of the funded system. In NF, the PAYG system is treated as if it were a fund-ed system without assets to cover liabilities.
In NF, the pension contribution consists of two components: the funded contribution (C1) and an additional contribution (C2). The funded contribution equals the present value of the annual accrual. The additional contribution corresponds the imputed re-turn on missing assets. If the total actual contribution equals the sum of these two components (C1+C2), the level of unfunded liabilities remains stable. However, there may be cases where a decreasing unfunded liability is desirable, such as when the pension system faces declining labour due to low fertility rates.
The NF model also provides a consistent basis for automatic adjustment of pension expenditures. In the extreme, the contribution rate can be fixed, transferring the need to adjust financing entirely to pension benefits. However, necessary adjustments can be divided to adjust pension benefits and contributions in the desired ratio.
In this web session, we will illustrate the NF model in the context of a simple old-age pension system, where the contribution level and/or benefit level are adjusted annually based on different return and birth rate scenarios. The effects of different policies will be examined on a yearly and generational basis.