Sunday, February 17, 2013

A Solution for U.S. Social Security

The Economist describes the three main models of government pensions, the two extremes "pay-as-you-go" (today's workers pay for today's pensioners, explicitly in Europe and implicitly in the U.S.) and defined contribution (as in 401-K-type corporate plans or in the fully funded Chilean scheme), and the brilliant in-between system of notional defined-contribution (NDC). The latter was first adopted by Sweden in the 1990s and more recently by Latvia, Poland and Italy. The plans define the contribution rate from the current workers (16% in Sweden). The money pays for today's pensions, but also counts toward an individual notional account. The notional capital in the accounts grows with the total wages in the economy. At retirement, the balance is annuitized. The beauty is the automatic adjustment of benefits. If the worker pool shrinks over time, or the longevity of the retirees increases, the per-year annuitized amount declines. If people work longer and retire later, the amount increases. The individual is sheltered from investment risk. The design is a simple use of college finance math: set the present value of future benefits equal to the accumulated value of the acounts. That is, the level of pensions is tied to how much we can afford. If only our politicians could add and subtract. Alas, they don't teach that in law schools...

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