NDC Schemes as a Pathway toward

Politically Feasible Pension Reform

András Bodorjoint work with Michal Rutkowski

TÁRKI NDC Book Launch, Budapest, September 19, 2012

Traditional median-voter based political economy models of pension reform are of limited use for guiding pension reform professionals for making meaningful (sustainability and adequacy enhancing) reforms to happen◦ Apply the emerging knowledge at the intersection

of psychology and economics in the pension reform context?

Revisit the NDC experience of Poland◦ Explain the political process through the power of

the emergence of collective intelligence

Motivation

I. Move from the Median-Voter Approach to Utilizing the

Psychological Foundations of Poltical Behaviors

Selén and Ståhlberg (2007)◦ Swedish NDC reform was politically feasible

because the value of contributions that would be paid under the reform proposal decreased more than the value of benefits for all age cohorts not older than 53 when the age of the median voter was 47

Median-voter models can explain observed outcomes, but have limited predictability power

Median-voter approach

1. Focus on explaining the size of the PAYG system as opposed the reform moves towards sustainability (Persson & Tabellini 2002)

2. Implicit assumption about contribution rate increases disregarding the reality of general revenue funding of pension system balance deficits

3. Homogeneous political participation assumption across age groups – assumption of similar drive in composite voting behavior by pension policy across generations

4. No behavioral response / no exist assumption for younger generations

Weaknesses of the Agent Rationality Assumption and the Medium-Voter Approach

5. No concern for nontransparent DB rules limiting the capability to estimate net personal effects of pension reform options

6. Full commitment assumption, i.e. governments do not default on pension obligations

Weaknesses of the Agent Rationality Assumption and the Medium-Voter Approach(cont’d)

Madrian & Shea – US 401k voluntary pension savings◦ Default options matter

2005 Bush proposal on US FDC reform◦ Political party preference matters more than age

group Boeri et al (2001) France, Germany, Italy,

Spain◦ More restrictive opt out option is more popular

Evidence on the flaws of the agent rationality assumption in the pension context

Thaler and Sunstein (Nudge) & Kahnemann (Thinking Fast and Slow)◦ Voting behavior is a System 1 activity that may only

gradually altered by interaction between System 1 and System 2 through indirect flow of rationality into the decision

◦ System 1 is particularly flawed in mathematical predictions Akerloff and Schiller (Animal Spirit)

◦ The role of stories: “Real estate prices has always just gone up and they always will”+ framing

Kahnemann (2003) – A psychological perspective on economics

Tversky and Kahneman (1986) “Rational Choice and the Framing of Decisions”◦ Framing: the brain’s information processing along stories

Emerging learning about psychology and political behavior

The flexibility of the retirement age◦ Is the retirement age an archaic construct?

Emergence of quasi ownership rights over NDC balances◦ Disney (2004) – the stronger the link between

contributions and pension benefits (i.e., the higher the weight of an individual saving component in the contribution rate) and the weaker the role of redistribution within the pension system (i.e., the smaller the weight of a tax component in the contribution rate), the higher the (formal) labor force participation rate will be.

◦ Reporting individual NDC balances make it harder to default on pension promises?

NDC “stories” that could give rise to meaningful reforms

Leveraging the pension wealth for better protection against unemployment risk◦ The case of Jordan

Linking NDC benefits to social benefits in transparent ways?◦ Supporting pension rights accumulation during

maternal care◦ Differential rights for armed services professionals

Joint ownership of spousal NDC balances? Case for FDC to NDC transition in cases of

limited access to capital markets◦ West Bank and Gaza example

NDC “stories” that could give rise to meaningful reforms (cont’d)

I. Policy-Making Process-

The Case of the NDC Reform of Poland-

The Emergence of Collective Intelligence

Framework of William Isaacs (1999)◦ Pre-commitment◦ Commitment building

Initiation Discovery Reform group formation

◦ Coalition building Reality check on the ground Generative dialogue and the emergence of the

concept Identity commitment

The Policymaking Process

Expert consideration beginning 1991 Funded system proposal Increase in pension spending Constitutional Tribunal intervenes in ad hoc

changes

Pre-commitment

Four proposals “Funding hawks” vs. “PAYG hawks” Shifting fortunes of MOF and MoL

Commitment building: Initiation

January 1996 Conference First emergence of NDC NDC as a possible compromise and face

saver Lack of meaningful instinctive opposition to

NDC

Commitment building: Discovery

Ministry of Finance Solidarity Trade Union Institute of Labor Ministry of Labor

First Pillar Flat pension of 20% of average wage

Basic pension with two elements: flat pension

financed from taxes and earnings-related

pension from contributions

Based on contributions from employer and

employee with maximum limit; benefit depends on length of

contribution and amount

Based on contributions from

employer and employee with

maximum limit of 250% of average wage and state

subsidy

Second Pillar Mandatory saving in private pension funds

Mandatory saving in pension funds

supplemented by privatization bonds

given to all employees

Voluntary savings in pension funds by

people earning more than average salary; tax

preferences

Voluntary savings in private funds for

people with highest income

Transition Mandatory participation for new

entrants, choice between systems for

employed, high transition costs

Expected transition period for forming

pension funds, social security contribution

divided between systems, budget

subsidies

Immediate changes; lower replacement rate

in pension system when contributions start to voluntary

private system

Gradual implementation; no reduction in costs of

basic system

Source: Orenstein (2008), p. 116.

Table 1: Pension Reform Proposals in Poland, 1995-1996

Commitment building: Reform group formation

• February 1996 Cabinet Reshuffle• Establishment of the Office of the

Plenipotentiary• Reform group formation• Proposals actors and veto actors

Education Opinion polls and focus groups Press, MPs, lawyers, academics,

government Staying on the message Emerging special role of the link between

pensions and wages

Coalition building: Reality Check on the Ground

The NDC decision in the reform team The “trap of understanding” and a small

backlash: pensions system demystified Collectivist vs. individualistic system Collective learning through new language and re-

labeling Conceptual twins and business class partition Peace between “PAYG hawks” and funding hawks Advantages of novelty Elegance and transparency Support of the Social Security Institution

Coalition building: Emergence of “Security through Diversity”

Government approval of “Security through Diversity”

Support of Tripartite Commission Why unions supported NDC? Legislative path: two distinct phases Political upside-down but the reform is in!

Coalition building: Identity commitment

Need for new approaches in the political economy of pension reform to support problem solving pension reform professionals

NDC design could be consistent with ‘stories’ appealing the psychological foundations of political behaviors

Crisis induced reforms are not friendly towards long-term systematic / paradigm changing reforms

An environment allowing the emergence of a reform supporting collective intelligence is critical for successful systematic reform

Conclusion