The Notional Defined Contribution Model: An Assessment of the Strengths and Limitations of a New Approach to Provision of Old Age Security

Abstract

Most public old-age pension schemes around the world are based at least in part on the pay-as-you-go defined benefit (PAYGO DB) model. As these schemes have matured and the limitations of this approach have become more salient, pension experts have begun considering alternative models. The Notional Defined Contribution (NDC) model, which is also financed on a PAYGO basis, has emerged as one of the major new approaches. In the years ahead it may be combined with or possibly displace the funded defined contribution model as the major alternative to the PAYGO DB model. Drawing primarily on evidence from NDC schemes in 6 countries (Sweden, Italy, Poland, Latvia, the Kyrgyz Republic, and Mongolia), the goal of this paper is to describe the NDC model and to review its strengths and limitations relative to the major alternatives. A four pillar pension scheme is proposed to illustrate how a NDC pillar might be integrated into a multi-pillar scheme. One strength (relative to the PAYGO DB model) is that it makes a more explicit link between contributions and eventual pension benefits; however, the flip-side of this strength is that it provides less adequate pension benefits to low-wage workers due to the lack of income redistribution. The fiscal burden of the transition is less than that associated with a shift to a funded defined contribution scheme, but NDC schemes lack many of the potential economic benefits associated with funded defined contribution schemes, such as contributing to economic growth. The NDC model may become common among the nations in the process of making the transition from centrally planned to market economies, among Western European nations, and among developing nations. It is less likely to be adopted in nations that currently have fully or partially privatized schemes in place. In the United States, the model will probably get relatively little attention in the debate over Social Security reform, at least for the foreseeable future. However, it is a model that would put workers with low wages and irregular work histories at less risk than the funded defined contribution alternative being actively considered in current debates about Social Security reform in the United States.