Addressing the Legacy Costs in an NDC Reform: Conceptualization, Measurement, Financing

24 Pages Posted: 30 Nov 2010

See all articles by Robert Holzmann

Robert Holzmann

University of Malaya; IZA Institute of Labor Economics; CESifo (Center for Economic Studies and Ifo Institute); World Bank

Alain Jousten

University of Liege; IZA Institute of Labor Economics; Netspar; International Monetary Fund (IMF)

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Date Written: October 18, 2010

Abstract

The paper provides a framework for the conceptualization, definition and estimation of legacy costs that need to be addressed in a reform that transforms an unfunded defined contribution (NDB) scheme into a notional (or non-financial) defined contribution (NDC) scheme. As the new contribution rate is fixed and, perhaps, reduced, paying for the accrued to date liabilities leaves a financing gap that needs to be covered. The paper comes to the following key conclusions: (i) to render an NDC reform credible and fully effective in its desired results, it is crucial to determine the legacy costs of the reformed system – no matter how these costs will be financed; (ii) for a shift from an NDB scheme to an NDC scheme with a fixed and long-term-sustainable contribution rate, the legacy costs amount to the actuarial post-reform deficit, and are finite; (iii) two key sources of the legacy deficit are identified: inherited legacy costs reflecting prior reforms and benefits above the steady-state under the old scheme, and reform-induced new legacy costs due to the shift toward a lower sustainable contribution rate; (iv) to estimate legacy costs, actuarially and macro-economically based projection models have advantages over pure actuarial studies, as they are less dependent on very technical parameter assumptions that may not be consistent with general equilibrium considerations; (v) distributive effects play both at the intergenerational and intra-generational level, as benefits and costs of the reform are borne unequally by different subgroups of the current and future population; (vi) to improve equity and efficiency aspects of an NDC reform it is strongly suggested to address legacy costs in an explicit manner and with external financing; (vii) in the developing world, one promising way to co-finance the legacy costs is the use of an increased coverage to strengthen the PAYG asset; (viii) for developed countries, theoretical models show that tax financing in particular via indirect taxes such as VAT is an interesting tool, but empirical limitations tend to dampen the real-world usefulness.

Suggested Citation

Holzmann, Robert and Jousten, Alain, Addressing the Legacy Costs in an NDC Reform: Conceptualization, Measurement, Financing (October 18, 2010). Netspar Discussion Paper No. 10/2010-061, Available at SSRN: https://ssrn.com/abstract=1716749 or http://dx.doi.org/10.2139/ssrn.1716749

Robert Holzmann

University of Malaya ( email )

University of Malaya
Kuala Lumpur, Wilayah Persekutuan 50603
Malaysia

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

Alain Jousten (Contact Author)

University of Liege ( email )

Place des Orateurs 3
Batiment B31
4000 Liege
Belgium
+32 4 366 3198 (Phone)

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Netspar

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

International Monetary Fund (IMF)

700 19th Street, N.W.
Washington, DC 20431
United States

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