Applying the Swedish pension brake

In non-financial defined contribution (NDC) pension systems the contribution rate is kept at a constant level. A key element is the balance mechanism which is automatically applied if the finances appear insufficient. The balance mechanism is based on the ratio of assets to liabilities. When the ratio is below unity, it will slow down the indexation of both notional pension accounts and pension benefits. Thus the burden of adjustment will fall on replacement rates, but when and how, depends on what the demographic and economic future will contain. We apply the balance mechanism to the Finnish private-sector earnings-related pension system and simulate the future with stochastic population projections and asset yields. The results show that depending on the contribution rate level, a direct application of the balance mechanism may turn out to be a slow way of running down the system, or end up with huge funds. The problems may appear very far in the future. Scaling the balance mechanism appropriately, however, results in financial stability.