Adressing the legacy costs in an NDC reform: Conceptualization, measurement, financing

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 intoa 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 costsreflecting 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 legacycosts, 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 isstrongly 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 financingin particular via indirect taxes such as VAT is an interesting tool, but empirical limitations tend to dampen the real‐world usefulness.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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