Addressing 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 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