On the Feasibility of Notional Defined Contribution Systems: The German Case

Abstract

Notional defined contribution (NDC) systems have strongly been being debated in the worldwide pension literature in the past years. This paper deals with the feasibility of such NDC systems. The focus is on the German case, where the recent 2004 pension reform introduced a so-called sustainability factor, that de facto incorporates some crucial characteristics of an NDC system into the public pension system, but maintains the traditional benefit indexation formula approach. The paper analyzes the effects a hypothetical introduction of an NDC system would have on the financial situation of the German PAYG system.

It is found that a genuine NDC system would be feasible in the sense that it would be financially possible and would achieve gross pension levels above, equal or only slightly below those that can be forecasted for the standard pensioner under the present German pension system. However, it is shown that an NDC system would require large buffer funds which are currently not available. Furthermore, the distribution of pension income among cohorts and across time would be very different and may be hard to motivate from a political perspective.

Altogether, it becomes clear that an NDC system cannot solve the demographic problems but simply copes with them in a different way than conventional PAYG systems. Thus, it does not replace the necessity to supplement the public pension system by a funded second and third private pillar in order to prepare for the future demographic changes.