We describe a framework to measure cost neutrality of the consolidation of two partially funded, earnings-related PAYG pension schemes into one, from the perspective of the financers of the schemes, typically employers of the insured workers.

The framework was developed in the Finnish Centre for Pensions in 2018-2021 for a working group tasked with consolidating the two largest Finnish statutory pension schemes (the public pension schemes for private sector employees and municipal employees) cost neutrally for all financing parties. The objective was to strengthen the risk-bearing capacity of the schemes, especially against workforce migration between sectors. The new scheme would have covered almost 90 per cent of the Finnish labour force. Ultimately, achieving cost neutrality robustly enough was deemed infeasible. Our framework was central to this analysis.

In our framework, an earnings-related PAYG pension scheme has future obligations, which arise from pension insurance contracts, and resources, which consist of assets (that can be negative) and future contributions. These can be thought of as random variables. The assets evolve in time contingent on the cash flows to and from the scheme and investment returns. The obligations and resources are assumed to be in balance indefinitely i.e., the funds stay bounded as a percentage of wages. When investment returns exceed wage growth, this implicitly defines a theoretical forward-looking minimal sustainable premium as a percentage of wages.

If two schemes have different sustainable premiums, the sustainable premium of the consolidated scheme will be a weighted average of the prior sustainable premiums. Hence a consolidation of two schemes can be cost neutral only if the individual schemes have the same sustainable premium. If they differ, they can be brought closer by different neutralisation methods, e.g., by excluding some obligations or resources from the consolidation, by calculating a neutralisation margin, which the financers of the financially weaker scheme must pay to strengthen funding before the consolidation. After making assumptions on the distributions of the obligations and resources, we run simulations to measure how well cost neutrality is achieved by the different neutralisation methods.

Find the Q&A here: Q&A on 'Investments and Reserves for Pension Funds'