In all fairness, what is fair?

November 2018
Fairness 2
The sense of fairness is a strong human characteristic. It is surprising that a economically fair pension system can be perceived as very unfair, but fairness is in the eye of the beholder.

The Dutch and Swedes have approached the state pension differently. Two culturally similar populations, two different perceptions of fairness.

The Dutch

The Netherlands has a flat state pension. Everybody who lives in the country for a set number of years will receive the same amount in state pension. The Dutch have introduced a Basic Income for old people. This is not a uniquely Dutch idea, the UK has followed a similar route.

Contributions to the state pension system is a percentage of salary up to certain income level. The current level of contributions is not enough so the state budget has to bridge the gap between annual contributions and pension payments. This disparity will increase as baby-boomers enter retirement, but in order to relieve this in the future, the Dutch have linked retirement age to life expectancy.

The Swedes

In 1994, Sweden reached a cross parliamentary pension agreement. The goal of the reform was to make the state pension system generationally neutral; economically fair between individuals and separate from the state budget. In other words, a self-financed state pension where the outcomes are directly linked to individuals’ contributions. This was a total rebuild of the state pension system.

The mandatory Swedish system has two parts: the first leg is pay-as-you-go with a capital buffer and the second leg is an individual pot invested in the financial markets. There is a clear relationship between how much an individual has put into the system and what they will get out of it. By design, the state pension can be reduced if the Swedish economy and/or the global financial markets declines. For those who do not contribute enough to the self-financed state pension, there is poverty protection in form of a guaranteed pension (social welfare).

A fairness conundrum

The Swedes opted for an economically fair and fiscally robust pension system. Intra- and inter-generational effects are kept to a minimum. The system can withstand demographic humps and the state budget is less exposed to an ageing society.

In comparison, the Dutch Basic Income for old people is redistributive both within and across generations. The state budget is negatively exposed as the baby boomers move into retirement, creating inter-generational transfer from the working population to the retirees.

But it is very difficult to find a Dutch person who considers their state pension system to be unfair. While there are lots of angry Swedes who believe they have been unfairly treated. How can this be? This is a fairness conundrum.

The angry Swede

In Swedish tabloids, there are occasionally stories about pension unfairness. Let’s illustrate this with an upset retired nurse, whom we shall call Eva. Eva spent her entire career working in a hospital. Her state pension is low so it is difficult for her to make ends meet. In comparison, someone who has not worked will receive a guaranteed pension (i.e. social welfare) of almost the same amount as Eva. This makes Eva really upset about how ‘unfair’ this system is. Eva argues that she has done her part of the deal. She has worked hard her whole life, paid both her taxes and pension contributions every month. She asks herself: “and what do I get for that – absolutely nothing!”

Technically, Eva could not be more wrong. It is actually the high-income earners who have been contributing to the guaranteed pension. There is a ceiling for how much pension one can build up, but there is no limit to the contributions paid into the system – a hidden tax on high income earners but, on the other hand, they have a longer life expectancy. Eva actually gets exactly what she has paid for since she lives in a country that has the most economically fair state pension system in the world for middle earners. If Eva were to receive more than she paid for, that would be unfair. But good luck trying to explain this to Eva.

It’s all in the framing

The lesson from these two examples is that it is more important that the system is perceived as being fair, than actually being economically fair. In that sense the Dutch have done really well.

In the Netherlands, state pension is paid from the budget. Once we have paid our pension contributions to the state budget we lose track of them. This is called compartmentalisation. We cannot relate what we have paid in contributions to what we actually get back in our state pension. Therefore, we solve another problem: how to re-distribute the state budget fairly. In this framing we consider it fair that an equal amount is paid to all retirees from the collective pot of money, called the state budget.

In Sweden, state pension contributions are earmarked and personalised. Having a clear link between contributions and pension payments dramatically changes how we perceive fairness. Framed this way, most of us think it’s unfair if we have saved for our state pension and someone else gets it for free. But Swedes are not particularly egoistic, they are known their socially redistribution system with high progressive taxes.

The Swedish communication challenge

The main challenge for Swedes is that, for some, there are hardly any differences in outcomes from the self-financed state pension and retiring on social welfare. Why undertake all the effort of building a economically fair, but very complex, system if there are only small differences in the outcome?

One could therefore argue that it is perhaps better to follow suit with the Dutch and introduce a Basic Income for old people. Personally, I would recommend that Sweden keeps the current system as it has many advantages.

But, Swedes must learn to accept that pensions are expensive and outcomes are uncertain. The obvious long-term solution is increasing individual contributions to the self-financed state pension. It will take decades before this works its way through the system. A short-term step may be to begin calling the guaranteed pension for what it is – social welfare – so that people like Eva can, at least, get some comfort from the fact that they are not living on social welfare.