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Prefunding pensions:
Options and arguments
Edward Whitehouse
World Bank core course
Washington DC, April 2013
Agenda
Different financing mechanisms: funding and pay-as-you-go
Advantages and disadvantages
Conditions favourable to funding
Design of funded schemes investment/provider choices
administrative charges
guarantees
pay-out phase
Moving from pay-as-you-go to funding
Unfunded/pay-as-you-go schemes
Use contributions from current workers to pay benefits to current retirees
This gives current workers “promises” in return for contributions
Promises must be met by future generations
Promises have different legal weights countries:
from constitutional right to changeable promise
Main motivation of pay-as-you-go was earlier benefit payout
An example: the United States
Real rate of return on contributions (%)
Prefunding
Contributions from current workers are used to accumulate assets
These assets are used to pay benefits in the future
Schemes can be partially funded
Benefits for current workers will be paid for by a mix of accumulated assets and taxes/contributions paid by future workers
Potential advantages of funding
Better able to deal with ageing of the population
Limits fiscal liabilities
Removes some labour-market distortions
Helps develop capital markets
Possibly increases savings and investment
Reduce politicisation of the pension system
Better rates of return on pension contributions
Rates of return: PAYG and funded
Sustainable rate of return on PAYG = growth of labour force + increase in average earnings
can turn negative when labour force starts to shrink
Rate of return on funded = capital-market return
historically, even with financial crises, this has been greater than wage growth in developed countries
Distorted labour markets
PAYG schemes often:
encourage early retirement
are not portable between different jobs
are based on final salary, encouraging under-reporting of earnings in early years
Funded schemes:
generally pay higher benefits to people who work longer
are easily portable between different jobs
are based on contributions in each and every year
Politicisation of pensions
Politicisation can be a problem:
uncertainty in retirement benefits of current pensioners and workers
potentially divisive political battles between those who receive pensions and those who pay for them
Under PAYG, easy for governments to make promises of future benefits
they will be out of office before the costs have to be met
With funded schemes, higher benefits only possible with higher contributions now
Capital-market development
PAYG schemes: can hinder capital-market development if substitute for private savings for retirement
Funded schemes tend to lead to greater variety of financial-market instruments offered
Savings are usually intermediated through financial markets
Some suggestion that this has a positive impact on savings and economic growth
Ideal conditions for funding
Is the macroeconomy stable enough to offer reasonably safe financial instruments?
Are sufficient financial instruments available?
option of foreign investment
but exchange-rate issues and political economy
Financial market regulation and supervision must be strong
contributions to a funded pension are mandatory, unlike other savings instruments
they are also longer-term savings
Administrative capacity: record-keeping, valuation
Investment risk
Funded schemes subject to investment risk
Important to distinguish time periods
long-term risks are not too large because rates of return relatively stable
short-term risks can be large if the markets fall when you want to retire
Measures to mitigate risks of financial crises
Important to remember risks with PAYG
political risk: a new government changes its mind
fiscal risk: there isn’t enough money to pay for pensions (arrears)
Scale of investment risk
Percentile of distribution
10 20 30 40 50 60 70 80 90
Market data
Rate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0
Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6
Note
10% contribution
OECD average mortality rates
40-year term to age 65
50:50 equity:government-bond portfolio
Market and individual returns
Administrative charges
0.75-2.00% in accumulation stage
0.25-0.50% for annuity purchase
Tracking error
0.25-0.30% reduction in return
Agency and governance effects
Portfolio restrictions
Ageing might reduce future returns
Administrative charges
Complex charge structures
comparisons are difficult both between countries and between providers
A single measure of charges:
charge ratio: proportion of accumulated balance
reduction in yield: proportion of assets in fund at any one time
Administrative charges
Complex charge structures
comparisons are difficult both between countries and between providers
A single measure of charges:
charge ratio: proportion of accumulated balance
reduction in yield: proportion of assets in fund at any one time
Illustration:
assume 3.5% real return, 2% wage growth and 40 year term
0
5
10
15
20
25
30
35
40
45
50
0 0.5 1 1.5 2 2.5 3
Charge, % of assets
Charge,
% of accumulation
Percentile of distribution
10 20 30 40 50 60 70 80 90
Market data
Rate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0
Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6
Rescaled
Rate of return 3.2 3.8 4.3 4.7 5.0 5.4 5.7 6.2 6.7
Replacement rate 32.2 36.8 41.2 45.2 48.6 53.5 57.6 65.3 74.2
Scale of investment risk
Note
10% contribution
OECD average mortality rates
40-year term to age 65
50:50 equity:government-bond portfolio
Types of guarantee in overall
pension/tax systems
Portfolio of different kinds of pensions:
subject to investment risk:
DC plans in many OECD, LAC and ECA countries
not subject to investment risk:
DB/points in Costa Rica, Uruguay, Slovak Republic, Latvia, Lithuania, Estonia, Croatia, Bulgaria, Romania, Switzerland
NDC in Poland, Sweden
basic in Kosovo, Netherlands, New Zealand, new UK scheme
offset investment risk:
targeted, means-tested, minimum benefits in Australia, Mexico, Hong Kong
Role of taxation
Australia
Replacement
rate
0
0.25
0.5
0.75
1 2 3 4 5 6 7 8 9
Deciles of distribution of investment returns
Superannuation
guarantee
Australia
1 2 3 4 5 6 7 8 9
Superannuation
guarantee
Replacement
rate
0
0.25
0.5
0.75
Deciles of distribution of investment returns
Age pension
Australia
1 2 3 4 5 6 7 8 9
Replacement
rate
0
0.25
0.5
0.75
Deciles of distribution of investment returns
Superannuation
guarantee
Age pension
Other countries
Denmark Poland
10 25 50 75 90
Targeted and basic
After taxes
0
20
40
60
80
100
120
140
Percentile point of distribution of investment returns
Replacement rate (% of gross earnings)
Defined contribution
10 25 50 75 90
Public earnings - related
After taxes
0
10
20
30
40
50
60
70
80
90
Percentile point of distribution of investment returns
Replacement rate (% of gross earnings)
Defined contribution
Defined contribution
Defined contribution
Defined contribution
Rate of return guarantees
Should meet pension principles, e.g., transparency, self-financing
Should enhance security and adequacy
Five key design issues:
fixed return (Switzerland, Iceland) or minimum (Belgium, Germany)
real or nominal (Czech Republic, Germany)
level (often zero: CZR, DEU; 2% CHE; 3%+ BEL)
absolute (above) or relative (to other funds: Chile Poland; or to benchmark return: Slovenia)
period covered (6 mnths SVK, 1 yr CZR, 3yrs CHL, entire period of membership DEU)
Costs
Capital 2% Indexed Ongoing Floating
Guarantee 0% nominal
2% nominal
0% real
0% nominal
1yr interest rate
Period Membership Membership Membership Annual Membership
Charges (%) 0.86% 3.33% 3.67% 6.08% 15.96%
Loss in pension (%)
1.28% 4.98% 5.49% 7.14% 23.81%
Providing funded schemes 1
Many possible structures
single public agency (provident funds)
single pension fund, but privately managed (UK Nest)
a few private pension funds (Uruguay)
many private pension funds (Chile, Poland)
public and private pension funds (Mexico, Russia)
Investment choice
single portfolio per pension fund
multiple portfolios per pension fund
restrictions on who can own what type of portfolio
Paying out funded pensions
Annuity
pension balance transferred to insurance company which provides regular payments
indexation?
survivors benefits?
Programmed withdrawal
balance divided by life expectancy determines pension in any given year
remainder continues to earn interest
Lump sum
Combination of or choice among the above
Moving from PAYG to funding:
transition costs
If all or part of contributions of current workers are diverted to funded accounts, how can current pensions be paid?
Possibility of transition ‘double burden’
one generation pays for its own and its parents’ pensions
Also, current workers also have rights accrued in the public, PAYG scheme
e.g. a 40-year old may have 20 years of contributions in the PAYG scheme and needs compensating
Accrued rights
Existing pensioners: benefits continue to be paid as before
Existing contributors:
maintain a pro-rated benefit from the PAYG scheme
‘recognition bonds’: value reflects accrued benefits, bond can be accessed at retirement
How are accrued rights valued?
e.g., indexation, retirement age, accrual rates, minimum pensions
Transition costs and design issues
Who is allowed to switch to the funded scheme?
option or mandatory?
age cut-offs?
Gradual increase in contribution rates to funded scheme over time
Room to increase overall contribution rates?
‘add-on’ versus ‘carve-out’ funded scheme
Recommended