Design alternatives for social pension programs

Robert Palacios, World BankInternational Conference – “Funded Systems: Their Role in Solving the Pension Problem”Varna, BulgariaMay 31-June 1, 2007

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Contents

The ‘coverage gap’ motivating social pension policies

The role of social pensions today

Design and future role of social pensions

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The ‘coverage gap’

Almost all countries mandate pension coverage for formal sector workers

But after operating for decades, coverage of these schemes has remained stagnant and for the poorest, it may not make sense (James (1999)).

There is little evidence that coverage is significantly affected by type of scheme or whether it is funded or not

There is, however, a strong correlation to income per capita which is a proxy for many factors

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The long run ‘coverage gap’

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The global coverage/income pattern suggests that it will take a long time for coverage rates to rise in developing countries

Fitted line including TSE dummy

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The long run ‘coverage gap’

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We also know that coverage rises with income within countries

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What are the policy options?

Find ways to expand existing contributory schemes

Statutory mandate can be expanded Better enforcement Improve schemes in terms of the ‘deal’ or rate of

return to contributors Reduce administrative costs Reduce non-pension incentives to be in the informal

sector Set up parallel schemes designed specifically

to increase voluntary participation by informal sector workers

Introduce or expand non-contributory or ‘social pensions’

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Social pensions – their role today

Palacios-Sluchynsky (2006) document a wide variety of SPs ranging from universal with large benefits to narrow with small targeted benefits

Proponents of large social pension schemes note that because it is not tied to a previous contribution history, it is the only program that can address the problems of the current or soon to be elderly

However, introducing or expanding social pension programs may imply important fiscal tradeoffs and may lead to certain distortionary behavior

Existing research provides limited guidance while many countries are now increasing the role of SPs

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Social pensions – their role today

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South Africa

Mauritius

Bolivia

Namibia

Brazil

Botswana

Nepal

Egypt, Arab Rep.

Turkey

Costa Rica

Colombia

Chile

Bangladesh

India

Uruguay

Russian Federation

Argentina

Estonia

Algeria

Dominican Republic

The bars for each country show the ratio of the social pension to per capita income x the ratio of the number of recipients to the number of elderly

Many countries (e.g., India, Chile, Kenya) are introducing or expanding SPs

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Social pension design issues

Key SP parameters are: Eligibility requirements

Age Income Residency

Benefit level Palacios, Sluchynsky and Biletsky (2007)

suggest the need to take into account initial conditions and devise a dynamic SP policy

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Parameters – eligibility age

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Health and productivity of the elderly will be lower in poor countries and for poor within the country

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Parameters – eligibility age

While the SP eligibility age should be coordinated with the contributory scheme age, the latter are not often tied to life expectancy

y = 0.2634x + 0.831

R2 = 0.269810

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Normal retirement age

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However, more countries are introducing this link

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Parameters – eligibility age

There is a case for poor countries to have lower social pension eligibility ages than in richer countries

The social pension age minimum can be higher than the contributory pension age minimum when the latter benefits are adjusted on an actuarially fair basis and contributors have achieved the target smoothing objectives (replacement rates)

Both types of eligibility ages can be structured flexibly with a view towards maintaining the ‘pension wealth’ constant; this automatically handles increasing longevity over time

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Parameters – benefit levels

Generally subjective, but should compare to three numbers

Poverty line Other social assistance type benefits Contributory scheme target benefits

Poor countries probably can focus more on absolute poverty while middle and higher income countries may tend to look at relative poverty

Ad hoc or discretionary benefit changes over time should be avoided in favor of indexation based on objective indices to avoid inter-cohort inequities, make fiscal costs transparent and minimize populism

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Parameters – benefit levels

Benefit level should be designed with both contributory and social pension components integrated into objectives

Australia Denmark

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Parameters – income tests

Social pensions are not intended to supplement the income of rich elderly, but universal plans exist in several countries New Zealand, Mauritius, Botswana, Brunei

Rationale often cited is that it is simple to administer; but this comes with a fiscal cost and less redistribution

Where income tax net is wide, this can be dealt with through progressive income tax

But most LICs and MICs have narrow tax bases

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Parameters – income tests

A taper or partial offset with income is one option and is used in several countries, but it may be difficult and costly to assess hh incomes

A more practical and cheaper approach is to apply a “pension test”

There are two problems with the pension test: It will result in regressive errors by ignoring non-

pension income and, It would reduce incentives to participate in the

contributory scheme

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Parameters – income tests How convincing are these arguments? First, there will be errors, but some of this can be

dealt with through income tax and some can be dealt with through joint annuity provisions

Second, there is little evidence that rates of return affect participation in contributory schemes (except in the case of retirement behavior) – requires long term view that is rare.

Third, as explained by Valdes-Prieto (2000), optimal income tax theory (Slemrod et. al., 1994) is consistent with a declining marginal tax on income for more productive workers and targeting makes this possible.

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APV

PMG

PASIS

PILARCONTRIBUTIVO

Chilean SP reform

PILARSO LID AR IO

PILARVO LU N TAR IO

PILARCONTRIBUTIVO

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Initial conditions and dynamic SP policy

Most high income OECD countries are in a steady state policy - high coverage and not likely to significantly change the role of SPs

Low and middle income countries (LICs and MICs) in contrast may still choose a different long term SP policy (e.g., Bolivia, Chile)

We argue that initial conditions matter and that the SP policy should be dynamic and adapt as the contributory schemes expand

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Initial conditions and dynamic SP policy

Country types

PPP$YCAP Coverage ratio Ratio 20-59/60+ population

LIC >4500 17% 7.6 MIC 4500-15,000 51% 6.3 HIC 15,000+ 90% 3.4 TSE 2000-20,000 66% 3.7

Source: authors’ calculations based on World Bank pension database and SIMA.

We focus on three stylized cases to see general policy implications of different SP policies

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Simulation of dynamic SP policy

Case 1: shift to a universal SP at 40% of YCAP Case 2: allow 100% pension test and

introduce DC scheme with 40% target RR at Lifetime Average Income per capita (LIA)

Case 3: allow 50% pension test and introduce DC scheme with 40% RR target at LAI

Case 4: CPI index the SP with 40% RR target at LAI and introduce DC scheme

Coverage of the DC scheme allowed to expand and mature along with growth in income per capita growth over a 60 year period

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Results for LIC

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In the first year, there is only the universal pension…in case 1, this remains the long term policy

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Results for LIC

In case 2, we apply a 100% pension test and introduce the DC scheme so that at maturation it looks like this…

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Contributory Social

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Contributory Social

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Results for LIC

The long run cost of the SP is significantly lower due to DC scheme

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2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065

Real GDP Growth, % Social, %GDPNPV of Social, %GDP

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2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065

Social, %GDP NPV of Social, %GDP

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Results for LIC

In case 4, the objective is absolute poverty, so the CPI indexed SP declines relative to incomes

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Contributory Social

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Results for LIC

Case 4 has lowest long run fiscal cost

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2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065

Social, %GDP NPV of Social, %GDP

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Social, %GDP NPV of Social, %GDP

Case 2 Case 4

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Results for MICs and TSEs

The tradeoffs differ for MICs because (a) they are already older but (b) they have higher coverage – (a) raises SP costs while (b) reduces them

Same is true for TSEs, except that there is a special pattern of temporarily declining coverage that affects the trajectory of the SP costs.

TSEs are also older than MICs generally. In TSEs, the SP can be seen as a bridge between

a period of high coverage before and after the transition

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Conclusions There is increasing pressure in many countries to

introduce or expand SPs in light of persistently low coverage of contributory schemes, funded or not

Social pension parameters should be carefully considered and viewed in conjunction with contributory schemes

Pension tests may be the most practical mechanism for controlling costs through targeting

A dynamic SP policy can reduce the long term fiscal costs as contributory schemes expand and mature

Initial conditions will result in different combinations of social vs contributory pensions and different time paths of convergence to steady state

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Thank you