Rethinking Pension Reform:

Late Prof. Franco Modigliani

& Arun Muralidhar

www.mcubeit.com Dr. Arun Muralidhar

The New Yorker

New Yorker, June 1999

Franco TributeFranco Tribute

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Agenda U.S. Social Security and current problems

Case for funding (and investing in equities)

Privatization - European & South American experience

A swap ensures DB and no manipulation of assets

The impact of these proposals on market efficiency

The impact of reform on the budget and the asset management industry

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The Pension Fund Balance Sheet

FutureFutureContributionsContributions

Current Current AssetsAssets

FutureFutureReturnsReturns

PENSION PENSION BENEFITSBENEFITS=

Funded ratio = assets/liabilitiesFunded ratio = assets/liabilities

Can be funded completely, partially or PAYGO

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Background on U.S. Social Background on U.S. Social Security Security

Pay 12.4% of salary as contribution (w. caps at $87,900)

Contributions split equally between employer and employee

Average benefit = 50% of average of 35 best years of salary

Defined benefit, but redistribution (top earnings bracket may get only 35%; lowest can get 70%)

“Pay-As-You-Go”: Some funding thanks to Alan Greenspan

For many, SS accounts for 90% of retirement income!!

Inflation adjusted pensions

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Background on U.S. Social Background on U.S. Social Security Security

Receipts = $630 bn; Payments = $480 bn

Trust Fund = $1.5 trillion

47 mn people receive benefits; 154 mn people covered

Trust Fund projected to grow to $4 trillion by 2013

Current surpluses are invested in “government debt” – earned 6% in 2003

Problems not immediate – can go on for 40 years

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PAYGO Formula

Taxable Wages* SS tax = Pension Benefits

Taxable Wages depends on Rate of Growth of Real Income (Labor Force + Productivity Growth)

Increasing longevity increases pension benefits

Often, no incentive to control pension promise

Ratio of contributing worker to pensioner dropped from 9 to 2-3

A “Ponzi” Scheme and the Bjorn Borg solution……..

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Need for Reform – Social Security Crisis

Pay-as-you-go (PAYGO) systems face a crisis

Caused by low population and productivity growth

Contributions will need to rise dramatically or benefits will need to be cut to be sustainable

Often, there is a poor link between contributions and benefits; benefits are often too generous

Many countries do not have budget cushions to bail out these systems – Maastricht Criteria!!

Two different issues: (1) Best System; (2) Transition

Need for Reform - The U.S. Case

Contribution rates without reform

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074

Year

Per

cen

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f to

tal

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Effective Cost Ratio

Current contributions

Current contribution

12.4%

Contributions without Reform

Problems are much worse in Europe, Emerging Mkts!!

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Latin America and Europe

In many European cases, current contributions are as high as 30% of salaries – projected to rise further!!

Benefits very generous – often 100% of final salary

Pension cost can be as high as 6-10% of GDP

Rates of return in the 1980s of governmental systems often very negative (-37% p.a. in Peru)

Projected rate of growth of labor force + productivity < rate of return on assets

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PAYGO versus Funding

Long term, Funding = lower contributions (r > population growth + productivity growth)

Volatility of contribution under PAYGO is very high

No savings – contributions finance dissaving of the elderly

Cannot just transition immediately, as Funding dominates because funds were set aside

Funded systems can impact capital markets

Funding implies some investment in equities

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When Funding Dominates….Cost and Contribution Rates for Alternative Systems and Selected ScenariosAssumptions: Working Life = 40 Years; Average Salary = 50% Replacement

Cost Ratio = Pay-as-you-go Scheme Contribution Rates for Different Scenarios

Retired Life - 16 Years Retired Life - 18 Years

Real Productivity Growth Real Productivity Growth0% 1.00% 1.40% 2.00% 0% 1.00% 1.40% 2.00%

Population Growth

0% 20.00% 15.40% 13.40% 11.90% 22.50% 17.20% N/A N/A1% 15.05% 11.70% 10.40% 9.00% 16.77% N/A N/A N/A2% 11.24% 8.80% 7.00% N/A 12.41% N/A N/A N/A

Table 3.1BCost Ratio = Funded Scheme Contribution Rates for Different Scenarios

Retired Life - 16 Years Retired Life - 18 Years

Real Productivity Growth0% 1.00% 1.40% 2% 0% 1.00% 1.40% 2%

Return on Assets0% 20.00% 20.11% 20.15% 20.23% 22.50% 22.62% 22.67% 22.75%1% 15.05% 15.33% 15.45% 15.63% 16.77% 17.08% 17.21% 17.41%2% 11.24% 11.60% 11.75% 11.97% 12.41% 12.81% 12.97% 13.22%3% 8.33% 8.70% 8.86% 9.10% 9.12% 9.53% 9.70% 9.96%4% 6.13% 6.48% 6.63% 6.86% 6.66% 7.04% 7.21% 7.46%5% 4.49% 4.80% 4.93% 5.14% 4.84% 5.17% 5.32% 5.54%6% 3.26% 3.53% 3.64% 3.82% 3.50% 3.78% 3.90% 4.09%

Approx. replacement 50% 41% 38% 34% 50% 41% 38% 34% on final salary

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The Golden SS Funding Rule

c* + (r-)At-1*= p*

c* is the contribution rate, r is the nominal return on investments, is the growth of income = population growth + productivity growth (r- is the net return defined as the gross rate of return from investments and reduced by adjustments for productivity growth and population growth)

A* is the steady state asset ratio to wages, and p* is pension cost relative to the wage bill or cost ratio.

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DB versus DC – can look similar

DB: Inter and intragenerational risk sharing

DB: sponsor bears the risk; pooling lowers cost

DC: Offers choice to individuals who bear the risk

DC: Allows for bequeathing assetsKEY EQUATIONContributions, compounded at the expected return on assets (with or without volatility)

= Expected final wealth at retirement = Expected present value of desired annuity as

of the retirement date

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The 3-Pillar Approach (World Bank)

Pillar 1: PAYGO; DB; Government; Mandatory

Pillar 2: Funded; DC; Private; Mandatory

Pillar 3: Funded; DC; Private; Voluntary

Because Pillar 1 was struggling – changed all aspects.Bush Administration favors creation of Pillar 2.

Privatization only privatizes risk!!

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Problems with Privatization Model The key problem is only a financing problem

Was meant to keep government away from funds

Individuals are gambling with retirement funds

Private accounts = high fees = lower pensions

Can lead to unpredictable pensions

Value of choice overrated – e.g., Sweden, Australia

U.S.: Shift 2% of contributions from SS – how??

Governments and individuals will pay a lot to ensurethat elderly do not retire poor

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Problems with Privatization Model

Fees take a huge chunk out of pensions

Gross Gross Gross Gross Loss on Replacement Replacement Replacement Replacement ReplacementFinal Salary Average Salary Final Salary Average Salary Final Salary

(1) (2) (3) (4) (5) = (1)-(3)Argentina 70.0% 222% 47.00% 148% 23%Chile 93.0% 296% 72.00% 228% 21%Columbia 93.0% 296% 79.00% 249% 14%Mexico 112.0% 356% 86.00% 274% 26%Peru 75.0% 238% 63.00% 199% 12%Uruguay 70.0% 222% 51.00% 162% 19%

Gross Net Fees "Seepage"

(% of wages) (% of wages) (% of wages) =Fees/GrossArgentina 7.5% 5.0% 2.5% 33.3%Chile 10.0% 7.7% 2.3% 23.0%Columbia 10.0% 8.4% 1.6% 16.0%Mexico 11.5% 8.8% 2.8% 23.9%Peru 8.0% 6.7% 1.3% 16.3%Uruguay 7.5% 5.5% 2.1% 27.3%

Contributions

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Will Chile Get Pickled? Hidden Debt

Mandatory participation = DB will lead to lowest debt

Table 4.8: Results with 40 different participants in the plan

INVESTMENT POLICY: EXPECTED RETURN 6.5 PERCENT, VOLATILITY 5.2 PERCENT

Probability That Participant Will Not Meet Their Target Wealth

Expected Amount by Which the Participant is Below Her Target Wealth

Downside Risk When the Participant is Below Her Target Wealth

Expected Debt of the Plan

DC 53.6 percent 36,562 8.8 percent 6,236,624

CFDB 53.3 percent 23,590 5.7 percent 4,670,100

Welfare gains of CFDB (i.e., the difference between DC & CFDB)

Absolute

Relative

0.3 percent

0.6 percent

12,972

55.0 percent

3.1 percent

54.4 percent

1,566,525

33.5 percent

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Problems with Transitions

Need to get the funded system going with money

Debt financed transitions risky – a big leverage play

Surplus financed transitions are best

Problem: President Bush blew the surplus

Tax rebates will come to roost in higher contributions or consumption taxes

Intergenerational issues are key – who pays?Transition does not require “double contributions”

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Transition to Partial or Fully Funded?

Full funding implies the Golden SS rules applies

To get to full funding, transition cost is very high

Asset-wage ratio = 3.5X (or 2.3X national income)

Partial funding requires smaller cost

In the US case, assumed 1.1% extra contributions; asset-wage ratio = 1.6X (or 1.1X national income)

Full funding would crowd out private investors

Some argue that a 1.9% increase could keep PAYGO

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Even Australia/Sweden will Struggle

Australia: Mandatory participation (driven by Labor)

Some company DB schemes, but largely DC

Pooled people into industry schemes – lower cost

Problems: Too many small schemes – cost is high

Not sophisticated: consultants used = additional fees

Potential conflicts – trustees can represent AM firms

Where choice offered – not used!!

Estimated reduction in pensions 10-15% (Bateman)

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Our Solution – Only Two Pillars

Pillar 1: Funded (Partially or Fully); DB; Public Governance/Private Management; Mandatory

Pillar 2: Funded; DC; Private; Voluntary (Pillar 3)DB = Guaranteed Return on Contributions

Assets Pooled to Minimize CostsSwap between Treasury and SS to

Guarantee ReturnBlue Ribbon Board like Canada and

IrelandVariable Contribution to Minimize Risk to

Govt.

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How Does the Swap Work?

SSA pays Treasury return on invested portfolio; Treasury pays SSA guaranteed real rate + inflation

Long term swap rate = 5% real

Invested in mkt cap weighted index (stocks + bonds)

Prevents manipulation of funds = shows up in the budget as payment in the swap

SS is always whole; smoothes returns over decades

Government (best risk taker) bears risk

Create a sinking fund; allow variable contributions

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Why Our Solution Is Better?

Contributions are Lower and More Predictable

Benefits are Protected (and Minimizes Cost to Governments and Participants)

Lower Asset Management Costs

Better For Unsophisticated Participants

Access to DB and DC Leads to Optimal Choice

Choice is not really exercised: Australia, Sweden

Transition cost borne equally by all generations

Explaining the Transition – Zero Growth

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2052 2054 2056 2058 2060

Pensions (CR)

Required Contribution (ex Transition Cost)

Zero Growth Scenario: Transition from PAYG to Funding

(% Taxable Payroll)

Interest on TF

Transition Cost

NF Pensions

NF Contributions

22.5%

4.84%

27.34%

Transition to New System - The U.S. Case

Comparison of Contribution Ratesunder Different Reform Scenarios - Smoothing Contributions

0.00%

5.00%

10.00%

15.00%

20.00%

2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074

Year

Per

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Effective Cost Ratio

Household Contributions with Proposed Plan

Transition Cost

Current contribution

Interest from Trust Fund

M Contributions

12.4%

13.5%

14.4%

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Investment Issues

Should portfolio be U.S. only or global?

Initially U.S., but ideally global return on capital

Should assets be managed passively or actively?

Initially passive, but ETFs can allow active

Role of alternative assets?

Canada has already invested in alternatives

Internal or external? No strong bias

Too much passive – implications for voting & valuation

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The Appropriate Rate of Return…..

Average return on equity has been remarkably stable - around 7% (Siegel 1994 and 1999).

The return on equity corresponds to profit; profit is not a satisfactory measure of the return on capital when the firm is financed partly by debt

Investing in an indexed portfolio of an share of the market portfolio of stock and bonds (70:30).

Estimate of the real interest rate =3%

Equals an estimate of return on capital of 6% -- (Bosworth (1996) arrives at an estimate of 6.2%)

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The Appropriate Rate of Return….

Must look at pre-tax value as that is relevant to Treasury

6% return on total corporate capital after corporate tax.

Corporate income tax = 30% on the levered profit, plus a 30% debt at a real interest around 3.3%, results in an estimated 8% of the pre-tax return on total capital,

1% for interest, 7% for equity before tax, of which 2% is attributable to the tax

This estimate of a pre-tax return on the unlevered market portfolio is close to a well-known estimate of Poterba (1998)

Gives the Treasury a premium of 3% for bearing risk

How To Achieve Retirement Objectives – The Two Pension Fund Theorem

0

20

40

60

80

100

Replacement

Rates (%)

Probability of notachieiving a

replacement rate

GuaranteedReplacement Rate

MarketPortfolio-M

B

A

Markowitz EfficientFrontier

A’s Investments :70% DB, 30% Market Portfolio

B’s Investments: 50% DB, 50% Market Portfolio

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Pillar “3” is No Breeze

Average sophistication is low

Poor advice on asset allocation (strategic & tactical)

Too much focus on manager selection

Rating schemes are poor – Morningstar, IR tells you little about risk-adjusted performance, skill etc.

Measures that do (M2, M3, SHARAD, Q-sum) beyond reach of most individuals

Fees can be mitigated through ETFs etc.

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ConclusionsConclusions Do not fix what is not broken (DB)

Do not transfer risk and choice to those least capable of bearing or using it

Invest in the market with guarantee structure

A combination of DB and DC are critical

Variable contributions to manage risksLonger the delay to reform, the higher the

cost

AppendixAppendix

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Arun Muralidhar - BioArun Muralidhar - Bio

Chairman of Mcube Investment Technologies, LLC and Managing Director at FX Concepts, Inc.

Author of “Innovations in Pension Fund Management”

Head of Investment Research and Member of Investment Management Committee, World Bank Investment Department, 1995-1999

Derivatives and Liability Management, World Bank Funding Department, 1992-1995

Managing Director and Head of Currency Research, JPMIM, 1999-2001

BA, Wabash College (1988); PhD, MIT Sloan (1992)