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