Pensions Core Course 2013: Prefunding pensions - options and arguments

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Text of Pensions Core Course 2013: Prefunding pensions - options and arguments

  • 1. Prefunding pensions:Options and argumentsEdward WhitehouseWorld Bank core courseWashington DC, April 2013

2. AgendaDifferent financing mechanisms:funding and pay-as-you-goAdvantages and disadvantagesConditions favourable to fundingDesign of funded schemes investment/provider choices administrative charges guarantees pay-out phaseMoving from pay-as-you-go to funding 3. Unfunded/pay-as-you-go schemesUse contributions from current workers to paybenefits to current retireesThis gives current workers promises in returnfor contributionsPromises must be met by future generationsPromises have different legal weights countries: from constitutional right to changeable promiseMain motivation of pay-as-you-go was earlierbenefit payout 4. An example: the United StatesReal rate of return on contributions (%) 5. PrefundingContributions from current workers are used toaccumulate assetsThese assets are used to pay benefits in thefutureSchemes can be partially funded Benefits for current workers will be paid for by a mixof accumulated assets and taxes/contributions paidby future workers 6. Potential advantages of fundingBetter able to deal with ageing of the populationLimits fiscal liabilitiesRemoves some labour-market distortionsHelps develop capital marketsPossibly increases savings and investmentReduce politicisation of the pension systemBetter rates of return on pension contributions 7. Rates of return: PAYG and fundedSustainable rate of return on PAYG = growth oflabour force + increase in average earnings can turn negative when labour force starts to shrinkRate of return on funded = capital-marketreturn historically, even with financial crises, this has beengreater than wage growth in developed countries 8. Distorted labour marketsPAYG schemes often: encourage early retirement are not portable between different jobs are based on final salary, encouraging under-reporting of earnings in early yearsFunded schemes: generally pay higher benefits to people who worklonger are easily portable between different jobs are based on contributions in each and every year 9. Politicisation of pensionsPoliticisation can be a problem: uncertainty in retirement benefits of currentpensioners and workers potentially divisive political battles between thosewho receive pensions and those who pay for themUnder PAYG, easy for governments to makepromises of future benefits they will be out of office before the costs have to bemetWith funded schemes, higher benefits onlypossible with higher contributions now 10. Capital-market developmentPAYG schemes: can hinder capital-marketdevelopment if substitute for private savings forretirementFunded schemes tend to lead to greater varietyof financial-market instruments offeredSavings are usually intermediated throughfinancial marketsSome suggestion that this has a positive impacton savings and economic growth 11. Ideal conditions for fundingIs the macroeconomy stable enough to offerreasonably safe financial instruments?Are sufficient financial instruments available? option of foreign investment but exchange-rate issues and political economyFinancial market regulation and supervision mustbe strong contributions to a funded pension are mandatory, unlikeother savings instruments they are also longer-term savingsAdministrative capacity: record-keeping, valuation 12. Investment riskFunded schemes subject to investment riskImportant to distinguish time periods long-term risks are not too large because rates ofreturn relatively stable short-term risks can be large if the markets fall whenyou want to retireMeasures to mitigate risks of financial crisesImportant to remember risks with PAYG political risk: a new government changes its mind fiscal risk: there isnt enough money to pay forpensions (arrears) 13. Scale of investment riskPercentile of distribution10 20 30 40 50 60 70 80 90Market dataRate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6Note10% contributionOECD average mortality rates40-year term to age 6550:50 equity:government-bond portfolio 14. Market and individual returnsAdministrative charges 0.75-2.00% in accumulation stage 0.25-0.50% for annuity purchaseTracking error 0.25-0.30% reduction in returnAgency and governance effectsPortfolio restrictionsAgeing might reduce future returns 15. Administrative charges Complex charge structures comparisons are difficult bothbetween countries and betweenproviders A single measure of charges: charge ratio: proportion ofaccumulated balance reduction in yield: proportionof assets in fund at any onetime 16. Administrative charges Complex charge structures comparisons are difficult bothbetween countries and betweenproviders A single measure of charges: charge ratio: proportion ofaccumulated balance reduction in yield: proportionof assets in fund at any onetime Illustration: assume 3.5% real return, 2%wage growth and 40 year term051015202530354045500 0.5 1 1.5 2 2.5 3Charge, % of assetsCharge,% of accumulation 17. Percentile of distribution10 20 30 40 50 60 70 80 90Market dataRate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6RescaledRate of return 3.2 3.8 4.3 4.7 5.0 5.4 5.7 6.2 6.7Replacement rate 32.2 36.8 41.2 45.2 48.6 53.5 57.6 65.3 74.2Scale of investment riskNote10% contributionOECD average mortality rates40-year term to age 6550:50 equity:government-bond portfolio 18. Types of guarantee in overallpension/tax systemsPortfolio 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 KongRole of taxation 19. AustraliaReplacementrate00.250.50.751 2 3 4 5 6 7 8 9Deciles of distribution of investment returnsSuperannuationguarantee 20. Australia1 2 3 4 5 6 7 8 9SuperannuationguaranteeReplacementrate00.250.50.75Deciles of distribution of investment returnsAge pension 21. Australia1 2 3 4 5 6 7 8 9Replacementrate00.250.50.75Deciles of distribution of investment returnsSuperannuationguaranteeAge pension 22. Other countriesDenmark Poland10 25 50 75 90Targeted andbasicAfter taxes020406080100120140Percentile point of distribution of investment returnsReplacement rate(% of gross earnings)Definedcontribution10 25 50 75 90Public earnings-relatedAfter taxes0102030405060708090Percentile point of distribution of investment returnsReplacement rate(% of gross earnings)DefinedcontributionDefinedcontributionDefinedcontributionDefinedcontribution 23. Rate of return guaranteesShould meet pension principles, e.g.,transparency, self-financingShould enhance security and adequacyFive 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: ChilePoland; or to benchmark return: Slovenia) period covered (6 mnths SVK, 1 yr CZR, 3yrs CHL,entire period of membership DEU) 24. CostsCapital 2% Indexed Ongoing FloatingGuarantee 0%nominal2%nominal0%real0%nominal1yr interestratePeriod Membership Membership Membership Annual MembershipCharges (%) 0.86% 3.33% 3.67% 6.08% 15.96%Loss inpension (%)1.28% 4.98% 5.49% 7.14% 23.81% 25. Providing funded schemes 1Many 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 26. Paying out funded pensionsAnnuity pension balance transferred to insurance companywhich provides regular payments indexation? survivors benefits?Programmed withdrawal balance divided by life expectancy determinespension in any given year remainder continues to earn interestLump sumCombination of or choice among the above 27. Moving from PAYG to funding:transition costsIf all or part of contributions of current workersare diverted to funded accounts, how cancurrent pensions be paid?Possibility of transition double burden one generation pays for its own and its parentspensionsAlso, current workers also have rights accruedin the public, PAYG scheme e.g. a 40-year old may have 20 years of contributionsin the PAYG scheme and needs compensating 28. Accrued rightsExisting pensioners: benefits continue to be paidas beforeExisting contributors: maintain a pro-rated benefit from the PAYG scheme recognition bonds: value reflects accrued benefits,bond can be accessed at retirementHow are accrued rights valued? e.g., indexation, retirement age, accrual rates,minimum pensions 29. Transition costs and design issuesWho is allowed to switch to the funded scheme? option or mandatory? age cut-offs?Gradual increase in contribution rates to fundedscheme over timeRoom to increase overall contribution rates? add-on versus carve-out funded scheme