Labor Market Effects of Pension Reform

Augusto Iglesias P.PrimAmérica Consultores

May 31, 2007.

Pension systems and labor markets

• Creation of employment and increases in productivity (and wages) are primary social goals

• Competitive pressures coming from globalization make efficient labor markets more necessary than ever

• There are mutual interactions between pension systems and labor markets: as the pension system influences labor markets, changes in labor market conditions will, in turn, have an impact on the pension system itself: Coverage Relative size of different pillars (and public expenditure on pension

programs)

Pension systems and labor markets

• Pension systems have different impacts on labor markets: Employment level (and unemployment rates) Employment composition (formal and informal sectors) Labor productivity and wages

• The force of these impacts depends on the way in which the pension system affects: Individuals decisions: how much to work?; in which sector?;

when to retire? Employers decisions Savings and investments (not to be analyzed here)

Pension reform and labor markets

• The change of the pension system will also have an impact on labor markets: How does the reform affect the supply of labor? How does the reform affect the demand for labor? What are the macro consequences of pension reform (and their

respective impact on labor markets)?

• Our question today: what is the impact on labor markets of moving from a DB - PAYG to a DC- Funded pension program?: Individuals and firm decisions Coverage

Impact on individuals and firm decisions

• The tax component of pension contributions• The level of contribution rates• Retirement decisions• Labor mobility

The tax component of pension contributions (in a two sector model)

• If pension reform reduces the tax component of contributions: Gross wages are reduced and net wages increase in the formal

sector: employment increases Labor supply in the informal sector decreases (higher net wage

and probability of finding a job in the formal sector): wages in the informal sector increase; employment decreases

Total labor supply increases: wages in both sectors decrease and total employment increases

Total productivity increases: as employment in the formal sector increases and total employment increases

Impact on unemployment rates is undetermined: depends mainly on elasticity of labor supply

The impact of pension reform on employment and wages

• Evidence: Pension reform in Chile resulted in an increase of approximately

2% in the informal sector wage rate. Edwards; Cox-Edwards (2002)

Pension reform in Chile resulted in a (modest) reduction in unemployment. Edwards; Cox-Edwards (2002)

Because of pension reform, total employment grew between 1.3% and 3.7%; employment in the formal sector grew between 3.2% and 7.6%; and employment in the informal sector grew between 1,1% and 1,3% (Chile). Corbo/Schmidt-Hebbel (2003)

Are contributions to funded systems considered less as a tax?

• Yes:Closer relationship between contributions and

benefits Personal accountsHigher rate of returns for contributions

• No:Whatever the specific characteristics of the pension

system, it´s likely that a large percentage of workers will finally receive a DB (guaranteed by the state)

Are contributions to funded systems considered less as a tax?

• Evidence:

Almost 50% of contributions to the new pension system are not considered as a tax (Chile) Torche/Wagner (1997) and Edwards/Cox (2002)

Tax component of contributions depends on credibility of social security institutions (Argentina) Colina/Ronconi/Tommasi (2002)

The level of contribution rates

• If rate of return (net of fees) of funded systems is greater than the implicit rate of return of contributions in a PYG system, pension reform could lead to lower contributions rates (long term rate between 5% - 6% for developed economies and 7% - 8% for emerging economies. Davis, 2007)

• Lower contribution rates mean higher take-home pay (net wages), lower cost of labor, or both. Their impact on labor markets is similar to a lower “tax component” of pension contributions

Rates of return on personal accounts

Source: Palacios (2003)

CountryReal rate of return since

inceptionStandard deviation

Real wage growth

Return wage growth

differential

Maximun to minimun

return ratio

Real income per capita

growth

Return capita growth

differential

Argentina 11,7% 13,4% -0,8% 12,5% 1,17 -0,4% 12,1%

Bolivia 16,2% n.a 8,8% 7,6% n.a 0,4% 15,8%

Colombia 11,8% 2,6% 1,4% 10,4% 1,13 -0,3% 12,1%

Chile 10,5% 9,3% 1,8% 8,7% 1,05 4,5% 6,0%

El Salvador 11,3% 3,6% -0,2% 11,5% 1,30 0,5% 10,8%

Mexico 10,6% n.a 0,0% 10,6% n.a 2,8% 7,8%

Peru 5,7% 7,5% 1,8% 3,9% 1,06 2,4% 3,3%

Uruguay 9,5% n.a 3,6% 5,9% 1,06 -0,3% 9,8%

Labor mobility

• Within the formal sector labor mobility between employments and firms partially depends on the characteristics of the pension system

• Funded individual accounts guarantee the portability of pension rights (“automatic vesting of contributions”)

• Individual accounts also increase the probability of uniform pension rules between different economic sectors

• Pension reform which reduces obstacles to labor mobility should have a positive impact on productivity

Retirement decisions

• Pension systems have an impact on labor market retirement decisions:

Statutory retirement age Pension amount Pension and work decisions Incentives to defer or to advance retirement age

Retirement decisions

• Pension rules in many “real world” DB pension systems penalize workers for working after statutory pension age. Also, they generate incentives for early retirement:

Cap on pensions (no more pension rights accumulate after some max. number of years of contributions)

Pensions based on final (or best) years of earnings encourage retirement immediately after those years

Pensions adjustments for early retirement are not actuarially fair

Pensions are not compatible with paid work

Retirement decisions

• Postponment of pension age pays more in a DC pension program than in a DB pension program

• Pensions based on individual account balances are more “neutral” than “real world” DB pensions in terms of retirement decisions

• Postponement of retirement age increases labor force participation rates of older people (and total employment)

Defined contibution pension

Defined benedit pension

Pension reform and retirement decisions: the evidence

• Participants in DC pension plans retire later from the labor force compared with participants in DB plans (USA). Munell/Cahill/Jivan (2003)

• “Substantial increase in labor participation rates for

older men after pension reform in Chile”. James/Cox (2007)

Impact of pension reform on coverage(of contributory pension programs)

• Expectations have not been met • Coverage of contributory pension programs

depends mainly on the distribution of labor between formal and informal sectors, and on unemployment rates

• The impact of pension reform on coverage will therefore depend on the size of the reduction in contribution rates and on the tax component of contributions

Impact of pension reform on coverage: the evidence

• The impact is difficult to assess because, in most cases, many other things are changing at the same time as the pension reform

• Results differ from country to country:

Packard (2001): Introducing pension personal accounts increases the percentage of economically active population contributing to pension systems, although this happens gradually over time (panel data for 18 LA countries)

Colina/Ronconi/Tommasi (2002): Pension reform has had a small positive impact on coverage. The impact is concentrated on higher income workers (Argentina)

Cox/Edwards (2002): Because of the smaller “tax effect” of pension contributions, pension reform has relevant and positive impacts on labor demand and labor market participation rates (Chile)

Final remarks• Labor market effects of pension reform will depend a lot

on the specific design of the new pension program• Some of the effects may be achieved by improving the

design of the PYG system • However some other effects are due to the nature of a

DC -funded pension program• Substitution of a DC -funded pension program for a DB-

PYG, brings the opportunity to increase employment in the formal sector and labor market efficiency

• Coverage does not only (or mainly) depend on the characteristics of the pension program

• To achieve the expected results, the new pension program must be carefully designed and implemented

References

• V. Corbo; K. Schmidt-Hebbel: “Macroeconomics effects of pension reform in Chile” (2003)

• A.Cox; E. James:”Pension reform and postponed retirement: evidence from Chile” (2007)

• R.Disney; E. Whitehouse: “Pensions plans and retirement incentives” (1999)

• S.Edwards; A. Cox: “Social security reform and labor markets: the case of Chile” (2002)

• A. Iglesias: “Mercados del trabajo y cobertura previsional” (2005)• OECD: “Coping with low labour-force participation” (April, 2005)• R. Rofman; A. Luchetti: ”Pension systems in Latin America:

concepts and measurement of coverage” (November, 2006)• S. Valdés: “Políticas y Mercados de Pensiones” (chapters 5, 6 and

7) (2002)• World Bank: “Can pension reform reverse the trend to earlier

retirement?” (2001)

Thank you

Augusto Iglesias P.

PrimAmérica Consultores

May 31, 2007.