Pension trends in_emerging_markets

No. 2|2008

International Pension Papers

Pension Trends in Emerging Markets – The Rise of DC Plans and Its Consequences

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No. 2|2008Allianz Global Investors International Pension Papers

Imprint

Publisher: Allianz Global Investors AG, International Pensions, Nymphenburgerstr. 112-116, D-80636 Munich, [email protected]

http://www.allianzglobalinvestors.com | Author: Dr. Alexander Börsch, Senior Pensions Analyst, Allianz Global Investors AG, [email protected]

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Critical IssuesCentral and Eastern Europe (CEE) and Asia have undertaken far more ex-tensive and fundamental pension reforms than those in Western industrialisedcountries. The basis of the reforms in both regions is a strong, fully funded pillar:

– The pillar is of the defined contribution (DC) type in all and participation is mandatory in most countries.

– Portability, transparency and calculability were the primary considerations in introducing DC systems.

Three key drivers of pensions reform are evident:– Asian aspiration to establish formal pension systems – Lack of sustainability of previous CEE pension systems – Significant demographic changes resulting in an unprecedented speed

of ageing

To ensure the sustainable success of DC plans and adequate living standardsafter retirement, government and stakeholders need to address four issues: (1) improving financial education; (2) designing adequate plans; (3) providingtransparent and suitable products; (4) introducing appropriate regulations.

The new DC systems will rapidly build a massive amount of pension assets.The yearly growth rate is projected to be 19% for CEE and 17% for the emergingAsian economies.

Pension Trends in Emerging Markets – The Rise of DC Plans and Its Consequences

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No. 2|2008Allianz Global Investors International Pension PapersAllianz Global Investors International Pension Papers

ContentIntroduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

The Design of Pension Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6CEE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Reform Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Demographic Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Why DC Schemes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Pension Asset Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Challenges in DC Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Challenge I: Financial Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Challenge II: Plan Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19Challenge III: Regulating DC Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Investment Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20Guarantees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

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1 This paper covers

Bulgaria, China, Croatia,

the Czech Republic, Esto-

nia, Hong Kong, Hungary,

India, Latvia, Lithuania,

Poland, Romania, Singa-

pore, Slovakia, Slovenia,

South Korea, Taiwan and

Thailand. There is no

uniform definition of

emerging economies.

The World Bank divides

economies into: low,

lower middle, upper

middle and high income.

Low- and middle-income

economies are usually

considered emerging

economies if they have

high growth rates. Sever-

al economies examined

are high-income econo-

mies, such as the Czech

Republic, Estonia, Hong

Kong, South Korea, Sin-

gapore, Slovenia and Tai-

wan. They are emerging

in the sense that they

only recently became

high-income economies

as opposed to traditional

industrialised countries

like the United States and

Western Europe.

2 South Korea is the only

country in the sample

where recent pension

reforms allowed DB plans

in addition to DC plans.

Awave of pension reforms has been im-plemented in industrialised countries

since the early 1990s. Less publicised, butmore far reaching are those reforms imp-lemented in emerging economies1. In theemerging economies of Asia and Central andEastern Europe (CEE), demography is a pow-erful driver of reform as the outlook is notmuch rosier for many emerging economiesthan for the industrialised countries in termsof the aging population.

However, demography is not the sole rea-son for pension reform. At least as importantare the facts that previous systems in CEElacked sustainability and the aspiration ofAsian countries to establish formal pensionsystems. Obviously, economic, political andcultural differences between the emergingeconomies are huge. Nevertheless, manyemerging economies have followed a similarpath of reforms, one that greatly differs fromthat taken in the industrialised world.

This reform path is based on a stronglyfunded pension pillar that takes the form of individual defined contribution (DC)accounts2. Broadly speaking, there is a con-siderable degree of convergence in the pen-

sion systems of the emerging markets. Thispattern has profound implications for allstakeholders. Pension plan members aremore dependent than before on capital mar-kets for their retirement income. They enjoygreater degrees of freedom, but also havegreater responsibility. The public policy chal-lenge is to provide them with financial edu-cation so they can handle this new responsi-bility sensibly. The rise of DC schemes alsorequires appropriate plan design and regu-lation so that the advantages of DC plans canflourish. As capital market development is of-ten at an early stage in emerging economies,regulation can be crucial for the success ofDC plans. Lastly, financial services providersneed to develop and deliver the right retire-ment products and solutions, taking intoaccount the demand structures of the coun-try in question.

This paper investigates the results of pen-sion system reforms, the reasons for the re-forms, their consequences and the futuredevelopment of pension markets. It focuseson Asia and CEE, as most countries describedunder the label of emerging markets arelocated within these two regions.

Introduction

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Bulgaria Croatia Czech Rep. Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia

Allianz Global Investors International Pension Papers

The Asian and CEE countries had signifi-cantly different starting points for pen-

sion reforms. The most obvious differencesbeing economic development and wealth.Almost all of the countries are growing quick-ly, however, some are developing from verylow levels. The poorest country is India witha GDP per head that is only a fortieth of that

of Singapore. The richest CEE country, Slove-nia, has a per capita income only 60% of Sin-gapore, but is still ten times wealthier thanChina. So, the economic differences betweenthe countries are enormous, which makesthe similarity of solutions implemented inboth regions even more surprising. (Chart1/2)

The Design of Pension Reform

Chart 1 GDP per head [2007] and GDP growth in CEE [2004-2007]

Source: Allianz Dresdner Economic Research, Eurostat

€10,000

€12,000

€14,000

€16,000

€18,000

€ 8,000

€ 6,000

€ 4,000

€ 2,000

€ 0

12 %

10 %

8 %

6 %

4 %

2 %

0 %

CEE

The CEE reforms occurred during the transi-tion from a command to a market economy.Under socialist rule, pensions were the ex-clusive realm of the state. The link betweencontribution and benefits was tenuous withbenefits largely depending on years of serv-ice. The retirement age was generally low

and several occupations enjoyed consider-able privileges. Obviously, this system couldnot be retained when the CEE countries trans-formed into market economies. However, thesituation was aggravated during the begin-ning of the transformation. High official un-employment and increasing employment in

GDP per head GDP growth

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China Hong Kong India Singapore South Korea Taiwan Thailand

Chart 2 GDP per head [2007] and GDP growth in Asia [2004-2007]

Source: Allianz Dresdner Economic Research

€10,000

€15,000

€20,000

€25,000

€ 5,000

€ 0

12 %

10 %

8 %

6 %

4 %

2 %

0 %

the shadow economy coupled with a sky-rocketing number of pensioners (resultingfrom early retirement programs) put dra-matic strains on the then-existing system.

In response, all CEE countries initiatedparametric reforms in the public pillar, suchas increasing retirement age, reducing in-centives for early retirement and establish-ing a stronger link between contribution andbenefits. As part of the reforms undertakenfrom the 1990s onwards, many countriesintroduced a mandatory capital-funded pil-lar. These followed World Bank recommen-dations and include individual DC accounts.

The system works like this. A portion ofthe social security contribution to publicpensions is redirected into a private pension

fund selected by the member. Hungary wasthe first country to introduce such a systemin 1998, followed by Poland. The most recentcountries to introduce this pension designwere Slovakia in 2005 and Romania in 2007.Of the 11 CEE countries, eight have nowintroduced such a mandatory pillar. Onlythe Czech Republic (which relies on volun-tary pension savings), Slovenia (which runsa Western-style occupational pension sys-tem) and Lithuania (which has a funded pillar on a voluntary basis) remain the ex-ceptions.

GDP per head GDP growth

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Pension reform in Hungary

In 1998, Hungary was the first CEE country to introduce mandatory pensions, providing a role

model for other CEE countries. It also substantially restructured its public pension pillar and intro-

duced voluntary pension funds. The funded pillar was made compulsory for new labour market

entrants younger than 42 years of age, while existing employees could choose to join or not.

Around 50% of the labour force opted in. Other CEE countries have achieved similar rates, reflect-

ing a lack of trust in the public system. Of the total contribution of 26%, 8% goes into individual

accounts. The mandatory funds can invest up to 30% of their assets abroad; a maximum limit on

equities was lifted in 2005. In other regards, Hungarian investment regulation is also compara-

tively liberal. Pension funds can invest a minor share of their assets in hedge funds and private

equity. Recently, Hungary introduced a fourth pillar to further boost private pension savings and

financial market development.

The World Bank model of pension reform

A strongly funded pillar operating on a mandatory basis is the key element of the World Bank

model of pension reform. The model aims to establish a multi-pillar approach and the rationale

is simple. A pension system has three functions: to provide savings, redistribution and insurance.

A dominant public pillar (or any other form of single pillar system) is unable to fulfil all these func-

tions equally and efficiently. The over-reliance on the public pillar results in labour and capital mar-

ket distortions, ill-targeted redistribution and old-age insecurity due to political or inflation risks.

As a result, according to the World Bank model, pension systems should consist of at least three

pillars. The public pillar should alleviate old-age poverty through redistribution and insure against

a multitude of risks. The second pillar should also be mandatory and fully funded. It fulfils the

savings function and boosts capital accumulation and financial market development. In principle,

both occupational and private plans are possible in this pillar. Finally, the third pillar should provide

private retirement savings for those who prefer greater financial security in their old age. This

multi-pillar approach separates the functions of savings and redistribution, while all three pillars

combine to provide insurance (World Bank 1994).

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Pension reform in China and India

The challenges of pension reform are particularly pressing in China and India. Both countries are

undergoing staggering economic growth and, as a result, experiencing a loosening of family-

based old-age provision. In the case of China, this is compounded by an adverse demographic

development. Increasing the coverage rates of the formal pension system is the main challenge

for both countries. China started pension system reforms in the late 1990s, before that a cradle-

to-grave social security system based on state-owned enterprises existed. The new system con-

sists of a public pay-as-you-go approach with mandatory DC accounts and voluntary occupation-

al pensions, known as Enterprise Annuities. The system is in the process of being implemented

and currently only applies in urban areas. One of the main problems is that many accounts in the

mandatory funded pillar are empty as local governments used that capital for other pension pay-

ments. Pilot projects to refill this 1B pillar are ongoing. The coverage rate is 50% in urban areas

and 9% in rural areas (where a different, voluntary and locally administered system is in place).

India has a highly fragmented system with a limited social safety net, several schemes for pub-

lic servants and two mandatory schemes for private employees (from which employers can opt

out and establish company funds). There are also voluntary occupational schemes and a public

provident fund for voluntary savings. Except for the latter, these schemes exclusively cover the

formal workforce (around 12% of the population). Recent reforms were less ambitious than in

China. To ease pressure on public finances, a new DC scheme was established for public servants

to replace the old DB scheme. It will also be open to all citizens on a voluntary basis in hopes that

informal sector workers will join. However, political opposition has hampered its development.

Although the World Bank model has alsobeen the broad leitmotiv of pension reformsin Asia, these emerging markets came froma completely different starting position.Whereas CEE countries needed to radicallyrestructure an existing, yet moribund sys-tem, the emerging Asian countries had toestablish a formal pension system fromscratch. This process is still ongoing.

Traditionally, the main component ofretirement income in Asia has been familysupport from one’s own children. Strongfamily values and social norms supportedthis pattern. For example, in 1990 the aver-age South Korean over 60 years of age re-ceived 32% of his/her income from working,55% from children, 10% from other sourcesand 3% from public and private pensions

Asia

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Voluntary DC

Mandatory DC


0 5 10 15

Chart 3 Number and type of DC schemes in Asia and CEE Mandatory DC: Bulgaria,

China (1B pillar), Croatia,

Estonia, Hong Kong, Hun-

gary, India, Latvia, Poland,

Romania, Singapore, Slo-

vakia, Taiwan, Thailand

Voluntary DC: China (EA),

Czech Rep. (private DC),

Lithuania, Slovenia, South

Korea (DC/DB)

The following table shows the results of pension reforms in Asia and CEE. Almost allcountries in the regions have now introducedDC schemes. Of the 18 countries investigat-ed, 17 have introduced DC schemes, of which14 are mandatory.4 (Chart 3)

An important dimension of DC schemesis the issue of individual choice. This has

wide-ranging implications for regulations,products and the autonomy of pension planmembers. Individual choice is widespread in the emerging markets investigated. Mostcountries allow some form of individualchoice, but that choice is constrained. HongKong offers the greatest choice with mostemployees covered by master trust schemes.In these schemes, there is normally a choice

Reform Results

4 In the graph, China is

counted twice as the

country has introduced a

mandatory and a volun-

tary DC scheme.

3 Unless otherwise

stated, data were provid-

ed directly by the OECD.

(World Bank 2000). Comprehensive publicpension systems and private schemes werevirtually non-existent, except for public sec-tor employees. When South Korea introduceda public pension system in 1988, it was thefirst country to do so.

However, socio-economic changes haveput the family support system under pres-sure. Rapid economic growth and industrial-isation have led to a decline of the agricultur-al sector, decreasing fertility rates, increasinglongevity and to a rapid urbanisation cou-pled with increased mobility. For instance,the urbanisation rate in South Korea grewfrom 28% in 1960 to 80% in 2005.3 As a result,the need for formal retirement systems hasgrown tremendously to help people avoidwidespread old-age poverty. The focus of re-

forms has been very much on funded occu-pational pensions. Several countries in Asia,such as Hong Kong and India, do not operatea public pay-as-you-go system.

The rush towards funded DC pensionsbegan in the late 1990s. Since then, China,Hong Kong, India, and Taiwan have all intro-duced DC schemes of various designs, whileThailand plans to do so. Singapore has had a DC scheme since 1955, which is the onlypillar of its welfare and pension provision.South Korea modernised its company pen-sion system through the introduction ofdefined contribution and defined benefitschemes. A trendsetter was Australia, whichintroduced a mandatory DC scheme in 1992and is often seen as a role model for theregion.

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No investment choice Individual investment choice

Mandatory occupational pensions

Hong KongSingaporeIndia (planned)HungarySlovakiaPolandEstoniaLatvia

BulgariaChina (1B pillar)CroatiaRomaniaTaiwan

Voluntary occupational pensions

South KoreaLithuania

China (Enterprise Annuities)Slovenia

Voluntary private pensions only Czech Republic

between four and six investment funds. Inall, more than 300 funds are approved.5 Inthe other countries, the choice set usuallyconsists of three options with differing risk-return profiles.

In CEE, the trend is to allow members achoice of three options when they are youngand assign them to the most conservativefund when they approach retirement so as tominimise investment risk. This system is inplace in Slovakia and will be introduced inHungary from 2009 onwards. What drivesthe decision to allow individual choice is anunder-researched issue. Political, culturaland economic factors all have a crucialimpact, however, how they exactly influencethe decision is unclear. (Table 1)

Almost all emerging economies applyquantitative restrictions to their pensionfund investments. There are maximum limitseither for certain investment classes, espe-cially equities, or for foreign investments. For

example, the limit for equity investments is between 20 and 40% in Bulgaria, Croatia,Poland, Singapore and Slovenia. It is lower inthe Chinese Enterprise Annuity system. Incountries with individual choice, retirementwealth is dependent on the chosen fund andits risk-return profile. However, strict limita-tions to asset classes can make individualchoice appear meaningless. For example, DCplans in South Korea cannot invest in equityor equity funds and in funds with 40 to 60%equity share. What they can do is to invest infunds with a share of foreign bonds and ininvestment-grade bonds of OECD countries,but in both cases only to 30% of assets. Hence,meaningful differences in risk-return profilesare not possible. In addition, internationalinvestments are constrained. Poland has thetightest restrictions – only 5% of assets canbe invested outside the country. In countriessuch as Hong Kong or Slovakia, foreign in-vestments can amount to 70% of assets.

5 Data in this and the

following section are

taken from Allianz Global

Investors 2007a and

2007b.

Table 1 Investment choice in pension plans *

* Whether or not there

will be individual choice

in Thailand’s system is

not yet decided

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Pension reform in the emerging marketshas been mainly triggered by three fac-

tors: the aspiration of Asia to increase cover-age of formal pension arrangements, lack ofsustainability of the socialist system in CEEand foreseeable demographic developments.Contrary to popular expectations, it is notonly the industrialised countries that areaging. In several emerging markets popula-tion ageing is even more severe than in theindustrialised world and, on average, com-parable in magnitude.

The old-age dependency ratio is the mostcommon indicator to measure ageing. It de-picts the ratio of the population 65 years andover in relation to that aged 15 to 64. In otherwords, it measures how many pensionersthere are for every 100 people of working age.The higher the ratio, the higher the financialburden imposed on the working populationif a public pay-as-you-go system is in place.For instance, Western European EU members

will see their old-age dependency ratio risefrom 26 in 2005 to 53 in 2050. The problem isnot as acute in the United States, but theold-age dependency ratio will still climbfrom 18 to 34.6

Demographic developments in the emerg-ing markets are more dramatic than in theUnited States and often surpass even West-ern Europe. For example, dependency ratiosin Bulgaria, the Czech Republic, Hong Kong,Singapore, Slovenia, South Korea and Taiwanwill be higher than in Western Europe; Croa-tia, Hungary, Poland, Romania, Slovakia willcome close. Among the 18 countries investi-gated, only one will have a more favourabledependency ratio than the United States,namely India. On average, the ratio of theemerging economies will increase from 18today to 50 in 2050. The CEE countries areslightly older today, with a ratio of 22, but willend up with a value of 50. Asia’s dependencyratio will rise from 12 to 49. If India is exclud-

Demographic Trends

6 The old-age dependen-

cy ratio in 2050 reflects

the expected develop-

ment of pensioners to

working age population.

Bulgaria Croatia Czech Rep. Estonia Hungary Latvia Lithuania Poland Romania

2050

Slovakia Slovenia

Chart 4 Old-age dependency ratios CEE


50

60

70

40

30

20

10

0

2005

13


ed, the Asian countries will have a ratio of 54in 2050, slightly more unfavourable than inEurope. (Chart 4/5)

The most important issue in this processis speed of ageing. Currently, the ratios aremore favourable than in industrialisedcountries, so ageing will progress at anunprecedented pace. China is a case in point:the country will become old within one gen-eration. According to the World Bank, theworking population as a share of total popu-lation will peak in 2011 at 882 million andfall steadily afterwards at a rate of 0.1 to 0.4%per year (World Bank 2007). Within the next20 years, the share of over 65-year-olds willdouble and within the next 40 years morethan triple (United Nations Population Divi-sion Database). As a result, China and otheraffected countries had to – and will continueto have to – react fast.

The main reason for the ageing process is the combination of higher longevity anddeclining fertility rates. Rising life expectan-cy is due to reduced mortality in higher agegroups caused by better nutrition, livingconditions, hygiene and access to medicaltreatment. This especially applies to theAsian emerging economies. For example,average life expectancy in South Korea hasincreased by more than 30 years since theearly 1950s. Since the early 1980s, it increasedby around 11 years. South Korea also offers a dramatic example of decreased fertility.While in the 1960s, the average South Koreanwoman gave birth to six children, nowadaysthe fertility rate is 1.2 children per woman.To keep the population constant, a fertilityrate of 2.1 children would be required. Thesedevelopments taken together have two conse-quences: a shrinking and an older population.

Chart 5 Old-age dependency ratios Asia


China Hong Kong India Singapore South Korea Taiwan Thailand

2050

50

60

70

40

30

20

10

0

2005

14


To address this situation, governments in emerging markets aimed to establish

funded pillars that provide adequate retire-ment savings without interfering with macro-economic goals while providing enterpriseswith sufficient flexibility. The traditionalmodel of pension provision through definedbenefit plans in industrialised countries wasnot attractive as these are, for various rea-sons, in the process of being restructuredthemselves and an ongoing shift towards DCplans is evident.

The main characteristic of DC plans isthat they are long-term savings. In their pureform, DC plans do not have an insurance orguarantee component. In other words, capitalaccumulation is determined by contributionrate and asset performance. In a DB plan,pension benefits depend on the employee’sfinal or average salary. Benefits are defined inadvance and the employer must cover themirrespective of asset performance.

This implies a different risk allocation. InDC plans, the investment risk – the risk thatassets perform poorly – is borne by the pen-sion plan member. In a DB plan, the plan

sponsor assumes this risk. On the other hand,if assets perform better than expected or inline with expectations, DC plan membersbenefit. The second major risk of pensionprovision, the risk of outliving one’s assets(longevity risk), is also borne by DC planmembers, while in DB plans the sponsor has to shoulder it. In return, wage path, jobtenure and default risk is borne by the mem-ber in DB plans, but greatly reduced in DCplans (Oxera 2008). This makes it is hard, ifnot impossible, to determine which plan isbetter in any absolute sense as the choiceinevitably involves trade-offs.

Those features of DC plans that are mostattractive to firms and governments in emerg-ing markets are portability and calculability.As DC plans are mostly individual accounts,these individual accounts can be easily trans-ferred from previous to new employers with-out any disadvantages. In DB plans jobchanges reduce pension benefits as expect-ed pension benefits normally accrue only toemployees who stay with their employerthroughout their career (Broadbent, Palum-bo, Woodman 2006). This is not surprisingas one of the main motivations for DB plans

Why DC Schemes?


Vesting requirements in Taiwan’s old DB system

Another problem of DB plans are vesting requirements. Under the old occupational DB system in

Taiwan, the Old Labour Pension Fund, employers were obliged to contribute between 2 and 5% of

the employees’ gross salary to the fund. Despite the mandatory character of the system, only around

10% of private sector employees were eligible for benefits. This was mainly the result of vesting re-

quirements and their poor fit with labour market conditions and company structures. Employees

were required to have worked for more than 25 years for an employer to receive benefits. However,

the average tenure was less than nine years and the average life span of firms 13 years. As a result,

only employees of large companies or state-owned enterprises were likely to receive benefits.

15


is the retention of employees and so long-tenure is rewarded (Munell 2006). However,job mobility is increasing, so the reductionof pension benefits in case of job switchingis detrimental for employees.7 Consequently,DC plans are beneficial for mobile employees.

Another advantage of DC plans from theviewpoint of employers is the calculability offinancial payments. As they must only paydefined contributions to the plan, employersavoid the risk of unexpected payments asso-ciated with employee retirement in caseswhere capital markets develop worse than

expected or retired employees live longerthan foreseen in mortality tables. This is adanger that can threaten the existence ofcompanies and is illustrated by the US auto-mobile industry. General Motors is reportedto have projected pension obligations ofaround USD 85 billion (Global Pensions, 9 August 2006). Other advantages for em-ployers include lower administrative costs,especially as DB regulation has grown in-creasingly complex.

A structural reason for the popularity ofDC plans in emerging markets is the indus-

Establishing voluntary DC plans in China: Enterprise Annuities

Chinese pension reform of the late 1990s introduced occupational pensions into the country. In

2004, a voluntary occupational DC system was created, known as Enterprise Annuities (EA). Many

existing funds were accumulated before EA legislation and are referred to as legacy EAs. These

take several forms and are managed by the regional administration, local social security bureaus,

industry-wide bodies or by insurance companies. Legacy EAs account for EUR 7.3 billion (RMB 75

billion) in pension assets, newly created EAs for EUR 1.6 billion (RMB 16 billion). Legacy EAs are

allowed to continue to operate, but will be required to comply with EA legislation in the future and

do not enjoy preferential tax treatment. In case of new EAs, employer contributions are tax-exempt

up to 4% of wages, while there is no tax benefit for employee contributions. However, tax treat-

ment is subject to regional differences.

The new EAs were adopted by 263 enterprises and cover 940,000 employees as of mid-2006.

EAs must be established as a trust that can take the form of either an internal (pension council)

or external trustee (professional trustee). The Lenovo Group registered the first countrywide EA

plan in 2006. One of the main hurdles in the future is the low acceptance of EA plans among

small- and medium-sized enterprises (SMEs). Only 50 of 23 million SMEs in China had registered

new EA plans by mid-2006. The limited tax relief, high administrative costs, missing awareness

and knowledge of the EA system, as well as a tendency to avoid participating in the social security

system, are key reasons for the low acceptance of EA plans among SMEs (Hu et al. 2007).

7 In the UK, it is estimated

that a worker who switch-

es jobs six times in his/

her career experiences

portability losses in DB

schemes of 25-30% of the

full service pension (of

someone with the same

salary but a full career at

the same employer). See

Blake 2003.

16


trial composition of these economies andeconomic trends. In the industrialised world,especially the United States, DB plans tendto be concentrated in unionised, well-estab-lished and large firms with a high share oflong-service workers (Munnell 2006; Clark,Monk 2006), while employment is increasing-ly shifting towards high-tech and service sec-tors and to smaller firms for which DC plansare more suitable. The economic structure ofAsia mainly consists of small firms.

Among the 3.2 million firms in SouthKorea, one of the economically most ad-vanced countries in Asia, 3 million have lessthan ten employees (OECD 2007). Hence, acompany DB pension fund would not makesense for the overwhelming majority of firmsin this context; for risk sharing between andamong cohorts, the average firm size is fartoo small. The alternative of establishing in-dustry-wide DB plans has not been pursuedin any of the countries yet.

For all these reasons, coupled with advicefrom the World Bank arguing for its multi-pillar model, DC plans appear more appro-priate to the economic situation in emerg-ing markets. Above all, their simplicity andportability are of appeal.

17


With their move towards fully fundedpensions, reforms in Asia and CEE

will obviously boost the accumulation ofpension assets in the years and decades tocome. Projections by Allianz Dresdner Eco-nomic Research / Allianz Global Investorsquantify the impact of these developments.Based on current data on population, work-force, income, pension scheme participa-tion rates and the likely development ofthese indicators in the future, it is expectedthat pension assets in CEE will grow fromtoday’s EUR 50.8 billion to EUR 244.9 billionin 2015. This corresponds to a compound

annual growth rate of 19.1%. The pensionassets in Asian emerging economies arelikely to grow from their current EUR 251.9billion to EUR 1,049.3 billion in 2015, a com-pound annual growth rate of 17.2%.8

(Chart 6)

This massive capital build-up indicatesthe degree to which citizens in these tworegions will be exposed to capital marketdevelopments. Investment behaviour andasset allocation will be crucial to ensure an appropriate living standard after retire-ment.

Pension Asset Projections

8 Numbers for CEE

include assets in the

mandatory second pillar

pension funds as well as

assets in the voluntary

pension funds (the tax-

favoured third pillar in

CEE). In Asia, occupation-

al assets are included

and voluntary individual

retirement savings for

India, Singapore, South

Korea and Thailand.

Details in Allianz Global

Investors (2007a, b).

Asia

251.9

50.8

244.9

1049.3

CEE

2015Chart 6 Pension asset development in Asia and CEE [€ bn]

Source: Allianz Dresdner

Economic Research /

Allianz Global Investors.

Population size of the

Asian emerging markets

stands at 2.6 billion, while

107 million people live in

CEE.

1000

1200

600

400

200

0

2006

CAGR: 17.2% CAGR: 19.1%

800

18


These developments imply new chal-lenges for pension plan members, spon-

sors, regulators, asset managers and insur-ance companies. The main question is howto handle risks in DC plans, especiallyinvestment risk. In systems with the possi-bility of choice, there is a need for risk man-agement on an individual level through sen-sible investment choices. In all systems, thegovernment intervenes substantiallythrough regulation and this influences thedirections of investment policy and assetallocation. Politics has several means to

influence the behaviour of those who man-age pension assets, and it can also influencethe capacity of plan members to makeappropriate choices through financial edu-cation and the establishment of an invest-ment culture. In addition, the design of pen-sion plans can influence the behaviour ofplan members and asset managers. In vol-untary plans, plan design is a crucial factorfor the incentives of an individual to join,and in all plans the design of the defaultoption is critical for those who are unwillingor unable to make an active choice. (Table 2)

Lack of financial literacy is a problem allover the world. Survey research indicates thatmany people have problems understandingeven basic financial concepts. For example,in one of the arguably most developed finan-cial markets, the US, one third of participantsin a study could not correctly answer an easyquestion regarding compound interest. Onlyslightly more than 50% of participants under-stood that holding a single equity is morerisky than an equity fund (Lusardi, Mitchell2006). In Japan, 71% of people surveyed hadno knowledge about investments in equitiesand bonds (OECD 2005).

This problem is likely to be more severe in countries with a short history of capitalmarket development and a population withlimited experience of financial markets andinstruments. For example, in India more than50% of survey participants did not have aclear understanding of the concept of infla-tion (Bhushan 2006). A lack of financial edu-cation can harm the sufficiency of retirementsavings in DC plans as systematic invest-ment errors accumulate over a long time.Participants are directly exposed to risk andresponsible for their own risk managementwithin the limits set by regulation. The neces-

Challenges in DC Plans

Plan member /investment choice

Plan designFinancial education /investment culture

Asset manager/ investmentstrategy

Design of defaultoption

Investment regulationGuarantee requirementsRange of permitted assetclasses and products

Table 2 Key factors influencing DC pension plans

Challenge I: Financial Education

19


sity of improving financial literacy not onlyapplies to pension plan participants, but alsoto pension plan trustees, who play a crucialrole in plans without individual choice.

This has two implications. The first is that financial literacy and advice need to beincreased. The OECD has called on govern-ments to provide financial education alreadyat school. It demands that these programs

should especially focus on crucial planningdecisions such as pensions, and that gener-ally financial knowledge should be promot-ed (OECD 2005). However, the state cannotsingle-handedly improve financial educa-tion. Other stakeholders, such as financialinstitutions, employers, trade unions or con-sumer groups, need to join forces to achievea satisfactory level of financial education.

Important as it is, financial education canonly deliver significant results in the me-dium- and long-term. An immediate way to mitigate possible detrimental effects ofmodest financial education is offered by arelatively new line of research: behaviouraleconomics and finance. The main tenet ofthis research is that individuals do not alwaysbehave rationally, especially not in financialmatters, but are subject to various psycho-logical and behavioural biases that influencetheir saving and investment decisions.

Among them and of special significancefor DC and long-term savings are: problemsof self-control, framing effects (i.e., choicesare influenced by how they are presented),lack of firm preferences, inertia, reliance onpast asset performance, overweighting ofloss avoidance and overconfidence in owncapabilities (Mitchell, Utkus 2006). Thesepsychological biases apply to the decision tosave as well as to subsequent investmentchoices, often resulting in insufficient retire-ment savings and/or sub-optimal asset per-formance.

However, there is no need to simplyaccept these findings as unchangeable partsof human nature. It is possible to designpension plans to counteract these tenden-

cies. There are several options to achievethis, but two main rules have materialised:

• First, in order to ensure a higher partici-pation rate in voluntary occupationalplans, automatic enrolment can be intro-duced. This means employees have tomake an explicit decision to opt out of theplan instead of making a decision to optin. Empirical research has shown thatparticipation rates increase substantiallyunder this regime (Benartzi, Thaler 2006).

• Coupled with that, there should be anappropriate default choice in the DC planfor members unwilling or unable to makea choice. For the others, the menu ofchoice should not be too large as choiceoverload and complexity reduces planparticipation and the willingness to makeinvestment choices at all.

The last point is highly relevant for man-datory plans with individual investmentchoices; here choice overload cannot resultin decreasing plan participation, but it canresult in overreliance on the default option.For example, in the mandatory Swedishindividual account system, the PremiumPension, members can choose among morethan 700 funds and can do so at certain in-

Challenge II: Plan design

20


tervals. In the 2005 round of selection, lessthan 10% of members made an active choice.The others were enrolled in the default fund.Choice overload is key to an explanation(Sundén 2006). Consequently, the design of the default option is crucial.

Asset managers can help to design suit-able default solutions, but that is not all.Financial decisions regarding retirementand long-term savings belong to the mostessential financial decisions in life, but also to the most complex. Consumers andtrustees need tailored advice and suitableand transparent products that match theirrisk profiles and general preferences. In thissense, the financial industry needs to con-

tribute to the success of the new pensionschemes by helping consumers make theright decisions. They also need to developproducts tailored to the demand structuresof individual countries. These can differstrongly from country to country, for exam-ple, in terms of investment culture.

In all, there are ways to control the risksinherent in DC plans, but plan design mustbe appropriately calibrated to protect planmembers from making sub-optimal choices.Financial education must be promoted toenable plan members to responsibly lookafter their retirement saving decisions aswell as other financial decisions.

At first glance, it seems easier to regulate DC plans than DB plans. After all, there areno liabilities to match, DC plans by defini-tion cannot be under-funded and no dis-count rates need to be determined. Never-theless, DC plans have different regulatorychallenges. On the one hand, implementa-tion of the above mentioned design featuresrequires that they be permitted by law. Forexample, while choice overload is a seriousproblem, no choice is probably even moreproblematic.

If there is only one fund for all members,they cannot match their investment to theirrisk preferences or to personal situations likeage. Consequently, a one-size-fits-all invest-ment strategy is likely to be suboptimal formany members. For example, according tocapital market theory, young employeesshould invest a substantial share in highyield, but risky assets, as short-term finan-cial market swings would not affect them. Ifthe pension fund is invested conservatively

throughout their career, they will face thedanger of insufficient retirement savings. Inturn, insufficient retirement savings implythat the government will have to take care of these future retirees. Besides that, somefreedom of choice makes pension benefitsmore tangible and may lead to a heightenedgeneral interest in financial matters. Despitethese arguments, countries like Bulgaria,China, Croatia, Romania or Taiwan do notforesee any choice in their DC pension plans.

Investment RegulationAnother major regulatory challenge concernsinvestment regulation of pension funds.There are two main principles of regulatingpension funds, the prudent person principleand quantitative restrictions. The prudentperson principle applies in Anglo-Saxoncountries and, increasingly, in WesternEurope. It is the most liberal form of invest-ment regulation and is based on the premisethat pension funds or asset managers areobliged to invest in the same way as prudent

Challenge III: Regulating DC Plans

21


investors would do for themselves, particu-larly with regard to diversifying assets. Inthis sense, the prudent person rule targetsthe behaviour of asset managers and thedecision-making process and not the actualinvestment decisions. On the other hand,quantitative restrictions specify the finan-cial instruments that pension funds caninvest in as well as the maximum limits ofcertain asset classes in the portfolio.

Asian and CEE countries have opted forquantitative restrictions as a means of regu-lating pension funds. In most countries, thereare limits for equity holdings and other fi-nancial instruments, as well as for the shareof foreign assets in the portfolio. From theviewpoint of capital market theory, theselimits are not without problems. It is arguedthat restrictive maximum limits for certainfinancial instruments, especially equity, ren-der pension funds inflexible by constrainingasset allocation and thus the upside potentialof pension funds.

If equity limits are overly restrictive, theymay result in suboptimal asset performancebecause pension funds cannot sufficientlytake advantage of the higher-yielding equitymarkets. Research on the U.S. financial mar-kets shows that in the period between 1928and 2006 stocks outperformed bonds by 6.6percentage points, in the period between1966 and 2006 by 4.1 percentage points andin the period between 1996 and 2006 by 5.1percentage points (Damodaran 2008). Capson international invest-ment can hindereffective asset allocation by impeding anappropriate diversification across countries.In the case of restrictive regulations, assetperformance is dependent on domesticmarkets and economic cycles, resulting ininvestment risk higher than it needs to be.

Nevertheless, especially for emerging mar-kets, there are some arguments in favour ofquantitative restrictions. These include vola-tile markets, inexperienced regulators, limit-ed internal controls and weak governancestructures (Davis 2002). More important stillis a trade-off for policy-makers between theobjective of local capital market developmentand optimal asset allocation of pensionfunds. It was hoped that the funded pensionsystem would lead to quantitative and quali-tative capital market development. Qualita-tive improvements refer to the generation of“institutional capital”, which includes betterlegal and regulatory frameworks and moreprofessional investment management, moretransparency and better governance struc-tures. To achieve these goals, pension assetsshould, to a certain degree, flow into nation-al financial markets. However, substantialinflows of pension assets may result in im-balances between supply and demand, par-ticularly when local capital markets lack liquidity, which could lead to distortions inasset pricing. Hence, the trade-off betweenthe desire to develop local capital marketsand efficient pension fund investing is a del-icate matter and policy-makers need to strikea balance.

GuaranteesMinimum return guarantees are anotherregulatory instrument often applied. Sevenof the eleven CEE countries apply minimumguarantees. Minimum return guarantees cantake the form of absolute guarantees. Thishas been the case in the Czech Republic,where pension funds have to generate posi-tive returns every year. In Taiwan, pensionfunds have to meet the two-year bank depositrate. In Poland, Bulgaria, Croatia, Slovakiaand Slovenia, guarantees take the shape ofrelative performance goals where a bench-mark, based on the performance of all pen-sion funds, must be met. For pension fund

22


Pension system reforms in the emergingmarkets of Asia and CEE have been fun-

damental and far-reaching. While CEE coun-tries had to reform their state-centred pen-sion system inherited from socialist times,the Asian countries had to establish andexpand their pension systems. Nevertheless,both regions have ended up with similarsystems, at least regarding occupationalpensions, namely fully funded DC systemswith individual accounts. In the context ofemerging economies, the flexibility andtransparency of DC plans was key for thedecision. The broad design of the pensionsystem is converging towards the WorldBank model. This development fuels an im-pressive build up of assets. The combinedpension assets of Asia and CEE are likely tomore than quadruple between now and 2015.

To ensure that these assets will provideretirement security through sufficient accu-

mulation of wealth, action on several frontsis required. Financial education needs to beimproved, the design of pension plans needsto take behavioural dispositions of membersinto account, asset managers need to pro-vide transparent products and give soundadvice, while regulation should not overlyrestrict investment opportunities or encour-age suboptimal investment strategies on thepart of pension funds.

By introducing a strong funded pillar, governments in Asia and CEE are following areform path that promises to generate sus-tainable pension systems. Now that a solidfoundation is in place, the fine-tuning of theparameters of the system becomes the majortask. It is of utmost importance that the DCsystems function properly as, within a fewyears, the living standards of a significantand growing part of the population will de-pend on the capital they generate.

Conclusions

members, absolute return guarantees havethe advantage that retirement savings arepredictable. In the case of relative returnguarantees, the risk of choosing a poorlyperforming fund is minimised.

As a result, in some regards, retirementplanning is becoming easier. Nevertheless,there is a trade-off. Capital market theoryargues that the necessity to secure short-term profitability may lead to homogeneousinvestment strategies in the pension fundmarket. This “herding” effect may result in similar performance by pension funds,which reduces the number of real choicesfor potential and existing pension fundmembers.

A second related problem is that effectivelonger-term investment strategies cannot bepursued if the guarantee applies to annualminimum returns. In this case, pension fundsmust sacrifice long-term returns for short-term profitability. In brief, quantitative re-strictions and annual minimum guaranteesare somewhat problematic. Both limit theholdings of volatile assets, including equi-ties, which have higher long-term returns,but can have negative returns in individualyears. Their existence can be justified by thecurrent modest level of financial market de-velopment. However, a good case exists forrestrictions to be eased as investor experi-ence and institutions develop.

23


Allianz Global Investors 2007a. Central and Eastern European Pensions 2007. Systems and Markets.Munich.

Allianz Global Investors 2007b. Asia-Pacific Pensions 2007. Systems and Markets. Munich.

Benartzi, Shlomo; Thaler, Richard H. The Behavioral Economics of Retirement Savings Behavior.Research Report, AARP Public Policy Institute, Washington D.C.

Bhushan, Gyan 2006. Impact of Financial Education on Economic Development: Indian Experience.Presentation at the G8 International Conference on Improving Financial Literacy, 29-30 November2006, Moscow.http://www.oecd.org/document/15/0,3343,en_2649_201185_37583951_1_1_1_1,00.html

Blake, David 2003. The UK Pension System: Key Issues. Pensions, Vol. 8, No. 4, pp. 330-375.

Broadbent, John; Palumbo, Michael; Woodman, Elizabeth 2006. The Shift from Defined Benefit toDefined Contribution Pension Plans – Implications for Asset Allocation and Risk Management. Paper prepared for the working group on Institutional Investors, Global Savings and Asset Allocation estab-lished by the Committee on the Global Financial System, Bank for International Settlements, Basel.http://www.bis.org/publ/wgpapers/cgfs27broadbent3.pdf

Clark, Gordon; Monk, Ashby 2006. The 'crisis' in defined benefit corporate pension liabilities Part I:Scope of the problem. Journal of Pension Economics and Finance, Vol. 12, No. 1, pp. 43-54.

Damodaran, Aswath 2008. Dataset Historical Returns on Stocks, Bonds and Bills – United States. New York University, Stern School of Business, New York. Date accessed 28 Feb. 08.http://pages.stern.nyu.edu/~adamodar/

Davis, Philip 2002. Prudent person rules or quantitative restrictions? The regulation of long-term insti-tutional investors' portfolios. Journal of Pension Economics and Finance 1, pp. 157-191.

Global Pensions 2006. GM reduces pension obligation by US$4bn. 9. August 2006.

Hu, Yu-Wei; Pugh, Colin; Stewart, Fiona; Yermo, Juan 2007. Collective Pension Funds: International Evi-dence and Implications for China's Enterprise Annuities Reform. OECD Working Papers on Insurance andPrivate Pensions, No. 9, OECD, Paris.

Lusardi, Annamaria; Mitchell, Olivia 2006. Financial Literacy and Planning: Implications for RetirementWellbeing. Pension Research Council Working Paper 2006-1, Wharton School, University of Pennsylvania.

Mitchell, Olivia; Utkus, Stephen 2006. Lessons from Behavioral Finance for Retirement Plan Design. Pension Research Council Working Paper 2003-6, Wharton School, University of Pennsylvania.

References

24


Munell, Alicia 2006. Employer-sponsored Plans: The Shift from Defined Benefit to Defined Contribu-tion. In Clark, Gordon; Munnell, Alicia; Orszag, Michael (eds.), The Oxford Handbook of Pensions andRetirement Income. Oxford University Press, Oxford.

OECD 2007. Economic Surveys: Korea. Vol. 2007/6. Paris.

OECD 2005. The Importance of Financial Education. Policy Brief July 2005, Paris.

Oxera 2008. Defined Contribution Pension Schemes. Risks and Advantages for Occupational RetirementProvision. Report to the European Fund and Asset Management Association (EFAMA).http://www.efama.org/05Home/10AboutEFAMA/specialreport/Oxera_Report.pdf/file_view

Sundén, Annika 2006. The Swedish Experience with Pension Reform. Oxford Review of Economic Policy,Vol. 22, No. 1.

United Nations Population Division 2007. World Population Prospects: The 2006 Revision Database.http://esa.un.org/unpp. Date accessed: 26.1.2007

World Bank 2007. China Quarterly Update, September 2007, Washington, http://siteresources.worldbank.org/CHINAEXTN/Resources/318949-1121421890573/cqu_09_07.pdf

World Bank 2000. The Korean Pension System at a Crossroads. Korea Countrv Management Unit, EastAsia and Pacific Region, Report No.20404, World Bank, Washington.

World Bank 1994. Averting the Old Age Crisis. Policies to Protect the Old and Promote Growth. OxfordUniversity Press, New York.

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Appendix

Δ GDP 2001- 06* Δ GDP 2007-12*GDP/head [€]

Bulgaria

China

Croatia

Czech Republic

Estonia

Hong Kong

Hungary

India

Latvia

Lithuania

Poland

Romania

Singapore

Slovakia

Slovenia

South Korea

Taiwan

Thailand

3,790

1,690

8,400

12,440

11,230

18,990

10,200

701

8,520

8,170

8,080

5,500

22,580

10,100

16,400

14,840

12,040

2,680

5.1

9.8

4.6

4.3

8.0

4.7

3.8

7.4

7.7

7.4

3.4

5.6

4.0

4.0

3.6

4.6

3.2

5.1

4.4

9.0

3.8

4.3

5.8

5.0

3.1

8.1

5.5

5.5

4.4

4.8

5.6

4.8

3.6

4.6

4.1

4.9

GDP per head and GDP growth * average GDP growth 2001- 2006 ** estimated

Source: Allianz Dresdner

Economic Research

26


20502005

Bulgaria

China

Croatia

Czech Republic

Estonia

Hong Kong

Hungary

India

Latvia

Lithuania

Poland

Romania

Singapore

Slovakia

Slovenia

South Korea

Taiwan

Thailand

25

11

26

20

24

16

23

8

23

23

19

22

12

16

22

13

13

11

61

39

50

55

43

58

48

21

44

45

51

50

59

51

56

64

63

38

Old-age dependency ratios in CEE and Asia

27


TypeIntroduced

Bulgaria

China

1B pillar

EA

Croatia

Czech Republic

Estonia

Hong Kong

Hungary

India

Latvia

Lithuania

Poland

Romania

Singapore

Slovakia

Slovenia

South Korea

Taiwan

Thailand

2002

1997

2004

2002

1994

2002

2000

1998

2004

2001

2004

1999

2007

1955

2005

1992

2005

2005

planned

Mandatory DC

Mandatory DC

Voluntary DC

Mandatory DC

Voluntary private DC

Mandatory DC

Mandatory DC

Mandatory DC

Mandatory DC

Mandatory DC

Voluntary DC

Mandatory DC

Mandatory DC

Mandatory DC

Mandatory DC

Voluntary DC

Voluntary DC/DB

Mandatory DC

Mandatory DC

DC schemes in Asia and CEE


www.allianzglobalinvestors.com

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Pension trends in_emerging_markets

Education

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