Why Consider Prefunding Pensions? -...
Transcript of Why Consider Prefunding Pensions? -...
Why consider prefunding
pensions?
Edward Whitehouse
OECD
World Bank core course
Washington DC, November 2009
Agenda
Different financing mechanisms:funding and pay-as-you-go
Advantages and disadvantages
Design of funded schemes
Moving from pay-as-you-go to funding
Initial conditions needed for 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
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 aging of the population
Better rates of return on pension contributions
Limits fiscal liabilities
Removes some labour-market distortions
Helps develop capital markets
Possibly increases savings and investment
Reduces politicisation of the pension system
Demographic change: ageing
0
2.5
5
7.5
10
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
OECD-30
Oldest
OECD
country
Youngest
OECD
country
Number of people of working age per person of pension age, 1950-2050
Ageing and unfunded schemes
Ageing occurring because:
fewer babies (reversable?)
longer lives (permanent?)
Impact on pension systems is to increase number of retirees relative to contributors
Governments must
increase contributions, raise retirement ages or cut benefits to maintain fiscal sustainability
It becomes increasingly difficult to protect workers in their old age
An example: the United States
Real rate of return on contributions (%)
Ageing and funded schemes
Likely impact of ageing on capital markets uncertain, but probably small
Different cohorts may have different rates of return on their contributions
But not systematically related to ageing
Also, option of foreign investment if returns are higher elsewhere
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 larger than wage growth
Fiscal liabilities
PAYG scheme: government responsible for covering deficit
No fiscal liabilities for new entrants in a pure funded scheme
Individuals‟ benefits are based on amount they saved
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
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
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
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)
Old-age poverty
Funded schemes have risks of poverty for:
people with incomplete work histories (unemployment, disability, childcare etc.)
people with low levels of earnings
But PAYG schemes that tie benefits closely to contributions have the same problem
Also, political and fiscal risks
Pension systems with funding
There is generally also a PAYG-financed benefit in systems with funded schemes
Ranges from:
minimum pension/means-tested scheme only (Australia, Mexico, Kazakstan, El Salvador, Hong Kong)
basic pension only (Kosovo, Netherlands, new system in UK)
earnings-related, public schemes (Uruguay, Costa Rica, Slovak Republic, Poland, Hungary, Latvia, Lithuania, Estonia, Croatia, Bulgaria, Macedonia, Switzerland, Sweden)
Providing funded schemes 1
Many possible structures
single public agency (Russia)
single pension fund, but private (Bolivia)
a few private pension funds (Uruguay)
many private pension funds (Chile, Poland, Hungary)
public and private pension funds (Mexico)
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
Collection and record-keeping
Centralised:
social-insurance agency
tax authorities
separate institution (public or private)
Decentralised
individual funds do the work
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
Conditions for a funded scheme
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