Diamond Barr 2010

8/11/2019 Diamond Barr 2010

1/24

Reforming Pensions: Lessons from Economic Theory and Some Policy Directions [withComment]Author(s): NICHOLAS BARR, PETER DIAMOND and Eduardo EngelSource: Economa, Vol. 11, No. 1 (Fall 2010), pp. 1-23Published by: Brookings Institution PressStable URL: http://www.jstor.org/stable/25800053.

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2/24

NICHOLAS

BARR

PETER DIAMOND

Reforming

ensions:

Lessons

from

Economic

Theory

nd

Some

Policy

Directions

Pension

systems

have

wide-ranging

and

important

effects.

They

influ

ence

the

living

standards of

older

people

and hence thewelfare of both

older

people

and

their children.

They

can

also

affect

national economic

performance through potential

effects

on

the labor

supply

and

saving.

The

design

of

pensions

therefore

matters.

In

discussing

the

topic,

this

paper

draws

on

two

of

our

earlier works.1

It

starts

by

setting

out

some

central lessons

from

economic

theory.

The

second

section

derives

some

policy

implications

of

particular relevance toLatin America. The policy chapters inour two earlier

books

focus

particularly

on

two

countries in which

we

have worked:

China,

which is

important

because

of

its

size,

and

Chile,

which

is

important

because

its

1981

reforms

were

widely adopted

in Latin

America

and elsewhere and

which has become

an

exemplar

in

the

pension

debate.

Box

1

defines

some

of

the relevant

terms.

The final section concludes.

KeyLessonsfrom conomicTheory

Economic

theory

offers

a

series

of conclusions

that should

frame

policy

design.

Some

of

them,

though

apparently

obvious,

are

frequently forgotten;

others

can

be counterintuitive.

We

focus

on

five

sets

of lessons:

pension

sys

tems

have

multiple

objectives;

different

pension

systems

share

risks

differ

ently,

both

across

people

and

over

time;

there

is

no

single

best

pension

system;

pensions

should

be

analyzed

in

a

second-best

context,

that

is,

taking

account

of market

imperfections

and other

distortions;

and amove to

funding

may

or

may

not

be the

right

policy.

Ban

is with the London School

of

Economics;

Diamond is

with

the

Massachusetts

Institute

of

Technology.

1. Barr

and

Diamond

(2008,

2010).

1

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3/24

2

ECONOMIA,

all 010

BOX

1.

Terminology

Defined-benefit

DB)

pensions

are

systems

n

hich

the

pension

benefit

s

determined

s

a

function

f

the

worker's

historyf coveredearnings.Theformulamay be based on theworker'sfinalwage and lengthfservice ronwages overa

longer eriod

(for

xample,

a

full

areer).

A DB

system

may

be

fully

r

partially

unded,

r

it

may

be unfunded.

n

pure

DB

arrangement,

nsofar

s

the

degree

of

funding

s

maintained,

the

sponsor's

ontributions

re

adjusted

tomeet

anticipated

obligations;

hus,

he

risk f

varying

ates

f

return

o

pension

assets

falls

n

the

sponsor.

Defined-contribution

DC)

pensions

are

systems

n

hich the

benefit

s

etermined

by

the

value

of assets

accumulated

toward

person's

pension.

Benefits

may

be taken

s a

lump

um,

s

a

series

f

withdrawals,

or

through

n

annuity.

he

expected

discountedvalue

of

benefits

s hus

equal

to

the value of

assets

(in

technical

erms,

he

benefits

re

determined

actuarially).1

pure

DC

plan adjusts

obligations

o

match available

funds,

o

that the

individual

ears

the

portfolio

isk.

Fully

unded

pensions

pay

all benefits rom

ccumulated

funds.

ee also

partially

unded

pensions.

A

noncontributory

ension

isbased

on

age

and

years

of

residence.

Notional efined-contributionNDC) ensionsarefinanced n a pay-as-you-go rpartially undedbasis,with a person's

pension

bearing

quasi-actuarial

relationship

o his

or

her

lifetime

pension

contributions.

Partially

unded

pensions

pay

benefits oth from

ccumulated

ssets

and

from

urrent

ontributions.

Pay-as-you-go

PA

YG)

ensions

are

paid

out

of current

evenue

(usually

y

the

state,

from

ax

revenue)

rather

han

out

of

accumulated funds.

Partially

unded

pensions

are

often

referred

o

as

PAY6.

A

provident

und

ays

a

defined-contribution

pension

based

on

the

performance

f

a

single,

entral und

rather han

on

the

performance

f individual

ccounts.

1. The

discountedalue

epends

n

therelevantnterest

ate

nd

load actors.

Pension

Systems

ave

Multiple

bjectives

For

the individual

or

family,

the

major objectives

of

pensions

are

consump

tion

smoothing

(redistribution

from

one's

young

self

to

one's older

self)

and

insurance.

Governments

have

additional

objectives, including

poverty

relief

and redistribution.

Any

analysis

of

pension

reform needs

to

take

account

of

the full

range

of

objectives

alongside

other

policy goals,

such

as

economic

efficiency

and

output

growth.

Differentension

Systems

hare isks

Differently

Separate

from

their

redistributive

effects,

different

pension

systems

share

risks

differently.

Pension

systems

are

subject

to

multiple

sources

of

risk,

and

they

have different

underlying

philosophies

of

who

should bear

those

risks. This

section looks

at

four

types

of

pension,

with

a

focus

on

how

they

distribute

risk.

We startwith two polar extremes of fully funded systems: pure funded


(DC)

plans

and

pure

funded

mandatory

defined-benefit

(DB)

plans.2

In

the

case

of

the

former?also known

as

funded

individual

accounts?individual

workers

set

aside

a

given

fraction

of their

earnings

to

2.

See the

glossary

in

box

1

for

a

brief

definition of

these

terms.



4/24

Nicholas

Barr

nd

Peter

Diamond

3

buy

private

financial

assets,

which

are

accumulated

until retirement.

At

that

point,

the retirees

can

either

purchase

an

annuity

or

take

a

series of

with

drawals from the accumulation. Fluctuations in the cumulative return on

assets

during working

life

affect the individual

account

holder

by

affecting

the

amount

available

to

finance retirement.

If

theworker

buys

an

annuity,

he

or

she

will have faced the risk

in the

pricing

of

annuities,

reflecting

both

mor

tality projections

and

asset returns

from this

point

forward. Once the

annuity

is

purchased,

however,

further fluctuations

in

asset returns

and the

develop

ment

of

mortality compared

to

the

projections

used

in

pricing

the

annuity

are

borne

by

the insurance

company,

unless

annuity

benefits

are

indexed

for

asset

returns

(a

variable

annuity)

or

for

mortality

realizations. As the insurance

company

adapts

to

the realizations of

returns

and

mortality,

it

may

in

turn

adjust

the

price

of its

policies,

the

compensation

it

pays

its

workers,

and the

returns

to

its

shareholders

(if

it is

not

a

mutual

company).

If the retiree does

not

buy

an

annuity,

he

or

she faces

mortality

and

return

risks.

That

is,

the risks

of different

outcomes

up

to

retirement

fall

on

the individual

retiree,

since

benefits

adjust

to

what

is in

a

worker's individual

account at

the time of retire

ment.

Annuitization shifts

risks

after retirement

to

insurers,

but the retiree

still

faces

the risk of the

pricing

of

annuities

at

the

start

of retirement.

In

the

case

of

pure

funded

mandatory

defined-benefit

(DB)

plans,

individ

ual workers receive retirement

benefits based

on

a

formula

relating

benefits

to

their

earnings history.

Thus,

both

asset

return

and cohort

mortality

risks

are

managed

through

adjustments

in contributions and

are

therefore borne

by

the

workers

during

their

working

lives. That

is,

in

order

to

sustain

full

funding

for the

provision

of

future

benefits

as

set

out

in

the benefit

formula,

contribu

tions need to be adjusted as returns vary and mortality projections change.

Since

a

single

fund is available

for

all benefits

and

changes

in

contribution

rates

are

normally

uniform

across

workers,

there

is

a

collective dimension

in

that the need

at

any

time

depends

on

the full

array

of workers

who

share

in

the need

for

aggregate

contributions.

A

plan

does

not

have

to

be

fully

funded

at

all times?fluctuations

in

the

degree

of

funding

are

a

device

for

shifting

risks

intertemporally

and,

therefore,

across

workers born

in different

years.

The

fund

may

purchase

annuities,

shifting

risks

to

insurance

companies.

A

plan may have a sponsor who absorbs the risk, such as a corporate employer

or

the

government relying

on

taxes

in addition

to

contributions.

The former

shifts risks

to current

and

future

workers

at

the

firm,

shareholders,

and

possi

bly

customers,

if

the

company

responds

to

a

pension

deficit

by

raising

its

prices.

If the

government

is the

sponsor,

the

risks

are

shifted

to

current

and

future

taxpayers.



5/24

4

ECONOMIA,

all 010

Thus,

one

element

in the distinction between

DB

and DC

plans

is the

focus

on

adjusting

contributions

or

adjusting

benefits.

In

practice,

corpora

tions and

governments

commonly adjust

both,

so

that

plans

are

not

typically

pure,

although

the

labeling

can

affect

the

legislative

outcome.

A

second ele

ment

is

the

collective

aspect

of

having

a

single

fund

rather

than

individual

accounts.

This

opens up

opportunities

for

risk

sharing

within

the DB

con

text,

although

governments

could redistribute

across

individual DC

accounts

and

may

provide

insurance

on

the

rate

of

return,

financed

from

outside the

pension

system.

A

central fund has

lower

administrative

costs

and avoids

poor decisionmaking by workers, although it is at risk of poor investment

decisions

by

the

fund

managers.

However,

a

central

fund

forgoes

the

oppor

tunity

to

have

different

degrees

of

asset

return

risk forworkers with different

levels of risk aversion.

Corporate pensions

should

remain close

to

fully

funded

since

corpora

tions

can

fail,

leaving

the

workers with less than

planned

or

leaving

it

to

the

government

to

insure the

workers.

While

occasionally

governments

go

bank

rupt

as

well,

this

risk is

not

significant

in

countries

with

sound economies

and effective governments. Governments can therefore have systems thatare

less than

fully

funded,

but still well

designed.

The

extreme

version has

no

funding?something

that

is

not

standard

practice

since

most

systems

main

tain

a

buffer fund for short-run

fluctuations,

and

government

plans

sometimes

provide

significant

funding.

A third

option

is

a

pay-as-you-go (PAYG)

defined-benefit

system

financed

by

social

security

contributions.

In

this

arrangement,

there

are no

assets,

so

the rate-of-return risk is

of

no

significance.

Instead,

the risk

to

the

plan's income comes from fluctuations in the earnings of covered workers,

given

the contribution

rate.

Since there is

no

opportunity

for

surpluses

and

deficits,

the risks

are

shared

among

current

workers

through

changes

in

contributions.

If

the fund

can run

surpluses

(partial funding)

or

deficits

(borrowing

against

future contributions

or

using previous

surpluses),

the

risks

can

be

shared with

future

workers

or

eased

by

the

presence

of

accu

mulated

past

contributions.

Any

accumulation,

whether

positive

or

negative,

involves

risk in

rates

of

return.

There is also the risk

of the

evolution of

mor

tality

rates:

if

people

live

longer,

the

cost

of

paying

a

given

level

of

benefits

will

increase.

A

final

option

involves

systems

financed

at

least in

part

by

general

tax

rev

enues.

For

example,

in

a

noncontributory

pension

(referred

to

as a

citizen's

pension),

the

risks

are

shared

by

all

taxpayers

and

are

thus

spread

across

gen

erations

(since

future

taxes

as

well

as

current taxes

can

change

as

debt

varies).



6/24

Nicholas

Barr

nd PeterDiamond

5

In

practice,

plans

are

not

pure,

and countries

frequently

adjust

both

con

tributions and

benefits,

thus

sharing

risks between workers

and

pensioners.

A

central

question

for

policymakers

is how risks should be

shared,

a

question

with both

efficiency

and

equity implications.

As with

redistribution,

different

answers are

possible,

but it is

a

major

error

to

ignore

the

question.

There

s

No

Single

est ension

System

Policymakers

face

a

series of

constraints

in

pursuing

the

multiple objectives

mentioned

above,

including

fiscal

capacity

(stronger

fiscal

capacity

makes

it easier for the system to find additional revenues for a pension system);

institutional

capacity

(stronger

institutional

capacity

makes

feasible

a

wider

range

of

design options);

the

empirical

value of behavioral

parameters

(such

as

the

responsiveness

of labor

supply

to

the

design

of

the

pension

system

and

the

effect

of

pensions

on

private saving);

and the

shape

of the

pretransfer

income distribution

(a

heavier lower tail increases the need

for

poverty

relief).

The

reason

why

there

is

no

single

best

system

is

simple: policymakers

at

different times and in different

places

attach different relative

weights

to the

various

objectives;

and

the

pattern

of

constraints,

including

political

and his

torical

constraints,

will

differ

across

countries.

If

objectives

and constraints

differ,

the

optimum

will

generally

differ,

as

well.

Pensions

hould

e

Analyzed

n

Second-Bestontext

The

assessment

of

the

optimal pension

system

should

be made

in

a

second

best context.3 Simple theory assumes that individuals make optimal choices

and that labor

markets,

savings

institutions,

and insurance markets exist and

function

ideally.

Those

assumptions

do

not

apply

to

pension

systems

because

workers

and

pensioners

face information

problems,

behavioral

problems,

missing

markets

(for

example,

the lack

of

private

instruments

to

provide

indexation),

and broader

factors such

as

the

inescapable

existence

of distor

tionary

taxation.

Framing

the

argument

in

second-best

terms starts

from

the

multiple objec

tives of pension systems. Thus, policy has tooptimize (notminimize ormax

imize)

across

a

range

of

objectives,

which

cannot

all

be achieved

fully

at

the

same

time.

Policy

has

to

seek

the

best balance between

consumption

smooth

ing,

poverty

relief,

and

insurance,

and

this

balance

will

depend

in

each

society

3.

For

a

fuller

discussion,

see

Barr

and

Diamond

(2008,

section

4.2 and

box

9.6).



7/24

6

ECONOMIA,

all 010

on

the

weights given

to

those

and other

objectives

and

to

the different

con

straints that societies face.

AMove

o

Funding

ay

r

May

ot ethe

ight

olicy

In

assessing

whether,

and

to

what

extent,

a

move

to

funded

pensions

might

increase

welfare,

policymakers

need

to

ask

two sets

of

questions.4

First,

is

a

move

toward

funding

welfare

improving?

For

example,

does it increase

out

put,

either

by increasing savings

in

a

country

that is short of

saving,

or

by

strengthening capital

markets,

thereby

improving

the

efficiency

with

which

savings

are channeled into

productive

investment? Does it have desirable

intergenerational

redistributive effects?

Second,

even

if

a

move

toward fund

ing

is

in

principle

welfare

improving,

is such

a move

feasible? Does the

coun

try

in

question

have the

economic

conditions and

institutional

capacity

necessary

to

implement

schemes that

are

safe and

administratively

cheap?

The

answers

to

these

questions

will

vary

over

time and

across

countries.

First,

an

increase in

saving

may

not

be the

right objective, particularly

in

a

country

where the

saving

rate

is

already

high

(for

example,

China).

Second,

a move to

funding

may

or

may

not

increase

saving.

For

example,

fund

ing

through

the

issue of

new

government

bonds

will not

do

so.

Similarly,

increased

mandatory pension saving

may

be

largely

offset

by

declines

in

voluntary private saving

or

by

increases

in

government

borrowing,

perhaps

to

help

finance the transition

costs

of

a move

to

a

regime

with

more

funding.

Third,

formal

capital

markets

may

or

may

not

allocate

funds

to

investment

more

effectively

than

informal

capital

markets. Gains in the

effectiveness

of

capital

markets will

depend

on

effective

administration

and

on

political sup

port

for

improved regulation.

Thus,

funding

may

increase national

saving

or

expand

explicit public

debt,

or

both;

and it

may

improve

the

operation

of

cap

ital

markets. Either is

possible;

neither

is

inevitable.

The economic

case

for

funding

has

to

be

analyzed

in

each

country.

In

addition

to

the

potential

effects

on

output,

a

move

to

funding

has inter

generational

effects.

If

funding

is

to

raise

output

growth

in the

future,

it

must

increase

saving today.

But for

saving

to

increase,

there

must

be

a

decline in

consumption, by government or by today's workers or by today's retirees.

Thus,

a

move

to

funding

generally imposes

a

burden

on

today's

generations

to

the

benefit of

future

generations,

an

outcome

that

may

or

may

not

be

good

policy.

More

generally,

introducing

a new

PAYG

system

allows the

early

4. For

a

fuller

discussion,

see

Barr and

Diamond

(2008,

section

6.3).



8/24

NicholasBarr nd Peter

Diamond

7

cohorts

to

receive

larger

pensions

than

if

the

new

system

were

fully

funded.

Consequently,

any

choice between

PAYG,

partial funding,

and full

funding

is also and

necessarily

a choice about the

intergenerational

distribution of

income and of risks.

Even if

funding

does

increase

output,

the

change

cannot

be

presented

as an

unambiguous improvement.

The

answers

to

these

questions

shed

light

on

whether

a move

to

funding

might

be

optimal.

A

separate

issue is whether it is feasible. Funded

pensions

make

significant political

demands

on

government

and

require

significant

institutional

capacity

in both the

public

and

private

sectors.

The

litany

of

funded schemes that have

failed

completely

or

that have

not

lived

up

to

the

promises

thatwere made for them attests to the

importance

of these

opera

tional

issues,

as

well

as

to

the

dangers

of

basing policy

on

untested and

per

haps

excessively

optimistic predictions.

Policy

mplications

In discussing policy direction in the context of Latin America, it is helpful

to start

with

consumption

smoothing.

This discussion establishes

the

con

text

for

examining

poverty

relief

generally

and the

2008

reforms

in

Chile

in

particular.

Consumptionmoothing

It

is

a

mistake

to

conflate

the

separate

concepts

of individual

accounts

and funding. Individual accounts can be fully funded (such as the Chilean

DC

scheme),

partially

funded,

or

PAYG

(for

example,

a

notional defined

contribution

scheme

with

no reserves

beyond

a

buffer fund

to

cover

a

few

months of

payments).

The discussion

below looks

first

at

notional

defined

contribution

(NDC)

pensions

and then

at

reform

options

for funded indi

vidual

accounts.

ndc

pensions.

A recent

innovation

internationally,

pure

NDC

systems

mimic funded

individual

accounts,

but

on a

largely

or

wholly

pay-as-you-go

basis. In the simplest such scheme, each worker pays a contribution of a fixed

percentage

of

his

or

her

earnings,

which

is

credited

to

a

notional

individual

account,

while

theworkers'

contributions

this

year

largely

or

wholly

pay

this

year's pensions.

The

government

keeps

a

record

of

individual

contributions,

each

year

attributing

a

notional

interest

rate

to

each

worker's

accumulation.

When the

worker

retires,

his

or

her

notional

accumulation

is

converted

into



9/24

8

ECONOMIA,

all

010

an

annuity.

In

a

pure

NDC

system,

benefits

are

strictly

related

to

the size

of

a

person's

notional accumulation.5

The

system

can

also

incorporate

redistribu

tion,

such as minimum benefits or

pension

credits for

caring

activities,

and

the scheme

can

incorporate

partial

funding.

NDC schemes

have

a

range

of

potential

advantages.

The

system

is sim

ple

from

the

point

of

view of the

worker,

and

the fact that

it is administered

centrally keeps

administrative

costs

low.

Risk is

kept

low,

since

an

unfunded

NDC

pension

system

is

not

affected

by capital

market

volatility,

themain

source

of

risk

to

funded individual

accounts. An NDC

system

does

not

require

the

institutional

capacity

to

manage

funded schemes.

In

addition,

saving

may

be the

wrong

policy,

or

people

may

not want to

save.

Finally,

NDC

can

be

partially

funded

and

can

be

the basis for

a

future

move

to

full

funding,

so

the

approach

may

provide

a

starting point

if financial

market

tur

bulence continues.

As discussed

earlier,

solid

analytics

should

underpin

the choice

between

NDC and

funded

accounts.

The choice should

be

economic,

not

primarily

political.

funded individual accounts. If policymakers want a system with

funded

individual

accounts,

there

are

different

ways

to

implement

the

policy.

In the best-known

arrangement,

workers have

significant

individual

choice

over

their

pension provider,

as

in

Chile

and

Sweden.

Choice

is

generally

assumed

to

be

welfare-enhancing. Simple

economics

argue

that

policy

should

allow

people

to

choose

their

own

pension

provider

in

a

competitive

market.

Such

choice,

it is

argued,

benefits

the individual

in

the

same

way

as

choice

and

competition

for

clothes,

cars,

restaurants,

and

MP3

players.

That view

needs to be tempered by two sets of factors, however: impediments to good

choice

by

individuals;

and the fact that choice has

costs.

The model of thewell-informed

consumer

does

not

hold

in

many

areas

of

social

policy,

as

demonstrated

by

the economics

of information.

In

the

con

text

of

pensions,

there

is

ample

evidence

of

poor

information.

Many

do

not

understand

basic

concepts

in

finance:

Orszag

and

Stiglitz

quote

the

chairman

of theU.S.

Securities

and

Exchange

Commission

as

stating

that

over

50

per

cent

of Americans do

not

know the

difference

between

a

stock and

a

bond.6

5.

The

system

is

quasi-actuarial

in

that

the

interest

rate

attributed

to

a

worker's notional

accumulation is

not the market

return

to

financial

assets,

but

an

interest

rate

determined

by

the relevant

pensions legislation?for example,

the

growth

in the total

wage

bill of covered

workers

each

year.

6.

OrszagandStiglitz(2001,p.

37).



10/24

Nicholas

Barr

nd

Peter

Diamond 9

Most

people

with

an

individual

account

do

not

understand

the

need

to

shift

from

equities

to

bonds

as

they

age,

and

virtually

nobody

realizes the

signifi

cance

of administrative

charges

for

pensions.

As

noted,

choice has

costs,

and

in the

case

of

individual

accounts

those

costs

are

significant:

over a

full

career,

an

annual

management

charge

of 1

percent

of the

individual's

accu

mulation reduces the accumulation

(and

hence

the

pension) by

20

percent.7

Recent lessons

from behavioral economics

also

yield

powerful

lessons,

explaining

such

phenomena

as

procrastination (people

delay saving,

do

not

save,

or

do

not

save

enough),

inertia

(people

stay

where

they

are),

and

immo

bilization

(whereby

conflicts and confusion lead

people

to

behave

passively,

like

a

deer in the

headlights).8

These

bodies of

theory

suggest

that the

benefits

of

wide

choice

are

likely

to

be

very

limited,

and

for

most

people

likely

to

be

outweighed by

the

costs

of

choice.9

These considerations

suggest

a

series of

guidelines

for the

design

of individual

accounts:

?Use automatic

enrollment;

?Keep

choices

simple

(for

most

people,

highly

constrained choice

is

a

deliberate and welfare-enhancing feature of good pension design,

although

one

of

the

options

could be

to

allow

individual

choice);

?Design

a

good

default

option

for

people

who make

no

choice;

and

?Decouple

fund

administration

from fund

management,

with

account

administration

centralized

and

fund

management

organized

on a

whole

sale,

competitive

basis.

The U.S.

Thrift

Savings

Plan for federal civil

servants

complies

with

these

criteria.10

The

plan

offers

participants

a

very

limited

choice

of

portfolios.

Ini

tially therewere three: a stock market index fund, a fund holding bonds

issued

by

private

firms,

and

a

fund

holding

government

bonds.

In 2007 work

ers

could

choose from

six

funds,

including

a

life-cycle option

(that

is,

an

option

inwhich

a

person's

portfolio

shifts

automatically

from

mainly

equi

ties

to

mainly

bonds

as

he

or

she

ages).

A

government

agency

keeps

central

ized

records of

individual

portfolios.

Fund

management

is

on a

wholesale

basis.

Investment

in

private

sector

assets

is handled

by

private

financial

firms,

which

bid

for

the

opportunity

and

which

manage

the

same

portfolios

in

the

voluntary private

market,

providing

insulation from

political

interference.

7.

See

Barr

and

Diamond

(2008,

Box

9.4).

8.

For

a

fuller

discussion,

see

Barr

and

Diamond

(2008,

Box

9.6).

9.

For

a

fuller

discussion,

see

Barr and

Diamond

(2008,

section

9.3).

10. For

more

information,

see

the

U.S.

Thrift

Savings

Plan

website

(www.tsp.gov).



11/24

10

ECONOMIA,

all 010

This

plan

thus

(a)

simplifies

choice

for

workers,

respecting

information

constraints,

(b)

includes

automatic

enrollment,

(c)

has

a

default

option,

and

(d)

keeps

administrative costs

astonishingly

low,

at as little as 6 basis

points

annually,

or

60

cents

per

$1,000

of

account

balance.

By

the end of

2009,

the

program

had

grown

to

include 3.2

million active

participants

and 4.3

million

total

accounts

and

held

assets

of

$244

billion.

The

United

Kingdom

is intro

ducing

a

similar

arrangement.11

Poverty

elief

Pure DC individual accounts provide consumption smoothing, but theydo not

provide

adequate

poverty

relief for

workers with limited

lifetime contribu

tions,

typically

as a

result of

low

earnings, fragmented

careers,

or

a

work his

tory

substantially

in the informal

sector.

In this

regard,

the

post-1981

system

in

Chile,

which is based

heavily

on

individual

accounts,

offers three

primary

lessons:

first,

mandatory

funded individual

accounts

can

be

part

of

a

good

reform,

but such

a

reform

is

not

easy

and

depends

on

complementary

reforms;

second,

private supply

and

competition

alone

are

not

sufficient

to

keep

down

transactions costs or

charges;

and,

finally,

unless

accompanied by

a robust

sys

tem

of

poverty

relief,

individual

accounts

do

not

constitute

a

pension

system,

but

only

part

of

a

pension

system.12

To

explain

the

shape

of

Chile's 2008

reforms,

it is

necessary

to

consider

the

changes

in the economic and social environment

within which social

pol

icy

operates.

The

contributory

principle

assumed thatworkers had

long,

sta

ble

employment,

so

that

coverage

would

grow.

History

has

not

sustained this

supposition.

To

explain why,

consider

the

way

the world has

changed

over

the

past

sixty

years.

Social

policy

in

1950

was based on a series of

assump

tions: theworld

was

made

up

of

independent

nation

states;

employment

was

generally

full time

and

long

term;

international

mobility

was

limited;

the

sta

ble nuclear

family

with

a

male breadwinner and

a

female

caregiver

was

the

norm;

and

skills,

once

acquired,

were

lifelong.

While these

assumptions

were

not

entirely

true

even

then,

they

held well

enough

to

be

a

realistic basis for

social

policy.

The

world

today

is

very

different.

There

is

increasing

international

com

petition.

The

nature

of work is

changing,

with

more

fluid labor markets.

11.

See

the website of the

U.K. National

Employment Savings

Trust

(www.nestpensions.

org.uk).

12. Barr and Diamond

(2008, p. 238).



12/24

NicholasBarr nd Peter

Diamond

11

International

mobility

is also

increasing,

and

it

is

likely

to

continue

to

do

so.

The

nature

of the

family

is

changing,

with

more

fluid

family

structures

and

rising

labor-market

participation

by

women.

Finally,

the half-life of skills

has declined.

Given this

new

environment,

the

key

drivers of

change

when

considering

pension design

are more

diverse

patterns

of

work,

which

create

problems

in

terms

of

coverage

for

contributory

benefits tied

to

employment,

and

increas

ingly

fluid

family

structures,

which make itdifficult

to

base women's

benefits

on

their husbands'

contributions.

Those circumstances

create

a

case

for

a

noncontributory

basic

pension,

that

is,

a

pension

financed from

general

taxation and awarded

at

a

flat

rate to

any

one

who

meets

an

age

and residence

test.

The

Chilean Presidential

Advisory

Council

on

Pension Reform

put

the

point succinctly:

The

prevailing image

at

the time of the

pension

reform

[in

Chile in

1981],

of

a

workforce

composed

mainly

ofmale

heads of

household,

with

permanent

jobs,

contributing

contin

uously throughout

their active

lives,

has become less and

less

representative

of the real situation of

the

country

and will become

even

less

so

in

the future.

This

means

that the system designed at thatpoint in time is also gradually los

ing

its

ability

to

respond

to

the

needs of the

population

as a

whole. 13 For

these

reasons,

Chile

introduced

a

noncontributory pension

(the

Pension

Bdsica Sol

idaria)

in

2008,

initially

for

pensioners

in

the

poorest

40

percent

of the

popu

lation and

rising

to

60

percent

when

fully phased

in.

The

case

for

a

non-contributory pension

is that it

strengthens

poverty

relief

in

terms

of

coverage,

adequacy,

and

gender

balance;

improves

incentives rel

ative

to

income-tested

poverty

relief;

provides good targeting

(in

that

age

is

a

useful indicator of poverty); and can assist international labormobility. The

obvious

question

is how

to

pay

for such

a

benefit. Three instruments

can

match

expenditures

with

budgetary

constraints: the size

of the

pension,

the

age

at

which it is first

paid,

and the

option

of

an

affluence

test,

which

keeps

benefits

from the best-off

segment

of the

population.

The Chilean mechanism for

con

trolling

beneficiaries

was

mentioned above.

In

Canada,

95

percent

of older

people

get

the

full

flat-rate

benefit,

and

only

2

percent

are

entirely

screened

out.

In

the

Netherlands,

the benefit is awarded

only

on

the

basis of

age

and

res

idence, with no testof income or assets. Box 2 summarizes the international

experience

with this

type

of

pension.

13.

Presidential

Advisory

Council

on

Pension Reform

(2006).



13/24

BOX

2.

NoncontributoryPensions

A number

f

countries

ave

implemented

noncontributory

ension

system.2 igh-income

ountries

ith

this

arrangement

nclude

ustralia,

anada,

the

Netherlands,

nd

New

Zealand.

For

middle-income

countries,

he

noncontributory

ension

introduced

n

hile in 008

is

discussed

in he text.

outh

Africa lso

has

a

noncontributory

pension,

namely,

he

State

Old

Age

Grant. he

case

is

interesting

n hat

it

reaches

not

only

urban

pensioners,

ut

also the

rural

elderly.

he

pension,

which is

paid

to

men

at

age

65

and

women at

60,

is

financed

rom

general

revenue

ith

no

contribution

onditions. he

benefit

s

round

half f

average

household

income

nd is

hus

high

relative

o

the

very

ow

incomes f

most

nonwhites

n

outh

Africa,

ut low

relative

o the incomes

f

the better ff.

Originally

ntroduced

s

poverty

elief

or

hites

during

he

1930s,

the

plan

was

gradually

xpanded

tocover ll race

groups.

Research

suggests

that it s

highly

ffective

oth in

erms

f social

policy

nd

in he

way

the

plan

is

implemented:

The South

African

ocial

pension

is

n

example

of

a

transfer

plan

where

eligibility

s

determined

by

age.

In

spite

of the

simplicity

f the

targeting

indicator,

he

pension

is

ffective

n

reaching

he

poorest

households

nd thosewith children_The

South

African

authorities

ave

overcome

the

difficultiesf

making

cash transfers

o

even

remoterural

reas

and

of

checking ligibility

among

even

illiterate

pensioners. 3

nmost

urban

reas,

people

receive

he

pension

through

ank

accounts

or

post

offices.

In

rural

reas,

government

as

outsourced

delivery

o

the

private

ector,

rganized

at

the

provincial

evel.At its

est,

the

system

s ffective

nd innovative.

n

ome

areas,

vehicles fitted

ith cash

dispensers

go

to

designated

places

at

preordained

imes.Pensioners

nter

their dentificationumber

or

ingerprint),

nd

their

pension

is

paid

out.

Notionally,

there is

government

fficial

n

hand to

provide

help,

but this

facility

s

patchy.

Anumber f low-income ountries lso have

noncontributory

ensions

(sometimes

alled social

pensions), including

Bolivia,

Botswana, Namibia,

nd

Nepal.

Total

spending

s

typically

mall

in

hese

cases

(below

1

percent

f

GDP

in

Botswana, Namibia,

nd

Nepal),

and

the benefit

s lso

generally

mall.4

Pensions

of

this

ort

have the

great

potential

dvantage

of

extending

overage

to

people

with

limited ontributions

records,

specially

women

andworkers

in he

informal

ector. n

assessing

their

desirability

nd

feasibility

n

particular

country,

olicymakers

eed

to

consider

range

f factors:

?How well

could the

pension

be

targeted?

he

cost

effectiveness

f

a

noncontributory

niversal

pension

depends

on

the

accuracy

f

age

as a

targeting

evice. In

principle,

he

more

poor

people

a

country

as,

the

greater

he

importance

f

poverty

elief nd

the

better-targeted noncontributory

ension

will be.

The

extent

to

which

age

alone is

good

indicator,

however,

ill

vary

rom

country

o

country, epending,

for

example,

on

the

extent

to

which old

people

live

lone

or as

part

ofan extendedfamily.

?Is administrative

capacity

ufficient?ven

simple

pension

has

administrative

equirements.

he

government

must

be able

to

establish

people's

ages

and

to

guard

againstmultiple

claims

by

one

person

and

claims

by

relatives

n

behalfof

a

pensioner

who

has

died.

?Is

the

cost

of

delivery

ow

enough

relative

o

the

size

of

pension

being

considered?

Finally,

here

a

government

as

the

necessary

mplementation

apacity,

olicymakers

ave

a

range

f

options

for

containing

osts.

First,

he level f the

pension

can

be

kept

low.

For

example,

it s

only

10

percent

f

GDP

per

capita

in

Botswana and

Nepal.

Second,

the

age

at

which the

pension

is

irst

paid

can

be

set

high.

In

Nepal,

only

1.1

percent

f the

population

is lder

than the

qualifying

ge.

Finally,

f

dministrative

capacity

ermits,

further

option

is

o

pay

a

smaller

pension

at

first

for

xample,

to

pensioners

ged sixty-five

o

seventy-five)

nd

a

larger

ne

thereafter

to

those

seventy

five nd over).

2.

For urther

iscussion

f

noncontributory

ensions,

ee

Willmore

2007).

3. Case ndDeaton

1998,

.

1359).

4.

Willmore

2007,

able

).



14/24

Nicholas

Barr

nd

Peter

Diamond

13

Conclusion

In considering the implications of economic theory for thedesign of pension

systems,

a

number of

conclusions stand

out.

First,

the

analysis

should

con

sider the

pension

system

as

a

whole. Pension

design

affects the labor

market,

economic

growth,

the distribution

of

risk,

and the distribution of

income,

including

effects

by gender

and

generation. Analysis

should consider the

entire

pension

system.

There is

no

efficiency gain

from

designing

one

part

of

the

system

(such

as

individual

accounts)

without distortions

if

distortions

are

then

placed

elsewhere

to

accomplish

other

objectives.

Hence,

there

can

be

no

gain

from an actuarial second-tier

pension given

the need for a

poverty-relief

element

in

the first tier.What is relevant for

analysis

is the combined effect

of the

system

as a

whole.

Consequently,

analysts

must

simultaneously

con

sider the

parts

of the

pension

system

that

provide

poverty

relief and those

whose

primary

focus is the

pursuit

of other

objectives.

Second,

the economic crisis has

provided

some

strategic

lessons.

Perhaps

the

key

lesson

for

pensions

is the

importance

in

any

reform

of

explicitly

ask

ing

how risk should be shared.

With

pure

funded individual

accounts,

all

of the risk falls

on

the

worker,

and modifications

frequently

leave the

worker

bearing

a

large

fraction of

the risk.

Many

(including

us)

regard

this concentration of risk

as

undesirable. One

way

of

sharing

risk

more

widely

is

to

buttress individual

accounts

with

a

tax-financed noncontribu

tory

pension.

Third,

there

are

many

choices,

which widen

as

a

country's

economic and

administrative

capacity

grows.

To

illustrate,

we

briefly

describe

pension

sys

tem

options

for

a

middle-income

developing country

and for

an

advanced

country.

A

middle-income

developing

country

has

two

main

options

for its

first-tier

pension:

a

noncontributory

tax-financed

pension

(see

box

1),

with

or

without

an

affluence

test

(examples

include

Australia,

the

Netherlands,

New

Zealand,

South

Africa,

and

Chile);

or a

simple

contributory

PAYG

pension,

such

as a

flat-rate

pension

based

on

number of

years

of contributions

(such

as

the basic

state

pension

in the

United

Kingdom).

For the second tier, the options include a publicly organized earnings

related defined-benefit

pension,

or

possibly

a

notional


pension;

or a

provident

fund defined-contribution

pension

(Malaysia,

Singa

pore),

inwhich the

design

of

any

tax

concessions

should

consider

the

extent

to

which

tax

benefits

are

regressive.

If

the

first

tier

includes

a

contributory

pension,

the second-tier

mechanisms

can

be

separate

from it

or

integrated.



15/24

14

ECONOMIA,

all

010

The third

tier

comprises

voluntary


pensions

at

the

level of the

firm

or

the

individual;

any

tax

benefits

should be

designed

to

avoid

excessive

regressivity.

In

an

advanced

country,

the

options

for the first-tier

pension

are

either

a

contributory pension

aimed

at

poverty

relief,

with

a

large

array

of

possible

designs

(many

countries

use

this

type

of

system,

including

theUnited

King

dom);

or

a

noncontributory

tax-financed

pension,

with

an

affluence

test

(for

example,

Australia

and South

Africa)

or

without

(for

example,

the Nether

lands

and New

Zealand).

There

are

several

options

for the second

tier:

a

publicly organized

defined

benefit

pension,

which

may

be

integrated

with the

first-tier

contributory

pension

(the

United

States)

or

operated

separately

(France,

Germany,

and

Sweden);

a

notional defined-contribution

pension

system

(Sweden);

an

administratively cheap savings plan

with

access

to

annuities

(for

example,

the

Thrift

Savings

Plan

in

theUnited

States);

mandatory

occupational

funded

defined-benefit

pensions

(this

is the de facto

system

in

the

Netherlands);

or

funded defined-contribution

pensions

(Chile,

Sweden),

possibly

including

an

anti-poverty element (Mexico).14

As in the

case

of the

developing

country,

the

third tier

comprises

volun

tary


pensions

at

the level of the

firm

or

the

individual;

any

tax

benefits should

be

designed

to

avoid

excessive

regressivity.

Finally,

for

an

effective

pension

system,

two

things

matters

above

all:

effective

government

and

output

growth.

These factors

are

simple

to

identify

but difficult

to

achieve.

An effective

government

will

manage

a

PAYG

sys

tem

responsibly,

and

itwill

create

themacroeconomic and

regulatory

stability

within which funded schemes can flourish. In contrast, ineffective govern

ments

are

prone

to

make

irresponsible

PAYG

promises

and

to

pursue

policies

leading

to

macroeconomic

instability.

Robust

output

growth,

by

relaxing

resource

constraints,

makes it easier

to

realize the

plans

of

both workers and

pensioners.

14.

The

system

in

the Netherlands is

now

moving

more

toward

a


arrangement.



16/24

Comment

Eduardo

Engel:

This

paper

provides

a

masterful

primer

on

the economics of

pensions.1

Barr and

Diamond also

cover

the

shortcomings

of

arguments

for

privatizing pensions

in Latin

America,

as well as

problems

thatwere not

envisioned

at

the time of

reform.

I

organized

a

lecture

on

pensions

in

the

undergraduate

course

I

teach

at

Yale

on

economic

policy

in

Latin America

based

on

this

paper,

and itworked

very

well.

In

these

comments,

I

provide

additional evidence

illustrating

the

paper's

main

points

and discuss

issues

on

which I differ.

Among

the

latter,

I

argue

that

political

economy

considera

tions

may

temper

some

of the

paper's policy

recommendations.

Promise

A

pension

system

based

on

individual

accounts

as

part

of

a

fully

funded


system

was

introduced

in

Chile

in

1981.

Argentina,

Bolivia, Colombia,

Costa

Rica,

theDominican

Republic,

El

Salvador,

Mexico,

Peru,

and

Uruguay

introduced similar

systems

in

the decades that

followed,

sometimes

as one

ofmany options and

in

other

cases as

themain

or

only

option

available

for

new

entrants to

the

labor force.2

Four main

arguments

for the Chilean

pension

reform

were

given

in

the

early

1980s.

First,

providing

well-defined

ownership rights

reduces the risk

of

opportunistic

behavior aimed

at

obtaining

a

larger

share

of

accumulated

funds and

current taxes

destined

to

finance

pensions.

Both advocates

and

detractors

of

theChilean

reform

provided ample

evidence

that the old

system

was

plagued

by

blatantly

unfair

and

corrupt

practices.3

Second,

competition

1.

I

thank Eduardo

Bitran,

Ronald

Fischer,

Eduardo

Lora,

and Claudio Raddatz

for

com

ments

and

suggestions.

2. Arenas and

Mesa-Lago

(2006).

3.

Arellano

(1985);

Pinera

(1991).



17/24

16

ECONOMIA,

all 010

among

pension

providers

would lead

to

better

service and

higher

returns

on

savings,

translating

into

higher

pensions.

A

third

argument,

closely

related to

the first ne, was that the new system would foster sounder

public

finances

by

reducing

the

burden

on

the

government

budget

imposed

by

the

partially

unfunded

systems

in

place

at

the

time.

Jose

Pinera,

labor

minister at

the

time

of

the

Chilean

reform,

went

so

far

as

to

claim

that

the

fiscal

cost

of

the

reform

would

be

zero.4

Finally,

many

arguments

were

presented

linking

a

system

based

on

individual accounts to

the

development

and

deepening

of

financial

markets.

Experience

As is

so

often

the

case

with

economic

reforms,

the

benefits

are

oversold

and

a

number of

problems

are

not

anticipated.

The

transition

from

a

system

with

defined

benefits

to

one

with

defined

contributions

based

on

individual

accounts

evidently

has

a

cost

for

public

finances.

Taxes must

finance

pen

sions

for

those

belonging

to

the old

system

for

a

period lastingmany decades,

with

no

recourse

to

social

security

contributions

from

workers

entering

the

new

system.

Only

a

comparison

of

steady

states

that

ignores

the

transition

costs

involves

no

fiscal

cost.5

The

analysis by

Barr

and

Diamond

also

tempers

the

enthusiasm for

pen

sion

systems

based

on

individual

accounts

as

a

means

to

develop

financial

markets.

I

do

not

have

space

to

address

the

debate

on

whether

pension

reform

fosters

the

development

and

deepening

of

financial

markets.6

The

potential

is

there, especially

for

countries thatprivatized publicly held utili

ties

concomitantly

with

reforming pensions,

since

the

long-term

financing

needs of

privatized

utilities

match

the

pension

fund

managers'

demand

for

long-term

assets.

Nonetheless,

the

challenges

faced when

addressing

this

question

empirically

based

on

aggregate

evidence

are

large,

since

other

4.

20

respuestas

acerca

de

la

prevision

dio

ministro

Pinera,

El

Mercurio,

15

November

1980,

p.

Al.

5.

The

present

discounted

value

of

government

outlays

will

also

be

higher

with

reform

than

without

reform,

since

the

transition

from

the

partly

unfunded

defined-benefits

system

to

the

fully

funded


system

with

individual accounts

is

the

converse

of

the

well

known

result

according

to

which

introducing

social

security

constitutes

a

Pareto

improvement

(Samuelson,

1958).

6.

See

Raddatz and

Schmukler

(2005)

for

a

good

summary

of the

main

issues and

references.



18/24

Nicholas

Barr

nd

Peter Diamond 17

reforms coincided

with

pension

reform

in

many

countries,

making

identifi

cation

close

to

impossible.7

A more promising route to study the impact of pension reformon financial

markets is

to

use

microeconomic data

to test

specific

channels for

potentially

beneficial

effects. Raddatz and Schmukler

provide

an

interesting example

along

these

lines.8

They

look

at

investment

strategies by

Chilean

pension

fund

managers

and

find that

theymainly

hold bank

deposits,

government

paper,

and short-term

assets;

that

they

tend

to

hold similar

portfolios

and fol

low

momentum

trading strategies;

and that

they

do

not

actively

trade the

assets

they

hold. All of

this

suggests

that

even

if

pension

funds

helped

create

markets for

long-term

instruments, as

they

most

likely

did,

they

did not con

tribute

to

making

these markets

particularly liquid.

Raddatz and Schmukler

conclude

that

the

observed investment

patterns

are

not

consistent with the

initial

expectations

that

pension

funds

would be

a

dynamic

force

stimulating

the overall

development

of

capital

markets,

especially

that

of

secondary

trad

ing

markets. 9

Competition

The

advantages expected

from

competition

did

not

materialize. As noted

by

Barr and

Diamond,

the economics

of information and behavioral economics

both

help

explain why.

For

example,

95

percent

of

account

holders of Chile's

private pension providers

do

not

know the administrative

charges they

pay,

despite

the

fact

that

they

receive

quarterly

statements

containing

these

charges

and that this is themain determinant of

differences in

returns

across

pension

funds.10

It

is

therefore

not

surprising

that

competition

among

providers

has

been

weak,

leading

to

average

annual

returns

on

capital

for these

companies

that

are

many

times those obtained

by

assets

facing

similar

risk

profiles

else

where

in

the

economy.

For

example,

the

average

annual

return

of

pension

administrators

in

1998-2003

was

53

percent,

which is four times

larger

than

normal returns.11

Despite

such

high

returns,

no new

firm

entered

the

industry

7. For

example,

orande

(1998) argues

that

hile's

high

growth eriodbeginning

n

1985

is

explained

by

increased

savings

that

resulted from

pension

reform.

8.

Raddatz and

Schmukler

(2005).

9.

Raddatz and

Schmukler

(2005,

p.

7).

10. Berstein

and Ruiz

(2004).

11.

Valdes-Prieto and

Marinovic

(2005).



19/24

18

ECONOMIA,

all

010

between

1998 and

2010,

when the

system

was

reformed

to

introduce

more

competition

(see

below).

Interestingly,well-designed competition for thefield can be a good surro

gate

when

competition

in the

field

does

not

work

properly.12

Private

pension

markets

provide

an

excellent illustration

of this

powerful

idea.

In

February

2009,

theChilean

government

auctioned

the

individual

accounts

of all

work

ers

entering

the

labor market

over

a

two-year

period,

with the

accounts

being

awarded

to

the

pension provider

bidding

the lowest

fees.

If

an

incumbent

won

the auction

with

a

bid lower than

the fees

it

charged

existing

customers,

it

had

to

pass

on

the

reduction

in

charges

to

all

customers. Workers

assigned

to

the

winner are free tomove to another

provider

if

they

so desire.

The

winner of the auction offered

a

commission

16

percent

below

the low

est

commission

in themarket.

Furthermore,

the

winner

was

new

to

the indus

try,

the first

entrant in

more

than

a

decade.

Having

a

Demsetz

auction lowers

entry

costs

significantly,

since

new

firms

can

count

on a

sufficiently large

number

of clients

(approximately

7

percent

of

themarket

in theChilean

case)

to

operate

at

an

efficient

scale without

having

to

invest

in

marketing. Despite

the

fact that incumbent

pension providers

lobbied

strongly

against

the

auc

tion

and succeeded

in

watering

down the

extent to

which it reduced

entry

costs,

the

outcome

is

promising

and

may

lead

to

significant

fee

reductions in

years

to

come.

Administrative

osts

Arellano

was

one

of the first

to

point

out

the

high

administrative

costs

of the

Chilean

pension

system.13

In

general,

the

administrative

costs

of

private

investment

funds

in Latin America

are

high.

As of December

2002,

fees

as

a

percentage

of total contributions

were are

follows:

Argentina,

36.2

percent;

Chile,

15.0

percent;

Colombia,

14.0

percent;

El

Salvador,

12.5

percent;

Peru,

22.1

percent;

and

Uruguay,

13.5

percent.14

Bolivia is the

one

exception,

with

administrative

fees

of

only

4.8

percent

of total contributions.

Why

are

admin

istrative

costs

so

much lower in Bolivia?

Bolivia learned

from the

Chilean

experience and used aDemsetz auction to reduce administrative costs by two

thirds.

Instead

of

allowing

free

entry,

Bolivia

opted

for

two

pension providers

12.

Chadwick

(1859);

Demsetz

(1968).

13. Arellano

(1985).

See

also Diamond and Valdes-Prieto

(1994).

14.

Barr and

Diamond

(2008,

table

9.2,

p.

166).



20/24

Nicholas

Barr

nd

Peter

Diamond

19

selected via

competitive bidding

based

on

the

lowest

average

monthly

admin

istrative

charges.15

Pensions

Diamond Barr 2010

Documents

Transcript of Diamond Barr 2010