Providing income security in old age ? A quick review of pension reforms

InternationalLabourOffice

Providing income security in old age ? A quick review of pension reforms

Michael Cichon Social Security Department 1 November 2011


22

Structure of presentation

Point One: The background noise: were paradigmatic reforms

really necessary?

Point Two: The theoretical pros and cons of paradigmatic pension reform

Point Three: Pension reforms in the crisis stress test

Point Four: What went wrong with pension reform in principle

Point Five: Elements of generic repair

strategies


3

One . Was paradigmatic reform

necessary?


44

The history of pension reform: the return to and old risk coping mechanism: savings….

PARADIGMATIC reforms introducing individual savings components into national pension systems attracted most attention :

– 1980/81 the Pinochet reform in Chile– During the 1990s and early 2000s 11 countries in Latin

America introduced fully funded elements into their pension schemes

– Between 1997 and 2008 10 Eastern European plus some Central Asian Countries followed countries followed

– SWEDEN Notional defined benefits 1994 – 2008 Reversal in Argentina– 2008 Renewed reform in Chile...– 2009 – 2010 Reversals in Eastern Europe

But PARAMETRIC reforms were equally prominent :

– Since the 1990s and many European and OECD countries largely focussing on pension age increases


55

Point One: beyond the ageing hype: were paradigmatic reforms really necessary ? Projected system dependency rates -source EU


66

Point One: beyond the ageing hype: were paradigmatic reforms really necessary ? Projected system dependency rates


77

Point One: The need for paradigmatic reforms remains in doubt…projected cost in % of GDP


88

Point One: The need for paradigmatic reforms remains in doubt…projected cost in % of GDP


9

The challenge beyond the ageing hype… Projected total social expenditure in the EU…

Age related Government expenditure in % of GDP EU 27

2007 2060 ChangePensions 10.2 12.6 2.4Health 6.7 8.2 1.5Long-term care 1.2 2.3 1.1Unemployment 0.8 0.6 -0.2Education 4.3 4.1 -0.2Total 23.2 27.8 4.6

Source: EU EPC


1010

Point One: The challenge beyond the ageing hype… Projected total social expenditure in the EU…

International

Labour

Office

Age related social expenditure, EU, 2007-2060

-4-202468

1012

Belgium

Czech

Rep

ublic

German

y

France

Netherl

ands

Poland

Sweden UK

Pensions

Total


11

Point One: The challenge beyond the ageing hype… The 50:50 rule


12

Point One: The challenge beyond the ageing hype…


13

Point One: The challenge beyond the ageing hype… The 50:50 rule


14

Two. A quick review of the theoretical pros

and cons of paradigmatic pension

reform


Financing Social Protection: The PAYG vs. Funding debate

Pro funding– Funding would avoid ageing triggered CR

increases– Create domestic resources for investment– Increase national savings rate and hence growth– DC schemes are in automatic financial equilibrium

15


Contra funding– Future benefit levels vulnerable to inflation and

capital market performance– Low compliance = low protection– No social redistribution and risk sharing– Double burden during transition or implicit debt

(through borrowing)– on the level of GDP all schemes are PAYG

anyway– Funded system equally vulnerable to ageing– Concentration of investment power in too few

hands– ageing can be counteracted by activity rates and

pension ages– Ageing will not lead to exploding social

expenditure 16


Financing Social Protection: The PAYG vs. Funding debate

• On (tentative) balance:– Funded and unfunded schemes both subject to

demographic and economic risks; on GDP level both are PAYG

– Both vulnerable to bad governance and bad management– Contribution rate stabilisation easier under funded schemes– Social redistribution easier under PAYG schemes– Financing of transition cost can be difficult– Funding might support economic development– Defined benefit schemes with intelligent collective

funding ??

17


18

Three. Pensions in the crisis stress test


1919

Point Two: The crisis stress test: effects on the individual pension saver in DC schemes under different crisis scenarios

0

2000

4000

6000

8000

10000

12000

age 23 27 31 35 39 43 47 51 55 59 63

Total savings at 3% realrate if return withoutcrisisRate of return 3% withcrisis at age 40 andfurther rate of 3%Rate of return 3% withcrisis at age 40 andfurther rate of 5%Rate of return 3% withcrisis at age 50 andfurther rate of 5%Rate of return 3% withcrisis at age 55 andfurther rate of 5%Rate of return 3% withcrisis at age 60 andfurther rate of 5%


2020

Point Two: what we see in funded pension schemes – fund losses in 2008 ….and lost years of pension savings

2530

19

35

2622 22

3.1 3.8 2.2 4.6 3.2 2.6 2.65.6 7.0

4.18.4

5.9 4.8 4.8

05

10152025303540

Que

bec

pens

ion

plan

s (1

)

Dut

chP

ensi

onFu

nds

(2)

Chi

lean

AFP

s (3

)

Irish

Pen

sion

Fund

s (4

)

US

Sta

tean

dM

unic

ipal

Pen

sion

Fund

s (5

)

Nor

way

G

over

nmen

tP

ensi

onFu

nd (6

)

Sw

edis

hpe

nsio

nFu

nd A

P1

(7)

loss in % of value ofreserves at the end of 2007

loss of pension savings inyears (assumed 9% annualincrease) (8)

loss of pension savings inyears (assumed 5% annual

increase)


2121

Point Two: …what we see in funded pension schemes

Development of funding levels in Dutch second tier pensions funds, 2007 - 2009

0

2040

60

80

100

120

140

160

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

perc

ent Estimated funding ratio ( % )

Share of pension schemes underfunding ratio of 105%


2222

Point Two: Effect of the crisis: what we see in funded pension schemes …


2323

Point Two: Effect of the crisis: what we see in funded pension schemes …

Table: Years of contributions lost for standard savers since July 2007 by category of portfolio (adjusted losses net of fees)

Fund A Fund B Fund C Fund D Fund E Fund F December 2009 -199% -142% -5% none none None? April 2010 -270% -249% -108% none none None? Source: R. Bluhm, 2010


24

Point Three: what the crisis has shown so far

– Temporary and permanent losses of pension funds which were at peak times as big be as big as the fiscal stimulus package of 5-6 trillion US $ ,

– Even if pension funds levels may have recovered individual losses of contribution years remained

– crisis and pension reforms have increased the insecurity about future pension levels dominantly in DC schemes

– Crisis amplified the systemic fiscal stress that the pardigmatic reform created

– In the long run – if crisis related unemployment persists for half a decade - then DB schemes may also have to be adjusted but the burden can be shared between contributors and pensioners


25

Generic problems : Response… Table 2: Recent changes in second-tier systems in Central European Countries5

Change in contribution rate diverted to second tier Change in state mandate to

invest contributions in privately managed individual accounts

Previous rate Adjustment of rate

Hungary 8% of earnings Reduced to zero (December 2010) Mandate repealed

Poland 7.3% of earnings Reduced to 2.3% of earnings (2011), rising to 3.5% in 2017 ---

Estonia 6% of earnings

Suspended (June 2009-December 2010); restored to 3% (2011) Planned increase to 6% (2012) and 9% (voluntary) depending on GDP growth (2014-2017)

---

Latvia 8% of earningsa

Reduced to 2% (2009) Planned to increase to 6% by 2013, if financial conditions permit

---

Lithuania 5.5% of earnings Reduced to 2% of earnings (2009)b

Government proposed worker option to withdraw from second tier; currently before Parliament

Romania 2% of earnings Frozen at 2% (May 2008-March 2010); raised to 2.5% (March 2010)

---

Slovak Republic 9% of earnings N/A

Existing account holders could opt out of second tier (November 2008-June 2009); second tier made voluntary for new hires (since 2008)

Sources: SSA 2006 & 2010; SSA 2007-2011; World Bank (2009); Zaman (2010); IPE "Baltic Round-up," December 2, 2010; Leppik (2011) a. The rate had been scheduled to rise to 10% in 2010. b. Since their inception, individual accounts have been voluntary; but those who join have contributions diverted from the public pension systems, creating transition costs. Once enrolled, workers may not opt out.


26

Three. What went wrong with pension reform

in principle?


27

Generic problems

Privatised schemes helped to stabilise pension contribution rates but…

In LA failed to increase coverage Charged too high fees In Eastern Europe:

– Covering of transition cost left completely unclear (Hungary 0,8 – 1,4% of GDP for 43 years, Poland 1.5 – 2.2. % of GDP over 50 years )

– Same concern in Chile … – No provisions for the payout modalities of the second tier in Hungary and

Poland… – Reform was interest driven by private insurance companies (e.g. Poland and

Slovakia…)– Asset and contribution based fees reduced the savings of workers considerbaly

…


28

Generic problems : fees…

Table 3.Fees and contributions in individual accounts in Latin American countries as of June 2007 (percent)

Country Admin fee a Mandatory contribution a Fees as apercentage ofcontributions

Argentina 1.00 4.61 17.8 Bolivia c 0.50 10.00 4.8 Chile 1.71 10.00 14.6 Colombia d 1.58 11.00 12.6 Costa Rica 0.29 3.96 6.7 Dom Rep 0. 0.60 7.40 7.5 El Salvador 1.40 10.00 12.3 México 1.02 7.48 12.0 Peru 1.81 10.00 15.3 Uruguay e 1.79 12.22 12.8

SOURCE: AIOS 2007. NOTE: AIOS = Asociación Internacional de Organismos de Supervisión de Administradoras de Fondos de Pensiones

a. As a percentage of the worker's salary. b. The employee's contribution as a percentage of salary, except in Colombia, Dominican Republic, El Salvador and Mexico where the

figure also includes the employer's contribution as a percentage of covered payroll.

c. A fee for administering the investment portfolio is also charged. d. Fees are also charged for transferring, exiting, and making voluntary contributions.

e. A custody fee on the account balance is also charged.


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Generic outcome of paradigmatic reforms

Financial stabilisation of individual funded pension tiers

Increased social uncertainty for individuals

Financial destabilisation of PAYG tiers

Increased fiscal de-stabilisation


30

Four. Generic repair strategies


31

Point Four: Generic repair strategies …a few reminders first

Transfer schemes /pension schemes can only define entitlements to a share of present/future consumption (not absolute amounts) – no society can promise more

Markets cannot be asked to secure the income of people who cannot or can no longer operate in markets

The statement that pension schemes can only be stabilised by paradigmatic reforms is a myth…

The statement that countries can only afford a basic social safety net type welfare state in the globalised economy and an ageing society is likewise a myth…


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Key principles of ILC Policy recommendations for the extension of coverage : focus on outcomes not on institutional set-ups

Universal coverage of basic income security and essential health care –not necessarily uniform coverage.

Progressive realization of universal coverage and higher levels of security Benefit levels and poverty protection as predictable rights (i.a. through

Ratification of ILO conventions), Social and economic adequacy of benefit levels

Financial and fiscal sustainability

Good governance with the state as the ultimate guarantor of social security rights and benefit levels and the participatiosn of sociaL partners


33

Point Four: Options for solutions combining financial and social stabilisation...are not abundant

Process: Solutions have to be found in a process of national dialogue

System wide: Adopt social floor guarantee and adhere to convention C. 102

DC pillars: – Find innovative pension level guarantees – if second pillars

have to survive... ; – reduce the size if fiscal space does not allow the financing of

the transition DB pillars:

– long-term planned increases of contribution rates and definition of government subsidies

– Phased increase of retirement age + reasonable relationships between time in work and time in pensions Or adopt NDC schemes with social redistribution...

– Changing indexing method but protecting purchasing power of pensions


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What is needed… A DB Guarantee for a DC or NDC scheme…

– In a given country the General average premium (GAP) for a pension scheme with an accrual rate of 1.33 % be calculated at a defined point in time

– If a DC scheme charges a contribution that is equal to a fraction or a multiple of the GAP it has to provide for the same fraction or multiple of the accrual rate of 1.33 percent.

– At the age of retirement in year n her scheme has to provide a present value (or the above fraction thereof) for the total number of insurance years t (starting from 0) of contributions that is equal to

– If I=w then

for funded schemes and at least that for NDC schemes

Side comment: This means that the NDC tier in Russia may be underfunded

tntnx

n

ottn

ttn

twWeiWCR

)1(***0133.0)1(** ,0

0133.0*,nxeCR


A side-kick: The identity of the NDC benefit formula and the classical DB pension formula

An NDC is equivalent to a DB scheme with a linear pension formula, constant contribution rate and with actuarial reductions or increments for early or late retirement and an:

accrual rate in the equivalent DB scheme that is equal to = constant contribution rate/life expectancy (annuity factor) at normal retirement age


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What is needed to avoid « a waste « of the crisis …

National and interntional reviews of three decades of pension reforms based on

Observed experience on systemic effects of pension reforms

New academic knowledge An analysis of the reasons for reform A return to basics (i.e. redefining the primary function

of pension systems…securing old age income security )

A contextual view (i.e. pensions in the context of overall social budgets and their role in economic devlopments)

Providing income security in old age ? A quick review of pension reforms

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