Pension System Analysis: Tatyana Bogomolova World Bank, HDNSP

Transcription

1 Pension System Analysis: Basic Concepts and Identities Tatyana Bogomolova World Bank, HDNSP

2 Outline General framework for quantitative analysis of pension systems Key factors: demographic, economic, pension system design Simple economics of PAYG DB schemes Simple economics of Funded DC schemes 2

3 Pension system: main flows Demography Contributors Beneficiaries Economy PS revenues PS design PS balance PS expenditures Accumulated assets/debt 3

4 Mi Main groups of ffactors Demographic environment Economic environment Pension system design 4

5 Demographic factors Population, age/gender composition working age and old age population, old age dependency ratio Fertility (total fertility rate, replacement level) Mortality rates life expectancy, life expectancy at retirement Disability prevalence rates Migration flows, age and gender composition World-wide trend population aging decreasing fertility, increasing life expectancy 5

6 Economic factors Macroeconomic indicators GDP Inflation Interest rates Labor market indicators Labor force participation rates Unemployment rates Informal sector Wages, earning profile, income distribution 6

7 Pension system design (system revenues) Coverage Exemptions Contribution rate Covered wage (ceilings/floors, basic vs total compensation) 7

8 Pension system design (system expenditures) Coverage Eligibility criteria: retirement age vesting period qualifying conditions for disability and survivorship benefits Rules for benefit e calculationscu at Indexation of post-retirement benefits 8

9 PAYG Defined Benefit systems Financing: i workers contributions ti today are used to pay pensioners today; in return, workers get a promise that t they will receive a pension tomorrow paid for by workers tomorrow Benefits: calculated based on a prescribed (defined benefit) formula; normally linked to individual s wages, years of contributions, accrual rate 9

10 PAYG DB finances Total expenditures: EXP = B*P Total revenues: REV = C*E Books are balanced when B*P = C*E where: C = average contribution B = average benefit (pension) P = number of pensioners E = number of contributors 10

11 PAYG DB finances (cont.) Given that: B = RR*W; C = W*CR; and DR = P/E The pension fund balance equation can be presented as: CR=RR*DR where: CR = contribution rate RR = average replacement rate (relative pension level) W = average wage DR = system dependency rate (the inverse support ratio) 11

12 How to keep the system in balance? Adjust contribution rate (CR) Adjust replacement rate (RR) Adjust parameters/policy p variables affecting the dependency rate (DR) Combination of the above More direct control of CR and RR; less control over DR 12

13 Equilibrium contribution rate If replacement rate is fixed (target RR) Contribution rate required to finance a given average replacement rate is: CR = RR*DR So if the dependency rate grows the contribution rate has to be increased in order to bring the pension fund into balance 13

14 Equilibrium replacement rate If contribution ti rate is fixed Another way to balance the system is through the replacement rate affordable replacement rate is: RR = CR/DR So, if the dependency rate grows and the contribution rate remains unchanged the replacement rate has to be reduced in order to keep the system in balance 14

15 Key determinants of average replacement rate Policy choices about target individual replacement rate Benefit formula Policy choices about pension indexation method Economic factors: wages, wage growth rate 15

16 Benefit formula: typical structure Accrual rate per year of service Min/max replacement rates, min/max pensions Measure of fi income (reference wage, pensionable earning measure) -ceiling on pensionable wages - averaging period - valorization rules Penalties for early retirement, increments for late retirement 16

17 Post-retirement pensions: indexation methods Price indexation: pensions move with the price level; their real value remains unchanged Wage indexation: pensions move with wages; their relative value remains unchanged Combination of price and wage indexation (e.g. Swiss formula) Other indexation rules (ad hoc, fixed %, progressive indexation, i etc.) 17

18 How to affect finances through system dependency rate? If contribution rate and replacement rate are fixed: DR = CR/RR Dependency rate is not a policy variable, but some policy choices can change it 18

19 Key determinants of system dependency rate: numerator Number of pensioners (P) Demographic factors (old age population, mortality rates after retirement life expectancy at retirement) Policy choices in pension system (retirement age, rules for early retirement, coverage in the past, vesting period, eligibility criteria for receiving disability pensions, survivors benefits) 19

20 Key determinants of system dependency rate: denominator Number of contributors (E) Demographic factors (working age population, fertility in the past, mortality, migration) Economic factors (school-leaving age, labor force participation, p unemployment, size of the informal sector) Policy choices (coverage, retirement age, rules for early retirement, contribution rate (if high evasion), other) 20

21 Retirement age Quantitative analysis of various pension systems: retirement age is the most effective policy variable to adjust tlong run dependency d rate Changes in retirement age affect both the numerator and denominator in DR=P/E If life expectancy increases, retirement age has to be adjusted to keep the system in balance in the long run 21

22 Policy choices: how much freedom? From the basic relationship (CR=RR*DR) To make a PAYG DB financially i sustainable, policy makers can change only two of the three key parameters: - contribution rate - replacement rate - retirement age Once two parameters are set, the third is determined endogenously Limits for setting exogenous parameters (e.g. replacement rate social and political, contribution rate economic, retirement age physical, social and political) 22

23 Funded defined contribution systems Financing: Contributions are put into individual s account Assets are accumulated and earn interest Accumulated capital used to pay for pensions Benefits: Calculated based on accumulated capital 23

24 Capital accumulated by the year of retirement AC = C 1 *(1+r) N + C 2 *(1+r) N C N *(1+r) where AC = accumulated capital C t = CR t * W t N = number of working years r = rate of return (here assumed to be constant) C t = contribution in year t, for t = 1, 2,, N CR t = contribution rate in year t, for t = 1, 2,, N W t = worker s wage in year t, for t = 1, 2,, N 24

25 Benefit payout: annuity When worker retires, accumulated capital (AC) is turned into pension which is set so that: B +B/(1+d) B M /(1+d) M =AC Initial benefit calculation: B 0 =AC/AF where B t = B t -1 * indexation coefficient, t>0 M = number of retirement years d = discount rate AF = annuity factor No bequest to survivors, longevity risk borne by annuity provider 25

26 Annuity factor: If a person of certain age and gender is promised a benefit=$1, with specified indexation rules, how much is such a promise worth in today s dollars? 1+ ind 1 * surv 1 /(1+d)+(ind 1 *ind 2 )* (surv 1 * surv 2 )/(1+d) 2 + where ind t = indexation coefficient in year t of retirement surv t = probability of surviving from year t-1 to t d = discount rate 26

27 Benefit payout: programmed withdrawals The account continues to earn interest t while pensioner withdraws funds Benefit is recalculated each year: B t = RC t / LE t,a where RC t = remaining capital in year t LE t,a = life expectancy at age a in year t If dies early, the remaining balance is turned over to survivors; if lives long, B t may become very low; longevity risk borne by individuals id Other payout forms (lump sums, required minimum annuity, etc.) 27

28 Main determinants of benefit levels Contribution rate Individual s wages Rate of return, rate of return-wage growth gap Passivity ratio (retirement years/working years years of service, retirement age, life expectancy) Administrative costs Annuity factors (life expectancy, indexation, single vs joint, discount rate) 28

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