Why consider prefunding pensions? Edward Whitehouse OECD

Transcription

1 Why consider prefunding pensions? Edward Whitehouse OECD World Bank core course Washington DC, November 2009

2 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

3 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

4 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

5 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

6 Demographic change: ageing Number of people of working age per person of pension age, Youngest OECD country 5 OECD Oldest OECD country

7 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

8 An example: the United States Real rate of return on contributions (%)

9 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

10 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

11 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

12 Distorted labour markets PAYG schemes often: encourage early retirement are not portable between different jobs are based on final salary, encouraging underreporting 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

13 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

14 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

15 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)

16 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

17 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)

18 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

19 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

20 Collection and record-keeping Centralised: social-insurance agency tax authorities separate institution (public or private) Decentralised individual funds do the work

21 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

22 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

23 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

24 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