Social security financing
Importance of financing Its design influences: efficiency on a micro and macroeconomic level The effectiveness of redistributive mechanisms Economic sustainability Political economy of the system ("political sustainability")
Sources of financing Taxes Who pays? When? On what bases? By means of which institutions? Contributions Objectives of social security system VARIABLES Economic, social, political, demographic
Design options Financing Taxes Contributions Eligibility conditions Non- contributory Contributory Non-contributory pensions: Social pensions Non-social pensions Minimum pensions Basic benefits Standard/ordinary pensions (Compulsory or voluntary)
Sources of financing Financing via: Taxes Social contributions There is no link between contributions and level of benefits; not dependent on employment Either calculated as a proportion of income from employment or fixed. Forms the basis for the granting of benefits
Social contributions Contribution base Compulsory charges deducted from wages and allocated to financing social benefits. These are generally set by applying a contribution rate in line with earnings in order to calculate the amount to be deducted from wages. These may be undifferentiated (to finance various benefits) or specific Contribution rate "Contribution"
Contribution rate Fixed rate vs Variable rate In line with income/wages In line with risk Unlimited vs With limit or ceiling "Contribution"
The public nature of a social security system lies in its source of financing (established by public authorities, compulsory or mandated)... regardless of whether the entity or entities managing the system are public or private.
Flow of funds in a social security system Employer contributions Contributions of insured persons Fines Government subsidies Investment income Social security institutions Assets invested Payment of benefits Administrative costs Investment costs Short-term benefits Long-term benefits Benefits occupational risks Unemployment benefits Family allowances Health care Illness Maternity Funeral benefit Pension Disability Pension Old-age Pension Survivor's Health care Temporary incapacity Permanent disability Dependant's benefits Unemployment benefits Periodic dependant supplements Family allowances Pregnancy benefit Other benefits
Financing scheme Synonyms: financing model, funding model "A set of technical and actuarial principles that govern the functioning of the mechanisms designed to maintain the financial equilibrium." Who provides financing? How is it financed? Rules for action to guarantee financial equilibrium: premium level, reserve level, pension adjustments, requirements, scope of benefits, the way in which they are calculated, and so on.
Financing systems Collective financing (defined benefit): Partial or total funding General average premium Scaled premium Notional defined contributions Allocation Individual funding: Individual funding Mixed (combination)
Short-term benefits Health/health care benefits Temporary financial incapacity benefits: illness, maternity Funeral assistance Nurseries Other 3/2/41
Calculation of contribution rates Obliges the institution managing the system or a legislative body to adjust contribution rates when financial resources are considered to be insufficient METHOD established by law Maintains the financial solvency of the regime
Contingency fund for the payment of benefits A contingency fund should be set up in order to deal with unexpected increases in benefit costs The appropriate level depends on various factors: The type of benefits Contingency funds Epidemiological Natural Macroeconomic
Financing defined benefit pension systems
Long-term benefits (retirement and pensions) What financing scheme? Factors that determine the costs, evolution of expenditure, advantages and disadvantages Contribution rates behave differently under the different schemes They require long-term actuarial models: demographic and financial forecasts (estimated, projected) Need to know the characteristics of each financial system. 3/2/50
Typical development of costs: long-term cost curve 1st Stage 2nd Stage Tends to stabilize 3rd Stage Time
Elements that determine the level of costs in a pension system Benefits covered: I, V, M Required period of time in the system or making contributions Age requirements for each benefit Formula for calculating benefits Replacement/substitution rate Number of years' pension entitlement: retirement age vs. life expectancy (longevity) Pension adjustment mechanism Growth in real wages (productivity) Demographic structure: new contributors (ageing +
Simple/annual/pay-as-you-go scheme The income for the period of equilibrium (usually one year) are equal to the period's expenditure. There is no accumulation of funds, only a contingency fund The premium is adjusted to match the cost, but in practice does not change every year Advantages and disadvantages: demographic risk vs financial risk; intergenerational transfers.
Annual distribution Premium = cost Years
General average premium The premium is calculated at the level required for the current value of all probable future revenue to be equal to the current value of total probable future expenditure. During the first period (some decades) revenue will exceed expenditure. The surplus goes to the technical reserve. In the future, when the cost exceeds the premium (higher expenditure than revenue from contributions) the returns on the reserve are used to cover the difference.
General average premium Fixed premium Years Over the long term, the returns on the reserve are used to finance part of the benefits
Scaled premiums A scheme that lies between simple distribution and the general average premium. Period of equilibrium are established during which the premium does not vary. Financial equilibrium is guaranteed during this period in order to then proceed to another step. There is an accumulation of funds, but to a lesser extent than in the general average premium system. The interests on the reserve are used to finance expenditure.
Scaled premiums Premium Years The returns on the reserve are used to finance a (small) proportion of the benefits
Criticisms of the efficiency of the redistribution mechanisms contained within defined benefit systems ("pay-as-you-go") Redistribution over various generations can be socially unfair: today's poor youth finance the benefits of the nonpoor older generation The formula used to calculate redistribution is often regressive, favouring individuals with higher incomes Individuals with higher incomes have incentives for evasion The use of taxes can be regressive: they move from the population as a whole to groups in the formal economy (protected).
Financing of pensions via individual funding
Individual funding Defined contribution scheme: individuals are not guaranteed a set level of benefits. Funding is full but individual. It is used as a retirement savings system but does not cover contingencies. At the end of the savings period, the amount saved is used to buy a life or temporary annuity. The ILO's position: it does not include solidarity mechanisms and should be complemented with other mechanisms in order to guarantee a certain level of solidarity.
Who shoulders the burden of systemic risks? In defined benefits systems... The collective assumes the burden of risk In individually funded systems... Each individual takes on the risk 3/ /118
Benefits in systems based on individual funding Saves during working life Fondo acumulado Más Rendimientos Fulfils the requirements and purchases pension Menos Comisiones Menos Gastos
Types of old-age pensions in individual accounts Life annuity Programmed retirement Programmed retirement with life annuity
Factors that determine the level of benefits in an individual account system Years of active contribution Density of contributions Productive structure Typical career path for the economic activity Longevity: life expectancy at the point of retirement Administration fees Profitability of investments Gender
Basic concepts related to actuarial valuations
Equilibrium variables of a pension insurance Contribution rate Number of contributions (requirement) Density of contributions (regulated) Replacement rate Period of pension entitlement
Discussion topics In what way can financing mechanisms influence incentives for contributory participation (expanded coverage)? How can non-contributory benefits be made compatible with contributory benefits in order to maintain incentives? The role of sustainable funding as a priority for public policy Measures to improve gender inequalities How unemployment and precarious employment influence systems