World Bank Core Course on Pensions November 9-20, 2009 Washington, DC. David A. Robalino Labor Team Leader Social Protection and Labor The World Bank

World Bank Core Course on Pensions November 9-20, 2009 Washington, DC. David A. Robalino Labor Team Leader Social Protection and Labor The World Bank

Majority of pension reforms have involved adjustments to the parameters of Earnings Related Systems. Between 1995-2005, 18 countries increased the retirement age; 57 increased contribution rates; 28 modified benefit formulas; 10 changed vesting periods; and 14 changed the contributory base and/or indexation mechanisms. Adjustments, however, tend to be ad-hoc or discretionary: Usually financial problem is the motivation. Policy makers and stakeholders then negotiate which parameters can be changed. Linkages between the various parameters are ignored.

How to design a parametric reform to converge to a good Defined-Benefit pension scheme financed, at least in part, on a pay-as-you-go basis: Financially self-sustainable over the long run. Predictable: there are clear rules driving adjustments in parameters. Provides incentives to work, enroll and contribute. If redistribution takes place, it is transparent and progressive (i.e., from high to low income workers). Can be an stand alone reform (e.g., Jordan). Can be part of a systemic reform (e.g., Latin America, Eastern Europe).

1. Review the set of parameters that are involved in the design of a DB pension system. 2. Discuss standard problems with the choice of these parameters. 3. Propose rules that ought to be applied when designing/reforming a DB system. Focus of the presentation is on DB systems, but concepts also apply to Points Systems

Income measure: Ceiling (other restrictions) on pensionable earnings. Number of past salaries included in the calculation of the pension. Revalorization mechanism for past salaries. Eligibility conditions: Statutory retirement age. Minimum retirement age (for early retirement). Minimum vesting period. Contribution rate.

Benefit formula: Accrual rate. Reduction factors for retirement prior or after the statutory retirement age. Maximum replacement rates and/or pensions. Minimum replacement rates and/or pensions. Indexation mechanism for pensions.

Behaviors: Enrollment / retirement strategies. Evasion / under-declaration of wages. Savings. Labor supply and demand. Parameters affect Implicit Rate of Return (IRR) that individuals receive on their contributions: Equity: Some individuals might receive higher IRR than others. Financial sustainability: If IRR is too high the system cannot be financially selfsustainable.

Reference salary: Usually only a few salaries count towards the pension (e.g., last salary or average of last 5 years): Creates a disconnect between contributions and benefits. Incentives to strategically manipulate wages. Large variations in IRR across individuals as a function of enrollment/retirement strategies and wage histories. Revalorization: Either revalorization is too generous and unsustainable or past salaries are not revalorized (thus including past salaries in the formula reduces the pension). Ceilings: Often no ceilings or high ceilings; middle and high income individuals are not encouraged to diversify sources of savings for retirement.

Retirement age: Not aligned with benefits, contribution rate, and life expectancy. Compromises financial sustainability. Vesting periods: Used to avoid early retirement and force longer contribution periods but can penalize individuals who enroll late in their careers. Contribution rate: Usually the parameter that is used to equilibrate the finances of the system. Mechanism does take into account that there is a limit to the level of the contribution rate that an economy can afford.

Accrual rate: Choices tend to be arbitrary. Accrual rate is not linked to the retirement age, the contribution rate, and life expectancy at retirement. Penalties for early retirement: There are no penalties or penalties are too low. Individuals have incentives for retirement over work. Contributes to the problem of financial sustainability. Maximum replacement rates and/or pensions: Used to control costs; but reduce incentives to delay retirement and contribute. Minimum pension guarantees: If not well designed can also reduce incentives to work and contribute and become unsustainable. Indexation of pensions: Ad-hoc, retirees not well protected, system vulnerable to overadjustments.

Implicit Real Rate of Return - % per year. 10 9 8 7 6 5 4 3 2 1 Individual with average earnings growing at 4%py Invidividual with average earnings growing at 2%py Individual with earnings of 50% of the average growing at 2%py 0 45 50 55 60 65 70 Retirement age Case of Jordan

10 Enrollment age = 35 Enrollment age = 45 Implicit Real Rate of Return - % per year. 9 8 7 6 5 4 3 2 1 Enrollment age = 30 Enrollment age = 25 0 45 50 55 60 65 70 Retirement age Case of Tunisia

First step, define objectives/mandate of the pension system: Targeted gross replacement rate for the average-full career worker. Ceiling on pensionable earnings. Level of the minimum pension. Second step, choose parameters/rules of the DB system to ensure that: System is financially self-sustainable over the long-term. System is predictable: there are no unexpected changes in benefits and/or contributions. System provides incentives to work, enroll and contribute. If redistribution takes place it is transparent and progressive (from high to low income workers).

120 110 Gross Replacement Rates 100 90 80 70 60 50 Morocco 40 30 0.5 1 1.5 2 2.5 Individual Income as a Proportion of Average Earnings

120 110 Gross Replacement Rates 100 90 80 70 60 50 Morocco Argentina 40 30 0.5 1 1.5 2 2.5 Individual Income as a Proportion of Average Earnings

120 110 Gross Replacement Rates 100 90 80 70 60 50 Chile Morocco Argentina 40 30 0.5 1 1.5 2 2.5 Individual Income as a Proportion of Average Earnings

120 110 Gross Replacement Rates 100 90 80 70 60 50 Chile Morocco Argentina 40 30 Mexico 0.5 1 1.5 2 2.5 Individual Income as a Proportion of Average Earnings

120 Gross Replacement Rates 110 100 90 80 70 60 50 Uruguay Morocco Argentina Chile 40 30 Mexico 0.5 1 1.5 2 2.5 Individual Income as a Proportion of Average Earnings

Uruguay Iran Iraq Yemen Costa Rica Egypt Spain Libya Algeria Bahrain Italy Argentina Morocco Netherlands Jordan Sweden Tunisia Peru Lebanon France Bulgaria Chile Germany Mexico United States Djibouti Average 0 20 40 60 80 100 120 Percent of Average Earnings

Colombia Iran Dominican Republic Latvia Algeria Uruguay Lithuania Bulgaria Egypt Slovakia US Poland Poland Luxemburg Hungary Norway Morocco Spain Korea Turkey El Salvador UK Sweden Russia Switzerland Average 0 2 4 6 8 10 Ceiling on Covered Wage (Multiple of Average Earnings)

Iran Colombia Louxembo Portugal Bahrain Egypt Jordan Spain Algeria El Salvador Lybia Tunisia Turkey Poland Peru Mexico Slovakia Djibouti Iraq Uruguay Costa Rica Switzerland Bulgaria Morocco UK Estonia Average 0% 10% 20% 30% 40% 50% 60% 70% Minimum Pension (Percent Average Earnings)

Total earnings (up to the ceiling) should be used to pay contributions and compute pensions. All past salaries included in the calculation of the pension: This policy is not introduced to reduce pensions, but to improve incentives and equity. Increase in the number of salaries should be gradual to allow information systems to catch-up. Past salaries should be revalorized: Inflation, average wage, wage bill, GDP, more complex formulas? Recommendation is to use the growth rate of the average covered wage.

Accrual rate: It is determined on the basis of the targeted replacement rate for a full-career worker (e.g., 40 years of contributions). If target is 60% of the income measure; then the accrual rate is 1.5%=60%/40. Statutory retirement age and contribution rate: Are chosen to ensure that the pension system is financially self-sustainable. Requires that the IRR paid by the system is below the long term growth rate of the economy: 2% to 3% per year. Given a choice for the contribution rate, the retirement age is computed taking into account estimates of life expectancy. Important: policy makers cannot choose both the contribution rate and the retirement age; the choice of one parameter implies the value of the other.

2.10% 1.90% 1.70% Sustainable IRR = 2% py Contribution rate = 20% Accrual Rate 1.50% 1.30% 1.10% 0.90% 0.70% Contribution rate = 15% 0.50% 55 57 59 61 63 65 67 69 Retirement Age Case of Egypt

2.10% Contribution rate = 20% 1.90% Sustainable IRR = 3.5% py 1.70% Accrual Rate 1.50% 1.30% 1.10% 0.90% Contribution rate = 15% 0.70% 0.50% 55 57 59 61 63 65 67 69 Retirement Age Case of Egypt

What happens when life expectancy increases? To keep the contribution rate and the accrual rate constant the statutory retirement age needs to be adjusted. In principle, it should be automatically indexed with changes in life expectancy. What about individuals retiring early? It is desirable to give individuals the flexibility to retire early. If they do, however, the accrual rate (i.e., the replacement rate) has to be reduced. Individual will have lower pensions for the same contribution period, but they will also receive the pension for a longer period of time. The reduction factors for early retirement also need to be adjusted when life expectancy changes.

25.0% Sustainable IRR = 3.5% py Adjustment to Replacement Rate 20.0% 15.0% 10.0% 5.0% 0.0% 55 57 59 61 63 65 67 69-5.0% -10.0% -15.0% -20.0% Statutory replacement rate is 65 Compensation -25.0% Reductions -30.0% Retirement Age Case of Egypt

What about individuals who do not have a full-career (e.g., contributed less than 40 years)? The accrual rate is linked to the retirement age not the length of service. Individuals who retire at the statutory age (say 65), with only 30 years of contribution, will have a lower replacement rate: 1.5%*30=45% instead of 60%. So, in principle, a minimum vesting period is not needed, except to be eligible for the minimum pension. Should there be a maximum replacement rate or a maximum pension? If other parameters are appropriately set, there is no need for a maximum.

Indexation of pensions: If the other parameters of the system are properly set pensions should be indexed automatically with inflation. This means, indexation is not subject to political discretion or the decisions/approval of a given ministry, the Cabinet, or the Parliament. But, indexation mechanism has to be built-in then in the setting of retirement age and contribution rate given the accrual rate Important to define exit mechanism: Example: if observed inflation > expected inflation do not index fully.

Once the new values of the parameters have been identified, implementation should be gradual: E.g., increasing retirement age from 55 to 60 over a 10 year period. Accrued rights should be respected: Adjustments to accrual rates only affect new contributions. This implies that the full effect of a parametric reform takes time to materialize: Important to start soon. Also implies that the parametric reform will not fully solve the financial problem: Need to devise mechanisms to finance the implicit pension debt (IPD) of the system at the time of reform.

Main challenges/drawbacks: Political constraints: difficult to cut benefits and increase retirement ages. If no transparent rules are adopted to guide adjustments to the parameters of the system, its long term financial sustainability is compromised. Even if these rules exist, there is the question of whether future governments will respect them. Individuals might distrust the ability of the system to deliver on its promises (pension promises are not backed by property rights).

A a, t G a, t C G a L k a, t s a, k 1 r k a A(a,t) = Accrual rate for retirement age a at time t. C = Contribution rate. G(a,t) = Annuity factor. s(a,k) = Probability of surviving between age a and age k. L = Maximum age individuals can live. r = Estimate of the sustainable real rate of return of the system (formula assumes that pensions are indexed with inflation).

A a, t P( a, t) 1 A( R, t) P(a,t) = penalty fore retirement at age a. A(a,t) = Equilibrium accrual rate at age a. R = Statutory retirement age.