Prefunding pensions:Options and argumentsEdward WhitehouseWorld Bank core courseWashington DC, April 2013
AgendaDifferent financing mechanisms:funding and pay-as-you-goAdvantages and disadvantagesConditions favourable to fund...
Unfunded/pay-as-you-go schemesUse contributions from current workers to paybenefits to current retireesThis gives curren...
An example: the United StatesReal rate of return on contributions (%)
PrefundingContributions from current workers are used toaccumulate assetsThese assets are used to pay benefits in thefut...
Potential advantages of fundingBetter able to deal with ageing of the populationLimits fiscal liabilitiesRemoves some l...
Rates of return: PAYG and fundedSustainable rate of return on PAYG = growth oflabour force + increase in average earnings...
Distorted labour marketsPAYG schemes often: encourage early retirement are not portable between different jobs are bas...
Politicisation of pensionsPoliticisation can be a problem: uncertainty in retirement benefits of currentpensioners and w...
Capital-market developmentPAYG schemes: can hinder capital-marketdevelopment if substitute for private savings forretirem...
Ideal conditions for fundingIs the macroeconomy stable enough to offerreasonably safe financial instruments?Are sufficie...
Investment riskFunded schemes subject to investment riskImportant to distinguish time periods long-term risks are not t...
Scale of investment riskPercentile of distribution10 20 30 40 50 60 70 80 90Market dataRate of return 5.5 6.1 6.6 7.0 7.3 ...
Market and individual returnsAdministrative charges 0.75-2.00% in accumulation stage 0.25-0.50% for annuity purchaseTr...
Administrative charges Complex charge structures comparisons are difficult bothbetween countries and betweenproviders A...
Administrative charges Complex charge structures comparisons are difficult bothbetween countries and betweenproviders A...
Percentile of distribution10 20 30 40 50 60 70 80 90Market dataRate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0Replaceme...
Types of guarantee in overallpension/tax systemsPortfolio of different kinds of pensions: subject to investment risk: D...
AustraliaReplacementrate00.250.50.751 2 3 4 5 6 7 8 9Deciles of distribution of investment returnsSuperannuationguarantee
Australia1 2 3 4 5 6 7 8 9SuperannuationguaranteeReplacementrate00.250.50.75Deciles of distribution of investment returnsA...
Australia1 2 3 4 5 6 7 8 9Replacementrate00.250.50.75Deciles of distribution of investment returnsSuperannuationguaranteeA...
Other countriesDenmark Poland10 25 50 75 90Targeted andbasicAfter taxes020406080100120140Percentile point of distribution ...
Rate of return guaranteesShould meet pension principles, e.g.,transparency, self-financingShould enhance security and ad...
CostsCapital 2% Indexed Ongoing FloatingGuarantee 0%nominal2%nominal0%real0%nominal1yr interestratePeriod Membership Membe...
Providing funded schemes 1Many possible structures single public agency (provident funds) single pension fund, but priv...
Paying out funded pensionsAnnuity pension balance transferred to insurance companywhich provides regular payments index...
Moving from PAYG to funding:transition costsIf all or part of contributions of current workersare diverted to funded acco...
Accrued rightsExisting pensioners: benefits continue to be paidas beforeExisting contributors: maintain a pro-rated ben...
Transition costs and design issuesWho is allowed to switch to the funded scheme? option or mandatory? age cut-offs?Gra...
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Pensions Core Course 2013: Prefunding pensions - options and arguments

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Pensions Core Course 2013: Prefunding pensions - options and arguments

  1. 1. Prefunding pensions:Options and argumentsEdward WhitehouseWorld Bank core courseWashington DC, April 2013
  2. 2. AgendaDifferent financing mechanisms:funding and pay-as-you-goAdvantages and disadvantagesConditions favourable to fundingDesign of funded schemes investment/provider choices administrative charges guarantees pay-out phaseMoving from pay-as-you-go to funding
  3. 3. Unfunded/pay-as-you-go schemesUse contributions from current workers to paybenefits to current retireesThis gives current workers “promises” in returnfor contributionsPromises must be met by future generationsPromises have different legal weights countries: from constitutional right to changeable promiseMain motivation of pay-as-you-go was earlierbenefit payout
  4. 4. An example: the United StatesReal rate of return on contributions (%)
  5. 5. PrefundingContributions from current workers are used toaccumulate assetsThese assets are used to pay benefits in thefutureSchemes can be partially funded Benefits for current workers will be paid for by a mixof accumulated assets and taxes/contributions paidby future workers
  6. 6. Potential advantages of fundingBetter able to deal with ageing of the populationLimits fiscal liabilitiesRemoves some labour-market distortionsHelps develop capital marketsPossibly increases savings and investmentReduce politicisation of the pension systemBetter rates of return on pension contributions
  7. 7. Rates of return: PAYG and fundedSustainable rate of return on PAYG = growth oflabour force + increase in average earnings can turn negative when labour force starts to shrinkRate of return on funded = capital-marketreturn historically, even with financial crises, this has beengreater than wage growth in developed countries
  8. 8. Distorted labour marketsPAYG schemes often: encourage early retirement are not portable between different jobs are based on final salary, encouraging under-reporting of earnings in early yearsFunded schemes: generally pay higher benefits to people who worklonger are easily portable between different jobs are based on contributions in each and every year
  9. 9. Politicisation of pensionsPoliticisation can be a problem: uncertainty in retirement benefits of currentpensioners and workers potentially divisive political battles between thosewho receive pensions and those who pay for themUnder PAYG, easy for governments to makepromises of future benefits they will be out of office before the costs have to bemetWith funded schemes, higher benefits onlypossible with higher contributions now
  10. 10. Capital-market developmentPAYG schemes: can hinder capital-marketdevelopment if substitute for private savings forretirementFunded schemes tend to lead to greater varietyof financial-market instruments offeredSavings are usually intermediated throughfinancial marketsSome suggestion that this has a positive impacton savings and economic growth
  11. 11. Ideal conditions for fundingIs the macroeconomy stable enough to offerreasonably safe financial instruments?Are sufficient financial instruments available? option of foreign investment but exchange-rate issues and political economyFinancial market regulation and supervision mustbe strong contributions to a funded pension are mandatory, unlikeother savings instruments they are also longer-term savingsAdministrative capacity: record-keeping, valuation
  12. 12. Investment riskFunded schemes subject to investment riskImportant to distinguish time periods long-term risks are not too large because rates ofreturn relatively stable short-term risks can be large if the markets fall whenyou 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 forpensions (arrears)
  13. 13. Scale of investment riskPercentile of distribution10 20 30 40 50 60 70 80 90Market dataRate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6Note10% contributionOECD average mortality rates40-year term to age 6550:50 equity:government-bond portfolio
  14. 14. Market and individual returnsAdministrative charges 0.75-2.00% in accumulation stage 0.25-0.50% for annuity purchaseTracking error 0.25-0.30% reduction in returnAgency and governance effectsPortfolio restrictionsAgeing might reduce future returns
  15. 15. Administrative charges Complex charge structures comparisons are difficult bothbetween countries and betweenproviders A single measure of charges: charge ratio: proportion ofaccumulated balance reduction in yield: proportionof assets in fund at any onetime
  16. 16. Administrative charges Complex charge structures comparisons are difficult bothbetween countries and betweenproviders A single measure of charges: charge ratio: proportion ofaccumulated balance reduction in yield: proportionof assets in fund at any onetime Illustration: assume 3.5% real return, 2%wage growth and 40 year term051015202530354045500 0.5 1 1.5 2 2.5 3Charge, % of assetsCharge,% of accumulation
  17. 17. Percentile of distribution10 20 30 40 50 60 70 80 90Market dataRate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6RescaledRate of return 3.2 3.8 4.3 4.7 5.0 5.4 5.7 6.2 6.7Replacement rate 32.2 36.8 41.2 45.2 48.6 53.5 57.6 65.3 74.2Scale of investment riskNote10% contributionOECD average mortality rates40-year term to age 6550:50 equity:government-bond portfolio
  18. 18. Types of guarantee in overallpension/tax systemsPortfolio of different kinds of pensions: subject to investment risk: DC plans in many OECD, LAC and ECA countries not subject to investment risk: DB/points in Costa Rica, Uruguay, Slovak Republic, Latvia,Lithuania, Estonia, Croatia, Bulgaria, Romania, Switzerland NDC in Poland, Sweden basic in Kosovo, Netherlands, New Zealand, new UK scheme offset investment risk: targeted, means-tested, minimum benefits in Australia,Mexico, Hong KongRole of taxation
  19. 19. AustraliaReplacementrate00.250.50.751 2 3 4 5 6 7 8 9Deciles of distribution of investment returnsSuperannuationguarantee
  20. 20. Australia1 2 3 4 5 6 7 8 9SuperannuationguaranteeReplacementrate00.250.50.75Deciles of distribution of investment returnsAge pension
  21. 21. Australia1 2 3 4 5 6 7 8 9Replacementrate00.250.50.75Deciles of distribution of investment returnsSuperannuationguaranteeAge pension
  22. 22. Other countriesDenmark Poland10 25 50 75 90Targeted andbasicAfter taxes020406080100120140Percentile point of distribution of investment returnsReplacement rate(% of gross earnings)Definedcontribution10 25 50 75 90Public earnings-relatedAfter taxes0102030405060708090Percentile point of distribution of investment returnsReplacement rate(% of gross earnings)DefinedcontributionDefinedcontributionDefinedcontributionDefinedcontribution
  23. 23. Rate of return guaranteesShould meet pension principles, e.g.,transparency, self-financingShould enhance security and adequacyFive key design issues: fixed return (Switzerland, Iceland) or minimum(Belgium, Germany) real or nominal (Czech Republic, Germany) level (often zero: CZR, DEU; 2% CHE; 3%+ BEL) absolute (above) or relative (to other funds: ChilePoland; or to benchmark return: Slovenia) period covered (6 mnths SVK, 1 yr CZR, 3yrs CHL,entire period of membership DEU)
  24. 24. CostsCapital 2% Indexed Ongoing FloatingGuarantee 0%nominal2%nominal0%real0%nominal1yr interestratePeriod Membership Membership Membership Annual MembershipCharges (%) 0.86% 3.33% 3.67% 6.08% 15.96%Loss inpension (%)1.28% 4.98% 5.49% 7.14% 23.81%
  25. 25. Providing funded schemes 1Many possible structures single public agency (provident funds) single pension fund, but privately managed (UK Nest) a few private pension funds (Uruguay) many private pension funds (Chile, Poland) public and private pension funds (Mexico, Russia)Investment choice single portfolio per pension fund multiple portfolios per pension fund restrictions on who can own what type of portfolio
  26. 26. Paying out funded pensionsAnnuity pension balance transferred to insurance companywhich provides regular payments indexation? survivors benefits?Programmed withdrawal balance divided by life expectancy determinespension in any given year remainder continues to earn interestLump sumCombination of or choice among the above
  27. 27. Moving from PAYG to funding:transition costsIf all or part of contributions of current workersare diverted to funded accounts, how cancurrent pensions be paid?Possibility of transition ‘double burden’ one generation pays for its own and its parents’pensionsAlso, current workers also have rights accruedin the public, PAYG scheme e.g. a 40-year old may have 20 years of contributionsin the PAYG scheme and needs compensating
  28. 28. Accrued rightsExisting pensioners: benefits continue to be paidas 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
  29. 29. 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 fundedscheme over timeRoom to increase overall contribution rates? ‘add-on’ versus ‘carve-out’ funded scheme
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