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Pensions Core Course 2013: Earnings related schemes: design, options and experience


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Pensions Core Course 2013: Earnings related schemes: design, options and experience

  1. 1. Earnings related schemes:Design, options and experienceEdward WhitehouseWorld Bank core courseWashington DC, April 2013
  2. 2. ObjectivesPrimary objective: ensuring older people have a decent standard oflivingSecondary objectives capital markets: institutional development encourage national savings labour markets retirement decisions restructuring public finances providing funds for socially/economically targetedinvestments
  3. 3. ObjectivesPrimary objective ensuring older people have a decent standard ofliving in retirementTwo interpretations ‘Adequacy’: ensuring older people meet a basicstandard of living ‘Insurance/forced savings’: ensuring a reasonablestandard of living in retirement relative to positionbefore retirement
  4. 4. Objectives and measuresAdequacy: an absolute measure of livingstandards individual pension entitlement as a proportion ofeconomy-wide average earnings pension levelInsurance: a relative measure of livingstandards individual pension entitlement relative toindividual earnings when working replacement rate
  5. 5. International experienceDifferent degrees of emphasis on the alternativeobjectives of adequacy and insurance/savingsTwo benchmarks: universal, flat rate benefit constant replacement rate
  6. 6. Benchmarks00.250.50.7511.250 0.5 1 1.5 0.5 1 1.5 2Relative pension level Replacement rateBasicBasicEarningsrelatedEarnings related
  7. 7. Relative pension levels:adequacy emphasisSource: OECDPensions at a Glance
  8. 8. Relative pension levels:insurance emphasisSource: OECDPensions at a Glance
  9. 9. Relative pension levels:intermediateSource: OECDPensions at a Glance
  10. 10. Benefit designRetirement-incomesystemZero pillar: mandatory,public, adequacyBasicResource-testedFirst pillar: mandatory,public, mainly incomereplacementDBPointsNDCPublic DCMinimum pensionsSecond pillar: mandatoryprivate, incomereplacementPrivate DCPrivate DBThird pillar: voluntaryprivate
  11. 11. Benefit design 1‘Adequacy’ schemesWhat is an adequate, minimum income for olderpeople? depends on family structures within a society must be defined relative to living standards of rest ofsociety (20-33% is the international norm) must be affordable; avoid shifting poverty to othergroups
  12. 12. Benefit design 1Types of adequacy schemeBasic scheme a flat amount per year of contributions or per year ofresidency paid to all older people (above a certain age) paid regardless of other income (pensions etc.)Targeted schemes set a target minimum income for all older people paid only if other income (pensions etc.) does notreach the target
  13. 13. Benefit design 1Country practiceOECD (24) ECA (10) LAC (9) MENA (10)Basic 10CanadaJapanNetherlandsUK4CroatiaCzech Rep.EstoniaLithuania2ArgentinaChile0Minimum 11FinlandFranceSpain7HungaryPolandSlovak Rep.8Mexico9EgyptIranMoroccoSource: World BankPensions Panorama
  14. 14. Benefit design 2‘Insurance’ schemesWhat should be the replacement rate objective? family support in old age non pension income (e.g., other savings, work) consumption needs in retirement are lower (e.g.,costs of work, no children to support) taxes and social contributions are lower duringretirementA replacement rate in the pension system of lessthan 100% means that the same living standardcan be maintained during retirement a target of 50-60% for an average earner isappropriate
  15. 15. Benefit design 2Retirement-income objectiveIdeal replacement rates are higher forlow-income workers than for higher-incomeFor high-income workers a ceiling on earnings that are eligible for pensionbenefits at the lower end of the international ‘norm’ (around125-200%) of average earnings is appropriateFor low-income workers use ‘adequacy’ schemes to boost replacement rates
  16. 16. Benefit design 2Types of insurance schemeEarnings-related: pension value depends on number of years ofcontributions and individual earnings variants: pure defined benefit (DB), notionalaccounts, pointsDefined contribution: pension value depends on contributions paid in andinvestment returns that they earn
  17. 17. Benefit design 2Country practice: mandatory schemesOECD (24) ECA (10) LAC (9) MENA (10)PublicNone 3 - - -DB/points 15 8 2 10NDC 3 2 - -PrivateDB 3 - - -DC 5 7 8 -Source: World BankPensions Panorama
  18. 18. Some equationsDefined benefitPointsNotional accountsTwo identities if u = x = nthen a = v / k = c / A
  19. 19. Benefit design 2Defined benefit schemesTarget replacement rate sets the ‘accrual rate’: pension value as a percentage of individual earningsresulting from a years’ contributions e.g., a 60% replacement rate implies 1.5% annualaccrual rate x 40 years’ contributionsAccrual rates are best ‘linear’ that means the same accrual rate for all years and atall ages
  20. 20. Benefit design 2Defined benefit schemesEarnings measure: ‘final’ salary used to be very common now countries have moved to lifetime average salaryExplanations: improved record-keeping computerisation makes lifetime calculations easier final salary no longer needed to protect against effectsof inflation between earning rights and retirementProblems of final-salary schemes: distributional effects strategic manipulation costs
  21. 21. Benefit design 3IndexationIndexation: automatic adjustment of pensions in payment toreflect changes in costs of living or standards of living not the arbitrary result of annual negotiation without adjustment, purchasing power of pension candecline quickly: indexation ensures adequacy in adynamic senseFew countries had automatic adjustments untilthe 1970s then, high inflation led all industrialised countries toadopt automatic indexation
  22. 22. Benefit design 4Pension eligibility ageAll pension systems have a ‘normal’ pensioneligibility age (even if people often retire earlier)There are no guiding principles as to what thisshould beTherefore, examine what other countries do ‘normal’ pension eligibility age life expectancy at that age
  23. 23. Benefit design 4Pension eligibility age0510152062 63 66 68 70SVK61 64 65 67 69FRASVN (61F) GBRESTAUSDNKDEUISLISR (64F)USANORNormal pensionable age, yearsNumber of OECD-34 countriesESPPRTSWETURCHE (64F)JPNAUTBELCANCZECHL (60F)FINGRCHUNIRLITAKORLUXMEXNLDNZEPOL (60F)Source: OECD Pensions Outlook 2012
  24. 24. Trends in life expectancy atage 65Men WomenAdditional yearsof life expectancy05101520251960 1980 2000 2020 2040 2050Lowest(TUR, KOR, CZE, HUN)Highest OECD country(NOR, ICE, JPN)Lowest(SVK, TUR)Highest(JPN, AUS)2010 1960 1980 2000 2020 2040 205005101520252010Lowest(TUR)Highest OECD country(NOR, CAN, CHE, JPN)Lowest(TUR)Highest (JPN)Source: OECD Pensions Outlook 2012
  25. 25. Trends in life expectancy atnormal pension age0510152025301960 1980 2000 2010 2020 2040 2050Lowest(IRL, DNK)Highest OECD country(GRC, ITA)Lowest(HUN, EST, CZE)Highest(GRC LUX)Additional yearsof life expectancy1960 1980 2000 2010 2020 2040 2050Lowest(IRL, DNK)Lowest(CZE, DNK, IRL)Highest(FRA, LUX)Highest OECD country(ITA, JPN)Men WomenSource: OECD Pensions Outlook 2012
  26. 26. Benefit design 4Pension age and retirement duration
  27. 27. Normal pension eligibility age should depend onlife expectancy across countries in one country over timeFlexibility in retirement may be desirableBut benefits for early retirees need to beadjusted to reflect the longer period for whichthey are paidBenefit design 4Pension eligibility age
  28. 28. Financing pensions 1A general principle: ‘Adequacy’ pensions should be paid for from thecentral government budget ‘Insurance’ pensions should be self-financing, that ispaid for out of contributions from individual membersand employersIn defined-contribution, ‘insurance’ pensions thisis simple to achieve the contributions made by or on behalf of eachindividual member will automatically equal thebenefits that he or she receives
  29. 29. Financing pensions 2In defined-benefit and other earnings-relatedschemes, this is more complicated to achieveActuarial/economic techniques can be used toshow which combinations of parameters andrules are feasibleThree key parameters target replacement rate pension eligibility age contribution rate
  30. 30. Defined contribution pensionsValue of pension is not set by the governmentInstead, it depends on the performance of theinvestments into which contributions are putOutcomes are uncertain because capital marketscan be volatile
  31. 31. Diversification ‘It is the part of a wise man to keep himself today fortomorrow, and not venture all his eggs in one basket’(Miguel de Cervantes, 1605, Don Quixote) Pay-as-you-go public pensions: sustainable rate of return = earnings growth + employmentgrowth Funded pensions rate of return in capital market directly or indirectly affectspension value Think of pension package as a ‘portfolio’ of different‘assets’
  32. 32. DiversificationInvestmentportfolioCanada France Germany Italy Japan SwedenUnitedKingdomUnitedStatesDomestic 21.2 -9.7 -8.6 -22.0 8.3 12.4 -28.2 3.5(34.4) (66.9) (76.1) (38.1) (69.2) (58.2) (15.3) (86.1)OECD-8 16.3 -26.0 -14.6 1.9 -15.2 8.8 -11.6 4.8(47.0) (24.2) (60.3) (93.4) (50.0) (69.7) (60.8) (83.3)Correlation between real earnings growth andreal return on ‘balanced’* portfolioCorrelation coefficient and p-value in per centNote: ‘Balanced’ portfolio comprises 50% equities,50% government bonds. ‘Domestic’ includes only homecapital markets, OECD-8 diversifies investments betweenall countries shown.
  33. 33. International experience0 25 50 75 100United StatesAustraliaCanadaSwitzerlandJapanNetherlandsUnited KingdomIrelandDenmarkOECDNew ZealandSwedenGermanyHungaryFrancePublic transfers Work Capital
  34. 34. Principles of pension design Adequacy ensure that all older people, regardless of their career history, haveenough money to survive Self-financing insurance benefits should be financed wholly from contributionrevenues without support from the central budget Secure pensions promises are sustainable and affordable pensions are protected against inflation Transparent people know what they can expect in retirement income Efficient administration is effective and costs are as low as possible avoids distorting economic choices (e.g., savings and retirementdecisions) limits opportunities for ‘gaming’ the system
  35. 35. IssuesWhat level should the adequacy pension be?What type of adequacy pension?What type of insurance pension?What target replacement rate?What pension eligibility age?