Design features of an IA System: What Can We Learn from Other Countries?

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Design features of an IA System What Can We
Learn from Other Countries?
By Estelle James
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Reasons for pre-funding

• Pre-funding makes system more sustainable, less
  sensitive to demographic change
• Earns investment return, requires lower payroll
  tax to maintain benefits (after transition stage)
• Avoids passing large debt to our children
• Pre-funding can help to increase national saving,
  therefore productivity and growth

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Problems with public management of funds

• Under current arrangement for trust fund,
  treasury gets exclusive access to funds, ious
  dont count in public debt so government may
  borrow more todaythis becomes taxpayers problem
  tomorrow
• If trust fund is invested in stock market leads
  to
• conflict of interest between govt as regulator
  investor
• political lobbying for inclusion, exclusion
• In other countries public funds get lower rate of
  return, political manipulation, misallocated
  capital
• Piecemeal reforms are necessary but inevitably
  involve build-up of trust fundshow can we avoid
  their use to finance larger government debt? IAs
  are one way out.

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Private investment also entails problems

• High administrative costs, financial market risk,
  accumulation may be used up too quickly, some
  workers may fall below poverty, transition cost
  problem
• I will outline how other countries solved these
  problems in their IA systems
• Devil is in the details, in answers to key design
  issues.

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1. What is best mix of funded and PAYG benefits?
Big range

• Chile and most Latin Americaalmost 100 of
  benefits from IAs, except for safety netminimum
  pension guarantee (MPG)
• Sweden2.5 tax goes into IAs, 16 goes into
  PAYG, safety net financed by general revenues.
  IAs only 15 of total payroll tax but expected
  to be 30 of total benefit
• Australia, Switzerland, Netherlands, UK, Poland,
  Hungaryprivate funded pillar 40-50 of total
• Mixture of PAYG funding diversifies risks

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2. If private, who chooses investment managers?

• WorkersLatin America, Eastern Central Europe
  (retail market-may lead to high costs)
• EmployersSwitzerland, Netherlands, Denmark,
  Australia, Hong Kong
• Long tradition of employer-sponsored plans,
  government recently made them mandatory
• Group plans cheaper to administer (institutional
  market)
• Initially DB, but shift toward defined
  contribution (DC)
• If DC worker bears risk and will demand choice of
  investment manager strategy
• Thrift Saving Plan in US, Bolivia, Kosovo
• competitive bidding process for fund managers
• workers get lower cost with limited choice

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3. How to keep administrative costs low

• Important to keep costs low If expenses are 1
  of assets annually, pension falls 20
• Chileadministrative costs high at start-up but
  about 1 of assets now (lt US mutual funds)
• Costs higher in new plans in rest of Latin
  America, E. Europe also US 401(k)s and
  Australian retail plans
• But costs only .1 of assets in TSP, .3-.5 in
  large employer plans in Holland, Australia,
  Switzerland
• Difficult to keep costs low when DC accounts are
  small, especially at start-up. How can we solve
  this problem?

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For low investment marketing costs use
institutional marketlimit choice

• Most Latin American and Eastern European
  countries use retail marketmany asset managers
  sell directly to individuals. High marketing
  cost.
• Bolivia, Kosovo, TSP, large employer plans, use
  institutional (wholesale) market
• small number of asset managers through
  competitive bidding
• Aggregate small accounts to capture scale
  economies, increase bargaining power, reduce
  marketing costs.
• Use passive investing (indexing to benchmark like
  SP500 or global index)
• Collect contributions through tax system,
  centralize record-keeping
• Amortize high start-up costs over time
• Should keep our IA costs to .3 of assets

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4. How to reduce risk and provide safety net to
low earners

• Stock market volatility is definitely a problem
• Every country with IA has minimum pension or flat
  benefit that sets floor (15-30 average wage)
• MPG or floor in most Latin America, Eastern
  Europe
• Flat or almost flat benefit in Western Europe,
  Australia
• We should consider floor tied to years of work
• Require broad diversification investments
• Portfolios restricted in Latin America E. Europe
• But not enough international diversification
• Chile limits in stocks after age 55 (less
  return, less volatility, less subject to date of
  retirement risk)
• UK has too much choice and workers made mistakes
• Carefully structure limited choice (like TSP) is
  best

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5. Guarantees

• Relative rate of return guarantee common,
  herding, index to benchmarks better
• Switzerland also sets floor on interest rate paid
  by pension funds insurance companiesproblems
• Private market can provide collar--floor
  upside potential--but must be carefully regulated
  (costly, credibility of guarantor, hard to
  evaluate price)
• Public guarantees often cost more than expected,
  moral hazard problems

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6. How to handle payouts

• How can we be sure that worker wont spend all
  his money before he dies? Annuities guarantee
  workers life-long income. Can private sector
  handle this? Will annuities be offered on good
  terms? Will workers buy?
• Chile has had IA system since 1982
• many workers have retired, government requires
  annuities or gradual withdrawals up to threshold
  of 70 replacement rate--2/3 have annuitized
• Chile requires that pensions are price-indexed,
  joint for married men--inflation insurance,
  protection for widows, at no public cost (indexed
  annuities difficult)
• Pensioners who work dont have to contribute to
  their accountencourages work
• Private sector can handle payout stage
• But only if government sets careful rules of the
  game
• Competitive bidding process for annuities (TSP)?

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7. How to protect women

• Women work less, earn less, live longer, and if
  married their husband are older, so they become
  widows with low incomes. Very old women are
  pockets of poverty in many countries.
• Women are the biggest gainers in lifetime income
  from the pension reform in Latin America. Why?
• Minimum pension guarantee or flat benefit helps
  low earners
• Survivors benefits purchased through group
  insurance contract during working stage
• At retirement, husbands required to purchase
  joint pension--financed by husbands (in US by
  taxpayers)
• Widows keep their own pension plus survivors
  pension (in US widows must choose between the
  two many women who work contribute get no
  additional benefit)

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8. How to handle the transition

• Chile, Latin America, Central Eastern
  Europeused carve-out from existing payroll tax
  that was high at start. Therefore transition
  financing gap
• Most downsized current benefits that were too
  generous
• Chile accumulated fiscal surplus before reform
  but still has large financing deficit (also
  deficit in old system)
• Debt finance played large role in most cases
• Australia, Netherlands, Switzerland, Denmark,
  Hong Kongadd-on, no transition cost problem
• US-We have relatively low pension debt and trust
  fund surplus so carve-out possible but low
  contribution rate so add-on possible. Mixture
  might be ideal.
• to increase national saving we shouldnt finance
  transition mainly by increasing public debt
  (otherwise higher personal saving offset by
  public dissaving)

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Conclusion

• Mixture of PAYG DB and funded IA would make
  social security sustainable, protect workers, and
  improve economyat least cost.
• The devil is in the details. IAs can make us
  better or worse off. What is best design?
• Competitive bidding, index funds, limited choice,
  diversification, gradual move out of stocks
• Minimum pension tied to years of work
• Annuities up to reasonable threshold
• Strategy for covering transition financing gap
• Avoid too much choice, retail market, no safety
  net, inadequate annuitization, pure debt-financed
  transition
• Ultimately we will have to make value judgment
  between reducing benefits vs. raising payroll
  taxes but IA can give us better terms of trade