Initial Conditions

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Pension Reform Options A General Framework

AFDC Workshop Governments Role in building
sustainable Pension Systems Meeting the
challenges of the Ageing Societies Gustavo
Demarco Shanghai, October 15, 2007
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Some common challenges of current pension systems

• Adequate benefits to ageing populations
• Financial sustainability
• Coverage extension
• Higher compliance
• Better governance and administration
• Institutional soundness (fragmentation)
• Regulation and supervision

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Demographic trends - 1
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Demographic trends - 2

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Cross-Country Relation between Income and Pension
Coverage
CH
Mongolia
Gabon
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Setting the targets

• There is space for social choice but this
• choice needs to respect some basic principles
• Sustainability
• Equitability
• Affordability
• Feasibility

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Choosing the mandate of the system
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Sustainability static approach

• Contributions c W L
• Benefits r W P
• Equilibrium
• c W L r W P
• c (W / W) (L/P) r
• If W W gt
• c / d r . . . Where d P/L

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Sustainability dynamic approach
Sustainable IRR 2 per year
Case of Egypt
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Current trends in Pension Reforms

• General principles, not universal ideal models
• Financial Sustainability
• Efficiency
• Equitability
• Feasibility (Economically and politically)
• Customized solutions
• Pragmatic approach
• Regional approach (rather than Global)

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The Pension Reform process

• Diagnosis (What problems?)
• Options (What possible solutions?)
• Potential impacts
• Economic feasibility
• a) Enabling conditions
• b) Costs of transition
• Political feasibility
• a) Social preferences
• b) A strategy of consensus

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Pension Reform Options

• Alternative contributory schemes
• PAYG - Parametric
• PAYG - NDC
• Fully Funded
• Multipillar
• The non-contributiry options
• Zero pillar

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Multi pillar Reforms

• Pillars
• Zero Non-contributory/social pension
• First Parametric or NDCs
• Second Funded, private management
• Third Voluntary, structured retirement plans
• Fourth Access to housing, health care, etc..

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Who defines what in Pension Reform?

• There is space for social choice but this
  should be limited to sustainable and
  equitable options
• The decision has a strong political component,
  and a strategy of consensus is always required
  (feasibility)

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Parametric Reforms

• Main advantages
• No major change in the operation of the pension
  system
• Principles of solidarity and intergenerational
  solidarity remain unaffected.
• Problems
• Not necessarily easier to pass and put into
  practice.
• Parametric changes are often discretionary or ad
  hoc.
• Parametric reform is not a one time reform.

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Main parameters of a DB pension system

• Income measure
• Ceiling on pensionable earnings.
• Number of past salaries included in the
  calculation of the pension.
• Revalorization mechanism for past salaries.
• Eligibility conditions
• Retirement Age (normal/early retirement)
• Vesting period
• Benefit Formula
• Accrual rate.
• Reduction factors for retirement prior or after
  the statutory retirement age.
• Maximum/minimum replacement rates and/or
  pensions.
• Indexation mechanism for pensions.

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Some common issues with parametric reforms

• Gradualism need to define a transition path
• Accrued rights and implicit pension debt.
• Political constraints difficult to cut benefits
  and increase retirement ages.
• Myopia to adjust to long term objectives
• The reform will be a long term process.

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PAYG Notional Accounts (NDC)

• Individual accounts
• Unfunded
• Notional return
• Benefits calculated to reflect contributions,
  notional returns and demographic changes
• NDC is simple and transparent, but it must
  respect some rules
• Choice of appropriate interest rate, life
  expectancy
• A balancing mechanism against shocks
• A financing mechanism to handle inherited
  commitments when moving from existing system

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Experiences with NDC reforms

• Countries with NDC-reformed schemes
• Sweden
• Latvia
• Poland
• Italy
• Kyrgyz Republic
• Countries with NDC-inspired reformed systems
• China, Brazil, Russia
• Countries with NDC-type systems
• Germany and France

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Some advantages of NDC

• Public debt is a source of financing transition
  from DB system.
• Mismanagement risk is lower than in funded
  schemes.
• Can improve fiscal management
• Implicit pension liabilities of NDC system appear
  as a debt of the government.
• Can facilitate the gradual transition to a FF
  system when the bonds are allowed to be traded.

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Basic features of funded pension schemes

• Managed by private companies (Insurance Companies
  or Specialized Pension Managers)
• Funded schemes
• No surplus or deficits gt No fiscal effects
• Defined contribution schemes Benefits depend of
  funds accumulation and of life expectancy

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Contributions in funded schemes

• Contributions are retirement savings
• The system may have more incentives to
  contribute, especially for higher income workers
  and those who contribute on a regular basis

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Benefits in funded schemes

• Normally defined contribution
• Automatic adjustment
• No need of financial support to deficits (no
  fiscal impacts)

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Funded schemes Options

• Public or private managers?
• Specialized managers? Insurance companies? Other
  financial intermediaries?
• Mandatory or voluntary?
• Substitutive or complementary to public pensions?
• Individual or group (occupational) plans?

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Funded schemes Individual or group?

• In individual plans workers may choose fund
  managers
• In group or occupational plans the employer
  chooses the pension manager
• Group plans offer more protection and with lower
  costs, but they limit individual choice.

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Advantages of funded schemes

• Automatic response to the problems of aging
  population
• No deficits
• In principle, less exposed to political
  manipulation
• More incentives to contribute gt higher expected
  benefits
• Higher return on savings
• Macroeconomic environment possible effects on
  capital market development and savings (?).

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Problems of funded schemes

• No redistribution of income is possible (only
  some cross subsidies among members)
• Minimum pension schemes must be defined as PAYG
  schemes
• Private costs of administration sometimes higher
  than public management

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Discussion of advantages and problems

• Private mandatory pension schemes may not be
  exempt from government interference
• Incentives to contribute do not operate
  automatically
• Level of pensions are not necessarily higher in
  private pension schemes
• Higher financial education is required

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Comparison based on macroeconomic effects

• No mandatory pension (funded or not, privately or
  publicly managed) is independent of the
  macroeconomic context
• Funded schemes may accompany and facilitate the
  development of capital market institutions, but
  the effects on the savings rate and the rate of
  growth of the economy have not been proved.

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Comparison based on administration costs

• Explicit costs of administration are usually high
  for private pensions, but public systems usually
  have huge implicit costs (inefficiencies,
  disability system costs, etc.)
• It is difficult to compare the costs of public
  and private administration. Concepts involved
  and levels of risks are usually non comparable

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Funded schemes The voluntary option

• Complement public pensions
• Improve benefits without imposing a burden on
  labor costs
• Types a) Individual accounts b) Occupational
  plans
• Quantitative impact usually modest, but
  qualitative effects may be important (development
  of institutions and regulations)
• Problem Fiscal treatment of voluntary retirement
  savings

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Funded schemes Alternatives and international
experience
Voluntary Mandatory
Total Chile Kazakhstan
Partial Canada USA Mauritius UK Australia Argentina Costa Rica

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Feasibility Technical pre-conditions

• Financial and actuarial projections
• IT Databases
• Administrative procedures Defined and flexible
• Regulatory framework and supervisory bodies
• Trained human resources

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Feasibility Economic environment

• Financial markets and institutions
• Capital markets and Insurance
• Macroeconomic environment

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Financial markets and institutions

• Financial intermediaries Experienced,
  competitive
• Financial Assets Diversification, Liquidity and
  low Volatility
• Market transactions
• Strong regulatory and supervisory body

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Capital Markets and insurance

• Develop capital market institutions, regulation
  and supervision
• Liquidity and low volatility
• Secondary markets of public bonds
• Individual insurance and annuities institutions,
  mechanism, regulation and supervision

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Macroeconomic environment

• Economic stability
• Growth
• Fiscal discipline
• Role for foreign investments

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Political feasibility

• Consensus among social partner
• Government
• Parliament
• Workers (Labor Unions)
• Employers
• Beneficiaries
• Financial Sector, Insurance
• Public opinion

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Restructure administration A minor reform?

• Reforms in the administration may be independent
  from parametric or structural reforms
• But.
• No country has gone through a successful
  parametric or structural reform without strong
  reforms in the administrative institutions and
  procedures

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Components of an administrative reform - 1

• Institutions
• Processes
• Governance structure
• Human resources
• Budget and resource allocation

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Components of an administrative reform - 2

• Information systems and IT
• Audits and supervision
• Customer service
• Communication, public education and public
  information
• Strategic Planning

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Restructuring institutions

• Institutional organization usually responds to
  history, rather than to the present needs.
• Options (I) centralized vs. decentralized
  administration
• Options (II) Autonomy vs. Integration (with
  Ministerial structure)

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Centralized or decentralized administration?

• Advantages of centralization
• Lower costs
• Common rules (ie, less inequalities)
• Disadvantages
• Costs of monopoly
• Diseconomies due to lack of specialization
• Coordination with local or regional offices
  (particularly in large countries)

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Autonomy or integration?

• Advantages of autonomy
• a) More efficiency
• b) Less interference
• Disadvantages / Risks of autonomy
• a) Loose of broad policy perspective,
  introspective institutions
• b) Political isolation lack of support when
  major reforms are needed

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Re-defining procedures Identify critical
processes

• Membership
• Collection
• Record keeping/individual accounts (history of
  contribution for every member)
• Investment of reserves
• Customer service
• Benefits procedures and actuarial calculation

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Governance structure and accountability

• Clear definition of roles and responsibilities
  associated to all critical processes
• Need to translate the definition of roles and
  responsibilities into an organizational chart
• Privilege professionalism minimize political
  interference in the appointment of staff in
  decision making processes that require technical
  expertise
• Define procedures of accountability of staff at
  all levels, and especially at the highest levels
  of the organizational pyramid (Link with
  Communication)

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Information Systems

• Income related schemes rely on good records of
  contributions.
• These records are often poor, and databases need
  to be developed or improved.
• Adopting IT requires a clear assessment of needs
  (including system operation and updates).
• In house or outsourced IT development?

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Audits

• Independent auditing services may help identify
  problems, find solutions and reduce costs
• Regular external audits are recommended in
  addition to internal audits
• Reviews need to include operational audits in
  addition to financial or actuarial audits

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Conclusions

• There is not an ideal model for pension systems,
  but there are principles that should guide the
  operation and reform of any pension system.
• The political component of a pension system is
  reflected in the mandate the design and
  operation should not be subject to
  discretionality or political manipulation.

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Conclusions

• The international experience provides several
  examples of reforms options, but each country
  should find its own path.
• The macroeconomic and political environment are
  constraints to the adoption of some types of
  reforms.
• Multipillar schemes are adequate when multiple
  objectives are pursued.