1

Issues in Group vs. Individual Provision

Lawrence Thompson

Senior Fellow

The Urban Institute

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Outline

1. Objectives of a pension system2. Role and structure of different pillars in a multi-pillar

system3. Issues affecting design of second pillar:

a) Structure and size of other componentsb) Distribution of system risksc) Degree of worker choiced) Operating costs

4. Concluding Observations•

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Objectives of a National Pension System

1. Primary Objectives:

a) Assure retired/disabled a minimum income

b) Assure minimal degree of earnings replacement

2. Secondary Objectives:

a) Increase national savings

b) Promote financial market development

c) Help restructure failing (state) enterprises

d) Minimize adverse side effects

e) Secure high returns on contributions

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Three Common Elements (Pillars) of a Retirement Income System

1. Redistribution program(s)

a. Defined benefit, pay-as-you-go, usually government operated

2. Mandatory earnings or contribution-related program(s)

a. Defined benefit and/or defined contribution

b. Pay-as-you-go and/or advance funded

c. Government and/or private operation

3. Voluntary programs

a. Advance funded, private operation

b. Increasingly defined contribution

c. Government oversight and subsidies

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Issues Affecting Second Pillar Design:Size and Structure of Other Components

1. Level of minimum income guarantee

– Establishes floor

2. Size of total mandatory component

– Limits the size of the 2nd pillar

3. Structure of minimum income guarantee

– Affects incentive structure

– Also influences size of 2nd pillar

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Level of Minimum:Ratio of Minimum Pension to Average Wage

Austria 35% Netherlands 24%

Belgium 40 Norway 34

Canada 24* Poland 33

Chile 25 Portugal 27

Denmark 31 Spain 27

France 42 Switzerland 18

Japan 23 United Kingdom 27

Kazakhstan 25 United States 22

* 29%, including income tested supplement35 year worker, 1997

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Structure of Minimum:Two Approaches

1. Fill the Gap

– Acts as a supplement to top up a second component benefit

– Found in Chile, Sweden, U.S.

2. Flat minimum

– Provides floor that second component is built upon

– Found in Russia, China, U.K., Netherlands, Denmark

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Fill the Gap Minimum(Chile, U.S.)

Ret

ire m

ent P

ensi

on

Preretirement Earnings

Minimum Pension

Earnings-r

elated

Pensio

n

Voluntary Supplem

entation

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Fill the Gap Minimum(Sweden)

Ret

ire m

ent P

ensi

on

Preretirement Earnings

Minimum Pension

Earnings-r

elated

Pensio

n

Voluntary Supplem

entation

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Flat Minimum

Ret

ire m

ent P

ensi

on

Preretirement Earnings

Basic Pension

Voluntary Supplem

entation

Earnings related Pension

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Size of 2nd component also depends on structure of the minimum

(Fill The Gap Minimum)

Ret

ire m

ent P

ensi

on

Preretirement Earnings

Minimum Pension

25%

50%

Earnings r

elated

Pensio

n

Earnings Related Pension

25%

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Size of 2nd component also depends on structure of the minimum

(Flat Minimum)

Ret

ire m

ent P

ensi

on

Preretirement Earnings

Basic Pension 25%

25%Earnings related Pension

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Comparison of Approaches

Flat grant:1. Uniform coverage in dignified manner2. Fewer disincentives (at least from benefit side!) 3. Less room for earnings-related component4. More budget resources5. Easier to administer• Fill the gap minimum:1. Fewer budget resources to finance2. More room for earnings-related component3. More difficult to administer, particularly if means-tested4. Compliance, savings and labor market disincentives5. Contingent liabilities

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Issues Affecting Second Pillar Design:Size and Distribution of System Risks

1. Of particular concern in pension programs:

a. Few alternative income sources at point of eligibility

b. Long lead time for individual supplementation

2. Major sources of risk

a. Demographic

b. Financial

c. Political/Institutional

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Demographic Risk

Two elements:

1. Change in mortality among aged

– Affects both funded and unfunded schemes

2. Change in birth rate (or net immigration)

– Affects unfunded schemes directly through change in beneficiary/worker ratio

– Affects funded schemes indirectly through changes in relative factor prices

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Incidence of Unanticipated Demographic Change

1. Defined contribution scheme:

– Impact entirely on retired worker

2. Defined benefit scheme:

– Initial impact on plan sponsor (or state)

– Ultimate impact likely to be shared between contributors and beneficiaries, at least initially

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Financial Risk

1. Of concern mainly in funded plans*.

2. Two elements of financial risk:

– Change in ratio of mean returns to mean wage growth rate

– Variation in annual mean returns and growth rates around known mean

* cost of unfunded plans can be sensitive to changes in real wage growth rate

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Impact of Change in Mean Return and Wage Growth on Replacement Rate at Retirement

Average Net Invest-ment Returns

Average Annual Wage Increase

1% 2% 3% 4% 5%

3% .42 .35 .30

4% .55 .46 .38 .32

5% .72 .59 .49 .41 .35

6% .77 .63 .52 .44

7% .82 .67 .56

35 year work history; 10% contribution rate; 15 year annuity

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Impact of Variations around the Mean

Analytical approach:1. Examine impact of variation in wage growth, investment returns,

and annuity interest rate2. Monte Carlo experiment with actual mean and standard deviation of

annual wage growth and annual average investment returns, 1953-953. Examine impact of four structures:

a. Traditional defined benefit -- sponsor absorbs all risksb. TIAA model -- wages (and contributions) vary; sponsor

smoothes other variationsc. Swedish model -- wages and accumulation returns vary; sponsor

smoothes annuity interest variationd. Chile model -- worker assumes all risks

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Impact of Second Component Structure on Replacement Rate Variation, U.S. Data

Mean

Standard

Deviation

St Dev as

% of Mean

1. Traditional Defined Benefit (sponsor absorbs all variation) .55 0 0%

2. TIAA Model (sponsor smoothes investment & annuity variation) .56 .05 9%

3. Swedish Model (sponsor smoothes annuity variation) .55 .21 38%

4. Chile Model (worker bears all risks) .57 .26 45%

Portfolio of 50% equities and 50% 10 year government bonds; actual average returns 1953-95;35 year work history; 10% contribution rate; 15 year annuity; administrative costs 1% of assets

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International Comparison:Mean & Standard Deviation, Chile Model

Country Mean

Standard

Deviation

St Dev as

% of Mean

Germany .40 .15 37%

Japan .25 .07 26%

United Kingdom .38 .21 55%

United States .57 .26 45%

“World Fund*” .62 .25 40%

Portfolio of 50% equities and 50% 10-year government bonds;Administrative costs of 1% (of assets) per year

*international average of returns; U.S. wage growth

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Incidence of Financial Market Risk

1. Risk of change in mean growth or return rate:a. Defined contribution scheme: Risk born entirely by retiring

workerb. Defined benefit scheme:

– Initial impact on plan sponsor (or state plan)– Ultimate impact likely to be shared between contributors

and beneficiaries2. Risk associated with variance in growth rates & returns:

a. Defined benefit scheme: no riskb. Defined contribution scheme:

– Risk born entirely by retiring worker – Size of risk depends on plan design

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Political/Institutional Risks

1. Unsustainable benefit promises

2. Decision gridlock

a. Cutting back defined benefits (France)

b. Resolving fiscal imbalances (Argentina)

3. Benefit adjustments to meet budget targets

4. Asset mismanagement

a. Political interference

b. Private mismanagement / regulatory failure

5. Underestimated transition costs

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Structure Affects Type of Political Risk

PAYG, DB Public Management

Funded, Defined Contrib.

Public Management

Private Management

Unsustainable promises

Decision Gridlock

Asset Mismanagement

Regulatory Failure

Transition cost

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Issues Affecting 2nd Pillar Design:Worker Choice

1. Type of choice:

a. Portfolio composition

b. Asset manager

c. Plan managers

2. Reason for providing choice:

a. Worker preferences

b. Political insulation

c. Improve quality of service

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Issues Affecting 2nd Pillar Design:Administrative Costs

1. Reduce investment returns

a. Limit (eliminate?) ability to lower contributions through advance funding

2. Vary with:

a. Degree of individual choice

b. Degree of centralization of administration

c. Level of service offered

3. May serve as insurance against certain forms of political risk

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Inflation Adjusted Market Returns, 1953-1995

Equity

returns

Bond

Returns

Mixed

Portfolio

Wage

Growth Gap

Japan 8.1% 3.8% 6.6% 5.0% 1.6%

Germany 7.4 3.9 6.3 4.8 1.5%

United Kingdom 7.8 1.8 5.6 3.6 2.0%

United States 8.2 2.2 5.6 1.0 4.6%

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Administrative Costs Under Different Models(Percent of Assets)

Accumulation Total

Australia 0.5 - 1.9 1.0 - 2.4

Latin America 0.6 - 1.4 1.1 - 1.9

Poland 0.8 – 1.0 ?

UK – personal pensions 1.2 – 1.3 1.7 – 1.8

– stakeholder pensions 1.0 1.5

US – 401(k) plans 0.8 – 1.9 1.3 – 2.5

– mutual funds 1.4

– TIAA 0.3

– thrift savings plan 0.1 ?

Switzerland 0.4

Denmark 0.3

Sweden 0.2 – 0.4 ?

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Second Pillar Model Variation

1. Defined benefit or defined contribution

2. Advance funded or pay-as-you-go

3. Centralization or decentralization of key functions

a. Collecting contributions

b. Keeping individual account records

c. Paying benefits

4. Degree of worker choice

5. Type of political risk minimized

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Comparative Strength of Different Funded Account Models

Political Worker Low

The approaches Insulation Choice Cost1. Latin American

2. United Kingdom 3. Switzerland 4. Sweden 5. Thrift plan 6. Singapore 7. (Canada)

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Concluding Observations I

1. Risks in pension system:

a. All models have risks, but nature and size varies from one model to another

b. Some forms of financial risk are unique to defined contribution plans

2. Individualization of pension provision:

a. Increases financial risk (variation around the mean)

b. Shifts more of demographic and financial risks to individual retired workers

c. Tends to increase administrative costs

d. Allows greater choice (to what end?)

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Concluding Observations II

3. Structure of second pillar influenced by: a. Relationship between minimum benefit and ceiling on mandated

benefitb. Political traditions

1) Pattern of political risks in each society2) Governance traditions

c. Preferences for:1) Providing choice in the mandatory system2) Spreading risks among general population

4. High administrative costs are:a. Either political insurance policy or (in part) dead weight lossb. Hard to reduce (costs are incomes)