1

Pension policy and financial

assessment of a new defined

benefit pension scheme

UNECOSOC conference

Achieving sustainable development through employment creation and decent work for all

24-25 February 2015

Jakarta, Indonesia

Hiroshi Yamabana

ILO Public Finance, Actuarial and Statistics Branch

(ILO SOC/PFACTS)

E-mail: yamabana@ilo.org

2

Structure of the presentation

1. Major dimensions of pension design

2. Current situation in Indonesia

3. Policy and design issues in Indonesia

4. DB / DC / NDC discussions

5. Proposed pension design (outline)

6. PAYG (Pay-as-you-go) cost rate

7. Financing of pensions

8. Some points for consideration

3

1. Major dimensions of pension design

1. Coverage (horizontal dimension)

- Beneficiaries vs. potential target beneficiaries

- Contributors vs. potential target contributors (in case of insurance schemes)

2. Benefits (vertical dimension)

- Benefit level vs. poverty line / minimum wage

- Benefit level vs. average wage (in case of social insurance scheme)

3. Financing (as a backbone)

- Long-term financial sustainability / equilibrium

Two-dimensional strategy

for the extension of social security coverage:

Building comprehensive social security systems

4

Coverage

Access to essential health care

and minimum income security for all

Social security benefits

of guaranteed levels

Voluntary insurance

under government

regulation

level of

protection

high

highlow

low

Horizontal dimension:

Guaranteeing access to essential health care

and minimum income security for all

Vertical dimension:

progressively ensuring

higher levels of

protection

guided by C.102 and

higher-level standardsfloor level

higher levels

(minimum C.102)

5

2. Current situation in Indonesia1. Coverage

- Different schemes for civil servants, army and police and private-sector workers

- No coverage for informal economy workers

2. Benefits

- Labour Law (Severance and service reward pay): lump sum

- Provident Fund for private-sector workers: lump sum

- Pension for civil servants: periodical payments

3. Finance

- Labour law: employers’ direct compensations

- Provident Fund: external, individual accounts

- Pension: external, collective financing (redistribution)

6

3. Policy and design issues in Indonesia

1. Coverage

- Wage earners: coordination

- Informal economy workers: extension (incl. tax-based schemes)

2. Benefits

- Wage earners: predictable and periodical payments with proper benefit adjustment / indexation (DB) as the main tier

- All the elderly: poverty alleviation basic pension

3. Finance

- External funding

- Inter- and intra-generational transfers / redistribution as needed

7

4. DB / DC / NDC discussions

1. Defined contributions (DC) scheme

- Individual saving, easy to understand; but

- Lump sum spent up in several years

- Amount substantially influenced by unpredictable investment return for decades

- Require high contribution rate (e.g. 20%) for substantial amount to be accumulated, from the beginning of the scheme, at the time of developing stage of economy

- Scare investment opportunities at the time of developing stage of economy

=> Some countries to revert back to DB, e.g. Argentina, Poland

8

4. DB / DC / NDC discussions (contd.)

2. Notional defined contributions (NDC) scheme

- ‘Notional’ individual saving, similar to DC, but not all amount in the account;

- Require high contribution rate (e.g. 20%) for substantial amount to be accumulated, from the beginning of the scheme, at the time of developing stage of economy

- Scare investment opportunities at the time of developing stage of economy

- Cannot cater for disability or survivors’ pensions

=> Adopted by countries with already high contribution rates, e.g. Sweden, Poland, Italy

9

4. DB / DC / NDC discussions (contd.)

3. Defined benefit (DB) scheme

- Benefit formulae and benefit conditions (e.g. retirement age) set in advance;

- Calculate the required contribution rate for the defined formulae and benefit conditions

- Gradually increase the contribution rate in future, with rationalizing benefits and conditions (e.g. retirement age)

- Adjusting benefits, contributions and reserve funds in line with demographic, economic and social conditions

- Usually include disability or survivors’ pensions

=> Adopted by many developed as well as east Asian countries (e.g. Japan, ROK, China, Thailand, the Philippines, Viet Nam, Lao PDR)

10

5. Proposed pension design (outline at the time of

study, no agreement yet)1. Coverage

- All wage earners working for an employer with 20 employees or more

- Civil servants, military and police: integration in 2029

2. Benefits

2.1 Old-age pensions

2.1.1 Qualifying conditions

- 15 years of contributions

- Retirement age: 56 -> 57 (in 2037) -> ……. -> 65 (in 2085)

2.1.2 Benefit formulae

- 1% x contribution years x individual career-average salary

2.1.3 Benefit adjustment / indexation

- 50% of inflation

11

5. Proposed pension design (outline)

2.2 Disability pensions

2.1.1 Qualifying conditions

- 15 years of contributions; or

- 30 monthly contributions / 36 most recent months

2.1.2 Benefit formulae (Same as old-age pensions)

- 1% x contribution years x individual career-average salary

2.1.3 Benefit adjustment / indexation (Same as old-age pensions)

- 50% of inflation

12

5. Proposed pension design (outline)2.3 Survivors’ pensions

2.1.1 Qualifying conditions

- 15 years of contributions; or

- 30 monthly contributions / 36 most recent months

2.1.2 Benefit formulae

- Widow: 70% x old age pensions

- Orphan: 50%

- Mother, father: 20%

2.1.3 Benefit adjustment / indexation (same as old-age pensions)

- 50% of inflation

3. Financing

- Contributions on wages:

5% by employers, 3% by employees

13

6. PAYG cost rate

IC = EB where:

IC: Annual contribution income

EB: Annual benefit expenditure

While

IC = NC * AW * CRPAYG

EB = NB * AB

where:

NC: Number of contributors

AW: Average wage of contributors

CRPAYG: PAYG cost rate

NB: Number of beneficiaries

AB: Average benefit

14

6. PAYG cost rate (contd.)Hence,

NC * AW * CRPAYG = NB * AB

NB * AB NB ABCRPAYG = ------------- = ----- * -------

NC * AW NC AW

= RD * RF where:

RD: Demographic ratio (i.e. what is the percentage of the number of pensioners compared with the number of contributors?)

RF: Financial ratio (i.e. what is the average benefit level compared with the average wage?)

15

6. PAYG cost rate (contd.)

CRPAYG = RD * RF

Example:

Think of the following cases to calculate CRPAYG(Demographic dividend / aging)

1. Young scheme with young demography:

RD = 20%

RF = 40%

2. Mature scheme with aged population:

RD = 50%

RF = 60%

16

Demographic ratio of the proposed scheme

0

10

20

30

40

50

602

01

6

20

23

20

30

20

37

20

44

20

51

20

58

20

65

20

72

20

79

20

86

20

93

21

00

21

07

21

14

old age pension Invalidity pension Survivors pension

Orphan pension cash benefits

17

Financial ratio of the proposed scheme

0

5

10

15

20

25

30

35

2,016 2,047 2,078 2,108

Old age pension Invalidity pension

Survivors pension

18

PAYG cost rate of the proposed scheme

0

5

10

15

20

25

30

2016 2047 2078 2108

19

Replacement ratio50 %

Old-age pensions

Contributions

40 years 20 years

60 years old

20

7. Financing of pensions

(1) PAYG financing method

Contribution rate will be annually increased annually.

Preparing for aging beforehand, by levying higher contribution rates than PAYG cost rate and relying on investment return on the reserves as well as advance savings.

(2) General average premium / contribution (GAP) method

- Constant contribution rate for a long period, sometimes assumed as forever.

(3) Scaled premium / contribution (SP) method:

- Constant contribution rate (for a certain period)

21

Scaled premium contribution rates

0

5

10

15

20

25

30

2016 2047 2078 2108

PAYG Base scenario Scaled premium

22

8. Some points for consideration

(1) Tax-based universal pensions

(2) Social insurance system to provide higher benefit level for wage earners (as partial income replacement)

(3) Faster scheme integrations for formal economy

(4) Better annual accrual rate (4/3% instead of 1%) to comply with C.102

(5) Better minimum pensions for disability and survivors’ pensions to comply with C.102, especially for those with short contributing periods

(6) Indexation in line with the wage increase or inflation (not 50% of inflation)

(7) Faster increase in the retirement age (and above 65 as needed)

(8) Scaled premium financing method

(9) Contribution level gradually adjusted in years to come, taking into account aging, affordability of contributions and investment opportunities

23

8. Some points for consideration

(10) Establishment of the design, financing and investment strategies, and the overall governance structure of a new scheme, including demographic decision making process through tripartite consultations

(11) Tripartite Governance of the new pension scheme, building trust among tripartite partners and governance of the scheme

(12) More effective social security system, e.g. more emphasis on job matching and vocational training for unemployed

(13) Coordinated systems of social security, more emphasis on periodical benefits than lump, more emphasis on external financing than direct compensations, consideration on coordination on different benefits (new DB scheme, provident fund, service reward pay)