THE CHALLENGE OF AGEING

– PENSION REFORM, INTERNATIONAL

TRENDS AND FUTURE IMPERATIVES

Chris Daykin, UK Government Actuary

Chairman, PBSS Section of IAA

Nairobi, 7 June 2007

GOVERNANCE OF SOCIAL SECURITY

Financial governance of social security> good overall governance and accountability> monitoring of income and expenditure> short, medium and long term projections> systems of control and audit> internal and public reporting> investment strategy and monitoring

GOVERNANCE OF SOCIAL SECURITY

The role of the actuary in social security> demographic projections> estimates of future benefit outgo> estimates of future contribution income> long-term projections of financial balance> short/medium-term estimates of cash-flow> development of funding strategies> asset/liability management> actuarial control cycle> design and costing of pension reform proposals> transparency and disclosure of information about costs

INCREASING LONGEVITY

Expectation of life at age 65 on cohort basis, E&W

10

14

18

22

26

1850 1900 1950 2000 2050

Year age 65 attained

Expe

ctat

ion

of li

fe (y

ears

)

10

14

18

22

26

FemalesMales

EXPECTATION OF LIFE, AFRICAN MALES, 1950-2010

30

35

40

45

50

55

60

65

70

1950 1970 1990 2010

Eastern AfricaMiddle AfricaNorthern AfricaSouthern AfricaWestern Africa

EXPECTATION OF LIFE, AFRICAN FEMALES, 1950-2010

30

35

40

45

50

55

60

65

70

75

1950 1970 1990 2010

Eastern AfricaMiddle AfricaNorthern AfricaSouthern AfricaWestern Africa

DEPENDENCY RATIOS, 1970-2030 (nos. 65 & over per 1000 aged 15-64)

0

20

40

60

80

100

120

140

1970 1990 2010 2030

Eastern Africa

Middle Africa

Northern Africa

Southern Africa

Western Africa

PENSION REFORM

What are the key objectives?> increase coverage and adequacy of benefits> reduce inequalities of provision between sectors> improve incentives for saving> ensure sustainability of structure and financing> avoid unaffordable increases in public expenditure> recognise the impact of future increases in longevity> reduce perverse incentives in labour market> improve retirement incentive structures

PENSION REFORM

What is the role of actuaries in pension reform?> analysis of costs of existing arrangements> advice on design of alternative structures> modelling the transition> regulation of complementary schemes> modelling impact on individuals> impact on public expenditure/borrowing> modelling impact on investment markets

SOCIAL SECURITY REFORM

Some alternative routes to reform national systems> individual accounts> notional defined contribution> modification of defined benefit> flat-rate demogrant> means-tested basic pension

INDIVIDUAL ACCOUNTS

Individual account reforms> started in Chile in 1981> by now includes most countries in Latin America…> …also several countries in central and eastern Europe> competitive private sector investment vehicles> usually mandatory for formal sector workers> compulsory purchase of annuities at retirement

> or some form of programmed withdrawal

> promoted by World Bank in Averting the Old-Age Crisis

INDIVIDUAL ACCOUNTS

Individual account reforms - evaluation> coverage is still a major problem…> …individual accounts are not enough of an incentive> transaction costs generally remain high…> …competition does not bring down the charges> churning and mis-selling have been an issue> pension levels may not be adequate…> …too many people will qualify for the minimum pension

SOCIAL SECURITY REFORM

Alternatives> to achieve similar incentive effects to individual accounts> …without high transaction costs or mis-selling problems> …but maintaining fairness between generations> …passing on to individuals the risk of greater longevity> …and avoiding the cross-subsidies of defined benefit

NDC PENSION REFORM

Notional Defined Contribution> structured as defined contribution…> … but on a PAYG basis rather than funded> clear link between contributions and benefits…> …but not subject to investment risk> targets lump sum at pension age…> with ‘notional’

purchase of an annuity

> permits flexibility of retirement age> passes on part of longevity risk

SWEDEN

Swedish NDC> DB state scheme replaced by NDC> revalorisation of individual accounts by average wage> automatic economic regulator of pensions increase> annuity value responds to improving mortality> automatic balancing mechanism to maintain in balance…> …as otherwise both benefits and contributions are fixed

SWEDEN

Automatic balancing mechanism (‘actuarial accounting’)Annual balance sheet for scheme:

Liabilities = present value of all future outlay for pensions in payment+ accumulated individual accounts for all persons not yet in

receipt of a pension

Assets =real assets in buffer fund + value of future contributions

Value of future contributions = contribution rate x wage mass x expected turnover duration

SWEDEN

Expected turnover duration

0

20

40

0 5 10 15 20 25 30 35 43 50 55 60 65 70 76 85 90 95

Ste

ady

stat

e pe

nsio

n lia

bilit

y

(in y

ears

of c

ontri

butio

ns)

= turnover duration 33 years

Age group

Expectedincome-weighted

age of income earners Pay-in duration + Pay-out d.

Expected pension weighted age of pensioners

Expected pension-capital-weighted average retirement age

1

00 5 10 15 20 25 30 35 43 50 55 60 65 70 76 85 90 95

= turnover duration 33 years

Age group

Expectedincome-weighted

age of income earners Pay-in duration + Pay-out d.

Expected pension weighted age of pensioners

Expected pension-capital-weighted average retirement age

SWEDEN

Real individual accounts> mandatory funded individual accounts (PPM)> 2½% of earnings> contributions collected with NDC contributions of 16%> low administrative costs> choice of nearly 800 investment funds> default arrangements if no funds selected

SWEDEN

Overall evaluation> hailed by many as a success> PAYG system made sustainable> cohort longevity risk passed on to individual members> dependency ratio risk passed to members through ABM> concern about expected fall in replacement ratios…> …and arbitrary effect of automatic balancing mechanism

FINLAND

Improved targeting> basic pension used to be flat-rate and contributory > mandatory earnings-related scheme> industry-wide rather than individual employer schemes > basic pension turned into a minimum pension guarantee…> …measured against the earnings-related pension> …so no means-test or asset test> dramatically cut the cost of the basic pension…> …and focussed expenditure on lower paid

FINLAND

Dealing with demographic ageing> objectives of recent reform of earnings-related scheme

> to postpone average age of retirement by 2 to 3 years> to adapt the pension system to increased expectations of life> to reduce pressures for future increases in contributions

> average of last 10 years → career average revalued> variable accrual rate

> 1.5% a year from 18 to 52> 1.9% a year from 53 to 62> 4.5% a year from 63 to 68

FINLAND

Dealing with demographic ageing> introduction of “life expectancy coefficient”Life expectancy coefficient for year N (>2009) =

cohort life expectancy for those reaching 62 in 2009cohort life expectancy for those reaching 62 in N

Multiply pensions of those reaching 62 in N by life expectancy coefficient for year N

Thus adjusting a DB pension benefit for improving life expectancy

GERMANY

Dealing with demographic ageing> still has earnings revaluation rather than prices but…> …revaluation is to net instead of gross wages> higher retirement age > reduced replacement rate at 65> contribution rate not to exceed 22% in 2030> “sustainability factor”

GERMANY

Pension adjustmentChange in pensions =

Change in average income, net of contributionsx sustainability factor

Sustainability factor for year x = value for year x-1 ofNumber of active contributors

Number of pensioners

divided by corresponding value for year x-2

NEW ZEALAND

Citizen’s pension> flat rate of benefit at or just above means-testing level> indexed to national average earnings> eligibility dependent on period of residence in NZ> individual entitlement, whether single or married> not dependent on pattern of working life> simple to understand and operate> no savings disincentive effects

NEW ZEALAND

Kiwisaver> new, voluntary, work-based savings scheme> automatic enrolment for those starting new job> those in a job will be able to join if they wish> contributions from employees at 4% (or 8%)> contributions collected by Inland Revenue through PAYE> individual choice of scheme (with default)> employers can select a scheme –

but no need to contribute

> no withdrawal until age 65…> …except for deposit on a first home (after >3 yrs contns.)> existing DB or DC pension schemes can be exempted

CANADA

Control based on steady state funding level> 1998 amendments to Canada Pension Plan> contributions increased from 6% to 9.9% from 1997 to 2003> small reduction in long-term benefit target> excess contributions to be invested in markets…> …under control of CPP Investment Board> three-yearly actuarial valuation…> …monitoring steady-state rate of contribution

CANADA

Control based on steady state funding level> if steady state rate is higher than 9.9%...> …and if ministers cannot agree on what to do> then automatic adjustment mechanism is triggered:

> contribution rate is increased over 3 years by ½

of excess of steady state over 9.9% (subject to maximum increase of 0.2% a year)> benefits are frozen (i.e. not indexed any more)> after 3 years, situation is reviewed following new actuarial valuation

UNITED KINGDOM

Continuous pension reform since 1975> State earnings-related pension (1975)> contracting out (1975)> basic pension linked to RPI (1980)> personal pensions for contracting out (1987)> cut back of SERPS (1988)> equalisation of pension age at 65 (by 2020) (19950> State Second Pension replaced SERPS (2002)> pension credit with an earnings link (2003)> trend to more dependence on means-testing> longevity risk offset by revaluation and rising pension age

UNITED KINGDOM

Expenditure from National Insurance Fund as % of GDP

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060

Past data and future price uprating Future earnings uprating

1950

UNITED KINGDOM

Pensions by year of award as % of earnings (at average earnings levels)

0%

5%

10%

15%

20%

25%

30%

35%

40%

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2 060

Basic Serps Increase due to S2P

1950

UNITED KINGDOM

Issues to be addressed> declining value of BP (and S2P)> shift to dependence on means-tested benefits> residual problem of coverage for older women> declining significance of defined benefit plans> defined contributions generally low> individuals shouldering more of the risk

UNITED KINGDOM

White Paper proposals (May 2006)> restore earnings link for basic pension> raise pension age to 68 by 2046> individual accounts with auto-enrolment> reform contribution conditions (30 years needed)> abolish DC contracting-out

UNITED KINGDOM

Proposals now being enacted (May 2007)> restore earnings link for basic pension (from 2012 or later)> raise pension age to 68 by 2046

> 65 → 66 between 2024 and 2026> 66 → 67 between 2034 and 2036> 67 → 68 between 2044 and 2046

> invested individual accounts with auto-enrolment

PENSION REFORM

Goals of a pension system

Primary goals> To provide adequate, affordable, sustainable and robust old-age incomeSecondary goals> To create developmental effects by

> minimizing negative impacts> leveraging on positive impacts

PENSION REFORM FRAMEWORK

World Bank framework (1994)

1st

PillarMandatory unfunded public defined benefit social security2nd

PillarMandatory funded and privately managed defined contribution3rd

PillarVoluntary savings retirement plan (or occupational pension plans)

PENSION REFORM FRAMEWORK

World Bank framework (2005)Pillar zeroNon-contributory scheme providing minimal level of protection1st

PillarMandatory unfunded publicly managed DB or NDC providing some longevity insurance2nd

PillarMandatory funded and privately managed DC (or DB)3rd

PillarVoluntary savings plans –

regulated and privately managed

4th

PillarInformal intergenerational financial and non-financial support

SOME GENERAL LESSONS

Increasing coverage> use of demogrant

(citizenship pension)

> simpler than means-testing> but more expensive to give benefits to everyone> general budget financing

> keep universal pension at very low level (pillar zero)> supplement with social insurance for employed workers> flat-rate benefits on DB basis> …supplementary savings through individual accounts> …or occupational pension schemes

SOME GENERAL LESSONS

Sharing longevity risk1. target lump sum at retirement…

> …and convert to pension using current annuity value> …funded individual accounts or NDC

2. index retirement age based on cohort expectation of life...> …or maintain ratio between working and retired life periods

3. raise retirement age at intervals to offset rising cost4. overall adjustment mechanism such as

> life expectancy coefficient> sustainability factor> automatic balancing mechanism

5. risk-sharing between contributors and pensioners

CONCLUSIONS

Wide range of solutions – DC favoured> everywhere has a different solution> but all are starting from different points> DC widely favoured for its incentive structure…> …but lacks basic characteristics of protection> …unless in with-profits form or with strong underpin> many national DC systems have a minimum pension

CONCLUSIONS

Wide range of solutions – new DB thinking> DB mostly moving to career-average revalued…> …which is equivalent to a type of DC> NDC is really a DB structure dressed up as DC> focus on fund at retirement facilitates longevity solutions> cash balance is another alternative DB/DC hybrid…> …or perhaps revisit with-profits DC> reconsider survivorship in light of individual entitlement

CONCLUSIONS

Wide range of solutions – efficient savings> mandatory DC necessary to achieve full coverage…> …or almost mandatory> contributions should be collected centrally> avoid insurance wrappers> don’t have too much choice of investment funds> guaranteed minimum should underpin state pension only

THE END

Questions and discussion