Transcript BASIC PRINCIPLES OF PENSION ECONOMICS Estelle James •

BASIC PRINCIPLES OF
PENSION ECONOMICS
•
by
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Estelle James
World Bank Institute
•
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Key choice: Pay-as-you-go
(PAYG) v. Funding (FF)
• We will discuss basic principles of pay-asyou-go (PAYG) and funded social security
schemes,
• how they evolve through time
• and how to make them sustainable and
better for the economy
• lays the groundwork for discussion of
pension modeling
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Pay-as-you-go (PAYG) and
defined benefit (DB) systems
• Most industrialized countries have PAYG DB
systems: Pension contributions are not saved.
Instead, worker’s contribution today is used to pay
pensioners today, according to Defined Benefit
formula. In return, worker gets a promise that he will
receive a pension tomorrow, paid for by workers
tomorrow.
• What is required contribution rate to balance the
fiscal books of the social security system? How does
this contribution rate change over time?
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How to balance revenues and
expenditures under PAYG
• Total expenditures = B*P, total revenues = C*W
• Books are balanced (B*P = C*W) when
C = (B)/(W/P) and CR = BR/(W/P) where:
–
–
–
–
–
C = average contribution
CR= contribution rate = C/average wage
B = average benefit
BR = benefit rate = replacement rate = B/average wage
W/P = #workers/pensioners = support ratio
=1/dependency ratio
• So contribution rate required to cover expenditures
depends on benefit rate, # workers, # pensioners 4
Example of required contribution rate
• Assume:
– promised benefit (BR) = 60% wage
– System is new & populations young, W/P = 8.
– So each point of CR yields 8 points BR.
• Then: required CR = 60/8 = 7.5% (China past)
• But:
– As population and system age, W/P = 2
– So each point of CR yields 2 points BR.
• Then: required CR = 60/2 = 30% (China future)
• Required CR higher if unemployment, evasion.
– If 15% unemployment & 35% evasion & arrears,
required CR = 60% (collection a problem in China)
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Required contribution Rate depends
on Benefit Rate and Support Ratio
But what determines BR and W/P?
• BR and W, and P depend on demographic,
economic and policy variables.
• We will spend next 3 days discussing these
3 types of variables, how they are chosen or
estimated, and what is their impact.
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Benefit rate (BR) depends on key
policy choices
• BR depends on policy choices about
– target replacement rate and
– indexation method
• Important not to make target BR too high
because it will cost workers too much CR-40-50% is good target replacement rate.
• Young workers with families are often
neediest group--can’t afford high payroll tax
• Difficult to change BR for pensioners, but
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can change promises for young workers
W (# workers) depends on economic,
demographic and policy variables:
• Demographic--fertility rate over past 20-50 years
determines size of population in active age range
(1-child policy in China reduces this)
• Economic
– school-leaving age (date of entry to labor force)
– labor force participation rates
– unemployment rate
• Policy choices in social security system:
– Retirement age
– coverage rate
– evasion and arrears rate
• Important to choose policies that keep W high
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P (# pensioners) depends on:
• Demography: mortality rate, life expectancy
after retirement
• Policy choices:
– retirement age
– survivors benefits
• Life expectancy will grow rapidly in China.
Important to raise retirement age or #
pensioners and system cost will increase
• Later presentations discuss demographic,
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economic and policy variables in detail
Sustainability of PAYG System
• PAYG requires low contribution rate in
early years. Easy to pay first generation of
pensioners because many workers, few
retirees, system runs surplus
• But PAYG is nonsustainable as system
matures and population ages
• Lower fertility, higher life expectancy=
fewer workers, more pensioners, W/P falls
• Higher CR and retirement age needed
• PAYG is in trouble in almost every country 10
Implicit pension debt in PAYG
system
• As workers contribute, they are promised
future pension, so implicit pension debt
accumulates, but no funds accumulate to pay
debt: system has liabilities but no assets
• IPD is present value of future benefits owed to
pensioners and workers for past contributions:
– B1 (1+r) + B2/(1=r)2 + ... BT/(1+r)T
– where r = discount rate that shows future $ has
lower value than present
• Usually not legally binding or backed by
bonds, but difficult to renege
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Implicit Public Pension Debt, 1990
Explicit debt
Canada
Implicit public pension debt
France
Germany
Italy
Japan
United States
0
50
100
150
200
250
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300
Implicit pension debt in industrial
countries
•
•
•
•
> 100% GDP in most industrial countries
> 200% GDP in some countries
> explicit debt (bonds) in all countries
Future generations will have to pay this
debt; requires high tax rate and makes shift
to funded pension system more difficult
• China has relatively low pension debt--6070% GDP--because of low coverage rate
• China is in better position to shift to funded
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system and avoid high pension debt.
Parametric reforms (change in policy
variables) can improve PAYG finances
• Reduce BR by cutting replacement rate,
switching from wage to price indexation
• Raise W/P by increasing retirement age and
reducing early retirement--this is key policy
change but politically difficult everywhere
• Try to reduce evasion and arrears
• Raise contribution rate
– but this may decrease formal sector employment, wages
– future burden may be shifted to government’s budget,
less resources for other services
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– risk for workers if future pensions are not affordable
Example of how retirement age
affects W/P and CR under PAYG
• Suppose there are ten million people in
every age group from age 20-80. Target
replacement rate = 40%
• If retirement age W/P required CR
• 65
• 60
• 50
3/1
2/1
1/1
13.3%
20.0%
40%
• Evasion and arrears make matters worse
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Parametric reforms are necessary
but politically difficult
• Later we show simulations that calculate
long run impact of parametric reforms
• These reforms are important for PAYG and
also for partially funded system
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Shift to funding
• Funded system is less sensitive to
demography, more sustainable, better for
the economy than PAYG
• China is planning to make this shift. But
must figure out how to cover implicit
pension debt if part of CR goes into
individual accounts--transition costs
• Good to do now before implicit pension
debt becomes larger as coverage expands
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•
Fully funded (FF) defined
contribution
(DC)
systems
Assets are accumulated to match liabilities, and
earn interest, so no implicit debt or unaffordable
promises.
• Large stock of assets (wealth) builds:>100% GDP
• Can be used to increase sustainability, economic
growth; so many countries moving toward funding
• In Defined Contribution (DC) funded system, part
of contribution is put into individual’s account.
Pension depends on accumulated contributions +
investment earnings. Doesn’t depend on W/P.
• But: depends on rate of return--so fund
management and investment choice are crucial
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Rate of return important under FF DC
• If funds earn 5% interest, replacement rate of 60%
requires CR = 10% under FF DC
– under PAYG if W/P = 2, would require CR > 30%
• Rate of return is crucial: Suppose worker works 40
years, retires 20 years, wage growth=2%, CR=8% (China)
• Then: If interest rate, r = 2%, RR = 20% under FF DC,
–
4%, RR = 36 %
–
5%, RR = 48%
– Where RR = replacement rate of worker’s final year wage
• Each interest rate point raises RR 8-12% or cuts CR
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Rate of return must be higher
than rate of wage growth
• Interest rate determines growth rate of funds in
account.
• Rate of wage growth determines final year wage.
• Crucial that r > rate of wage growth; otherwise
funds in account grow slower than wages and FF
DC gives low replacement rate of final year’s wage.
• Will be big problem in China unless investment
policy changes
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Contribution rate required to pay replacement rate =
40% under PAYG and funding
Contribution rate
20
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15
10
7
5
PAYG
0
0
2
4
Assumptions
rate of wage growth = 2%
worker works 40 years, retires for 20 years
r = net rate of return for funded plan
horizontal lines show FF DC; for top line r =
2% and for bottom line r = 5%
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8
10
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Workers/pensioners
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What the slide shows
• This slide shows that required contribution
rate in PAYG system starts very low when
many workers, few pensioners, but system
becomes expensive when W/P falls.
Tempting at first, but pay later.
• Funded system has level costs, independent
of demography.
• But contribution rate needed for target
replacement rate depends on r, rate of return
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Important that r > wage growth rate
How are accumulated
contributions turned into pension?
• Suppose worker works for 40 years and his
accumulated contributions + interest =AC
• When worker retires, AC is turned into
pension. Suppose system expects average
worker to live 10 years. Then, annual
pension payments set so that AC = present
discounted value of all payments:
PP1/(1+r) + PP2/(1+r)2 +…PP10/(1+r)10 = AC
This is actuarially fair pension: EPVPP = AC
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How life expectancy and retirement age
determine size of pension under FF DC
• Now suppose average worker lives 15 years.
But system expected him to live 10 years.
Either he gets no benefit in last 5 years, or
system has large unfunded liability
• Crucial to take actual life expectancy into
account in determining annual pension
• Currently China does not do this--it divides
AC by 10 even though life expectancy > 15
Will cost more than expected--burden to MOF
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• Will get worse as life expectancy rises
Example of how life expectancy
after retirement affects pension
under actuarially fair FF DC
• Suppose r=5%, wage growth=2%, CR=8%
• Then if worker works age 20-65, retires age
65-80, his replacement rate = 58%
– if he works age 20-60, RR = 48%
– if he works age 20-50, retires 50-80, RR = 24%
• This provides incentive for people to work
longer--good for economy as # young
workers falls
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Important to simulate expected
pension under DC
• Under funded DC plan, system does not
guarantee a particular benefit. But policymakers should have a target replacement rate
(RR) in mind and should model relationship
between RR, contribution rate, investment
return and retirement age needed to reach RR.
• Shouldn’t lead workers to expect more than
they are likely to get. Adjust contribution rate,
retirement age or investment policy so they are
consistent with desired RR. Not consistent
today in China due to low r and retirement age.26
Evasion
• Under FF DC if worker evades making
contributions, his account remains small, his
pension is small
• This is bad for him, but it doesn’t become a
burden on others, undermine fiscal
sustainability of system, lead to higher CR
• Under PAYG worker who evades or whose
employer is in arrears may still receive
benefit--becomes a burden to the system 27
Summary
• PAYG DB has advantage that it can give
pensions to first generation of workers who
have not contributed, and it can redistribute
to low earners, if society desires this
• But disadvantage that is is not sustainable in
its original form. Costs start low but rise
sharply as system matures and population
ages. Very sensitive to demography
• Large implicit pension debt accumulates-burden on future generations & government.
Political risk: promised benefit won’t be paid.28
Summary (continued)
• FF DC less sensitive to demography and
evasion. Contribution rate is more stable.
• Accumulates large stock of assets, not debt
• Benefit is very sensitive to rate of return-crucial to invest funds well.
• Financial market risk: r and benefit may be
lower than expected
• Both systems require modest target
replacement rate and rising retirement age as
longevity increases--otherwise costs will be too
high for workers and society
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Important to model long run
effects of both systems
• Important to do simulations showing current
situation, long run effects of parametric
reforms and impact of individual accounts-if funded and if unfunded (notional, PAYG)
• Sensitivity analysis to different assumptions
given great uncertainty about future
• Later we discuss how to do this and give
examples using PROST and other models
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