A constructive critique of pension policy in Ireland

1
A constructive critique of pension policy in
Ireland

• Shane Whelan
• UCD School of Mathematical Sciences

2
Outline of Talk

• Background/context
• A system to last 100 years and more
• Our current system
• A snapshot of how it delivers to aged
• Outlook for current system
• projected half a century
• An alternative to the current system
• A State Annuity Fund
• Two possible extensions
• Conclusion

3
Background

• Some men have less prudence than brutes,
• and will make no provision against age until it
  comes.
• Daniel Defoe (1697), An Essay on Projects.
• Pensions only part of the welfare of the elderly
• health care
• Societys attitude to elderly (crime, etc)
• Pension policy has wide ranging influences in
  economy
• Slowing the process of urbanisation in Ireland
  over the last century
• State pensions are important issue to electorate
• Disquiet when reduced
• Ireland 1924 France 1995 Italy 1998

4
Background

• Candidate for Best Paper on Pensions
• Enumeration and Classification of Paupers, and
  State Pensions for the Aged. Charles Booth,
  Journal of the Royal Statistical Society in 1891.
• Sets out rationale behind our current system.
• And, for most of 20th century, that of New
  Zealand, UK, Australia, Canada,
• In contrast to compulsory earnings-related scheme
  in Germany (1889), Italy (1919), France (1930),
• Cutler Johnson (2004) what is particularly
  apparent about social security systems is how
  durable they are...so making the initial
  decisions correctly is a particularly important
  issue (p.116).

5
Irelands Current System

• Pensions policy has two distinct aims
• to relieve poverty in aged.
• to smooth income over adult lifetime.
• For each aim there is a distinct structure
• State pension a flat rate pension to relieve
  poverty.
• Occupational/private pensions to give a degree
  of income smoothing over lifetime.
• Each has distinct method of financing
• State pension pay-as-you-go (social contract).
• Allows improvements immediately.
• Risk is demographic change/breakdown of social
  cohesion.
• Occupational/private pensions pre-funding with
  taxation incentives (financial contract).
• Improvements need to be financed over decades.
• Occupational pensions tend to be incomplete
  contracts.
• Large investment risk

6
Delivery of Current System
Breakdown of Income of Retired Couples in
Ireland, Year 2000
Source Hughes Watson (2005)
7
Delivery of Current System
Breakdown of Income of Retired Couples in
Ireland, Year 2000
Source Hughes Watson (2005)
8
Outlook for Current System Poverty Relief
Expenditure on Public Pension System in Europe,
Year 2000 and forecast Year 2050 as a of GDP
Source Economic Policy Committee (2001)
9
Outlook for Current System Poverty Relief

• No crisis in affordability of State pension
• Even allowing for real increases of the order of
  2 projected over 50 years
• Projected costs allow for pensions to be more
  than doubled in real terms by 2050.
• So elbow room to increase current real rate if
  desired
• Increase it immediately in real terms and index
  to prices rather than wages?
• Purchasing power of (State) pension now is lowest
  it will be!
• Make it a true, universal citizens pension of a
  single amount?
• So no complicated entitlement rules, no means
  test, separately paid to each individual in a
  couple
• This is closer to Charles Booths original
  proposal back in 1891

10
Outlook for Current System Income Smoothing
Occupational/Private Pension Coverage in Ireland,
by Age and Type
Source CSO(2004)
11
Outlook for Current System Income Smoothing
Growth in the Value of Assets of Irish Pension
Funds, 1983-2004
Source From IAPF Surveys
12
Outlook for Current System Income Smoothing

• Higher pensions from private/occupational schemes
  in short-term (next decades)
• Higher benefits and higher security
• But not significantly greater coverage
• But what is longer term outlook for
  private/occupational pensions?

13
Outlook for Current System Income Smoothing

• Pensions Act (1990) Amendments fundamentally
  changed regulation of defined benefit schemes
• Early leavers benefits improved
• liabilities increased
• key safety valve in financing schemes closed
• Funding Certificate
• imposes need to demonstrate regularly that
  termination liabilities are exceeded by assets
• required to fund revealed deficit over short
  time-scale
• Overall pension promise seen as a pension
  guarantee
• Increased cost burden creates threat to future
  role of the defined benefit scheme
• effect will be noticed only after a couple of
  decades.
• Income smoothing objective in doubt for long term
  future

14

• Irelands
• Pension Crisis
• is in
• Private not Public Provision

15
Closer Look at Current Policy Objectives

• Adequacy Target Half gross pre-retirement
  income, subject to minimum one-third of average
  industrial earnings
• Coverage Target 70 of workers over age 30 to
  have private pension

16
WHY?

• Adequacy Target
• Surely replacement ratio should be based on
  after-tax incomes
• Overstates pension required by those with high
  incomes?
• Why industrial wage in a service economy?
• Coverage Target
• What about those in non-remunerative employment
  who help society achieve the common good?
• What of Collective as opposed to Individual?
• The costs to society

17
Question

• Why do people not save for retirement?

18
Question

• Why do people not save for retirement?

19
Why to people save for retirement?

• Three-quarters of the 52 saving are members of
  occupational schemes
• Effectively compulsory savings
• Remaining 13 could be motivated by taxation
  incentives rather than retirement provision
• i.e., they intended to save anyway and do so by
  pension products because it is more tax efficient
  

20
Risk Transfer

• Risk discourages pension savings.
• Uncertainty might create complacency.
• Investment risk one of the key risks
• Prior to retirement.

21
Investment Risk before Retirement
Contribution Rate by Year of Age to Fund Pension
Accruing
22
Risk Transfer

• Risk discourages pension savings.
• Uncertainty might create complacency.
• Investment risk one of the key risks
• Prior to retirement.
• After retirement.

23
Investment Risk after Retirement
Real Value of Flat-Rate Pension for Retiree in
1971
24
Risk Transfer

• Risk discourages pension savings.
• Uncertainty might create complacency.
• Investment risk one of the key risks
• Prior to retirement.
• After retirement.
• The essence of the defined benefit scheme is to
  transfer risk from single individual to larger
  collective.
• Can we retain this essence?

25
Risk Transfer

• Risk discourages pension savings.
• Uncertainty might create complacency.
• Investment risk one of the key risks
• Prior to retirement.
• After retirement.
• The essence of the defined benefit scheme is to
  transfer risk from single individual to larger
  collective.
• Can we retain this essence?

26
Suggestion State Annuity Fund

• State assumes investment risk but on terms that
  are cost neutral over the long term.
• State issues index-linked annuities (or linked
  with rises in basic State pension) at fixed
  guaranteed rates to all retirees.
• Removes all risks after retirement (investment,
  longevity, default).
• Achieves full benefits of economies of scale.
• Brings clarity to the amount needed for a
  targeted pension.
• Helps individual/scheme manage risk
  pre-retirement as now targeting a lump sum at
  retirement.

27
Mechanics of State Annuity Fund

• All moneys from tax-exempted pension vehicles
  must be applied to purchase the State
  index-linked annuity come retirement age
• Otherwise cannot be cost neutral
• NTMA arranges investment of purchase money
• Perhaps it adopts a more matching investment
  strategy for these liabilities
• So National Debt is now redefined more broadly
• Pension payments in same manner as the basic
  State pension

28
Two Possible Extensions of Basic Idea

• Break the link between pension system and tax
  system
• So no tax relief on pension contributions
• But annuity rate made more generous to reflect
  net funds applied
• Taxation of net saving must then be reviewed
• With aim of reducing it, as pension fund would
  produce a negative real return over the very long
  term (100 years) with current tax system
• This achieves a huge simplification of system and
  reduces duplication of saving products (gross and
  net) but it is a radical proposal, necessitating
  complicated transition arrangements.
• Under the annuity scheme earlier, the annuity
  rate must change (infrequently) over the long
  term to reflect changes in longevity and
  long-term capital market trends
• Could keep annuity rate fixed but change
  retirement age to reflect?
• Or, use Turners suggestion, and divide each
  additional three years of life expectancy into
  two for working life and one for retirement
  (broadly in line with the current split).
• A decision in principle needed.

29
In Summary

• Majority will be dependent on State flat rate
  schemes for at least the next couple of decades
• State flat rate pension appears affordable into
  the future
• Elbow-room to increase level
• Simplify them all into one universal pension of
  single amount?
• There is a threat to DB Schemes
• DC or private schemes not up to the challenge to
  replace
• Must keep essence of DB scheme in new framework
• transferring risk to those more able to bear it.
• Suggest a compulsory State annuity scheme.
• Suggested two possible extensions of it.

30
A constructive critique of pension policy in
Ireland

• Shane Whelan
• UCD School of Mathematical Sciences