BASIC PRINCIPLES OF PENSION ECONOMICS

1
BASIC PRINCIPLES OF PENSION ECONOMICS

• by
• Estelle James
• World Bank Institute
  

2
Key choice Pay-as-you-go (PAYG) v. Funding (FF)

• We will discuss basic principles of pay-as-you-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

3
Pay-as-you-go (PAYG) and defined benefit (DB)
systems

• Most industrialized countries have PAYG DB
  systems Pension contributions are not saved.
  Instead, workers 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?

4
How to balance revenues and expenditures under
PAYG

• Total expenditures BP, total revenues CW
• Books are balanced (BP CW) 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

5
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)

6
Required contribution Rate depends on Benefit
Rate and Support RatioBut 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.

7
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--cant afford high payroll tax
• Difficult to change BR for pensioners, but can
  change promises for young workers

8
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

9
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, economic
  and policy variables in detail

10
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

11
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 (1r) B2/(1r)2 ... BT/(1r)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

12
Implicit Public Pension Debt, 1990
Explicit debt
Canada
Implicit public pension debt
France
Germany
Italy
Japan
United States
0
50
100
150
200
250
300
Percentage of GDP
13
Implicit pension debt in industrial countries

• gt 100 GDP in most industrial countries
• gt 200 GDP in some countries
• gt 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--60-70
  GDP--because of low coverage rate
• China is in better position to shift to funded
  system and avoid high pension debt.

14
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 governments
  budget, less resources for other services
• risk for workers if future pensions are not
  affordable

15
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 3/1 13.3
• 60 2/1 20.0
• 50 1/1 40
• Evasion and arrears make matters worse

16
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

17
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

18
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) buildsgt100 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 individuals account.
  Pension depends on accumulated contributions
  investment earnings. Doesnt depend on W/P.
• But depends on rate of return--so fund
  management and investment choice are crucial

19
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 gt 30
• Rate of return is crucial Suppose worker works
  40 years, retires 20 years, wage growth2, CR8
  (China)
• Then If interest rate, r 2, RR 20 under
  FF DC,
• 4, RR
  36
• 5, RR
  48
• Where RR replacement rate of workers final
  year wage
• Each interest rate point raises RR 8-12 or cuts
  CR

20
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 gt rate of wage growth otherwise
  funds in account grow slower than wages and FF DC
  gives low replacement rate of final years wage.
• Will be big problem in China unless investment
  policy changes

21
Contribution rate required to pay replacement
rate 40 under PAYG and funding
Contribution rate
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
Workers/pensioners
22
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
  Important that r gt wage growth rate

23
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/(1r) PP2/(1r)2 PP10/(1r)10 AC This
  is actuarially fair pension EPVPP AC

24
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 gt 15 Will cost
  more than expected--burden to MOF
• Will get worse as life expectancy rises

25
Example of how life expectancy after retirement
affects pension under actuarially fair FF DC

• Suppose r5, wage growth2, CR8
• 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
  

26
Important to simulate expected pension under DC

• Under funded DC plan, system does not guarantee a
  particular benefit. But policy-makers 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.
• Shouldnt 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.

27
Evasion

• Under FF DC if worker evades making
  contributions, his account remains small, his
  pension is small
• This is bad for him, but it doesnt 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

28
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 wont be paid.

29
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

30
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