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BASIC PRINCIPLES OF PENSION ECONOMICS

• by

• 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-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

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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

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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 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.

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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 can change promises for young workers

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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, economic and policy variables in detail

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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

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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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Percentage of GDP

0 50 100 150 200 250 300

France

Germany

Italy

Canada

United States

Japan

Explicit debt

Implicit public pension debt

Implicit Public Pension Debt, 1990

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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--60-70% GDP--because of low coverage rate

• China is in better position to shift to funded system and avoid high pension debt.

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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– risk for workers if future pensions are not affordable

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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

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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

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5

10

15

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0 2 4 6 8 10 12

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PAYG

Contribution rate

Workers/pensionersAssumptionsrate of wage growth = 2%worker works 40 years, retires for 20 yearsr = net rate of return for funded planhorizontal lines show FF DC; for top line r = 2% and for bottom line r = 5%

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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 Important that r > wage growth rate

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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

• Will get worse as life expectancy rises

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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 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.

• 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.

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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

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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.

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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