Key Social Security Policy Choices in Thailand

by

Estelle James

Key policy choices that affect sustainability, equity, growth

• Structure:– Pay-as-you-go (PAYG) or funded (FF)?– Defined benefit (DB) or defined contribution (DC)?– Public or private management?

• Substance– What is the target replacement rate?– What is the normal retirement age? – How much and what kind of redistribution?– How much coverage?

1. Pay-as-you-go (PAYG) v. Funding (FF)

• Most industrialized countries have PAYG systems: Worker’s (W) contribution today is used to pay pensioners (P) today.

• Required CR = (RR)/(W/P) where CR = contribution rate, RR = replacement rate, W/P = support ratio

Example of PAYG• Assume:

– promised benefit (RR) = 40% wage

– System is new & populations young, W/P = 8.

– So each point of CR yields 8 points RR.

• Then: 40% RR requires 5% CR (Thailand today has even higher W/P, lower CR--new system)

• But:– As populations and system age, W/P = 2.

– So each point of CR yields 2 points RR.

• Then: 40% RR requires 20% (Thailand 2030?)

• In long run W/P < 2, each point CR yields < 2

Advantage of PAYG system

• Low contribution rate needed in early years. Easy to pay current generation of retirees, and they get benefits that far exceed their contributions

Problems with PAYG systems

• Non-sustainable: Initial low CR is deceptive because few retirees, but high contribution rate needed as system matures and populations age.

• Equity: first cohorts get large redistribution (B>C), later cohorts lose

• Security: Overly generous benefits promised at first, but high political risk: promises may not be kept in future because of high costs

PAYG Problems (Cont’d): Impact on economic growth

• High payroll tax later may decrease formal sector employment and income

• Initial transfer decreases national saving

• Hidden implicit pension debt (IPD) accumulates--present value of obligations to workers (figure)

• Future burden may be shifted to government’s budget, less resources for other services

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

Fully funded systems• Assets are accumulated to match liabilities, and

earn interest, so no IPD, unaffordable promises or inter-generational transfers

• Can be used to increase sustainability, national savings and growth

• Requires higher CR initially, much lower CR later; that is why many countries are moving toward pre-funding

• But: financial market risk--so fund management and investment choice is crucial

Example : FF system• If funds earn 5% interest, each point of CR yields 6 points

of RR, so 40% RR requires only 7% CR; while PAYG in long run would require > 20% CR

• Rate of return is crucial: Suppose worker works 40 years, retires 20 years, wage growth=2%, CR=10%.

• Then: If r = 2%, RR = 25%,

– 4% 44 %

– 5 % 60%

• Each interest point raises RR 10-15 percentage points

• If r > 2%, FF costs less or gives higher benefits than PAYG in long run

Contribution rate required to pay replacement rate = 40% under PAYG funding

0

5

10

15

20

0 2 4 6 8 10 12

7

17

PAYG

Contribution rate

Workers/pensionersAssumptionsrate of wage growth = 2%r = net rate of return for funded planPension is indexedworker works 40 years, retires for 20 years

2. Defined benefit (DB) v. Defined contribution (DC)

• In DB benefit depends on number of years worked and wages per year, according to formula

• In theory--benefits are guaranteed – but in practice promises too generous, not kept

• In theory--could penalize early retirement – but in practice usually doesn’t

• In theory--provides safety net to low earners– but in practice high earners often benefit the most– DB pillars in L. America, Ireland, Switzerland, HK

redistribute to low earners in different ways

Defined contribution plans (DC)• Contribution is specified; retirement income depends on

accumulated savings + interest

– Close link between benefits and contributions

• No hidden redistributions to high earners

– but other safety net is needed for low earners

• Rate of return determines accumulation, pension

– so high rate of return important, benefit uncertain

• For company plans--DC more portable than DB

• Provident funds in Thailand are DC: What is rate of return? expected benefit? Are funds portable? are annuities available? Where is social safety net?

Questions for new Thai plan• Sustainability:Thailand recognizes need for pre-

funding. New DB system is partially funded at first--but becomes PAYG as soon as workers start to retire. By 2020’s system will run deficit.

• How much will contribution rate rise in future, how much will benefit rate fall?

• Equity: How much will present generations gain, future generations lose?Where is social safety net?

• Growth: What is impact on employment, formal-informal sectors, retirement age, long term saving? Will large IPD build up, become govt burden?

3. Public v. private management?• Crucial question: if funds are accumulated, how

will they be managed and invested?

• Empirical evidence shows private competitive management earns higher return than public management--portfolios are diversified, economic rather than political criteria determine investments

• New plans in Latin America, Hong Kong use private management; Ireland is trying to insulate public funds from political control

Difference between annual compounded real publicly-managed pension fund returns and bank deposit rates in 20 countries (from worst to best)

-1.8%

-12% -10% -8% -6% -4% -2% 0% 2% 4%

Japan

Kore a

Philippine s

Sw e de n

US

M ala ys ia

India

Morocco

Singapore

Canada

Jam aica

Cos ta Rica

Ke nya

Guate m a la

Sri Lank a

Ecuador

Egypt

V e ne zue la

Zam bia

Uganda

Ave rage

gros s re turns m inus bank de pos it r ate

Difference between real annual compounded publicly-managed pension fund returns and real income per capita growth in selected countries

Source: IMF International Finance Statistics; Authors’ calculations.

-8.4%

-50% -40% -30% -20% -10% 0% 10%

Philippines

Morocco

US

Sweden

Malaysia

Canada

India

Japan

Korea

Jamaica

Sri Lanka

Singapore

Kenya

Guatemala

Costa Rica

Ecuador

Tanzania

Egypt

Venezuela

Zambia

Uganda

Peru

Average

gross returns minus income per capita

-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

United Kingdom (84-96)

Sweden (84-93)

United States (84-96)

Belgium (84-96)

Chile (81-96)

Ireland (84-96)

Netherlands (84-96)

Spain (84-93)

United Kingdom (70-90)

Australia (87-94)

Denmark (84-96)

Switzerland (84-96)

Japan (84-93)

Netherlands (70-90)

Hong Kong (83-96)

Denmark (70-88)

Canada (75-89)

United States (70-90)

Japan (70-87)

Switzerland (70-90)

Average public schemes

Average private schemes

Gross returns minus income per capita growth

Funded plans in Thailand• Crucial question for Thailand--how will provident funds,

public employees’ pension fund and partially funded DB plan be invested?

• Will they maximize return and productivity?• How will private funds be regulated?• How will public funds be insulated from political

manipulation? • Dilemma: build-up of funds in new DB plan and GPF can

reduce required CR in future, but increase political manipulation. Can private competitive management prevent this?

International experience

• In next few days we will discuss how many countries --Hong Kong, Singapore, Malaysia, Latin America, Switzerland--have handled questions of funding v. PAYG and how to manage funds--advantages and problems of each system--to help analyze what is best system for Thailand

4. What is the target replacement rate?

• Replacement rate (RR) tells how large pension is compared with wage level

• Higher RR requires higher CR--so trade-off between consumption when young and old

• Young have children, work expenses

• Rule of thumb: mandate 40-50% RR, those who want more can save more, redistribute to poor. Many countries pay pensioners more, but this costs more when young

Replacement rate in Thailand • New DB system provides RR = 35% for worker with 35

years contributions• This is modest benefit but in medium term will require

>20% CR if PAYG• Below poverty for low earners• Should RR be raised, espec for low earners?• Or should PAYG part be reduced and part of burden

shifted to funded plan? If PAYG RR were 20% and funded plan provided 20%, this would cut long run CR to 14% instead of 20%.

• Funded part: second pillar of multi-pillar system--we will discuss further.

5. Normal retirement age

• Retirement age has big effect on pension fund and economy

• Impact on required CR:Suppose PAYG, stable population, people start work at age 20, die at 80, RR = 40%:– if retirement age = 60, W/P = 2/1, CR = 20%

– if retirement age = 65, W/P = 3/1, CR = 15%

• Later retirement age decreases CR, increases experienced labor force, GDP, growth

Retirement age in Thailand• Currently retirement age in Thai system is 55,

no actuarial penalty for early retirement or reward for postponed retirement. This raises dependency rate, CR, lowers RR

• Workers in formal sector, covered by social security, live longer than average

• Does Thailand want to keep low retirement age, or to raise benefits, or to cut long run contribution rate instead? Early retirement is very costly, to the system and economy

6. What kind of redistribution?

• Should social security be redistributive or tie benefits to contributions? If redistributive, toward whom?

• Most analysts say close benefit-contribution link (DC) reduces work disincentives but safety net for low earners should also be provided (well structured DB)

• In new Thai DB plan chief gainers are: high earners, early retirees, first cohorts to retire; no safety net

• Noncontributory means-tested scheme targeted toward rural poor

• Is this the redistribution you want?

7. Coverage by contributory system--how fast to increase?

• Currently only 25% of labor force covered• Important to expand. How fast? Expand when:• Inclusion will make workers better off, not

worse off: low earners may be better off with more take-home pay, family system for old age

• System is sustainable, equitable, good return• Government has capacity to monitor

compliance--avoid culture of evasion• Public program won’t crowd out family system

Policy choices for Thailand• Aging rapidly, needs economic growth• How high total replacement rate and how much

from PAYG v. funded, DB v. DC, public v. private management?

• How should pension funds be invested? • How can public funds be insulated from political

manipulation?• How should private funds be regulated? • What should normal retirement age be, how to

discourage early retirement?• How to target redistributions and how fast to

increase coverage?• Answers determine sustainability, equity, growth