rethinking pension reform: late prof. franco modigliani & arun muralidhar dr. arun muralidhar
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Rethinking Pension Reform:
Late Prof. Franco Modigliani
& Arun Muralidhar
www.mcubeit.com Dr. Arun Muralidhar
The New Yorker
New Yorker, June 1999
Franco TributeFranco Tribute
3
Agenda U.S. Social Security and current problems
Case for funding (and investing in equities)
Privatization - European & South American experience
A swap ensures DB and no manipulation of assets
The impact of these proposals on market efficiency
The impact of reform on the budget and the asset management industry
4
The Pension Fund Balance Sheet
FutureFutureContributionsContributions
Current Current AssetsAssets
FutureFutureReturnsReturns
PENSION PENSION BENEFITSBENEFITS=
Funded ratio = assets/liabilitiesFunded ratio = assets/liabilities
Can be funded completely, partially or PAYGO
5
Background on U.S. Social Background on U.S. Social Security Security
Pay 12.4% of salary as contribution (w. caps at $87,900)
Contributions split equally between employer and employee
Average benefit = 50% of average of 35 best years of salary
Defined benefit, but redistribution (top earnings bracket may get only 35%; lowest can get 70%)
“Pay-As-You-Go”: Some funding thanks to Alan Greenspan
For many, SS accounts for 90% of retirement income!!
Inflation adjusted pensions
6
Background on U.S. Social Background on U.S. Social Security Security
Receipts = $630 bn; Payments = $480 bn
Trust Fund = $1.5 trillion
47 mn people receive benefits; 154 mn people covered
Trust Fund projected to grow to $4 trillion by 2013
Current surpluses are invested in “government debt” – earned 6% in 2003
Problems not immediate – can go on for 40 years
7
PAYGO Formula
Taxable Wages* SS tax = Pension Benefits
Taxable Wages depends on Rate of Growth of Real Income (Labor Force + Productivity Growth)
Increasing longevity increases pension benefits
Often, no incentive to control pension promise
Ratio of contributing worker to pensioner dropped from 9 to 2-3
A “Ponzi” Scheme and the Bjorn Borg solution……..
8
Need for Reform – Social Security Crisis
Pay-as-you-go (PAYGO) systems face a crisis
Caused by low population and productivity growth
Contributions will need to rise dramatically or benefits will need to be cut to be sustainable
Often, there is a poor link between contributions and benefits; benefits are often too generous
Many countries do not have budget cushions to bail out these systems – Maastricht Criteria!!
Two different issues: (1) Best System; (2) Transition
Need for Reform - The U.S. Case
Contribution rates without reform
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074
Year
Per
cen
tag
e o
f to
tal
wag
es p
ayab
le
Effective Cost Ratio
Current contributions
Current contribution
12.4%
Contributions without Reform
Problems are much worse in Europe, Emerging Mkts!!
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Latin America and Europe
In many European cases, current contributions are as high as 30% of salaries – projected to rise further!!
Benefits very generous – often 100% of final salary
Pension cost can be as high as 6-10% of GDP
Rates of return in the 1980s of governmental systems often very negative (-37% p.a. in Peru)
Projected rate of growth of labor force + productivity < rate of return on assets
11
PAYGO versus Funding
Long term, Funding = lower contributions (r > population growth + productivity growth)
Volatility of contribution under PAYGO is very high
No savings – contributions finance dissaving of the elderly
Cannot just transition immediately, as Funding dominates because funds were set aside
Funded systems can impact capital markets
Funding implies some investment in equities
12
When Funding Dominates….Cost and Contribution Rates for Alternative Systems and Selected ScenariosAssumptions: Working Life = 40 Years; Average Salary = 50% Replacement
Cost Ratio = Pay-as-you-go Scheme Contribution Rates for Different Scenarios
Retired Life - 16 Years Retired Life - 18 Years
Real Productivity Growth Real Productivity Growth0% 1.00% 1.40% 2.00% 0% 1.00% 1.40% 2.00%
Population Growth
0% 20.00% 15.40% 13.40% 11.90% 22.50% 17.20% N/A N/A1% 15.05% 11.70% 10.40% 9.00% 16.77% N/A N/A N/A2% 11.24% 8.80% 7.00% N/A 12.41% N/A N/A N/A
Table 3.1BCost Ratio = Funded Scheme Contribution Rates for Different Scenarios
Retired Life - 16 Years Retired Life - 18 Years
Real Productivity Growth0% 1.00% 1.40% 2% 0% 1.00% 1.40% 2%
Return on Assets0% 20.00% 20.11% 20.15% 20.23% 22.50% 22.62% 22.67% 22.75%1% 15.05% 15.33% 15.45% 15.63% 16.77% 17.08% 17.21% 17.41%2% 11.24% 11.60% 11.75% 11.97% 12.41% 12.81% 12.97% 13.22%3% 8.33% 8.70% 8.86% 9.10% 9.12% 9.53% 9.70% 9.96%4% 6.13% 6.48% 6.63% 6.86% 6.66% 7.04% 7.21% 7.46%5% 4.49% 4.80% 4.93% 5.14% 4.84% 5.17% 5.32% 5.54%6% 3.26% 3.53% 3.64% 3.82% 3.50% 3.78% 3.90% 4.09%
Approx. replacement 50% 41% 38% 34% 50% 41% 38% 34% on final salary
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The Golden SS Funding Rule
c* + (r-)At-1*= p*
c* is the contribution rate, r is the nominal return on investments, is the growth of income = population growth + productivity growth (r- is the net return defined as the gross rate of return from investments and reduced by adjustments for productivity growth and population growth)
A* is the steady state asset ratio to wages, and p* is pension cost relative to the wage bill or cost ratio.
14
DB versus DC – can look similar
DB: Inter and intragenerational risk sharing
DB: sponsor bears the risk; pooling lowers cost
DC: Offers choice to individuals who bear the risk
DC: Allows for bequeathing assetsKEY EQUATIONContributions, compounded at the expected return on assets (with or without volatility)
= Expected final wealth at retirement = Expected present value of desired annuity as
of the retirement date
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The 3-Pillar Approach (World Bank)
Pillar 1: PAYGO; DB; Government; Mandatory
Pillar 2: Funded; DC; Private; Mandatory
Pillar 3: Funded; DC; Private; Voluntary
Because Pillar 1 was struggling – changed all aspects.Bush Administration favors creation of Pillar 2.
Privatization only privatizes risk!!
16
Problems with Privatization Model The key problem is only a financing problem
Was meant to keep government away from funds
Individuals are gambling with retirement funds
Private accounts = high fees = lower pensions
Can lead to unpredictable pensions
Value of choice overrated – e.g., Sweden, Australia
U.S.: Shift 2% of contributions from SS – how??
Governments and individuals will pay a lot to ensurethat elderly do not retire poor
17
Problems with Privatization Model
Fees take a huge chunk out of pensions
Gross Gross Gross Gross Loss on Replacement Replacement Replacement Replacement ReplacementFinal Salary Average Salary Final Salary Average Salary Final Salary
(1) (2) (3) (4) (5) = (1)-(3)Argentina 70.0% 222% 47.00% 148% 23%Chile 93.0% 296% 72.00% 228% 21%Columbia 93.0% 296% 79.00% 249% 14%Mexico 112.0% 356% 86.00% 274% 26%Peru 75.0% 238% 63.00% 199% 12%Uruguay 70.0% 222% 51.00% 162% 19%
Gross Net Fees "Seepage"
(% of wages) (% of wages) (% of wages) =Fees/GrossArgentina 7.5% 5.0% 2.5% 33.3%Chile 10.0% 7.7% 2.3% 23.0%Columbia 10.0% 8.4% 1.6% 16.0%Mexico 11.5% 8.8% 2.8% 23.9%Peru 8.0% 6.7% 1.3% 16.3%Uruguay 7.5% 5.5% 2.1% 27.3%
Contributions
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Will Chile Get Pickled? Hidden Debt
Mandatory participation = DB will lead to lowest debt
Table 4.8: Results with 40 different participants in the plan
INVESTMENT POLICY: EXPECTED RETURN 6.5 PERCENT, VOLATILITY 5.2 PERCENT
Probability That Participant Will Not Meet Their Target Wealth
Expected Amount by Which the Participant is Below Her Target Wealth
Downside Risk When the Participant is Below Her Target Wealth
Expected Debt of the Plan
DC 53.6 percent 36,562 8.8 percent 6,236,624
CFDB 53.3 percent 23,590 5.7 percent 4,670,100
Welfare gains of CFDB (i.e., the difference between DC & CFDB)
Absolute
Relative
0.3 percent
0.6 percent
12,972
55.0 percent
3.1 percent
54.4 percent
1,566,525
33.5 percent
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Problems with Transitions
Need to get the funded system going with money
Debt financed transitions risky – a big leverage play
Surplus financed transitions are best
Problem: President Bush blew the surplus
Tax rebates will come to roost in higher contributions or consumption taxes
Intergenerational issues are key – who pays?Transition does not require “double contributions”
20
Transition to Partial or Fully Funded?
Full funding implies the Golden SS rules applies
To get to full funding, transition cost is very high
Asset-wage ratio = 3.5X (or 2.3X national income)
Partial funding requires smaller cost
In the US case, assumed 1.1% extra contributions; asset-wage ratio = 1.6X (or 1.1X national income)
Full funding would crowd out private investors
Some argue that a 1.9% increase could keep PAYGO
21
Even Australia/Sweden will Struggle
Australia: Mandatory participation (driven by Labor)
Some company DB schemes, but largely DC
Pooled people into industry schemes – lower cost
Problems: Too many small schemes – cost is high
Not sophisticated: consultants used = additional fees
Potential conflicts – trustees can represent AM firms
Where choice offered – not used!!
Estimated reduction in pensions 10-15% (Bateman)
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Our Solution – Only Two Pillars
Pillar 1: Funded (Partially or Fully); DB; Public Governance/Private Management; Mandatory
Pillar 2: Funded; DC; Private; Voluntary (Pillar 3)DB = Guaranteed Return on Contributions
Assets Pooled to Minimize CostsSwap between Treasury and SS to
Guarantee ReturnBlue Ribbon Board like Canada and
IrelandVariable Contribution to Minimize Risk to
Govt.
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How Does the Swap Work?
SSA pays Treasury return on invested portfolio; Treasury pays SSA guaranteed real rate + inflation
Long term swap rate = 5% real
Invested in mkt cap weighted index (stocks + bonds)
Prevents manipulation of funds = shows up in the budget as payment in the swap
SS is always whole; smoothes returns over decades
Government (best risk taker) bears risk
Create a sinking fund; allow variable contributions
24
Why Our Solution Is Better?
Contributions are Lower and More Predictable
Benefits are Protected (and Minimizes Cost to Governments and Participants)
Lower Asset Management Costs
Better For Unsophisticated Participants
Access to DB and DC Leads to Optimal Choice
Choice is not really exercised: Australia, Sweden
Transition cost borne equally by all generations
Explaining the Transition – Zero Growth
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2052 2054 2056 2058 2060
Pensions (CR)
Required Contribution (ex Transition Cost)
Zero Growth Scenario: Transition from PAYG to Funding
(% Taxable Payroll)
Interest on TF
Transition Cost
NF Pensions
NF Contributions
22.5%
4.84%
27.34%
Transition to New System - The U.S. Case
Comparison of Contribution Ratesunder Different Reform Scenarios - Smoothing Contributions
0.00%
5.00%
10.00%
15.00%
20.00%
2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074
Year
Per
cen
tag
e o
f to
tal
wag
es p
ayab
le
Effective Cost Ratio
Household Contributions with Proposed Plan
Transition Cost
Current contribution
Interest from Trust Fund
M Contributions
12.4%
13.5%
14.4%
27
Investment Issues
Should portfolio be U.S. only or global?
Initially U.S., but ideally global return on capital
Should assets be managed passively or actively?
Initially passive, but ETFs can allow active
Role of alternative assets?
Canada has already invested in alternatives
Internal or external? No strong bias
Too much passive – implications for voting & valuation
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The Appropriate Rate of Return…..
Average return on equity has been remarkably stable - around 7% (Siegel 1994 and 1999).
The return on equity corresponds to profit; profit is not a satisfactory measure of the return on capital when the firm is financed partly by debt
Investing in an indexed portfolio of an share of the market portfolio of stock and bonds (70:30).
Estimate of the real interest rate =3%
Equals an estimate of return on capital of 6% -- (Bosworth (1996) arrives at an estimate of 6.2%)
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The Appropriate Rate of Return….
Must look at pre-tax value as that is relevant to Treasury
6% return on total corporate capital after corporate tax.
Corporate income tax = 30% on the levered profit, plus a 30% debt at a real interest around 3.3%, results in an estimated 8% of the pre-tax return on total capital,
1% for interest, 7% for equity before tax, of which 2% is attributable to the tax
This estimate of a pre-tax return on the unlevered market portfolio is close to a well-known estimate of Poterba (1998)
Gives the Treasury a premium of 3% for bearing risk
How To Achieve Retirement Objectives – The Two Pension Fund Theorem
0
20
40
60
80
100
Replacement
Rates (%)
Probability of notachieiving a
replacement rate
GuaranteedReplacement Rate
MarketPortfolio-M
B
A
Markowitz EfficientFrontier
A’s Investments :70% DB, 30% Market Portfolio
B’s Investments: 50% DB, 50% Market Portfolio
31
Pillar “3” is No Breeze
Average sophistication is low
Poor advice on asset allocation (strategic & tactical)
Too much focus on manager selection
Rating schemes are poor – Morningstar, IR tells you little about risk-adjusted performance, skill etc.
Measures that do (M2, M3, SHARAD, Q-sum) beyond reach of most individuals
Fees can be mitigated through ETFs etc.
32
ConclusionsConclusions Do not fix what is not broken (DB)
Do not transfer risk and choice to those least capable of bearing or using it
Invest in the market with guarantee structure
A combination of DB and DC are critical
Variable contributions to manage risksLonger the delay to reform, the higher the
cost
AppendixAppendix
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Arun Muralidhar - BioArun Muralidhar - Bio
Chairman of Mcube Investment Technologies, LLC and Managing Director at FX Concepts, Inc.
Author of “Innovations in Pension Fund Management”
Head of Investment Research and Member of Investment Management Committee, World Bank Investment Department, 1995-1999
Derivatives and Liability Management, World Bank Funding Department, 1992-1995
Managing Director and Head of Currency Research, JPMIM, 1999-2001
BA, Wabash College (1988); PhD, MIT Sloan (1992)