Success Stories in Social Security

Congreso de l’Asociación Colombiana de Actuários

Bogota, Colombia

23 November 2011

Chris Daykin, Chief Executive, IAA Fund

The need for reform

Problems facing many social security schemes• demographic ageing• effective retirement age too low• poor overall levels of coverage• inadequate or volatile outcomes from DC schemes• inadequate protection against longevity in DC schemes• perverse incentives affecting behaviour, e.g. retirement

Drivers of pension reform

What are the principal drivers for policy-makers?• to ensure sustainability of structure and financing• to avoid large increases in public expenditure• to reduce intergenerational dependency• to reduce perverse incentives in labour market• to improve retirement incentive structures• to improve incentives for saving• to increase the level of coverage

Pension reform

Reform strategies• contribution adjustment and reform• benefit adjustment and reform• reform of retirement age and structures• new approaches to financing old schemes• development of funded supplementary pensions• comprehensive or structural reform (including re-reform)

Typology of reform

Contribution adjustment and reform• raise contributions as needed to meet PAYG costs• increase coverage of scheme• facilitate participation of migrants to increase income• reform contribution structure to achieve redistribution• tackle abuse and non-compliance to reduce leakage

Typology of reform

Benefit adjustment and reform• modify indexation of benefits• modify benefit calculation (e.g. averaging period)• remove incentives to early retirement• provide encouragement for later retirement• tighten eligibility conditions for award of disability pension

Typology of reform

Changes to retirement age• an obvious choice – increases contribution period and

reduces pay-out period• …but is it politically acceptable?

– United Kingdom (to 66 by 2020 and 68 by 2046)– Germany (to 65 by 2009(M), 2015(F))– Italy (from 55/50 to 60 and then 65)– United States (from 65 to 67 by 2022)– Japan (from 60 to 65 by 2014(M), 2019(F))– Denmark (from 67 to 65)

Typology of reform

New approaches to financing• shift some of the cost to general revenue• introduce additional ear-marked taxation• pre-fund part of the future liability• introduce funded component

Typology of reform

Possible structural reforms of social security• introduce funded individual accounts• move to notional defined contributions• introduce or increase flat-rate element• …or introduce non-contributory demogrant (basic pension)• link pension to residence instead of contributions• make greater use of means-testing

Influence of World Bank

Let’s go back to 1994 (“Averting the Old Age Crisis”)

World Bank recommend a multi-pillar system

1st Pillar

Mandatory unfunded public defined benefit social security

2nd Pillar

Mandatory funded, privately managed defined contribution

3rd Pillar

Voluntary savings retirement plan (or occupational pensions)

Pension reforms

Individual account reforms• inspired by the reform in Chile in 1981• but now including most countries in Latin America• also several countries in central and eastern Europe• using competitive private sector investment vehicles• mandatory for formal sector workers• compulsory purchase of annuities at retirement• …or some form of programmed withdrawal

Pension reforms

The Chilean model• reform of 1981• compulsory contributions to AFPs• choice of pension fund (AFP)• underpin on annual return• recognition bonds for previous rights• high levels of transaction costs• minimum pension guaranteed by state• surprisingly high fiscal costs of guarantee

Pension reform in Chile

The Chilean model• has this been a success story?• has it lived up to its early promise?

– many years of good returns (Chile was lucky in its timing)– less good performance more recently– concern about costs of minimum pension guarantee– and lack of protection for many workers

• it certainly inspired many other reforms• but Chile is now implementing new reforms

– particularly focused on introducing a universal basic pension

Pension reforms

Individual account reforms – general experience• coverage is still a problem…• …individual account structure is not a sufficient incentive• transaction costs are generally quite high• churning and mis-selling have been an issue• too many people will qualify for the minimum pension• minimum pension creates incentive problems of its own• individual accounts perpetuate income inequalities • investment and longevity risks fall on individuals• some governments have attempted to turn the clock back

Pension reforms

Problems with pay-out phase• uncertainty about life expectancy• programmed withdrawal has potential problems• need for more annuitisation to protect pensioners• compulsory annuitisation may be unpopular• high concentration of longevity risk for insurers• need for very long-dated bonds to match liabilities• preferably index-linked if backing indexed annuities• investment mis-match risk for insurers

Pension reformsWorld Bank new framework (2005)Pillar zero

Non-contributory scheme providing minimal level of protection

1st Pillar

Mandatory unfunded publicly managed DB or NDC providing some longevity insurance

2nd Pillar

Mandatory funded and privately managed DC (or DB)

3rd Pillar

Voluntary savings plans – regulated and privately managed

4th Pillar

Informal intergenerational financial and non-financial support

NDC

Notional (or non-financial) defined contribution• structured as defined contribution… • … but on a PAYG basis rather than funded• clear link between contributions and benefits• choice of revaluation approaches• targets lump sum at pension age…with ‘notional’

purchase of an annuity• permits flexibility of retirement age• passes on part of longevity risk• needs some mechanism to keep it in balance

NDC

Why has the World Bank become so keen on NDC?• DB is seen as “flawed” – heterogeneous characteristics• NDC creates better incentive structure

– benefits linked directly to contributions– penalty for retiring early– good trade-off between work and leisure

• internalises adjustment to life expectancy• can be made self-adjusting in other ways• radical change easier to effect• much harder to “game” than DB

NDC - Sweden

The Swedish reform in 1994• previous DB social security scheme replaced by NDC• …with fairly rapid transition• revalorisation of individual accounts by average wage• credits for sickness and other absences• automatic economic regulator of pensions increase• annuity responds to improving mortality• automatic balancing mechanism

NDC - Sweden

Automatic balancing mechanism (actuarial accounting)Annual balance sheet for scheme:

Liabilities = present value of all future outlay for pensions in payment+ accumulated individual accounts for all persons not yet in

receipt of a pension

Assets =real assets in buffer fund + value of future contributions

Value of future contributions = contribution rate x wage mass x expected turnover duration

NDC - Sweden

Expected turnover duration

0

20

40

0 5 10 15 20 25 30 35 43 50 55 60 65 70 76 85 90 95

Ste

ady

stat

e pe

nsio

n lia

bilit

y

(in y

ears

of c

ontr

ibut

ions

)

= turnover duration 33 years

Age group

Expectedincome-weighted

age of income earners

Pay-in duration + Pay-out d.

Expected pension weighted age of pensioners

Expected pension-capital-weighted average retirement age

1

00 5 10 15 20 25 30 35 43 50 55 60 65 70 76 85 90 95

= turnover duration 33 years

Age group

Expectedincome-weighted

age of income earners

Pay-in duration + Pay-out d.

Expected pension weighted age of pensioners

Expected pension-capital-weighted average retirement age

NDC - Sweden

Overall evaluation• hailed by some as a success story• imitated (partially) in several other countries• provides a sustainable PAYG system, but…• rising concern about expected fall in replacement ratios…• …and arbitrary effect of automatic balancing mechanism• impact is difficult to communicate and could mean major

changes to generosity of benefits without political debate

NDC

Should we regard NDC as a success story?• in some ways, yes• DC-like design is attractive in terms of transparency• leaving annuitisation until retirement increases flexibility• …and reduces exposure of scheme to longevity risk• automatic balancing mechanism is smart technical solution• …but there are questions over political sustainability

Where else might we look?

Chile and Sweden• at different times hailed by World Bank as models• both have demonstrated a degree of success• both have their critics and will not last for ever

• so are there systems which have stood the test of time?• are there reforms which now seem to be well settled?

Denmark

Denmark has seen little change since 1964• Basic old-age pension (Folkepension)

– paid on basis of residence– flat-rate (not depending on income)– financed from general revenue (i.e. no “contributions”)

• ATP (supplementary labour market old-age pension)– mandatory defined contribution– invested by government agency (ATP)– diversified growth fund providing equity like returns

• but without volatility of full equity exposure

– capital guarantee

• employer-sponsored complementary DC plans– with high levels of coverage since essentially compulsory

Finland

Finland has been through several reforms, but now…• mandatory earnings-related scheme• industry-wide rather than linked to individual employers• basic pension provides a minimum pension guarantee

– measured against earnings-related pension– so no general means-test or asset test– very efficient mechanism of providing underpin to income

• accrual of pension based on career average earnings• variable accrual rate

– 1.5% a year from 18 to 52– 1.9% a year from 53 to 62– 4.5% a year from 63 to 68

Finland

New approach to dealing with demographic ageing

by introducing life expectancy coefficient:

Life expectancy coefficient for year N (>2009) =

cohort life expectancy for those reaching 62 in 2009

cohort life expectancy for those reaching 62 in N

Multiply pensions of those reaching 62 in N

by life expectancy coefficient for year N

Thus adjusting a DB pension benefit for improving life expectancy

Australia

Mandatory super (or Award Superannuation)• basic social security payable only on a means-tested basis

– and also with an asset test

• mandatory minimum level of contributions to DC scheme• Super schemes are marketed to employers or industries

– Master Trusts (for a variety of employers)– Industry Funds (for particular industries)

• Minimum contribution rate – 9% from employers– voluntary contributions from employees– government matching of employee contributions for low income– discussion about increasing to 12%

New Zealand

Citizenship pension + Kiwisaver• basic citizens’ pension

– flat rate of benefit at or just above means-testing level– indexed to national average earnings– eligibility dependent on period of residence in NZ– individual entitlement, whether single or married

• Kiwisaver– new, voluntary, work-based savings scheme– automatic enrolment for those starting new job– those in a job will be able to join if they wish– contributions from employees at 2%, 4% or 8%– employers must contribute 2% and may contribute more– contributions collected by Inland Revenue through PAYE

Canada

Multi-pillar system• Old-age security (partly means-tested)

– financed from general revenue budgets

• Canada Pension Plan (career average DB scheme)– contributions at 9.9%– excess over PAYG rate is invested in markets by CPPIB– actuarial control and automatic adjustment mechanism– three-yearly valuation produces ‘steady state’ contribution– if steady state rate is higher than 9.9%... – …and ministers cannot agree on what to do– then automatic adjustment mechanism is triggered

• employer-sponsored pension plans – now mostly DC

Canada

Automatic adjustment mechanism • contribution rate is increased over 3 years by ½ of

excess of steady state over 9.9% (subject to maximum increase of 0.2% a year)

• benefits are frozen (i.e. not indexed any more)• after 3 years, situation is reviewed following new

actuarial valuation

Netherlands

Keeping a defined benefit system in place • basic old-age pension is flat-rate and non-contributory

– financed out of general revenue

• employees are members of industry-wide DB schemes– negotiated by collective agreement– compulsory membership as part of those agreements– conditional indexation– contribution rates for employers and employees are fixed– scheme is kept in balance by

• adjusting indexation• raising retirement age• adjusting benefits in other ways

– system under a lot of pressure and due for further reform

Pension Sustainability Index

Some general lessonsSharing longevity risk1. target lump sum at retirement…

– …and convert to pension using current annuity value– …funded individual accounts or NDC

2. index retirement age based on cohort expectation of life...– or maintain ratio between working and retired periods

3. raise retirement age at intervals to offset rising cost

4. overall adjustment mechanism such as– life expectancy coefficient– automatic balancing mechanism

5. risk-sharing between contributors and pensioners

Some conclusions

Wide range of solutions – new defined benefit thinking• DB mostly moving to career-average revalued…• …or to NDC - really a DB structure dressed up as DC• focus on fund at retirement facilitates longevity solutions• indexing retirement age also a possibility• cash balance is another alternative DB/DC hybrid• …or DC on a traditional insurance “participating” basis• flexible revaluation and only partly guaranteed benefits

facilitate risk-sharing

Some conclusions

Wide range of solutions – defined contribution favoured• each country has a different solution

• …but all are starting from different points

• DC widely favoured for its incentive structure…

• …but lacks basic characteristics of protection

• …unless in with-profits form or with strong underpin

• …or with a strong default fund exhibiting lower volatility

• exposes members to investment risk and interest rate risk

• …and also collectively to longevity risk

• minimum pension or DB underpin is desirable…

• …but care is needed to avoid this having a dominant effect

Some conclusions

Wide range of solutions – encourage later retirement• need stronger incentives to later retirement• a reason for DC but possible also with DB• higher pension age for unreduced pension forces trade-off• target lump sum at retirement instead of pension• annuitisation is needed – with innovative solutions• need better risk-sharing in decumulation phase

Success Stories in Social Security

Congreso de l’Asociación Colombiana de Actuários

Bogota, Colombia

23 November 2011

Chris Daykin, Chief Executive, IAA Fund