Summary Week 1 Bateman 2001

1. Introduction

 Pension policy PAYG is that payments by currently working generation finance transfer to
the currently retired.
 Currently a large working population is supporting a relatively small, retired population, the
opposite will be true in another generation.

1.1 Impetus for Reform

 PAYG social security schemes was good if demographic equilibrium had been maintained.
Population aging has but intolerable strain on the early promises that were made
 Figures from Chand and Jaeger 1996 shows the appeal of policies designed to have each
generation provide to a greater extent for its own retirement is understandable.
 Many countries shift to reform self-provision and privatisation
 Chand Jaeger estimates an aggregate 82% includes by 2050
 Asia (65 and over): 1990 100 Million & 2050500 Million approximately (Need for
optimising retirement plans)
 Things to consider of transitioning to retirement
 1. Chronological age must be distinguished from functional age,
E.g. 55 years old is still working age in Japan but not Afghanistan.
 2. Women live longer than men, and are more likely to end up living alone.
 3. Approximately 1/4 old person 60+ is “very old- 75+” and 2/3 of these people are women.

1.2 A Taxonomy of Retirement Provision Policies

 3 Pillars of retirement support

 1. Safety Net Pillar: allows recipients to avoid abject poverty
- Minimum social security pension to workers, contingent
on a minimum number of years of contribution.
- Or, available to the poorest sections of the aged
community, regardless of age or employment history.
 2. Compulsory earnings or employment related
participation pillar for workers. (Mandatory system in
Australia”
 3. Voluntary saving, concessional long term saving vehicle
as well as non-tax preferred voluntary saving

1.3 Rationale for Retirement Income Policy

Reasons for retirement social security programs: Redistribution, market failure, paternalism
(related to inadequate saving for retirement) and administrative efficiency in social insurance
delivery.

Redistribution: the intra0 and inter-generational aspects of redistribution and the importance of a
life cycle perspective.

Market Failure: adverse selection in the life annuity market, absence of adequate inflation insurance

E.g. social allocation of risk. Gordon and Varian (1988) emphasised the
intergenerational risk sharing function of social security, the idea that private markets
 will not be able to allocate risk efficiently between generations that are alive and those
which are unborn.
 Efficient allocation of retirement risks between live cohorts of different ages will be
difficult to achieve.
 Projection: Single male weekly average earnings over 35 years, $A1 million in order to
retire with income which is equivalent to 65% preretirement income.
 Life events are unplanned. We don’t know retirement age, illness or retrenchment.
Longevity is hard to predict.
 Existence of government policies may themselves discourage adequate voluntary life
cycle saving. Tax twice, but consumption is once.
 Private insurance against early retirement is expensive, if even offered at all.

1.4 Alternative reform strategy

 Parametric reform: In PAYG plan, possible to reform by altering the values of one more key
parameters.
 Critical parameters: Number of beneficiaries & works, contribution rate & value of the
benefit.
 Increase in eligibility age = reduce beneficiaries & increase contributing workers
 Alter survivorship provision= reduce beneficiaries
 Cutting back disability benefits = increase number of contributing workers
 Modification of indexation provisions= Reduce contribution rates

Structural reform: Any change that alters policy design rather than just its parameters.

Reforms that relies on public mandating rather than public provision.

E.g. Chile reformed its PAYG pension system in 1981, Australia has superannuation guarantee.

Hybrids: Combination of structural and parametric reform

 Involves piecemeal reform, in which reduction of government provision is accompanied by

increased mandating.
- E.g. Denmark and Netherlands rely on union agreements with employers to sustain
private provision.

Structural Reform Initiatives (Move towards  Private mandatory retirement structures)

 All structures with privately managed second pillars share many of the same challenges in
reform and implementation.
 From a list of 22 countries (Added private mandatory second pillars)
- 6 High income countries, 10 Latin America, 5 socialist countries.
- All high income country reforms, involved adding a tier to an existing system to
converting a voluntary scheme into a mandatory one.

The US Debate (1990s reforming the PAYG, DB social security system)  could use in discussions.
Comparisons

 Includes short-term measures (extending coverage, delaying benefit increases, taxing

benefits, longer-term measures [increase pension age to 67] & reducing benefits to early
retirees.
 Social Security Trust funds exhausted by 2030, raise payrolls by taxes
 Plan to restore financial balance and improving money’s worth
 1. Maintenance of Benefits (MB): Increase income taxes on SS benefits, 1.5% increase
extends it to 2045
2. Individual Accounts (IA): reduces social security benefits and introduces individual
counts alongside the social security system
3. Personal Security Account (PSA) two tier system: 1st tier = flat rate benefit to all
2nd tier= relatively large individual accounts.
4. 2 types of reforms: Keep current DB build and maintain a larger trust fund.
- Establishing individual DC accounts
5. Issue of Advance funding:
1. Increase taxes or reduce benefits in the short term to build up funds to pay for
future benefits.
2. 2. Diversify investment portfolios (stocks, corporate bonds) to achieve long-term
returns

1.5 Pros/ Cons of Mandatory Private Retirement Provision

 Improving national saving: Funded retirement income arrangements will contribute to

aggregate saving than PAYG arrangements.
-Private mandatory has a greater chance of improving national saving than a PAYG plan,
since it is funded.
- Liquidity constraint improves saving. Those who are liquid tend to save less.
 Political insulation: Mandatory private retirement has the advantage of complete separation
from public finances therefore  from legislation.
E.g. Australia, age pension has varied between 19% to 26% average earnings over last 20
years.
 Higher Retirement Incomes: Australia had never introduced an earnings-related public
pension and the voluntary private pension arrangements covered only 40% of employees.
- This superannuation guarantee promises high incomes in retirement for all employees.
 Financial Market development and innovations: Growth of private pensions in US played an
important role in growth of zero coupon bonds, collateralised mortgage obligations,
guaranteed investment contracts & interest rate futures.
- Would not have developed if private mandatory pensions / or slowed
 Design Diversification: Combining public and private provision allows for greater risk
diversification.
 Administration Cost: Pensions can be more efficient, 2% vs 17% in life insurance industry.
 Social Allocation of Risk(inter-generational risk sharing):
-Retirement provision policy designs which rely on 2nd pillar DC constrain the efficient social
allocation of retirement related risks.
E.g. Social security reform replacing the current scheme with individual accounts would
worsen the social allocation of risk.

1.6 Criteria for Assessment

 Coverage risk: statistical risk of a labour force participant falling outside the coverage
 Replacement rate risk: Retire will not have enough income to maintain standard of living
after retiring
 Investment Risk: Possibility amount saved for retirement is inadequate. Money invested will
perform
 Longevity Risk: Retiree will exhaust retirement saved before he dies
 Inflation risk: Risk of price increases which erode the purchasing power of lifetime savings
Criteria for the whole economy:

 Price distortion: main sources of distortion  Income tax & social welfare safety net
 Market failure: markets for financial instruments designed to facilitate a stable retirement
income flow are likely to fail in the absence of government intervention.
 Myopia: Short-sighted in lifetime economic planning, not to provide adequately for their
retirement.
 Saving: Adequacy of saving rate. Savings undertaken by future working population declines
because of low numbers,
1.7 Challenges in Private Mandatory Retirement Policy Design
 What challenges?
- Fully funded = Net rates of return are essential.
- Privately administered= governance needs to be specified, keep low overhead costs
- Stems from DC Structure= inter-cohort risk sharing needs attention
- Retirement streams sold privately = adverse selection must be addressed
Summary Week 2 It’s over BLAKE 2000!

2. How does Funding Matter?

 Changing jobs frequently disadvantages defined benefit schemes as there arises portability
losses
 4 Pillars: Unfunded state pensions (tax system), Funded Private pensions (savings
accumulated), Direct private savings and post-retirement work.
 Dependency Ratio: “Number of people in retirement: Number of people in work”
 2 Types of Organised Pensions

PAYG: Benefits are paid out of current income (e.g. government general revenue)

 Younger generations to older generations.

 E.g. security contributions Australia 22.8%
 Most state funded pensions are PAYG. Affected by the “intergenerational time bomb”
whereby there is not enough younger works to contribute tax for older generations.
e.g. “Germany has the worst projected ratio, will change from 1 in 5 1 in 2 somewhere
between 1990 to 2030.
 Labour productivity not making up for the shortfall. High labour productivity requires higher
capital per worker However net investments in Europe for example have been
inadequate.
 Increase the retirement age: Not effective as unemployment between ages 60-64 are
already low as is. E.g. “83% in France, 81% Netherlands, 70% in Italy and 65% in Germany”

Funded: Accumulation of assets to provide for future liabilities. (Youth to old age)

 Increase unviability of PAYG leads to reliance on private funded pension schemes.

 In the long run equilibrium, average return on assets will exceed the growth rate in the wage
bill due to dynamic efficiency of the economy
 One downside: Accumulate too much capital that rate of return on capital assets falls below
growth rate in national income and the economy dynamically inefficient.
 Another downside: Political risk  Large accumulated assets due to tax breaks
 More risks for Individually funded: Unemployment, Ill-health, disability or death-in-service

How does the Structure of your funding scheme matter?

Defined Benefit: Occupational final salary schemes  Depends on years of service in the scheme.

 High income replacement ratio for retirement

 Downside: Portability loss due to DB organised by specific employer.

Defined Contribution: Benefit of completely liquidity in porting over jobs.

 Disadvantage: Operating costs associated with running, may also take 1.5%-2.5% in
administration costs (BLAKE,2000).
- An estimated 10-20% lost in contributions due to fees alone
- Loss in initial marketing and set-up -> Charges are front-loaded at start of scheme
 Typically DB Contributions are 5-6% where as DC Contributions are 9.5%-12% to
2.2.2 Decumulation Phase: Annuities

 Problem 1: Adverse selection bias associated with mortality risk.

- Risk that people think they will live longer than the average person of the same age will
wish to purchase annuities.
 Problem 2: Mortality improvement over time leads to  Loading costs on schemes (Loading
risk)
 Problem 3: Inflation risk . Level annuities meets unanticipated levels inflation reduces real
value of pensions.
 Possible solution is to provide variable annuities that hedge these risks.

Section 3 How does management of Your Pension Fund Matter?

DB pensions (L) are independent of the value of the fund’s assets. End up with whatever value of the
underlying asset. DB is investing in a portfolio containing

These options embodied in DB schemes are exchange options (variant of Black Scholes)

Asset-liability management involves constructing a portfolio of financial assets matches the pension
liability in two factors, size and volatility

1. If pensions are always funded, assets are always sufficient to meet liabilities in full
2. If assets in the pension fund are selected so that aggregate volatility matches the volatility of
the liability. Surplus risk reduced to 0, which implies options in the DB schemes can be issued
free of charge

DC pensions on retirement date depends entirely on the value of funds’ assets on that date.

A DC scheme is invested in underlying financial asset. However, it is possible to manage a DC scheme

in such a way that it generates the same pension in retirement as a final salary DB scheme “Targeted
money puchase schemes”

A DC scheme  assessing degree of risk tolerance of the scheme member

4. How does the Investment Performance of your pension fund matter?

With Db schemes, the investment performance of the fund’s assets are of no direct relevance to the
scheme member, since the pension depends on the final salary and years of service, not investment
performance. However, invesment performance is critical to the size of the pension of the DC
Scheme, scheme members bear all the investment risk.
 4.1% point difference between the best and worst firms in the UK for 40 years could mean a
3.2 times larger accumulated fund. 5.9% = 5.3 times larger etc