Pension reform : is there a tradeoff between efficiency and equity?

In the past decade, Latin America has taken the lead in structural pension reform which replaces a publicly managed pay-as-you-go defined-benefit system with a system of privately managed, fully funded defined-contribution accounts supplemented by a social safety net This arrangement is designed to improve efficiency and growth, and preliminary evidence suggest that it has been successful in doing so. But traditional social security systems have been justified on the grounds that they are equitable and redistribute to low income groups. Are we in danger of exchanging equity for efficiency? The author argues that in fact traditional system produce many inequities, both within cohorts and across cohorts. So it is possible for pension reform to improve both equity and efficiency - a win-win situation rather than a tradeoff. The reforms undertake thus far have indeed reduced existing equity problems, but some old equity problems remain and some new ones have been created. The main policy lesson is this: Pension reforms should be carefully designed to improve equity as well as efficiency and growth. Only further empirical analyses will determine whether the redistributional goal has been achieved.Environmental Economics&Policies,Banks&Banking Reform,Labor Policies,Economic Theory&Research,Payment Systems&Infrastructure,Environmental Economics&Policies,Economic Theory&Research,Banks&Banking Reform,Pensions&Retirement Systems,Health Economics&Finance

Protecting the old and promoting growth : a defense of averting the old age crisis

The current social security systems in many OECD countries were adopted before World War II, when private financial markets were underdeveloped or in disrepute. They expanded sharply in the 1950s and 1960s, when real wages and population were growing rapidly. Under those circumstances, it seemed natural to rely on a publicly managed payroll-tax-financed pay-as-you-go (PAYG) system. But in the past 40 years, real wage growth has slowed and population growth has come to a halt in OECD countries, so tax rates must go up sharply if PAYG systems are to be retained. It has become increasingly important to minimize work disincentives and to increase labor productivity through capital accumulation, which the public pillar is not well-suited to do. Shifting partial responsibility to privately managed plans that are funded and that tie benefits to contributions is likely to improve economic growth and provide better benefits than will continued reliance on a payroll-tax-financed PAYG system, concludes the World Bank. The OECD countries can shift gradually to a two-pillar system by reducing and flattening the benefits in their public pillars and using the released resources (plus some additional contributions) to build funded defined contribution accounts in a new mandatory saving pillar. If developing countries follow the path of the OECD countries once followed, they will encounter dramatically escalating contribution rates, great intergenerational transfers, and related problems. Given their rapid rate of demographic aging, it is important for them to establish a multi-pillar system from the start. The author argues that the World Bank position differs from those of the International Labour Organization (ILO) and International Social Security Association (ISSA) because the Bank is more concerned about how social security systems affect the general economy; is troubled by inequities often found in current systems (in practice, if not on paper); believes that behavioral responses and factors of political economy sometimes make nonviable the design changes the ILO and ISSA recommend for public systems; and values risk diversification. (Financial markets are now both better and more global than before, so multipillar systems benefit from revenue and managerial diversificaiton, including international diversification.)Labor Policies,Environmental Economics&Policies,Banks&Banking Reform,Economic Theory&Research,Pensions&Retirement Systems,Economic Theory&Research,Pensions&Retirement Systems,Insurance&Risk Mitigation,Environmental Economics&Policies,Banks&Banking Reform

Coverage under old-agesecurity programs and protection for the uninsured - What are the issues?

Most old people in developing countries are uninsured by formal social security programs. Economic growth is the key to increased coverage, but policy also matters, argues the author. Contributory insurance programs may not work for much of the population in developing economies. Moreover, the tradeoffs between higher take-home pay and old-age benefits, between maximizing coverage and minimizing evasion, and between increased coverage and greater competitiveness, must be carefully evaluated before opting for expanded coverage, especially among low-income groups. Keeping the contribution rate low and including some redistribution toward low-income groups in contributory systems may help reduce the number of uninsured, while avoiding costly tradeoffs. Recent years have seen a tighter link between benefits and contributions in contributory systems - most obviously in the shift toward multi-pillar systems with large defined-contribution components, usually accompanied by a modest re-distributive public pillar. This tighter link makes social security systems more fiscally sustainable and may be considered a precondition for financially sound expansion of coverage. At the same time, the number of uninsured or underinsured (who have contributed only small amounts) could increase, as a result of the tighter benefit-contribution link. The uninsured fall into two groups: 1) Workers who spend much of their lives in agriculture or the informal sector (often self-employed or in small firms), in jobs not covered by contributory programs. Many of these workers are low earners, for whom contributing today for potential old-age benefits my not be welfare-enhancing - and governments do not have the capacity to compel contributions. Social security reforms that make benefits contingent on contributions should include better social assistance programs for these low-income groups. Efficient program design and program costs must also be considered. 2) Women who, having worked mostly in the household, expect to be supported by the family system, which may fail them in old age. Family support for dependent spouses should be incorporated into the pay-put phase of the defined-contribution pillar, to keep old women out of poverty.Environmental Economics&Policies,Economic Theory&Research,Social Protections&Assistance,Public Health Promotion,Labor Policies,Poverty Assessment,Environmental Economics&Policies,Economic Theory&Research,Insurance&Risk Mitigation,Insurance Law

Administrative costs and the organization of individual retirement account systems : a comparative perspective

What is the most cost-effective way to organize individual accounts that are part of a mandatory social security system? Defined-contribution individual account components of social security systems are criticized for being too expensive. The authors investigate the cost-effectiveness of two methods for constructing mandatory individual accounts: a) Investing through the retail market with relatively open choice among investment companies (the method first used by Chile and adopted by most Latin American countries). b) Investing through the institutional market with constrained choice. For the retail market, they use data from mandatory pension funds in Chile and other Latin American countries and from voluntary mutual funds in the United States. For the institutional market, they use data from systems in Bolivia and Sweden and from larger pension plans and the federal Thrift Saving Plan in the United States. The institutional approaches aggregate numerous small accounts into large blocks of money and negotiate fees on a centralized basis, often through competitive bidding. They retain workers'choice o some funds. Fees and costs are kept low by reducing incentives for marketing, avoiding excess capacity at system start-up, and constraining choice to investment portfolio that are inexpensive to manage. In developed financial markets, the biggest potential cost saving stems from constrained portfolio choice, especially from a concentration on passive investment. The biggest cost saving for a given portfolio and for countries with weak financial markets comes from reduced marketing activities. In the retail market, where annualized fees and costs range from 0.8 percent to 1.5percent of assets, use of the institutional market in individual retirement account systems has reduced those fees and costs to less than 0.2 percent to 0.6 percent of assets. This reduction can increase pensions by 10 - 20 percent relative to the retail market. Countries that can surmount rebidding problems, weaker performance incentives, inflexibility in the face of unforeseen contingencies, and an increased probability of corruption, collusion, and regulatory capture should seriously consider the institutional approach, especially at the start-up of a new multipillar system or for systems with small asset bases.Economic Theory&Research,Business in Development,Business Environment,International Terrorism&Counterterrorism,Access to Markets

Efficiency and equity in social spending : how and why governments misbehave

A hot issue in development economics is how much to rely on user charges and private organizations to provide such social services as health and education. Most analysts arguing on either side of the issue assume that any policy decisions involve a tradeoff between equity and efficiency. The authors argument is that in many settings in the developing world that assumption is incorrect. In many countries, they argue, the current situation is inefficient partly because it is inequitable; more equitable social spending would be more efficient in reducing mortality, for example, or in maximizing social returns to spending on education. The model they use assumes that the degree of efficiency and redistribution is endogenous, so the real problem is : how does one break into the chain of causes and bring about a new, more efficient and equitable equilibrium? The authors argue for a policy that concentrates government funding on public goods and encourages the market to do what it does best : fund and produce private goods. They recommend ten political strategies for reallocating government funds in the public sector in a way that maximizes the benefits of targeting, reduces costs, and minimizes resistance to change and the withdrawal of the middle and upper classes'political and tax support.Economic Theory&Research,Environmental Economics&Policies,Health Monitoring&Evaluation,Public Sector Economics&Finance,Health Economics&Finance

Health, government, and the poor : the case for the private sector

The authors present a case for user charges and some privatization of health care in developing countries. They demonstrate that - consistent with public choice theory - government actions in the health sector are neither equitable nor efficient in developing countries. In general, they increase the real income of influential middle and upper income groups - despite the fact that the greatest mortality gains would come from directing health spending to the poor. They discuss why government health interventions will become less effective than they have been. They point out that high mortality in developing countries is related more to poverty than it used to be, while pressure on governments to finance health care for the middle class and the rich is increasing because the population is aging and the costs of handling adult chronic diseases are rising. The inequity and inefficiency of government health programs reflect the current political equilibrium which, unfortunately, cannot be easily changed. Opportunities for change, including marginal changes in the distribution of political power, must be recognized and exploited whenever they arise. Information that increases public awareness of current inequities, fiscal stress, and tactical use of newly available resources may also create opportunities to alter the equilibrium.Health Systems Development&Reform,Environmental Economics&Policies,Agricultural Knowledge&Information Systems,Health Monitoring&Evaluation,Health Economics&Finance

The decumulation (payout) phase of defined contribution pillars - policy issues in the provision of annuities and other benefits

Most countries reforming their pension system, focus more on the accumulation phase, than on the decumulation (pay-out), because the number of beneficiaries is likely to be small initially, especially if older workers are discouraged from joining the new system. Policymakers place a priority on the new accumulation system being administratively efficient, and well regulated. But the decumulation phase must also be well organized, and efficient. The purpose of pension systems is, after all, to pay retirement benefits - old age, survivor, and disability pensions. The authors argue that: 1) Pay-out arrangements are likely to evolve gradually, through trial and error, as problems are discovered and tackled. 2) Adverse selection may not be as great a problem as is sometimes thought. 3) Many other annuity, and insurance market problems have yet to be solved, and policies must be formulated to make these markets work as well. The under-development of voluntary annuity markets is only partly explained by adverse selection, argue the authors. Other factors are also at work: the bequest, and precautionary motives for saving; individuals'myopia and ignorance; mistrust of insurance companies; the"luxury good"nature of annuities; tax policies that favor lump sum withdrawals; and, last but not least, public policies (such as the offer of social security pensions and the encouragement of occupational pension plans) that tend to crowd out individual annuities. The long-term success of pension reform depends on vigorous efforts to develop the insurance industry. Weak and under-developed in most developing countries, the insurance industry should play a central role in providing old age, survivor, and disability benefits. Many policy issues require careful thought, and extensive empirical analysis: Should annuitization be mandatory, and at what level? Should indexed (or"real") annuities be required? Should variable annuities be permitted, or encouraged? Should joint annuities be required? How much"group rating"and"risk classification"should be permitted?Pensions&Retirement Systems,Insurance&Risk Mitigation,Non Bank Financial Institutions,Contractual Savings,Banks&Banking Reform

Annuity markets in comparative perspective : do consumers get their money's wotrth?

Pension reforms normally focus on the accumulation phase, plus term insurance that provides bnefits for the disabled and for dependent survivors, all of which are immediate concerns. Decumulation of the capital in workers'retirement savings accounts appears to be far in the future. But in the second generation of reforms, countries have begun paying attention to eventual decumulation--either through gradual withdrawals or through annuitization, which provides longevity insurance. At this point, it becomes important to learn whether annuity markets exist and how they operate. The authors summarize preliminary results of a continuing research project that analyzes annuity markets in Australia, Canada, Chile, Israel, Singapore, Switzerland, and the United Kingdom. They focus on understanding whether annuity markets can be relied upon to provide reliable retirement income at reasonable prices. One way to approach this question is to explore whether the expected payouts and the"money's-worth ratio"differ across countries, and if so, why, and what light can be thrown on the existence and amount of adverse selection. Annuity markets are poorly designed for various reasons: worker myopia, precautionary and bequest saving (not erved by most annuity products), distrust of insurance companies (and unwillingness to turn sizeable savings over to them), adverse selection, and the crowding-out effect of social security (Which automatically annuitizes the largest share of people's retirement wealth). Preliminary findings suggest that the cost of annuities is lower than might be expected. When the risk-free discount rate is used, the money's-worth ratios of nominal annuities based on annuitant mortality tables exceed 90 percent--neither the industry"take"nor the effects of adverse selection appear to be as large as anticipated. But real annuities (in Chile, Israel, and the United Kingdom) have money's-worth ratios 7 to 9 percent lower than those of nominal annuities. And when the"riskier"corporate bond rate is used for discounting purposes, there is a further 7 percent reduction. The main policy issues include public versus private provision, the role of insurance companies in term and risk intermediation, the level of compulsory annuitization, and the need for robust regulation of annuity providers.Insurance&Risk Mitigation,Pensions&Retirement Systems,Non Bank Financial Institutions,Environmental Economics&Policies,Health Economics&Finance

Social Security Rules and Labor Force Participation of Older Workers: Evidence from Chile

Recent research has argued that incentives stemming from social security systems influence the worker’s decision to retire. The experience of Chile, which radically changed its system in 1981, offers an opportunity to test this hypothesis. The new system tightened access to early pensions, replaced an actuarially unfair defined benefit plan with an actuarially fair defined contribution plan, exempted pensioners from the pension payroll tax and allowed widows to keep their own pension in addition to their survivor’s benefit. Although the old system is being phased out, since 1981 the two systems have co-existed. Using probit analysis of the behavior of a retrospective sample of new and old system affiliates, we estimate the impact of the new social security rules on the probability of dropping out of the labor force, for older workers. We find large effects. Age of pensioning has been postponed. Labor force participation is much higher among affiliates of the new system compared with the old, especially for pensioners and women. This is not simply due to selection: Aggregate participation rates have increased as the new system’s share of total affiliates has risen.

Do Individual Accounts Postpone Retirement: Evidence from Chile

Postponing retirement will become increasingly important as a means to increase the labor force, its output and old age security, as populations age. Recent research has focused on incentives stemming from the social security system that influence the worker’s decision to retire. Defined benefit systems (both public and private) often contain penalties for postponing access to pensions or continuing to work while receiving a pension. In contrast, the tight link between contributions and accumulations and the actuarial conversion of accumulations into pensions in privately managed defined contribution systems may lead workers to postpone pensions or to continue working after withdrawals begin. The experience of Chile, which implemented its new system in 1982, offers an opportunity to test if the change in incentives has indeed produced the expected change in retirement behavior. Using probit analysis of household survey data from 1960 to 2002, we estimate the impact of the pension reform on the probability of 1) becoming a pensioner and 2) dropping out of the labor force, for older workers. We find strong effects of the new system on both propensities, in the aggregate and at the individual level after controlling for individual and macro-economic variables. In particular, restricted access to early pensions and the exemption of pensioners from the pension payroll tax appear to exert a powerful effect on labor force participation rates.