Reforming formal social security system in sri lanka

REFORMING THE FORMAL SOCIAL SECURITY SYSTEM IN SRI LANKA P. D. L. Wasana Karunarathne MA (Colombo) NATIONAL UNIVERSITY OF SINGAPORE 2005 ACKNOWLEDGEMENTS It is a pleasure and a privilege to be able to acknowledge the contribution of a long list of people, who have invaluably contributed at various stages of this thesis. First, I would like to express my gratitude to the Department of Economics of the National University of Singapore for giving me the opportunity and financial assistance to pursue the PhD degree. Words cannot express my feelings of gratitude towards my supervisors, Professor Mukul Asher and Associate Professor Tilak Abeysinghe. Without their dedicated guidance, endless support and encouragement throughout the past four years, this thesis would not have been completed. Despite having a tight schedule, they always managed to find time whenever I needed their assistance. I owe them a great intellectual debt and count it as a privilege to have worked with them. I would like to express my sincere thanks to Mr. D. Amarasinghe of the Department of Census and Statistics, Sri Lanka for coming up with the idea of this research topic, which has attracted lots of attention in Sri Lanka. I also acknowledge the support of Dr. Wickey Wickramanayake of Monash University and Dr. Gamini Premarathne of the National University of Singapore for providing me useful comments and suggestions. I wish to express my thanks to my cousin, Uthpala for helping me by proof- reading the thesis. My special thanks go to Mr. C.P.U. Karunatilake and Mr. P. Siriwardene of the Central Bank of Sri Lanka; Mr. Ravi Ranan-Eliya of the Institute of Policy Studies, Sri Lanka; and many officials in the Department of Pensions, EPF Department, Institute of Policy Studies, Department of Census and Statistics for their generous support during my ii visits providing me necessary data, research reports and other necessary information. Also, my heartfelt gratitude goes to Ms. Patricia Dickerson and Mr. Peter Johnson of the US. Bureau of Statistics for making special efforts to provide disaggregated level population statistics, which are not usually available in published form. I would also like to thank all of my friends; including, Janath, Medhavi, Eresha, Salantha, Krishanthi, Wijesinghe, Ruwan, Gamini, Sekar, Sadhna, Dammika, O G, and Prabhath for their constant support and encouragement. Also, I acknowledge the support of the administrative staff, particularly, Ms. Sagi Kaur of the Department of Economics of the National University of Singapore, throughout my candidature. I wish to express my sincere gratitude to my parents, my brother and sisters and my mother-in low for their love, endless support and encouragement throughout my life. Last, but not the least, my deepest gratitude goes to my loving husband, Dushmantha for being the grip of my life. Without his heartfelt love, patience, endless support and encouragement, completing this thesis would have been a miracle. My little son, Sandu should be acknowledged for filling my life with love. jtátÇt ^tÜâÇtÜtà{Çx iii TABLE OF CONTENTS Page ACKNOWLEDGEMENT ii TABLE OF CONTENTS iv SUMMARY ix LIST OF TABLES xii LIST OF FIGURES xv LIST OF ACRONYMS xvi Chapter 1.1 1.2 1.3 1.4 1.5 Chapter 2.1 2,2 2.2.1 2.2.2 2.2.3 2.2.4 2.3 2.4 2.4.1 2.4.1.1 2.4.1.2 2.4.2 2.4.2.1 2.4.2.2 Introduction Introduction The Need for Social Security: Why Government Intervention is Necessary The Social Security Dilemma: Demand Side and Supply Side Conflict Motivation and the Rationale for the Study: The Sri Lankan Contest: Objectives and Organization of the Study The Economics of Social Security: An Overview Introduction Key Terms in Pension Economics Public Vs. Private pillar Funded Vs. Pay-As –You-Go (PAYG) Arrangements Defined Benefit Plans Vs. Defined Contributory Plans The Multi-pillar Approach Instruments of Government Intervention for Provision of Social Security The Basic Economics of DB Social Security PAYG Social Security in Overlapping Generation Framework Reduction in Rate of Return Consumption Loss Due to Pay-as-you-go Social Security Impacts of PAYG Social Security on Savings Theory Empirical Evidence 11 12 13 14 15 17 19 20 22 23 26 29 iv 2.4.3 Labor Supply and PAYG Social Security 2.4.3.1 Theory 2.4.3.2 Empirical Evidence 2.4.4 PAYG Social Security and the Economic Growth 2.4.5 Demographic Trends and PAYG Social Security 2.5 Economic and Financial Impact of DC Pension Plans 2.5.1 DC Pension Plans and Aggregate Saving 2.5.2.1 Theory 2.5.2.2 Empirical Evidence 2.5.2 Impact on Labor Supply 2.5.3 The Impact on Financial Markets 2.6 Economics of Social Security Reforms 2.6.1 Parametric Reforms: Issues and Advantages 2.6.2 Moving from PAYG to Funded Systems (Radical Reforms) Appendix 2A: Basics of the Overlapping Generation Model 2A.1 Household Sector 2A.2 Production Sector 2A.3 Goods Market Equilibrium 2A.4 Factor Market Equilibrium 2A.5 Dynamic and Steady State 2A.6 The Golden Rule Level of Capital Chapter 3.1 3.2 3.2.1 3.2.2 2.2.3 3.3 2.3.1 2.3.2 2.3.3 2.3.3.1 2.3.3.2 2.3.3.3 2.3.3.4 3.4 2.4.1 2.4.2 3.5 33 36 40 43 44 46 50 51 53 55 56 62 63 65 66 66 67 International Experience of Social Security Reforms Introduction 68 Social Security Reforms in Australia 71 The Age Pension Program 71 Superannuation Guarantee 73 A Brief Assessment of the Current System 77 Social Security Reforms in Latin America 80 The Chilean Model 84 Social Security Reforms in Argentina 87 An Overall Assessment of Pension Reforms in Latin America 89 Fiscal Sustainability after Reforms 90 Fiscal Sustainability after Reforms 90 Pensions Under the New System 93 Impact on Fiscal System 94 Social Security System in Malaysia: A Comparable System The EPF Scheme 96 Public Sector Social Security Arrangements 99 Concluding Remarks 101 v Chapter 4.1 4.2 4.2.1 4.2.2 4.2.3 4.2.4 4.3 4.3.1 4.3.1.1 4.3.1.2 4.3.1.3 4.3.2 4.3.2.1 4.3.2.2 4.3.2.3 4.3.2.4 4.3.3 4.3.3.1 4.3.3.2 4.4 4.4.1 4.4.2 4.4.3 4.4.4 4.4.5 4.5 The Social Security System in Sri Lanka: An Overview Introduction The Demand for Social Security Reforms Demographic Trends Households’ Savings Behavior Labor Force and Employment Characteristics Fiscal Consolidation and Flexibility The Structure of the Current Social Security Arrangements Social Security Arrangement in the Private Sector Employees’ Provident Fund (EPF) Employees Trust Fund (ETF) Approved Private Provident Funds (APPF) Social Security Arrangement in the Public Sector Contributory Pension Fund (CPF) Public Service Pension Scheme (PSPS) Public Service Provident Fund (PSPF) Schemes for Dependant of Government Employees Pension Arrangements for the Informal Sector Farmers’ and Fisheries’ Pension Scheme Pension and Social Security Benefit Scheme for the Self-Employed An Assessment of the Existing System Limited Coverage Labor Market Distortions Administrative Cost Burdon on Budget Deficits Poor Investment Performance Concluding Remarks 102 104 119 119 122 123 125 125 131 134 135 136 137 142 143 144 144 145 146 147 147 148 149 149 153 Appendix 4A Computation of Public Service Pension: Pension Formulae 155 Chapter 5.1 5.2 5.2.1 5.2.2 5.3 5.3.1 5.3.2 5.3.2.1 5.3.2.2 5.3.2.3 Does Mandatory Pension Saving Crowd Out Voluntary Saving: An Econometric Analysis Introduction Saving Behavior in Sri Lanka Trends in Private Saving Trends in Mandatory Pension Saving Modeling Saving Behavior with Mandatory Pensions The Basic Model with Pensions Determinants of Private Saving Wealth and Disposable Income Demographic Factors Interest Rate 156 161 166 169 170 173 175 vi 5.3.2.4 Uncertainty 5.3.2.5 Financial Reforms and Financial Intermediation 5.4 The Methodology and Estimation 5.5 Results 5.6 Conclusion Appendix 5A Chapter 6.1 6.2 6.3 6.4 6.4.1 6.4.2 6.5 6.5.1 6.5.2 6.6 6.6.1 6.6.2 6.6.3 6.6.4 6.6.5 6.7 Chapter 7.1 7.2 7.3 7.3.1 7.3.2 7.3.3 7.4 7.4.1 7.4.1.1 7.4.1.1.1 7.4.1.1.2 7.4.1.2 7.5 7.5.1 7.5.2 178 180 182 186 194 197 Does EPF Earn Enough for the Members: A Portfolio Analysis and Policy Options Introduction EPF: Investment Performance and Member Balances Financial and Capital Markets in Sri Lanka Asset Allocation and Investment Returns: Simulation Exercise Methodology Data Results Simulation with Nominal Returns Simulation with Nominal Returns and Real Annuity Rates Policy Options (Parametric Reforms) Reforming the Investment Function (Portfolio Diversification) International Diversification Increasing Retirement Age Increasing Contribution Rate Introducing Inflation Indexed Annuity Schemes Concluding remarks 200 209 213 222 223 227 232 235 236 237 238 239 241 243 244 246 Reform Options For the Public Pension Scheme: Simulation of Pension Debt Introduction 250 Reform Options for PSPS 254 Measuring Public Sector Pension Liability: Review of Literature Accumulated Pension Obligation Method (ABO) 261 Projected Benefit Obligation Method (ABO) 262 Open System Method (ABO) 262 Estimating PSPS Liabilities: Baseline Scenario Methodology 267 Calculating Number of Beneficiaries Distributing Existing Pensioners in to a Demographic Profile 268 Calculating Number of New Pensioners (Current Workers) 269 Calculating the Pension Expenditure 270 Results Number of Future Pensioners 272 Future Pension Expenditure 275 vii 7.6 Concluding Remarks Appendix 7A Appendix 7B Chapter 8.1 8.2 8.3 8.3.1 8.3.2 8.3.2.1 8.3.2.2 8.3.2.3 8.3.2.4 8.3.2.5 8.3.2.6 8.3.2.7 8.4 Bibliography 283 284 286 Conclusion, Reform Directions and Future Reform Introduction Conclusions Reform Directions Reforming Public Sector Pension Scheme Reforming Private Sector Pension Scheme Enhance Professionalism of the Management Improve Investment Performance Address the Longevity Risk Limit Pre-Retirement Withdrawals Amalgamate EPF and ETF Extending Working Life Amend Tax Treatment Future Research 287 289 293 295 298 299 300 301 302 302 303 305 306 viii SUMMARY Designing a viable social security system in a developing country like Sri Lanka is a complex task, as it involves political, economic and social structure. The existing social security system in Sri Lanka is confined to the formal sector. A large segment (around 40 per cent) of the labour force in Sri Lanka is engaged in the unorganized sector, in which the employees are not protected with a dependable retirement benefit program. This thesis has attempted to provide policy recommendations for reforming the existing formal sector social security system in Sri Lanka. Despite its importance, the unorganized sector has to be left for future research as it would fill up another volume of research. The thesis focuses on the various components of the formal sector, giving special consideration to the two key components, namely the Employees’ Provident Fund (EPF), and the Public Service Pensions Scheme (PSPS). The former is a mandatory Defined Contribution (DC) savings scheme and the later is a Defined Benefit (DB) type noncontributory pay-as-you-go (PAYG) scheme. The analysis suggests that the existing system suffers from a lack of professionalism in design, governance structure, and administration. It is also deficient in terms of equity and adequacy. While the EPF has failed to protect its members against low level of retirement income security, publicly financed PSPS is not sustainable in the future. These limitations become particularly marked when international experiences are examined. The thesis contains eight chapters. Chapter provides the motivation and rationale for the study followed by a review of theoretical underpinning of pension economics and empirical literature explaining the economic impact of social security ix provision in Chapter 2. Economic and financial consequences of social security provision on capital accumulation, labour supply and financial markets have been reviewed. An economic discussion of social security reforms has also been provided. Chapter provides a comparative picture of social security provision and reforms in an industrial country, developing countries and economies in transition. The construction and reforms of the social insurance system in all three groups of these countries are observed in order to draw important lessons for Sri Lanka. An overview of Sri Lanka’s social security system is provided in Chapters 4. Major limitations of the existing social security setup in Sri Lanka are identified in this chapter. It also analyses the social and economic conditions of the country which demand urgent reforms to the existing social security system. The existing problems seem to loom ahead because of the demographic pressure and socioeconomic changes in the country. Chapter provides a rigorous econometric analysis to test the possible substitution effects between the mandatory and voluntary savings in Sri Lanka. 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MERCER: Kuala Lumpur, Malaysia. 325 [...]... is beyond the scope of this study The word system in the title refers to the notion that individuals derive their retirement income from a variety of 1 The term formal in the title is used because the research is focused on the formal sector social security system in Sri Lanka Moreover,, the existing social security system in Sri Lanka is confined to the formal sector Unorganized sector employees... 1.2 The Need for Social Security: Why Government Intervention is Necessary Before considering the need for reforming current social security institutions, it is worthwhile to understand the need for social security and the need for government intervention in the provision of social security This section briefly describes the rationale for government intervention in providing social security Old age... benefit type (DB), pay-as-you-go (PAYG) social security followed by an analysis of fully funded (FF) defined contributory (DC) pension plans in Section 2.4 Economic and financial impacts of pension reforms are discussed in Section 2.5 The second part of the thesis assesses the existing social security system in Sri Lanka In Chapter 4 Sri Lanka s existing social security system is broadly analyzed Chapter... lifetime savings and wealth to finance their needs after retirement However, researchers have pointed out that the current social security setup in many countries would not be able to cope with future demand-side shocks Instead, existing arrangements in these countries are collapsing mainly due to a variety of reasons including inefficiencies in the system and unaffordable promises made in the past In many... is worth stressing that this is the definition used in this study The objective of this thesis is to analyze the performance of existing formal 1 sector retirement system in Sri Lanka with a view of recommending suitable reform directions to improve the existing system in terms of efficiency, adequacy and sustainability This usage means that although, Sri Lanka has a range of other social benefit programs,... regulated The most direct way of such government intervention in pension provision is running PAYG pension schemes Besides arranging publicly financed social security arrangements, governments can intervene in this area by regulating and/ or managing contributory pension funds; regulating investment policies, mandating savings, guaranteeing benefits and by using tax policies Public pension plans are mostly... absence of safe investment opportunities, absence of inflation-adjusted annuities, and the problems in insuring the risk associated with the changes in the length of the retirement life Particularly in developing countries, where low income, uncertainty, and limited financial markets make it difficult for people to save enough for their old age, some sort of intervention in providing social security becomes... still not in- sight These limitations become particularly mark when compared with the international experience The above is only one side of the more general problem confronted by the social security system in Sri Lanka While the existing system is in crisis, the demand for formal retirement benefit programs is rapidly escalating due to population aging and other economic and social changes in the country... financial markets, and finally on economic growth Some critics also contend that public pensions undermine international competitiveness by increasing production costs A formal social security system therefore, should aim to provide sustainable, socially adequate and equitable retirement protection; while simultaneously minimizing adverse effects on economic efficiency, incentives, and international competitiveness... Accordingly, Chapter 2 provides a theoretical and empirical dialogue of economic consequences of providing different types of social security arrangements followed by a discussion of international experience of providing social security and social security reforms in Chapter3 In Chapter 2, key terms in pension economics are discussed after the introduction Section 2.3 analyses the basic economics of defined . term formal in the title is used because the research is focused on the formal sector social security system in Sri Lanka. Moreover,, the existing social security system in Sri Lanka is confined. lessons for Sri Lanka. An overview of Sri Lanka s social security system is provided in Chapters 4. Major limitations of the existing social security setup in Sri Lanka are identified in this chapter developing country like Sri Lanka is a complex task, as it involves political, economic and social structure. The existing social security system in Sri Lanka is confined to the formal sector. A large