Reforming formal social security system in sri lanka

Defined Contributory Plans 15 2.3 Instruments of Government Intervention for Provision of Social 2.4 The Basic Economics of DB Social Security 2.4.1 PAYG Social Security in Overlapping G

REFORMING THE FORMAL SOCIAL SECURITY SYSTEM

IN SRI LANKA

P D L Wasana Karunarathne

MA (Colombo)

NATIONAL UNIVERSITY OF SINGAPORE

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

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

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1.3 The Social Security Dilemma: Demand Side and

1.4 Motivation and the Rationale for the Study: The Sri Lankan

Chapter 2 The Economics of Social Security: An Overview

2.2.2 Funded Vs Pay-As –You-Go (PAYG) Arrangements 14 2.2.3 Defined Benefit Plans Vs Defined Contributory Plans 15

2.3 Instruments of Government Intervention for Provision of Social

2.4 The Basic Economics of DB Social Security

2.4.1 PAYG Social Security in Overlapping Generation Framework 20

2.4.1.2 Consumption Loss Due to Pay-as-you-go Social Security 23

2.4.3 Labor Supply and PAYG Social Security

2.4.3.1 Theory 33

2.4.3.2 Empirical Evidence 36

2.4.4 PAYG Social Security and the Economic Growth 40

2.4.5 Demographic Trends and PAYG Social Security 43

2.5 Economic and Financial Impact of DC Pension Plans 2.5.1 DC Pension Plans and Aggregate Saving 2.5.2.1 Theory 44

2.5.2.2 Empirical Evidence 46

2.5.2 Impact on Labor Supply 50

2.5.3 The Impact on Financial Markets 51

2.6 Economics of Social Security Reforms 53

2.6.1 Parametric Reforms: Issues and Advantages 55

2.6.2 Moving from PAYG to Funded Systems (Radical Reforms) 56

Appendix 2A: Basics of the Overlapping Generation Model

2A.1 Household Sector 62

2A.2 Production Sector 63

2A.3 Goods Market Equilibrium 65

2A.4 Factor Market Equilibrium 66

2A.5 Dynamic and Steady State 66

2A.6 The Golden Rule Level of Capital 67

Chapter 3 International Experience of Social Security Reforms 3.1 Introduction 68

3.2 Social Security Reforms in Australia 71

3.2.1 The Age Pension Program 71

3.2.2 Superannuation Guarantee 73

2.2.3 A Brief Assessment of the Current System 77

3.3 Social Security Reforms in Latin America 80

2.3.1 The Chilean Model 84

2.3.2 Social Security Reforms in Argentina 87

2.3.3 An Overall Assessment of Pension Reforms in Latin America 89

2.3.3.1 Fiscal Sustainability after Reforms 90

2.3.3.2 Fiscal Sustainability after Reforms 90

2.3.3.3 Pensions Under the New System 93

2.3.3.4 Impact on Fiscal System 94

3.4 Social Security System in Malaysia: A Comparable System

2.4.1 The EPF Scheme 96

2.4.2 Public Sector Social Security Arrangements 99

3.5 Concluding Remarks 101

Chapter 4 The Social Security System in Sri Lanka: An

Overview

4.1 Introduction 102

4.2 The Demand for Social Security Reforms

4.2.1 Demographic Trends 104

4.2.2 Households’ Savings Behavior 119

4.2.3 Labor Force and Employment Characteristics 119

4.2.4 Fiscal Consolidation and Flexibility 122

4.3 The Structure of the Current Social Security Arrangements 123

4.3.1 Social Security Arrangement in the Private Sector 125

4.3.1.1 Employees’ Provident Fund (EPF) 125

4.3.1.2 Employees Trust Fund (ETF) 131

4.3.1.3 Approved Private Provident Funds (APPF) 134

4.3.2 Social Security Arrangement in the Public Sector 135 4.3.2.1 Contributory Pension Fund (CPF) 136

4.3.2.2 Public Service Pension Scheme (PSPS) 137

4.3.2.3 Public Service Provident Fund (PSPF) 142

4.3.2.4 Schemes for Dependant of Government Employees 143

4.3.3 Pension Arrangements for the Informal Sector 144

4.3.3.1 Farmers’ and Fisheries’ Pension Scheme 144

4.3.3.2 Pension and Social Security Benefit Scheme for the Self-Employed 145

4.4 An Assessment of the Existing System 146

4.4.1 Limited Coverage 147

4.4.2 Labor Market Distortions 147

4.4.3 Administrative Cost 148

4.4.4 Burdon on Budget Deficits 149

4.4.5 Poor Investment Performance 149

4.5 Concluding Remarks 153

Appendix 4A Computation of Public Service Pension: Pension Formulae 155 Chapter 5 Does Mandatory Pension Saving Crowd Out Voluntary Saving: An Econometric Analysis 5.1 Introduction 156

5.2 Saving Behavior in Sri Lanka

5.2.1 Trends in Private Saving 161

5.2.2 Trends in Mandatory Pension Saving 166

5.3 Modeling Saving Behavior with Mandatory Pensions 5.3.1 The Basic Model with Pensions 169

5.3.2 Determinants of Private Saving

5.3.2.4 Uncertainty 178

5.3.2.5 Financial Reforms and Financial Intermediation 180 5.4 The Methodology and Estimation 182

5.5 Results 186

5.6 Conclusion 194

Appendix 5A 197

Chapter 6 Does EPF Earn Enough for the Members: A Portfolio Analysis and Policy Options 6.1 Introduction 200

6.2 EPF: Investment Performance and Member Balances 209 6.3 Financial and Capital Markets in Sri Lanka 213

6.4 Asset Allocation and Investment Returns: Simulation Exercise 222 6.4.1 Methodology 223

6.4.2 Data 227

6.5 Results 232

6.5.1 Simulation with Nominal Returns 235

6.5.2 Simulation with Nominal Returns and Real Annuity Rates 236

6.6 Policy Options (Parametric Reforms) 237

6.6.1 Reforming the Investment Function (Portfolio Diversification) 238 6.6.2 International Diversification 239

6.6.3 Increasing Retirement Age 241

6.6.4 Increasing Contribution Rate 243

6.6.5 Introducing Inflation Indexed Annuity Schemes 244

6.7 Concluding remarks 246

Chapter 7 Reform Options For the Public Pension Scheme: Simulation of Pension Debt 7.1 Introduction 250

7.2 Reform Options for PSPS 254

7.3 Measuring Public Sector Pension Liability: Review of Literature 7.3.1 Accumulated Pension Obligation Method (ABO) 261 7.3.2 Projected Benefit Obligation Method (ABO) 262

7.3.3 Open System Method (ABO) 262

7.4 Estimating PSPS Liabilities: Baseline Scenario 7.4.1 Methodology 267

7.4.1.1 Calculating Number of Beneficiaries

7.4.1.1.1 Distributing Existing Pensioners in to a Demographic Profile 268 7.4.1.1.2 Calculating Number of New Pensioners (Current Workers) 269

7.4.1.2 Calculating the Pension Expenditure 270

7.5 Results

7.5.1 Number of Future Pensioners 272

7.6 Concluding Remarks 283

Appendix 7A 284

Appendix 7B 286

Chapter 8 Conclusion, Reform Directions and Future Reform 8.1 Introduction 287

8.2 Conclusions 289

8.3 Reform Directions 293

8.3.1 Reforming Public Sector Pension Scheme 295

8.3.2 Reforming Private Sector Pension Scheme 8.3.2.1 Enhance Professionalism of the Management 298 8.3.2.2 Improve Investment Performance 299

8.3.2.3 Address the Longevity Risk 300

8.3.2.4 Limit Pre-Retirement Withdrawals 301

8.3.2.5 Amalgamate EPF and ETF 302

8.3.2.6 Extending Working Life 302

8.3.2.7 Amend Tax Treatment 303

8.4 Future Research 305

Bibliography 306

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 non-contributory 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 1 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

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 3 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 5 provides a rigorous econometric analysis to test the possible substitution effects between the mandatory and voluntary savings in Sri Lanka The short-run and long-run impact of mandatory savings on other forms of private savings show a significant offsetting of private savings due to mandatory savings, so the results strongly suggest the need for earning higher returns for mandatory savings

The investment performance of the EPF and its implications for member balances

is the focus of the Chapter 6 The portfolio simulation shows that investment performance

of EPF has been hampered by tight government regulations of investments Significantly low accumulated balance for members at retirement is the ultimate consequence The simulation further shows how EPF could improve the situation if diversified investment

An attempt is made to project the future liabilities of the public sector pension scheme (Chapter 7) Results suggest that the costs under the current practices can be controlled but it will create serious issues in terms of adequacy It is also found that the burden of the future pension expenditure is highly sensitive to the rate of GDP growth, changes in future pensions and wages and to the inflation

Various conclusions emerged from the above observations are summarized in Chapter 8 Importantly, policy recommendations derived from the theoretical background, empirical analysis and international experiences are provided in this Chapter Directions for future research are also discussed

LIST OF TABLES

Table 3.1 Different Categories of Superannuation Funds: Australia,

Table 3.2 Allocation of Total Superannuation Assets, Australia: 1995-2003 75

Table 3.3 General Features of Pension Systems: Latin America 82

Table 3.4 Main Features of New Pension Systems after Reforms:

Table 3.5 Coverage of the Reformed Pension Systems, Latin America: 2001 92

Table 3.6 Assets Held by Latin American Pension Funds (% of GDP):

Table 3.7 Percentage Distribution of Investment Portfolio,

Table 4.1 Demographic Properties of Population, Sri Lanka: 1946-2041 107

Table 4.2 Structure of the Existing Social Security System 124

Table 4.4 Defined Contributory Pension Schemes in Different Countries:

Table 5.1 Total Contributory Private Pension Saving and EPF

Table 6.1 Percentage Classification of Portfolio Allocation, EPF: 1974-2002 210

Table 6.2 EPF: Average Historical Nominal and Real Rate of Returns

Table 6.5 Share Price Indices of Regional and Major International Markets 218

Table 6.6 Colombo Stock Exchange: Share Market Activities: 1986-2002 221

Table 6.7 Nominal Returns: Average and SD (%): 1959-2002 228

Table 6.8 Real Returns: Average and Standard Deviation (%) 1959-2002 230

Table 6.9 Average Nominal and real Wage Growth Rates (%): 1959-2002 231

Table 6.10 Base Line Case: Capital Accumulation Ratio and

Table 6.11 Capital Accumulation Ratio (CAR) at Retirement, Summary of

Table 6.12 Replacement Rate (RR) at Retirement, Summary of Nominal

Table 6.13 Replacement Rate (RR) at Retirement, Summary of Nominal

Returns of Alternative Cohorts for Real Annuity Rates 237

Table 6.14 Capital Accumulation Ratio (CAR) for Different Parametric Reform

Options: Summary of Nominal Returns for Alternative Cohorts 238

Table 6.15 Replacement Rate for Different Parametric Reform Options:

Summary of Nominal Returns for Alternative Cohorts 238

Table 7.1 Percentage of Employees by Annual Gross Salary and

Table 7.4 Pension Expenditure under Different Scenarios: 2002- 2072 276 279

Table 7.5 Pension Expenditure as a Percent of GDP (7% Nominal Growth):

Table 7.6 Present Value of the Future Pension Liabilities: 2002 282

LIST OF FIGURES

Figure 4.1 Percentage Distribution of Pension Payments: 2001 142 Figure 5.1 Domestic and Private Saving Rates: 1959-2003 163 Figure 5.2 Saving Mobilization and Allocation of resources: 1959-2002 165 Figure 5.3 Share of EPF Saving (Net in GDP and Private Savings: 1959-2002 168 Figure 5.4 Real Per Capita Private Disposable Income: 1959-2002 172 Figure 5.5 Mid-Year Population and Its Growth: 1959- 2002 174 Figure 5.6 Nominal and Real Deposit Rates: 1959-2002 177 Figure 5.7 Inflation Measures as the Change in GDP Deflator 179 Figure 5.8 Domestic Credit to Private sector and Its Share in GDP 181 Figure 5.9 Non-EPF Saving Rate, Actual and Fitted Graphs 189

Figure 5.12 Impulse Response Multipliers of Non- EPF Saving Rates 191 Figure 6.1 Nominal and Real Rates of Return on EPF Investments: 1959-2002 210 Figure 6.2 Returns on Different Asset Classes 216 Figure 6.3 Market Capitalization of CSE and EPF’s New Investments

Figure 7.1 Pension Expenditure under Different Scenarios: 2002- 2072 278 Figure 7.2 Pension Expenditure as a Percent of GDP (7% Nominal Growth) 280

LIST OF ABBREVIATIONS

ABS Australian Bureau of Statistics

APPFs Approved Private Provident Funds

APRA Australian Prudential Regulation Authority

ASFA Association of Superannuation Funds of Australia Ltd

CAR Capital Accumulation Ratio

CBSL Central Bank of Sri Lanka

IMF International Monetary Fund

MSPS Mercantile Sector Provident Fund

OECD Organization for Economic Co-operation and Development

PROST Pension Reform Option Simulation Toolkit

RR Replacement Rate

TFR Total Fertility Rate

UNDP United Nations Development Program

Chapter 1 Introduction

1.1 Introduction

Social security is a challenging and complex area of research because of its disciplinary character Even the definition of social security has been a contentious issue One might define it as a social transfer (or social insurance) program, which includes means-tested income benefit programs, disability programs, child benefit programs, unemployment programs, and retirement pension programs However, the use of the word “social security” to define retirement pension programs can be frequently found in the literature This is because retirement pensions form the largest single component of most social security budgets Social security in terms of retirement pension can be identified as a comprehensive program, which provides retirement security for workers and their dependents In order to avoid any misunderstanding, it is worth stressing that this is the definition used in this study

multi-The objective of this thesis is to analyze the performance of existing formal1 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, a thorough analysis of them 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

sources, which fall under the five pillars of the World Bank’s classification of social security system

This chapter provides a background of the research and an introduction to the thesis

It first identifies the need for social security arrangements Important factor such as imperfect market conditions, individuals’ myopic behavior and low income levels are identified The existing issue of demand and supply side conflict of providing social security is summarized in Section 1.3 Section 1.4 discuses the motivation and the rationale of the research, followed by a summary of the objectives, and the organization

of the thesis

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 poverty or more generally, sharp decline in the standard of living of elderly, when their regular income ceases or reduces with retirement, has become a worldwide problem The gradual collapse of the traditional old age support mechanism, mainly due to economic and social changes associated with industrialization, urbanization, migration and increase in female labor participation, has enhanced the role of formal arrangements Perfectly competitive markets result in equilibrium position which is Pareto efficient; hence government involvement is not necessary on efficiency grounds However, equity issues and market

failures provide rationale for the need of government intervention in provision of social security

Neo-classical economists suggest that the most efficient way is to leave the decisions about financing consumption in retirement to voluntary individual choice and

to save according to their inter-temporal preferences of consumption before and after retirement However, due to many reasons; particularly the myopic savings habits of people, moral hazard, adverse selection, inadequate income levels, limited savings instruments, market failures and political considerations; people often end up with failing

to save adequately for their old age As a result, governments have increasingly begun to get involved in mandating social security in order to overcome these problems

One of the most general and simplest reasons for low levels of individual savings

is shortsightedness Such myopic behavior prevents savings during their working life and relies on relatives and the government to take care of them when they become older Most commonly, people may not consider long-term planning over their life- cycle that requires information on lifetime earnings, life expectancy, expected working life, expected retirement life, future health, and expected living standard On the other hand, the major reason for inefficient savings among lower- income households can be their low income level, which is marginally enough for their basic needs

The other side of the problem of market-based social protection system is the failure of the market system Firstly, existence of perfect competition would not be possible in reality particularly due to difficulties of satisfying rigid assumptions Secondly, even if the markets are competitive, they may not ensure a Pareto efficient

competitive markets Social security becomes essential when there are market failures such as 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 essential Thirdly, even if Pareto conditions are satisfied in a competitive market that does not necessarily guarantee

an equitable allocation of resources Income inequality creates different income classes leading to unequal opportunities The failure of market to provide adequate income levels for every one in the society has required government intervention for redistribution purposes (Atkinson and Stiglitz, 1980) Government thus has inescapable responsibility for providing better social security, although ultimately individuals must pay for their own retirement income directly or through taxes, or through a combination of the two (Asher, 2001a)

However, provision of formal social security arrangements has complex impact

on the whole economic, political and social setting of a country Pension programs in general have impact on savings, labor supply, 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 (Asher, 2001a)

The World Banks multi-pillar approach of providing social security suggests the advantages of introducing combination of different retirement income policies The multi-pillar approach recommends that the financial security for the old and the economic growth would be better served if governments introduced different pillars rather than relying on single pillar (World Bank, 1994) Multi-pillar approach is discussed in Section 2.2.4

1.3 The Social Security Dilemma: Demand Side and Supply Side Conflict

Providing old-age security has become an issue of universal concern in both developed and developing counties In many countries collapse of family-based social protection arrangements and recent demographic trends of population and individual aging has already increased the demand for formal social security arrangements; some other countries are expecting such experience in the near future The third stage of demographic transition that increases the population aging associated with low fertility rate and the individual aging due to reduced mortality rates have serious consequences on economic activities including social security These issues are discussed in Chapter 2 (Section 2.3) While, increase in number of older people and their life expectancy create higher demand for expenditure on old-age security systems, increase in system dependency ratio2 has direct and indirect effect on economic variables

Currently, developing countries are rapidly ageing compared to developed countries Thus these countries will have less time (than the developed countries) to adapt for the consequences of population ageing Therefore, even if current populations are

comparatively young in less develop countries; the issues of demographic ageing on social security should not be underestimated Developed countries have extensive social security arrangements, but social security schemes in developing countries are limited in size and scope In these countries, where low income and poverty are common features, large number of elderly will need greater support than elders in developed nations who generally have higher 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 countries the share of pension cost in public expenditure has resulted in higher budget deficits and growth in public debt Even if social security arrangements are totally financed through tax contributions with no subsidies or transfers from government budgets, increase in the contribution rates has created complicated effects through increase in tax burden Therefore, social security arrangements around the world will face greater threats in the future in terms of affordability and sustainability

As claimed by many researchers, social security mostly has negative impact on economic variables such as saving and labor force participation.3 The most prominent claim is that social security programs, particularly pay-as-you-go schemes discourage individual savings Comprehensive but complicated empirical literature on this claim can

be found Feldstein 1974, 1995; Auerbach and Kotlikoff (1987); Hubbard and Judd (1987) Leimer and Richardson (1992); Vent and Wise (1993); Davis (1995) Similarly a wide body of literature argues that social security, particularly Pay-as-you-go pension plans, by

encouraging workers to take early retirement decisions, distort labor market Boskin (1977); Boskin and Hurd (1978); Blinder, Gordon and Wise (1980); Burkhauser (1980); Hurd and Boskin (1981); Burtless and Moffitt (1984), Gustman and Steinmeier (1986);

Börsch-Supan (2000) and Gruber and Wise, (1997, 2002) are some of empirical studies that have identified such relationship between social security and labor force Therefore,

a reform towards an efficient social security setup, which minimizes the adverse effects

on other economic variables without hurting the social requirement for these programs, is

a top priority

1.4 Motivation and Rationale for the Study: The Sri Lankan Context

Sri Lanka has a fifty five year tradition of vigorous democracy with competing political parties, and an independent judiciary Although it has made a progress on economic reforms and has high levels of social achievements such as increased literacy and life expectancy, low infant mortality rates and broad gender equality, it remains at the bottom of the list of middle-income developing countries The prolonged twenty year ethnic conflict raging in the North and East Provinces has become a major threat to country’s economic progress

Since independence in 1948, Sri Lanka, mainly an agricultural economy, has undergone structural changes aiming a balanced economic development But, yet the growth in the economy remained highly dependent on export earnings; mainly from the garment sector and from plantation crops Although Sri Lanka has made progress in macro-economic reforms, progress on financial and structural reforms that would

In the process, the country, which is prominent among developing countries for its social achievements4 despite the low income levels, has developed a complex social security setup albeit in which various components are not well integrated While public sector pension scheme is in crisis due to unaffordable future promises, pension plans that cover private sector employees are criticized for accumulating insufficient member balances

There has been an inadequate professional level attention on the issue of social security in Sri Lanka until recent past when some leading organizations including the World Bank stressed the importance of reorganizing the existing program in terms of affordability and adverse economic consequences Although the recent governments have recognized the importance of urgent reforms to the existing system, a viable solution is 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.5

This research work is particularly important as there has been lack of research done in this area De Mel (2000) and Ranan_Eliya et al (1998) has identified some of the issues relevant to the existing social security system in Sri Lanka, but do not provide

4

The social development of the country, as measured by key indicators such as life expectancy and adult illiteracy rate are well ahead of other countries at similar income levels, and stand out even compared to

policy recommendations for reforms The World Bank study (World Bank, 2000), which has lack of empirical investigation, provides some general comments

1.5 Objectives and the Organization of the Study

The objective of this research is to analyze the major problems involved in the existing formal sector social security system in Sri Lanka with the aim of recommending reform directions for an economically viable and adequate social security system for the covered The thesis particularly analyzes the two major components of the Sri Lankan social security system; namely the Employees’ Provident Fund (EPF) and the Public Service Pension Scheme (PSPS) and provides recommendation to address identified issues related to adequacy, efficiency and sustainability

The thesis consists of three parts The first part provides a review of relevant literature 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 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

components of the system; the Employees’ Provident Fund (EPF) and the Public Service Pension Scheme (PSPS) While chapter 5 empirically tests the fascinating claim that negative impacts of pension savings on other forms of individual saving using time series data over the period of 1959-2002, Chapter 6 analyses the adequacy of EPF member balances and its investment performances Chapter 7 examines the issues concerned to public sector pension scheme and its sustainability in the future

Most importantly, the final part of the thesis provides policy options and reform directions for an efficient, viable and sustainable social security setup for the formal sector employees in the country

Chapter 2 The Economics of Social Security: An Overview

2.1 Introduction

The objective of social security is the provision of a sustainable, socially adequate and equitable retirement protection, while simultaneously minimizing adverse effects on incentives, economic efficiency, and international competitiveness (Asher, 2001a) Protecting aged against poverty and supporting them to maintain their income level without a sharp drop is the main goal that comes under the adequacy motive of social security Elderly are more vulnerable to poverty as their regular income ceases or is reduced significantly after retirement Equity aspects concern access to social security by overwhelming proportion of the population; avoidance of unduly large differences in benefit levels among different types of workers (eg Civil servants vs others); and financing arrangements which do not impose disproportionate burden or provide disproportionate benefits to some at the expense of others Efficiency aspect of social security comprises three major components; incentives, microeconomic efficiency and macroeconomic efficiency (Barr, 1993) The conflict of attaining equity and efficiency goals simultaneously is a complicated and well-known issue that has been debated for years Therefore, similar to any other welfare program, provision of social security involves a trade-off between protection and distortion

This chapter discusses the basic economics of providing social security It provides a foundation for analyses in Chapter 5, Chapter 6 and Chapter 7 Also, the

reform directions provided in Chapter 8 The chapter begins with discussing the key terms in pension economics that are used throughout the thesis (Section 2.2) It is important to discuss these terms, because readers may become uncomfortable with the usage of them in later chapters Instruments of government intervention for providing social security are discussed in Section 2.3 Economic impact of social security depends

on the nature of different social security programs Section 2.4 and Section 2.5 discuss consequences of DB, PAYG social security programs and fully funded DC programs Accordingly, economic impact of providing PAYG social security, particularly, its impact on saving, labor market decisions and economic growth are discussed in Section 2.4, followed by an analysis of economic and financial impact of fully funded defined contributory pensions in Section 2.5 Section 2.6 provides an economic analysis of social security reforms

2.2 Key Terms in Pension Economics

Three major approaches of retirement programs can be identified in pension literature, although these approaches have practically been implemented with variety of different institutional changes These are universal pension programs, Defined Benefit (DB) pension plans, and Defined Contributory (DC) pension plans Universal pension programs (with or without means- tested) offer similar benefits to all older residents, regardless of their previous employment or contributions Other two types discussed above are generally employment based While, DB plans can be either pre-funded (at least partially) or Pay-As-You-Go (PAYG) type, DC plans are generally Fully Funded (FF) Universal pension programs are publicly managed On the other hand, other two

types of pension programs can be publicly or privately managed These different approaches of retirement programs are defined in next few sections

2.2.1 Public Vs Private pillar

Need for government intervention in providing adequate retirement income for the elderly is widely recognized, although, there are many disputes concerning the form

of such involvement The government intervention on social security arrangements can take different forms It can be directly controlled or lightly 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 PAYG and DB type schemes Contrary to providing more security and mostly more benefits on employees’ perspective, public pillar is mostly criticized in terms of efficiency and affordability In terms of public management of contributory private pension plans, World Bank (1994) shows clear evidence that private pension management being better than the public ones World Bank further clarifies that publicly managed pension funds earn low rate of returns compared to funds that are privately managed, as they have been vulnerable to political influences

2.2.2 Funded Vs Pay-As –You-Go (PAYG) Arrangements

A social security arrangement is called a funded scheme, when the financing is from an accrued fund that is backed by some form of assets Funded arrangements account for the future liabilities at present, therefore maintain a designated asset based fund from which future payments are financed Funded pension plans further divide into two categories, fully funded or partially funded pension plans A fully funded pension plan maintains the full present discounted value of expected future liabilities of the designated plan A partially funded scheme, on the other hand is a designated asset based fund but do not maintain the full present discounted value of expected future liabilities In

an unfunded scheme, there are no assets set aside to pay the obligations made in the past; hence they are paid by current contributions.When the system is funded the Replacement Ratio (RR)1 depends positively on the real rate of return and negatively on the Passivity Ratio

A PAYG system is essentially an unfunded arrangement, in which retirement benefits are backed by implicit government debt or current worker contributions Hence

in a pay-as-you-go system pension obligations exist but there are no assets set aside to pay them This type of arrangement is thus an intergenerational contract of transfers between workers and pensioners as workers who pay for today’s pensioners are depended

on the tomorrow’s workers In a financially balanced PAYG system, pension benefits are exactly matched with the workers’ tax contributions A financially balanced system however does not exist when the system become mature as the system dependency ratio

1

Replacement Rate (RR): monthly (or annual) pension benefit as a percentage of monthly (or annual) salary Generally, RR is calculated using final salary, a minimum salary or an average salary for a specific

increases with the time Demographic ageing, particularly individual aging, which increases the system dependency ratio, further widen the gap between contributions and benefits Thus generally in PAYG systems deficits are typically absorbed in government budgets

2.2.3 Defined Benefit Plans Vs Defined Contributory Plans

Defined Benefit (DB) and Defined Contribution (DC) pension plans mainly distinguish according to their different risk-bearing characteristics In a DC plan, the retirement benefits are directly linked to the contributions and the contributions are determined in advance Each employee has an account into which both employer and employee make regular contributions At retirement, members receive benefits either as a lump sum or an annuity depend on the accumulated net contributions (gross contributions less withdrawals), and earnings of plan’s investments or more precisely the rate of return credited to their accounts Hence in a DC plan the size of the individual’s pension account at retirement directly determines retirement benefits

In DB plans the retirement benefits are pre-determined In a DB plan, benefits of employees’ are determined by a formula according to the years of employment and earnings, in most cases, wages or salary A DB formula can take different forms such as universal flat benefits, employment related flat benefits, mean-tested higher benefits, and income related benefits Universal flat benefits pay the same benefits for all employees above a certain age, regardless the age and history of the employment where as the employment related flat benefits pay same benefits for everyone per year of covered

employment When it is mean-tested higher benefits are paid for the employees with lower income or smaller assets

The DB formula, because of the promised benefits, reduces the risk of income uncertainty at retirement; however passes the risk to the younger generations or to the plan sponsor In contrast, DC plans’ participants bear the risks as the benefits levels wholly depend on the total contributions and the investment earnings of the accumulation

in the individual account These risks can me identified as longevity risk, inflation risk, risk of low returns yield due to poor management of fund, poor investment strategies and macroeconomic shocks such as volatility of interest rates etc

Longevity risk is one of the major problems involved in DC plans If the benefits are a form of a lump sum, the worker has to bear the full risk of his future standards of living The problem is crucial when the member balances are relatively low If the worker

is required to purchase an annuity upon the retirement, it may ease the problem of longevity, but will not be a solution for low level of welfare after retirement A single life annuity will not provide benefits for the survivor But the joint life annuity may generate inadequate payments to keep the standards of living of the retirees to pre-retired levels

Generally, DC plans are fully funded DB plans can be funded to any degree and vary across countries and over time Some countries such as in Africa, Middle East, United States, Japan and Sweden have adopted partially funded Defined Benefit plans However, there is no evidence for existence of fully funded Defined Benefit plans run by national governments (Iglesias et al, 2000) These plans are most often organized as either PAYG or partially funded

DC plans can be centrally managed or decentralized Privately-managed, decentralized pension plans can be seen in countries such as Latin America, Hungary, Poland Hong Kong, Australia, Switzerland, and in the United Kingdom Singapore, Malaysia, India, and Sri Lanka are some of the examples for countries those have centrally managed Defined Contribution plans; often called as Provident Funds

2.2.4 The Multi-pillar Approach

As a result of the growing realization of the inadequacy of single-pillar, government or private, the World Bank (1994) advocated a multi-pillar structure that comprises a redistributive element, a mandatory, fully-funded, element, and a third element providing for additional voluntary related savings2 The main characteristics of these pillars can be summarized as follows The first pillar, a Defined Benefit (DB) public pension scheme that ensures a basic income to retirees, disabled workers and survivors, can be characterized by a greater or lesser degree of pre-funding In most countries pension is financed largely by contributions and/or payroll taxes and in some cases general government revenue is the chief source The schedule of benefits can be means-tested or based on other qualifications such as age Second pillar is a mandatory defined contribution (DC), fully funded (FF) scheme These pension funds are publicly regulated but assets are managed either publicly or privately Contributions are paid by workers and employers and the benefits are depended on the accumulated balances upon retirement as lump-sum payment or an annuity based on the account value Third Pillar encompasses supplementary arrangements for workers who wish to enhance their

retirement income, or whose employers voluntarily compensate their work force partly through deposits to a private pension plan Similar to second pillar, retirement benefits can take the form of lump sum payments, phased withdrawals, or annuities These arrangements are publicly regulated in order to protect participants

There are different responses to the multi-pillar system Some researchers show the advantages of the system as it can combine the benefit of PAYG based economic growth with the advantages of funded schemes based on financial returns (Palmer, 2000) and reduced risks (Merton et al., 1987 and Dutta et al., 1999) Researchers have different arguments of selecting the size of each pillar Some researchers, Feldstein (1974, 76, 98) for example, recommend of having a minimized PAYG pillar Heller (1998) on the other hand shows limitations of relying upon mandatory, defined contributory schemes as the domain pillar As he argues, advantages of such schemes can obtain only at the expense

of significantly higher risks to the incomes of the future pensioners Secondly, if these schemes are pursed within the private sector, both the management of fiscal policy and the assessment of economic impact of fiscal instruments are likely to prove more difficult With these arguments he suggests that, although the fully funded, defined contributory pillar plays a major role in the multi-pillar system, it should not be the dominant pillar Decision of selecting the size of individual pillars, however, should take

by looking at the country specific circumstances

2.3 Instruments of Government Intervention for Provision of Social Security

In Chapter one, we briefly discussed the need for government intervention in providing social security With the belief that free market is not efficient enough to protect elderly from deprivation, many agree that some form of government intervention

in providing social security is necessary (World Bank, 1994) However, disputes exist on the level and the forms of such intervention Government intervention does not necessarily imply public provision or public management Rather governments can indirectly intervene through regulations and incentives Public provision of social security, the most direct form of state intervention, is mostly criticized because of the negative macroeconomic impact they create

Other than providing PAYG pensions, public management of fully funded pension funds is also common around the world (EPF schemes in India, Malaysia, Sri Lanka and CPF in Singapore are some examples) However, public management of these fully funded defined contributory pension funds are also criticized on performance grounds The main argument is those publicly managed pension funds are politically motivated thus are low in productivity As evidenced around the world rate of return earned by many publicly managed pension funds are relatively low compared with the privately managed pension funds (compare investment performance of these funds with privately managed funds in Australia, the UK or Chile for example (Iglesias and Palacios, 2000)

Regulations are the other form of intervention in social security In recent years private management of mandated individual pension saving is becoming widespread

programs through regulations, mostly influencing the investment policies Risk reduction motivations of these regulations are however criticized according to the theory of modern portfolio management Although some sort of government intervention is accepted in practice, direct investment regulations beyond prudential requirements are not preferred

in pension economics But these require high institutional, policy making and implementation capacity This is not found in all countries

Other than direct involvements, governments can boost private saving though tax incentives, providing necessary information, and some other measures such as controlling inflation and interest rates Further, using fiscal or other instruments to develop the financial structure, governments can create suitable and reliable environment for individuals to save enough on their own to support retirement needs

2.4 The Basic Economics of DB Social Security

DB plans can be either pre-funded (at least partially) or PAYG type However, many DB pension plans in the world are PAYG type Therefore this section analyses the issues relevant to PAYG social security provision

2.4.1 PAYG Social Security in Overlapping Generations Framework

The overlapping generation model (Samuelson, 1958, Diamond, 1965) that has been extensively used in studies of life-cycle saving behavior of individuals, facilitates the understanding of the basic economics of social security Feldstein (1998), Feldstein and Liebman (2000) have used the tools of the overlapping generation model to analyze

the impact PAYG social security on economic variables such as consumption, labor supply and saving

The essence of this approach is that there are two generations: working generation and the retired generation, alive at any point of time considered and the young in period t becomes old in period t+1 Let us assume first that economy initially has L0 amount of labor growing at a rate of n per period; second, there is no capital good in the economy; and third, products are consumed during the period in which they were produced If the number of workers at time t is Lt; then the labor supply at the period t+1 would be,

L L

w

But Lt+1 is equal to (1+n) Lt (equation 2.1) Then the ratio of benefits to contributions simply depends on the rate of the growth of the population;

n T

T

B t

) 1 )(

1 ( )

1 )(

1 ( 1 1 1

1 1

n g L

w

L w n g L

w

L w L

w

L w T

B

t t

t t

t t

t t

t t

t t

2.4.1.1 Reduction in Rate of Return

This section shows that when the assumption of absence of durable capital assets

is relaxed, the achievement of a Pareto improvement through social security becomes ambiguous The existence of capital stock implies that the individual have opportunities

of saving and investing on their own retirement needs As market based rate of return on investments is generally higher than the rate of return that earns by PAYG social security scheme, an introduction of tax based provision of social security may cause losses for each generation (Feldstein and Liebman, 2002; Feldstein, 1998)

To show this, consider the result of the previous section that tax deductions of social security brings about a rate of return equals to γt Hence, tax deduction of the

working generation in period t earns a return equals to,

t t t t

) 1 )(

( )

1 ( )

1

where, ρt is the discount factor.According to the above formulation, if rt > γt, there is a

present value loss for the rate of return for the working generation at period t

2.4.1.2 Consumption Loss due to PAYG Social Security

Provision of PAYG social security has negative impact on capital accumulation and labor force participation Theoretical and empirical research on capital and labor market and distortions of PAYG type of social security system will be discuss in next two