Chapter 18 improving the equity, transparency, and solvency of pay as you go pension systems

CHAPTER 18 Improving the Equity, Transparency, and Solvency of Pay-as-You-Go Pension Systems: NDCs, the AB, and ABMs Carlos Vidal-Meliá, María del Carmen Boado-Penas, and Ole Settergren CONTENTS 18.1 I ntroduction 18.2 N otional Defined Contribution Accounts (NDCs) 18.3 Actuarial Balance of the PAYG System 18.3.1 The Swedish Model 18.3.2 The U.S Model 18.4 Automatic Balance Mechanism (ABMs) 18.4.1 S weden 18.4.2 C anada 18.4.3 G ermany 18.4.4 J apan 18.4.5 F inland 18.5 Summary and Conclusions Appendix 458 Acknowledgments References 420 422 429 431 439 445 449 451 452 453 455 456 67 67 419 © 2010 by Taylor and Francis Group, LLC 420 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling T he a im of t his chapter is to show the advisability of introducing instruments f or i mproving eq uity, t ransparency, a nd so lvency i nto the pay-as-you-go (PAYG) pension system This is in line with the trend seen in some countries of applying actuarial analysis methodology to the field of public PAYG pension system management With this aim in mind, we explain and analytically develop various aspects of notional definedcontribution accounts (NDCs), the actuarial balance (AB), and automatic balance mechanisms (ABMs) The main conclusion reached is that these tools are not simply unrealistic theoretical concepts but a response to the growing social demand for transparency in the area of public finance management, the need to minimize the political risk faced by PAYG systems, the desire to set the pension system firmly on the road to long-term financial solvency, and the wish to increase contributors’ and pensioners’ confidence in the system in the sense t hat promises of pension payments will be respected JEL Classifications: H55, H83, J26, M49 18.1 INTRODUCTION Concern abo ut t he financial h ealth o f p ublic pens ion s ystems i n a ll i ts various f orms—solvency, su stainability, v iability, eq uilibrium—caused by population ageing is high on the agenda of many governments and international organizations such as the World Bank, the Organization for Economic Cooperation and Development (OECD), and the International Labor Organization (ILO) It c an t herefore be co nsidered, a s Holzmann and Palmer (2008) do, to be a q uestion of worldwide importance In the academic w orld, t oo, o ver t he la st t wo dec ades, t here s be en a h uge increase in the number of articles published on all types of issues related to public pension systems One aspect that has received much less attention in the literature concerns t he i nstruments t hat c an be a pplied to de al w ith one of t he ma in problems faced by traditional defined benefit (DB) pay-as-you-go (PAYG) systems: po litical r isk De aling w ith t his p roblem c an o ften, according to B oado-Penas (2008), b ring abo ut cl ear i mprovements i n t he s ystem’s equity, transparency, and solvency Political ri sk s hould b e u nderstood b asically as r eferring t o t he decisions t aken b y po liticians t ied t o t heir t raditional p lanning h orizon (often only years), which is clearly far less than that of the PAYG © 2010 by Taylor and Francis Group, LLC Improving the PAYG Pension Systems ◾ 421 pension s ystem Valdés-Prieto ( 2006a) po ints o ut t hat D B PAYG s ystems tend to require periodic adjustments due to demographic and economic uncertainties Relying on discretionary legislation for these social security m odifications c reates po litical r isk f or bo th co ntributors a nd beneficiaries Cremer and Pestieau (2000) argue that economic and demographic factors play a r elatively small role i n t he PAYG pension s ystem’s problems; political factors are far more important, and the process of reforming the pension system is mainly a po litical problem Financial (solvency) problems caused by fluctuations in fertility rates, population ageing, increasing longevity, and declining productivity growth can easily be addressed by t he ex perts, but social security systems a re established a nd reformed through the political process Consequently, the outcome is likely not to be socially optimal The most negative fac e of political r isk i s what Valdés-Prieto (2006b) terms “populism in pensions.” This can be defined as a form of competition between politicians in which voters are offered subsidies and benefits without their appreciating that it is they themselves who will pay through higher taxes, higher contributions, higher inflation, or reduced economic growth Populism in pensions is a phenomenon usually seen in countries with pension systems that are financed by PAYG; it is aggravated if a country suffers from a weak democratic structure and could also be i ncreased by a low level of education Where the financial method is capitalization, it is more difficult for populism in pensions to appear given that the pensions are financed in advance and there is an obligation to compile an actuarial balance (AB) sheet every year, from which the corrective measures to be applied are derived when necessary Finally, H olzmann a nd P almer ( 2008) st ate t hat soc ioeconomic changes—basically g reater pa rticipation by women i n t he labor ma rket, changes in family structures, and increasing globalization, which together imply greater integration of the goods and services markets, factors of production and k nowledge—call for a r eformulation of t he basic ideas governing pension system design, some of which have remained unchanged for more than a century The aim of this chapter is to show the advisability of introducing instruments to improve the equity, the transparency, and the solvency of PAYG pension systems This is in line with the trend seen in some countries of © 2010 by Taylor and Francis Group, LLC 422 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling applying ac tuarial a nalysis m ethodology t o t he field o f p ublic P AYG pension system management After this introduction, in Section 18.2 we give a brief description of various aspects of notional defined contribution (NDC) pension plans In Section 18.3, we concentrate exclusively on what will be described as the PAYG system’s actuarial balance (AB), focusing especially on some of the features of the Swedish and U.S methods Section 18.4 defines what is u nderstood by the term automatic balance mechanism (ABM) as applied to a pension system, and includes a brief presentation of those in place in Sweden, Canada, Germany, Japan, and Finland This chapter ends with the main conclusions, a bibliography w ith references, a nd four appendices i n wh ich we a nalytically develop the relationship between the main formulae for calculating the retirement pension i n PAYG s ystems, t he contribution a sset, a nd t he s ystem’s liabilities as shown in the AB for both Sweden and the United States 18.2 NOTIONAL DEFINED CONTRIBUTION ACCOUNTS (NDCs) The i ntroduction of what a re k nown a s N DC pens ion accounts (plans), NDCs,* as a component of modern multi-pillar pension systems in some countries, s be en o ne o f t he ma in i nnovations o f t he la st dec ade a s regards pens ion r eform They c an be f ound i n I taly (1995), Kyrgyzstan (1997), L atvia ( 1996), P oland ( 1999), S weden ( 1999), B razil† ( 1999), Mongolia (2000), and Russia (2002).‡ O ther countries such a s G ermany (Bưrsch-Supan and Wilke 2006), Austria (Knell 2005a),§ France (Jeger and Leliebre 005), Finland (Lassila a nd Valkonen 007a), Portugal (Barrías 2007), and Norway (Stensnes and Stølen 2007) have also incorporated elements of notional philosophy to assist in calculating or indexing the initial retirement pension The notional account is not a completely new concept As Gronchi and Nisticò (2006) point out, the original idea of the NDC was present in two * For an international perspective see the books by Hol zmann and Palmer (2006, 2007), and Holzmann, Palmer, and Uthoff (2008) † Th is does not have all the characteristics of a notional account system ‡ See Hauner (2008) § The author calls this a “notional defined benefit system” (NDB) as all the contributions made are registered i n a not ional account a nd a mount to 78% of t he a nnual contribution base and are revalued in line with the average increase in the contribution bases If the individual retires at a ge 65 a fter 45 years of contributions, his entitlement will be (1.78 ì45) =80.1% of the contribution base â 2010 by Taylor and Francis Group, LLC Improving the PAYG Pension Systems ◾ 423 papers published in the 1960s by Buchanan (1968) and Castellino (1969), which were rediscovered in the late 1990s by Gronchi (1998) and ValdésPrieto (2000) The latter t races t he origin of t he concept back t o France in 1945, in what was known as the points system* (PS), and to the United States in the 1980s, when Boskin et al (1988) proposed a reform of the pension system based on ideas in which the concept of notional accounts was implicit According to Vidal-Meliá et al (2004), a n otional account is a v irtual account r eflecting t he i ndividual co ntributions o f e ach pa rticipant a nd the fictitious returns that these contributions generate over the course of the participant’s working life In principle, the contribution rate is fixed Returns are calculated in line with a notional rate that may be the growth rate of GDP, average wages, aggregate wages, contribution payments, etc.† When t he i ndividual r etires, h e o r sh e ( henceforth, h e) r eceives a pen sion that is derived from the value of the accumulated notional account, the expected mortality of the cohort retiring in that year, and, possibly, a notional imputed future indexation rate In this way, the notional model combines PAYG financing w ith a pens ion f ormula t hat depen ds o n t he amount contributed and the return on it At first glance, NDC plans simply appear to be an alternative way of calculating the amount of retirement pension, but in fact the notional method goes beyond what might be imagined from seeing the collection of formulae in Appendix 18.A.1 The account is called notional because it exists only on paper Money is not deposited i n a ny real account Nevertheless, t he amount of the pension is based on the fund accumulated in the notional account (K) C ontributions made to not ional accounts a re c apitalized at * The p oints s ystem for re tirement w as d eveloped i n Fr ance w ithin t he f ramework of c omplementary regimes for salaried workers (Association pour le régime de retraite complémentaire des salariés: ARRCO) and management (Association générale des institutions de retraite des cadres: AGIRC) Pension entitlement for p eople in these regimes was based on the accumulation of retirement points throughout working life See Appendix 18.A.1 † A somewhat over-simplified “truth” is that the most appropriate rate of return, from a financial stability point of view, is the growth rate of the covered wage bill, which reflects not only the variation in contributors but a lso the variation in contribution bases (productivity) In practice, this index is not a lways used—in Sweden, for i nstance, the index used, disregarding p eriods w hen t he automatic balance me chanism i s activated, i s t he g rowth i n average earnings, partly because it is considered to be less volatile Mechanisms are in place to deal with any negative fi nancial consequences that could arise from using this index or financial imbalances in the pension system deriving from demographic or economic shocks or turbulence in financial markets These are looked at in Section 18.4 © 2010 by Taylor and Francis Group, LLC 424 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling a notional rate of return This hypothetical return* is normally linked to some external index set by law When the individual retires, the notional account—in all countries that use them—is converted into a life annuity.† This is normally done by dividing the value of the notional account (K) by a conversion factor (g) t hat depends on l ife e xpectancy at t he c hosen re tirement a ge a nd the interest rate, which w ill indirectly bring about a r eduction in t he degree of va riation i n t he i nternal r ate of return (IRR) be tween generations T he base for calculating t he conversion fac tor should be se t by law and decisions need to be made a s to which mortality table and interest rate should be u sed in t he calculation a nd how t he mortality table should be updated.‡ It should also be determined whether or not the conversion factors for men a nd women should be sepa rated, as is common with pension plans with real capitalization, or whether some common c onversion f actor s hould b e u sed t o ave rage out l ife e xpectancy for men and women, as is generally the case in traditional PAYG systems Following Vidal-Meliá et al (2006), in order to calculate the initial pension of an individual at retirement age in notional account models, the contributions made and valued at the date of retirement are made equal to the pension that that individual will receive until his death, which is also calculated at the date of retirement Hence the initial pension at normal retirement age will be t he product of the conversion factor (CvF), g, and the notional capital (K): CvF P NDC R = g R −1 R −1 t=x i =t ∑ ct ⋅Wt ∏ (1 + ri ) (18.1) K * It is worth pointing out that the volatility of the return on notional accounts is usually less or much less than the return on a p ension plan under the capitalization system, which will depend on the choice of portfolio and the investment market † Th is i s one w ay it d iffers f rom a s ystem of i ndividual c apitalization a ccounts, i n mo st of these c ountries, opt ions ot her t han l ife a nnuities a re av ailable ( lump s um p ayments a nd programmed withdrawals) ‡ In Sweden and Brazil, demographic parameters undergo an adjustment process every year following observed survival rates In Italy, the review should be every 10 years According to Diamond (2005), the best way of putting an end to unwanted political manipulation would be to carry out annual adjustments with real data instead of projections © 2010 by Taylor and Francis Group, LLC Improving the PAYG Pension Systems ◾ 425 where ct is the contribution rate at moment “t” Wt i s t he co ntribution ba se f or t he r etirement co ntingency a t moment “t” ri is the real notional rate applied to capitalize the contribution g i s t he p redetermined co nversion fac tor, wh ich i s t he i nverse o f a n actuarial annuity In practice a n e stimated va lue c an be g iven for t he relevant va riable so as to ma ke t he initial pension as high as possible, and t he indexation of the pension in payment is adjusted annually in line with the behavior of the relevant variable If the variable actually behaves as forecast, pensions remain constant in real terms; if growth is greater than predicted, pensions grow in real terms; and if growth is lower than forecast, then pensions decrease in real terms A mechanism similar to this is applied in the case of Sweden Arguably, NDC systems have stronger immunity against political risk than more traditional DB PAYG systems According to Valdés-Prieto (2005), t he n otional acco unt s ystem i s a u seful wa y i n wh ich t o m inimize t he political r isk a ssociated w ith PAYG s ystems a s it i ncreases t he long-term financial solvency of the system, although it also increases the explicit economic risk affecting contributors.* Marin (2006) believes that the notional account system is a better way of managing and diversifying risk i n comparison to a ll other pension pa radigms a s it c reates no fa lse expectations about pensions to be received in the future, makes it difficult for contributors to be tempted to behave opportunistically, and is not subject to the financial risk of capitalization systems As r egards financial su stainability, Valdés-Prieto (2000, 002) sh ows that, e ven wh en a pplying t he m ost fa vorable f ormula ( model), N DCs can only achieve this in a r ather unrealistic steady state Hence notional account systems always require other financial adjustment mechanisms— such a s government g uarantees a nd re peated re course to le gislation—to be imposed in the same way as traditional benefit systems, or according to Settergren (2001), special measures such as ABMs, which will be looked at in Section 18.4 According t o Dia mond (2004, 006), a w ell-structured N DC s ystem with a decent-sized buffer stock of assets will be unlikely to need legislative * On this subject, see the papers by Vidal-Meliá et al (2006) and Boado-Penas et al (2007) © 2010 by Taylor and Francis Group, LLC 426 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling intervention as long as economic growth is high enough For Lindbeck and Persson (2003), a quasi-actuarial system with an exogenous contribution rate (i.e., a contribution-based system) will increase the financial stability of the pension system in the sense that politicians will not have made any promises concerning future pension benefits, although, as Börsch-Supan (2005) points out, only time will tell whether the political risk of NDC systems is really much less than traditional DB systems as some of the system’s parameters could always be modified As fa r a s t he i ntergenerational a spect i s co ncerned, f ollowing K nell (2005a,b), NDCs are more “forward looking” while DB PAYG systems have a more “ backward lo oking” c haracter “For ward lo oking” s ystems are more in line with principles of intergenerational fairness and responsibility, wh ereas “ backward l ooking” s ystems i ndicate t hat pe ople a re obliged to shoulder the burden of changes in the size of cohorts that have been determined before they were even born, or before they were part of the electorate or the labor force As Diamond (2006) and Barr and Diamond (2006) correctly point out, almost all the advantages attributed to NDCs could be obtained with a well-designed DB system, although of course this is precisely the difficulty inherent in such systems: the ease with which erroneous political decisions convert them into badly designed systems.* For Marin (2006), the superiority of the NDC system over the DB system lies not in the theory but in the practice and application The formulae that determine the initial pension for DB a nd NDC systems, respectively, may produce a v ery similar financially sustainable pension Also, the relationship of the NDC system to the PS is clear (see Appendix 18.A.1), although the problem with the PS is its highly discretional nature, similar to DB systems in this aspect, which, according to Valdés-Prieto (2000), is built into the system This can be seen from the way the authority in charge of the system can arbitrarily adjust the cost of buying new points, the contribution rate, and the value of points sold to obtain a pension every year Börsch-Supan (2006) states that discretional deviations have been frequent in the French PS, and the German system is not free of them either Börsch-Supan (2005) points out that NDC systems have a high level of transparency and, at least potentially, a deg ree of credibility that are not usually found in DB systems This is because the basic elements that determine t he a mount of t he pension appear naturally i n notional accounts, * On this subject, see the papers by Palmer (2006) and Williamson (2004) © 2010 by Taylor and Francis Group, LLC Improving the PAYG Pension Systems ◾ 427 whereas they not in the more complex formulae needed for calculating pensions in DB systems Marin (2006) argues that NDC systems encourage actuarial fairness and stimulate the contributors’ interest in the pension system as they bring to light any improper or hidden redistribution of benefits to privileged groups and reveal who really benefits from the legislation It also forces contributors to think about the relationship that exists between their contributions, the option to retire at different ages and the amount of pension in the form of a life annuity that they will eventually receive, a nd a ll t hese t hings ma ke pe ople m ore i nterested i n a nd m ore knowledgeable about the way the pension system works.* The NDC system allows for special circumstances to be taken into consideration—it enables married couples to share notional accounts during certain periods if they have children to look after, for example, or periods of military service—but the funding for this must come from the State and general taxation, and the appropriate entries must be made in the notional accounts According to Holzmann (2006, 2007), these positive features of the notional acco unt s ystem a re su fficient r easons f or p utting i t f orward as a f undamental r eferent f or t he f uture u nified pe nsion s ystem o f t he European Union Finally, following Vidal-Meliá et al (2004), although the notional account system has many positive elements, it also has some characteristics, which in most cases it shares with the traditional (DB) PAYG system: It d oes n ot f ully de al w ith t he p roblem o f dem ographic cha nge Although it takes the evolution of mortality into account, there is a delay before it does so Pensions are generally calculated only once— at the time they are awarded—and improvements in life expectancy are n ot t aken i nto acco unt wh en pens ions t hat ve a lready be en awarded and are still in payment are recalculated.† If t he contributor i s f ree to choose h is a ge of retirement, t his may result in an excessive number of early retirements, which, in turn, may cause pressure on the authorities to increase the amount of the guaranteed m inimum pens ion De spite t he ac tuarial ad justment incorporated into the NDC system, Palmer (1999), there is empirical * Every year in Sweden, all affi liates are sent what is known as the “orange envelope” containing information about the notional account and capitalization, plus a projection of expected benefits at ages 61, 65, and 70 † Th is point is also shared by capitalized pension systems © 2010 by Taylor and Francis Group, LLC 428 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling evidence that contributors use a higher personal discount rate than that applied in the actuarial adjustment and tend to retire as soon as they are allowed to, and for this reason a great deal of care needs to be taken when it comes to establishing the minimum retirement age In a sc enario with a fi xed contribution rate and a pers istent rise in longevity, the size of the pension tends to decrease For this reason, Barr (2006), the minimum retirement age needs to be raised in line with the increase in life expectancy.* If the return on the contributions using the chosen index were less than th e r eturn o n th e c apitalization fu nds—this w ould b e m ore likely in mixed systems sharing notional and individual capitalization accounts—then the individual might consider that there was an implicit cost (tax) in the notional accounts equivalent to the difference in return W hether t his would be a co rrect perception or not depends o n t he co ntributor’s deg ree o f r isk a version a nd t he r iskadjusted return Nominally positive difference i n y ield c ould a fter risk adjustment be negative.† According to Boado-Penas et al (2007), contributors take on the risk of how the index evolves and are subject to a r isk-return ratio they did not choose, that is, their risk aversion is not taken into account, whereas it is—or at least has the potential to be—in private capitalization funds It should also be pointed out that the index or indices chosen as notional rates can be h ighly volatile and submit the contributor-beneficiary to more risk than they would willingly take on The p ractical a pplication o f t his n otional acco unt s ystem t o t he retirement contingency needs to be combined with traditional formulae o r i nsurance f ormulae i n o rder t o co ver d isability a nd survivor benefits * This is shared by capitalized pension systems † The Swedish experience shows that since 1995 the average rate of return in the notional type (Inkomstpension) s ystem, me asured a s t he c apital-weighted r ate of re turn, has b een 3.1% The average annual variation in the rate of re turn, as measured by t he standard deviation, has been 1.1 percentage points Since t he fi rst payments into t he premium pension system in 995, t he ave rage re turn of t he pre mium p ension s ystem a fter t he d eduction of f undmanagement fe es h as b een 8% The a nnual v ariation i n t his r ate of re turn, a s me asured by the standard deviation, has been 14.3 percentage points The risk-adjusted return for the Inkomstpension system would be 2.81% and barely 0.41% for the premium pension system If the return were measured by means that took into account the degree of risk aversion, the comparison would still be more favorable toward the notional account system © 2010 by Taylor and Francis Group, LLC 458 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling faced by PAYG systems, the desire to set the pension system firmly on the road to long-term financial solvency, a nd t he w ish to i ncrease contributors’ and pensioners’ confidence in the system in the sense t hat promises of pension payments will be respected The pension system currently i n place in Sweden is the only one that incorporates all the tools described, but that does not mean that it cannot be improved, nor that it will necessarily emerge unscathed from the political stress test of the current economic crisis APPENDIX 18.A.1 RELATIONSHIP BETWEEN FORMULAE FOR CALCULATING RETIREMENT PENSION IN PAYG SYSTEMS If in a well-designed DB system, WtR is the term that stands for the nominal salary or contribution base for age t projected u ntil a ge R (n ormal retirement age): R −1 WtR = Wt ∏ (1 + ni ) i =t (18.10) where Wt is the salary or contribution base at moment t ni is the real annual rate used to capitalize the contributions or salaries then R −1 WM R − x WtR ∑ t=x = R−x (18.11) where x is the age of the contributor on entering the labor market WMR−x is the average salary during working life (R −x) indexed at the moment of retirement, or what is usually called the regulating base taking into account the whole working life Supposing t hat t he pension system g uaranteed a n accumulation rate, At, defined as the quotient between the contribution rate (ct) and the present value of a life annuity due of per year,* while “R” survives, increasing * This has been simplified to serve as an example Payments are in fact made monthly in arrears © 2010 by Taylor and Francis Group, LLC Improving the PAYG Pension Systems ◾ 459 at the accumulative annual rate of α, ctα , for each of the years contribuaR tions have be en made , wh ich de termines t he replacement r ate at retirement age, then the initial pension at normal retirement age will be Replacement rate PRDB = R −1 ct ∑ t = x WtR = A R −1W R −1 (1 + n ) − = − ( R x ) A ( R x ) WM R − x t t∑ t∏ t R−x aRα i=t t=x Regulating base At (18.12) Note t hat F ormula 18.12 i s va lid f or co ntributors wh o r etire a t n ormal retirement a ge I f t he a ffiliate s t he option to t ake early or late retirement, R*, all that would be needed is to introduce an actuarial correction (adjustment) factor, CvF, so that At* = CvF ⋅ At Replacement rate DB R* P aα c = αR αt aR* aR CvF At Years of contribution (R * − x ) WM R* − x = CvF ⋅ At Regulating base R * −1 R * −1 t = xe i =t ∑ Wt ∏ (1 + ni ) (18.13) At* Correction factor (CF) is greater than for values R* >R and less than for values R*