Rethinking Pension Reform: Late Prof. Franco Modigliani & Arun Muralidhar

1. Rethinking Pension Reform:Late Prof. Franco Modigliani& Arun Muralidhar Dr. Arun Muralidhar www.mcubeit.com

2. Franco Tribute New Yorker, June 1999 The New Yorker

3. Agenda • U.S. Social Security and current problems • Case for funding (and investing in equities) • Privatization - European & South American experience • A swap ensures DB and no manipulation of assets • The impact of these proposals on market efficiency • The impact of reform on the budget and the asset management industry

4. The Pension Fund Balance Sheet Funded ratio = assets/liabilities PENSION BENEFITS Current Assets = FutureContributions FutureReturns Can be funded completely, partially or PAYGO

5. Background on U.S. Social Security • Pay 12.4% of salary as contribution (w. caps at $87,900) • Contributions split equally between employer and employee • Average benefit = 50% of average of 35 best years of salary • Defined benefit, but redistribution (top earnings bracket may get only 35%; lowest can get 70%) • “Pay-As-You-Go”: Some funding thanks to Alan Greenspan • For many, SS accounts for 90% of retirement income!! • Inflation adjusted pensions

6. Background on U.S. Social Security • Receipts = $630 bn; Payments = $480 bn • Trust Fund = $1.5 trillion • 47 mn people receive benefits; 154 mn people covered • Trust Fund projected to grow to $4 trillion by 2013 • Current surpluses are invested in “government debt” – earned 6% in 2003 • Problems not immediate – can go on for 40 years

7. PAYGO Formula Taxable Wages* SS tax = Pension Benefits • Taxable Wages depends on Rate of Growth of Real Income (Labor Force + Productivity Growth) • Increasing longevity increases pension benefits • Often, no incentive to control pension promise • Ratio of contributing worker to pensioner dropped from 9 to 2-3 • A “Ponzi” Scheme and the Bjorn Borg solution……..

8. Need for Reform – Social Security Crisis • Pay-as-you-go (PAYGO) systems face a crisis • Caused by low population and productivity growth • Contributions will need to rise dramatically or benefits will need to be cut to be sustainable • Often, there is a poor link between contributions and benefits; benefits are often too generous • Many countries do not have budget cushions to bail out these systems – Maastricht Criteria!! • Two different issues: (1) Best System; (2) Transition

9. Need for Reform - The U.S. Case Problems are much worse in Europe, Emerging Mkts!!

10. Latin America and Europe • In many European cases, current contributions are as high as 30% of salaries – projected to rise further!! • Benefits very generous – often 100% of final salary • Pension cost can be as high as 6-10% of GDP • Rates of return in the 1980s of governmental systems often very negative (-37% p.a. in Peru) • Projected rate of growth of labor force + productivity < rate of return on assets

11. PAYGO versus Funding • Long term, Funding = lower contributions (r > population growth + productivity growth) • Volatility of contribution under PAYGO is very high • No savings – contributions finance dissaving of the elderly • Cannot just transition immediately, as Funding dominates because funds were set aside • Funded systems can impact capital markets • Funding implies some investment in equities

12. When Funding Dominates….

13. The Golden SS Funding Rule c* + (r-)At-1*= p* • c* is the contribution rate, r is the nominal return on investments,  is the growth of income = population growth + productivity growth (r-is the net return defined as the gross rate of return from investments and reduced by adjustments for productivity growth and population growth) • A* is the steady state asset ratio to wages, and p* is pension cost relative to the wage bill or cost ratio.

14. DB versus DC – can look similar • DB: Inter and intragenerational risk sharing • DB: sponsor bears the risk; pooling lowers cost • DC: Offers choice to individuals who bear the risk • DC: Allows for bequeathing assets KEY EQUATION Contributions, compounded at the expected return on assets (with or without volatility) = Expected final wealth at retirement = Expected present value of desired annuity as of the retirement date

15. The 3-Pillar Approach (World Bank) • Pillar 1: PAYGO; DB; Government; Mandatory • Pillar 2: Funded; DC; Private; Mandatory • Pillar 3: Funded; DC; Private; Voluntary Because Pillar 1 was struggling – changed all aspects. Bush Administration favors creation of Pillar 2. Privatization only privatizes risk!!

16. Problems with Privatization Model • The key problem is only a financing problem • Was meant to keep government away from funds • Individuals are gambling with retirement funds • Private accounts = high fees = lower pensions • Can lead to unpredictable pensions • Value of choice overrated – e.g., Sweden, Australia • U.S.: Shift 2% of contributions from SS – how?? Governments and individuals will pay a lot to ensure that elderly do not retire poor

17. Problems with Privatization Model Fees take a huge chunk out of pensions

18. Will Chile Get Pickled? Hidden Debt Mandatory participation = DB will lead to lowest debt

19. Problems with Transitions • Need to get the funded system going with money • Debt financed transitions risky – a big leverage play • Surplus financed transitions are best • Problem: President Bush blew the surplus • Tax rebates will come to roost in higher contributions or consumption taxes • Intergenerational issues are key – who pays? Transition does not require “double contributions”

20. Transition to Partial or Fully Funded? • Full funding implies the Golden SS rules applies • To get to full funding, transition cost is very high • Asset-wage ratio = 3.5X (or 2.3X national income) • Partial funding requires smaller cost • In the US case, assumed 1.1% extra contributions; asset-wage ratio = 1.6X (or 1.1X national income) • Full funding would crowd out private investors • Some argue that a 1.9% increase could keep PAYGO

21. Even Australia/Sweden will Struggle • Australia: Mandatory participation (driven by Labor) • Some company DB schemes, but largely DC • Pooled people into industry schemes – lower cost • Problems: Too many small schemes – cost is high • Not sophisticated: consultants used = additional fees • Potential conflicts – trustees can represent AM firms • Where choice offered – not used!! • Estimated reduction in pensions 10-15% (Bateman)

22. Our Solution – Only Two Pillars • Pillar 1: Funded (Partially or Fully); DB; Public Governance/Private Management; Mandatory • Pillar 2: Funded; DC; Private; Voluntary (Pillar 3) DB = Guaranteed Return on Contributions Assets Pooled to Minimize Costs Swap between Treasury and SS to Guarantee Return Blue Ribbon Board like Canada and Ireland Variable Contribution to Minimize Risk to Govt.

23. How Does the Swap Work? • SSA pays Treasury return on invested portfolio; Treasury pays SSA guaranteed real rate + inflation • Long term swap rate = 5% real • Invested in mkt cap weighted index (stocks + bonds) • Prevents manipulation of funds = shows up in the budget as payment in the swap • SS is always whole; smoothes returns over decades • Government (best risk taker) bears risk • Create a sinking fund; allow variable contributions

24. Why Our Solution Is Better? • Contributions are Lower and More Predictable • Benefits are Protected (and Minimizes Cost to Governments and Participants) • Lower Asset Management Costs • Better For Unsophisticated Participants • Access to DB and DC Leads to Optimal Choice • Choice is not really exercised: Australia, Sweden • Transition cost borne equally by all generations

25. Explaining the Transition – Zero Growth

26. Transition to New System - The U.S. Case

27. Investment Issues • Should portfolio be U.S. only or global? • Initially U.S., but ideally global return on capital • Should assets be managed passively or actively? • Initially passive, but ETFs can allow active • Role of alternative assets? • Canada has already invested in alternatives • Internal or external? No strong bias • Too much passive – implications for voting & valuation

28. The Appropriate Rate of Return….. • Average return on equity has been remarkably stable - around 7% (Siegel 1994 and 1999). • The return on equity corresponds to profit; profit is not a satisfactory measure of the return on capital when the firm is financed partly by debt • Investing in an indexed portfolio of an share of the market portfolio of stock and bonds (70:30). • Estimate of the real interest rate =3% • Equals an estimate of return on capital of 6% -- (Bosworth (1996) arrives at an estimate of 6.2%)

29. The Appropriate Rate of Return…. • Must look at pre-tax value as that is relevant to Treasury • 6% return on total corporate capital after corporate tax. • Corporate income tax = 30% on the levered profit, plus a 30% debt at a real interest around 3.3%, results in an estimated 8% of the pre-tax return on total capital, • 1% for interest, 7% for equity before tax, of which 2% is attributable to the tax • This estimate of a pre-tax return on the unlevered market portfolio is close to a well-known estimate of Poterba (1998) • Gives the Treasury a premium of 3% for bearing risk

30. How To Achieve Retirement Objectives – The Two Pension Fund Theorem A’s Investments :70 % DB , 30% Market Portfolio B’s Investments: 50% DB , 50% Market Portfolio

31. Pillar “3” is No Breeze • Average sophistication is low • Poor advice on asset allocation (strategic & tactical) • Too much focus on manager selection • Rating schemes are poor – Morningstar, IR tells you little about risk-adjusted performance, skill etc. • Measures that do (M2, M3, SHARAD, Q-sum) beyond reach of most individuals • Fees can be mitigated through ETFs etc.

32. Conclusions • Do not fix what is not broken (DB) • Do not transfer risk and choice to those least capable of bearing or using it • Invest in the market with guarantee structure • A combination of DB and DC are critical • Variable contributions to manage risks Longer the delay to reform, the higher the cost

33. Appendix

34. Arun Muralidhar - Bio • Chairman of Mcube Investment Technologies, LLC and Managing Director at FX Concepts, Inc. • Author of “Innovations in Pension Fund Management” • Head of Investment Research and Member of Investment Management Committee, World Bank Investment Department, 1995-1999 • Derivatives and Liability Management, World Bank Funding Department, 1992-1995 • Managing Director and Head of Currency Research, JPMIM, 1999-2001 • BA, Wabash College (1988); PhD, MIT Sloan (1992)