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Balancing the Roles of the Public and Private Sector in Pension Provision . Presentation to Chatham House Conference on European Pensions 2005: The Pursuit of Risk Free Pensions Peter S. Heller International Monetary Fund April 11, 2005. Principal Message.

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balancing the roles of the public and private sector in pension provision

Balancing the Roles of the Public and Private Sector in Pension Provision

Presentation to Chatham House Conference on

European Pensions 2005: The Pursuit of Risk Free Pensions

Peter S. Heller

International Monetary Fund

April 11, 2005

principal message
Principal Message
  • For countries where government is concerned with welfare of elderly, the government’s role in the pension system will be critical, independent of whether pensions are publicly or privately provided.
  • With aging populations, a balancing of public and private sector roles is inevitable;
    • Too heavy a government responsibility leads to fiscal sustainability concerns
    • Too limited a government role may result in government involvement through the backdoor of its welfare responsibilities. Governments must ensure that private pension systems adequately address key risks of an aging population.
    • With aging population, inevitable limits on potential intergenerational transfers from working population to retired population—implications for share of population that can be retired
1. Nature of the balance between public and private sectors depends on country-specific factors: Context is critical
  • Nature of existing pension system
  • Expectations of citizens on Govt’s role
  • Linkage to Government’s role in other social spheres—medical care; long-term care
  • Underlying demographics of a country
Terms of existing pension system influences magnitude of feasible reforms to shift balance between public and private provision
  • Length of time system has operated
  • Nature of promised benefits in public system (replacement rate; indexation; spouse, survivors, disability benefits
  • Magnitude of accrued pension rights
  • Existing cultural/social biases and beliefs
  • Where no pension system exists (China, India etc) and expectations of state’s role less apparent, govt has freer hand; constrained only to the extent there is a view that Govt must act, in welfare role, to prevent destitution of the elderly.
  • Situation where existing system may be bankrup (Eastern Europe)
difficulty of separating state s role in pension provision from its role in other social spheres
Difficulty of separating State’s Role in pension provision from its role in other social spheres
  • Adequacy of a public pension or of private savings not independent of how other key services in retirement are addressed and financed in a society
    • Who bears cost of medical care? Household or taxpayer? A pension that is adequate in a state-run health system may not be adequate if pensioner must also finance medical care
    • Similar considerations re long-term care
    • Fiscal costs for medical care/long term costs cannot be ignored in considering overall policy options re pensions
underlying demographics will shape the extent of feasible intergenerational transfers
Underlying demographics will shape the extent of feasible intergenerational transfers
  • For countries where populations are growing, with high fertility rates, policy options are greater: easier to contemplate PAYGO systems; choice between public/private sector pension provision shaped by nondemographic considerations
for aging populations policy choices are more constrained
For aging populations, policy choices are more constrained
  • Underlying demographics implies that with rising longevity, allowing longer period of retirement implies sharply rising elderly dependency rate
  • Whether public or private system, a basic transfer of income must take place between those in working population earning income and those in retirement; latter group rising sharply relative to latter if age of retirement unchanged;
  • Last constraint particularly limiting in the absence of policies to raise national savings and investment rate (enlarging size of national income pie)
For aging populations, whether public or private system, challenges in engineering transfer between working and nonworking populations
  • With public system of defined benefit nature, rising share of elderly forces increased govt outlays—rising payroll tax rate rates which may prove unsustainable (particularly if other aging-related costs) (unless retirement deferred); Most countries already have high tax burdens in GNP
  • With private savings system for retirement, disposal of assets of increasing elderly population to shrinking working population likely to imply falling asset prices (unless potential for international diversification of investments and asset sales to other nationals)
Implication: in an aging population, independent of whether a public or private system, limits imposed by demographics suggest that in the absence of a reduced period of retirement or increased income from higher investment rate, there are limits on the likely intergenerational transfer of income that is possible.

Why must public sector play a critical role in pension system, independent of whether it is largely public or private in its basic framework?

Role of public sector—whether directly in pension provision or indirectly, in regulation of private system– will be to
    • Structure system so as to limit the extent that the State will need to intervene to support substantial share of elderly population or picking up the pieces from private sector shortfalls (default or poor private sector investment return
    • Facilitate low cost pension provision and/or ensure broad functioning markets in face of uncertainty and inadequate financial instruments to cope with key risks.
with aging population there are limits on public sector role
With aging population, there are Limits on public sector role
  • Numerous studies suggest that present government commitments in pension provision will require significant increases in the payroll tax rate, in the absence of reductions in benefits or deferral of age at which retirement benefits are available.
  • Implication that present scale of public pension provision is not fiscally sustainable
  • Most recent estimates of S&P
  • Public sector can remain dominant provider only to the extent that private households willing to defer by several years the period over which public benefits received or accept much higher share of private financing of retirement benefits at unchanged retirement age (part-time work; reliance on savings)
More important to illustrate is that efforts to increase private sectors role in pension provision still needs significant government involvement
  • Illustrates the limits to a reduction in the public sector’s role in facilitating adequate incomes in retirement and limiting the State’s responsibility for preventing destitution among the elderly (likely picture for the middle income groups?).
i llustrating the role of government in mandating that households limit their exposure to risk
Illustrating the role of Government in mandating that households limit their exposure to risk
  • Pre-retirement, mandating a process to facilitate sufficient household accumulation of assets to provide for retirement incomes over uncertain life span
  • Post-retirement—mandating actions that can prevent households from decumulating assets too rapidly, resulting in inadequate incomes during retirement in the face of longevity, inflation and investment return risks
what are the key risks that need to be kept limited
What are the key risks that need to be kept limited?
  • Behavioral
  • Longevity
  • Investment
  • Inflation
  • Medical and Disability
behavioral risk limiting potential reliance of households on means tested pensions
Behavioral Risk: Limiting potential reliance of households on means-tested pensions
  • Myopia of Households pre-retirement: requires Government mandates on savings to assure sufficient assets for retirement needs; moral hazard of inadequate savings in context of means-tested pension system
  • Myopia of Households post-retirement: Government mandates requiring that appropriate annuities bought in the face of various risks
  • Poor household capacity to choose appropriate investment portfolios: mandates on portfolio of investments required of mandatory savings plans
  • Savings mandates to forestall evasion of payroll taxes through work in the informal sector; not easy to enforce, particularly in nonindustrial countries
  • Risk shifting: how to regulate sharing of mandatory savings between husbands and wives in the event of divorce
longevity risks
Longevity Risks
  • Various forms of longevity risk
    • Uncertainty as to how long a specific individual will live
    • Uncertainty as to how long a working cohort can expect to live during retirement, given increasing longevity trends
    • Uncertainty as to how long a retiree’s cohort will live
  • Government interest in mandating sufficient savings by households to provide for potential retirement income needs
  • Government mandates requiring purchase of annuities and specification of type of required annuity?
    • Addressing joint risks of earner as well as spouse: mandate only single life annuities? Joint life annuities? Indexed annuities?
    • Does Govt get involved in ensuring fair life table? The tails?
  • Government interest in facilitating the provision of financial instruments that hedge against unanticipated longevity; i.e. longevity bonds. Does government have to be involved in their provision? Is there market failure? If it does, it effectively bears longevity risk. Does it subsidize private sector involvement with such risks?
investment risks
Investment risks
  • What average real rate of return will prevail, not only until a worker retires, but in post-retirement period (a span of 70-80 years)? Inadequate supply of long-term government bonds? How to hedge against long-term investment risks? (note France just issued 50 year bond)
  • Does Government mandate portfolio options? Pre-retirement? Post-retirement? Limit on portfolio choices?
  • Do requirements to shift to higher share of government bonds expose government/tax payer in terms of fiscal sustainability?
  • Does significant government mandating of portfolio expose it to safety net if poor portfolio performance?
  • Does Government establish a mechanism to cover defaults of corporate defined benefit plans? (e.g., PBGC approach)
  • Risks associated with unregulated portfolio investment choices: Consequences in terms of inadequacy of post-retirement asset accumulation and investment incomes; risks of government involvement in terms of welfare outlays
    • Poor returns—risky investment choices
    • Poor net returns—costs of trading, shifting to new investment fund vehicles
inflation risk
Inflation Risk
  • Uncertainty as to the rate of inflation that will prevail post-retirement
    • Governments largely the issuer of indexed securities: UK: indexed gilt securities; US: TIPs
    • If Govt bonds are principal financial instruments used by insurance companies to back up sale of indexed annuities, then govt’s capacity to meet fiscal obligations ultimate backstop for these investments.
medical and disability risks
Medical and Disability Risks
  • If government not providing medical care for elderly directly (and thus setting limits on extent of its financial responsibilities), then it must mandate sufficient private sector savings or private sector insurance to limit the extent to which Government will need to intervene in financing medical care provision
  • Disability Risk: uncertainty as to state of health, degree of functionality and medical requirements of individual and household
    • Does government mandate purchase of disability insurance by households in the absence of a state disability insurance system?
enhanced need for government regulatory role over the insurance industry
Enhanced need for government regulatory role over the insurance industry
  • Government interest in regulating insurance industry in terms of life tables used; not easy
  • How to limit adverse selection by insurance industry in sale of annuities? Mandatory pooling?
  • Does government establish solvency standards or supervisory intervention procedures for protection of annuity beneficiaries?
  • How does government prevent against risky behavior of annuity providers (sell annuities and receive income, but fail to adequately invest and manage their annuity liabilities?) What reserve requirements established?
  • Fiscal sustainability considerations clearly relevant in a pension/cum medical care scheme reliant on substantial government provision (PAYGO system; national health insurance)
  • But even where private sector pension system dominant, fiscal sustainability critical given role of government financial instruments as backstop for system.
  • Even with heavy private sector role, government involvement in regulation; mandates; supervisory role; welfare provision

Finally, to assert a need for balancing does not address the multiple issues that frame the design of a public, private, or mixed pension system

  • Limits as to the extent of redistribution possible; limits as to the capacity to “save” for retirement; Public role may be to force higher ages of retirement cum provision of minimal incomes in the event of disability
  • Clarification of these issues better earlier than later—hard to change size of pie later on; avoids having to disrupt promised rights/expectations
  • Vulnerability to political economy risks of gerontocratic electorate