1 Financing techniques of social security schemes 28 August 2013 Luang Prabang, Lao PDR Hiroshi Yamabana ILO Financial and Actuarial Service (ILO FACTS) Social Protection Department (SOCPRO) ILO

2 Structure of the presentation 1.Short-term vs. long-term benefits 2.Pay-as-you-go (Annual assessment) financing method 3.Financing of short-term benefits 4.Financing of long-term benefits 5.Financing of benefits in kinds (mainly health care) 6.Summary

3 1. Short-term vs. long-term benefits 1.Short-term cash benefits -Sickness cash benefits -Maternity cash benefits -Temporary employment injury cash benefits -Unemployment cash benefits -Family benefits (child allowances) 2.Short-term in-kind benefits -Health care benefits (except chronic disease / long-term care) Period of payments: -So long as contingencies last, but sometimes with a maximum period -In general, for several months (to several years)

4 1. Short-term vs. long-term benefits (Contd.) 2.Long-term benefits (pensions, long-term care) -Old-age pensions -Invalidity pension -Survivor’s pensions (Widow’s and orphans benefits) -Employment injury (permanent) invalidity / survivors’ pensions Period of payments: -So long as contingencies last -In general for a long period on average (decades)

5 2.PAYG cost rate I C =E B (earnings-related system ) where: I C :Contribution income E B :Benefit expenditure While I C =N C * A W * CR PAYG E B =N B * A B where: N C :Number of contributors A W :Average wage of contributors CR PAYG :PAYG cost rate N B :Number of beneficiaries A B :Average benefit

6 2.PAYG cost rate (Contd.) Hence, N C * A W * CR PAYG = N B * A B N B * A B N B A B CR PAYG = =----- * N C * A W N C A W =R D *R F where: R D :Demographic ratio R F :Financial ratio

7 3. Financing of short-term benefits Period of payments: In general, several months (to several years maximum) =>Accumulation effects of beneficiaries are negligible. Hence: N B =N C *prwhere: pr:probability of occurrence or frequency The probability of occurrence is stable over short- to medium-term (except for unemployment benefits).

8 3. Financing of short-term benefits (Contd.) N B R D =---- N C =pr

9 3. Financing of short-term benefits (Contd.) A B R F =----- A W A B,M * M B = A W,M * 12 A B,M M B = *---- A W,M 12 =R R * DENS B where:

10 3. Financing of short-term benefits (Contd.) A B,M :Average benefit in a (paid) month A W,M :Average wage in a month M B :Average months’ duration of benefits R R :Replacement rate, e.g. 60% stipulated in a law DENS B :Density of benefits in a year =>Financial ratio is not related to contributing history. (different from pensions)

11 3. Financing of short-term benefits (Contd.) CR PAYG =R D *R F =pr*R R *DENS B Example: Think of the following case of sickness cash benefits: pr =20% R R =60% DENS B =1/12 (1 month)

12 3. Financing of short-term benefits (Contd.) pr:Probability of occurrence R R :60% etc. (stipulated in a law) DENS B :density of benefits in a year All the above-mentioned factors are stable in a short- to medium-term (except for unemployment benefits). =>PAYG financing method is suitable.

13 3. Financing of short-term benefits (Contd.) Note on unemployment insurance -Benefits fluctuates in line with economy -Needs more contingency reserves (e.g. 1-2 times of annual expenditure) to prepare for sudden expenditure fluctuation -Needs flexibility of the contribution rate setting, including the decrease as well as the increase of contribution rate.

14 4. Financing of long-term benefits (1)Defined-benefit scheme (DB scheme) -Periodical payments based on a set benefit formulae in the law (or regulations) -Contribution rate set afterwards to secure long- term financing (2)Defined-contribution scheme (DC scheme) -Contribution set beforehand -Lump sum payments based on the accumulated amount and investment return

15 4. Financing of long-term benefits Pros and cons Defined-benefit scheme (DB scheme) -Benefits adequacy secured and benefit predictable (except for future political risks) -Financing challenges ahead Defined-contribution scheme (DC scheme) -Financing challenges only in the investment of reserves, especially in the case of promising higher investment rate of return (RoR) than the real one. -Benefit adequacy problem, both in terms of amount and the periodicity remains.

16 4. Financing of long-term benefits In case of defined-benefit scheme (DB scheme) E B =N B * A B N B :Accumulated in a long period. One must measure the ‘stock’, not the ‘flow’.

17 4. Financing of long-term benefits (Contd.) A B =A W *R F R F :Financial ratio is related to contributing history, which normally prolongs as the scheme matures. Cost increase due to the ‘stock’ effects (aging and the maturity of the scheme) is essential.

18 4. Financing of long-term benefits (Contd.) CR PAYG =R D *R F Example: Think of the cases to calculate CR PAYG : 1.Young scheme with young demography: R D =20% R F =40% 2.Mature scheme with aged population: R D =50% R F =60%

19 4. Financing of long-term benefits (Contd.) Example:Thailand Social Security Office (SSO) Retirement age 55 years old Pension formulae (20% + 1.5% * (cont. years - 15)) * (last 5-year wage)

20 Example: Thailand Demographic ratio

21 Example: Thailand Financial ratio

22 Example:Thailand PAYG cost rate and GAP

23

24 4. Financing of long-term benefits (Contd.) Other financing method -Preparing for aging beforehand, by levying higher contribution rates than PAYG cost rate and relying on investment return on the reserves as well as advance savings. (1)General average premium / contribution (GAP) method -Constant contribution rate for a long period, sometimes assumed as forever. (2)Scaled premium / contribution (SP) method: -Constant contribution rate (for a certain period)

25 4. Financing of long-term benefits (Contd.) CR PAYG (PAYG contribution rate) (Total amount of benefits in a year) = (Total amount of wages in a year) CR SP (Scaled premium in a period) (Present value of benefits for a certain period) = (Present value of wages in a certain period) CR GAP (General average premium (GAP)) (Present value of benefits for a long period) = (Present value of wages for a long period)

26 General Average Premium (GAP) t 1 ∫B(t) e –δ(t-t 0 ) dt - F(t 1 ) e –δ(t 1 -t 0 ) t 0 C= t 1 ∫S(t) e – δ(t-t 0 ) dt t 0 ∞ ∫B(t) e –δ(t-t 0 ) dt t 0 C= ∞ ∫S(t) e –δ(t-t 0 ) dt t 0

27 Example:Thailand PAYG cost rate and GAP

28 Example:Thailand PAYG cost rate and SP contribution rate 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% PAYG cost ratio min res ratio = 3 min res ratio = 10

29 5. Financing of benefits in kind (mainly health care) Period of payments: In general, for several months, but sometimes for a very long time (especially in case of elderly care). Finance: -In general, PAYG<=Why? Modelling methodology: -Similar to short-term (non-accumulative); but -Aging effects are non-negligible (utilization, average cost). -Due attention should be also paid to cost increase caused by supply side (supply-driven effects).

30 Example of age-related utilization (Outpatient)

31 6.Summary 1.CR PAYG =R D * R F 2.Short-term (cash) benefits Stable R D, R F :Flow method applicable PAYG method appropriate for financing 3.Long-term (cash) benefits Dynamic R D, R F :Stock method applicable PAYG / SP / GAP methods depending on the context 4.Health care (in-kind benefit) Demand as well as supply driven Aging effects non-negligible PAYG, most realistic financing method