BASIC TYPES OF PENSION SCHEMES: Objectives and Constraints Gary Hendricks Regional Pension Workshop Majuro, Republic of the Marshall Islands April 25-29, 2016

Fundamental Types of Public Pension Schemes Individual Retirement Savings Schemes (Defined Contribution/DC/Provident Funds) Group Retirement Insurance Schemes (Social Security)

Individual Savings Schemes A collections of Savings Accounts of individual workers A fund holds and manages the accounts Each participating worker owns his/her account (just like in a savings account in a bank) Each worker’s participation in the Scheme is divided into two phases: Contribution Phase – savings are accumulated in the account Payout Phase – savings are withdrawn from the account

Individual Savings Scheme: Accumulation Phase Contributions on behalf of the worker are credited to the worker’s account All account balances are pooled and invested Investment returns are credited to individual accounts on pro rata basis All expenses are deducted from individual accounts on pro rata basis

Individual Savings Scheme: Payout Phase Law defines at what age workers can begin withdrawing assets from their accounts. Scheme may offer one or a range of options for withdrawing assets including a lump sum at retirement, periodic payments until account is exhausted, and annuities. Any account balance remaining at death of the worker is paid to worker’s beneficiaries.

Individual Savings Scheme: Summary Individual savings account are established for each worker Account balances are pooled and invested. All contributions plus a pro rata share of investment returns are credited to the worker’s account Pro rata share of all expenses are deducted from account. The worker’s account balance is available to finance his or her retirement. Financing Individual Accounts Contributions made on behalf of the worker Possible sources of contributions: The worker, the employer, the government Basis of contributions: Wages (International standard) Amount contributed: (other possibilities to mention: hours worked, some sort of measure of output or individual productivity)

Individual Savings Scheme: Objectives PRIMARY OBJECTIVE (often not directly unstated) Shift the financial risk of providing public pensions from the government to the individual worker FISCAL RELIEF: Relieve the need to provide direct general revenue financing or general revenue transfers to finance an existing and growing Social Security deficit INCENTIVIZE WORKERS Make workers more responsible for financing their retirement Increase workers’ feelings of empowerment with visible individual savings Encourage greater formal sector employment

Individual Savings Scheme: Objectives (cont.) SOCIAL GOALS Increase national savings rate Strengthen capital markets Create large pool of assets for domestic investment Distribute lifetime consumption more evenly for workers Raise funds for social investing by the government Supplement low Social Security benefits (floor of protections) PACIFY VESTED INTERESTS Pressure from asset managers, banks and financial sector generally Corruption

Individual Savings Schemes: Constraints and Limitations ADEQUACY Workers bare all of investment risk making benefit levels uncertain. Minimum guarantees must be financed separately. (Minimum guarantees will almost certainly destroy the system.) Account balances must be protected against pre-retirement withdrawals. Money not in the account, even temporarily, lowers retirement benefits. Contribution rate may be high (15%) even for minimally adequacy benefits. SYSTEM CONSTRAINTS Corruption must be at very low levels. Assets grow rapidly. Government must be disciplined and have strong political will. Assets grow rapidly. No social investing. No pre-retirement withdrawals. Sound well-regulated banking system is requisite. Developed financial infrastructure and regulation necessary for internal investment even if opportunities are there. Individual workers own the money.

Individual Savings Schemes: Constraints and Limitations (cont.) ADMINISTRATION Rigorous, fast, precise, and inexpensive Same day recording of contributions, daily re-valuation of assets and daily re-valuation of every account. Annuities Selection of providers and range of options offered Government needs to sign contracts for these and exercise some management On-GOING PUBLIC EDUCATION Government must provide extensive on-going education. Expectations regarding losses in asset values must be managed On-going reinforcement of NO early withdrawals

Group Retirement Insurance: Social Security Social Security is not savings schemes. In fact, there is no savings component for the individual worker. Assets are not owned by individual workers and contributions are not related directly to benefits. Contributions are like insurance premiums. Workers pay them and those that live long enough collect a pension. Those that die before retirement do not collect. Total premiums (contributions) collected must be adequate to pay the on-going benefits.

How Social Security Works Contributions in amounts specified by law are paid by or on behalf of each worker Contributions are set to cover cost of benefit payouts Contributions are deposited in a single account (the social security fund) No worker owns or has a right to any part of the fund Earnings on fund assets become part of fund An administrator maintains a records for each worker of time worked, contributions and wages Records are updated periodically (monthly, quarterly, annually) When a worker reaches retirement age , a pension is calculated and paid for life. A Formula specified by law s determines the benefit Factors in the formula usually include length of service and earnings among other things The benefit may be adjusted periodically for increases in cost of living inflation or for political reasons

Social Security: Financing With no direct connection between contributions and benefits, the financing method is specified by law and may rely on earmarked taxes, contributions based on wages paid by workers and/or employers, or by any other method that raises sufficient funds. Monthly pensions are paid out of the social security fund. And, each month the fund must have sufficient funds to pay all benefits. NOTE: Maintaining sufficient funds to pay benefits at all times is discussed in an later presentation.

Social Security: Objectives Provide adequate benefits at least cost Protect long service workers against poverty in old age Protect orphans and widows against lose of primary earner Provide for independence in old age through intergenerational transfers from young to old Avoid massive asset build-up inside government Making government a dominant player in capital markets Encouraging social investing with no investment returns to help finance pensions

Compare and Contrast Public DC and DB Schemes Adequacy Poverty alleviation Risk/Certainty of Outcomes Contribution Rate (DB/DC) Disability protection Family Protection Breaks in coverage Timing of Retirement Actuarial fairness and neutrality Work after retirement (credit/no credit) Administrative rigor and cost