Are People Smarter than We Give Them Credit for Are People Smarter than We Give Them Credit for? The case of Mandatory Pensions in Israel: Unintended (and predictable) Consequences of Policy Adi Brender Research Department Bank of Israel Seminar on: Aging, Retirement and Pensions: Trends, Challenges and Policy Leonardo Hotel Ashkelon: March 2018 The opinions and analysis presented in this lecture do not necessarily reflect those of the Bank of Israel

Background story: Old-age poverty High old-age poverty rate – 22 percent – much higher than the OECD average. Low pension eligibility among low-income retirees and low savings among low-wage employees. Policy-makers mandated pension savings. However: the ratio of old-age poverty to total poverty in Israel is similar to the OECD average. Hence the problem lies in the overall income distribution – not in the pension system. The forced savings hurt poor working families.

Outline Ex-ante analysis (based on pre-policy data) showed that a mandatory pension arrangement in Israel will have negative implications for the targeted population Impede life-time income smoothing and reduce benefits for low-income workers? Reduce lifetime benefits of the working poor relative to non-working households. These negative effects depend on the employer contributions’ incidence and the employment effect? Behavior during the arrangement’s first year - when enforcement was lax - as an indication for preferences. Use ex-post medium-term data to estimate the "tax" incidence and employment effect. הצגתי ב-2009 מאמר על המצב שלפני ההסדר וההשלכות הצפויות של ההסדר.

The Policy’s Rationale People do not save enough for pension Short-sightedness Psychological aversion to deal with being old Complexity of decision Too late to fix when the consequences are realized Cannot call upon past employers Fiscal cost Prevent “taking advantage” of the system However: If people are rational, honest and optimizing, intervention may be harmful to welfare.

What do we test and what we do not Examine responses at the margin, given the pre-existing social security and tax benefits. Do not argue that no intervention is warranted. Argue that people responded rationally to the “old” system and to the change. This seems to be a case of “too much” savings for the affected population.

The Mandatory Pension Arrangement Contribution rates according to the arrangement Beginning from Employer Contributions Employee Contributions Total Contribution 1.1.2008 1.67 0.83 2.50 1.1.2009 3.34 1.66 5.00 1.1.2010 7.50 1.1.2011 6.67 3.33 10.00 1.1.2012 8.34 4.16 12.50 1.1.2013 15.00 1.1.2014 12.00 5.50 17.50 The duty applies to income up to the average wage (70% of all employees earn less), for people who worked at least 6 months. Those who had previous coverage – from day 1. Exempt individuals – in 2008: those who worked less than 9 months for the same employer.

Pension Savings Incentives in Israel Tax incentives at the contribution and withdrawal stages – relevant to those above the tax threshold. Yields on accumulated savings are exempt from capital gains taxation – relevant for those who want to save. Social security replacement rates are high for low income employees – but depend on family characteristics. Social security income guarantee is offset against pension benefits.

Implications for the Incentives to Save Characteristics Affecting the Decision to Begin to Contribute Characteristic Cause for behavioral effect Effect Low wage Sufficient replacement rate through old-age allowances and income guarantee (-)   No tax benefits on withdrawal Wage below the tax threshold No tax benefits at the time of contribution Married woman Insufficient replacement rate through old-age allowances as spouse is likely to work, even if he does not work currently. (+) Working spouse Insufficient replacement rate through old-age allowances. No offset of allowances against pension. Spouse contributing to pension Additional contribution is unlikely to be offset against the old-age income supplement Female Even if currently unmarried, expected to have a working spouse later in her career. Children Consumption smoothing, liquidity. Older age - no past contribution Insufficient accumulation to overcome the pension offset against the old-age income guarantee Arab Unlikely to have a working spouse, especially if currently single or has a non-working spouse Small Employer Worse terms in pension funds

The Targeted Population (Brender, 2010) About 38% of all employees did not contribute to pension in 2007: their types are consistent with the incentives

Characteristics of the relevant population 75% of those who reach retirement live with a spouse. Little change in relative income positions after age 30-35; current wages from this age are a good proxy for lifetime income. Wages of low income people grow slower. Spouses incomes are positively correlated. 90% have children during their life, 80% more than 1 child.

Characteristics of typical households 30%-35% 6% 20%

Consequences of the Arrangement for the Target Population Impedes income smoothing: Poverty during working/parenting years Excessive replacement rate Reduces lifetime income: Offset of income guarantee Employer contribution incidence? State benefits (tax + Soc. Sec.) at all income levels were similar before the arrangement was adopted.

2008 as a window to observe preferences Lack of clear enforcement mechanism 51% began to contribute, compared to 17% in 2007 By 2012 more than 80% contributed Mobile target population (between employers) Large sample – 80,000 non-contributors Panel data: behavior before and after

Three Tests Consistency of the decision to begin contributing with the a-priori incentives Did the impact of these variables decline compared to pre-arrangement years? Match between factors affecting beginning to contribute and contribution rates Helps to sort obedience from preferences Did wages fall to compensate for employer contributions?

Factors affecting the decision to begin contributing: 2007-8 compared to 2006-7   z Marginal effect between 2006 and 2007 between 2007 and 2008 Individual characteristics: * 2.99 0.0120 18.40 0.1159 Gender (0 – men, 1 – women) -11.71 -0.0487 -21.44 -0.1333 Resides in an Arab town (binary variable) 2.95 0.0031 8.08 0.0128 Age -5.12 -0.0001 -9.58 -0.0002 Age squared -1.56 -0.0078 -1.25 -0.0097 Married man (binary variable) 4.47 0.0242 8.90 0.0719 Married woman (binary variable) -3.36 -0.0091 -4.02 -0.0162 Number of children aged 0-3 -5.72 -0.0135 -6.04 -0.0211 Number of children aged 4-8 -5.34 -0.0093 -7.79 -0.0195 Number of children aged 9-18 Change in incentives for young workers: the age effect is decreasing from 35. It decreased at all relevant ages prior to the arrangement.

Income and Employer Characteristics   Marginal effect between 2006 and 2007 between 2007 and 2008 Income and employment characteristics: * 0.0188 0.0046 Annual income (in 10,000s of NIS) 0.0777 0.1254 Annual income >48,000 – tax threshold (binary variable) Spouse characteristics: 0.0851 0.1032 Does spouse work? (binary variable) 0.0409 0.0996 Does spouse contribute to pension savings? (binary variable) Employer characteristics: 0.0000 0.0001 Size of employer (number of employees) -0.1325 -0.3692 Up to 15 workers (binary variable) -0.1043 -0.2903 15-30 workers (binary variable) -0.0799 -0.2039 30-50 workers (binary variable) *** -0.0172 -0.2419 Switched employer between the two years (binary variable) ** 0.0272 -0.0426 Switched employer*worked less than 9 months (binary variable) 0.0590 0.1234 Employed in the public sector (binary var.)

Contribution Rates More than 60% of those who began saving in 2008 did so at the minimum mandated rate of 0.83%, compared to only 18% in 2007. Beginning to contribute was associated with the factors that make pension savings desirable If these factors reflect obedience, they should not correlate with saving above the minimum required rate If they reflect preferences, they should also be correlated with contributing above the minimum.

Factors affecting workers starting to save in 2008 to contribute at above-minimum rates Individual and income characteristics   z Marginal effect between 2007 and 2008 Individual characteristics: * -6.27 -0.0515 Gender (0 – men, 1 – women) 5.74 0.0118 Age -6.56 -0.0002 Age squared 3.13 0.0294 Married woman (binary variable) -3.76 -0.0172 Number of children aged 0-3 -2.71 -0.0088 Number of children aged 4-8 *** -1.85 Number of children aged 9-18 Income and employment characteristics: 27.76 0.0462 Annual income (in 10,000s NIS) 9.43 0.0715 Annual income >48,000 (binary variable) -15.88 0.0191- Wage in 2007 (in 10,000s NIS) The age effect begins to decrease at 34

Spouse and Employer Characteristics   z Marginal effect between 2007 and 2008 Spouse characteristics: * 8.75 0.0757 Does spouse work? (binary variable) 5.46 0.0026 Annual income of spouse (in 10,000s NIS) Employer characteristics: 17.07 0.0001 Size of employer (number of employees) 5.73 0.0430- Up to 15 employees (binary variable) 6.39 0.0469- 15-30 employees (binary variable) 4.39 0.0391- 30-50 employees (binary variable) 4.80 0.0551 Switched employer between the two years (binary variable) 6.29 0.1223 Switched employer*worked less than 9 months (binary variable) 9.43 0.0820 Employed in the public sector (binary variable) Those who were exempt and began contributing anyway did so at higher rates

Wage and Employment Effects – Medium-term A key argument of those favoring the mandatory pensions is that most of the burden is imposed on employers. Given a legal minimum wage, weak employees – the target group - are protected from wage cuts. Hence, income smoothing is not substantially influenced. Employment is not very sensitive to labor cost at the low end of the wage distribution due to a high non-tradable proportion.

The analysis Examine the change in wages and employment between 2007 and 2012 (when the share of contributors was equalized) of those who worked in 2007. Compare the changes between contributors and non-contributors in 2007 – controlling for observables. Since there may be unobservable differences correlated with the economic cycle: compare the dif-in-dif to a parallel cyclical period in Israel. Employment effects: hard to detect due to low labor supply elasticity (0.05-0.1) of the relevant group.

Key Results (Conditional) Wages of those who did not contribute increased between 2007-2012 by 7.5% less than the wages of the employees that did contribute. During 2001-2006 the gap was 3%. The difference of 4-4.5% is equivalent to the employer contribution (net of severance pay fund) at 2012. The results are robust to changes of period, income and age ranges, ethnicity and gender. Occupation and industry composition do not account for the difference. Negative employment effect is not statistically discernible, perhaps due to its small size. Tests of industry and occupation – which are not reported – did not show a significant difference.

Conclusion Ex-ante analysis suggested that the mandatory pension arrangement harms the target group. Ex-post analysis finds a behavior that is consistent with employees trying to avoid contributing when it was possible – in line with incentives. Both the decision to contribute and contribution rates suggest rational optimization by employees – in line with objective simulations.

Conclusion – cont. There was essentially no relief via employer contributions; almost the entire incidence fell on the employees. Given low labor supply elasticity: most of the burden fell on wages – not employment. These results were predictable based on ex-ante analysis and data that were available in real-time.

If it ain’t broken don’t fix it