1. What Other Countries have Done: Issues for Government and Providers Presented at IIF conference, Dublin, November 2006 By Estelle James

2. 2 Since 1981, over 30 countries have adopted multi-pillar pension systems First pillar for redistribution (safety net) –to avoid old age poverty, cushion risk –like Ireland’s flat benefit Second mandatory pillar for retirement saving –usually defined contribution—link benefits with contributions to improve work incentives and portability, avoid perverse redistributions –funded—to build national saving, avoid higher payroll taxes, make it sustainable as populations age –funds privately managed—to avoid problems with public fund management Third pillar for voluntary saving and insurance

3. 3 Most reforming countries fall into two groups: 1) OECD Australia, Switzerland, Denmark, Holland, HK –Previously had modest public safety net (Pillar I) –50% of labor force covered by employer-sponsored plans (collective bargaining)—Pillar III, but impossible to go higher on voluntary basis Wanted to raise coverage, avoid fiscal pressures as populations aged, increase saving and productivity So employer plans became mandatory to cover other half, as Pillar II –Initially were DB, with employers and/or unions making investment decisions, but now shifting to DC with greater worker investment choice Ireland is at this cross-roads today

4. 4 2) Latin America & Eastern/Central Europe Previously had public benefits that were too generous, expensive, bad work incentives (PI+II) –Required high payroll tax (>25%) that cut take-home pay, added to labor costs and unemployment –Many plans were insolvent, inflation without indexation, change was needed –Wanted to increase saving, develop financial markets –No tradition of company plans So they split system into PI--smaller redistributive public benefit + PII--private funded DC plan based on individual accounts and worker choice –part of contribution diverted to accounts –limited choice, lots of regulations—not simply private –many implementation issues

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6. 6 Key issues governments faced How high contribution rate and replacement rate? What is share of public and private pillars? Should private pillar be mandatory? How to design public pillar, protect low earners? How to design private pillar –how much investment choice for workers? –how to keep administrative costs low? –how to contain risk? –how to organize payout stage I will run through these issues and explain how other countries have dealt with them

7. How large pillars I, II and III? Do we need a mandatory Pillar II?

8. 8 Benefit rates in pillars I, II and III Three levels: poverty, modestly adequate wage- replacement, comfortable retirement Poverty avoidance (25-30% of average wage) –job of Pillar I –larger Pillar I means greater equality but larger tax distortions and disincentives—so trade-off Modestly adequate wage replacement rate –Pillars I + II –40-50% RR combined; Pillar II 35-90% of total, depending on country and income level Comfortable retirement (70% replacement rate) –Pillar III (voluntary since some won’t want high rate) –if Pillars I + II are large, no Pillar III Ireland now has pillars I and III; does it want II?

9. 9 Do we need mandatory Pillar II? Arguments for mandatory –many workers myopic, won’t save enough voluntarily –if not mandatory may lead to larger costly Pillar I Arguments against: –Tax distortion may depress economy –forces some workers to save too much –regulations limit worker who would have saved anyway –trade-off between protecting myopes vs. hurting others Is soft mandatory (with opt out) a compromise? –will workers understand their choices? –can they be asked to make irrevocable decision at 18? –will most workers stay in for full career? take contribution holidays? withdraw for UnE, med. needs)? –probably will increase coverage, but not full coverage –(but women, self-employed, small employers, informal sector often not covered by hard mandatory either)

10. Design options for Pillar I Issues for flat benefit

11. 11 Options for Pillar I--safety net Minimum pension guarantee (Latin America) –government tops up second pillar benefit if < floor –cheapest way to prevent poverty –for contributors only; but many not eligible Flat (uniform) benefit (W. Europe, Argentina) –more inclusive, less distortionary, but costly –costs can be reduced by means-testing (Australia, Hong Kong) or claw-back (Canada) –but means-testing and MPG raise moral hazard problems (disincentive to work, save) and non- transparent contingent liability Earnings-related –E. Europe, Sweden–usually implies large costly Pillar I

12. 12 Ireland has flat benefit; issues: How large? (often 25-30%) For contributors + variations for classes of non- contributors—conflicted and complex. –Should this be simplified, based on residence? At what retirement age? Allow early retirement with actuarial adjustment? Price vs. wage indexation of benefit? –price indexation maintains real value; wage indexation higher, maintains value as % of average wage –price index cheaper, less protection to future cohorts –implies that absolute poverty matters, while wage indexation emphasizes relative poverty –Swiss indexation (50-50) is a compromise –big issue in UK and US

13. Who chooses investment manager in Pillar II? How much choice for workers?

14. 14 Pillar II:Who chooses investment manager? How much choice? Workers—Latin America, E. & Central Europe –choice of asset manager but little portfolio choice Employers and/or unions—Switzerland, Netherlands, Denmark, Australia, Hong Kong –long tradition of employer-sponsored plans, in last 20 years became (quasi) mandatory –initially DB, but shift toward defined contribution (DC) –i f DC, workers bear risk, so they will demand choice of investment manager and strategy 3 rd method--competitive bidding process by govt. –for small number of fund managers and portfolios –workers get lower cost with limited choice –Kosovo, Bolivia, US Thrift Saving Plan (civil service)

15. 15 Problems with unlimited choice High administrative and marketing cost High risk--workers make mistakes Implicit liability--Employers or government may be left with responsibility for mistakes Most countries are moving toward limited choice

16. How to keep administrative costs and fees low Controlling collection and record-keeping, marketing, investment costs

17. 17 Wide range of administrative costs Important to keep admin. costs low: If fees are 1% of assets annually, pension falls 20% Surest way to raise net returns is cut costs In Chile, fees were high at start-up, now about 1% of assets yearly (< US mutual funds) Fees > 1% of assets in other L.American countries, E. Europe, Australian retail plans, US 401(k)’s But Thrift Saving Plan (TSP) in US costs <.1% of assets,.3-.7% in large employer pension funds in US, Australia, Switzerland, Netherlands Admin. costs stem from record-keeping, marketing and investments. How can Pillar II keep costs low?

18. 18 Scale economies the key to low R&C costs Collection, communication, & record-keeping –fixed cost per account ($20-$30 depending on level of services) so high % of small accounts –fixed cost per account falls as # of accounts grows Therefore high R&C costs as % of assets at start- up, fall as average balance and # accounts rises. Crucial choices for government and industry: –contribution rate?—determines how long it takes for average account to grow large –should small accounts be subsidized? –should record-keeping be centralized or outsourced?

19. 19 Marketing costs depend on how Pillar II is organized 1.Retail market (most L. America, E.&C. Europe) – fund hires salesmen to attract individual workers – competition takes form of marketing, not low price – marketing costs are half of total, more at start-up 2. Group market through employer plans (OECD) – employer and/or union chooses for group –less marketing, lower costs, less worker choice –their costs will rise as they shift to DC with choice 3. Institutional market (Kosovo, Bolivia, US TSP) –– government aggregate contributions, chooses small # of fund managers in competitive bidding process –cuts marketing costs, increases scale economies –but less worker choice, innovation, political insulation

20. 20 How to cut investments costs Encourage use of index (passive) funds, low turnover funds, electronic trading Again, trade-off between choice vs. low cost In long run fees can be 1.3% otherwise— large difference in pension size Especially important if object is to cover low earners with small accounts

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23. How to dampen risk to worker Public and private guarantees?

24. 24 How to cushion risk Initially most portfolios fixed income, but now expanding to include equities—higher risk, return Diversification important –between industries, asset classes (small financial markets in Latin America and E. Europe limit diversification, but not in W. Europe) –not enough international diversification Rules limit risky investments (but unclear which investments add risk—e.g. derivatives?) Importance of well-constructed default fund –Many workers don’t choose –Gradual shift to bonds to avoid interest rate vulnerability on retirement date? (Chile, TSP) –Difficult to educate workers on risk-return trade-off

25. 25 Guarantees Demand for public guarantees but these entail contingent liability and moral hazard problems Private guarantees— –relative rate of return guarantees in L.America –absolute guarantees rare—costly, difficult to regulate –regulations require minimum return for employer plans in Switzerland; inflexible and difficult to set right terms –if used, should cover lifetime not annual return Many dangers with guarantees, but if no guarantees, worker bears risk in DC plan, so hard social choice

26. How to organize the payout stage What is the role for annuities?

27. 27 Payout stage: require annuities? Will workers consume DC funds before death? Annuities guarantee life-long income but don’t allow flexible withdrawals. Will annuities be offered on good terms? Will workers buy them? Should they be mandatory or tax-encouraged? Latin America permits annuity or gradual withdrawals. Lump sum only after high pension (70% replacement rate) Australia and Hong Kong less restrictive—leaves greater burden for means-tested benefit Conflict between private property vs. basic rationale for Pillar II—lifelong retirement income

28. 28 Other policy choices re annuities Use competitive bidding or retail market? (most countries use retail, TSP uses comp. bidding) Community rating or risk differentiation? –unisex tables? (common in Europe, not Latin America) –different socio-economic groups, DNA, family history? –if no risk differentiation, redistribution between groups –and adverse selection if annuitization is voluntary Joint annuities required? (to protect widows) Indexed annuities required? (inflation insurance) –requires inflation-indexed bonds to invest in) –each extra protection costs Variable annuities? (higher return, less security) Govt. guarantee if insurance company defaults?

29. 29 Experience of Chile with payouts Many workers have retired since 1981, annuities or gradual withdrawals required if replacement rate < 70% 2/3 have annuitized: limited options and aggressive marketing by insurance companies Pensions must be price-indexed and joint Early retirement permitted once threshold is met –But pensioners who work don’t have to contribute to their accounts—so older men work more now Private sector can handle payout stage –Money’s worth ratio 100% (EPDV of benefits/premium discounting at government bond term structure) –Insurance industry has grown dramatically –But bolstered by government guarantees –Tight regulation needed

30. 30 Conclusion: devil is in the details Multi-pillar systems can be high or low cost, risky or secure, restrictive or flexible, depending on detailed arrangements Different choices for different countries Ireland should be aware of the range of options and their consequences Trade-off between preventing people from making mistakes (save too little, wrong investments, high costs and risk, consume saving too quickly) vs. allowing informed people to make their optimal choices