Pension Analysis and the PER

Richard P. Hinz, Adviser, HDNSPAnita M. Schwarz, Lead Economist, ECSHD

April 2007

Objectives of a Pension System

Reduce poverty among the elderly Smooth consumption between working

years and retirement years– Implication: those who earn and consume more in

working years will consume and earn more in retirement years

– Very different from other public expenditure programs which ideally would be designed to allocate equal or greater share of expenditures to the poor

Pension Systems Usually Contributory

Historically contributory – part of the compensation package– Government provides a mechanism whereby employers and

employees can save for old age in the absence of secure market-based instruments

Also makes pension reforms extremely different– People have acquired rights from the contributions they have made

Raises problems for redistribution analysis– Need to net out historical contributions from current expenditures– Only those who contribute get pensions; low income individuals

often don’t contribute; so pension expenditure skewed toward higher income individuals as is pension revenue

Who is Covered Under the Pension System?

Contributors to the pension system can range from 5% of the labor force to 95%

Percentage of the elderly covered can be different from percentage of labor force covered– ECA, Brazil, Georgia

What programs exist to provide assistance to those not covered?

Coverage is Fundamental in How to Evaluate the Pension

System High coverage systems

– Meaningful to include redistribution within system Low coverage systems

– Financing of the pension system should come from those who are covered

– Low coverage system running a deficit results in highly regressive transfers from general revenues broadly collected to the few who are covered and generally have higher incomes

– Redistribution within the pension system of secondary importance

Fiscal status of the pension system now and in the future

Is the system sustainable now and in the future?– Note that the relevant future for pension systems is usually 50-75

years into the future Will promises being made to those beginning work today be kept?

Do proposed reforms improve sustainability?– Frequently do nothing in the short to medium term– With move to a funded system, reform can actually worsen the

short and medium term position– Need measures like implicit pension debt

Implicit Pension Debt

What does the government owe pensioners and contributors as of today?– Pensioners are owed the present value of the current

benefit (indexed as by law) for the remainder of their expected lifespan

– Contributors are owed some prorated benefit to be received when they reach retirement age and to extend throughout the duration of their expected retirement period, prorated by the % of working career on which contributions have already been paid

Example of Fiscal Sustainability or Not in Context

of Turkish Pensions While Turkey starts

out with a deficit, most countries will eventually show a deficit in the long run

Life expectancy increases while pension parameters are usually not automatically adjusted

Projected Current Balance of Turkish Pension Funds, 2002-

2075

(8.0% )

(6.0% )

(4.0% )

(2.0% )

Year

% of GD

P

Turkish Reform Proposal

Current Account Deficits as % of GDP

(8.0%)

(7.0%)

(6.0%)

(5.0%)

(4.0%)

(3.0%)

(2.0%)

(1.0%)

1.0%

2005

2009

2013

2017

2021

2025

2029

2033

2037

2041

2045

2049

2053

2057

2061

2065

2069

2073

Year

% of

GDP

Base Case

Reform Case

Implicit Pension Debt as % of GDP

50.0%

100.0%

150.0%

200.0%

250.0%

Year

% of

GDP

Base Case

Reform Case

Benefit Structure :Are Benefits Adequate?

How do we define adequacy?– Relative to poverty level– Relative to average wage – ideally net wage

Workers pay pension contributions, health insurance contributions Note that inflation indexed pensions will result in a drop in the value

of the pension relative to economy-wide average wage during one’s retirement period

– Relative to pre-retirement wage Relative to final salary or relative to average lifetime salary?

– If average lifetime salary, how are salaries revalued to make them comparable?

Different measures can give very different results, but also provide different information

Example of Slovak Benefits

Average Male Pension as % of Economywide Average Wage

0

50

100

150

200

Pre-ReformMale

PAYGmale CurrentMale FutureMale

High Income

Avg Income

Low Income

Pension Relative to Pre-Retirement Wage

0102030405060708090

Pre-ReformMale

PAYGmale CurrentMale FutureMale

High Income

Avg Income

Low Income

Benefit Structure (2):Are the Benefits Fair?

Individuals are making contributions and receiving pensions – are they getting good value for their money?– Benefits could be high, but costs could be high too

Internal rate of return Fiscal link – if benefits are not perceived as

fair, people stop contributing – drop in revenue

Internal Rate of Return for Different Individuals in Slovak

RepublicInternal Rates of Return for Different Individuals

00.5

11.5

22.5

33.5

4

Pre-ReformMale

PAYGmale CurrentMale FutureMale

% ra

te o

f int

eres

t

High income

Average Income

Low income

Benefit Structure :How Redistributive is the

Pension System? Pension systems have multiple objectives:

– Poverty reduction in old age– Consumption smoothing

Countries choose to weight these two objectives differently– Australia/New Zealand heavily weighted toward poverty

alleviation– Austria, Sweden – strong link between contributions and benefits

No correct answer, but important to know what the system is actually achieving

Example from OECD countries, Pensions at a Glance

Countries with Highly Redistributive Benefits

0

0.5

1

1.5

2

Wage Relative to Average Wage

Pen

sion

Rel

ativ

e to

Ave

rage

Wag

e

Canada

Germany

Ireland

Japan

New Zealand

United Kingdom

United States

Pensions at a GlanceCountries where Pensions are Closely Linked to Contributions

00.5

11.5

22.5

Wage Relative to Average Wage

Pen

sion

Rel

ativ

e to

Ave

rage

Wag

e

Finland

France

Italy

Netherlands

Tools

PROST model:– Fiscal analysis

SR and LR sustainability Implicit pension debt

– Individual level social analysis Vary starting age, retirement age, starting wage, wage

growth, work history, and mortality experience Pensions as percentage of economy wide wage Pensions as percentage of own final salary Internal rate of return provided by pension system

PROST

Developed at the Bank; has been used for more than 85 countries

Available to all our client countries once counterparts are trained

Training programs and manuals available

Countries with PROST licenses as of July 2005

Countries Using PROST

APEX methodology

Simulates pension benefits for individuals beginning work at age 20 and retiring at the retirement age for all different income levels

Shows what different individuals get in relation to what they earned, taking into account tax treatment and ceilings and floors on contributions and benefits

APEX model

Developed by Edward Whitehouse and AXIA Economics

Now the model of the OECD In use for all OECD countries,

Pensions at a Glance Preliminary work on many of our

countries as well

Benefit-Incidence Not That Useful

Public System for Private Sector Workers

Public System for Federal Civil Servants

Decile TOTAL Active Workers

Pensioners Active Workers

Pensioners

1 0.9% 0.9 1.4 0.2 0.0 2 1.7% 3.3 2.2 1.2 0.0 3 4.7% 6.2 5.4 1.9 3.2 4 6.7% 7.8 8.2 4.7 3.1 5 7.2% 11.1 8.9 4.9 1.6 6 9.6% 11.3 10.3 7.8 6.7 7 11.7% 12.6 12.9 11.5 8.1 8 15.8% 14.1 15.5 14.9 16.8 9 17.9% 15.4 17.1 23.6 19.8 10 23.9% 17.3 18.0 29.2 40.6

URBAN 95.0% 93.4 94.5 91.4 97.9 RURAL 5.0% 6.6 5.5 8.6 2.1