Demographics issues and Pension systems. Najat El Mekkaoui de Freitas Université Paris Dauphine.

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1 Demographics issues and Pension systems Najat El Mekkaoui de Freitas Université Paris Dauphine May, 2009

2 The demographic and economic challenges Over the next decades many countries will see a big shift in the age-composition of its societies with the share of elderly people increasing vis-àvis the share of working age people. The most consequence of this trend is that : few workers per person of retirement age and thus an increasing demographic burden on the public pension and health care systems.

3 The demographic and economic challenges Demographic and economic challenges are more severe in developed country (less in USA) than in developing countries.

4 Plan: Positive analysis : I Demographic issues. II Pension Systems and reforms. III Corporate and centralized pension systems and management of longevity risk

5 I Demographics Issues

6 World Population (source : ONU)

7 Demographics Table. Increase in dependency ratios, Difference EU USA Japan France The number of people in working age per retiree will decrease from 4 to 2.

8 Participation rates are low because : there are strong financial incentives to retire early arising from the design of pension systems and/or other benefit programs.

9 II Pensions sytems and main reforms

10 II - 1- Type of system : Pay as you go (PAYG) system in which benefits are earnings related and with a strong redistribution (financement instantané) ; Funded system :fully funded (FF) system with contribution related benefits and no redistribution (non instantané).

11 - Specificities of the pension plans Defined Benefit: A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. More commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. Traditional, supported by labor unions. Now in decline.

12 - Specificities of the pension plans Defined Contribution (DC) -1-: A defined contribution plan does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan.

13 - DC plans -2- Contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans : 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.

14 Specificities of the pension plans Insurance compulsory for DB plans, ex: Pension Benefit Guarantee Corporation (PBGC)-USA. Investment - subject to the prudent man rule, which requires a sensible asset diversification. - quantitative/qualitative restrictions

15 TAX POLICY OF PENSION FUNDS

16 The French pension system : The French retirement system is based on a statutory pay-as-go system. In 2006, the statutory scheme accounted for 98% of total pension expenditure. The State pension scheme is dependant on the sector of activity in which the worker participates. The supplementary schemes, which complement the general State regime, are financed on a pay-as-yougo basis. These compulsory supplementary pensions are financed by the ARRCO for all the employees and by the AGIRC for executives only.

17 The French pension system : Civil servants and public-sector company employees are covered by many special schemes. Civil servants, after completing 15 years of service, are covered by the State pension service.

18 The French pension system : The major role of the statutory scheme in France has made difficult to have a large presence of voluntary or sectoral schemes. Until 2004, third pillars were, for the most part inaccessible for French workers.

19 The pension system in USA : The United State s pension system is divided into three pillars. The pension system is governed by the federal government's tax collection agency (Internal Revenue Service), the Social Security Administration, and the Labour Department Agency. Another federal agency, the Pension Benefit Guaranty Corporation, insures retirement benefits for those under private pensions.

20 The pension system in USA The Social Security program is the most important pension system run by the government. It provides full benefits to working people who retire and apply for their pension at the age 65 or older. While Social Security constitutes a considerable amount of pension income for retirees, most Americans find that it only provides a portion of their retirement income needs.

21 The pension system in USA The pension wage is determined on the basis of the earnings for 40 years. The system is flexible, people can take their retirement early, between the ages of 62 and 65, but will receive reduced benefits.

22 The pension system in USA : Occupational pension plans There is no law in the United States obliging employers to create occupational pensions funds for employees. In 2006, approximately half of the private-sector employees were covered by occupational pension provision arrangements provided by employers. There are two forms of pensions funds that the employer may choose to provide: defined benefit and defined contribution.

23 II- 2 - Main reforms

24 Main policy actions Increase employment rates, in particular of old-age workers ; Link retirement age to longevity gains ; Reforms improving the link between pension benefits and contributions ; Introduce funding ; Comprehensive reforms are more likely to offset the impact of ageing than piecemeal reforms But, how to implement them?

25 Main reforms aspects PAYGO: Increase in retirement age, vesting period, Development of Social security reserve funds, Development of centralized funds, Development of corporate pension funds, Development of corporate saving, Development of personal saving.

26 Types of adjustments 1 - source : GAO

27 Types of adjustments 2 - source : GAO

28 Others measures Development of centralized funds, Development corporate saving (public, private sectors), Development of personal saving.

29 III - A corporate and centralized pension systems and management of longevity risk

30 A - A corporate pension plans Development of pension funds. Private saving is today a very important part of the household retirement income. They manage around USD 16 trillions in assets at the end of 2005.

31 - A pension plans Asian countries : an increasing on funded pensions in order to secure retirement income for the elderly. China and India : growth in defined contribution pension plans. Singapore : growth of private pension funds.

32 - Specificities of centralized funds : the Singapore Central Provident Fund (CPF) Formed in 1955 A mandatory saving system called the CPF. Managed centrally by the government. An individual account for each member. Defined contribution plans * Malaysia, Fiji, Indonesia and India also adopt CPF Singapore has the highest combined contribution rate (33%) and the highest asset of CPF as % of GDP (63 %).

33 - Specificities of centralized funds : the Singapore Central Provident Fund (CPF) not just for retirement, also for... housing, medical needs and education.

34 - The employee Provident funds in Malaysia Created in 1951, Fully funded, Individual accounts, Defined contribution, Coverage : all employers over 15 Taxation : contributions taxe deductible Low costs.

35 B Household, pension Saving and Invesments Evolution of saving managed by pension funds. Investment policies.

36 Evolution of Pension funds assets in selected countries Canada Italie Portugal Espagne Royaume-Uni Etats-Unis

37 Investment Rules A Prudent person rule (PPR) versus quantitative assets restrictions (QAR) (see table : Investment regulation - Europe) PPR : The rule is interpreted as requiring a sensible asset diversification. Ex. USA, UK. : According to the Department of Labour, the trustee must act "in the sole benefit of the beneficiaries", which means to select investment with "the care, skill, prudence and diligence".

38 Exceptions Limits for US and UK pension funds : US : 10% in case of DB plans (sponsor s firm) UK : 5%. to protect against the positive correlation of sponsor's and pension fund's insolvency. No limits in case of DC plans (ENRON, General Electric, etc.)

39 2 - Consequences of accumulating household saving in corporate pension funds system, in centralized plans.

40 - Situation today of pension plans : The US plans case The PBGC estimates that underfunding of US corporations single-employer DB pension plans reached $450 billion in (it was never higher than $110 billion until 2002). This resulted in losses for the PBGC of $23 billion in 2004 and 2005 (never higher than $3.6 billion until 2002).

41 Policy Responses Policymakers have responded in various ways to deficits in pension levels. Measures: minimum funding retirements have been changed in a number of countries.

42 Policy Responses: In Anglo-Saxons countries. The interest rates used to determine current liabilities must reflect the timing of future benefits payment under the plan.

43 Limits for centralized funds: Return of the fund managed by CPF board is lower than return managed by institutional fund managers. Absence of compulsory life annuities purchase. Retirees are vulnerable to inflation and longevity risk. Lack of diversification. Weak transparency (who manage the funds?)

44 Conclusion Corporate funds and centralized funds contribute to financing old age but in order to have a better risk management... Need to : Share the risk between employees and employers, Adopt a prudential regulation, Follow a diversification of assets, Develop an annuity markets to provide a greater degree of protection against the longevity risk.

45 Thank you

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