Asian Reality: Improving Retirement Adequacy By Mukul G. Asher Professor, LKY School of Public Policy National University of Singapore e-mail: sppasher@nus.edu.sg To be presented at the Retirement Conference 2006. Asian Retirement- Ready or Not? 9-10 th October 2006 1
Organization I. What is Adequacy? II. Factors Impacting Adequacy in the Accumulation Phase III. Factors Impacting Adequacy in the pay-out (or decumalation) phase IV. Adequacy in selected countries V. Concluding remarks 2
I. What is Adequacy?/1 Should adequacy be assessed with respect to: Retirement only? Or Retirement plus health care? While health financing is usually separately analyzed, increasing longevity and shift towards life-style diseases suggests considering it in conjunction with retirement financing. 3
I. What is Adequacy?/2 In any defined contribution system, the two phases are 1) Accumulation Phase 2) Pay-out or Decumulation Phase These are depicted in figure 1. 4
I. What is Adequacy?/3 Figure 1: Accumulation and Pay-out (or decumulation) phases of DC schemes Cumulative Balances $ Accumulation Phase Decumulation Phase Working- phase Withdrawal Age Retirement Period 5
I. What is Adequacy?/4 Cumulative Balances = Net contributions (contributions minus withdrawals, plus interest credited to accumulated balances. Pay-Out (Decumalation Phase) = Funds accumulated can be spent rapidly or slowly. Death may occur before the funds are exhausted or the reverse is also possible. So, there is a need to protect against longevity risk. As it is the purchasing power of the fund that is relevant, protection against inflation risk is also desirable. Source: Author 6
I. What is Adequacy?/5 Investment risks need to be managed in both accumulation and pay-out phase. In the pay-out phase, it is essential to address longevity and inflation risks. Longevity risks refers to accumulated funds being exhausted before death. Inflation risks refers to maintaining real value of the pension benefits throughout the retirement period. 7
I. What is Adequacy?/6 Pension experts suggest that the replacement rate (ratio of retirement to pre-retirement income) of about two-thirds is required for financial security in the old-age, protected against longevity and inflation risks (in addition risk protection against health care needs is also required). 8
I. What is Adequacy?/7 Why less than 100% as replacement rate? Munnell and Soto(2005b) cite the following reasons: Taxes are lower No need to save as much for retirement. No need to pay for mortgage or other assets. Work-related expenses are lower. 9
I. What is Adequacy?/8 Both the numerator and denominator should be carefully defined. The pre-retirement income can be defined in different ways. Last-drawn salary; average salary of last five years; salary for best five out of last ten years; income defined to include not just salary but also other income (interest, capital gains, dividends, rents, etc). Similarly, retirement income could include just public pension, public plus private pension, income from all sources, including children, etc. 10
I. What is Adequacy?/9 It is essential to be explicit about the definition. For public policies, broader definition of replacement rate is appropriate, with disaggregation among various components. ( Munnell and Soto, 2005b). In countries where female labor force participation rate is fairly low, the survivors insurance is also essential. 11
I. What is Adequacy?/10 Disability insurance is also usually included as a part of risk protection package. The above suggests that annuity markets (and social insurance where applicable) for retirement, as well as health insurance coverage (or other forms of risk management) are relevant. The non-financial aspects of ageing (such as psychological well being, family and community involvement, etc) should not be ignored as these significantly impact the quality of life of the individual. 12
I. What is Adequacy?/11 Adequacy should be viewed in its totality, i.e. replacement income should be obtained from a variety of sources. Using bond-like quality of human capital will increasingly be a necessity as formal retirement age lags behind longevity trends. 13
II. Factors Impacting on Adequacy in the Accumulation Phase/1 Age at which accumulation begins Number of years of contributions and accumulations during the working life Initial wage base and its growth Initial contribution rates and its subsequent movements Rate of interest (or return) credited to member s account net of all expenses and taxes - Real interest rate = nominal interest rate (net of taxes) - relevant inflation rate 14
III. Factors Impacting on Adequacy in the pay-out (or decumalation) phase/1 Macroeconomic conditions Efficiency of the Annuity Markets Types of Risk pooling arrangements 15
III. Factors Impacting on Adequacy in the pay-out (or decumalation) phase/2 Other factors impacting on the total retirement income are: Family and community support Role of reverse-mortgage type Instruments Opportunities to use bond-like quality of human capital in old age. 16
IV. Country Malaysia Philippines Adequacy in selected countries/1 Table 1: Key Provident and Pension Fund Organizations and Indicators in Southeast Asia Organizations Employees Provident Fund (EPF) Government Pension Fund, Malaysia (GPF) Social Security System (SSS) Government Service Insurance System (GSIS) Contributors as Percent of Labor Force a 50.6 (March 2006) b NA 20-25 c (2003) 4.5 (2003) Contribution Rate (2004) 23.0 NA 8.4 ( 5.07/3.33) 21.0 (12/9) Wage Ceiling (2004) No No P 15,000 per month No wage ceiling Member Balances (USD Billion), Percent of GDP 72.2, 52.8 (March 2006) NA 3.3, 3.8 (June 2005) 3.7, 4.3 (early 2005) Singapore Central Provident Fund (CPF) Government Pension Fund, Singapore (GPF) 58.3 d (December 2005) NA 30.0 f NA $4,500 per month from January 2006 74.8, 61.6 (December 2005) NA Thailand Social Security Organization (SSO) 21.2 e (2003) 6.0 B15,000 month 20.0, 11 (early 2005) Government Pension Fund, Thailand (GPF) 3.5(2003) 6.0 Yes 7.8, 4.6 (2005) 17
IV. Adequacy in selected countries/2 A) Figures in brackets refer to year to which data refers. B) Includes 4017 foreign workers. C) Membership in the SSS is 23 million but the active contributors are 6-8 million. D) Foreign workers are around 25% of the labor force and are excluded. E) The SSO coverage is overstated as the figure refers to members rather than active contributors. If the provident funds of SOEs are included, the coverage rate may be as high as 25%. F) This rate applies to those below 55 years of age. Lower rates apply to those above 55 years. Sources: Information obtained for official sources in each country. 18
Table 2:Singapore, CPF: Balances of Total Members (2001-2005) Year Total Number (in 000) As a % of total contributions Total Balance (in SGD million) As a % of total Balance Average Balance (SGD) 2001 2923 19.5 92221 17.6 31550 2002 2963 20.0 96422 18.4 32542 2003 2978 20.0 103539 20.0 34768 2004 3018 20.2 111873 21.0 37069 2005 3048 20.4 119787 23.0 39300 The average balance per member is only SGD 40,000. But this does not permit adequacy analysis. Source: calculated from the CPF Annual Report 2005. In 2005, active members are 45.3% of total members. 19
IV. Adequacy in selected countries/3 Ideally, it is the actual household income and asset data that are relevant for adequacy estimates. In the US, Health and Retirement Study (HRS) is conducted annually to help analyze the issue. ( Munnell and Soto, 2005a) There is no counterpart of such study in Southeast Asia. This reflects weak empirical evidence based policymaking in the region. 20
IV. Adequacy in selected countries/ 4 High share of pre-retirement withdrawals for housing, healthcare, etc mitigates against the benefits of power of compound interest. 21
Table 3:Singapore, CPF: Contributions and Withdrawals (2001-2005) Year Contributions (S$ million) Withdrawals (S$ million) Withdrawals/Contributions 2001 18322 18860 103% 2002 16165 14821 92% 2003 15870 11816 74% 2004 15320 10310 67% 2005 16105 11776 73% Avg. for 2001-2005 n.a n.a 81.8% Source: calculated from the CPF Annual Report 2005 22
Table 4: Singapore: CPF, Sensitivity of Results to Potential Policy Changes A B C D E Total Wealth ($000) Proportion in Housing Replacement Rate Earnings Subsistence IRR on Property 1. Base Case 1774.3 75% 28% 296% 582% CPF Changes 2. Both CPF Accts ROR up from 0% /1.5 % to 5% real 2052.6 65% 34% 359% 4.60% 3. % to Special CPF Acct up from 4% to 8% 1800.3 74% 30% 319% 5.34% 4.CPF contribution ceiling held at 0% nominal instead of 0% real 1598.5 83% 17% 186% 5.23% 5. CPF contribution rates lowered from 40% to 30% 1604.6 83% 14% 148% 4.61% HDB Changes 6. ROR on HDB property falls 4% real to 0% real 768.5 36% 32% 339% 0.77% 7. ROR on HDB property 4% real- >10 years, 0% real thereafter 749.1 37% 30% 322% 0.47% 8. ROR on HDB property 0% real- >10 years, 4% real thereafter 1797.6 74% 30% 316% 6.04% 9. HDB resale levy falls from 22.5%/25% to 0% 2296.2 77% 34% 364% 7.42% 23
IV. Adequacy in selected countries/5 Notes: Assumes male head of household married to same age non-working wife. Source: McCarthy, Mitchell and Piggott (2001). 24
IV. Adequacy in selected countries/6 Simulations in Table 4 suggest that under the current structure and trends, replacement rate from CPF for an above average wage earner will be in the teens. Policy question: Where would the difference between at least two-thirds needed and the simulated rate come from? Family, reverse mortgages, family support, etc are possibilities. But these must be explicitly modeled. 25
Table 5: Gross Real Returns to Pension Fund in Selected Countries Country Malaysia (EPF) Singapore (CPF) Argentina Chile Colombia Costa Rica Mexico Time period 1990-2004 1987-2004 1994-2002 1994-2002 1994-2002 1994-2002 1994-2002 Real Return (percentage per annum) 3.4 1.3 10.4 10.3 9.9 7.0 10.4 Peru 1994-2002 6.6 Note: Returns to members (i.e. affiliates) of the fund may be lower than to the fund in Latin America. For 26 Malaysia and Singapore, returns reflect what has actually been credited c to the members accounts. Sources: : Gill et al.(2005) for Latin America; Asher (2006).
IV. Adequacy in selected countries/7 The real returns in Singapore and Malaysia are low relative to Latin American Countries. (Table 5) The returns for Latin America are to the funds and not what is credited to the members. Even with this correction, the previous statement holds. 27
Table 6:Malaysia, EPF: Balances of Active Members (December 31,2005) Balances (RM) Total Number (in 000) As a % of Total contributors Total Balances (RM million) As a % of Total Balance Avg. Bal (RM) Total (million) 5260 100.0 204295 100.0 38833 10000 1932 36.7% 7241 3.5% 3748 10,001-50,000 2159 41.0% 54788 26.8% 25379 50,001-100,000 701 13..5% 48989 24.0% 69876 100,001-300,000 413 7.8% 63865 31.3% 154690 300,001 56 1.1% 29410 14.4% 521532 Source: calculated from the EPF Annual Report 2005. Those who are current contributors. In 2005, active members are 47.8 % of the total members. 28
IV. Adequacy in selected countries/8 The average balance is about RM 40,000. Even at age 55 average withdrawal was only RM 44,000 in 2005. Table 6 provides data on balances of Active members. 29
Table 7:Malaysia, EPF: Contributions and Withdrawals (2001-2005) Year Contributions (RM million) Withdrawals (RM million) Withdraw als/contri butions 2001 18172 21968 121% 2002 20056 12727 63% 2003 20143 11501 57% 2004 21860 13403 61% 2005 24367 13432 55% Avg. for 2001-2005 n.a n.a 71.4% Source: calculated from the EPF Annual Report 2005 30
IV. Adequacy in selected countries/9 The EPF has not made calculations of the replacement rates. But these are likely to be low. The policy question faced by Malaysia is the same as for Singapore. Pre retirement withdrawals have accounted for 71.4 percent of contributions during the 2001-05 period. This diminishes the possibility of benefiting from the power of compound interest. 31
IV. Adequacy in selected countries/10 Singapore and Malaysia are among the most established provident funds in Asia. The replacement rates for other national provident fund systems such as in India, Sri Lanka, and Indonesia are also quite low. Moreover, the coverage of the labor force in these countries is also low. Thus, these countries also face the policy question similar to that of Singapore. 32
IV. Adequacy in selected countries/11 Pay-out or Decumulation Phase In all national provident funds, there is no mandatory annuitization of accumulated balances. Few choose to buy annuities. Examples: In 2005, in Singapore s CPF, 57,754 members were in a position to choose withdrawal methods. (CPF Annual Report, 2005) 33
IV. Adequacy in selected countries/12 Only 5.4 percent bought annuities. The data to ascertain adequacy of these annuities are not available. A survey by Hewitt Associates in October-November 2005 found that in the US only 18 percent of respondents offering occupational pension plans indicated that they already offered annuities as a form of payment options. Of the remainder only 20 percent indicated that they are likely to consider offering annuity options. The pay-out phase has not received due attention by the policy makers, development of the annuity markets remains a major challenge. In view of increased longevity, this phase deserves urgent attention. 34
IV. Adequacy in selected countries/13 For civil servants, who constitute at most two to three percent of the labor force, the adequacy in terms of the replacement rate and addressing longevity, inflation, and survivors risk is not a major concern in Asian countries. The cost of providing such benefits to the civil servants however is a major concern in some countries such as Sri Lanka, and India. 35
Adequacy in selected countries/14 Occupational Pension Plans Underdeveloped and inadequately supervised Individual Retirement Accounts: In their infancy 36
V. Concluding Remarks/1 The issue of retirement adequacy will be a major challenge in Asia. Empirical evidence based, systemic approach involving all the different tiers is needed. The annuity markets are undeveloped. More innovative approaches, including risk-sharing by all stakeholders, including the government, is needed to address the decumulation phase of the Defined Contribution (DC) Schemes. 37
V. Concluding Remarks/2 To address the adequacy issue, besides the traditional factors such as favorable macroeconomic environment, greater professionalism in design and management of provident and pension fund plans, more effective regulation, and much higher level of financial literacy will be needed. These are not easily achieved. The adequacy issue will therefore continue to be a major challenge for Asia. 38
Appendix: Asher, M.G (2006) Social Security policy in an Era of Globalization and Competition: Challenges in Southeast Asia, processed. Gill, I.S, Packard, T and Yermo, J(2005), Keeping the Promise of Social Security in Latin America, The World Bank, Washington, DC 39
Appendix: Munnell, A.H and Soto, M (2005a) Sorting out Social Security replacement rates, Centre for Retirement Research at Boston College, 19, November. Munnell, A.H and Soto, M (2005b) How do Pensions affect Replacement Rates?, Centre for Retirement Research at Boston College, 37, November. McCarthy, D., Mitchell, O.S., and Piggott J. (2001), Asset Rich and Cash Poor: Retirement Provision and Housing Policy in Singapore, Pension Research Council, Wharton School, University of Pennsylvania, Working Paper 2001-10. 40