University of New South Wales Group Group leader: John Piggott Contributing members: Hazel Bateman, Suzanne Doyle, Sachi Purcal Executive summary - January 2002 One of the economic imperatives of the new millennium is the call for smaller government. An implication of this change in electoral stance by the world s major economies is that services which have traditionally been provided by government, are now being provided by the private sector, sometimes under compulsion from government. As mandating replaces provision, new policy challenges arise these have their basis in a new emphasis on the interactions between public and private institutions. Nowhere has the substitution of mandating for provision been more evident, or more controversial, than in retirement provision. The high profile associated with social security and retirement policy reform has its origins in global population aging, which adds urgency to the reform debate, and a renewed appreciation of financial risk on the part of households, which had been dormant since the introduction of mass social security plans in the first half of the last century. It has been further highlighted by a strong stance taken by the World Bank pension group, which has consistently advocated privately administered mandatory accumulations as the preferred retirement policy model, rather than the prototypical OECD unfunded publicly provided social security policy. Various countries, both within and outside the Bank s client base, have chosen pension reform strategies which rely heavily on mandated private provision of retirement provision. This project studied the development of defined contribution retirement provision as a complete or partial replacement for pay-as-you-go social security. It documented the emergence of DC retirement systems, identified the economic policy issues implied by this trend, developed appropriate methodologies for dealing with these, and generated results with applications to Japan. The project has demonstrated that the trend towards private mandating of retirement provision is continuing to gain strength, both in developed economies and in less developed countries. Several OECD countries have undertaken structural reform to move their retirement provision polices in this direction, while others have made parametric changes which have the same effect. The US is debating parametric change in this direction, as is Japan. Among less developed nations, more than a dozen countries, especially in Latin America and in the transition economies of Eastern Europe, have developed policies embracing private mandation of retirement provision. A major lesson from this accumulating real world experience is that countryspecific pitfalls tend to be determined by what the new policies are replacing. But there are several recurring areas of difficulty. These include the regulation and implementation
of pension fund investment, policy towards retirement income products, and administrative costs and governance. This project has focused heavily on the first two of these. Neither social security policy formulation, nor the reform of social security, have been well informed by economic models which explore how retirement might be best financed, and how the financial risks associated with aging might be best insured against. The present wave of reform, in which Japan is a major participant, provides a new and highly relevant opportunity to develop economic models which address this question. Social security systems of the conventional OECD type not only provide a retirement income flow for retirees, but typically also offer coverage against early death. They thus replace, in some degree, not only private saving and investment, but also life insurance and annuity markets. It follows that research into the linkage of these policies with private markets must depend on an economic model which captures both investment and saving patterns, and insurance decisions. A major thrust of the project has been the development of an optimising model, calibrated to Japanese data, capturing these features of the real world. This rigorous microeconomic numerical simulation model allows the computation of optimal financial planning over the life cycle. This problem had previously been solved in the presence of uncertain investment returns, but had not incorporated insurance markets to deal with survivor bequests (life insurance) and annuitisation with any degree of generality or flexibility. Our model has enabled analysis of both investment/saving and life insurance/annuity questions. Perhaps more importantly in the long term, the model represents a rigorous but tractable empirical methodology for simultaneously analysing investment and insurance choices, and thus provides a normative benchmark against which both public policy and private choices may be assessed. The first topic in this project compared public provision and mandatory accumulations in the following way. We asked what would have been the outcome had employer and employee contributions to social security been invested in domestic stocks, for an individual on average earnings, retiring today. The purpose of this exercise was to highlight the distinction between public and private provision for retirement, and to provide the investigators with a means to become familiar with the Japanese social security arrangements, as a prelude to contributing to the reform debate. Ex post comparisons of this kind are intrinsically misleading, because social security provides insurance against investment risk. We therefore assumed an expected rate of return equal to the realised rate of return, and a volatility of returns equal to the observed volatility over this period. This enabled us to trade off risk and return in a counterfactual private provision scenario. We found that, on the whole, social security payouts were higher than the counterfactual, in which contributions were invested in the domestic stock market would have allowed. However, and more generally, we found that increasing the sophistication
of the investment strategy generates outcomes, or distributions of outcomes, which dominate those implied by the simple constant proportions position. While this comparison was of interest, it was very specific to the Japanese case in a particular time period. It allowed us to draw conclusions about what would have been better in a particular context, but not to say very much about what should have been an ex ante ideal. For this, a life cycle optimisation approach is required. We began by assuming that there was no labour market uncertainty, and a constant investment opportunity set. With these assumptions, which are standard in the literature, we were able to develop numerical simulation models which allowed for varying survivor bequests, annuity loadings, and different levels of publicly provided social security, parameterised to Japanese mortality, investment experience, and policy structures. This numerical approach can be thought of as a model of financial planning. It allows both popular financial advice and the prescriptions of financial economics to be quantitatively assessed. The model finds that age-phasing dominates constant-proportions strategies. It also points to the importance of providing channels for risky investment after retirement. Even after retirement, individuals will hold as much as one third of their wealth in risky assets. But most products providing longevity insurance insist on a safe underlying asset allocation. In addition, life insurance demand, generated by a desire to purchase insurance against early death and its impact on dependants, is shown to be considerably less than advocated by guides such as the Human Life Value Rule. In addition, the model provided a vehicle for assessing existing social security arrangements, along with proposed reforms, and thus permitted a novel perspective on the macroeconomic implications of social security. We find that private financial accumulations are reduced by about 25% at the age of retirement as a result of a 50% of wage social security promise. We are also able to use the model to explore why voluntary annuity markets are so thin, not just in Japan, but globally. There are several possible explanations for this phenomenon. Among them are the existence of a bequest motive, the loadings charged by insurance companies on private annuities, thus rendering this kind of insurance expensive, and the possibility that social security already provides annuity flows which are sufficient to meet demand. Results suggest that the bequest motive is the strongest single deterrent to annuity purchase, followed by social security. Administrative loadings, even when set as high as 30%, do not on their own lead to dramatic reductions in annuity purchases. This model is novel methodologically as well as in its specific application, and represented a breakthrough in numerical life cycle financial analysis which we hope to exploit in the journal literature. Because the model is cast in a rigorous microeconomic optimisation framework, results can provide guidance on how public policy might best be integrated with private life cycle investment and saving behavior, and therefore sheds light on the central question of how the two domains should be encouraged to interact. Work has continued on this model, mainly in the direction of generalisation. Progress has been made in relaxing the assumptions of a constant investment opportunity
set, and safe labour income, but this entails much computational complexity. Preliminary results exist, but are not yet readily interpretable in a real world setting. A major limitation of this approach to life cycle asset and insurance allocation lies in the nature of the annuity product embedded in the model. It captures the essence of the annuity longevity insurance but is in other respects highly stylised. Many different retirement income products can be designed, with features which provide various degrees of coverage of longevity, investment, and inflation risk. In Chapter 9, we report research which examines annuities in greater detail. This research uses stochastic process analysis to explore consumer preference towards a number of retirement income products which offer varying patterns of coverage against risks confronting the elderly. It also analyses the nature of public liability if guarantees over pension fund benefits are offered by the government. Here, we sacrifice the rigour of an optimisation model, relying instead on welfare comparisons. But this enables us to represent retirement products in much greater detail. We assume a retirement policy framework in which mandatory defined contribution accumulations are paid out at retirement, and regulations over retirement income streams must be separately stipulated. A social welfare safety net is assumed, in which either a minimum pension is guaranteed by the government, or a universal social welfare payment is provided. The insurance coverage and payout profiles of several different annuity products are considered. Numerical simulation of annuity payouts for a 65 year old male, in the presence of longevity, investment, and inflation risk, is used to gain insight into their implications for social welfare benefits and consumer preference valuation of alternative products by the retiree. We find that with a minimum pension guarantee, the variable annuity is the most preferred of the annuities we study, for a broad band of accumulation levels and degrees of risk aversion. In some cases, the expected government outlays associated with first pillar obligations were also lower. These findings hold only for the lower accumulation groups, but in a policy context they are perhaps the most important. Annuity mandation, and concern about government responsibility for individual welfare in retirement, is unlikely to be focused on the rich. A second broad finding is that inflation insured annuity products were popular, especially with the rich and risk-averse. As well, except for the poor, inflation indexed products yielded lower expected public liabilities than most other products. Third, non-life instruments, especially when tied to risky investments, are popular, but tend to be quite expensive for government revenue. We have considered only two first pillar safety net designs. They might be seen as two extremes, between which a variety of tapered benefit structures lie. Research not reported in this chapter suggests that tapered benefits extended to higher income ranges replicate the pattern of consumer preference and public outlays we report for the guarantee case.
In drawing out the policy implications of the research project, for Japan and other countries, the starting point is that population aging, along with calls for smaller government, are leading to greater private involvement in retirement provision. The UNSW Group takes no position on this development rather, starting from what we see as an inevitable trend, we have undertaken research designed to inform the implied policy environment. The policy implications of our research might be summarised as follows: Accumulating world experience with the extreme form of greater private participation in retirement provision private mandatory retirement policies suggests that important areas of difficulty include efficient investment of pension accumulations, and the form of, and market for, retirement income pro ducts. Current social security payouts in Japan are higher than private domestic investment of contributions over the last 30 years would have allowed. This points to the importance of global diversification in the investment of private retirement accumula tions. If individual accounts are introduced, investment strategies should take into account the correlated labour market risk. Broadly, it is probably sensible to phase investment from risky towards safe as workers age. Consideration should be given to making this kind of investment strategy a default. For example, each decade, the proportion of accumulation in risky assets could be reduced. For Japan, we find that private financial accumulations are reduced by about 25% at the age of retirement as a result of a 50%-of-wage social security promise. Analysis of annuity demand suggests that the bequest motive is the strongest deterrent to annuity purchase, followed by social security. Administrative loadings, even when set as high as 30%, do not on their own lead to dramatic reductions in annuity purchases. In considering policy towards retirement products available for purchase with private pension accumulations, instruments which combine continued exposure to investment risk with full coverage of longevit y risk are likely to be desirable from a social point of view. Many individuals continue to prefer some exposure to risky assets, even in retirement. This finding is supported not only by our Japanese modeling research, but also by other research which examines consumer preference across annuity types. With a government backed minimum pension guarantee in place, the variable annuity is the most preferred annuity type across a fairly broad band of retirees. The public pension guarantee liability is moderate. Inflation indexed annuity products are also strongly preferred by the rich and risk averse, and these are least costly to a government backed pension guarantee. Nonlongevity insured products tend to be the most expensive to the government.