PENSION POLICIES WHAT WORKS? WHAT DOES NOT WORK? Pablo Antolin - - PowerPoint PPT Presentation

PENSION POLICIES WHAT WORKS? WHAT DOES NOT WORK?

Pablo Antolin Principal economist and Head OECD Private Pensions Unit, Deputy Head OECD Financial Affairs Division

• 1. Main OECD messages
• 2. Framework of thought

➢ Objectives and risks

• 3. Challenges facing pension systems

➢Ageing, low growth, low return environment

• 4. Changing pension landscape

➢Growth of funded pension arrangements ➢Strengths and weakness of DCs

• 5. Need for improvements: OECD Roadmap for

the Good Design of DC Pension Plans

➢ Accumulation: investments, risk-adjusted returns, defaults ➢ Retirement phase: longevity protection/sharing

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Structure of the talk

➢ Diversify the sources to finance retirement

➢Financial economics: do not put all the eggs in the same basket

➢ Funded private pensions complementary to public pensions and not a substitute

➢How pension objectives are met and risks shared

➢ Non-contributory pensions (safety net) financed from the budget, general taxation ➢ Improve design funded pension (coherence): OECD Roadmap for the Good Design of DC Pension Plans

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Main OECD messages on pensions

➢ The primary objective of pensions is to make sure that people have resources at old age (economic security) ➢ This includes 1. Reduce or eliminate poverty at old age 2. Make sure people save during their working life to finance their retirement: saving for retirement – consumption smoothing 3. Insurance against risks during working life and in old age

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Objectives of pension systems

➢ Other secondary goals of pension systems 1. Financial and fiscal sustainability 2. Adequacy

➢ What is adequacy? Minimum, living standard, income or RR ➢ Balance act btw sustainability and adequacy

3. Coverage 4. Preserve inter and intra-generational equity 5. Support (not distort) incentives to work and save

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Objectives of pension systems

➢The first objective is to bring people at old age above certain level of income (poverty alleviation) ➢It leads to redistribution. ➢It is part of the State safety net. ➢They include basic, national or minimum pensions ➢They are non-contributory public pensions ➢OECD main message: finance them from the budget, from general taxation.

Poverty alleviation

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➢ It is financed through contributions ➢ It can be PAYG (current contributions cover current pensions) or funded (accumulated assets back up pensions). ➢ PAYG financed pensions are generally managed by the public sector: Public pensions ➢ Funded pensions are generally managed by the private sector. ➢ Funded pensions can be occupational (linked to an employment relationship) or personal (no employment link). ➢ It can be mandatory (compulsory) or voluntary, especially funded private pensions

Saving for retirement – Consumption smoothing

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➢Contributory based pensions, whether funded private or PAYG financed public, depending on the relationship between contributions and benefits (pension payments) can be:

− Defined benefits plans: pension benefits are pre- defined (e.g. public pensions, funded DB pension plans) − Defined contribution plans: pensions benefits depend on the amount of assets accumulated at retirement (e.g. DCs, 401(k)s, Superannuation, Riester, PPM, ATP, UK auto-enrolment, individual accounts)

− They may include some type of guarantees (e.g. minimum returns, minimum income floor)

Saving for retirement – Consumption smoothing

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• 1. Whether they are mandatory or voluntary

➢ Soft-compulsion auto-enrolment with opt-out

• 2. How pension benefits are financed

− PAYG: with current contributions − Funded: with assets accumulated

• 4. Relationship btw contributions and

pensions: DB, DC, guarantees

• 5. Employment relationship: occupational,
• personal. Role of the employer:

➢ record keeping, contributes Criteria to assess different pension programs within a country pension system

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• 4. Who manages the plans: public or private
• 5. Who bears the risk: employer (DB), State

(employer, tax payer public pensions), individuals (DCs), or risk sharing. ➢No pillars, characteristics ➢Important a combination: PAYG and funded, mandatory and voluntary, DB and DC

Criteria to assess different pension programs within a country pension system

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➢Planning for retirement requires to make assumptions regarding several parameters going forward. ➢Parameters such as: GDP growth, productivity, employment/ unemployment, wage growth, inflation, returns to investment, interest rates (discount rates), and life expectancy. ➢Future is uncertain, assumptions rarely materialise as expected: risks

Risks

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➢ Labour market risks: spells unemployment, career real wage paths (flat, hump-shaped, growth) ➢ Macroeconomic risks: inflation, GDP growth, productivity growth ➢ Financial risks: returns to investment, volatility ➢ Demographic risks: longevity risk ➢ Pension management risks: costs, asset and risk management ➢ Social risks: disability and family members survivors ➢ Political risks: pension policy changes ➢ All these risks will affect the adequacy, coverage and the sustainability of pension policies.

Risks

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➢ All countries have a combination of the different type of arrangements or programs: public, private, PAYG, funded, occupation, personal. ➢ It just changes the weight of each components in the

• verall retirement income

➢ All countries have a non-contributory public pension (safety net): minimum, national or basic pension ➢ Most countries have PAYG financed public pensions ➢ All countries have funded private pensions:

➢ all have voluntary personal, ➢ some have occupational, either voluntary or mandatory, DB or DC

Pension systems across OECD countries

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➢ Occupational defined benefit plans either mandatory (e.g. Korea, Netherlands) or voluntary (e.g. Canada, Germany, Finland, Japan, UK, USA) ➢ Occupational defined contribution plans either mandatory (e.g. Australia, Chile, Baltics, Hong- Kong, Korea, Mexico, Singapore, Sweden, Turkey), voluntary (e.g. Canada, Czech Republic, France, Germany, Japan, Slovak Republic, Poland, USA), or auto-enrolment (e.g. Italy, New Zealand, UK, USA)

Pension systems across OECD countries

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CHALLENGES FACING PENSION SYSTEMS

➢ Pension systems (PAYG DB, funded DB and DC, whether voluntary or mandatory) face many challenges

➢Population ageing:

➢financial sustainability, solvency and adequacy

➢Financial and economic crisis ➢Economic environment characterised by low interest rates, low returns, and low growth

➢Less resources to finance retirement

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Challenges facing pension systems

Population Ageing

➢Population ageing refers to an increase in the average age of the population ➢Increase is the result of a decrease in fertility, (already over: return to previous levels)  baby boom. ➢And an increase in life expectancy (LE). ➢The baby boom is temporal ➢The increase in LE is relatively permanent effect (bar wars and epidemics)

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Population ageing: Increase in the median age

5 10 15 20 25 30 35 40 45 50 55 Brazil China France Germany Japan USA

Japan Germany France USA China Brazil

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Population Ageing

• Fertility returns to previous lower levels, stable

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

1933 1935 1937 1939 1941 1943 1945 1947 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

USA France OECD

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Population Ageing

• Fertility fall (developing countries)

1 2 3 4 5 6 7

India China South Africa Brazil

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Population Ageing

• Large increases in life expectancy

60 65 70 75 80 85

1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Life expectancy at birth (increase = 2.2 yrs per decade)

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Population Ageing

Large increases in life expectancy (at age 65)

10 12 14 16 18 20 22 24

1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Life expectancy at 65 (increase = 1 yrs per decade)

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Population Ageing: Implications

• More people in retirement and for longer.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Brazil China Japan USA Germany France Source: UN Population Projections, 2010 Revision

Number of people in working age per person 65+

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Population Ageing: years contributing to years in retirement

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 2022 2025

Working from 25 to 65 over life expectancy at 65

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What is the impact of PA on pensions?

▪ Basic principle: what it goes in (saving during working life) and what it gets out (pension benefits during retirement) need to be equal

• Baby boom (temporary): smaller cohorts

working than retiring.

• This affects mainly PAYG-financed pensions

because current workers pay for current pensions.

• Affects also indirectly (through returns on

investment) funded pensions

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What is the impact on pensions?

▪ Higher life expectancy (permanent) increases the years in retirement relative to the years saving to finance retirement.

• ΔLE creates problems of
• Sustainability to PAYG-funded public pensions
• Funding and solvency to funded DB pensions
• Adequacy to funded DC pensions
• PA also affects pensions indirectly through

GDP growth, wage growth and returns on investment

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➢ Differentiate btw baby boom (temporary) and improvements in life expectancy (permanent?)

➢Baby boom: costs already incurred ➢Life expectancy: account for it, problem with uncertainty about future improvement (longevity risk)

➢ Higher dependency ratio means

➢Intense fiscal pressures on PAYG DB pensions: sustainability problems

➢ More years in retirement to be financed (relative to years saving for retirement)

➢Solvency problems for fund DB pensions ➢Adequacy problems for DC pension

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Population ageing: implications

How to address the impact of PA on pension gap of ageing populations? ➢ Link retirement age to life expectancy (Sweden): PAYG-financed pensions. ➢ Postpone retirement.

➢Levels and increases in life expectancy differ across socio-economic groups

➢ Link years contributing to years in retirement (NDC, DCs): ratio constant. ➢ Contribute and contribute for long periods

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How to address the impact of PA on pension gap of ageing populations? ➢ Increased role of DC pension arrangements (more direct and straightforward link between pension benefits and contributions) ➢ Promote annuities to protect people from longevity risk ➢ Different approaches to share longevity risk (pooling) ➢ Account for mortality improvements (mortality tables) and allow for financial instruments to hedge longevity risk.

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➢Low internal returns in PAYG schemes (wage growth), which raises (compounds) financial sustainability issues ➢Loss of confidence in private pensions, mistrust that public pensions will deliver promises ➢Low financial returns generate retirement- income adequacy concerns, especially on DC ➢Funded DB pensions and insurance companies providing promises (e.g. annuities) may be in trouble as their long-term promises cannot easily be adjusted and the assets backing those promises may lose value

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Economic environment low interest rates, low returns, and low growth

➢Changing pension landscape: more diversified and balanced

➢Reforms of PAYG public pensions => lower role of PAYG public pensions in financing retirement ➢A shift from DB pension arrangements (based

• n a promise) to DC pension arrangements

(direct and straight-forward link between contributions and pension benefits)

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Consequences and changes

➢Increased role of funded pensions: pension arrangements in which assets back pension benefits ➢In line with OECD long standing policy messages:

➢Diversification of the sources to finance retirement ➢Encourage funded pensions to complement PAYG public pensions

Changing pensions landscape: more diverse and balanced

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The growing importance of funded pension (assets as % GDP)

50 100 150 200 Malaysia Greece Indonesia Turkey Hungary Belgium Austria Thailand Germany Slovenia Czech Poland Italy France Norway Portugal Slovak Latvia Spain Estonia Mexico N Zealand Korea Japan Israel Ireland Finland Chile Sweden UK Australia Switzerland USA Iceland Canada Netherlands Denmark

33 Source: OECD, Global Pension Statistics

2000 -2016

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The growing importance of funded pension arrangements (assets as % GDP)

13 countries more than 50% of GDP, up from 10 in 2000 7 countries more than 100% of GDP, up from 4 in 2000

➢The growth in funded pension arrangements comes mainly from arrangements in which there is a direct and straightforward link between contributions, assets accumulated and pension benefits (DC pensions) ➢Advantages: direct link, incentives and no generosity problems Increased role of DC pension arrangements

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➢ Disadvantages:

➢Retirement income is uncertain ➢Burden shifted to individuals

➢ They put more of the risks of saving for retirement (e.g. investment and longevity risk) onto individuals ➢ Individuals need to take decisions on how much to save and for how long, how to invest, and how to allocate the resources available to finance retirement ➢ They may not be the best prepared to take them

➢Individuals have low financial knowledge ➢They suffer from behavioural biases (present bias, loss aversion, procrastination, inertia, use simple heuristics,

• verconfidence, overextrapolation, use simple rules of

thumb, framing)

DCs are here to stay, have advantages, but also disadvantages

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➢Challenges facing pensions have created a problem of adequacy (current contribution levels and contribution periods may not bring about as high retirement income as expected) ➢The question is then, given all those problems: ageing, environment of low growth and returns, low financial knowledge, and behavioral biases ➢How can pensions deliver pension income which it is up to people’s expectations?

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DCs are here to stay, but we need to improve their design

IMPROVE THE DESIGN OF DC PENSION ARRANGEMENTS OECD ROADMAP GOOD DESIGN OF DC PENSION PLANS

➢Issues we need to deal with

➢Contribute more and for longer, How? ➢Compulsion vs voluntary, ➢Improve the functioning of financial incentives ➢Use and design of defaults, as well as nudging ➢Tackling the costs of running private pensions ➢Improve design of the accumulation phase ➢Improve structure retirement phase of DC plans ➢Financial knowledge and communication

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Improve design the design of DC pension arrangements

• 1. Ensure the design of DC pension plans is

coherent, globally and internally

• Take into account the overall pension system
• Internal consistency between the accumulation and the

retirement phase

• Monitor all risks affecting retirement savings (labour

market, macroeconomic, financial and demographic)

• 2. Encourage high participation rates, adequate

contributions and long contribution periods

• 3. Promote well-designed incentives, in particular

voluntary systems

• 4. Promote low-cost retirement savings instruments

We need to improve the design of DC pension arrangements

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➢Compulsion (1st best), voluntary, automatic enrolment (2nd best, costly) ➢Financial incentives ➢Matching contributions on top of fiscal incentives (EET, TEE, etc.) ➢Financial education and financial advice ➢Automatic escalation of contributions

➢Same more tomorrow, easy escalation ➢Link increase contribution growth of wages

Participation, contributions, long contribution periods and improve incentives

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➢Problems with competition btw providers: increase costs (e.g. Mexico) ➢Caps on fees (shifting): UK, Sweden. ➢Structural changes

➢Defaults, passive investment (HK: DIS) ➢Centralised systems (e.g. Singapore, Sweden) ➢Chile: promote competition through auctions

Lower costs of providing pensions

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• 5. Establish appropriate default investment

strategies, but also provide individuals with a choice of funds with different risk profiles and investment horizons

• 6. Use life-cycle strategies as the default option to

protect people close to retirement against negative outcomes

We need to improve the design of DC pension arrangements

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➢ DC plans aimed at providing people with choice ➢ People are either unwilling or unable to choose among investment strategies (low financial knowledge and behavioural biases) ➢ Default investment strategies concentrate on reducing the risk of extreme negative outcomes on retirement income, specially when close to retirement. ➢ Appropriate default: balance trade-off between potential retirement income and associated risk (extreme negative outcomes) ➢ Choose probability threshold to assess risk: e.g. I strategies reduce downside risk to 99% ➢ Life cycle strategies: reduce downside risk, easy to understand, no panacea, gliding path (dependant on the structure of the retirement phase), organised around one fund (TDF), multi-funds (Chile)

Default investment strategies

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• 7. Encourage annuitization as protection against longevity

risks

• The main goal of saving for retirement and pension

arrangements is to have a stream of income during retirement that protects individuals against the risk of outliving their resources (LR)

• Life annuities provide protection against LR, but iliquid, rigid

and individuals dislike them (use of framing?). Different products with different options (expensive, risk management)

• Drawdown programs provide flexibility and liquidity, but lack

protection from LR

• OECD recommends to combine drawdown programs with

deferred life annuities (e.g. age 85). This strikes a balance between flexibility, liquidity and protection from LR (tail risk). At least as a default.

We need to improve the design of DC pension arrangements

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• 8. Promote the supply of annuities, innovation and

cost-efficient competition in the annuity market

• Different types of annuity products, with guarantees
• Risk management
• Change framing (no investment products but

insurance)

• Providers need financial instruments to hedge risk
• Recognise risk, model it, incorporate it (dynamic

tables) and update regularly.

We need to improve the design of DC pension arrangements

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• 9. Develop risk-hedging instruments to facilitate

dealing with longevity risk

• Idiosyncratic versus aggregate LR (mechanisms to

share them)

• Hedging vs transferring risks (longevity swaps instead
• f buy-ins)
• Bespoke solutions versus standardised solutions
• Role of the State: transparent, liquid and standardised

market (issue longevity indices). Regulation (require tables including improvements and update them regularly). LIBs

10.Ensure effective communication and address financial literacy

We need to improve the design of DC pension arrangements

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➢Financial education is useful and important, but there are limits to what it can achieve ➢Even well informed and knowledgeable people face high transaction costs assessing complex

• ptions

➢Pension statement (simple) =>Promote people to be pro-active: save more and for longer. ➢National programs: focus, cost assessment, evaluations

Improve financial knowledge and effective communication

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➢ Promote funded pensions ➢ Improve governance and the regulatory framework ➢ Increasing coverage (tax incentives, auto- enrolments), ➢ Encourage higher contributions (matching contributions) ➢ Extend contribution periods, especially by postponing retirement ➢ Promote good designed defaults

➢Investment: life-cycle, structure retirement phase ➢Combination with annuitization: protection from LR

Main messages: OECD Roadmap

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THANK YOU VERY MUCH!

OECD work on pensions

www.oecd.org/insurance/private-pensions