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BASIC TYPES OF PENSION SCHEMES:
Objectives and Constraints
Gary Hendricks
Regional Pension Workshop
Majuro, Republic of the Marshall Islands
April 25-29, 2016
Fundamental Types of
Public Pension Schemes
• Individual Retirement Savings Schemes
(Defined Contribution/DC/Provident Funds)
• Group Retirement Insurance Schemes
(Social Security)
Individual Savings Schemes
• A collections of Savings Accounts of individual
workers
• A fund holds and manages the accounts
• Each participating worker owns his/her account
(just like in a savings account in a bank)
• Each worker’s participation in the Scheme is
divided into two phases:
– Contribution Phase – savings are accumulated in the
account
– Payout Phase – savings are withdrawn from the
account
Individual Savings Scheme:
Accumulation Phase
• Contributions on behalf of the worker are
credited to the worker’s account
• All account balances are pooled and invested
• Investment returns are credited to individual
accounts on pro rata basis
• All expenses are deducted from individual
accounts on pro rata basis
Individual Savings Scheme:
Payout Phase
• Law defines at what age workers can begin
withdrawing assets from their accounts.
• Scheme may offer one or a range of options
for withdrawing assets including a lump sum
at retirement, periodic payments until account
is exhausted, and annuities.
• Any account balance remaining at death of
the worker is paid to worker’s beneficiaries.
Individual Savings Scheme:
Summary
• Individual savings account are established for
each worker
• Account balances are pooled and invested.
• All contributions plus a pro rata share of
investment returns are credited to the worker’s
account
• Pro rata share of all expenses are deducted from
account.
• The worker’s account balance is available to
finance his or her retirement.
Individual Savings Scheme:
Objectives
• PRIMARY OBJECTIVE (often not directly unstated)
– Shift the financial risk of providing public pensions from
the government to the individual worker
• FISCAL RELIEF:
– Relieve the need to provide direct general revenue
financing or general revenue transfers to finance an
existing and growing Social Security deficit
• INCENTIVIZE WORKERS
– Make workers more responsible for financing their
retirement
– Increase workers’ feelings of empowerment with visible
individual savings
– Encourage greater formal sector employment
Individual Savings Scheme:
Objectives (cont.)
• SOCIAL GOALS
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Increase national savings rate
Strengthen capital markets
Create large pool of assets for domestic investment
Distribute lifetime consumption more evenly for workers
Raise funds for social investing by the government
Supplement low Social Security benefits (floor of
protections)
• PACIFY VESTED INTERESTS
– Pressure from asset managers, banks and financial sector
generally
– Corruption
Individual Savings Schemes:
Constraints and Limitations
ADEQUACY
• Workers bare all of investment risk making benefit levels uncertain.
• Minimum guarantees must be financed separately. (Minimum guarantees
will almost certainly destroy the system.)
• Account balances must be protected against pre-retirement withdrawals.
Money not in the account, even temporarily, lowers retirement benefits.
• Contribution rate may be high (15%) even for minimally adequacy
benefits.
SYSTEM CONSTRAINTS
• Corruption must be at very low levels. Assets grow rapidly.
• Government must be disciplined and have strong political will. Assets
grow rapidly. No social investing. No pre-retirement withdrawals.
• Sound well-regulated banking system is requisite.
• Developed financial infrastructure and regulation necessary for internal
investment even if opportunities are there.
Individual Savings Schemes:
Constraints and Limitations (cont.)
ADMINISTRATION
• Rigorous, fast, precise, and inexpensive
• Same day recording of contributions, daily re-valuation of assets
and daily re-valuation of every account.
• Annuities
– Selection of providers and range of options offered
– Government needs to sign contracts for these and exercise
some management
On-GOING PUBLIC EDUCATION
– Government must provide extensive on-going education.
– Expectations regarding losses in asset values must be managed
– On-going reinforcement of NO early withdrawals
Group Retirement Insurance:
Social Security
• Social Security is not savings schemes. In fact, there
is no savings component for the individual worker.
Assets are not owned by individual workers and
contributions are not related directly to benefits.
• Contributions are like insurance premiums. Workers
pay them and those that live long enough collect a
pension. Those that die before retirement do not
collect.
• Total premiums (contributions) collected must be
adequate to pay the on-going benefits.
How Social Security Works
• Contributions in amounts specified by law are paid by or on behalf of each
worker
– Contributions are set to cover cost of benefit payouts
• Contributions are deposited in a single account (the social security fund)
– No worker owns or has a right to any part of the fund
– Earnings on fund assets become part of fund
• An administrator maintains a records for each worker of time worked,
contributions and wages
– Records are updated periodically (monthly, quarterly, annually)
• When a worker reaches retirement age , a pension is calculated and paid
for life.
– A Formula specified by law s determines the benefit
– Factors in the formula usually include length of service and earnings among
other things
• The benefit may be adjusted periodically for increases in cost of living
inflation or for political reasons
Social Security:
Financing
• With no direct connection between contributions
and benefits, the financing method is specified by
law and may rely on earmarked taxes,
contributions based on wages paid by workers
and/or employers, or by any other method that
raises sufficient funds.
• Monthly pensions are paid out of the social
security fund. And, each month the fund must
have sufficient funds to pay all benefits.
NOTE: Maintaining sufficient funds to pay benefits
at all times is discussed in an later presentation.
Social Security:
Objectives
• Provide adequate benefits at least cost
• Protect long service workers against poverty in old age
• Protect orphans and widows against lose of primary
earner
• Provide for independence in old age through
intergenerational transfers from young to old
• Avoid massive asset build-up inside government
– Making government a dominant player in capital markets
– Encouraging social investing with no investment returns to
help finance pensions
Compare and Contrast Public DC and
DB Schemes
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Adequacy
Poverty alleviation
Risk/Certainty of Outcomes
Contribution Rate (DB/DC)
Disability protection
Family Protection
Breaks in coverage
Timing of Retirement
Actuarial fairness and neutrality
Work after retirement (credit/no credit)
Administrative rigor and cost