PENSION REFORM – lessons for the UK from other countries

1. PENSION REFORM – lessons for the UK from other countries Chris Daykin, Government Actuary

2. PENSION REFORM • What are the imperatives? • recognise the impact of longevity • ensure sustainability of structure and financing • avoid large increases in public expenditure • reduce intergenerational dependency • reduce perverse incentives in labour market • improve retirement incentive structures • improve incentives for saving • increase coverage

3. PENSION REFORM • Reform strategies • usually start with state sponsored social security • contribution adjustment and reform • benefit adjustment and reform • comprehensive or structural reform • reform of retirement age and structures • new approaches to financing old schemes • development of funded supplementary pensions

4. PENSION REFORM • Possible structural reforms of social security • move to notional defined contributions • introduce or increase flat-rate element • link pension to residence instead of contributions • make greater use of means-testing… • …or reduce dependence on means-testing • partially fund social security • increase role of funded private pensions

5. PENSION REFORM • Notional Defined Contribution • structured as defined contribution… • … but on a PAYG basis rather than funded • clear link between contributions and benefits • choice of revaluation approaches • targets lump sum at pension age… • with ‘notional’ purchase of an annuity • permits flexibility of retirement age • passes on part of longevity risk • demographic adjustment factor needed to keep in balance

6. Examples of NDC (broad definition) France Sweden Italy Poland Latvia Brazil China Russia Kyrgyz Republic Mongolia PENSION REFORM

7. PENSION REFORM • World Bank views on NDC • DB is “flawed” – heterogeneous characteristics • NDC creates better incentive structure • benefits linked directly to contributions • penalty for retiring early • good trade-off between work and leisure • internalises adjustment to life expectancy • can be made self-adjusting in other ways • radical change easier to effect • much harder to “game” than DB

8. LESSONS FROM SWEDEN • Swedish NDC • DB state scheme replaced by NDC • …with fairly fast transition • revalorisation of individual accounts by average wage • credits for sickness and other absences • automatic economic regulator on pensions increase • annuity responds to improving mortality • automatic balancing mechanism

9. LESSONS FROM SWEDEN • Automatic balancing mechanism (‘actuarial accounting’) • Annual balance sheet for scheme: • Liabilities = • present value of all future outlay for pensions in payment • + accumulated individual accounts for all persons not yet in receipt of a pension • Assets = • real assets in buffer fund + value of future contributions • Value of future contributions = • contribution rate x wage mass x expected turnover duration

10. LESSONS FROM SWEDEN • Expected turnover duration

11. LESSONS FROM SWEDEN • Individual accounts • mandatory funded individual accounts (PPM) • 2½% of earnings • contributions collected with NDC contributions of 16% • low administrative costs • choice of 700 investment funds • default arrangements if no funds selected • 90% of wage-earners covered by occupational schemes • operated largely on industry-wide basis

12. LESSONS FROM SWEDEN • Overall evaluation • hailed by many as a success story • sustainable PAYG system • increased level of savings achieved through PPM • but high level of disinterest in investment choice • rising concern about expected fall in replacement ratios… • …and arbitrary effect of automatic balancing mechanism • inequality of earnings mirrored in retirement income • still need minimum pension guarantee… • …but this is price indexed and dwindling away

13. LESSONS FROM FINLAND • Improved targeting • basic pension used to be flat-rate and contributory • mandatory earnings-related scheme • industry-wide rather than individual employer schemes • basic pension turned into a minimum pension guarantee… • …measured against the earnings-related pension • …so no means-test or asset test • dramatically cut the cost of the basic pension… • …and focussed expenditure on lower paid

14. LESSONS FROM FINLAND • Dealing with demographic ageing • objectives of reform of earnings-related scheme • to postpone average age of retirement by 2 to 3 years • to adapt the pension system to increased expectations of life • to reduce pressures for future increases in contributions • to unify and simplify the various separate schemes • to harmonise public and private pension schemes • average of last 10 years → career average revalued • variable accrual rate • 1.5% a year from 18 to 52 • 1.9% a year from 53 to 62 • 4.5% a year from 63 to 68

15. LESSONS FROM FINLAND • Dealing with demographic ageing • introducing life expectancy coefficient • Life expectancy coefficient for year N (>2009) = • cohort life expectancy for those reaching 62 in 2009 • cohort life expectancy for those reaching 62 in N • Multiply pensions of those reaching 62 in N • by life expectancy coefficient for year N • Thus adjusting a DB pension benefit for improving life expectancy

16. LESSONS FROM GERMANY • Dealing with demographic ageing • still earnings not prices revaluation but… • …revaluation to net instead of gross wages • higher retirement age • reduced replacement rate at 65 • changes to survivorship and disability pensions • contribution rate not to exceed 22% in 2030 • sustainability factor

17. LESSONS FROM GERMANY • Pension adjustment • Change in pensions = • Change in average income, net of contributions • x sustainability factor • Sustainability factor for year x = value for year x-1of • Number of active contributors • Number of pensioners • divided by corresponding value for year x-2

18. LESSONS FROM GERMANY • More funding in Germany • Riester pensions • some tax privileges • administratively complex • full guarantee must be given on capital invested • benefits must be paid as whole of life annuities • Pensionsfonds • allows corporate pensions to be externally funded • more flexible than Pensionskasse or Unterstützungskasse • definite trend towards more pre-funding • further types of pension product

19. LESSONS FROM DENMARK • Citizenship pensions • Folkepension introduced in 1956 as universal benefit • payable from age 67 • depended on citizenship and residence in Denmark • pension age reduced to 65 in 1999 to save money • much of Folkepension is now means-tested • problems with its application to immigrants • ATP is second pillar of public pension • DC, fully funded and based on insurance principles

20. LESSONS FROM DENMARK • Using with profits for occupational schemes • effectively compulsory through collective agreements • mostly DC (but also DB) • based on with-profits deferred annuity contracts • possibility of purchasing temporary annuities… • …using a proportion of the fund available at retirement • …and then another temporary annuity…

21. LESSONS FROM NEW ZEALAND • Citizen’s pension • flat rate of benefit at or just above means-testing level • indexed to national average earnings • eligibility dependent on period of residence in NZ • individual entitlement, whether single or married • not dependent on pattern of working life • simple to understand and operate • no savings disincentive effects

22. LESSONS FROM NEW ZEALAND • Kiwisaver • new, voluntary, work-based savings scheme • automatic enrolment for those starting new job • those in a job will be able to join if they wish • contributions from employees at 4% (or 8%) • contributions collected by Inland Revenue through PAYE • individual choice of scheme (with default) • employers can select a scheme – but no need to contribute • no withdrawal until age 65… • …except for deposit on a first home (after >3 yrs contns.) • existing DB or DC pension schemes can be exempted

23. LESSONS FROM HONG KONG • Mandatory Provident Fund • no history of social security… • …but widespread DB occupational schemes • MPF introduced in 2000 • MPF contributions of 10% of salary + allowances… • …with earnings floor and ceiling • occupational retirement schemes can opt out

24. LESSONS FROM AUSTRALIA • Means-testing and mandatory saving • no contributory social security • universal pension subject to test of income and assets • mandatory employer contribution of 9% from 2002/03 • mandatory employee contribution of 3% from 2002/03 • Industry Funds and Master Trusts • administrative problems at start • 90% of administration now with two providers • individual choice of fund finally being introduced

25. LESSONS FROM ELSEWHERE • Other countries to study • Netherlands • Switzerland • Ireland

26. PENSION REFORM • Goals of a pension system • Primary goals • To provide adequate, affordable, sustainable and robust old-age income • Secondary goals • To create developmental effects by • minimizing negative impacts • leveraging on positive impacts

27. CONCLUSIONS • Wide range of solutions – DC favoured • everywhere has a different solution • but all are starting from different points • DC widely favoured for its incentive structure… • …but lacks basic characteristics of protection • …unless in with-profits form or with strong underpin • many national DC systems have a minimum pension • and few have the legacy problems that the UK has

28. CONCLUSIONS • Wide range of solutions – new DB thinking • DB mostly moving to career-average revalued… • …which is equivalent to a type of DC • NDC is really a DB structure dressed up as DC • focus on fund at retirement facilitates longevity solutions • cash balance is another alternative DB/DC hybrid… • …or perhaps revisit with-profits DC • reconsider survivorship in light of individual entitlement

29. CONCLUSIONS • Wide range of solutions – encourage later retirement • need stronger incentives to later retirement • a reason for DC but possibilities with DB also • higher pension age for unreduced pension forces trade-off • target lump sum at retirement instead of pension • alternative annuitisation possibilities • need better risk-sharing in decumulation phase

30. CONCLUSIONS • Wide range of solutions – efficient savings • mandatory DC necessary to achieve full coverage… • …or almost mandatory • contributions should be collected centrally • avoid insurance wrappers • don’t have too much choice of investment funds • guaranteed minimum should underpin state pension only

31. THE END • Questions and discussion