Optimal pension modes in a mandatory pension system by Wojciech Otto

1. Optimal pension modes in a mandatory pension systembyWojciech Otto FIAP International Seminar Investments and Payouts in Funded Pension Systems Warsaw, 28-29 May 2009

2. Major reforms in CEECs • Introduction of the mandatory two-pillar pension system: • Hungary 1998, Poland 1999, Latvia 2001 • Estonia, Croatia, and Bulgaria 2002 • Slovakia 2005, Romania 2008 • Pillar I: Notional DC • Contributions: 12.2% of salaries in Poland, 9% - 18,5% in other CEEC • Pillar II: Fully Funded DC • Contributions: 7.3% of salaries in Poland, 5% - 9% in other CEEC • Contribution base cap of 250% of average salary in Poland, similar caps in other CEEC • Disability benefits, orphans’ and widows’ pensions etc., • Remain unchanged, financed on the traditional PAYG basis by separate contributions

3. Transition to the new system Transition eligibility: • Mandated transition to the new two-pillar system for young workers (PL: under 30 in 1999) • Mandated stay in the old system for old workers (PL: over 50 in 1999) • For medium aged workers (PL: 30-50 in 1999) choice between: • entering the new system (with contributions split between pillar I and II) • entering only new pillar I (directing there all contributions) Treatment of acquired pension rights: • Poland: • Rights acquired prior to the reform converted into initial balance of the individual account in pillar I • Individual account in pillar II started from zero at inception • Hungary: • No individual accounts in pillar I, benefits based on a formula, to be corrected down by 25% for those who enter pillar II (a solution infringes acquired rights of older workers who decided to switch to the new system)

4. Current phase • In most CEECs the payout phase has not yet started • Most CEECs declared mandatory annuitisation, but: • details of final solutions have been designed: • already for pillar I • not yet for pillar II • Pillar II in Hungary: • At the moment lump sums allowed • Final solutions envisaged for members with at least 15-years participation (not needed until 2013) • Pillar II in Poland: • Temporary phased withdrawals for retirees until 65 • Concerns in fact only females retiring in 2009-2013 • In 2009: few thousands of them, small accumulated amount per head • Next years: rapidly growing number, increasing amount per head • 65-olds of both gender will appear in 2014, final payoff solutions needed then

5. Payout mode from pillar I Payouts from pillar I: • life annuity indexed by inflation rate plus some fraction (20% for instance) of real average wage rate Radical version of initial benefit formula (Poland, Latvia): • Balance of individual account subdivided by expected remaining lifetime in months • Basis: last available national life tables (calendar-year) • Solidarity reduced to: • Minimum Pension Guarantee • Widows’ pensions • both related to the sum of pensions from pillar I & II

6. Payouts from pillar II: priorities • Longevity risk protection seems to be a natural priority as: • Replacement rate of pension (aggregate pillar I and II) will not be higher than under the old system • Cap on contribution base (250% of average salary in Poland) reduce generosity of pensions of high earners • If pensions are unnecessarily generous, the response should be rather to reduce contributions, because generous mandatory pension systems are costly • Preferences competing with longevity risk protection such as: • Bequests • Unforeseen excessive medical expenses/LTC • Protection against other contingencies should be met rather by voluntary pillar III (and other voluntary savings), where flexibility of payouts should not be restricted

7. Deficiencies of mandatory annuitisation - demand side • Mandating annuitisation neglects natural diversity of individual preferences due to objective and subjective factors: • Wealth already annuitised, other financial wealth, other tangible and intangible net assets (family links etc.) • Individual expected lifetime different from average used for rating by providers • Individual risk attitude, time preferences • However, free choice of various payout options does not imply optimal decisions made by retirees, as: • Lack of financial literacy is quite common in CEECs • Rationality of individuals is limited, especially under uncertainty, complexity, and long-run effects of decisions to be undertaken • Remark: empirical findings of behavioural economics come from rich countries mainly! • Moreover, free choice costs (adverse selection)

8. Deficiencies of mandatory annuitisation - supply side • Returns to scale → poor chance for competition between providers in small countries • One state-owned provider desired(?) • „Poor value” of fixed annuities as compared to lump sum or phased withdrawals due to: • High (even if fair) price of full guarantees in respect of investment and longevity risk • Competition between providers focused on acquisition of new business • annuitant has no way to derive benefits from better performance of competing providers once the contract has been concluded • Timing risk • i.e. risk of bad choice of annuitisation date, due to possible different asset mix prior and after conversion of pension savings into annuity

9. Are annuities really inefficient? Microeconomic inefficiency: • Adverse selection • However, this concerns mainly voluntary annuity markets • Expensive investment and inflation guarantees • However, this concerns annuities fixed in nominal terms or CPI-indexed • Expensive longevity guarantees • Apart of adverse selection effects, this is due to: • Limited predictability of the process of improving longevity Macroeconomic malfunction: • Attempts to hedge investment and longevity risk leads to: • Investments in public debt (especially in case of CPI-indexed annuities) • Pressures on governments to issue longevity bonds or similar instruments • Both are in contradiction to major goals of reforms, namely: • Reduce pension obligations and embedded risk of the state • Promote growth of the economy • Prevent wasting returns from privatisation of state enterprises

10. Comparing efficiency • Inefficiency of annuities is often illustrated in the literature by comparing two options: • A withdrawal scheme from an equity fund (no guarantees at all) • Life annuity indexed by CPI (full inflation and longevity guarantee) • The second option appears to be superior only for persons with very low risk tolerance, or of very advanced age. • Hence it is argued that annuitisation should be deferred until old age such as 75 or 80, and that the large portion of savings should be used to cover withdrawals prior to that age. • However, when considering two other options as well: • lifelong annuity that pays a fixed number of units of an equity fund (longevity guarantee, no inflation/investment guarantee) • Withdrawal scheme from a fund investing in inflation-indexed bonds (inflation guarantee, no longevity guarantee) • Then much earlier annuitisation appears to make sense

11. Guarantees and diversification • Competitive markets cover diversifiable risks almost for nothing • Diversification effect comes from pooling: • Pooling assets diversifies risk of investment in individual security/venture • Pooling lifelong benefits’ liabilities diversifies risk of unknown lifetime of an individual person • High price of guarantees comes from non-diversifiable part of risk: • Investment: market risk, interest rate risk, inflation risk • Longevity: risk due to errors made when projecting life table that reflects the true lifetime probability distribution of a retiring cohort • Transfer of non-diversifiable risk does not remove risk premium, unless two parties are exposed to opposite risks • This is theoretically the case of an annuity provider and a life insurer, but: • Aggregate exposure of the market for pillar II annuities would be many times larger than exposure of the life insurance market

12. Efficient solutions • The whole diversifiable risk should be removed from a pensioner, just because this could be done at the low cost • Some part of non-diversifiable risk may be removed as well, but removing too much will cost a lot (as in the extreme case of CPI-indexed annuities) • Hence the efficient solution should be based on profit sharing between the provider and the pool of annuitants, where: • Profit (and risk) to be shared comes from combined effects of investment performance and survival gain • An advantage comes from the fact that investment risk and longevity risk are weakly correlated (if correlated at all) • A drawback is that solutions are more complex and so might be less transparent than phased withdrawals or fixed annuities.

13. Profit sharing: basic scheme An Annuity Fund (AF) is separated from the managing company (provider). AF reserve is calculated as if annuities were fixed in nominal terms, on the basis of assumed interest rate (AIR) and assumed mortality table (AMT). • At the beginning of year (boy) the Annuity Fund is balanced: Assets(boy) = Reserve(boy) • Valuation of assets and liabilities at the end of year (eoy) renders the AF surplus: Surplus := Assets(eoy) – Reserve(eoy) • The provider transfers a part (say, 10%) of AF surplus to its own account • Annuities are corrected according to the indexation rate R defined as: R := 90% × Surplus / Reserve(eoy) • Reserve changes by the same rate R, and so the opening balance for a new year is again cleared: Assets(boy) = Reserve(boy) Note: sharing rule is the same for positive as well as for negative surplus

14. Profit sharing: special cases • 100% share of a provider corresponds to the fixed annuity • 0% share of a provider corresponds to TIAA-CREF annuities (offered to retiring college teachers in USA) • In this case providers’ revenues come from commissions • 10% providers’ share in surplus when positive, and 100% when negative (solution proposed in Poland) • Assures that payouts never decrease, but each year may increase • Imposing AIR = 1% helps to mitigate asymmetry of the sharing rule • Additional measure of reducing asymmetry: • Profits from a given year are used at first to reimburse losses covered by the provider in last few years, and only the excess of profits over the reimbursed amount is shared with annuitants • Additional source of stable revenues: commission on payouts • Promoting commissions on payouts and suppressing commissions on single premium prevents providers to make profits at inception, and assures transferability of the portfolio

15. Profit sharing: pros and cons Advantages: • Profit sharing makes provider following the fortune of annuitants, but providers’ share should be balanced: • Too small provider’s share removes incentives for investing efficiently • Too large providers’ share reduces automatically annuitants’ benefits, and requires larger solvency capital (and so larger risk premium) • Managing more funds by one provider allows for switching between funds of different risk profiles • Enables designing a path of gradual switching from risky to risk free investments (and mitigating this way the timing risk) • Allows to locate the above switching process within the post-annuitisation phase instead of doing it as early as in the pre-annuitisation period Disadvantages: • Parameters used for reserving cannot be discretionary (transparent rules and sound supervision needed) • voluntary manipulation allows for redistribution between the provider and the pool of annuitants and between subgroups within the pool

16. Mitigating adverse selection Problem: • How to avoid adverse selection and costly acquisition targeted at „good risks”, that would arise as: • A member chooses between competing life annuity providers • Differentiating annuity conversion rates by risk factors other than age is prohibited (as in pillar I, and in old pension system) Responses: • Centralised distribution • No free choice between products differing by the degree of protection against longevity • As between level and escalating (or CPI-indexed) annuities • Special arrangements reducing providers’ incentives to seek after easy profits made on: • Attracting as many males and as few females as possible • Attracting persons with poor medical prognosis

17. Removing gender disparity risk At the end of year the Clearing House (CH) sets the coefficient bsuch that the following equation holds: where SRj and URj are reserves set up in Annuity Fund number j for contracts written during last year on the basis of different life-tables: • SRj is based on gender-specific life-tables • URj is based on unisex life-tables Now clearing takes a form of transfers of assets: • if(b·URi > SRi), the difference is transferred from AF number j to the CH • if (SRi>b·URi), the difference is transferred from the CH to AF number j Outcome: • Providers are exempted from this part of risk stemming from gender disparity that results from multiplicity of providers • Some part of risk remains, and this is exactly that part of risk to which even the single monopolistic provider would be exposed Note: The clearing system can be adapted to the case when life-tables specific to groups distinguished on the basis of another risk factor are available

18. Poor health at retirement On the side of members this is a problem of social fairness: • Savings are inheritable before annuitisation • But are totally lost in case of death soon after For the mechanism designer this is a challenge how to mitigate incentives for undesirable behaviour of agents Solution proposed in Poland: • Life annuity supplemented by life insurance: • with sum assured equal to premium paid just after inception • decreasing then linearly to zero within 3 - 4 years The solution works better when mandatory, because then incentives for undesirable behaviour disappear on both sides. Optional solution may make members more comfortable, but: • Does not remove provider’s incentives for seeking people seriously ill, and informed poorly enough to make a bad choice • Due to adverse selection, annuity without supplementary life insurance would not be much cheaper than annuity with the supplement

19. Final remarks • Designing efficient solutions for payout phase of new pillar II is still ahead of CEE Countries • Temporary solutions applied in Poland and Hungary have given few years more to work out final solutions • However, few years is not much, as the task is fairly complex • Learning by trial and errors is unavoidable, however, international exchange of opinions and experience can make this process quicker and less costly Thank you for attention Contact: wotto@wne.uw.edu.pl