1 / 37

The Cost of Minimum Pension Guarantee

The Cost of Minimum Pension Guarantee. Tapen Sinha, ING Chair Professor, ITAM and Professor, University of Nottingham, UK tapen@itam.mx. What is the problem we study?. Governments often promise a minimum level of benefits under an accumulation scheme

star
Download Presentation

The Cost of Minimum Pension Guarantee

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. The Cost of Minimum Pension Guarantee Tapen Sinha, ING Chair Professor, ITAM and Professor, University of Nottingham, UK tapen@itam.mx

  2. What is the problem we study? • Governments often promise a minimum level of benefits under an accumulation scheme • If future does not turn out to be rosy, what is the likelihood that the government has to foot the bill of this guarantee? How much would it cost? • Using the actual experience of the past eight years, and including actual features of the Mexican system, we calculate the probability distribution of such promises

  3. The Chilean Experience • To make the reform in Chile in 1981 more acceptable, the Chilean government issued a guarantee of a minimum pension • At the time, the calculations indicated that very few people will actually fall back on it • Two unexpected outcomes • First, instead of a 80-90% density, the average worker had 50-60% density • Second, the management fees ate up between 20 and 25% of contributions

  4. Pension System in Mexico • Investment Regime • Minimum Pension Guarantee • Model • Results • Conclusions

  5. Current Mexican pension regime (for the formal sector) In 1997, Mexico moved from a defined benefits system (a la US Social Security) to a defined contribution system (a la Chile) The system is publicly mandated but funds are privately managed The funds are called AFORES (Administradoras de Fondos para el Retiro) There are three components to each fund: government component, private compulsory component and private voluntary component There is a government contribution There is also a government guarantee

  6. Contribution is 6.5% of the base salary (SBC)There are three component Monthly Contribution as percentage of SBC Other Contributions • Each individual can also make voluntary contribution to the system. But such funds are maintained separately • 1.125% Worker • 5.150% Employer • This is called Cuota Social (cs). • 5.5% of minimum wage • indexed for inflation • 0.225% Govt TOTAL 6.5% Note: There is an upper limit to the SBC equivalent to 25 times the minimum wage

  7. Pension System in Mexico • Investment Regime • Minimum Pension Guarantee • Model • Results • Conclusions

  8. Investment regime under the new system The AFORES invest in special funds called SIEFORES. Until 2004, the SIEFORES had extremely restricted investment regimes. For example, investment in anything other than high grade inflation protected bonds were not allowed In January 2005, new investments were allowed such as foreign bonds in currencies other than pesos as well as in other instruments provided that capital is protected from erosion (through synthetic instruments such as futures and options)

  9. ACTUAL INVESTMENT STRUCTURE IN THE PENSION SYSTEM Allowed Financial Instruments & Limits Affiliated Workers • Debt Instruments with inflation protection – lower limit 51% • Foreign Debt – up to 20% • Assigned Workes • Workers over 56 years old • Workers who choose to invest under this SIEFORE SIEFORE-1 • Foreign Instruments – up to 20% • Equity Notes – up to 15% • Workers under 56 years SIEFORE-2

  10. SIEFORE Fund 1 SIEFORE Fund 2 Type Upper Limit Upper Limit Government bonds √ 100% √ 100% Private debt with ratings mxA-1+ and mxAAA1 √ 100% √ 100% Private debt with ratings mxA-1 and mxAA[1] √ 35% √ 35% Private debt with ratings mxA-2 and mxA1 √ 5% √ 5% Value of foreign debt √ 20% Foreign debt √ 20% Structured notes with capital protection √ 15% [1] Private debt with ratings by Standard & Poor’s

  11. Pension System in Mexico • Investment Regime • Minimum Pension Guarantee • Model • Results • Conclusions

  12. The nature of minimum pension guarantee The government promises to pay a minimum level of benefits if the amount of money accumulated in the worker’s account does not reach certain minimum value What does the government promise? The Federal Government promises the equivalent of one minimum wage to any worker who has contributed to the new system for 1250 weeks or 24 years (even if it is not continuous) The government promises to pay an annuity of one minimum salary for life for each worker in the system

  13. A digression on minimum wage

  14. Although small today, the number of people who become beneficiaries of this promise is rising Number of people entitled to minimum pension guarantee thousands,2005 Government burden of such a guarantee is rising... (millions of pesos) 86 4.3 4 66 3.5 2.8 49 2.2 35 1.7 25 1.3 17 .9 8 .19 Source: IMSS data

  15. ....and this will continue to rise because the workers under the regime largely have low wages (with over half earning no more than 3 times the minimum wage) Salary level of workers under the IMSS system 2004 8.6% 15.06% More than 10 MW 20.65% 6 to 10 MW 4 to 5 MW 55.68% 1 to 3 MW M.W.= Minimum Waves Source: IMSS

  16. Pension System in Mexico • Investment Regime • Minimum Pension Guarantee • Model to Calculate the Cost of the M.P.G. • Results • Conclusions

  17. The model is as follows: The first element describes the distribution of the variable rate of return, the second describes the law of motion, the third is a contribution at each period taking into account the commission charged Equity Returns Accumulation Contribution No commission

  18. The rate of return is the actual rate that prevailed during 1997-2005 in Mexico mM = 0.00757452 equivalent of 9.48% annual sM = 7.12315% Adjusted Log Likelihood = 135.017 For the riskless rate, we took the real rate of return of Bondes182 (a government bond with inflation indexation) rf = 4.63% annual

  19. Monthly rate of return of the Mexican broad market index IPC was indeed Normal during 1997-2005

  20. Underlying assumptions for running simulations • Retirement Age. 65 years • Contribution period. 25 and 40 years respectively • Contribution Rate. 6.5% of base salary • Contribution frequency. Monthly • Commissions. We use the actual and projected commission structure taking into account the loyalty discounts offered by some AFORES • Inflation. We calculate everything in real terms

  21. Measuring the guarantee costWe can conceptually think of the guarantee cost as an implicit put option for the government at the retirement age Payoff (T) = max{ PMG – VT , 0} Payoff VT PMG Where PMG: Price of a contingent annuity that pays the equivalent of one minimum salary in real terms VT: Funds accumulated in the worker’s individual account at retirement

  22. We could value the option using traditional Black Scholes option pricing model (it requires risk neutral valuation and the assumption of complete contingent markets) Simulation • 1,000 realizations of the final amount for each level of salary assuming different levels of investment in equity Cashflows • We calculate the present value for each trajectory Average • The average payment is the value of the option

  23. We need to calculate the single premium contingent annuity of one minimum salary (the government guarantee) The net premium for such an annuity is calculated using the following euqation Where SM97: Minimum salary current in 1997 but brought forward to 2005 f : Administrative and acquisition fee 1% sm: Security Margin of 2% We also assume that at retirement the worker is married and his spouse is four years younger than him (average in Mexico) *We use the mortality table used by the Mexican Social Security

  24. Pension System in Mexico • Investment Regime • Minimum Pension Guarantee • Model to Calculate the Cost of the M.P.G. • Results • Conclusions

  25. PROBABILITY TO EXERCISE THE GUARANTEE UNDER THE ASSUMPTION THAT THE WORKER CONTRIBUTES TO THE SYSTEM DURING 40 YEARS Probability *Measured in multiples of minimum wage Equity Fraction Income*

  26. WHEN WE REDUCE THE CONTRIBUTION TIME TO 25 YEARS, THE RESULTS CHANGE DRAMATICALLY Probability *Measured in multiples of minimum wage Income* Equity Fraction

  27. Option value PROBBS Probability of exercising the MPG option for the workers whose base salary is BS BS Base salary SFi,BS Final accumulated sum for indvidual i with initial salary BS PN Net premium cost for the MPG N Number of times the experiment is conducted.

  28. We also calculate the cost of the option for the government Option Price Option price, 25 years thousands Income* Equity Fraction *Measured in multiples of minimum wage

  29. The cost of this promise can be 0.5-2% of GDP foreverWhat can the government do to minimize this problem? It can encourage people to invest larger proportion in stocks rather than bonds (by setting the default option) It can change the contribution rate (currently set at 6.5% of the salary) to something higher (and that will make it similar to other countries in the region What we DO know from the simulations is that even by eliminating management fees for the low income workers, it will not make a big difference in government liabilities (neither will modest rise in income)

  30. Wage Observations from data….that leads to…. Old Young 1997 2005 Time

  31. …the following lifetime wage profile Wage 20s 30s 40s 50s 60s

  32. Males in Quintile 3

  33. Wage rate Stylized Fact Men in 50s Men in 40s Men in 30s Men in 20s Time

  34. Pension System in Mexico • Investment Regime • Minimum Pension Guarantee • Model to Calculate the Cost of the M.P.G. • Results • Conclusions

  35. CONCLUSIONS • Minimum pension guarantee is present to serve a social purpose: protecting low income individuals from falling into poverty • But it also binds the government to future costs • High commission (between 20% and 30% of contribution) directly affect the minimum pension guarantee: therefore, governments should seriously consider strategies for reducing commissions • The capital protection regulation currently in place does not eliminate all downside risks • While allowing for investment in broad stock indexes can increase upside for the workers, it can significantly increase the burden for the government especially for low income workers

More Related