COMMONALITIES AND DIVERSITIES IN MULTI-PILLAR SYSTEMS by Estelle James

1. COMMONALITIES AND DIVERSITIES IN MULTI-PILLAR SYSTEMSby Estelle James

2. Many countries have reformed their systems to: • Protect the old in a sustainable way • Be equitable • Benefit labor and financial markets--enhance economic growth • Often this requires structural reform--multi-pillar system with mix of tax financing and pre-funding, public and private management • Many countries in this region are moving in that direction

3. I will: • Describe commonalities in multi-pillar reforms • Analyze differences and reasons for them • Outline remaining issues and problems • Many variations on this theme, so many choices to be made and many remaining problems once basic design is set

4. Movement toward multi-pillar system • Multiple instruments for multiple objectives • Pillar I, for redistribution: social safety net, publicly managed, tax financed • Pillar II, for retirement savings: individual accounts, funded, privately managed • Pillar III: voluntary • Co-insurance against uncertainty through diversified income sources and management

6. Diffusion of structural reform around the world, 1980-2000 25 20 15 Cumulative number of reforming countries 10 5 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

7. Number Contributors to Mandatory Multi-pillar Systems, 1982-2000

8. Structural reformers have commonalities and differences • Commonalities--diversified retirement income sources:DB+DC, privately managed funded pillar + public social safety net • Differences: • Relative size of public and private pillars • Nature of public pillar • Who chooses private investment managers • Administrative role for central soc sec agency • Policy-makers must evaluate which is best

9. First Pillar • Keeps people out of poverty and diversifies income sources • Publicly managed • But important differences in size and degree of targeting

10. Types of first pillars: Size and targeting • Minimum pension guarantee (MPG) or means-tested (MT)--Chile, Hong Kong, Australia, Kazakhstan--smallest • Flat--Ireland, UK, Netherlands (Argentina is becoming means-tested)--medium • Earnings-related (ER)--Uruguay, Hungary • NDC--Poland, Latvia--also ER, large • MPG and MT cheapest, most redistributive, general revenue finance; MT--transactions costs • ER & NDC most costly, least targeted, payroll tax

11. Why do some reforming countries choose large public pillars? • When countries shift contributions to funded private pillar, this creates temporary financing gap--transition cost • Countries with small IPD’s (<100%) have low transition costs, can make large shift, while those with large IPD’s (>200%) often keep large PAYG public pillar • Transition economies are mixed group, because of different demographics • Large first pillar can be DB or NDC

13. A small digression: What is NDC? • Contribution + notional interest rate credited to workers’ account but account is not funded--contribution is used to pay current pensions. When workers retires “notional” accumulation is turned into pension, that is financed with other workers’ contributions--remains PAYG • Notional interest rate and conversion rate to annuity is set by government

14. Pros and cons of NDC • Remains PAYG--doesn’t increase national saving, develop financial markets, avoid inter-generational redistributions; still sensitive to demographic change • But DC gives close link between benefits and contributions, which may have good labor market effects. If conversion rate is actuarially fair, penalizes and may discourage early retirement.

15. Pros and cons (Cont’d) • Advantages: • Large first pillar keeps transition costs low, because keeps PAYG • If first pillar is large, NDC may have labor market advantage over DB. • Disadvantages: • keeps most disadvantages of PAYG systems • Notional interest rate and conversion factor to annuities are subject to political pressures because not market-determined • Not redistributive; some other arrangement (minimum pension) needed for safety net

16. Second Pillar (individual accounts) • Mandatory saving • Defined contribution: worker accumulates contributions + interest • Funds are privately managed but regulated--investment diversification with some choice

17. Why mandatory? • If voluntary, many workers would stay out of system. • Permits PAYG pillar to remain small • Sometimes low earners are exempt from second pillar, get high replacement rate in first pillar (Switzerland)

18. Why defined contribution (DC)? • Links benefits to contributions, less likely to be regarded as tax • More sustainable--immunizes system to evasion and early retirement (if worker retires early or evades, annuity declines) • Discourage early retirement • Avoids hidden redistributions within cohort

19. Why funded? • Avoids • Benefit promises that are too high • Sharp tax increases as populations age • Intergenerational transfers • Builds saving, especially long term saving--important for economy • Even countries with NDC first pillar have funded DC second pillar

20. Why competitively managed? • To maximize productivity by allocating capital according to economic, not political criteria • To get best return on savings for pension fund • To reduce risk by investment diversification (public & private securities, international) • To avoid hidden build-up of government deficits • To develop financial markets

24. Key differences: managers are chosen in different ways: • Latin American model (Chile, Mexico, Kazakhstan)--workers choose fund manager; but investment portfolios tightly constrained • OECD model (Australia, Switzerland, Hong Kong)--employer or union choose manager but greater portfolio variety • Institutional model (Bolivia, U.S. TSP)-- aggregate small contributions into large blocs and negotiate fees centrally to cut costs; competitive bidding limits choice

25. Why do some countries use worker choice, others employer-union choice of investment manager? • In many industrial countries, large employer-sponsored funded plans existed; these became base for mandatory Pillar II, to gain employer and union support; may cut costs • But this may not be political equilibrium in DC systems: workers may demand more control over investment strategy if they bear risk (principal-agent problem)

26. Admininstrative centralization v. financial privatization • Some countries centralize collections of contributions, disability and survivors insurance, while others decentralize • Depends on political power of social security bureaucracy and government’s desire to win their support • Examples: in Mexico and Poland collections are centralized; Hungary, HK, Chile decentralized

27. Conclusion • Therefore basic principles are common but how they are put into action varies widely • Not two reforming countries have reformed in exactly the same way • You task is to figure out the best way for your country