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Financing retirement income: Move to defined-contribution pension system: will change government’s regulatory role

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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Financing retirement income for the elderly imposes heavy fiscal burdens on many countries. For western industrial countries and a number of Asian countries, those burdens are expected to increase as their populations age. Others, notably transition countries, are already facing daunting financial problems in their social security systems. In both cases, policymakers face the same question: how to reform the public pension system so that its finances remain stable in the long run.

Defined benefits to defined contributions

In response to those pressing policy issues, the World Bank under the guidance of its then-chief economist, Lawrence Summers (now U.S. Treasury Secretary), developed a new pension policy framework for its member countries in the early 1990s (see also Averting the Old Age Crisis, Oxford University Press, 1994). Among the Bank’s key recommendations is to replace public defined-benefit systems financed on a pay-as-you-go basis with a three-pillar system. In a pay-as-you-go defined-benefit system, contributions of current workers finance the benefits of current retirees, and benefits are set according to a formula that takes into account previous earnings, years of service, and age at retirement. In the suggested three-pillar system, only the first pillar, which provides a guaranteed minimum retirement income, would be financed on a pay-as-you-go-basis. The mandatory second pillar would be set up as a pre-funded defined-contribution system. In a defined-contribution system, benefits are determined by the contributions a worker makes to his or her retirement account and the returns on those retirement savings. The third pillar would be voluntary and would finance supplementary retirement income.

An important and little-discussed question in moving to a defined-contribution public pension system is how to draw down retirement savings accumulated in individual accounts.

Retirement income

In a defined-contribution system, individuals enter retirement with a stock of assets. In a mandatory system, workers must transfer a certain proportion of their income to individual accounts. Within the limits set by government regulation, they can then decide how to invest their assets. When they retire, workers must finance their income needs with those savings. Traditional public pension systems provide a lifelong stream of income to the original beneficiary and usually also to survivors. Such an income stream, called a life annuity, protects against uncertainty about the length of life. Two important considerations for defined-contribution systems are whether pensions with the same lifelong income stream would be available to future retirees and which types of government intervention might be necessary. Without access to life annuities, retirees who live longer than expected would spend all their assets and then be without means, most likely drawing on government income support. Therefore, how accumulated retirement assets are withdrawn has a potentially large impact on government coffers if regulations and oversight are insufficient.

Retirees in a defined-contribution system could convert their retirement savings into a lifelong income stream by purchasing annuities in the private market. Private markets offer a variety of annuity contracts, the simplest one offering a lifetime income for a single person. Others provide an income stream for a spouse and other survivors at the same or a lower level. Some annuities—called refund annuities—pay a lump sum to survivors if the person receiving the annuity dies before a certain age. Annuity income can also be fixed or variable. Fixed annuities pay a fixed nominal amount each month; variable annuities are backed by a portfolio of risky assets, and the amount paid to beneficiaries of annuities depends on the return the portfolio earns.

Demand for annuities

Despite the large variety of available annuity products, annuity markets are very thin, even in countries with highly developed financial markets. That empirical observation is surprising from an economic perspective. The risk-sharing properties of annuities should make their return attractive to retirees; one would thus expect many retirees to supplement their other pension income by converting their private savings into annuities. The fact that only a small number of retirees currently value annuities enough to purchase them is important for two reasons. First, it could indicate some problem in the annuities market that requires government intervention. Second, to the extent that current annuity demand reveals preferences for consumption allocation in old age, policymakers in countries that introduce individual accounts should adapt their regulations.

One frequently mentioned concern is that private annuities markets suffer from adverse selection, which arises if the insurance company has less information about a potential customer’s risk properties than the customer. As a result, insurance companies must raise their prices, because the unidentifiable “bad” risks—in the case of annuities, individuals with a longer-than-average lifespan—purchase more insurance than the “good” risks. The price increase could lead more good risks to drop out of the market, possibly until very few market participants remain. Indeed, there is empirical evidence that annuities markets in the United Kingdom and the United States are less favorably priced because people who purchase annuities live longer than average.

In addition to adverse selection, a variety of other factors affect the current demand for private annuities.

First, as a result of public and company pensions, many people already receive much of their retirement income in the form of annuities and might wish to use their remaining assets for purposes other than converting them into a stream of income. Second, families may decide jointly about consumption, taking into account that one or the other family member might die. Such a decision-making process would lead family members to leave bequests for each other and reduce the risk of outliving resources, thus diminishing the need to purchase annuities in the private market. Particularly in developing countries without extensive public support systems, families are known to provide implicit insurance. Third, retirees face the threat of large and lumpy health care expenditures. If annuity contracts were irreversible, retirees would choose to keep some cash on hand for health expenditures. Fourth, the portfolio of annuities often cannot be tailored to meet retirees’ risk-return preferences, and annuities generally do not protect against inflation. Retirees may therefore prefer to invest in other assets.

Role of government

In considering the withdrawal of funds from individual pension accounts, governments that decide to reform their pension systems must consider simultaneously the cost to the government arising from benefit guarantees, the functioning of insurance markets, and retirees’ consumption needs. Both protecting the government’s finances and ensuring the functioning of insurance markets would favor mandatory annuitization of retirement savings. Retirees who are forced to purchase annuities are less likely to run out of resources later in life, which reduces the risk that the government will need to step in with income support. At the same time, because retirees would not be able to opt out of the annuities market, mandatory annuitization would eliminate adverse selection. However, a mandate restricts retirees’ possibilities to allocate resources between different types of consumption—including health care—and bequests.

The following guiding principles can be established for regulating withdrawals. First, retirees should be required to purchase an inflation-protected annuity with survivor coverage that is higher than the government’s minimum benefit guarantee or public support system. Under such a provision, people who live unexpectedly long will not qualify for government assistance if they run out of money or inflation erodes their income. The government should also limit the risks retirees can take with their annuitized savings by restricting the variability of annuity income. However, different types of annuities, such as refund annuities, should be permitted so that income streams can be adapted to personal preferences.

Second, the government must decide whether it wants to impose restrictions on the way annuities are priced. Without restrictions, insurance companies would price annuities differently on the basis of retirees’ gender, health, and other individual characteristics, although this outcome may be considered politically or socially unacceptable. The government must also strike a balance between consumers’ desire for privacy and annuity insurers’ need for information. Finally, governments need to regulate the portfolio choices of annuity insurers. Implicit or explicit guarantees by the government to bail out those whose annuity company fails could otherwise lead insurers to make overly risky investment choices.

In summary, moving from traditional public defined-benefit systems to mandatory defined-contribution systems changes the government’s role. The government would need to establish explicit regulations for the amounts to be annuitized, survivor coverage, the types of annuities that can be purchased, the variability of annuity income, and the price and investment policy of insurers.

Copies of IMF Working Paper 99/153, Regulation of With-drawals in Individual Account Systems, by Jan Walliser, are available for $7.00 each from IMF Publication Services. See page 11 for ordering information.

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