Chapter

II Pension Regimes and Saving—A Framework for Analysis

Author(s):
Alfredo Cuevas, George Mackenzie, and Philip Gerson
Published Date:
September 1997
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How a pension regime affects saving depends crucially on its basic design (Box 1; Table 1), as well as on the forces and influences that motivate saving by individuals.3 The life-cycle hypothesis (LCH) of consumption, although somewhat extreme in its assumptions (and implications), has become the standard vehicle for analyzing the saving decision.4 This paper uses it as the starting point for its discussion.

In its simplest form, the LCH implies that consumption is a function only of lifetime wealth.5 It is not affected by changes in the pattern of income over time. Provided that wealth—defined to include not only financial and real assets (the traditional accounting definition), but also the expected value of future income from labor (human capital wealth)—does not change, neither should the pattern of consumption over time. Because consumption does not fluctuate (or fluctuate much) with disposable income, the propensity to save out of disposable income will vary over an individual’s life. It will be high in the prime earning years and low or negative in retirement.

The LCH has a remarkable implication for pension system design. Unless pension reform alters the wealth of pension plan participants, it will not affect consumption. It may affect the distribution of saving between the public and the private sector, but not its total amount. For example, an increase in contributions to a funded public pension plan may lead to an increase in public sector saving, but this will be exactly offset by a fall in private sector saving.

The LCH implies that pension reform can affect the saving rate in one or more of three ways: (1) by affecting the average wealth of plan participants; (2) by redistributing wealth between different age groups, which will have different propensities to save; and (3) by redistributing wealth among members of the same age group with different propensities to save.

The LCH in its simplest and most extreme form, however, rests on strong and basically implausible assumptions about human behavior and financial markets. Capital markets are far from being as perfect as the LCH requires. Even in countries where these markets are well developed, individuals normally require physical collateral (e.g., a residential dwelling) to borrow substantial sums of money. Interest rates on unsecured loans are typically much higher than the rates on short-term financial assets, so that consuming on the strength of future income becomes expensive, and credit limits are in any case stricter. Even in the United States, with its highly developed financial markets, comparatively few elderly people purchase annuities, probably because these cannot be had on even moderately favorable terms (Warshawsky, 1987). Indexed annuities are extremely rare, as are indexed occupational pensions.6 These problems are compounded in countries where financial markets are less well developed.

Capital market imperfections aside, a person who cannot rely on the support of an extended family in old age and who tries to determine how much to save for retirement is confronted with what can be a bewilderingly complex decision. When we decide between “jam today” and “jam tomorrow,” the information at our disposal is clearly limited: unlike the choice between tea today and coffee today, the experience of old age cannot be repeated. This uncertainty about the future can lead some people to save too much, but it is doubtful that most are so far-sighted as to be able to save enough to maintain their accustomed standard of living in old age. Indeed, the traditional arguments for publicly provided pensions include the assertions that savings vehicles are inadequate and that much of the population will need to be protected from its own improvidence.7

Table 1.Selected Countries: Basic Features of Public Pension Schemes
CountryDegree of FundingTypeForm of BenefitMaximum Replacement Ratio (in percent)Indexation (index, degree, and frequency)Redistributive ElementCoverage (in percent of economically active population)Financing SourcePension Expenditure (in percent of GDP) and Year
ArgentinaNDBA,BN/AO1,AYes56%PT,GR25.41994
Australia (old)N/ADBA.FR25% of average wageCPI,F,BNo100%GR3.81989
Australia (new)3FDCA.ERN/AN/AYes100%PTN/A
Canada4NDBA.ER25% of max. pensionable earningsCPI, F, A5No100%PT3.81990
Chile (new)FDCB.IERN/ACPI,FYesBroadC5.761989
Colombia (old)NDBA,ER85%7W,F,AYes30%PT2.31993
FranceNDBA.ER50%8CPI.FYes100%PT11.91992
GermanyNDBA,ER70% (average)W,F,AYes, modestUniversalPT8.91992
IsraelNDBA,B30%W,FYesUniversalPT5.01989
ItalyNDBA,B80%CPI, F, AYes, significantUniversalPT.GR13.91990
JapanPDBA,BN/AW,F,AYesUniversalPT.GR5.01990
PeruNDBER100%W9Yes30%PT.GR0.71986
SingaporeFDCB.IERN/AN/ANoUniversalC2.21989
South AfricaN/ADBA.FRN/ACPI, F, AYesUniversalGRN/A
SpainNDBA,B80%CPI, F, AYes, significantUniversalPT,GR9.2101995
Sweden4PDBA,ER60% (ER component)CPI, F, AYesUniversalPT7.01990
Switzerland11NDBA,B40% of average wageIndex12YesUniversalPT,GR10.11992
TurkeyNDBA,B85%CPI, F, BYesUniversalPT.GR132.41986
United KingdomNDBA,B25% for earningsCPI.AYesNearly 100%PT.GR4.21990
United StatesPDBA,ER41 % of average wage14CPI.AYes, significantUniversalPT4.51990
Uruguay (old)15NDBB,ER80%W,F,QYes, significant80%PT.GRM1613.01994
Uruguay (new private)FDCBN/AN/AN/AN/APTN/A
Uruguay (new public)NDBB.ER80%W, F, three times annuallyYes, significantN/APT.GR16N/A
Sources: World Bank; Organization for Economic Cooperation and Development; country authorities; and U.S. Social Security Administration.Notes: Degree of fundingPartial (P)Full (F)None (N)Type of planDefined benefits (DB)Defined contributions (DC)Form of benefitLump sum (LS) or annuity (A) or both (B)Flat rate (FR) or earnings-related (ER) or both (B); or indirectly earnings-related (IER)(the case of defined-contributions plan)IndexationIndex: CPI, wages (W), other (O)Degree: partial (P), full (F)Frequency: Annual (A)Biannual (B)Quarterly (Q)Financing sourcePayroll tax (PT)General revenues (GR)Contribution (C)Other (O)

Indexation of pensions to average contribution (AMPO) was suspended by the Social Security Solidarity Law in early 1995.

Under the revenue-sharing arrangement, a part of tax revenues is earmarked for social security.

New system budgeted in 1995—to be phased in by 1998.

ER scheme only.

For existing pensioners.

State and privatized.

The replacement ratio cannot exceed 85 percent of the worker’s salary or 20 minimum wages.

Basic pension (regime general).

Usually adjusted with central government wages.

Projected.

First tier only.

Every two years, or when index—a simple average of CPI and wage index—increases over 8 percent (whichever comes first).

General revenues, if deficit

But declines with income.

New system took effect January 1, 1996.

Includes earmarked taxes.

Sources: World Bank; Organization for Economic Cooperation and Development; country authorities; and U.S. Social Security Administration.Notes: Degree of fundingPartial (P)Full (F)None (N)Type of planDefined benefits (DB)Defined contributions (DC)Form of benefitLump sum (LS) or annuity (A) or both (B)Flat rate (FR) or earnings-related (ER) or both (B); or indirectly earnings-related (IER)(the case of defined-contributions plan)IndexationIndex: CPI, wages (W), other (O)Degree: partial (P), full (F)Frequency: Annual (A)Biannual (B)Quarterly (Q)Financing sourcePayroll tax (PT)General revenues (GR)Contribution (C)Other (O)

Indexation of pensions to average contribution (AMPO) was suspended by the Social Security Solidarity Law in early 1995.

Under the revenue-sharing arrangement, a part of tax revenues is earmarked for social security.

New system budgeted in 1995—to be phased in by 1998.

ER scheme only.

For existing pensioners.

State and privatized.

The replacement ratio cannot exceed 85 percent of the worker’s salary or 20 minimum wages.

Basic pension (regime general).

Usually adjusted with central government wages.

Projected.

First tier only.

Every two years, or when index—a simple average of CPI and wage index—increases over 8 percent (whichever comes first).

General revenues, if deficit

But declines with income.

New system took effect January 1, 1996.

Includes earmarked taxes.

Box 1.Basic Features of Public Pension Plans

A number of basic features of public pension plans have a bearing on their impact on saving.

Public pension plans may be either unfunded PAYG, partially funded, or fully funded. Most public plans are either PAYG or partially funded (e.g., Japan). The plans of Chile and Singapore, which are fully funded, are notable exceptions (see Box 2). With PAYG plans, current revenue is expected to finance current pension obligations, and the rate of the payroll tax—the standard financing source for public pension plans—is adjusted from time to time to ensure that revenues and expenditures balance. Reserves are maintained only to finance temporary or cyclical shortfalls in revenue. Under a funded plan, the rate should in principle be set initially at a level that is expected to ensure that the plan will always be self-financing (i.e., so that no subsequent increase in the rate will be required). This implies that the expected present value of benefits equals the expected present value of contributions over an essentially indefinite period.

A related distinction is between defined-beneflts and defined-contributions plans. The former typically defines plan participants’ benefits as a function of salary and work history. Letting P equal the value of the pension, N the number of years of coverage, Y pensionable income, and b a constant, one fairly standard formulation for an earnings-related pension is P = bYN (with N typically subject to a maximum of 30–35 years). Y is usually an average of income over some subperiod within the contribution period, generally near the end of working life.

A defined-contributions plan does not define the benefit; plan participants, upon retirement, get back their contributions plus their accumulated return, with the pension benefit taking the form of one lump-sum payment or a series of lump-sum payments or an annuity. Most public pension plans are defined-benefits plans rather than defined-contributions plans; Chile and Singapore are, again, exceptions. A defined-contributions plan is fully funded by definition; if its investment experience is poor, the average pension benefit will be reduced. A defined-benefits plan may be either funded to some degree or unfunded. Its “fundedness” is never perfect, in that any calculation of the actuarial soundness of a plan is based on uncertain assumptions, especially as to the rate of return to plan assets.

Pension benefits may take the form of an annuity (typically, although not always, a life annuity with some right of survivorship) or a lump sum, or a mix. The U.S. Old-Age, Survivor, and Disability Insurance (OASDI) system provides a life annuity with survivors’ benefits. Under Singapore’s Central Provident Fund (CPF), which is a defined-contributions plan, retiring participants can withdraw all of their account in one lump sum, except for a set amount (about $21,500 in 1993) that must be used to finance a fixed monthly pension.

Benefits may be either flat rate or earnings related. Until recently, Australia’s plan provided only a flat-rate benefit, although the benefit was means tested. Many plans have a flat-rate and an earnings-related component (Japan, United Kingdom). Any plan with a minimum pension has a flat-rate element to it over a certain income range. Finally, pension plans may or may not have a redistributive component. Pensions that are solely earnings related do not, unless the replacement ratio varies inversely with income level. In practice, most earnings-related pension plans do have a redistributive component because most have some combination of minimum and maximum pensions and contribution levels.

The degree and modalities of indexation of a pension annuity are important features that vary substantially across countries. The U.S. system and that of a few other countries now offer full indexation to the consumer price index (CPI). Some countries have legislated an indexation provision without having been able to honor it on a timely basis (e.g., Argentina prior to the reforms of the early 1990s, and Bolivia, Mexico, and Peru at various times during the 1980s).

A basic feature of a pension plan is its replacement ratio, which is the ratio of the pension benefit to some measure of income earned during the contribution period. This parameter should be known in a defined-benefits plan that can honor its promises; a defined-contributions plan, by definition, cannot guarantee any particular replacement ratio.

Last, the macroeconomic implications of public pension plans depend on their relative size. In addition to the replacement ratio, their size depends on the extent of their coverage, namely, the share of the working-age population eligible to contribute, or some similar indicator. Also important is the degree of maturity of the plan. Immature plans are those that have not yet reached their full size or their long-term dependency ratio—the ratio of pensioners to contributors—because the current generation of retired persons will not have contributed long enough (if at all) to qualify for a full pension. The plans of all industrial countries have more or less universal coverage and are already mature. The plans of the Southern Cone countries are also mature. Their coverage is quite broad but not universal.

The finances of PAYG plans are affected heavily by maturation and by underlying demographic trends because the equilibrating contribution rate varies directly with the ratio of retired to working-age persons—the dependency ratio.

If the average pension is B, the payroll tax rate t, the number of contributors L, the contributions base (the average wage) W, and the number of pensioners P, cash-flow equilibrium of a PAYG plan requires the following: BP = tWL; or, t = (P/L)(B/W). Thus, the required contribution rate varies directly with the dependency ratio (P/L) and the average replacement rate (B/W).

To summarize, even if the extreme version of the LCH were to apply, pension regimes could affect the saving rate by affecting the wealth of plan participants. As explained below, PAYG schemes can affect participants’ wealth by creating what has come to be known as social security wealth (SSW). A fortiori, when capital markets are imperfect and plan participants must make complicated choices in conditions of great uncertainty, other channels of influence are opened. As a result, when public pension plans are introduced, it may not be possible for their contributors to maintain the same level of consumption.

The framework outlined here has typically been used to analyze public pension systems, but applies to private pension regimes as well.

See, for example, Auerbach and Kotlikoff (1995) and Blanchard and Fischer (1989).

Saving would also be a function of the interest rate—the relative price of consumption now compared with consumption in the future. Studies of saving typically find it is not elastic with respect to the rate of interest.

Diamond (1996), in a discussion of the feasibility of a Chilean-style reform in the United States, notes (p. 83) “to date, there are no privately provided annuities indexed to the … CPI, so these would need to be developed…[this] would probably need CPI-indexed Treasury securities…” These are now being issued.

See Barr (1993). When a significant share of the population is improvident, compulsory saving plans can be justified as a means of surmounting the free-rider problem that is created when society feels an obligation to support the destitute elderly, whether or not they have attempted to make adequate provision for their old age. As regards savings vehicles, in many developing countries, real rates of return on savings deposits and other instruments have been negative on average for lengthy periods of time, although the trend toward financial liberalization has made such poor rates of return less common.

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