1. Prefunding pensions:
Options and arguments
Edward Whitehouse
World Bank core course
Washington DC, April 2013

2. Agenda
Different financing mechanisms:
funding and pay-as-you-go
Advantages and disadvantages
Conditions favourable to funding
Design of funded schemes
 investment/provider choices
 administrative charges
 guarantees
 pay-out phase
Moving from pay-as-you-go to funding

3. Unfunded/pay-as-you-go schemes
Use contributions from current workers to pay
benefits to current retirees
This gives current workers “promises” in return
for contributions
Promises must be met by future generations
Promises have different legal weights countries:
 from constitutional right to changeable promise
Main motivation of pay-as-you-go was earlier
benefit payout

4. An example: the United States
Real rate of return on contributions (%)

5. Prefunding
Contributions from current workers are used to
accumulate assets
These assets are used to pay benefits in the
future
Schemes can be partially funded
 Benefits for current workers will be paid for by a mix
of accumulated assets and taxes/contributions paid
by future workers

6. Potential advantages of funding
Better able to deal with ageing of the population
Limits fiscal liabilities
Removes some labour-market distortions
Helps develop capital markets
Possibly increases savings and investment
Reduce politicisation of the pension system
Better rates of return on pension contributions

7. Rates of return: PAYG and funded
Sustainable rate of return on PAYG = growth of
labour force + increase in average earnings
 can turn negative when labour force starts to shrink
Rate of return on funded = capital-market
return
 historically, even with financial crises, this has been
greater than wage growth in developed countries

8. Distorted labour markets
PAYG schemes often:
 encourage early retirement
 are not portable between different jobs
 are based on final salary, encouraging under-
reporting of earnings in early years
Funded schemes:
 generally pay higher benefits to people who work
longer
 are easily portable between different jobs
 are based on contributions in each and every year

9. Politicisation of pensions
Politicisation can be a problem:
 uncertainty in retirement benefits of current
pensioners and workers
 potentially divisive political battles between those
who receive pensions and those who pay for them
Under PAYG, easy for governments to make
promises of future benefits
 they will be out of office before the costs have to be
met
With funded schemes, higher benefits only
possible with higher contributions now

10. Capital-market development
PAYG schemes: can hinder capital-market
development if substitute for private savings for
retirement
Funded schemes tend to lead to greater variety
of financial-market instruments offered
Savings are usually intermediated through
financial markets
Some suggestion that this has a positive impact
on savings and economic growth

11. Ideal conditions for funding
Is the macroeconomy stable enough to offer
reasonably safe financial instruments?
Are sufficient financial instruments available?
 option of foreign investment
 but exchange-rate issues and political economy
Financial market regulation and supervision must
be strong
 contributions to a funded pension are mandatory, unlike
other savings instruments
 they are also longer-term savings
Administrative capacity: record-keeping, valuation

12. Investment risk
Funded schemes subject to investment risk
Important to distinguish time periods
 long-term risks are not too large because rates of
return relatively stable
 short-term risks can be large if the markets fall when
you want to retire
Measures to mitigate risks of financial crises
Important to remember risks with PAYG
 political risk: a new government changes its mind
 fiscal risk: there isn’t enough money to pay for
pensions (arrears)

13. Scale of investment risk
Percentile of distribution
10 20 30 40 50 60 70 80 90
Market data
Rate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0
Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6
Note
10% contribution
OECD average mortality rates
40-year term to age 65
50:50 equity:government-bond portfolio

14. Market and individual returns
Administrative charges
 0.75-2.00% in accumulation stage
 0.25-0.50% for annuity purchase
Tracking error
 0.25-0.30% reduction in return
Agency and governance effects
Portfolio restrictions
Ageing might reduce future returns

15. Administrative charges
 Complex charge structures
 comparisons are difficult both
between countries and between
providers
 A single measure of charges:
 charge ratio: proportion of
accumulated balance
 reduction in yield: proportion
of assets in fund at any one
time

16. Administrative charges
 Complex charge structures
 comparisons are difficult both
between countries and between
providers
 A single measure of charges:
 charge ratio: proportion of
accumulated balance
 reduction in yield: proportion
of assets in fund at any one
time
 Illustration:
 assume 3.5% real return, 2%
wage growth and 40 year term
0
5
10
15
20
25
30
35
40
45
50
0 0.5 1 1.5 2 2.5 3
Charge, % of assets
Charge,
% of accumulation

17. Percentile of distribution
10 20 30 40 50 60 70 80 90
Market data
Rate of return 5.5 6.1 6.6 7.0 7.3 7.7 8.0 8.5 9.0
Replacement rate 54.8 63.7 72.3 80.2 86.9 96.7 104.9 120.4 138.6
Rescaled
Rate of return 3.2 3.8 4.3 4.7 5.0 5.4 5.7 6.2 6.7
Replacement rate 32.2 36.8 41.2 45.2 48.6 53.5 57.6 65.3 74.2
Scale of investment risk
Note
10% contribution
OECD average mortality rates
40-year term to age 65
50:50 equity:government-bond portfolio

18. Types of guarantee in overall
pension/tax systems
Portfolio of different kinds of pensions:
 subject to investment risk:
 DC plans in many OECD, LAC and ECA countries
 not subject to investment risk:
 DB/points in Costa Rica, Uruguay, Slovak Republic, Latvia,
Lithuania, Estonia, Croatia, Bulgaria, Romania, Switzerland
 NDC in Poland, Sweden
 basic in Kosovo, Netherlands, New Zealand, new UK scheme
 offset investment risk:
 targeted, means-tested, minimum benefits in Australia,
Mexico, Hong Kong
Role of taxation

19. Australia
Replacement
rate
0
0.25
0.5
0.75
1 2 3 4 5 6 7 8 9
Deciles of distribution of investment returns
Superannuation
guarantee

20. Australia
1 2 3 4 5 6 7 8 9
Superannuation
guarantee
Replacement
rate
0
0.25
0.5
0.75
Deciles of distribution of investment returns
Age pension

21. Australia
1 2 3 4 5 6 7 8 9
Replacement
rate
0
0.25
0.5
0.75
Deciles of distribution of investment returns
Superannuation
guarantee
Age pension

22. Other countries
Denmark Poland
10 25 50 75 90
Targeted and
basic
After taxes
0
20
40
60
80
100
120
140
Percentile point of distribution of investment returns
Replacement rate
(% of gross earnings)
Defined
contribution
10 25 50 75 90
Public earnings-
related
After taxes
0
10
20
30
40
50
60
70
80
90
Percentile point of distribution of investment returns
Replacement rate
(% of gross earnings)
Defined
contribution
Defined
contribution
Defined
contribution
Defined
contribution

23. Rate of return guarantees
Should meet pension principles, e.g.,
transparency, self-financing
Should enhance security and adequacy
Five key design issues:
 fixed return (Switzerland, Iceland) or minimum
(Belgium, Germany)
 real or nominal (Czech Republic, Germany)
 level (often zero: CZR, DEU; 2% CHE; 3%+ BEL)
 absolute (above) or relative (to other funds: Chile
Poland; or to benchmark return: Slovenia)
 period covered (6 mnths SVK, 1 yr CZR, 3yrs CHL,
entire period of membership DEU)

24. Costs
Capital 2% Indexed Ongoing Floating
Guarantee 0%
nominal
2%
nominal
0%
real
0%
nominal
1yr interest
rate
Period Membership Membership Membership Annual Membership
Charges (%) 0.86% 3.33% 3.67% 6.08% 15.96%
Loss in
pension (%)
1.28% 4.98% 5.49% 7.14% 23.81%

25. Providing funded schemes 1
Many possible structures
 single public agency (provident funds)
 single pension fund, but privately managed (UK Nest)
 a few private pension funds (Uruguay)
 many private pension funds (Chile, Poland)
 public and private pension funds (Mexico, Russia)
Investment choice
 single portfolio per pension fund
 multiple portfolios per pension fund
 restrictions on who can own what type of portfolio

26. Paying out funded pensions
Annuity
 pension balance transferred to insurance company
which provides regular payments
 indexation?
 survivors benefits?
Programmed withdrawal
 balance divided by life expectancy determines
pension in any given year
 remainder continues to earn interest
Lump sum
Combination of or choice among the above

27. Moving from PAYG to funding:
transition costs
If all or part of contributions of current workers
are diverted to funded accounts, how can
current pensions be paid?
Possibility of transition ‘double burden’
 one generation pays for its own and its parents’
pensions
Also, current workers also have rights accrued
in the public, PAYG scheme
 e.g. a 40-year old may have 20 years of contributions
in the PAYG scheme and needs compensating

28. Accrued rights
Existing pensioners: benefits continue to be paid
as before
Existing contributors:
 maintain a pro-rated benefit from the PAYG scheme
 ‘recognition bonds’: value reflects accrued benefits,
bond can be accessed at retirement
How are accrued rights valued?
 e.g., indexation, retirement age, accrual rates,
minimum pensions

29. Transition costs and design issues
Who is allowed to switch to the funded scheme?
 option or mandatory?
 age cut-offs?
Gradual increase in contribution rates to funded
scheme over time
Room to increase overall contribution rates?
 ‘add-on’ versus ‘carve-out’ funded scheme