Disability benefits in an individual account system by Estelle James FIAP conference, 2007

Wide variation in disability costs Disability take 10-30% of total soc sec costs OECD: ranges from 2-3% of wage in low cost countries (US, Japan) to 5-10% in high cost countries (Netherlands, Portugal, Spain) higher cost in E.& C. Europe (>10% in Poland) lower cost (<1% of wages) in Latin America Variations due to: exogenous forces--health and age of population policy choices--size of benefits, if to death or old age abuses—moral hazard, lax assessment, corruption, substitute for early retirement or unemployment benefit incentives from financing mechanism

How is disability handled in multi-pillar systems? Does disability use DC, pre-funding and private insurance, as in retirement scheme, or does it use DB, PAYG finance and public management? How are disability and old age benefits integrated? if disability benefits greater, moral hazard problem is money in individual accounts applied toward disability benefits? Kept to retirement age? Different countries have used different models Which model yields lowest cost and most accurate targeting of benefits? Are policy choices leading to high cost avoided?

Several models in countries with individual accounts (IAs) Disability benefit is DB in all cases—young disabled workers won’t have large DC accounts PAYG and publicly managed in Europe; pre-funded and private insurance in Latin America Sweden—IA preserved until switch to old age benefits at 65; government runs & finances disability benefits on PAYG basis (Latvia similar) E. and Central Europe— disability benefit remains to death; public agency runs; individual surrenders IA funds and gets PAYG benefit (or keeps funds in IA and get smaller PAYG benefit) Doesn’t avoid cost problems

Chilean model Disabled individual is guaranteed a DB (lifetime annuity = 70% wage for permanent disability); kept to death even if person returns to work Funds in IA applied to disability annuity but if not enough this is topped up by additional payment Each AFP must purchase group insurance policy that covers cost of top-up for its affiliates Insurance companies sell group policy to AFPs and offer annuities to disabled workers Cost of insurance < 1% of wage; included in general administrative fee Similar in other Latin countries, with variations

How Latin American system differs from public PAYG Largely pre-funded: through accumulation in retirement account through additional payment when person is permanently disabled, to finance lifetime annuity Assessment procedure includes participation by private pension funds and insurance companies, who have a pecuniary interest in controlling costs (if cost falls with admin.fee constant, profits rise) Available data suggest this approach keeps successful claims and costs low, less sensitive to population aging and political pressures to grant disability benefits

I. Role of AFPs in assessment procedure in Chile Initial claims evaluated by Regional Medical Boards chosen by Superintendencia of AFPs But AFP Association has organized medical observers who attend regularly and monitor procedure AFPs appeal approved claims to Central Board To be insured, individual must have worked & contributed in recently AFPs have contribution records, check eligibility Reference wage: average earnings during past 10 years (price-indexed). AFPs check records for low density of contributions AFPs have reps on Technical Commission that determines medical criteria for granting disability

Some empirical results In 2004 only 25% of claims were accepted as fully disabled and insured (some of rest got MPG) Reference wage often 60% of wage when working Age-specific disability rate lower than elsewhere Example: age 45-54, 2.9 per thousand insured members accepted as new disabled in Chile, compared with 7.8 per thousand in US, 8.6 in OECD, 18.1 in Poland Insurance fee/wage 1% instead of 1.8% in US (to age 65), 3-5% Europe, >10% Netherlands, Poland Similar costs in other Latin American countries Less work disincentives, good for economy

II. Impact of pre-funding on costs in Chile vs. PAYG system Pre-funding takes place in two stages Accumulation in IA applied toward disability DB Additional payment covered by group D&S insurance So if worker becomes permanently disabled, lifetime cost is covered up-front rather than yearly as in PAYG I used simulations to compare D&S insurance fee in pre-funded Chilean scheme with annual costs in PAYG scheme for same population structure and incidence of disability

Simulation results In short run new Chilean-type scheme is more expensive than new PAYG scheme because balance in IAs small compared with promised DB; also transition costs of previous system In long run Chilean scheme costs 25% of PAYG Accumulation in IAs cover about half total cost Anticipated investment earnings reduces additional payment needed to cover lifetime annuity Pre-funded system is less sensitive to population aging. Larger account balances partly offset higher disability rates for older workers But pre-funding makes system sensitive to interest rate shocks because annuities are more expensive if interest rates are low (recent large fee hikes)

Recent issues Cross-subsidization—disability fee is same % of wage for all members. So young workers, women subsidize others. New reform may change this by allowing different price for women Selection—each AFPs may try to cut its cost by attracting affiliates with low disability incidence. New reform may change this by requiring pooled disability insurance for all AFPs

What can other countries learn? Using private companies to participate in disability assessment can be reality check against overly-generous programs—saves money for workers, who ultimately pay disability fee Pre-funding lifetime disability through money in IA+additional payment from insurance companies makes costs higher in short run, much lower in long run less sensitive to population aging but more sensitive to interest rate changes Worth serious consideration as way to curb excess disability benefits in countries that are having trouble controlling costs