The World Bank Old Age Income Support in the 21st Century Robert Holzmann Sector Director, Social Protection The Financial Sector Post-Crisis: Challenges and Vulnerabilities Brookings Institution, April 26-27, 2005

The World Bank 2 Enhancing Job Opportunities in ECA 2 Road Map Background of Bank Report Conceptual Underpinnings (excerpt) Key components of reform direction Goals of pension system and reforms Criteria of for evaluation of reform proposals The (net) benefits of funding Design and Implementation Issues (excerpt) Costs and fees – how to contain? Readiness of financial market and minimum conditions? How to regulate private and funded pillars? How to provide retirement products?

The World Bank 3 Enhancing Job Opportunities in ECA 3 Key Components of Reform Direction Type of Reform Necessity, such as –Short and long term fiscal pressure –Social-economic changes –Challenges and opportunities of globalization Reform Design Options, such as –Parametric reform of existing system(s) –Fully market-based approach –Non-financial or notional defined contribution system –Public pre-funding of existing/reformed system –Multi-pillar reform Enabling Environment, such as –Economic stability –Fiscal and administrative capacity –Readiness of financial sector –Commitment by government and main stockholders

The World Bank 4 Enhancing Job Opportunities in ECA 4 Goals of a Pension System and Reform Primary goals: To provide adequate, affordable, sustainable and robust old-age income –Adequate refers to both the absolute and relative level (i.e. poverty alleviation and income replacement) –Affordable refers to the financing capacity of individuals and the society –Sustainable refers to the financial soundness of the scheme, now and in the future –Robust refers to the capacity to withstand major shocks, coming from economic, demographic and political risks Secondary goals: To create developmental effects –by minimizing negative impacts (e.g. labor market) –by leveraging on positive impacts (e.g. financial market development)

The World Bank 5 Enhancing Job Opportunities in ECA 5

The World Bank 6 Enhancing Job Opportunities in ECA 6 Criteria for Evaluation of Reform Proposal Four primary content criteria –Does the reform make sufficient progress toward the goals of a pension system, and meet distributive concerns? –Is the macro and fiscal framework capable of supporting the reform? –Can the administrative structure operate the new (multi-pillar) pension system? –Have steps been prepared to establish to regulatory and supervisory arrangements and institutions to operate a funded pillar? Three primary process criteria –Is there a credible commitment by government –Is there local buy-in and leadership –Does it include sufficient capacity building for implementation

The World Bank 7 Enhancing Job Opportunities in ECA 7 The (net) Benefits of Funding Role of financial sector in growth, and role funding for pensions remains area of dispute Scenario considerations to determine (net) benefit –Mature system operating (large) funded pillar (e.g. Australia, Netherlands, Denmark) –Mature system operating (large) PAYG (e.g. Germany, France, Italy, Japan) –Immature system with low coverage (as most developing countries)

The World Bank 8 Enhancing Job Opportunities in ECA 8 Mature system operating large funded pillar Would these countries be better off by reducing their funded for an unfunded pillar? Enhancing output (potential main benefit 1/3) –Through higher aggregate saving? Seems to depend on mandating and institutional set-up Narrow versus broad funding –Better inter-temporal government fiscal position? –Through improved labor markets? –Through contribution to financial sector development? Dealing with population aging –Funding no panacea for aging but facilitates adjustment Enhancing individual welfare –Better isolation against political risks (after Argentina?) –Individual choices (at which price?) –High rate of return (risk adjusted?)

The World Bank 9 Enhancing Job Opportunities in ECA 9 Mature and large PAYG system Potential benefits still valid, but limited, while the transition costs may be too high for full reversal Implicit pension debt (accrued to date liability) is some times annual expenditure of GDP But countries are reducing the public generosity, implicitly relying on two reactions by individuals: longer working and more saving

The World Bank 10 Enhancing Job Opportunities in ECA 10 Immature Systems with Low Coverage Potential benefits are very high, in particular through labor market, savings and financial sector development effects Coverage and hence implicit debt is relatively low in percent of GDP (but not in tax capacity) But capacity to deliver on primary objectives may also be restricted

The World Bank 11 Enhancing Job Opportunities in ECA 11 Costs and Fees: How to contain? High fees– irritation for supporter and central argument for opponents of funded schemes Cost and fees seem to falling over time, but often still amount to a reduction in pension level of 30 and more percent (i.e. 150 on more basis points on assets) Savings on administrative expenses (economies of scale and scope) through use of central clearing house (such as in Sweden) Limiting of marketing costs through blind accounts or switching constraints Limiting of asset management fees by restrictions on individual choice and, passively managed accounts, employers choice in provider, or competitive bidding of restricted number of asset managers Decreasing costs, however, may no be sufficient as individuals seem to have a very low price elasticity of demand while providers (pension funds) seem to form oligopolistic structures (Chile has now 6 PF compared to prior 24). How to create regulated arbitrage?

The World Bank 12 Enhancing Job Opportunities in ECA 12 Readiness and Minimum Conditions Not all countries are ready for funded provisions, but ideal conditions may not be needed Polar cases of yes and no easily established, but more difficult for large grey zone Which main criteria should be applied? –Level of per capita income as indicator for demand –Macroeconomic stability and credible macro policy –Sound banking system, government debt market, and? –Capacity and willingness to regulate pension institutions and products How should the criteria be measured?

The World Bank 13 Enhancing Job Opportunities in ECA 13 How to Regulate and Supervise Private and Funded Pillars? Experience in LAC and ECA in addition to OECD indicates less and more controversial regulation General support for from “Draconian Rules” to gradual relaxation Basic and largely uncontested regulation to be applied from the beginning, such as –Appropriate licensing and capital requirements –Full segregation of pensions assets from other activities –Use of external custodian and transparent asset valuation rules More controversial rules include –Market structure and portfolio choice –Minimum funding standards for DBs –Minimum rate of return guarantees

The World Bank 14 Enhancing Job Opportunities in ECA 14 Regulation and Supervision - II Non-controversial rules of supervision, e.g. –Need of independent, proactive, well-financed and professional staff in supervisory body –Vetting of application for licensing –Off-site surveillance and on-site inspection More controversial rules and questions, e.g. –Single purpose (pioneered in Chile) or integrated supervisory agency –How to guarantee the independence of the supervisory –How to accomplish oversight and accountability of the supervisor

The World Bank 15 Enhancing Job Opportunities in ECA 15 How to Provide Retirement Products? Focus so far on accumulation phase gives way to investigating the capacity of private sector to deliver appropriate retirement products (phased withdrawal, annuities, ?) Work program of Financial Sector and Social Protection to review conceptual issues and experience Is there a demand-side problem to explain annuity puzzle such as –Underestimating (remaining) life expectancy –Strong bequest motive –Incomplete insurance markets for other risks increase the marginal value of traditional (non-insurance) assets

The World Bank 16 Enhancing Job Opportunities in ECA 16 Retirement Products - II Is there a supply side problem due to investment or longevity risk as appropriate assets to hedge these risks do not exist? Can private sector fully insure investment and longevity risks at reasonable/competitive prices? Is there a need to share the risk between individual and provider? Does the government need to assume both main risks and be the final provider of annuities? What type of providers should be allowed to offer annuities? What kind of products should be allowed? When must the private annuity market be ready? Should there be price indexation of annuities?