1. 1 REFORMING SOCIAL SECURITY: WHAT CAN INDONESIA LEARN FROM OTHER COUNTRIES? by Estelle James Prepared for USAID workshop on social security, Jakarta

2. 2 Population aging and its impact on public spending Proportion of world’s people > 60 will increase from 9% to 16% by 2030 Indonesia’s elderly will increase: from 7% to 16% Public spending on health and pensions increases as population ages, so spending on health and pensions will > 10% of GDP in Indonesia by 2030 Young workers today will be 60+ in 2030, so important to set good old age security system now This will have a major impact on economy— quantity and productivity of labor and capital Many countries are reforming their social security systems to get better economic and equity effects

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4. 4 Major lessons Don’t rush into DB scheme without careful actuarial analysis of long term costs—otherwise Finance Ministry will be faced with huge pension debt (already the case for civil service) Pre-funding important but don’t increase it until you have a competitive structure that will: –earn a high rate of return with low administrative costs –Diversify your investment portfolio to raise return and reduce risk Informal sector cannot be covered by contributory scheme—requires finance from general treasury

5. 5 Traditional schemes In past, many countries had pay-as-you-go (PAYG) defined benefit (DB) schemes –DB—pension based on worker’s wage and years of contributions –PAYG—contributions by workers (or govt) today used to pay pensions of retirees today, no investments –Indonesia has this in civil service but not private sector Some countries had defined contribution (DC) plans—workers get back contributions + interest (no DB). Funds accumulate but invested by public agency (Jamsostek)—political control, low returns Both these plans had big problems. Recently, many countries have switched to DC plans with funds under private competitive management

6. 6 PAYG schemes worked well when systems were new and no retirees, but require large contribution rate increases now Why higher contribution rate? –Workers evade contributions so less revenue –Workers retire early so collect benefits for more years –Population ages so fewer workers, more pensioners Problems caused by high contribution rate –Less take-home pay if worker pays –Higher labor costs, less employment if employer pays –Fewer workers in formal labor force (evasion, early retirement) so less economic growth

7. 7 Other problems caused by PAYG DB schemes Redistributes to high earners (who live longer) and first covered generations (high benefits, low contributions)—these are better-off groups, not poorest groups Government owes workers large unfunded pension debt in return for contributions (>100% GDP)--paying this debt may reduce public spending on health and education May discourage saving, investment, economic growth

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9. 9 Potential effects of new DB in Indonesia Evasion, early retirement, low returns already Government would accumulate large pension debt (which it can’t afford) Higher contribution rate would reduce wage for middle-income workers, raise labor costs so fewer jobs for minimum-wage workers—bad for growth If PAYG, 7% contribution rate could finance av. pension that is only 10% of average wage in 2030 Civil service already faces DB problems— pensions will cost over 30% of payroll by 2030 In private sector Indonesia has avoided problems of PAYG DB so far and should continue to do so

10. 10 How have countries reformed? Over 30 countries in Latin America, Europe, Asia- Pacific have adopted multi-pillar system to avoid these problems One pillar handles peoples retirement savings –Shift to DC plan (not primarily DB) –Shift to pre-funding rather than PAYG –Funds are privately managed to avoid political control Another pillar provides safety net (redistribution) A third pillar is voluntary retirement savings Chile was first country to reform in 1981. So far: large assets, increased saving, greater formal labor supply, financial market development, economic growth, poor are protected

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13. 13 Commonalities Why DC? –prevents implicit pension debt (no benefit promise) –avoids perverse redistributions, incentives for evasion and early retirement (penalty for early retirement) –keeps system solvent even if workers retire early, evade Why fully funded? –avoids steep future payroll tax increases as population ages--pensions financed by own savings, not current tax –can be used to mobilize long term domestic saving for investment, increase productivity and output Why private management of funds? –To get higher return and better allocation of capital –improve financial markets –reduce risk by diversification (including international)

14. 14 Pre-funding avoids large contribution increases, but works well only with high rate of return. Monopolistic public funds have low rates of return, inefficient allocation of capital, evasion –Public managers required to invest in government bonds, failing state enterprises –Singapore CPF earned < 2% real; Jamsostek lost money--earned 38% < inflation 1978-2000 –To get a reasonable replacement pension, rate of return must be 2-3% higher than wage growth –To help economy, savings should be used productively So reforming countries are using private competitive markets, diversified portfolios (including international diversification)

15. 15 Most publicly managed funds earned less than bank deposit rate

16. 16 Private pension plans have achieved high returns

17. 17 Importance of high rate of return: pension/final wage from 7% contribution (also important to raise retirement age) (real wages assumed to grow 3% yearly) Real rate of return Retirement age r=2%r=5% 55 (contribute 35 years)13% replacement rate28% replacement rate 65 (contribute 45 years)29% replacement rate64% replacement rate

18. 18 Key differences among new systems— how investment managers are chosen Latin American model (retail market)-workers choose investment managers for their own accounts—choice, but expensive OECD model (group market)—employers and/or unions choose investment managers for entire company or occupation—lower admin. costs but agency problems (what’s best for employers may not be best for workers) –In UK employers can opt out of state plan and individuals can opt out of state or employer’s plan— maximum choice, but may be confusing –Employer opt-out is possibility for Indonesia

19. 19 Institutional market Government aggregates many small accounts into large money blocs and negotiates group rate through competitive bidding process (Bolivia, Kosovo, US Thrift Saving Plan for federal govt employees) Workers are given limited choice among managers and portfolios Designed to keep costs low, prevent big mistakes, get good returns This might work well in Indonesia with redesigned JAMSOSTEK one part of competitive scheme

20. 20 What are other countries in Asia- Pacific region doing? Singapore is allowing workers to opt out of CPF into personal accounts (retail) Australia and Hong Kong require employer to choose investment manager (group plan) India is requiring all new civil servants to enter DC plan; workers choose among small group of investment managers selected in competitive bidding process (institutional model); existing workers are grandfathered into old scheme. –This could be the basis for civil service pension reform in Indonesia.

21. 21 New experiments with centrally managed funds Canada, Ireland, New Zealand—keep DB but fund Most portfolios managed externally with competitive bidding, explicit selection and monitoring criteria, strict disclosure Board chosen on basis of professional competence, not as representatives Object is to maximize returns with moderate risk; no social or targeted investments (ltd govt bonds); Foreign investments and passive investments dominate (reduce risk and costs) This would not work here, because Indonesia would probably not adopt such strict restrictions.

22. 22 What to do about poor workers and informal sector? Can’t collect contribution from informal sector, need non-contributory plan Almost all reforming countries include a safety net financed out of public treasury— could be minimum pension guarantee (MPG), means-tested benefit, flat benefit or compressed earnings-related benefit

23. 23 The safety net Minimum pension guarantee (Latin America) –pension topped up if < 25% average wage –only for contributors (20-25 years) –Chile has social protection for non-contributors Means-and asset-tested benefits (Australia, Hong Kong, South Africa)—non-contributory –takes account of all income –may discourage work and saving –high transactions costs, mistargeting and bribery—leakage –hard to apply in extended family context –probably means-tested safety net is not a good plan for Indonesia

24. 24 Safety net: Flat benefits (Netherlands, New Zealand, UK, Mauritius, Namibia, Botswana, Kosovo, Nepal) For all residents, financed by general revenues, covers informal sector and women Costs more than means-tested benefits because reaches more people But cheaper to administer, less corruption, doesn’t discourage work, saving—better for countries with low administrative capacity Should all old people get a small flat benefit? Depends on whether households with old people are relatively poor and other budgetary priorities Flat benefit of 20% per capita income (120,000 R) to people > 70 would cost Indonesia.4% GDP.But improving health services may be more important.

25. 25 Conclusions—policy recommendations Over 30 countries trying to avoid problems of high costs, large deficits, early retirement, evasion are moving toward systems that use –Funded DC plan with competitive management –Safety net to protect lowest earners –Avoid large PAYG DB and publicly managed funds

26. 26 Key questions for Indonesia Should new DB plan be introduced? (risky for government, expensive for workers and employers. If DB is used it should be small, compressed, contain penalty for early retirement) What is best way to manage investment of funds? How to avoid past problems in Jamsostek and Taspen? (competitive management with limited choice and diversified portfolios?) What kind of safety net? If wish to cover informal sector must be financed by public treasury, not be contributory scheme. Small flat benefit for very old possible but depends on budgetary priorities and whether hh with old members are poor hh. (Health services may be more important).

27. 27 Next steps Important to simulate very long run costs and distributional effects of different policies, with alternative assumptions, before acting New draft act is ambiguous on many points— good, because careful analysis needed. Gives Indonesia opportunity to reform its current system and move it on a path toward greater economic growth and old age security