Abstract
Following on from section 4 where the key factors to be considered in any move to funding have been laid out, the present section goes on to provide a series of systemic simulations, where the internal rate of return and transition burden issues raised in the previous section are to the fore. While the simulation possibilities in this area are enormous the objective of the present section is to highlight a number of basic scenarios which illustrate key choices for a funded system, in particular the choice between a compulsory V voluntary system (sections 5.1 and 5.2) and whether a mixed PAYG / funded system provides a credible alternative to one or other system. In fact, as this section will make clear, a mixed pension system (75% PAYG / 25% funded) can be seen as a realistic scenario for the EU at the present time in that the size of the transition burden would appear to preclude an immediate shift out of the PAYG system, due to the large financial burden which would be placed on workers if such a shift was to be considered over only one generation. This is where the big contrast with the US starts to manifest itself since, according to Modigliani et al (2000), the US could make such a 100% transition to funding in a relatively painless way since “the US is in the lucky position of being able to provide all the additional resources needed to fund the system without ever raising payroll contributions”, although the authors do go on to stress that in order to achieve this, the transition period required would be long — many decades in fact.
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Given the replacement rate under the funded scheme and the evolution of the average duration in retirement, the contribution rate is determined by equalising, at each date, the present discounted value of pension contributions to the present discounted value of the funded pension the worker can expect in the future.
Since this simulation is purely illustrative, there are a number of simplifications introduced, the effects of which will be looked at in the second half of this sub-section. Firstly, while such a mandatorily imposed form of retirement savings would, in certain circumstances, be implemented with the help of government tax incentives or subsidies, this extra cost is not allowed for here. Secondly, the contentious issues of both the relatively high administration costs associated with funded pension schemes and the issue of replacing a defined benefit (DB) PAYG system with a defined contribution (DC) funded approach is avoided. Both these latter concerns can be excluded from the present simulation, for ease of exposition, by modelling this shift to funding through the use of a perfectly competitive annuities market where the contributor and the pension fund operator basically enter into a formal contract where a net replacement rate is agreed and the required annual contribution rates (as a percentage of wages) needed to achieve this degree of pension generosity are fixed accordingly. While this particular annuites market approach simplifies the explanation of the basic mechanisms at work in a shift to funding, it is still a close reflection of what happens in practice, with workers normally agreeing to pay a pension fund or insurance company a set percentage of their salary for an agreed number of years and with the final pension paid being dictated by the rate of return earned on the accumulated assets. In the present example, it is assumed that the rate of return will be equivalent to the 51/4–51/2 per cent real interest rate assumed in the central scenario. One important difference with the real world situation however is that the model does not allow for uncertainty in that it assumes that the real rate of return will not be as volatile as it is in practice and consequently this methodology will produce results which are closer to a DB, PAYG scheme, rather than a DC, funded scheme. In fact it would be entirely logical for such a shift to funding from the PAYG system to continue to be channelled through the low cost national tax system. Both the PAYG and present funding simulations are both in essence compulsory savings systems, with a properly ring-fenced, government controlled, funded system having the advantage of the government underwriting the volatility risk of a private funded system. The cost to government of underwriting this risk would be low since governments, unlike private institutions, have the unique advantage of being able to spread the risk over a number of generations.
According to research quoted in Miles and Timmermann (1999), the average return on an equal-weighted portfolio of equities and bonds was of the order of 51/4 per cent in Europe over the 30 year period up to 1995 and the real interest rate in the model is also of the order of 5 1/4 –51/2 per cent and consequently represents a good proxy for tracking the evolution of pension fund returns over the next 50 years.
This sharp reduction in the real return for funding is likely to be significantly attenuated in the event of a more gradual abolition of the PAYG system.
As the initial build up in savings is unwound so also is the initial gain in terms of growth.
In terms of the cost of tax incentives, according to the 2001 OECD report on trends in “Net Social Expenditure”, tax breaks (in the form of tax exemptions for contributions to private pension funds) aimed at stimulating the take up of private pension plans vary enormously from country to country. For example for the year 1997 tax breaks for private pensions were of the order of 1% of GDP in the Netherlands and the US compared with voluntary private pension expenditure of 3.2% and 3.6% respectively suggesting that tax incentives may represent close to 30% of the contributions made to voluntary private pension funds. This ratio is even higher in the case of Ireland and the UK and substantially lower in the case of Germany. This latter figure for Germany is a little surprising in the light of the figures being mentioned in relation to the recently agreed German pension reform proposals where a much higher budgetary cost is assumed — for example some estimates suggest that the generation of an additional €45 billion of private pension fund assets in Germany will cost the German exchequer around €10 billion in tax incentives.
A recent study by Murthi, Orszag and Orszag (2001), which looked at the specific experience of the UK with a decentralized system of individual pension accounts, suggests that the administration costs issue is a serious one. According to this study the average lifetime costs for a typical worker associated with an individual pension account is made up of a combination of fund management / administration costs, coupled with alteration fees and the cost of annuitising the fund upon retirement and that all these costs in total consume, over the individuals working life, an incredible 40 to 45 percent of the value of the pension account.
Most private sector DC schemes around the world have a system of insurance in operation to recognise the greater risk associated with DC schemes, with these insurance instruments having the effect of smoothing out the volatility of returns, thereby limiting the potential losses which any individual could be faced with in a funded scheme. In terms of the actual insurance costs of providing a minimum rate of return for defined contribution pension schemes, the World Bank, using option-pricing models similar to those used in derivatives markets, estimates that “for a reasonable set of assumptions, the cost of the minimum absolute and relative rate-of return guarantees is of the order of 4–7 percent of total assets per year”. Source: “Guarantees — Counting the cost of guaranteeing defined contribution pensions”: World Bank’s Pension Reform Primer.
It should be pointed out that the positive rate of return differential in favour of funding of roughly 2 % points which underpins Graphs 17a and 17b (and 1 % points for Graph 18) should, if anything, be higher due to the following factors. One of the key reasons explaining the decline in the rate of return for funding in these compulsory savings simulations is that the PAYG system is abolished immediately but clearly this decline can to a large extent be offset by adopting a more gradual approach. Furthermore, the rates of return for the PAYG system used in the simulations may, on the other hand, be unduly optimistic since firstly, these central scenario rates of return assume no change in the replacement rate of the PAYG system over the next 50 years (i.e. the NRR stays at 74% versus an assumption of a fall to 58% using the EPC’s own assumptions); and secondly, they are based on a real wage growth assumption which uses GDP per person employed rather than compensation per employees, with the latter growing, on average, at a 1% point lower annual rate than the former over the last number of decades.
This 25% figure is purely illustrative — depending on the transition burden faced by individual Member States a much higher % shift could be contemplated.
The importance of keeping the savings issue to the forefront of discussions needs to be underlined since this is the factor which will ultimately decide the success of a funded approach. While credible arguments can be made in favour of funded schemes regarding their potential benefits in terms of savings, unfortunately a review of the empirical literature in this area points to no conclusive evidence to this effect. In this regard, the voluntary savings simulation in Section 5.2 shows clearly that, in the absence of some element of mandatory savings, the boost to overall savings from funding will be muted and could in fact lead to serious underfunding problems in terms of future retirement income provision.
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© 2004 Springer-Verlag Berlin Heidelberg
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Mc Morrow, K., Roeger, W. (2004). Economic Assessment of a Full / Partial Shift to Funding. In: Welfens, P.J.J. (eds) The Economic and Financial Market Consequences of Global Ageing. European and Transatlantic Studies. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-540-24821-7_10
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