33388 World Bank Pension Reform Primer Switching The role of choice in the transition to a funded pension system T he transition from a wholly public, pay-as-you- private element. The range of possible choices is go pension system to one where pensions are shown in Figure 1. At the left-hand side, all also provided by individual, privately managed workers, including new labor-market entrants, can pension accounts does not directly affect those choose to stay in the pay-as-you-go system or receiving pensions at the time of the reform. switch to the funded plan. At the other end, rights Nevertheless, it could affect all current and future in the old scheme are frozen and all new rights are workers. A critical policy choice is whether these earned in the defined-contribution, funded workers should be allowed, encouraged or forced scheme. to divert their pension contributions to the new The spectrum of switching strategies 1 voluntary for current compulsory only for compulsory for new compulsory for and future workers new entrants and younger workers all workers Argentina (1994) Chile (1981) Croatia (1999) Bolivia (1997) Colombia (1994) Hungary (1997) El Salvador (1998) Kazakhstan (1998) Peru (1993) Poland (1999) Mexico (1997) United Kingdom (1988) Uruguay (1996) T he experience of 12 reforming countries is therefore largely notional. But new labor-market covers the spectrum of possible policies. entrants are not offered the same guarantee. However, even this broad range masks some important differences between countries. In In Colombia and the United Kingdom, People can Mexico, for example, people are guaranteed their also switch back to the public scheme at any time rights from the old defined-benefit scheme in the future. In Colombia, the accumulated fund regardless of how their new defined-contribution is transferred to the public scheme, which assumes account performs. Given the short accumulation the entire defined benefit pension liability. In the period, the vast majority of older workers will United Kingdom, individuals keep the receive the public pension. The switch to funding accumulated balance in their individual account This briefing is part of the World Bank's Pension Reform Primer. For more information, please contact Social Protection, Human Development Network, World Bank, 1818 H Street NW, Washington, D.C. 20433; telephone: +1 202 458 5267; fax +1 202 614 0471; e-mail: socialprotection@worldbank.org. All Pension Reform Primer material is available on the internet: http://www.worldbank.org/pensions Switching 2 when they switch back to the public scheme and then accrue new public defined-benefit rights. The switching decision Their pension is the sum of the two. In contrast, 2 people in Argentina, Hungary and Poland can switch back to the public scheme only once and pension the option is time limited. The individual switching decision Diverting pension contributions from public, pay as you go defined-benefit to private, defined-contribution schemes affects each age group differently. We funded illustrate the effects with a stylized model. The retirement model assumes that the rate of return, net of age transaction charges, in the private scheme is higher 40 age over the long term than the implied return in the public plan. This assumption is an important rationale for the reform, and is supported by empirical evidence. The pay-as-you-go system, we A high enough implicit rate of return in the pay-as- assume, continues unaltered. People opting for you-go scheme relative to market returns would the funded system divert their whole pension deter even younger workers from switching (to the contribution to the defined-contribution account. extent that they believed the promise, see below). So they would have to be forced to switch from Figure 2 shows the stylized model. The effect of the deficit-financed pay-as-you-go scheme to the compounding the higher return in the funded plan funded plan. But, this would be politically is to widen the gap between the pension provided difficult. Indeed, just as difficult as reducing the by the private and public scheme according to the implicit rate of return in the pay-as-you-go scheme length of time contributions accumulate. Younger by cutting benefits. This impedes reform of workers, with more years of accumulation, immature pension programs as early generations experience the largest gain. Older workers, if typically receive a windfall. Paradoxically, this is forced to join the private scheme, would forfeit exactly the time when the fiscal burden of the practically all of their pensions. In this example, a transition to funding would be smallest. 40-year-old would expect to break even from the shift to the private scheme. Uncertainty The pensions `contract' lasts most of a lifetime. These differences in accruals are standard As a result, pension benefits are uncertain, and this characteristics: defined-benefit plans tend to have affects all types of pension plan. `backweighted' benefits (where pension rights are earned predominantly later in life) whereas Private defined-contribution pensions are subject compound interest means that defined- to capital-market risk, as their value depends contribution pensions tend to be `frontloaded'. crucially on investment returns. The analysis assumes a pay-as-you-go equilibrium where total contribution revenues match total Defined-benefit pensions, such as most public benefit payments in a given period. The implicit schemes, suffer from earnings uncertainty, return on people's contributions to the pay-as-you- particularly when their formula averages earnings go scheme is, in this case, the long-run rate of over a short period of `final' or `best' years. growth of the wage bill. However, in practice, Defined-contribution schemes protect against this many pay-as-you-go schemes offer a higher return. risk. In the long-run, this either means rising contribution rates or a pension plan deficit All kinds of pensions can be vulnerable to inflation financed from general government revenues. risk, both when the entitlement is calculated and 3 Switching during retirement. Real pension payments have change and future benefit promises and their often fallen rapidly in times of high inflation--as effects on the pension system's finances. Political in Latin America in the 1980s and the former resistance is likely to come principally from Soviet Union in the 1990s. workers who have already paid into the system and are then forced to switch to the new scheme. Most importantly, the poor financial prospects of Even when credits are given for past pay-as-you-go schemes imply a significant policy contributions, how these accrued rights are valued risk with public pensions. Instances of benefit can be controversial. cuts---sometimes retrospective--are common. Of course, a financially sustainable plan will be The economic objectives of reform can conflict, more stable than a scheme where contribution particularly when it comes to deciding the rate of rates or transfers from the general government change from pay-as-you-go to funding. Once the budget will need to rise in future. size of the funded component of the new system is chosen, the pace of this transition depends mostly Private pensions offer some insurance against this on the age below which it is advantageous to policy risk, because governments are unlikely to switch. The lower this age, the slower the confiscate private property (although there is a risk transition. But, a slow transition would postpone of effective confiscation through changes in the benefits of the reform, including taxation, means tests for social assistance or improvements in labor and capital markets. In the guarantees of funded pension benefits). The extreme case of only new workers participating, government also has a role in preventing fraud, the new scheme may not reach the critical mass ensuring the private-pension sector is competitive, necessary to ensure viability. On the other hand, a has reasonable administrative costs and strong rapid transition could exacerbate short-run fiscal incentives to find investments with the best trade- pressures. Most countries have chosen a middle off between risk and reward. path, with younger workers participating in the new scheme, and all of these opted for voluntary Pensions of all forms are risky. Whether a public switching. or private scheme is `more risky' or perceived to be more risky will vary from country to country and Minimizing transition costs person to person. There is an `excess return' to the individual on contributions to a funded scheme over the pay-as- Switching and reform objectives you-go plan in a certain world (shown by the A successful reform must meet a number of triangle between the two lines in Figure 2). It is objectives. First, the new scheme should aim to `excessive' because the replacement rate rises in provide a reasonable level of retirement income. the long run for the same contribution. This triangle is also an opportunity cost to government. Secondly, the benefit level must be consistent with Empirical analysis of switching in the United long-run fiscal policy. The diversion of payroll Kingdom (below) shows that this opportunity cost taxes from financing current pay-as-you-go can be very large. In general-equilibrium pensions into the funded scheme will increase simulations, this loss means higher distortionary deficits at first, so short-term fiscal constraints are taxes to finance the transition and, lower growth. also important. The government can appropriate this excess Thirdly, pension reform has microeconomic return, either by cutting the contribution rate to objectives: improve the workings of capital and the funded part of the system, or reducing residual labor markets. pay-as-you-go benefits for younger workers. Lower contribution rates might increase labor Finally, the reform must be politically palatable. It supply and reduce evasion. Lower pay-as-you-go is vital to inform the public of demographic benefit levels would help finance the transition deficit. Both of these policies can be implemented Switching 4 while keeping the target pension level constant. for them to switch to the multi-pillar scheme. The Countries have tended to cut public pension result is sensitive to the assumptions, especially the spending by reducing accrual rates in the defined- net rate of return. Nevertheless, the optimal benefit formula for people who switch. switching age range lies within a 6-8 year range for reasonable assumptions. Switching in Hungary Analysis of the incentive to switch played an The incentive structure reflects two deliberate important part in the design of the Hungarian policy decisions: reform. Special attention was paid to informing q Keeping the incentive to switch small to workers about their choice. The formula for minimize fiscal costs for a desired average valuing current workers' accrued rights and the switching age in the mid-late 30s. residual public pay-as-you-go pension, was q Maintaining a similar replacement rate in the designed to minimize individual excess returns. As long-run of 60-65 per cent. a result, total pension benefits are fairly constant Figure 4 shows preliminary data based on the first across the age range. 915,000 Hungarians who had chosen the new scheme by the end of 1998. The bars show the This analysis was based on an individual model. share of workers in each eligible age group that Users enter earnings, career path, expectations of chose to switch. Policymakers seem to have retirement age and rates of return. The model achieved their target switching age of between 33 then predicts pension benefits from both the pay- and 37. as-you-go pension and taking the funded pension option. A similar tool was available to inform Hungary: switching by age 4 individuals' pension choice. Switching incentives in Hungary 3 50% 45% 40% 70 PAYG 35% Switching 30% 60 fundedsecond 25% Cohort 20% of 50 pillar 15% PAYG Percent 10% 40 firstpillar 5% 0% 30 15-24 25-29 30-39 40-54 55-59 60-74 18 30 40 50 Switching in the United Kingdom Figure 3 shows the results of the model. The line Two unique features of the UK pension system gives projected pensions from the pay-as-you-go complicate the analysis of switching: plan. The gradual decline for younger people reflects changes in the benefit formula that were q There was a large funded sector before reform. part of the reform of the old scheme. The residual Employer-run defined-benefit pensions, public pay-as-you-go pillar shows the same decline covering about 45 per cent of employees, (the lower solid area). Nevertheless, the could already substitute for the public plan. compound-interest effect means the return from q People choosing a personal pension could opt the funded second pillar is higher for the young. back into the state scheme at any point in the The younger workers find that the sum of the future. This option included new labor-market private and public benefits provides an incentive entrants. 5 Switching Figure 5 shows the structure of incentives in the year olds. The average age of personal-pension first years of the reform. Personal pensions are members rose from 29 to 33. Younger workers `front-loaded': the returns are larger at younger appear to have been persuaded to switch initially, ages. This is again because of compound interest, but later cohorts delayed their decision until their but also because over time, the rebates of social- mid 20s. The effective switching rate--excluding security contributions paid into the funded people already out of the public scheme and pension will decline. This is designed to match the covered by employer pensions--was 80 per cent decline in the value of the state plan to younger for men aged 25-55 and 50 per cent for women. age groups. An individual up to age 50 would be better off in a personal pension than in the state UK: switching by age 6 earnings-related pension scheme, known by its acronym, Serps. -19 Switching incentives in the UK 5 20-24 6 0 0 0 age 25-34 5 0 0 0 4 0 0 0 35-49 1994-95 3 0 0 0 personal pension 1987-88 50- S e r p s 2 0 0 0 0 10 20 30 40 50 1 0 0 0 per cent of employees covered 0 3 0 4 0 5 0 6 0 70 Between 1988-89 and 1995-96, the government a g e paid £17.7 billion into people's personal pension accounts. Actuarial estimates put the long-run The gray bars in Figure 6 show who switched in saving on Serps benefits at £9.2 billion. The net the first year of the reform. The government cost--£8.5 billion--arises because the government forecast 0.5 million would take out personal did not adjust the payment into personal pensions pensions, although a contingency plan allowed for to reflect different returns at different ages (Figure a maximum of 1.75 million. In the end, 3.2 million 5) until 1996. With age-related rebates, the annual people switched in 1987-88. Ex-post analyses net cost has now been cut from £1.8 billion to showed that switching was strongly related to age, £0.5 billion a year. just as the incentive structure would suggest: 20 per cent of under 35s switched, compared with 5 Switching in Latin America per cent of over 35s. The government had simply Funded pension coverage in Argentina in 1996 neglected to take these incentives into account (two years after reform) and in Chile in 1985 (four when calculating the likely switching outcome. years after) shows a remarkably similar pattern, Also, the new plans were aggressively sold by the with a very strong inverse correlation between age financial-services industry, often inappropriately. and switching. The higher coverage of younger (The regulators estimate that there were over 0.5 workers in Chile is because switching became million cases of mis-selling). compulsory for new labor-market entrants in 1983, while in Argentina, they had a choice between pay- By 1994-95, there were 5.6 million people with as-you-go public and funded private pensions. personal pensions, 28 per cent of employees. However, the age pattern changed. The take-up In Colombia, the pattern in 1997 was similar, but rate fell from 20 per cent of under 20s to just 5 per with fewer than 10 per cent of 45-54 year olds cent, while it rose from 20 to 40 per cent of 25-34 switching, compared with over 50 per cent in Switching 6 Argentina and Chile. Unlike other Latin-American q The experience of Hungary and the United countries, Colombian state pensions had not been Kingdom show this results from the structure discredited and had not had financial difficulties. of switching incentives. The public scheme also promised generous q In Argentina, Peru and the United Kingdom, benefits so older workers were happy to stay. switching rates were lower for the very youngest workers. This might be because of Latin America: switching 7 myopia or reflect their lower earnings. q Fewer women tend to switch, the only 100 exception being Hungary. q Government forecasts often underestimated 80 Argentina the number of switchers. This may be due to Chile 60 poor microeconomic analysis of the switching (%) Colombia incentives (as in the case of the United 40 coverage Kingdom). But independent analyses correctly Peru anticipated switching in Hungary and Uruguay. 20 Uruguay q Voluntary switching is the most popular way 0 of handling the transition and helps increase 20 25 30 35 40 45 50 55 60 age support for the reform. It is also likely to make it more difficult for a new government to reverse the reform. Switching in Peru in 1997 has the same pattern of inverse correlation with age. However, fewer people switched than in other Latin-American Experience of forced switching countries, probably because there were no clear A mandatory switch rapidly and definitively closes rules in place for calculating recognition bonds (to the public scheme. In some countries where the cover accrued rights in the state system) and for a current system has collapsed, this may be seen as minimum pension guarantee. Indeed it is an advantage. surprising that so many workers switched without knowing how their past rights would be treated, a Reforms in Bolivia and Kazakhstan force all sign that policy risk was perceived to be high. workers to transfer to the new private pensions and to accept a formula that values their Uruguay has the most complicated policy. People contributions to the old public plan. Similar below age 40 and new entrants earning more than reform proposals in Argentina and Hungary were 5,000 pesos a month were forced to switch. There abandoned when it became clear that the valuation was an extra incentive for people earning less than of accrued rights would be challenged in the 7,500 pesos a month because their public pensions courts. The absence of such challenges in Bolivia were cut by a quarter. Although the government and Kazakhstan is interesting. It could reflect anticipated 50,000 people would switch, differences in the legal system or the political independent studies put the figure much higher. economy of these countries or it might be that the By mid-1997, 400,000 had joined the new scheme. valuation was generous, pre-empting criticism. In Bolivia, the forced switch may have been helped Preliminary data for El Salvador also confirm the by the new `Bonosol'/'Bolivida' program, financed strong age-related switching pattern in the region. with privatization proceeds which provides a flat benefit to all adult Bolivians at age 65 separate Conclusions: switching behavior from the contributory scheme. Several preliminary conclusions emerge from In Mexico, the right to continue in the pay-as-you- countries with voluntary switching: go system was enshrined in the constitution. q The proportion switching falls with age. Therefore, the only way to replace the old system fully was to guarantee a minimum return at least as large as that from the state scheme. This means 7 Switching that almost all older workers will continue to Conclusions and recommendations receive the old pay-as-you-go benefit as before. They have no incentive to monitor the q Governments' policy options range from performance of their pension fund and the cost of an entirely voluntary switch to an entirely administering their accounts is wasted. mandatory one q In practice, reforms in 12 countries span There are two risks with forced switching this spectrum but most include some q The reform could just as easily be reversed by element of choice a new government, since switching was q Given a higher rate of return in the imposed and not a choice. funded scheme for younger workers, the q Minimizing political and legal resistance might government must determine how to be costly if the valuation of accrued rights is adjust the rest of the system to maintain raised above the level necessary to persuade the target replacement rate most workers to switch. True preferences are q Older workers are best excluded from revealed when workers have a choice. reforms, because there is little time to build substantial funds in the new private Policy options scheme The proportion of the workforce switching is q But a mandatory cut-off age is arbitrary central to the success of reform and can have a and leads to political or legal challenges profound impact on the public finances. While a q Heterogeneous perceptions within age critical mass must be achieved in the early years, it groups also suggest that there is no is not necessary to force all workers into the new "right" mandatory cut-off age scheme. There are economic and political q Officials are often concerned that they advantages to voluntary switching and most cannot control the speed of transition or countries have taken this approach. There are five ensure that a critical mass of participants main ways to manage voluntary switching: joins the new system. But voluntary q The window for switching out could be switching in eight countries had a extended if too few workers switch initially. consistent pattern and the transition is q If inertia is likely to be important, the predictable with the correct analysis government can specify a default option. In q Fiscal studies of switching are also Argentina, younger workers are switched to useful for public information. the new scheme by default. Governments can and should manage q The value of pay-as-you-go benefits can be the switching process, by altering adjusted to alter the incentive to switch as in incentives and ensuring people make Hungary or the contribution rate to the funded informed choices plan could be altered as in the United Kingdom (where the initial 7.8 per cent personal pensions contribution now varies between 2.3 and 9 per cent with age). q Incentives to switch can be affected indirectly, by altering guarantees of funded pensions or adjusting the opportunity to switch back to the public scheme. q The government can explain the switching option to minimize the risk of misinformed choices. In Hungary, the model of individual returns to different pension choices is available on the internet, at public-information centers and is used by new private pension funds. Switching 8 Further reading On proposals in the United States: Palacios, R.J. and Whitehouse, E.R. (1998), `The Gustman, A.L. and Steinmeier, T.L. (1998), role of choice in the transition to a funded `Privatizing social security: first-round effects pension system', Social Protection Discussion of a generic, voluntary, privatized U.S. social Paper no. 9812, World Bank. (Internet: security system', in Feldstein, M. (ed.), www.worldbank.org/pensions) Privatizing Social Security, University of Chicago Press for National Bureau of Economic Holzmann, R. (1998), `Financing the transition to Research. multipillar', Social Protection Discussion Paper no. 9809, World Bank. On uncertainty and pensions: Kotlikoff, L.J., Smetters, K.A. and Walliser, J. Bodie, Z. (1990), `Pensions as retirement income (1998), `Opting out of social security and insurance', Journal of Economic Literature, vol. 28, adverse selection', Working Paper no. 6430, pp. 28-49. National Bureau of Economic Research, Bodie, Z., Marcus, A.J. and Merton, R.C. (1988), Cambridge, Massachusetts. `Defined-benefit versus defined-contribution (Internet: www.nber.org) pension plans: what are the real trade-offs?', in Bodie, Z. Shoven, J.B. and Wise, D.A. (eds), On Hungary: Pensions in the US Economy, University of Palacios, R.J. and Rocha, R. (1998), `The Chicago Press for National Bureau of Hungarian pension system in transition', Social Economic Research. Protection Discussion Paper no. 9805, World Bank. On Latin America: Marquez Mosconi, G. (1997), `An assessment of pension System Reform in Uruguay in 1995', Social Programs Division, Inter-American Development Bank, Washington D.C. On Poland: Gora, M. and Rutkowski, M. (1998), `The quest for social security reform: Poland's Security through Diversity', Social Protection Discussion Paper no. 9815. On the United Kingdom: Whitehouse, E.R. (1998), `Pension reform in Britain', Social Protection Discussion Paper no. 9810, World Bank. Disney R.F. and Whitehouse, E.R. (1992), The Personal Pensions Stampede, Institute for Fiscal Studies, London.