Article in The Actuary by Philip Booth, Oskari Juurikkala and Nick Silver
A few years ago, we had a major debate within the actuarial profession about private versus state provision of pensions. Questions such as “should the state provide higher pensions on a pay as you go basis?” and “are pensions best left to the private sector?” were hotly debated.
An undercurrent in that debate was a view amongst many in the profession that the state should provide a basic level of pension and that private pensions should be built on top of that basic level. An obvious response would be to point out that, if private pensions are a better vehicle for income provision in old age, it is a pity to design a pensions system that creates a form of apartheid whereby the poor receive all their income from the state and the better off receive most of their income from the private sector. However, those who argue that point of view need to demonstrate how the private sector can provide for the poor in old age.
Examining the possibilities for private pensions for the poor is a major objective of an Institute of Economic Affairs’ research project, which has been awarded a $225,000 grant by the Templeton Foundation to examine income provision for the poor in old age. The challenge of the project is to look beyond the developed world to income provision for the poor in under-developed countries. In both developed and under-developed countries the preliminary work shows quite clearly that there are two major issues that transcend the points that came up time and again in the Institute of Actuaries’ debates. In the rest of this article, we do a whistle-stop tour of the world, describing some of the challenges facing countries in different positions.
Developing countries: saving against the odds
There is little point debating which pensions models should be adopted in under-developed countries in which there are no capital markets, property rights are not well defined and properly enforced, and corruption is endemic. In this situation promises from the state are not believed and private sector institutions cannot develop. These problems are not specific to pensions. More generally, under-development in many countries in Africa, South and Central America and parts of Asia arises because the basic institutional framework for a market economy does not exist. Transplanting pensions policy blueprints will simply not work.
A good example of this is the formal pension systems in Nigeria. The oldest scheme, which catered for public sector employees, was subject to constant political manipulation. Pensions were, in some cases, not paid for several years, and even the promised benefits were often inadequate due to rampant inflation against which pensioners had no protection. Inaccurate record keeping also gave opportunities for corruption.
In Nigeria, formal pension schemes for private sector workers have not fared much better. A compulsory savings scheme soon collapsed due to fund mismanagement by the government and widespread evasion by employers. The scheme was transformed in 1994 into a PAYGO scheme, which has only survived better because the funds left from the previous scheme were consumed during the transition. But the coverage of the scheme is limited to employees of larger companies, and many people are reluctant to participate because of the poor credibility of the government in financial affairs. Over 90% of Nigerians are still outside any formal pension scheme.
Nevertheless, even in countries that do not have a well developed framework for formal saving, the poor still make provision for old age in whatever way they can – the myopia that some people seem to think prevents people taking rational savings decisions is simply not in evidence. In Nigeria, several methods of securing some provision for old age are evident. The most obvious is to ensure that a family has sufficient children to provide for parents in their old age – a sort of private, and sustainable, PAYGO pension system.
A safer, more tangible, way to invest for the future is to invest in the human capital of children. This happens widely amongst even the poorest in society. Unlike more tangible forms of investment, the lack of secure ways to save is not a problem when investing in education. A child’s education will lead to higher wages in the future and better enables the child to look after their parents in old age. This is facilitated by the existence of strong social ties with children generally looking after their parents in old age.
Also, informal private arrangements, rather like tontines, are very much in evidence. Families pool their money and the survivors use the pool to provide them with an income. The agreements are not enforceable in the inefficient and corrupt courts, and thus they are limited to small groups of people who know and trust each other.
It is clear that individuals are resourceful in difficult circumstances. Policy must involve developing effective legal frameworks to legitimise and make enforceable the forms of inter-generational transfer that already take place, thus allowing such voluntary activity to deepen. Steps have to be taken to provide the basic legal infrastructure for a market economy to thrive before more formal methods of pension provision will emerge.
Middle income countries – the pride of Chile
At the same time, many countries have implemented so-called Chilean systems, which really involve compulsory long-term savings in defined contribution schemes. Typically, workers are obliged to allocate a certain percentage of their salary to personal retirement accounts, and the funds are managed by specialised investment companies.
The Chilean system, which dates from 1981, has several merits. It has abolished the perverse incentives of the previously unsustainable state PAYGO schemes, which encouraged early retirement and low private savings rates. Savings have increased substantially and labour markets have become more flexible, reducing unemployment. Retirement income has increased substantially under the private schemes. Moreover, even though coverage rates in Chile are lower than in the developed world, they are the best in Latin America. Finally, the pensions industry prides itself in its customer-friendliness and service.
Forced savings schemes have not worked as well in other Latin American countries. For example, Mexico and Argentina have implemented Chilean-style reforms with less success. Although these reforms have undoubtedly improved on the earlier, almost bankrupt, state schemes there are many hurdles still to be overcome.
One problem relates to coverage: in Latin American, a substantial proportion of all companies and workers operate extra-legally. Another challenge is that those who take part in forced saving may be disappointed, because financial markets are less developed. In Mexico and Argentina, pension funds have had to rely heavily on government securities, which have given both poor and insecure returns. There are also strict limits on investment abroad, which creates a substantial investment risk given the political volatility of the two countries. Finally, the implementation of the reforms has been half-hearted, favouring vested interests and trying to mix past bankrupt schemes with new private ones. As a result, pension systems in these countries are unnecessarily complex.
One can ask whether Chilean-style private pensions are advisable at all in under-developed countries. The question is urgent, because several developing countries are following Chile’s example. Nigeria is currently in the process of replacing all its formal pension schemes with a compulsory savings scheme (although, even if successful, the vast majority of Nigerians will continue to be outside formal schemes). There may be serious management difficulties in countries with endemic and widespread corruption, even if formal checks are placed in the legal framework. Moreover, one wonders whether compulsory retirement savings are what most people need. In Nigeria, where life expectancy is 43, most people will not reach retirement age, but are faced with more pressing needs for their scarce resources. Forced-savings schemes tie up the meagre funds these people have, and they cannot access them in times of more urgent need.
Developed Countries: Demographic Doom
In most developed countries there is no shortage of provision though formal pension schemes. In the UK, both private sector and public sector schemes are beset by particular difficulties. However, a little-discussed problem is that we are reaching the point where the demographic composition of the electorate, in nearly all EU countries, is such that it may become impossible to promote meaningful pension reform. The more urgent reform becomes, the more difficult it will be to achieve. This problem was largely ignored in the recent debate surrounding the Turner Report. It is studied in the discipline of public choice economics. Put simply, with an ageing population the majority of voters will lose significantly from reductions in the size and scope of state pensions and the so-called “median voter” will have a strong incentive to vote for increasing pensions. This phenomenon was very well illustrated in the 2005 election campaign. The Labour Party climbed down on proposed reforms to public sector pensions. The Conservative Party contrived special proposals for exempting pensioners from particular taxes. The challenge is to make pensions policy more impervious to political manipulation, which certainly points in the direction of more personal responsibility.
In both developed and under-developed countries, the challenges for pensions policy in the field of political economy are as significant as the more widely discussed financial and micro-economic problems. In under-developed countries, governments need to perform their basic functions of enforcing contracts and protecting property rights. Only then will long-term savings be secure. Developed countries are suffering severe ageing which will bring financial problems for PAYGO schemes, but also make pension reform that reduces costs increasingly difficult: to an ever greater extent younger generations will be exploited by politicians responding to the preferences of ageing electorates.
Philip Booth, Oskari Juurikkala and Nick Silver are working on the
IEA Empowerment Through Savings Programme