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Can Pension Reform Save Our Retirement Savings? 

The Freeport News

The Bahamas

November 8, 2005


In most countries, including the Bahamas, public pension plans are structured as defined-benefit systems, financed on a pay-as-you-go (PAYG) basis, usually through payroll taxes that should be adjusted periodically to ensure that revenues are sufficient to meet current pension obligations. However, since the pioneering work of Harvard professor Martin Feldstein more than twenty years ago, many economists now believe that when a country sets up a PAYG plan, saving and capital accumulation start to decline, hurting prospects for growth. The first generation of retirees under PAYG systems typically contributes much less than they receive. 

For instance, The National Insurance Board (NIB) is currently distributing regular retirement benefit payments to approximately 15,820 pensioners, or 3,144 is categorized as old age non-contributory pensioners, which means that their level of contributions were insufficient of this amount. Twenty percent or 3,144 is categorized as old age non-contributory pensioners, which means that they are receiving more than they contributed. In addition, regular retirement benefit payments have increased from 9,778 to 12,676 or 30 percent from 2000 to present.

However, contributions over the past few years have been improving, with 2005 projecting to be much better than 2004. Further it is believed that first retirees enjoy, in effect, an increase in wealth, which encourages them to increase their consumption spending. Contributors view what they pay into the plan as a form of involuntary saving, rather than as a tax, and reduce their voluntary savings in order to maintain current consumption levels. The aging of populations has made public pension plans worldwide extremely costly and has inspired many efforts at reform. Some countries have chosen to leave the basic design of their plans intact while raising the retirement age and/or increasing the contribution rate or lowering benefit levels. 

In the Bahamas, the Social Securities Reform Commission is proposing the following changes to our National Pension Plan: 

1. Equity & Relevance 
* Indexation of ceiling & pensions i.e. pegging benefit payments to an inflation index)
* Indexed career insurable earnings for RET pension (instead of best three-year average) i.e. revaluing past wage to current wage. 

2. Broadening NIB's scope 
* Gratuities included in insurable wages 
* RET pension even if still working 
* Unemployment benefit 
* Disaster Assistance Fund 

3. Improving operations 
* Reduced operating costs 
* New approach for self-employed contributions 

4. Improving long-term sustainability
* Higher normal pension age 
* Higher contribution rate 
* Revised investment guidelines 


Some countries have introduced radical structural changes by replacing defined-benefit plans with privately administered defined-contribution plans. Nonetheless, a heated debate has developed over the relative merits of these two approaches to reform and, in particular, over their impact on saving. The pension windfall The first retirees under a new PAYG system may well get a very good deal, because the expected present value of their pensions tends to be much greater than the value of their contributions. 

This happy state of affairs may be due to a number of reasons - for example, the first retirees may be eligible to receive a full pension after only 15-20 years of contributions as in the case with old age non-contributory pension. Current workers, even those who contribute over their full working lives, may also enjoy a windfall if programmes are actuarially unsound and the present value of expected benefits is greater than the present value of expected contributions. 

This "social security wealth" may lead to an increase in consumer spending and thus a decline in saving. Approaches to reform Conventional reform: The conventional approach which is currently under review or being exercised by NIB views the plan as simply a tax-and-transfer system; from this standpoint, a pension system can generate more saving by spending less and taxing more. This approach seeks to mitigate, if not eliminate, the less desirable features of public pension plans without changing their basic design. 

Expenditures are reduced by raising the retirement age and/or lowering the replacement ratio (the ratio of pension benefits to pensionable income) or increasing the contribution rate. Radical reform: The more radical approach to reform, which was pioneered by Chile, involves introducing an altogether different type of plan - a defined-contribution plan that is privately administered (although still subject to considerable governmental regulation). 

In a radical reform of its pension system in the early 1980s, Chile set up a defined-contribution system that is basically a compulsory saving plan. All Chilean workers (except the self-employed) are required to deposit 10 percent of their salary (subject to a ceiling), plus an amount for commissions and disability insurance, in an account with the pension company of their choice. The money can be withdrawn only upon retirement, either in regular installments or in a lump sum. The Chilean system has been highly praised. As a privatized system, it is said to be less vulnerable to political manipulation than PAYG systems because its terms are harder to change. 

To the extent that participants see their contributions as involuntary savings that yield an adequate rate of return, the system may eliminate the labour market distortions associated with a payroll tax. The payroll tax that finances a PAYG system can also be seen as a form of saving, if benefits are closely linked to contributions - that is, the bigger the contribution, the higher the return - but the implicit rate of return is often very low. Personal saving should indeed increase when a funded, defined-contribution scheme is introduced, to the extent that individuals do not reduce their voluntary saving by the full amount of their mandatory saving in capitalized pension accounts. 

The argument that replacing an existing PAYG scheme with a new, funded pension scheme will have a beneficial impact on national saving cannot be accepted uncritically. In the simplest example, if the mandatory contribution rate under the new, privatized system is the same as the payroll tax rate of the PAYG system being replaced and retirement benefits are equally generous, pension reform will have no impact on the disposable income or wealth of individuals. Problems with radical reform While a radical reform of the public pension system may boost national saving, it is not without some potentially serious problems. First, there is the issue of who bears the risk of poor investment performance. In addition, experience suggests that the administrative costs of privatized pension schemes are much higher than those of existing public schemes.

Finally, the lack of efficient annuity markets in most, if not all countries tends to make the payment of benefits under defined-contribution plans costly for retirees. Pensions: not just savings Although those in favour of replacing public pension schemes with privatized, defined-contribution plans have argued that radical reform is needed to stimulate national saving, the impact of such a course of action is likely to be small unless contributions are increased or benefits lowered. 

Conclusion 

The greatest differences between the two types of reform may have less to do with their macroeconomic implications - such as their impact on saving, investment, and output growth--than with political and social issues, such as who should bear the risk of poor economic performance, to what extent the pension system should be used to redistribute wealth between and within generations, and even what is the appropriate scope of governmental participation in economic and financial activity. 

All pension programmes, whether defined-benefit or defined-contribution involves trading current income for a claim on future assets. Thus, they all require a decision about how current output should be divided between consumption and investment, and how consumption should be divided between current workers and retirees. This is an issue about which politicians will likely have as much to say as economists - if not more. 

Other issues also merit consideration - the most enthusiastic advocates of pension plan privatization, for example, argue that its impact on labour markets and employment is so beneficial that it practically pays for itself. It is important to remember that pensions are not only, or even primarily, about national saving. Indeed, the primary purpose of pensions is to ensure an adequate standard of post-retirement living for individuals, consistent with the resources available to society. A reform that jeopardizes this objective cannot be considered worthwhile, whatever its impact on national saving. 


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