79208 This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The material in this publication is copyrighted. FINANCIAL SECTOR ASSESSMENT PROGRAM MALAWI TECHNICAL NOTE CONTRACTUAL SAVINGS: INSURANCE AND PENSIONS SEPTEMBER 2008 INTERNATIONAL MONETARY FUND THE WORLD BANK MONETARY AND CAPITAL MARKETS FINANCIAL AND PRIVATE SECTOR DEVELOPMENT DEPARTMENT VICE PRESIDENCY AFRICA REGION VICE PRESIDENCY i Contents OVERALL ASSESSMENT ............................................................................................................1 I. GENERAL INSURANCE ...................................................................................................2 A. Penetration and Market Structure .............................................................................2 B. Product Diversification .............................................................................................4 C. Portfolio Structure and returns ..................................................................................4 D. Regulation and Supervision of General Insurance ....................................................5 E. Micro Insurance .........................................................................................................6 II. LIFE INSURANCE AND PRIVATE PENSIONS ...................................................................8 A. Market structure and Penetration ..............................................................................8 B. Products .....................................................................................................................8 C. Pension Fund Management .......................................................................................9 D. Regulation and Supervision of Life Insurance and Private Pensions .....................10 III. PUBLIC PENSIONS .....................................................................................................11 A. Current PAYG system for Civil Service and Military ............................................11 B. Shift to a Contributory Pension scheme ..................................................................15 IV. SUMMARY AND RECOMMENDATIONS.......................................................................17 V. REFERENCES ................................................................................................................18 ii ACRONYMS IAIS International Association of Insurance Supervisors ICP Insurance Core Principles K Kwacha (1 US $ = 139 K) MRA Malawi Revenue Authority NASFAM National Smallholder Farmers Association of Malawi NGO Non Governmental Organization OIBM Opportunity International Bank of Malawi PAYG Pay-as-you-go RBM Reserve Bank of Malawi 1 OVERALL ASSESSMENT 1 The penetration level of the insurance and pension sectors in Malawi is low, but it seems adequate as compared with other countries in similar stages of development. Concentration and costs are high, the regulatory framework is outdated or inexistent and supervision is weak. An innovative pilot experience of weather micro-insurance is a good example of private- public partnership to reduce vulnerability and extend benefits, but the coverage is still low. The project faces several challenges, one of them being the need to invest in weather technology. Cost benefit analysis of public projects in this area should take into consideration the possible positive social benefits of income security for vulnerable rural population. The analysis needs to take into account that possibilities to increase micro- insurance penetration may be affected by the level of education of farmers, as well as their specific knowledge of insurance products and their confidence in insurance companies. Life insurance and private pension plans have an acceptable level of development as substitute of the non existing mandatory pensions for private sector workers, but they need a stronger supervision and regulation to enhance their benefits. Rules should seek to promote portfolio diversification, higher portability of pensions and old age income security through well defined benefit rules (included indexation). RBM has limited capacity as integrated supervisor for the whole financial sector. It faces strong constraints to perform its role as insurance supervisor, and is far from being able to do it with private pensions. If the government adopts decisions extending the competence of RBM to private pensions, a careful evaluation of resources needs to be done and a capacity building plan has to be adopted. In any case, RBM needs to develop more effective tools to perform its duties with limited resources, including the shift to a risk based supervision approach. The public PAYG pension scheme for the civil service is too onerous and the projected long term financial situation shows an increasing burden on the public budget. A series of parametric reforms triggered by the wage reform for the civil service of 2004 have been ad hoc and non systematic. The parametric changes have represented changing rules over time, and further changes will probably happen, since the financial projections show an increase in the pension burden. In spite of the generous parameters of the public PAYG scheme, inflation erodes pensions and most benefits are paid as lump sums, affecting the ability of the pension system to provide lifetime income protection. It is recommended that the government of Malawi: a) Enact pending legislation to strengthen the regulatory framework and the supervision capacity of the insurance and private pension sectors; b) Enhance the capacity of the supervision authority through an adequate training program; c) Evaluate a parametric reform for the civil service pension 1 This Note was prepared by Gustavo Demarco, World Bank. 2 scheme including a redefinition of the accrual rate, vesting period, retirement age and indexing rules that are compatible with long term target expenditures. I. GENERAL INSURANCE A. Penetration and Market Structure 1. Gross premium in 2006 was K 3 billion, representing 1.13 percent of GDP. This ratio is low as compared with more developed economies, but it is not very different from market penetration indicators of other countries in the region, except South Africa.2 Figure 1. Insurance Market penetration in selected countries Premia / GDP (% ) 20% 17.97% 16% 12% 8% 2.59% 4% 1.27% 1.21% 1.13% 0.73% 0.47% 0% da i al a n a ca aw bi ni ny g an ri Be ne m al Ke Af Za Ug M Se h ut So Sources: World Bank WDI, Sigma 6/02 and RBM (2005) 2. The insurance sector in Malawi shows high concentration. In 2006, eight companies operated in the market of general insurance; the largest manages 50 percent of total assets and the two largest represent 80 percent. Most of the companies have local owners, and only two of them are owned by foreign capitals (jointly representing 26.3 percent of the market). One licensed reinsurance company operates locally, but more than 70 percent of reinsurance is provided by foreign re-insurers licensed by the Reserve Bank of Malawi (RBM). 3. Underwriting results are high (about 50 percent of total underwriting, although the percentage was higher in the past).3 This is partly explained by high management expenses, which may in turn be caused by inefficiencies, diseconomies of scale or by 2 It should also be noted that the information does not correspond to the same years, so the comparison is only approximate and indicative. 3 Underwriting result is defined as the difference between premia and claims incurred plus commission. Operating results include investment income and expenses minus management expenses, taxes and other expenses. 3 market concentration. As observed in Figure 3, management expenses evolved together (and in similar levels) with underwriting results between 2002 and 2006. It is also noticeable that returns on investments are below the volume of expenditures. Figure 2. Market concentration in the Insurance Sector of Malawi - 2006 Market structure in the General Insurance sector of Malawi (Liabilities) 60 50 40 % 30 20 10 0 n CO I r en l e L ya te UG io AI im ar t iz un Ro NI G Pr Ch Ci Re Source: FBM (2006) Figure 3. General Insurance Market of Malawi Performance indicators of the General Insurance Market of Malawi 1000 800 million K 600 400 200 0 2002 2003 2004 2005 2006 Underwriting Results Net Investment income Management expenses Taxes Source: RBM (2005) 4. For the market as a whole, solvency and liquidity rates are within acceptable levels, although RBM has expressed concerns in the particular case of some small companies. While this situation should not represent a major risk for the insurance sector, the limited supervision capacity of RBM results affected when even minor risks are observed in the market, as will be discussed below. 4 B. Product Diversification 5. The analysis by branch also shows strong concentration: As in most middle or low income countries, auto insurance represents the highest percentage of the portfolio of the companies, usually associated with the mandatory nature of this type of insurance. This is the case in Malawi, where it represents about 60 percent of total underwritings. Out of the rest of the business lines, fire insurance comes next, but it only represents about 20 percent of total underwriting. Personal Accident insurance (which includes workers’ compensations) only represents 6 percent of gross premium. This pattern of branch concentration is common in emerging economies with insufficiently developed financial markets. Concentration in short term risk may be explained by a diversity of factors, including regulatory requirements as well as the lack of instruments of longer maturity. 6. The analysis of trends (Figure 4) shows that the evolution of general insurance is largely driven by auto insurance, with the rest of the branches showing much less clear patterns of evolution in the last five years. It is particularly remarkable that personal accident insurance not only represents a low percentage of the market, but also it has reduced its market share in the last years, while other insurance products expanded quite significantly. Figure 4. Insurance Underwriting by branch General Insurance Underwriting by branch in Malawi 1000 800 million K 600 400 200 0 2002 2003 2004 2005 2006 Motor Fire Personal Accidents Miscelllaneous Total C. Portfolio Structure and returns 7. Returns on investment of reserves are limited by the restrictive portfolio options. Insufficient financial and capital market development impose a strong limitation to portfolio diversification. In addition, regulations do not allow investing abroad, thus imposing an additional constraint to asset diversification. 8. The returns on investments are not the result of active investment strategies. Portfolios of insurance companies are not diversified, reflecting a feature that is common to the rest of the financial sector. In fact, Table 1 shows a strong concentration in fixed deposits, government securities and current assets. It has to be noticed, however, that a 5 large amount of investment is in “other” assets, which notably include amounts due by policyholders and reinsurers, and therefore represent an additional burden to improve the performance of investments. Table 1. Insurance and Assurance Companies Selected Assets (million K) Investment Current Assets Cash and End of Fixed Government Fixed Current Total December Assets Real Estate Securities Deposits Other Loans Assets Other Assets 2001 84.3 98.7 393.0 114.5 156.8 133.3 57.3 1,041.9 2,091.1 2003 67.8 142.2 549.9 308.8 86.0 14.1 22.1 1,001.6 2,196.1 2004 120.0 1,415.2 826.8 4,385.2 2,239.3 61.8 -7.2 1,787.5 10,828.6 2005 332.6 722.1 1,013.1 5,816.2 4,737.1 74.3 25.4 2,158.3 14,883.9 2006 (Sep) 584.9 1,549.1 3,830.6 5,201.7 14,516.7 170.3 3,783.8 42.1 29,679.1 Source: Reserve Bank of Malawi (2006), based on information provided by Insurance Companies 9. Possibilities to diversify portfolio in small economies like Malawi are severely limited by the capacity of local the financial and capital markets to provide investment options. Removing restrictions to invest abroad may offer not only more diversification options but also a more adequate instrument to expand long term insurance mechanisms such as life insurance and private pensions. D. Regulation and Supervision of General Insurance 10. The regulatory framework of the insurance sector is outdated (1957) and it does not reflect the current structure, operation and needs of the sector. An amendment to the Insurance Bill was prepared by the Ministry of Finance and submitted to the government for consideration of the Parliament. The project was discussed with stakeholders, who support the initiative and visualize it as a key element to set a regulatory framework for current operations. The initiative includes a revision of minimum capital requirements, strengthening of the regulatory capacity of RBM and introduction of governance and disclosure of information rules. However, beyond the optimism of the different actors for a more updated regulatory framework, the limitations of RBM as insurance supervisor go beyond the legal definition of competences. 11. The Non Banks Department of RBM, in charge of supervising insurance, is staffed with 11 professionals to perform all on site and off site controls of insurance, pensions and other non financial intermediaries. A self assessment of the Insurance Supervision capacity conducted by RBM concludes that most of the 28 Insurance Core Principles developed by IAIS (2003) are either not observed or partly observed. Constraints to adequate staffing include budgetary as well as technical skills. 12. On site inspections are integral but they are not performed on a regular basis and they do not adjust to written procedures. Findings and recommendations are communicated to the companies, but RBM has no enforcement capacity to impose disciplinary or corrective measures. Even if additional human and technical resources were available, the supervision authority needs to adopt an alternative risk-based supervision strategy in order to better focus on the areas or processes that show higher degrees of vulnerability and to better allocate its limited resources. Written manuals of 6 procedures would make the inspection process predictable and help the private managers to be better aligned with regulations. 13. Off site controls are based on quarterly returns requested to the companies. These returns (balance sheets) have a standard format, but some of them are received in paper and RBM has not yet set in place tools to perform tests with the IT support. Routine controls impose a high burden on the limited resources of RBM. A shift to an alternative approach to supervision will require, in any event, a consistent improvement in the quality and frequency of information. 14. In order to perform a stronger role in a growing insurance market, RBM needs to develop an action plan to substantially expand its limited supervision capacity. The current staffing of the non banking institutions department is clearly insufficient, but a potential expansion will also need a focused program to build institutional capacity. Customized learning programs may be complemented with global training events offered by academic centers, international institutions and cooperation agencies. Participation in regional or global activities of the international associations of insurance and pension supervisors might be a source of learning from best international practices and from the experience of other countries. E. Micro Insurance 15. The rural sector in Malawi represents more than 80 percent of labor force. A large number of producers have limited or no access to financial products. In the case of insurance, lack of coverage implies high vulnerability due to higher exposure to risks, especially those associated with recurrent droughts. The development of mechanisms to reduce the vulnerability to external shocks in low income countries has been an area of concern of the World Bank for some years.4 One of the mechanisms successfully adopted in some countries is indexed weather insurance. The system consists of a simple mechanism that reduces the covered contingency to a range of values of an indicator or index such as a weather index (typically reflecting rains in a year). 16. An incipient experience of weather micro-insurance product has been successfully developed with the participation of the Insurance Association of Malawi. Through this operation, 3,500 small farmers can have access to credit to buy seeds by insuring repay. A weather index is used to decide on objective grounds if the insurer will totally or partially re-pay the credit to the bank. 17. Micro-insurance projects face a number of difficulties that need to be sorted out. One of them is to engage the private sector as provider in a line of business with lower expected returns. In Malawi the use of weather indexes has proved to be successful at reducing costs, since the companies do not need to deal with multiple individual claims, and subjectivity is eliminated in assessing the contingency. A second important aspect that was successfully sorted out in Malawi is the elimination of direct relationship between the client and the insurance company. In fact, the small producers operate in 4 See, for example: Nehru, V. and M. Dorfman (2005). 7 groups (“farming clubs”), and an NGO (“National Smallholder Farmers Association of Malawi - NASFAM”)5 deals with the lending institution (“Opportunity International Bank of Malawi – OIBM”). Insurance companies have responded to this initiative by providing the coverage with the intermediation of the Insurance Association of Malawi. The Association distributes the policies among its members without need to deal individually with any of them.6 18. This project, supported by the World Bank and other international donors, faces a number of challenges. One of the problems that need to be addressed is to extend the benefits beyond the currently limited coverage radius of 30 km from the weather stations (located in airports). A crucial difficulty to implement indexed weather insurance in countries like Malawi is the existence of multiple small microclimates and high variability of weather between sub-regions. In cases like this, required investments to extend the technology become critical. 19. Further difficulties to the extension of weather insurance have been reported in a recent study conducted by X. Gine and D. Yang (2007). The study reports negative correlation between new technology adoptions (hybrid maize seeds) with insured versus non insured loans. While the authors do not identify a single factor to explain the empirically lower take-up of insured vs. uninsured loans, farmers’ education and limited understanding of insurance products have been identified as severe limitations to the expansion of weather micro-insurance in Malawi. 20. Recommendations for the General Insurance market:  Market concentration, high costs of intermediation, ad hoc adjustment of contracts and limited investment options are sufficient reasons for a sounder regulatory and supervisory structure in the insurance sector of Malawi.  A new regulatory framework is critical to enhance the capacity of RBM to supervise the insurance market, being able to address more adequately the controls that need to be set in place in order to minimize the impact of market concentration and address the problems of limited information. RBM needs to improve its supervision capacity through adequate staffing, capacity building, adopting of standard supervision procedures and use of modern IT supported supervision tools.  Further improvements should be introduced in the regulatory framework as a necessary condition to support the expansion of insurance market, to increase operations in the less traditional branches and to improve 5 NASFAM provides technical assistance and marketing to nearly 100,000 farmers in Malawi. OIBM is a microfinance lending provider for improved seeds. 6 Currently all eight licensed insurance companies are members of the Insurance Association of Malawi 8 investments by offering a more diversified menu of investments, potentially expanding the space for foreign investments.  The experience of weather insurance should be monitored and supported by the government as a clear example of the capacity of private sector mechanisms to reduce vulnerability of poorer groups. A cost-benefit analysis may be conducted to determine the feasibility of investing in extending the network of weather stations, as well as investing in educational campaigns to educate farmers on the advantages of insurance products. II. LIFE INSURANCE AND PRIVATE PENSIONS A. Market structure and Penetration 21. Individual life insurance has experienced some growth in the last years; but private pension administration and asset management is dominant in the portfolio of life insurance companies. 22. While pension provision for private sector workers is not mandated by law, about 450 private pension plans currently operate, covering 150,000 active workers. Contributions are defined by each plan in the trust deed, but a common practice is 15 percent of payroll (10 percent paid by the employer and 5 percent by the employee). 23. Coverage of the private pension system is low as compared with other countries that have mandatory pension schemes. However, very few low income countries have been able to develop a voluntary market for private pensions like the Malawian. While expansion of the market would be highly desirable, the economic structure of the country (with more than 80 percent of rural population) imposes a natural ceiling to the expansion of the system. 24. Private pension management is also highly concentrated. Three insurance companies operate in the market (NICO, Old Mutual Life Insurance and Vanguard). The largest two administer 90 percent of the pension plans (315 out of the current 350). Other pension plans are “self managed” by the employers, but in practice most of them are administered by a trust (“Indetrust”) that includes around 100 Plans and only specialized financial sector companies (like banks) manage their own pension programs. Specialized management is a positive condition for an unregulated market like the Malawian, but this certainly does not preclude non explicit governance issues or conflicts of interest in the fiduciary responsibilities of pension fund managers. B. Products 25. Private pension plans in Malawi are funded occupational schemes. Employers contribute to the plans on a voluntary basis, so the level of contribution (and, therefore, the amount accumulated by individuals) varies from one plan to another. Pension fund managers do not set the rules of the plans. However, the managers offer the option of “pool funds” that are centrally managed with similar rules, and most of the employers 9 prefer this option to the customized “segregary funds”. In the absence of regulations, market concentration contributes to homogenizing the market and it is a “second best” option to a common set of rules, with standard contribution rates of 15 percent (10 percent paid by the employer and 5 percent deducted from payroll). 26. The plans are not integrated, and pension rights are not portable. Workers who move from one job to another may not have the option of continuing contributing, they may move to a plan with different rules, or they may simply use the fund accumulated in the old job and start a new job without any retirement savings. Most commonly, workers who move to another job receive a lump sum that may serve to any short term purpose, in detriment of the long term objectives of pension arrangements. 27. According to Tax Act regulations, benefits are paid upon retirement (age 60) in the following way: 1/3 as gratuity (lump sum) and other 2/3 as annuity provided by the insurance companies or the funds. However, pensions below K 36,000 per year (raised to 120,000 effective July 2007) can be fully withdrawn as a lump sum. 28. The development of a market for annuities faces a number of challenges. For an economy with high history of inflation, lack of explicit regulations regarding indexing or adjusting procedures is a serious drawback. Although there are no general patterns, there are usually two types of annuities: a) fixed, and b) progressive. In the first case, the amount of the annuity is defined “constant”; in the second, the initial capital withdrawals are lower and gradually adjust to higher amounts. In both cases, ad hoc adjustment mechanisms are often set in place to reflect the performance of investments. This is an indirect but non transparent mechanism of adjustment to the loss of value of the Kwacha. 29. In absence of adequate mechanisms to adjust pensions, people have a strong preference to receive their payments as lump sums as opposed to annuities. The decision is quite rational, but it compromises the main objective of a pension system: to provide income protection in the old age (and after disability or death of a worker). Due to myopia of individuals, most countries in the world had to introduce savings for retirement on a mandatory basis, and even those with well developed private retirement savings programs have restrictions to withdraw the amounts accumulated as lump sum. 30. While regulation is not the only factor to promote the development of a market for annuities, it is a pre-condition to support this development. In Malawi, a recent amendment to the Taxation Act, echoing public expectations, has substantially increased the maximum amount that retirees are allowed to receive as a lump sum from 36,000 K per year to 120,000K. Given the observed strong preference for present consumption in view of the inadequacies of annuity products, it is expected that very few beneficiaries will opt to receive their pensions as monthly installments. C. Pension Fund Management 31. In the absence of regulations for private pensions, information is very limited and only in some cases pension fund managers disclose their information voluntarily. As a 10 general rule, however, it is very difficult to produce any analysis of the sector with so limited access to information, even for the public agencies in charge of supervising. 32. Limited investment options and prohibition to invest abroad also restrict portfolio diversification of pension funds. There is no information for the whole market, but a leading pension fund administrator has the following portfolio structure: a) Treasury Bills: 25 percent; b) Deposits: 10 percent; c) Loans: 14 percent; d) Shares: 39 percent; e) Real Estate: 12 percent. Limits to diversify portfolios structure affect the possibility to diversify options for different groups or to invest in longer term instruments, as it would normally be expected for pension funds. D. Regulation and Supervision of Life Insurance and Private Pensions 33. The regulatory framework and supervision of Life Insurance and Private Pensions are even weaker than in the case of General Insurance. As a consequence of the regulatory and supervisory vacuum, availability of information is very limited. Accumulated funds are estimated in about K 45 billion (around 15 percent of GDP), most of which are managed as pools by Life Insurance Companies or a trust. The annual flows of contributions to the funds are estimated in an amount close to K 5 billion. 34. Private Pension schemes in Malawi are extremely under-regulated. The few existing rules at present are included in the Taxation Act, and include the obligation to register, to submit annual reports and to report new pension payments to the Malawi Revenue Authority (MRA). 35. The Income Tax Commissioner of MRA exerts the only formal supervision over the pension plans, but it lacks operational and enforcement capacity. There is only one person assigned to this task, and IT support is inexistent. Private pension plans are required to send their financial statements to MRA every year, as well as any amendment to the plan. However, due to the severe constraint of resources and technology, the information is neither processed nor used for any control purpose. 36. One of the main obstacles to develop the market for private pensions is the overlapping between this benefit and the severance pay. Although both types of benefits are conceptually different, in the absence of a mandate to contribute to a pension scheme, severance pays are increasingly used as a substitute of pensions. This practice has been extended to the extreme case of unduly duplication of benefits upon retirement and the consequent reluctance of employers to continue financing voluntary pensions. According to a Judiciary statement, this situation is the consequence of the ambiguous text of the Labor Act and can only be solved with an amendment of this act. 37. The Ministries of Labor and Justice have been working together in the preparation of an amendment to the current legislation. The new bill would allow employees to choose either severance or pension benefits. While this solution would correct the duplication, it does not appear to address the specificity of both types of benefits. The political economy of this legal reform, however, seems to be an even harder obstacle, and the duplication of benefits does not appear to be corrected in the near future. 11 38. Taxation rules for voluntary pensions are usually considered mechanisms to entice the market development. Although there is no general agreement regarding the expected impact, it is clear that taxation rules must be coherent and double taxation should be precluded. In its origin, the system did not tax contributions up to a certain level, and taxed the benefits, also above a certain minimum. The erosion of the ceilings by inflation distorted tax collection, and corrective mechanisms set in place have been “ad hoc”, responding to short term needs rather than long term planning. The structure of taxation is thus complex and unclear. The system should move back to clearer (standard) criteria of taxation with explicit mechanisms to adjust ceilings. 39. Recommendations:  At minimum, preserving the existing incentives for voluntary pensions requires a clear regulatory framework as a necessary (but not sufficient) condition; this should include a clear delimitation of the coverage of pensions vs. severance pay, and stable and transparent taxation rules.  Adoption of adjustment mechanisms to correct the effects of inflation on the amounts of pensions will preserve the income of retirees and prevent the use of “ad hoc” discretionary solutions and distortions.  Similar considerations as in general insurance regarding the supervision capacity of RBM. III. PUBLIC PENSIONS A. Current PAYG system for Civil Service and Military 40. Pension provision for the Civil Service and Military is organized as a pure Pay-as- you-go (PAYG) scheme that covers about 125,000 active workers and pays benefits to about 30,000 beneficiaries. 41. There are minimum conditions of age and years of service to be eligible for a pension, but the conditions may substitute each other in some cases. A civil servant will be eligible if he/she has: a) 60 years of age and minimum of 10 years of service; or: b) minimum of 20 years of service, regardless of the age. At 10 years of service, a lump sum is paid as termination benefit. With less than 10 years of contribution there is no right to any benefit. In the case of the Military, a minimum of ten years of service is required, and there is no minimum retirement age. 42. Although there are no contributions to the public pension scheme, an “implicit contribution rate” was estimated by Gillingham et al. (2006) as equivalent to 22 percent to 30 percent of salaries, depending on the assumptions of sustainable returns.7 As 7 The rate of 30 percent corresponds to a rate of return of 2 percent per year, while the rate of 22 percent corresponds to 4 percent. In both cases, implicit cost of life insurance for disability and survivorship pensions were included. (Gillingham, R. et al, 2006). 12 compared with any international standard, these rates are very high and reflect the generosity of the system.8 43. Before year 2004, pensions were calculated as a percentage of the basic salary. An accrual rate of 3.3 percent per year of service was used to compute pensions. Basic salaries did not include allowances or gratuities, so pensions were equivalent to about 1.1 percent of gross salary per year of contribution.9 Total pensions in 2003 represented 0.70 percent of GDP. 44. In year 2004, a wage reform for the civil service re-defined salaries to include all concepts as remuneration, producing a significant increase of the salary base for taxes and pensions. The unexpected effect on pensions was corrected with the ad-hoc mechanism of replacing the last salary by the average of the last five years of service for pension calculation. The effect of this measure was to reduce the replacement ratio (as percentage of the last salary) in the first year after the reform, although the overall pension bill significantly increased. As time passed, however, this ad-hoc mechanism would lose all effectiveness. The accrual rate was later re-defined to (partially) compensate for the definition of the reference wage. 45. The wage reform of the civil service triggered a discussion on longer term issues that had been so far absent in the pension policy discussion in Malawi: Would the civil service pension scheme be able to provide affordable and equitable pensions in sustainable conditions? 46. A contributory PAYG pension scheme is sustainable in the long term if the present values of pensions and contributions are equivalent in that timeframe.10 In the case of non contributory schemes the concept of sustainability needs to be re-defined: in the absence of contributions, a target (maximum) pension payment as a percentage of GDP could be used alternatively. Before 2004, the cost of the civil service pension scheme was 0.7 percent of GDP.11 Regardless of any long term factor that might have affected the sustainability of the public pension system in 2004, the wage reform produced a phenomenal increase in pension expenditures 47. Since 2004, the basis of calculation was changed to the average of the worker’s salaries perceived during the three years prior to retirement. In order to compensate for the higher salary based used, the accrual rate was redefined as 2.5 percent per year for lower salaries and 2.2 percent for higher salaries. This change in the rules of the system 8 The basic parameters of a PAYG system are: contribution rate, accrual rate, retirement age, vesting period and indexing rules. Given a sustainable rate of return for the pension system, there parameters are inter- related. In a sustainable PAYG pension scheme, some of the parameters may be discretionally defined, according to the objectives of the pension system, but at least one of them will necessarily result endogenous. 9 This percentage is the result of applying 3.3 percent to a basic salary that represented about one third of the gross salary. 10 Holzmann, R. and R. Hinz (2005) 11 Gillingham et al. (2006). 13 implied a shift from a mainly redistributive pension scheme that paid basic benefits to an earnings related scheme. 48. As seen in Figure 5, however, salaries in the public sector grew faster than public pensions, even after year 2004. This can be explained by a number of reasons, such as the following: a) the adjustment in the accrual rate factor; b) the use of average salaries without indexation as base income for pension calculation purposes; c) the lack of indexation rules; and d) the relative immaturity of the pension system. Figure 5. Salaries and Pensions of the Public Service Malawi - Salaries and Pensions of the Public Service Billion Kwachas 25.00 20.00 15.00 10.00 5.00 0.00 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Salaries Pensions Source: Reserve Bank of Malawi (2006) 49. The lower accrual rates are insufficient to prevent by themselves an explosive evolution of pensions as the system matures and covered population structure evolves. In fact, when compared with international standards, an accrual rate of more than 2 percent per year of service is high, and in the case of contributory systems it can only be associated with high contribution rates if the system has to be financially sustainable. 50. The fact that the Malawian pension system is a pure PAYG scheme precludes an explicit discussion of long term sustainability, but in essence, long term financing problems may be similar to those of a contributory scheme if the parameters are too generous. In a contributory scheme, the inconsistency (long term non sustainability) will be manifest in the mismatch between revenues and expenditures. In a non contributive scheme, it may take the form of an explosive growth of benefit payments. 51. The current accrual rates for the public service pensions in Malawi is even more generous if we take into account the comparatively short vesting period in the current regulations. In fact, workers may be eligible for pensions since they have only 10 years of contribution. Lower total replacement ratio is not enough as disincentive for early retirement, since the accrual rate is constant along the whole career. 14 52. The use of averages is another usual mechanism to lower the pensions as opposed to the last salary.12 Generous accrual rates were applied in the past to base salaries. Change in base salaries affected pension calculations. Adjustment was made by reducing the accrual rate from 3.3 percent per year to 2.5-2.2 percent calculated on average of last 3 years. 53. Pensions are paid upon retirement as a monthly payment, but part of the total benefit (up to 25 percent of full pension) may be received as a one time payment or “Gratuity”. A reduced pension with a present value of the remaining 75 percent is paid monthly. 54. Inflation erodes pensions. In Malawi, as in several other countries, the absence of indexation mechanisms is an instrument to adjust pensions to an affordable level for the public budget. However, this adjusting mechanism is both inequitable and inefficient. In fact, the absence of automatic adjustment mechanisms introduces an unintended income redistribution effect from the older pensioners to the recent retirees. By this distributional effect, only recent retirees receive the promised generous pensions, but these will result substantially reduced by inflation and lack of indexation. 55. Automatic indexation is needed in order to preclude non desired income redistribution from older to new pensioners. Since this would impact the financing of the system, the parameters need to be adjusted to reflect the long term sustainable level of pension that the budget is able to maintain. As Figure 6 shows, the introduction of indexation mechanisms will result in an increasing fiscal burden of the public pension system, unless the parameters of the system are revised accordingly. As observed in the graph, under the assumptions adopted for projection, wage indexation will increase the burden of the public pension system by 10 percent in only 5 years. Gillingham et al (2006) also show that preventing an explosive expansion of pension expenditure is possible if the key parameters of the system (accrual rate, reference income, retirement age) are adjusted accordingly. 12 In theory, this mechanism can be used to reduce the risk of salary fluctuation, but this argument is weak when applied to public pension schemes. It may also be used to reflect more accurately the worker’ s contributory history, or to better define the target income to be replaced by pensions. 15 Figure 6. Public Pensions Projected with Different Indexation Mechanisms Malawi: Public Pensions projected with different indexation mechanisms 2.5 2 % of GDP 1.5 1 0.5 0 03 04 05 06 07 08 09 10 11 20 20 20 20 20 20 20 20 20 Baseline Wage indexed benefits Price Indexed benefits Source: Gillingham et al (2006), based on information provided by the Ministry of Finance of Malawi B. Shift to a Contributory Pension scheme 56. The pension system for civil service and militaries was designed as a pure PAYG non contributory scheme in which the system’s liabilities are the sole responsibility of the government as employer. 57. Since the government became aware of the need to introduce reforms in order to make the current system sustainable, a number of alternative projects have been under analysis. Among them, three main groups deserve special consideration: a) Shifting to a funded contributory scheme; b) Moving to a contributory PAYG scheme; c) Parametric reforms of the current pure PAYG scheme. 58. The shift to a funded contributory scheme is the most radical option. For several years after the Chilean pension reform of 1981, such a paradigm has deserved particular attention from countries trying to move away from the trend to chronic deficits in the pension systems. The system has also been promoted as a catalyst of private savings and growth. In recent years, closer attention is being paid in the international debate on pension reforms to the “enabling conditions” that need to be verified before adopting such radical reforms.13 In the case of Malawi, with poor financial market development, insufficient experience in the provision of annuities and weak supervision, conditions are not yet verified for such a radical option, as noted by Gillingham et al (2006). 13 Holzmann and Hinz (2005). 16 59. The shift to a PAYG contributory scheme faces two main obstacles. The first is the need to invest public reserves, which will impose additional demands in governance and institutional development.14 The second difficulty is to make contribution rates explicit. As mentioned above, necessary contribution rates for the current pension system are very high and they might be considered unacceptable. It should be noted, however, that while the existing system does not impose an explicit cost to the employer (i.e., the government), the implicit cost should not differ from those of the non contributory PAY scheme so long as the parameters of the system are not substantially reviewed. While this does not happen, the Civil Service Pension Scheme will impose a similar burden to the budget, and this will increase as the system matures and more workers retire. 60. A consistent parametric reform of the pure PAYG should follow the principles of sustainability, affordability and equitability. Discretionary manipulation of parameters is not effective to address these reforms, even if the changes are in the right direction. This was the case with recent reforms adopted in Malawi: the direction was right but they were adopted on an “ad hoc” basis, under a weak regulatory framework and without the participation of key social partners. 61. Examples of parametric reform options are presented by Gillingham et al (2006). With strong limitations due to the lack of reliable databases, the authors project two alternative reform scenarios: a) baseline with wage indexation; b) accrual rate of 2 percent, price indexation and discount of lump sums (lower cost options). The result in the first scenario is an increase of pension expenditures to 3.14 percent of GDP in 2025 (starting at 0.7 percent in 2004). The less expensive option is, however, also costly since expenditures rise to 1.72 percent of GDP. It should be noted that the higher costs would be equivalent to an increase in contribution rates, already high at the onset of the reform. Higher retirement age, while consistent with the parametric reform, should not be considered as an effective instrument to substantially reduce pension expenditure (Gillingham et al, 2006). 62. Sustainable and affordable combinations of PAYG parameters need to adjust to the equilibrium equation: A (a,t) = c / [g (a,t)], where A (a,t) is the accrual rate for retirement age “a” at time “t”, and: g (a,t) = g [ s(a,t), r], where s (a) is the probability of survivorship at age “a”, r is the sustainable return rate of the PAYG scheme, and: 14 Musalem, Alberto and Robert Palacios (2004). 17 Indexing rules are necessary to preserve the real value of pensions, but this in turn will require further reduction of accrual rates in order to have (implicit) contribution rates acceptable for international standards. 63. Recommendations:  The reforms introduced in the civil service pension scheme in recent years are in the right direction but they were designed on an ad hoc basis, and further analysis of the long term implications needs to be conducted in order to design a set of parameters that is consistent with the principles of sustainability, equitability and affordability.  The shift to a contributory scheme may be an important next step to make the system more transparent; however, governance and investment policies, as well as the institutional and regulatory framework need to be set in place before this reform takes place.  Enabling conditions are not verified in Malawi for the introduction of a systemic shift to a funded pension scheme; in the near future, it is recommended to limit these schemes to the voluntary tier of the pension system.  Parametric reforms should include indexation rules, which will in turn require further review of accrual rates and eligibility conditions to long term affordable levels. IV. SUMMARY AND RECOMMENDATIONS 64. The insurance and private pension sectors in Malawi show a low level of penetration, but they seem acceptable in comparison to other countries in similar stages of development. Concentration and costs are high, the regulatory framework is outdated or inexistent and supervision is weak. 65. There are some innovative experiments with (weather) micro-insurance, the main challenges being its extension through the adoption of necessary investments and increasing education in the uses and possibilities of insurance mechanisms. 66. Life insurance and private pensions plans are not regulated, portfolios are not diversified, and benefit rules (included indexation) are defined on an “ad-hoc” basis. 67. The parameters of the current PAYG pension scheme are very generous and they severely compromise an evolution at socially acceptable costs. Conditions are not verified to shift to a funded scheme, and a possible move to a contributory PAYG scheme would not solve the basic parametric inconsistencies. The move to a sustainable pension scheme will inevitably imply the need top review the benefit formula and adjust the accrual rate. 68. In spite of the generous parameters of the public PAYG scheme, inflation erodes pensions and most pensions are paid as lump sums, affecting the ability of the pension 18 system to provide lifetime income protection. Explicit indexing mechanisms are recommended, once the sustainable parameters for the system are adopted. 69. In order to address the issues mentioned above and to promote sound and sustainable growth of the insurance and pension systems, it is recommended that the government of Malawi:  Enact pending legislation to strengthen the regulatory framework and the supervision capacity of the insurance and private pension sectors.  Develop a capacity building program to improve the quality of supervision, including training in the adoption of a risk based supervision strategy.  Reassess the sustainability and affordability of public pension scheme and, in light of the results, review retirement age, accrual rate and indexation mechanism. V. REFERENCES Alexander Forbes Financial Services (2000): “Financial Report on the Actuarial Investigation into the Possible conversion of the Malawi Civil Service Pension Scheme to a funded arrangement as at 31 May 2000”. Mimeo. Carmichael, Jeffrey (2005): “Malawi: NBFI Capacity Building Strategy. Final Report”. FIRST Initiative-Carmichael Consulting Pty. Nerang, QLD, Australia. Mimeo. _________________ (2006): “Malawi: Strengthening the Legal Framework for NBFIs and providing preliminary advice on Pension Reform. Final Report”. FIRST Initiative- Promontory Financial Group Australasia. Singapore. Mimeo. Gillingham, Robert, Thomas Dalsgaard and John Greenlees (2006): “Malawi: Reform of the Civil Service Pension System. Aide Memoire”. International Monetary Fund, Fiscal Affairs Department. Washington DC. Gine, Xavier and Dean Young (2007): “Insurance, Credit and Technology Adoption: Field Experimental evidence for Malawi”. Mimeo. Holzmann, Robert and R. Hinz (2005: “Old-Age Income Support in the 21st Century: An International Perspective on Pension Systems and Reform”. The World Bank, Washington DC. International Association of Insurance Supervisors (IAIS) (2003): “Insurance Core Principles and Methodology”. Musalem, Alberto and Robert Palacios (2004): “Public Pension Fund Management”. The World Bank. Washington DC. 19 Roth, Jim, M. J. Mc Cord and D. Liber (2007): “The Landscape of Microinsurance in the World’s 100 Poorest Countries”. The Microinsurance Centre. Appleton, Wisconsin. Nehru, V. and M. Dorfman (2005): “Managing the debt risks of Exogenous shocks in low income countries”. World Bank, Washington. Mimeo. QED Actuaries and Consultants (Pty) (2005): “Confidential Report on the Actuarial Investigation into the possible conversion of the Malawi Civil Service Pension Scheme to a funded arrangement as at 31 December 2004”. Mimeo. Reserve Bank of Malawi (2006): “Financial and Economic Review”. Vol. 38, Nr. 4. Blantyre. Mimeo. ______________________ (2005): “Insurance Annual Report 2005”. Blantyre. Mimeo.