46853 1 World Bank ­ Human Development Network The Financial Crisis and Mandatory Pension Systems in Developing Countries Short- and medium-term responses for retirement income systems T he international financial crisis has severely allow for a better diversification of risks and thus affected the value of pension fund assets provide better protection to individuals who may be worldwide. The unfolding global recession will vulnerable to the kind of economic shocks now also impose pressures on public pension schemes being experienced. financed on a pay-as-you-go basis, while limiting the Increasing attention should be paid to capacity of governments to mitigate both of theses managing the exposure of individuals to short effects. Governments are reacting to these events in term financial risks in funded systems. different ways. Some are asking whether the balance Strengthening the management of exposure can between funded defined-contribution and unfunded be achieved through both default portfolios pension schemes should be reconsidered. A few designed for workers nearing retirement age and also have already taken actions to reverse prior reforms. the development of phased transitions to the payout This note discusses the potential impacts of the of benefits that limit the impact of short term financial crisis on fully funded and pay-as-you-go financial volatility. retirement-income systems in World Bank client countries, and identifies key short- and medium-term policy responses. The note does not go into depth The impact of the financial crisis on on the issues identified. Stand-alone technical notes funded defined-contribution pensions will be prepared subsequently. This note itself will The impact of the financial crisis on individuals be updated and refined as new issues emerge. participating in funded defined-contribution schemes The main messages from the note can be depends on four main factors: (i) changes in asset summarized as follows: prices and the potential recovery over the medium Abrupt policy changes in response to the term; (ii) the proportion of pension wealth that is immediate circumstances should be avoided. supported by funded individual account assets; (iii) Pension systems are designed to function over long the presence of minimum social pensions or time periods. Poorly designed short term responses guarantees that are integrated into the pension system; to relatively rare events can potentially have negative and (iv) the requirement and framework for long-term consequences on the capacity of pension mandatory annuitization of the accumulated balance systems to reliably provide adequate levels of at retirement. retirement income. Losses in asset values over the last 12 months reported by It is important to observe that only a small pension funds have been considerable. In client countries number of retiring individuals are affected by with funded systems these losses have ranged the crisis. Targeted measures can be considered to between 8% and 50% (Table 1). While the losses are mitigate the losses in their savings and the value of disturbing to plan members over the short term, they their pensions. should not be taken as an indicator of the overall The current crisis strengthens the need for longer term performance of the funds which is the diversified multi-pillar pension systems. These relevant perspective for any pension system. Indeed, The Financial Crisis and Mandatory Pension Systems in Developing Countries 2 from 1994 through 2007, in 13 countries for which Retirement-income systems that are more exposed data is available, the mandatory pension funds to the financial crisis include those of Chile, El experienced an annual real rate of return of 6% per Salvador, Mexico and Peru, where defined-benefit year (Figure 1). In Chile, for instance, even with the pension systems were eliminated and the majority of losses observed up to August of this year, real returns retirement incomes will come from funded defined for 2002-2008 ranged between 3% to 10% a year contribution pensions (Figure 2). In Mexico, depending on the type of portfolio. (AFP, 2008). however, the government guaranteed that overall pensions under the new system would be at least as Table 1: Real Returns of Mandatory Pension Funds large as those under the pre-reform pay-as-you-go (year-on-year) scheme for people already covered. The impact of the declines in asset values in Mexico will therefore Growth Balanced Conservative Chile 13-Oct -46.1 -23.1 0 be compensated for persons who retire before asset Mexico 30-Sept -8.3 -6 -0.5 values recover. Peru 10-Oct -47.8 -33.9 -14.5 Uruguay 30-Sept -7.5 Croatia 30-Oct -14.1 Figure 2: Role of Financial Assets in the Retirement Estonia 15-Oct -30.5 -20.9 -9.7 Package Hungary 15-Oct -35 -18 Lithuania 15-Oct -48.4 -32.6 -9.4 C h ile P e ru Poland 30-Sept -17.4 M e xic o Slovak Republic 13-Oct -12.4 -10.3 -2 E l S a lv a d o r Ic e la n d U nite d K in g d o m Source: Bank staff. D e n m a rk L atv ia N eth e rla n ds S lo va k R e p u b lic Figure 1: Long Term Pension Fund Returns D o m in ica n R e p ub lic A u stra lia P o la n d E s to n ia Uruguay Ire lan d U n ite d S ta te s Peru L ith u a n ia S w e d e n Poland C a n a d a B u lga ria Chile H u n g a ry A rge n tin a El Salvador U ru g u a y G e rm a n y Bolivia C o s ta R ic a M a n d a tory de f ine d co n trib utio n S w itze rla n d D e fin e d b e n e fit Mexico N o rw a y Vo lu n ta ry p riv a te p e n s io n s B e lg iu m Costa Rica 0 2 5 5 0 7 5 1 0 0 Colombia P riva te p e n sio ns , p e rc en tag e o f to ta l re tire m en t p a c ka g e Hungary Argentina Note: calculations are based on weighted average pension wealth and are for full-career workers. See OECD (2007) and D'Addio, Seisdedos and Croatia Whitehouse (2008). Czech Republic Source: APEX model and Whitehouse (2007). 0 2 4 6 8 10 12 14 Real Average Gross Annual Return 1994-2007 (%) Many countries also provide social pensions or offer minimum Note: For countries where the reform was implemented after 1994 (e.g., pension guarantees. The main objective of these Croatia) the rate of return is from the point of inception. Source: Bebczuk and Musalem (2009) provisions is to prevent poverty during old-age. They are part of contributory or non-contributory (zero-pillar) systems. The average value of these Most countries with mandatory funded pensions have multi- benefits across countries for which information is pillar systems in which funded individual accounts form only part of the overall retirement package. In a majority of available is around 30% of the average economy- wide earnings (Figure 3). As a result, even where countries, the pension individuals receive also has a pensions are heavily exposed to fluctuations in the defined-benefit component and often there are value of financial assets, in many cases minimum minimum pension guarantees (see below). All of the pension guarantees shield lower-income workers countries in Eastern Europe/Central Asia (ECA) from poverty. Of course declines in asset prices can except Kazakhstan that introduced funded schemes still materially reduce retirement benefits. maintained a defined-benefit system as well. In Lithuania and Hungary, for example, less than 30% of the retirement benefit package for retirees today comes from financial assets in individual accounts. 3 The Financial Crisis and Mandatory Pension Systems in Developing Countries .Figure 3: Minimum Pension Guarantees lower rate of return, they shield plan members from Iran most of the losses in asset values. In Chile, which Colombia Portugal Brazil introduced the multiple funds in 2002, older workers Egypt Louxembourg are limited to the more conservative funds one of Jordan Switzerland Algeria which is a default option if they make no other El Salvador France Spain choice. As a result 80% of the members within 5 UK years of retirement age are invested in one of the Tunisia Turkey Peru two most conservative portfolios and have been Croatia Mexico Poland USA Hungary largely shielded from losses. Although small in Slovakia Iraq Uruguay number, however, if these retiring workers are Costa Rica Average Bulgaria severely affected it will have a potentially important Morocco Estonia influence on the way in which the reformed 0% 10% 20% 30% 40% 50% 60% 70% Minimum Pension (Percent Average Earnings) pensions are perceived and a political influence well Source: Staff calculations, Robalino et al. (2005), and Whitehouse (2007) beyond the economic impact and so will likely need to be addressed in some manner. Only a small number of workers will retire during the period in which their pensions would be reduced due to the decline in asset values. Those workers facing the most Are defined-benefit pay-as-you-go important recent decline in their pension benefit are pensions affected as well? those who have to retire in the midst of the crisis and, Earnings related pay-as-you-go pension systems will in particular, those who are mandated to transform be affected in a less dramatic and immediate way as their accumulated retirement savings into an annuity. the economic downturn reduces their stream of Most of the countries with mandatory funded revenue and potentially increases benefit claims. systems have established these during the last twenty Indeed, the emerging global recession will reduce years and typically included only workers who were contribution revenue in most countries as a result of more than 20 years from the normal retirement age. decrease in employment or reductions in the level of Although some permitted older workers to also earnings on which contributions are levied. In switch into the funded system, except in a few addition, pension expenditures from such schemes countries, the rates for older workers were not very will likely increase as more individuals retire from high. Therefore there are relatively few individuals the labor force and seek pension benefits in the face with a large reliance in a funded account who will be of an economic downturn. Disability claims can also retiring in the short term. increase in response to higher unemployment. The situation varies between regions. In the The extent of the financial impact depends significantly on the countries of Eastern and Central Europe and Asia maturity of the scheme. Countries which will face the (ECA) that reformed their systems beginning in the greatest fiscal pressures are those where financial early 1990's the full cohorts will retire in 15 or more flows from contributions and investments are less years and partial cohorts in 4 years (see Annex). In than current expenditures, and those where liquid Latin America, where reforms occurred earlier the reserves could face the greatest fiscal pressures. situation is different as funded pillars already affect Examples of countries in this situation include: workers retiring now (see Annex). But even in these Azerbaijan, Brazil, Egypt, Morocco, Russia, Serbia, cases there is a minority of plan members who are and Tunisia. Those countries in a less frail financial affected. For instance, in the case of Chile, the situation will need to reduce cash balances country with the oldest funded pillar, only 5% of temporarily and/or draw on reserves. However, it plan members have to retire in the next 5 years and should be possible to repair the effects once the many other countries have a far lower percentage. crisis has passed. In addition, some funded systems have established The effects on members will depend on how governments deal multiple portfolios that include conservative options with the shortfall in revenues. They could finance that are primarily invested in short term government pension-scheme deficits in full. Alternatively, they debt. Although these portfolios provide a relatively might partially default on pension promises, by The Financial Crisis and Mandatory Pension Systems in Developing Countries 4 delaying pension payments or failing to index Similarly, moving asset allocations to what are benefits, for example. The balance between the two perceived as more secure instruments such as short options will be politically determined as pensions are term government debt may placate members with just one of a range of competing demands for diminishing accounts but will severely limit the limited public resources. The main difficulties will be opportunities for higher retirement benefits. observed in countries that have overall fiscal deficits Analysis of historical patterns in the asset markets of and rely on external debt financing that has become developed countries demonstrates that, despite increasing difficult to refinance with the global credit significant variation in rates or return due to market crunch. volatility, a diversified portfolio of assets would In some cases (as recently occurred in Argentina) countries result in a higher level of retirement savings over that have introduced funded second pillars may be tempted to nearly all time periods (see Munnell, Webb, and re-allocate the portion of the social insurance contributions that Golub-Sass, 2008). previously went to pay-as-you-go schemes back to the public Secondly, governments should recognize that the current schemes. Although this might address short term cash financial crisis is a rare "extreme" event. As such, it flow issues, it does not improve the overall public requires temporary measures to deal with the effects net-liability position, and it risks having negative of the crisis rather than structural changes in policy. long term consequences on the individual benefit Moreover, any compensation arrangements that may position. In addition to diminishing the be considered need to be carefully designed. Once diversification of the overall retirement system and established these could be very difficult to eliminate placing workers at the risk of future benefit even when conditions no longer warrant them. reductions if the system can not remain viable over Thirdly, governments should not underestimate the potential the long term with the increased liabilities, this will positive effects that long term institutional investors (such as also close funded account when asset values are low, pension funds) can have on the financial system enterprise locking in losses and precluding members from the financing, and ultimately employment and growth. opportunity to benefit from any recovery in prices. Countries with well-developed, regulated and supervised pension funds (such as Chile) have been Short-term responses able to weather past shocks much better as the purchase of commercial bonds partially In the short-term, governments are advised not to compensated for reduced access to Bank loans. overreact to current economic conditions and to There is emerging evidence that pension funds are carefully analyze the full consequences of policy moving into loan markets previously dominated by responses in the context of the long-term planning commercial and investment banks (such as in the horizon relevant for pensions. Three general Netherlands). recommendations are made. The following short-term measures should be First, governments should avoid short-term reform reversals considered: that have not been properly assessed and that may come at a high price for future retirees. Reverting workers more · Establishing a public information campaign to explain than five years from retirement to a pay as you go the situation to members of funded and defined- system may be attractive and politically expedient. benefit pension schemes, informing the public of However, this implies that government would be the volatility of investment returns, providing reinstating an implicit pension liability with the pay- detailed information on the actual and as-you-go system (in exchange for the assets they anticipated effect on benefits for workers of borrow now) and that will need to be financed in the different age groups, and describing measures future. Limiting contributions to funded systems in such as minimum and/or non-contributory the current period will also deny members the pensions to protect the poorest and most opportunity to receive higher pensions in the future. vulnerable. Such an effort would ideally be This is particularly true now when plan members undertaken in any event in order to improve the could purchase assets at relatively low prices and understanding and financial capability of workers thus accrue large potential gains. that will have beneficial long term effects beyond the pension system. The current crisis can 5 The Financial Crisis and Mandatory Pension Systems in Developing Countries provide the impetus for such an effort and benefits. Any such effort should bear in mind, creates an ideal opportunity for it to be effective however, that many pay-as-you-go pension as workers are more attentive to financial issues. systems cover only the wealthiest minority of the · Establishing a framework for phased or deferred labor force and that such support could come at annuitization or the alternative of receiving benefits the expense of other more vulnerable groups not through phased withdrawals on reaching retirement age. covered by the formal pension system. This is important for those funded schemes with · Reconsidering the valuation rules applicable to pension mandatory annuitization. As discussed above, fund assets in the context of the extreme current volatility the individuals most at risk from the rapid in financial markets. There has been a current (and decline of asset values are those very close to largely beneficial trend) toward requirements for retirement who potentially lock in the large mark-to-market valuation of the assets of all declines when they convert their savings into an types of financial institutions including pension annuity. Allowing for phased withdrawals and funds. While this generally increases the gradual purchase of annuities can enable transparency and the value of disclosure there individuals to realize the effects of an eventual may be circumstances, such as the current crisis, recovery by not requiring the liquidation of in which it proves to be counterproductive. invested assets until their value has some time to Regulators and supervisors (as some have recover. already done) may consider relaxing these rules · Considering a limited and time-bound support program to smooth presented valuation when extreme for the small group retiring in the midst of the crisis that short term price movements occur. Some will be most affected. Indeed, there are some, smoothing in periods of extreme volatility more primarily, low income workers with lower saving accurately reflect the true underlying values and levels who might, even under a phased annuity avoid the possible adverse reactions to large purchase or withdrawal program, be required to changes that prove to be very short term. liquidate their diminished accounts in the short term. This group could be assisted through Medium-term responses programs that a offer a minimum return guarantee, analogous to what has been provided The financial crisis provides a strong impetus for all in the banking system in response to the crisis. countries to review the design and implementation This help should be accessible only to people of policies to best achieve the core objectives of close to retirement and targeted by level of retirement systems. It particularly highlights the income. The principle would be to compensate value of diversification in the overall system design individuals facing a major decline in net and the need to effectively manage the risks replacement rates. Such an effort would then be associated with funded arrangements. Over the phased-out as the recovery reaches certain medium term, attentions should be given to the trigger points. In all cases, however, the following issues: opportunity costs and distributional effects of · Better diversifying the management of financial and other the public resources involved should be carefully macroeconomic risks. The financial crisis assessed. strengthens the case for a multi-pillar pension · Helping pay-as-you-go systems to remain financial viable system, which can be highly resilient in the face and protecting the benefits of low-income workers. As of even severe financial and economic suggested above, in many cases the government turbulence. The multi-pillar system would may need to provide additional financing for incorporate elements of a well targeted social public pension schemes to replace a decline in pension or minimum guaranteed benefit (a zero the collection of workers contributions. pillar) to ensure broad protection against Government could also consider options to poverty; a sustainable earnings based first pillar, maximize protection of low income workers and funded second pillar. The three operating facing declining salaries by offering flat-rate together would provide core benefits to the minimum pensions and full indexation of broad population even during the low points of The Financial Crisis and Mandatory Pension Systems in Developing Countries 6 the economic cycle. Key questions for effects of future economic volatility on the governments will be: (i) how to set the level of vulnerable elderly and lifetime poor. These the basic pension and its eligibility conditions to; systems need to be carefully designed to ensure and (ii) how to allocate the contribution rate their affordability and that they do not have between the first pillar (more exposed to labor negative incentive effects market risks) and second pillars (more exposed · Integrating unemployment savings and insurance options to financial risks). into an overall social insurance system. Pension · Improving the management of financial risks. For systems can become de facto unemployment the funded (second and third) pillars, the crisis insurance systems in period of economic should prompt renewed attention on the disruptions as workers losing their jobs seek to importance of well developed risk management claim retirement or disability benefits when other and governance standards and integrating these alternatives are not available. Some countries into the regulation and supervision of pension need to consider stronger restrictions on funds. In addition, mechanisms to better shield disability claims and early retirement, while retirees from the impact of account fluctuations strengthening the income-protection systems for immediately before retirement should be workers who lose their jobs. Policy options explored. These could include the introduction include combinations of unemployment of age based/life-cycle portfolios which require insurance and unemployment individual savings low and middle income workers to switch part accounts that can be accessed during spells of of their balances to less risky investments as they unemployment. get closer to retirement. Default age- and earnings-related asset allocations are also important in light of the observed inertia of contributors. · Making pay-as-you-go systems more sustainable, robust and secure. For the first pillar, countries should consider the adoption of Notional Defined Contribution schemes where benefits are linked to contributions and life-expectancy at retirement. Ideally, these systems would incorporate a reserve fund and an appropriate balancing mechanism to adjust to demographic and economic developments. At the minimum, countries with traditional defined-benefit systems should introduce changes in benefit formulas and eligibility conditions to: (i) gradually incorporate all salaries in the calculation of the pension, with past salaries indexed by the growth rate of the average covered wage; and (ii) link the calculation of the accrual rate to the retirement age and the contribution rate. If these two measures are adopted countries can also consider the automatic indexation of pensions. · Having a well designed zero pillar where affordable and justifiable. A well-designed zero pillar or the incorporation of a minimum pension guarantee into one of the other pillars can mitigate the 7 The Financial Crisis and Mandatory Pension Systems in Developing Countries Conclusions and recommendations Further reading AFP (2008), Rentabilidad de los Fondos de Pensiones debe Evaluarse en el Largo Plazo. Nota No 67. October 2008. The impact of the financial crisis extends beyond Santiago. Chile. immediate losses to pension fund assets. Bebczuk Ricardo N. and Alberto R. Musalem (2009). `Can Abrupt policy changes in response to the the Financial Markets Generate Sustained Returns on a Large Scale?', in Holzmann Robert (ed)., Aging immediate circumstances should be avoided. Populations, Pension Funds, and Financial Markets: Regional Pension systems are designed to function over Perspectives and Global Challenges for Central, Eastern, and very long time periods. Short term responses to Southern Europe, World Bank. Washington DC., in print. relatively rare circumstances can potentially have D'Addio, A.C., J. Seisdedos and E.R. Whitehouse (2008), negative long term consequences on the capacity `Investment risk and pensions: measuring uncertainty in of pension systems to reliably provide adequate returns, Social, Employment and Migration Working Paper no. levels of retirement income. 70, OECD. Measures to mitigate the affects on the relatively Holzmann, R. and R. Hinz, Old Age Income Support in the 21st small number of retiring individuals can be Century, World Bank, 2005. considered without fundamentally altering the Munnell, A., A. Webb and A. Golub-Sass (2008), How system design. much Risk is Acceptable, Center for Retirement Research at Boston College, November 2008, No. 8-20. The current crisis strengthens the need for OECD (2007), Pensions at a Glance: Public Policies across diversified multi-pillar pension systems that are OECD Countries, OECD, Paris. able to manage risks and provide protection to OECD (2008), Pension Markets in Focus ­ Highlights of the individuals who may be vulnerable to the kind of OECD Private Pensions Outlook", OECD, Paris, economic shocks now being experienced. December, Issue 5. Increasing attention should be paid to managing OECD (2008), Pensions in a Financial Crisis ­ How should the exposure of individuals to short term financial retirement-income systems respond to financial market turmoil? risks in funded systems through portfolios OECD, Paris, November. designed for workers nearing retirement age and Robalino, D., E.R. Whitehouse, A. Mataoanu, A. Musalem, the development of phased transitions to the E. Sherwood and O. Sluchynsky (2005), Pensions in the payout of benefits that limit the impact of shorter Middle East and North Africa: Time for Change, World Bank, Washington DC. term financial volatility Whitehouse, E.R. (2007), Pensions Panorama: Retirement-Income Systems in 53 Countries, World Bank, Washington DC. World Bank (2008), The Unfolding Crisis: Implications for Financial Systems and Their Oversight, http://www.worldbank.org/html/extdr/financialcrisis/ pdf/UnfoldingCrisis.pdf 1. pee on riodiretirspecified age c paemen yment or t This Pension Reform Primer Note was prepared by Mark Dorfman, Richard Hinz and David Robalino under the direction of Robert Holzmann, above etc in consultation with regional staff, financial sector pe´nsion n.mad r-for´m and PREM. IORNEF Follow-up: Robert Holzmann, pr RHolzmann@Worldbank.org PENSPRIMERORM equippmersonwith information ern.1. elementarybookto ofimp.e)rfections, faults or errors better by removalorabandonment v.t. & i. 1. make (institution, procedure World Bank Pension Reform Primer Annex Pension systems in Eastern Europe and Central Asia Country % Wage Proportion of Year Participation in Funded Year Funded Participants Retire to total Funded Scheme Funded Contribution Scheme Scheme to Funded Started Scheme Bulgaria 5% 21.7% 2002 Mandatory <42 Full cohorts in 2023 Croatia 5% 25.0% 2002 Mandatory <40, Voluntary 40- Partial cohorts of women by 2008 and of men by 50 2013; full cohorts of women by 2022 and of men by 2027 Estonia 6% 20.0% 2002 Voluntary Partial cohorts by 2012 Hungary 8% 23.9% 1998 Mandatory new entrants; Partial cohorts by 2008; full cohorts by 2035 voluntary for all others Kazakhstan 10% 100.0% 1998 Mandatory for all Full cohorts by 1999 but acquired rights in old system in addition Kosovo 10% 100.0% 2002 Mandatory for <55 Full cohorts by 2012 Latvia 8% 24.0% 2001 Mandatory <30, Voluntary 30- Partial cohorts by 2013; full cohorts by 2033 50 Lithuania 5.5% 22.0% 2004 Voluntary Partial cohorts by 2014 Macedonia 7.42% 35.0% 2006 Mandatory for new entrants Partial cohorts by 2016; full cohorts of women by 2043 and of men by 2045 Poland 7.3% 26.1% 1999 Mandatory <30; Voluntary 30- Partial cohorts of women by 2009 and of men by 50 2014; full cohorts of women by 2029 and of men by 2034 Romania 2%, 6.7% 2008 Mandatory <35; voluntary 36- Partial cohorts of women by 2023 and of men by increasing 45 2028; full cohorts of women by 2033 and of men to 6% by 2038 Russia 6% 30.0% 2002 Mandatory for <35 Full cohorts of women by 2022 and of men by 2027 Slovak 9% 31.3% 2005 Voluntary for all Partial cohorts by 2015 Republic Source: Regional Bank Staff Pension systems in Latin America and the Caribbean National Scheme Contribution Rates (Main system) % of % of workers Includes funded "True Employee Employer Self contributions to in funded scheme? Multipillar"(1) Employed funded scheme scheme Bolivia Yes No 12.2% 0.0% 12.20% 100.0% 100.0% Brazil No -- 8-11% 20.0% 20.00% -- -- Chile Yes No 12.5% 0.0% 100.0% 96.0% Colombia Yes No 7.8% 23.3% 31.00% 50.0% 56.0% Costa Rica Yes Yes 2.5% 4.8% 0.0% 100.0% Ecuador No -- 6-9% 1-3% 6.60% -- -- El Salvador Yes No 6.0% 7.0% 100.0% 98.0% Guatemala No -- 1.8% 3.7% 5.50% -- -- Haiti No -- 6.0% 6.0% -- -- Honduras No -- 1.0% 2.0% -- -- México Yes No 2.7% 6.3% 9.00% 72.2% 100.0% Nicaragua No -- 6.3% 15.0% -- -- Panamá Yes Yes 7.5% 3.5% 11.00% 68.2% n/a Paraguay No -- 9.0% 14.0% -- -- Peru Yes No 13.0% 0.0% 100.0% 72.0% Rep. Dominican Yes No 2.9% 7.1% 100.0% 93.5% Uruguay Yes Yes 15.0% 7.5% 15.00% 50.0% 43.0% Venezuela No -- 1.9% 4.8% -- -- 1/ Workers in the funded scheme also participate in a pay-as-you-go pillar. Source: Regional Bank Staff based on Mesa Lago (2008), FIAP (2008), and Goldschmit (2008).