Viewpoint The World Bank February 1996 Note No.72 Designing Mandatory Pension Schemes Some lessons from Argentina, Chile, Malaysia, and Singapore Dimitri littas In most countries, participation in a public pen- Whom to compel? sion system involving some kind of redistribu- tion is compulsory, while participation in The issue of who should be compelled to par- private pension schemes is voluntary. Public ticipate is complex. A strong case can be made and company pensions have enjoyed high for exempting some groups of workers- popularity as long as their promises seemed especially those under age twenty-five, those credible and generous. But there are growing with very low incomes, and those above the fears in many countries that the value of pub- normal retirement age. The treatment of un- lic pensions will not be sustained. There are employment spells, maternity leave, military similar fears about company pensions. The service, and university education creates com- credibility of conmpany pensions depends on plications that may have a serious effect on the integrity and solvency of large employers, defined benefit schemes based on final salary, which can no longer be taken for granted. though their impact on defined contribution systems is less important. These problems point to a need to refine, but not do away-with, compulsory saving. There is In practice, most countries with mandatory pri- clearly more justification for a compulsory vate schemes require all workers other than the scheme providing a minimum pension than for self-employed to participate. Self-employed a scheme that sets a high replacement rate for people usually are not covered because it is dif- preretirement earnings. But as the real value ficult to ascertain their incomes and monitor com- of public pensions declines, the case for pliance. Among countries with mandatory fully compulsory private pension schemes becomes funded second pillars, Chile and Switzerland fol- stronger. And if retirement saving is made com- low this approach. Argentina has made partici- pulsory, tax incentives should be used to en- pation compulsory for all workers, including the courage compliance. self-employed, though it remains to be seen whether self-employed workers will comply. Compulsion also imposes an obligation on the state to ensure that the system works well, is Defined contribution or benefit? simple and easy to understand, and will de- liver the targeted benefits. This obligation has Increasingly, compulsory schemes are of the implications for the management and regula- defined contribution variety with individual tion of the pension system. Other important capitalization accounts. These defined contri- design issues include the extent of compulsory bution schemes tend to be fully funded, fully coverage, the form and rate of compulsory sav- vested, and fully portable. Vesting and port- ing, and the extent of individual choice. ability rights are increasingly important as em- ployment patterns become less stable, though Drawing on the experiences of countries in the performance risk of pension funds is trans- Asia, Latin America, and elsewhere, this Note ferred to workers. But this risk can be reduced provides some guidance on how to impose through properly diversified portfolios and so- compulsion and which tax incentives to offer. phisticated annuity products. Financial Sector Development Departnent. Vice Presidency for Finance and Private Sector Development Designing Mandatory Pension Schemes Size of contribution? net investment return after deducting operat- ing costs, and on this score the Chilean and How large compulsory contributions should be other Latin American pension funds generally depends on what is considered an appropriate have done very well. The high costs stem targeted pension level and on whether there is mainly from high selling commissions and other a separate, redistributive public pillar. Experi- marketing costs related to workers' freedom to ence in Latin America suggests that a contribu- switch their accounts among competing pen- tion rate for long-term capital accumulation of sion fund management companies. Employer- less than 5 percent is inadequate. (An additional based pension funds have much lower 2 to 3 percent is required to cover operating operating costs. A compromise solution is to costs and premiums for term life and disability allow employer-based schemes as long as they insurance.) In Chile, the total contribution rate offer fully vested, fully funded, and fully por- has been about 13 percent (10 percent plus 3 table benefits. Allowing group contracts with percent), and in Argentina, it is 11 percent (7.5 independent fund managers could achieve the percent plus 3.5 percent). Ten percent for capi- same result, especially if employers negotiated tal accumulation is adequate for a reasonable the contracts and offered them to their employ- replacement rate if investment returns exceed ees on an optional basis. wage growth rates by 2 to 3 percentage points (or more) and if a person's active working life What types of regulation? is at least twice as long as retirement (calcu- lated to include the life expectancy and ben- The main focus of regulation should be pru- efits of dependent survivors). A higher dential norms and fiduciary standards. Rules contribution rate for long-term capital accumu- legally separating the assets of the pension fund lation is required if the gap between investment from those of the management company are returns and wage growth is smaller, if allow- essential so that the pension fund does not suf- ance is made for interrupted careers and there- fer if the management company becomes in- fore for a lower ratio of active years to retirement solvent. Proper custodial arrangements are years, or if a higher replacement rate is desired. necessary to prevent fraud, as are rules to dis- courage insider trading and self-dealing. Who should manage the funds? Detailed investment rules setting upper limits Experience in both industrial and developing on different assets by type and by issuer may countries shows that private decentralized (com- be necessary to ensure diversification in coun- petitive) management has achieved higher real tries with less developed capital markets (see returns than public centralized management. Note 71). Investment rules should emphasize Under centralized schemes, even in countries safety and profitability and should not direct with high growth and low inflation, such as Ma- funds into projects merely because they are laysia and Singapore, the investment returns to politically or socially desirable. Other structural individual accounts have been poor. In many rules that have been used in Latin American countries, especially in Africa and Latin America, countries-such as one account per worker, the investment performance of central agencies one fund per company, and one price (non- has been disastrous. In OECD countries, private discrimination between workers)-have aimed pension funds have generally achieved higher to protect workers by ensuring simplicity and investment returns than public pension funds. transparency. But they may go too far in re- stricting choice. In industrial countries, detailed The weakness of decentralized, non-employer- investment and structural rules are not neces- based funds such as those in Argentina, Chile, sary. Reliance on the "prudent man" rule and and other Latin American countries is their high benchmark portfolios (see below) should pro- operating costs. What matters, however, is the vide adequate protection. What state guarantees? alternative is to require management companies to spell out clearly the investment policies of State guarantees can take three forms: a mini- the funds they promote and to assume liability mum pension, a minimum return, and protec- for any shortfalls that result from deviating from tion from insolvency. A minimum pension those policies. Using benchmark portfolios and guarantee is essential if there is no separate detailed investment guidelines may be a better public pillar and any social assistance is low. approach in industrial countries, where the only Chile offers a minimum pension guarantee of constraint on fund management companies is about 25 percent of the average wage to work- potential loss of reputation and business. But ers who have contributed for at least twenty these penalties offer no consolation to retiring years. Argentina, which has a separate public workers who suffer large losses because fund pillar paying a basic universal pension of about managers fail to comply with their own invest- 30 percent of the average covered wage, does ment guidelines. not offer a minimum pension guarantee for the private pillar. Protecting workers from the insolvency of fund management and insurance companies (which If not properly formulated, minimum pension provide term life and disability coverage as guarantees may encourage strategic manipula- well as annuities) is essential and unavoid- tion by workers-that is, workers may try to able in a mandatory retirement saving scheme. contribute for the minimum period and for the To prevent moral hazard problems and ex- minimum amounts that would entitle them to cessive risk taking, regulators need to ensure draw the minimum pension. A better alterna- that such companies have adequate capital and tive is to guarantee an accrual factor of, say, reserves for the risks they assume. 0.75 percent of the average wage for each year of contribution, with a minimum no lower than Individual choice and competition social assistance. In an apparent oxymoron, individual choice A minimum return guarantee should not be is essential in a compulsory saving scheme. expressed in absolute terms. This could dis- In Malaysia and Singapore, workers can de- tort incentives and encourage management cide how to invest their own balances, pro- companies to adopt risky investment policies vided that they choose among approved at the expense of the state. Guaranteeing the instruments and maintain a minimum balance minimum return relative to the average for in their account. Approved instruments used the industry makes more sense because it to be limited to owner-occupied housing, but would protect workers from large deviations in recent years they have been extended to in returns. But it would also imply more uni- investments in both domestic and foreign se- form, and perhaps more conservative, invest- curities. In Argentina, Chile, and other Latin ment policies. Guaranteeing relative minimum American countries, workers can choose their returns leads to a need for minimum solvency fund management company and can switch requirements and investment reserves. These their account from company to company. In rules tend to increase the cost of entry for fact, account switching has become a big prob- management companies, but they may be es- lem in these countries: it happens on a large sential when a new system is introduced in a scale (about a third of active accounts are developing country with rudimentary capital switched each year in Chile) and seems to be markets. motivated more by the interests of selling agents than by those of the workers. For more advanced countries, other solutions may be needed to protect workers from exces- Improvements could be made in these coun- sive fluctuations and deviations in returns. One tries by increasing individual choice and thus Designing Mandatory Pension Schemes enhancing efficiency while retaining compul- sion schemes. Although not perfect, the EET sory saving for retirement. Some of these im- approach is the better option for both types provements could also make compulsory of schemes. One problem is that if the tax retirement saving schemes more palatable in exemption is offered at the marginal tax rate, more advanced countries. it favors high-income workers. So most coun- tries that operate an BET regime limit the First, group contracts could be allowed that exemptions to minimize the regressive im- offer discounts to group members and are pact and protect the tax base. Another prob- arranged by employers (or other groups with lem is that the exemption provides no benefit a common bond). Workers could be allowed for non-tax-paying workers. to opt out of company-based group schemes, though they might be discouraged by the A more equitable solution is to replace tax higher operating costs they might have to exemption with a tax credit system that pro- incur by doing so. Still, the right to opt out duces a uniform tax incentive effect for all would ensure that group schemes earn net workers-for example, by providing a direct investment returns as high as those of state contribution to workers' retirement sav- nongroup schemes. ing accounts. The Czech Republic has intro- duced a scheme that comes close to this Second, workers could be given the right to ideal-although because the scheme fails to invest in pension funds subject to less regu- link the tax credit to a minimum contribution lation (especially fewer and less draconian (or saving) rate, it has encouraged small investment rules), though they would not be amounts of saving rather than adequate sav- The Note series is en open forum intended to covered by government protections and guar- ing for retirement. This general approach, encourage dissemina- antees. Thus, workers who value the mini- which could be referred to as the CET re- tion of and debate on mum pension and minimum relative return gime, would be superior from the social point ideas, innovations, and best practices for guarantees could stay with the (heavily) regu- of view. It would eliminate the preferential expanding the private lated funds, while those who do not desire treatment of tax-paying workers and could sector. The views such protection could opt for less regulated contain the tax cost of these exemptions or published are those of the authors and should funds. A system based on benchmark port- achieve greater redistribution in favor of low- not be attributed to the folios could offer similar choices. income workers for a given tax cost. It would World Bank or any of its also encourage saving by low-income work- affiliated organizations.enorg Nor do any of the con- How to offer tax incentives? ers. Compliance by high-income workers might clusions represent decline, but high-income workers are less official policy of the A distinction is usually drawn between re- likely than others to require either compul- World Bank or of its Esecutive Directors gimes that exempt contributions and invest- sion or inducement to save for their old age. or the countries they ment income from taxes but tax pensions (the represent. EET regime) and those that tax contributions Dimitri Vittas, Adviser, Pensions and Insurance, Comments are welcome. but exempt investment income and pensions Financial Sector Development Department Please call the FPD (the TEE regime). These two regimes have (email: dvittas@worldbank.org) Note line to leave a different cash flow effects because of differ- message (202-458-11 11 or contact Suzanne ences in the timing of tax payments, but their Smith, editor, Room long-term effects are the same. G8105, The World Bank, 1818 H Street, NW, Washington, D.C. 20433, Many countries use the TEE concept for com- or Internet address pulsory public pension pillars and the EET ssmith7@worldbank.org. approach for voluntary company or personal SPrinted on recycled pension schemes, though some countries (for paper. example, Switzerland) apply the EET ap- proach to both public and occupational pen-