33380 World Bank Pension Reform Primer Guarantees Counting the cost of guaranteeing defined contribution pensions D ifferent types of pension involve different q Absolute benefit level, which implies that the kinds of uncertainty. For example, public- fund must generate a certain rate of return sector pension schemes involve a `policy risk', that q Relative rate of return to sector, that the fund the scheme might be reformed in the future so delivers a return close to the average for all that benefits turn out differently than expected. funds Private pension schemes are less subject to this q Relative rate of return to benchmark, that the policy risk, because governments are unlikely to fund delivers a return close to the return on a confiscate private property. But defined-contribu- chosen synthetic portfolio tion pensions do involve capital-market risk during Countries offer the whole range of these different the accumulation phase, when contributions and guarantees in practice. investment returns build up in the fund. The risk is that the pension fund's performance is insuffi- Absolute rate of return guarantees cient to give an individual member an adequate We begin with countries that offer an absolute retirement income. guarantee, shown in Figure 1. Governments, in their role as regulator, can do The provident funds of Malaysia and Singapore much to mitigate capital-market risk. They can offer a minimum nominal return of 2½ per cent a enforce prudential investment rules and allow year. (These are not private funds, but they are funds to diversify their portfolios. They can pro- mandatory and are based on individual defined mote competition by requiring standardized contribution accounts.) The government makes reporting and disclosure. They can also indirectly up the difference if investment returns fall short of influence the performance of the funds through the target. parallel improvements in the efficiency of domestic capital markets. In Switzerland, employer-based pension funds are required to provide annual returns on members' But many governments have gone further, and defined contribution accounts of at least 4 per cent provided explicit guarantees of fund performance. in nominal terms. Each fund must make up any shortfall. The result is that many Swiss schemes Types of guarantee pay 4 per cent a year regardless of the return on There are at least four potential types of guarantee: the underlying investment. q Absolute rate of return, that the fund delivers a pre-specified return This briefing is part of the World Bank's Pension Reform Primer: a comprehensive, up-to-date resource for people designing and implementing pension reforms around the world. For more information, please contact Social Protection, Human Development Network, World Bank, 1818 H Street NW, Washington, D.C. 20433; telephone +1 202 458 5267; fax +1 202 614 0471; e-mail socialprotection@worldbank.org. All Pension Reform Primer material is available on the internet at www.worldbank.org/pensions Guarantees 2 Note that these first three countries all specify a sion reform, but is complex to administer and minimum nominal return, which means the value potentially very costly. of the guarantee is vulnerable to inflation. Finally, Argentina and Uruguay established public Absolute guarantees 1 schemes with a guaranteed absolute rate of return. In Uruguay it is 2 per cent real, while in Argentina it is equivalent to the prevailing rate on bank de- Country Guarantee posits. This guarantee does not apply to members Argentina Bank savings deposit rate of the private pension schemes that are part of the Hungary 25 per cent of public scheme benefit same system. Malaysia 2.5 per cent nominal Mexico 100 per cent of old public scheme benefit Relative rate of return guarantees Singapore 2.5 per cent nominal Rate of return guarantees relative to the average Switzerland 4 per cent nominal for other pension funds are common in Latin Uruguay 2 per cent real America, as shown in Figure 2. Setting minimum rates of return in advance makes Chile, El Salvador and Peru require pension funds these ostensibly defined contribution plans more to earn a real return either 50 per cent of the sys- like a defined benefit scheme. This might be con- tem average or two percentage points below the sistent with a public policy objective that focused system average, whichever is the smaller. on target replacement rates. As in a defined bene- fit scheme, this creates a liability that depends on Relative guarantees the difference between minimum and actual rates 2 of return. This liability requires a sponsor to Country Guarantee underwrite the cost. Argentina smaller of: 70% of funds' average nominal return, A number of countries offer a more complicated and average nominal return minus 2% kind of absolute guarantee. Hungarians that chose Chile smaller of: to move to a new, public-private mixed system 50% of funds' average real return, and were promised that the annuity generated by the funds' average real return minus 2% private, funded component would be at least 25 Colombia minimum based on both average of per cent of their public benefit. The guarantee is funds' performance, and return on only available to people who contribute to the benchmark portfolio funded scheme for at least 15 years. Hungary 15% less than the yield on a government bond index Mexico transferred all workers to the new private Peru smaller of: scheme. The guarantee is that the government will 50% of funds' average real return, and make up the difference if the annuity provided by funds' average real return minus 2% the private scheme is lower than the benefit that Poland smaller of: they would have received under the old regime. 50% of funds' average nominal return, Indeed, most people nearing retirement are and average nominal return minus 4% virtually certain to trigger the guarantee. Uruguay smaller of 2% real, and fund's average nominal return minus 2% Because they are tied to the outcomes in a defined benefit scheme, the value of guarantees in Hun- gary and Mexico is both specific to the individual Private pension funds in Argentina are required to and a function of the relative performance of the pay a minimum relative to nominal returns. The public and private schemes. This is consistent guarantee is 70 per cent of the system average or with a perceived need to bolster support for pen- two percentage points below the average, which- ever is the smaller. The guarantee in Poland is also 3 Guarantees set relative to nominal returns, but funds can fall exceeds bond returns by more than 40 per cent short of the average by a greater margin. must be put aside as reserves. These two guarantees have very different effects at Financing guarantees different real returns and inflation rates. Figure 3 There are several different ways of financing looks at the effect of inflation, holding the real guarantees return constant at 5 per cent. In Chile, the q from resources within the pension fund guarantee is 50 per cent of the real return--or 2.5 q from the capital of the pension fund manager per cent--whatever the rate of inflation. In q from a central guarantee fund Argentina, the picture is more complex. At low q from the government levels of inflation, the guarantee is capped at two In practice, if yields fall below the minimum, the percentage points below the nominal return. But difference in made up sequentially from a range of as inflation increases, the guaranteed minimum these potential sources. return declines. At 10 per cent inflation, for example, the minimum return is 70 per cent of the In Latin America, the first source of funds to meet nominal return of 15.5 per cent, or 10.85 per cent guarantees is from a reserve established within the nominal. This is equivalent to a real return of 0.7 pension fund. In Argentina and Chile, for per cent. example, the guarantee is symmetric. Any returns 30 and 50 per cent above the system average must Guarantees and inflation 3 be paid into a yield fluctuation reserve. Secondly, fund managers must maintain a separate account 3 Chile from own resources. In Argentina, for example, 2.5 the asset manager must put aside the larger of $3m 2 or 2 per cent of assets. 1.5 minimum real return A shortfall in return is made up, first, from the 1 Argentina yield fluctuation reserve; secondly, from the 0.5 managers' cash reserve; and, finally, from the 0 private capital of the fund manager. If this is 0 2.5 5 7.5 10 insufficient, then the fund is wound up and the inflation rate shortfall made up by the government. The financing of guarantees works in a similar way in Other countries' formulae for the minimum return other Latin American countries. include an element guaranteeing returns relative to market benchmarks as well as or instead of Unlike Latin America, Hungary and Poland each guarantees relative to the average for pension have established a central pension guarantee fund. funds. In Colombia, half of the minimum return is Hungarian funds must pay between 0.3 and 0.5 per set as 90 per cent of the average of private pension cent of contributions into the fund, which aims to funds. The other half of the minimum depends on hold between 0.3 and 1.5 per cent of total assets in the return on a benchmark portfolio, some of the funded pension system. Poland's fund targets which depends on the actual asset distribution of 0.1 per cent of total assets. Again, any shortfall is the pension funds. made up sequentially. Hungarian funds maintain a yield fluctuation reserve within the fund, Hungary offers a return guarantee relative to a depositing a proportion of any return that exceeds benchmark as well as a minimum pension benefit. the maximum. Polish funds are required to keep Pension funds must make up any shortfall in between three and five per cent of assets aside to individual returns if investment performance is meet any shortfalls. The central guarantee fund below the returns on a government bond index by steps in when these reserves have been exhausted. more than 15 per cent. Investment income that Guarantees 4 In the event that the central guarantee fund is Perhaps the greatest danger with guarantees is that insufficient, the government steps in. their costs, both on pension members and the potential liability to the government, are not Dangers in offering guarantees transparent. This lack of transparency encourages All forms of investment protection, such as governments to offer or impose larger guarantees deposit protection, generate the problem of `moral than would be chosen if the costs to fund hazard': once the losses from a particular risk are members and the government budget were clearer. insured, people will take less care to avoid the This is especially true for absolute guarantees. events that trigger guarantees. Pension fund managers, for example, may choose high-risk Option-pricing models of the type used in assets with the potential for high rewards, knowing derivatives markets can estimate the cost of that returns will be protected if the investment providing different types of guarantees. For a does not pay off. reasonable set of assumptions, the cost of the minimum absolute and relative rate-of-return Regulators can attempt to avoid moral hazard in a guarantees is of the order of 4-7 per cent of total number of ways. First, guarantees should at least assets per year. part financed by self-insurance on the fund's resources or those of the fund managers. In the Further reading worst case when government guarantees may be Pennachi, G.G. (1998), `Government guarantees triggered, the cost to the fund managers should be on funded pension returns', Social Protection a high one, namely, winding up the fund. Discussion Paper no. 9806, World Bank. Turner, J.A. and Rajnes, D.M. (2000), `Limiting Secondly, regulators can restrict the portfolios of worker financial risk through risk sharing: fund managers to avoid excessive investment in minimum rate of return guarantees for risky assets. But these restrictions can have a high mandatory defined contribution plans', economic cost by preventing competition and International Labor Office, Geneva. reducing the extent of diversification. World Bank (2000), `Portfolio limits: pension investment restrictions compromise fund The result of the combination of rate-of-return performance', Pension Reform Primer briefing. guarantees and portfolio restrictions in a number of countries has been `herding' of fund managers. To avoid being an outlier in the distribution of Conclusions and recommendations returns (or relative to a benchmark) and so q Guarantees of the returns from funded triggering guarantees that may impose a cost on pensions can gain support for reform the fund-management company, fund managers q But poorly designed guarantees can regress towards the same portfolio. For example, undermine it and create large liabilities Chile's pension funds hold an average of around q The cost of guarantees should be made 30 per cent of assets in equities, with a standard as transparent as possible deviation of this weighting of just 1.6 per cent.. q Option-pricing models can be used to illustrate the cost of guarantees, to The herding effect is reinforced by the relatively inform the decision to offer guarantees, short period over which rate-of-returns are often the type of guarantee and how large it assessed. This encourages fund managers to reject should be potentially rewarding, but volatile investments. q Transparent financing of guarantees is This short investment horizon is inappropriate best served by forcing funds to put aside since pensions are long-term investments. Chile their own assets; this also provides has shifted from annual to three-year returns, better incentives for fund managers while Poland opted for two-year averaging from the start. 5 Guarantees qRelative return guarantees should be based on long periods and appropriate benchmarks