Saturday, June 13, 2009

First You Pay Then You Go

Innocent victims of the current global financial crisis include – next to the gullible millionaires who greedily entrusted their riches to Bernie Madoff; the shareholders of bankrupt companies and the millions of workers made unemployed in the last year – a larger group of less visible, less vocal but undeserving losers: old age pensioners.

The Pension Crisis

On 27 May 2009 the Financial Times ran a major feature (multimedia, interactive) on "The Pension Crisis”, by Cynthia O’Murchu, Helen Warrell, Steve Bernard and Norma Cohen . ”The financial crisis has wreaked havoc on retirement plans of all varieties, inflicting particular damage to employer-based and private retirement savings, which have gradually come to replace state pension provision [emphasis added]. Meanwhile workers themselves, who have built up a lifetime of savings in pension funds, are being forced to rethink their pension plans and even defer their retirement.” VIDEO See also Sharlene Goff, “Pensions warning over bet on shares”, FT 20 May 2009.

A leading independent pensions adviser, Dr Ros Altman, last May published a report Planning for Retirement: You're On Your Own, warning that the credit crisis had "hugely damaged" the UK's pensions system and destroyed the widespread belief that long-term stock market investment would produce generous pensions. "Essentially the entire UK pensions system has been based on a bet that equities would always do well enough over the long term to deliver reliably good pensions," she says in her report, "The old idea that stock markets can always be relied on to deliver strong returns has left millions facing an impoverished old age." (Goff, cited). In fact, over the past 10 years, equity returns have averaged just 1.2 per cent, compared with 16.1 per cent in the previous 10 years. The UK is a good illustration of what today is a universal problem.

The replacement of “state pension provision” with “private retirement savings” was pioneered in Pinochet’s Chile, championed by the World Bank in its countries of operation (especially in the economies of post-socialist transition), and became fashionable throughout the world over the last twenty years. The current pension “time-bomb” (O’Murchu et al., cited) is a pre-announced crisis, rooted in the hyper-liberal ideology of the Reagan-Thatcher years, and based on faulty economic theory. Nobody has the right to be surprised.

Pay As You Go …

There are two main alternative approaches to the provision of pensions. The first, traditional system is unfunded: pensions are paid, at a level of pre-defined benefits, out of the current pension contributions made by current employees. It is also called a re-distributive, or PAYG-Pay As You Go system. It is typical of the old socialist model.

PAYG is a kind of pyramid banking scheme, where pensions are paid out of current employee contributions just like Bernie Madoff paid interest out of new deposits. Except that the standard banking pyramid goes bust when deposits unavoidably at some point stop growing at least as fast as the rate of interest paid out; and before it happens Mr Ponzi runs away with the loot. Whereas the pension pyramid can be perfectly sustainable, since there are always new depositors (current employees making pension contributions) and there are gradual and orderly withdrawals (pensions paid only after reaching retirement age, and gradually, month after month).

The unfunded system is sustainable as long as the number of old age pensioners multiplied by their individual average pension is no greater than the number of current employees multiplied by their individual average pension contribution. Otherwise the uncovered difference is a claim on current government expenditure, and the present value of such uncovered differences is an explicit “pension debt” which should be counted as part of the government debt; its sustainability depends not on the specific characteristics of the pension system but on whether that overall government debt is sustainable.

Suppose the two sides – pension outlays and pension contributions revenues – balance. All future pensions are currently unfunded, and formally there is an implicit pension debt today equal to today's pensioners' pensions for the rest of their lives (plus the future pensions matured so far by current employees). But the day of reckoning never comes; that debt is buried and – as long as the balance between pensions and contributions is kept – it never surfaces nor need ever to surface. The government ability to run such a pension system is a kind of seigniorage, as long as the unfunded system is universal. Only if the two sides are not in equilibrium and pensions amount to more than current contributions, can that shortfall, cumulated and discounted over the residual lifetime of current pensioners, be regarded as today's "true", explicit component of public debt on account of pensions.

If current contributions are higher than current pensions you can set aside the difference as a reserve for the possible aging of the population, or for later pension rises. If the population does age and such reserve is not there or is exhausted, then pensions must be reduced, or contributions raised, or retirement age delayed, or some combination of all three, until balance is restored. Or the imbalance can be financed by the state budget, if the burden is bearable and sustainable.

… or Fully Funded?

The second kind of pension system is funded, with defined contributions but with benefits depending on the yield earned on the accumulation of individual contributions over time. In this case there is no problem with ageing, or with retiring age, since what you get always depends on what you put in, and on the success of the investment to which your cumulative contributions were put, by you or by a pension fund of your choice. Choice is reputed to be one of the advantages of the system. The other advantage claimed for it is the development of financial markets, which is regarded as a good thing in itself.

Does this funded system ensure a zero explicit and implicit pension debt? Yes, normally – until such a time as 2008-9 when insurance companies and banks go bust and stock exchange values fall by over a half. Then funded schemes end up with vanishing yields and capital values, i.e. pensions literally tend to vanish. “First You Pay and Then You Go”, they used to say in the pension crisis in Russia in the 1990s. Ultimately the government will have to look after the pensioners no longer covered by their nominally "funded" but shrinking pension schemes. The pension burden will ultimately fall on the public budget – inexorably and regardless of whether pensions are funded or unfunded.

Steady States and Transition

The funded system may or may not be superior to the PAYG system when both are compared in a steady state, but even if it were that would not necessarily mean that the transition from PAYG to funded is a good thing. For if and when you move to a funded system you make the buried, hidden, implicit pension debt behind the PAYG (today's pensioners' pensions for the rest of their lives), surface unnecessarily as an explicit real claim on current government resources. Whereas, as long as the balance is kept between pension outlays and pension contributions revenues, the unfunded system implicit debt remains buried and is of no consequence whatever. So much so that, if you wished to privatise a balanced funded pension system, there should be no shortage of takers without having to pay them the value of the implicit, buried, pension debt.

Therefore the best option is to keep PAYG but adjust pensions/contributions/retiring age so as to make the system – if not balanced – at least maintain the imbalance at levels that can be a reasonable and sustainable burden on the state budget. If you still want to change from PAYG to a fully funded system, you should consider the unnecessary cost surfacing into public accounts, and not necessarily expect the eternal boom needed to validate its alleged superiority, which depends on the yield on pension investments being consistently higher than the growth rate of the wage bill.

Alternatively, instead of moving from PAYG to a fully funded system, it is preferable to mimic the functioning of a funded system, with the state continuing to cash in the pension contributions of the currently employed, crediting them to contributors in personalised accounts yielding a rate of return equal to that of a chosen investment fund or even basket of securities, eventually determining future pension benefits. In this way the explicit burden on the government budget is not the total contributions of the currently employed otherwise lost in the transition to a funded system, but only the difference between pensions mimicking a funded system and what pension payments would have been under the standard PAYG.

The World Bank: No Pillars of Wisdom and Little Support for the Three They Claim

The World Bank advocates a Three Pillars pension system, composed of a PAYG (Pay As You Go) publicly managed, tax-financed minimum pension for all; a privately managed funded scheme; and additional voluntary retirement savings. The third, voluntary, pillar is neither here nor there, or rather is always possibly there regardless: voluntary savings can be encouraged by tax incentives but otherwise are nobody’s business other than the saver's. The other two are the real alternative; and it is clearly a question of relative proportions between the two pillars, rather than strictly an alternative between the two.

The World Bank’s favour of funded pension schemes is enshrined in two classic documents: Averting the old age crisis – Policies to protect the old and promote growth, 1994, and Social Protection Sector Strategy: from Safety to Springboard, 2001. A great deal of favour, well bias, is hidden behind the three pillars, but the insistence with which the World Bank urged the downsizing the PAYG pillar already in existence, and urged the introduction of a totally new funded system alongside an already existing rudimentary voluntary pillar should not fool anyone: “multi-pillar” is a cosmetic euphemism for the emphatic introduction of a funded pillar, and on a large scale.

But now the wind has changed. In 2006 the World Bank conducted an “Independent Evaluation” of the its own assistance to pension design: "Pension reform and the development of pension systems", see also “Pension Reform: How to Strengthen World Bank assistance”, in IEG Reach, 2 February 2006. The assessment finds that “… in a number of instances the Bank supported multi-pillar reform [read: funded systems] even though there were clearly weaknesses in the country’s underlying economic and financial structure. Moreover the Bank did not always fully consider non-contributory options to expand the social safety net to the populace outside the formal system”. “… despite expectations, in many countries with multi-pillar system, funded pensions remain poorly diversified and pension coverage has not been increased. In addition, the secondary objective of funded pillars – to increase savings, develop capital markets and improve labor flexibility – remains largely unrealised.” The Bank comes under bland but firm criticism for “overselling” the benefits of funded pensions in its countries of operation.

Nicholas Barr of LSE and Peter Diamond of MIT have now finally destroyed the theoretical foundations of the World Bank penchant for funded pensions and other aspects of its policies towards poverty and the aged, in their Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (forthcoming June 2009).

But the writing had been on the wall for sometime. See for instance John Eatwell, Michael Ellman, Mats Karlsson, D. Mario Nuti and Judith Shapiro, Soft Budget, Hard Choices: the Future of the Welfare State in Central Eastern Europe, IPPR, London 2000, Ch. 8 on pensions. Or Nicholas Barr, "Reforming pensions: myths, truths, and policy choices", IMF Working Paper 00/139, August 2000. Or P. Orszag e Joseph E. Stiglitz, "Rethinking Pension Reform: Ten Myths About Social Security Systems", in: R. Holman e J. Stiglitz (Eds), New Ideas About Old Age Security, Washington: World Bank, 2001, pp. 17-56.

In most countries, mis-selling pension plans is a prosecutable offence. In the UK “several pension companies are expected to be investigated and fined for advising customers to switch into a personal pension or self-invested personal pension (Sipp) against their best interests” (The Times, 5 December 2008). Why should the World Bank get away with mis-selling entire pension systems? It has become fashionable for all kind of institutions and governments to apologise for their past or recent misdeeds. They include Pope Benedict XVI, apologising for pedophile priests; the Anglican Church apologising to Darwin; the Canadian government to Inuit Indians; the Australian to Aborigines. Former Royal Bank of Scotland chief executive Sir Fred Goodwin told MPs on the Treasury Committee he "could not be more sorry" for what had happened (BBC, 10 February 2009).

It’s time for the World Bank President Robert B. Zoellick to at least say “Sorry” to the old-age pensioners for their loss of protection at such a difficult time.


D. Mario Nuti said...

A correction has been made in the post:

"if you wished to privatise a balanced funded pension system..."
should have read, and now reads:

"if you wished to privatise a balanced unfunded pension system..."

Massimo said...

Dear Mario, I subscribe to what you say in your post 100%.
I have been pointing to the weaknesses of the World Bank recipe for years in my Public economics course at Siena, and now I'm glad to see that (maybe) the wind is changing.

Francesco Bogliacino said...

I agree with the article. However, I have a couple of "related" points. I do think that PAYGO system should be maintained, but you know that they are usually under political pressure. You quoted the option of "mimic the fully funded" to maintain them sustainable, which is what have been done with contributions related schemes in Italy and other countries. But the ratio between pension and last wage may be too low under a sustainable system,. so you have to couple it with some other pillar.

The second point is demographic: if immigration is able to face the typical demographic pattern of developed countries and assuming that productivity is in line with indigenous workers, you may rebalance the system just opening the frontiers. I suspect that the problem is on the latter condition, which means that one has to think at some selective policy (assuming it to be legimimate, which is out of the scope of this comment).

Great post, in any case

Francesco Bogliacino

D. Mario Nuti said...

Great minds think alike. Thank you for your support, Massimo.

I take Francesco's point that a balanced PAYG system may imply too low a ratio between pension and last wage. But if it mimics the operation of a funded system it should give the same protection - such as there is - as funding. There the risk is of either a burden on the budget (if funding outperforms PAYG) or pensioners' impoverishment (if funding is outperformed by PAYG).

Immigration, by rejuvenating the host country's population, helps the sustainability of a PAYG system. The question is by how much. There are very different estimates, it is and remains an empirical question.