In my previous post, “First You Pay Then You Go”, I stressed the responsibilities of the World Bank in the current Pension Crisis. Over the last twenty years the Bank continuously, persistently and relentlessly advocated and promoted the transition from a dominant Pay As You Go to a dominant “funded” pension system, in its countries of operation and – through its general influence on government policies – worldwide. Such a move – wrapped up nicely, sealed and delivered as a “multi-pillar” package – transformed part or all of a virtual public debt, implicit in pension rights matured under the old PAYG system but sustainable in a continuing system, into an explicit real public debt that put a heavy strain on the fiscal resources of reforming countries. The move to a funded system also exposed old age pensioners to the risks of fluctuations and trends in the price of pension funds assets (see the previous post on both counts).
What does the World Bank have to say today about its own performance in pension reform, apart from the bland criticisms, mostly on the ground of “overselling” funded systems, voiced in its own “independent” assessment already reported?
The official World Bank position is summarized in a “Note” issued by its Human Development Network and published on 10 October 2008 [prepared by Mark Dorfman, Richard Hinz and David Robalino under the direction of Robert Holzmann]: The Financial Crisis and Mandatory Pension Systems in Developing Countries. “The note discusses the potential impacts of the financial crisis on fully funded and pay-as-you-go retirement-income systems in World Bank client countries, and identifies key short- and medium-term policy responses. The note does not go into depth on the issued identified. Stand-alone technical notes will be prepared subsequently. This note itself will be updated and refined as new issues emerge”. But repeated searches on Internet cannot find any such stand-alone technical notes, or updating, or refinements. Non-quotable papers originated in the Bank circulate informally but do not seem to add much. The valiant officials that drafted that Note did the best of a bad job, but the end result is a feeble, defensive, obfuscating collection of half-truths.
Seven Half Truths: 1. “No pension system is immune”
Half Truth n.1: Both funded and PAYG pension systems are in a crisis: “The international financial crisis has severely affected the value of pension fund assets worldwide. The unfolding global recession will also impose pressures on public pension schemes financed on a pay-as-you-go basis, while limiting the capacity of governments to mitigate both of these effects” (p.1).
The missing, other half, of the truth is that, as a result of the crisis, the additional pressure on funded systems is about ten times larger than on PAYG systems. The pension contributions of a PAYG system fall roughly at the same rate as GDP (a bit more or a bit less according to whether the wage share and/or the pension contribution rate fall or rise, or retirement age rises or falls), i.e. a few percentage points. Whereas the fall in the value of pension funds assets in 2008-2009 has been of the order of magnitude of 30-50 per cent or more. In a presentation to AARP (American Association of Retired Persons) International Section, on 16 December 2008, Robert Holzmann acknowledged that “Over the last 12 months, retirement accounts have lost $2 to $3 trillion in value. Between the 2nd quarters of 2007 and 2008, private pension fund assets declined by over half a billion dollars while state and local pension funds declined at rate of nearly $350 billion”... “rates of return for client countries with funded systems have decreased in value from a low of 8 percent to a high of more than 50 percent.” This was at end-2008; the situation has much worsened in the first half of 2009 and will not improve until 2010.
2. Small Numbers
Half-Truth n.2: “… only a small number of retiring individuals are affected by the crisis”.
How could it be otherwise? “The other missing half of the truth is that this is not thanks to World Bank promoted reforms, but because of lateness, slowness or incompleteness in their implementation.
Many countries still have a dominant PAYG system, which is unaffected by asset[s] values. In the EU, for instance, “In the majority of Member States PAYG provides almost all the pension income for those retiring today and there are only five Member States where funded provision is above 10% (these are Denmark on 16%, Slovenia and UK both on 22%, Ireland on 54%, and the Netherlands on 60%). A further three Member States are at, or slightly below, the 10% level (Germany, Cyprus, Belgium)” (Jerome Vignon [unsigned] “Non Paper – Pensions and the Financial Crisis – Informal Background Briefing Note”, European Commission, Directorate for Economic and Financial Affairs, December 2008).
Moreover, most of the countries that have implemented the transition to a funded system have done it too recently, and gradually enough, to have a significant impact – also due to exempting older workers or even leaving the change voluntary instead of mandatory. See the Table below (Vignon, cited). Even Mexico, that made the change twenty years ago, excluded the over thirty.
3. Multi-pillar diversification
Half-Truth n.3. “The current crisis strengthens the need for diversified multi-pillar system” (from the World Bank “Note” cited above). Next to a first pillar of PAYG or anyway a defined benefits system, a second “fully funded” pillar of defined contributions, a third pillar of voluntary savings, in that “Note” the World Bank now advocates as well even a “zero pillar” (sic), of non-contributory public pensions to take care of poverty among the aged. Which is fine, there is nothing to prevent individuals from saving or governments from making transfers to the poor. Except that diversification of pension systems is only needed to reduce the riskiness of the second and the third “fully funded” pillars, for both the first and the zero pillar do not depend on the price of financial assets.
If anything diversification is needed within the second pillar (and the third, but that is a matter for the individual saver not for public policy other than for tax incentives). So much so that the Bank advocates a “life-cycle” approach reducing the share of equities and raising that of government bonds in individual portfolios with the nearing of retirement age, and “the development of phased transitions to the payout of benefits that limit the impact of short term financial volatility” (Holzman, quoted above). Which is also fine, except that one wonders what has become of the presumed advantages of funded systems in terms of “choice”, reliance on stock markets rather than the state, and the enhancement of financial markets. What difference do pension funds make if they just intermediate between pensioners and the state?
4. Smoothing
Half-Truth n. 4. Governments should reconsider “the valuation rules applicable to pension fund assets in the context of the extreme current volatility in financial markets”, namely relaxing mark-to-market rules and allowing some “smoothing” valuation in order to “more accurately reflect the true underlying values and avoid the possible adverse reactions to large changes that prove to be very short run” (the “Note” cited). This of course would be beneficial to pension funds valuation but at the cost of the associated loss of transparency and disclosure. We know that banks have often abused of the relaxation of accounting rules in the valuation of their toxic assets; why tempt pension funds? It would be a high price to pay for a mostly cosmetic improvement.
5. Black Swans
Half-Truth n.5. “The current financial crisis is a rare “extreme” event” (from the World Bank “Note” cited above). Robert Holzman (in the presentation cited above) sticks his neck out further: “the current financial crisis is an extremely rare event, similar to those that have taken place every 50, 80, or 100 years in the past”. Well, 1929 was eighty years ago; even a single major crisis every eighty years means that everybody will be affected, either directly or through their parents or children. Nassim Nicholas Taleb’s bestseller, The Black Swan – The Impact of the Highly Improbable, (Random House, 2007) should be mandatory reading for the World Bank “Human Development Network” officials.
6. No Shocks
Half-Truth n.6. “Abrupt policy changes in response to the immediate circumstances should be avoided”. Compared with World Bank advocacy of shock therapy in post-socialist economies in the 1990s, this call for gradualism, experimentation and reflection is only to be welcomed. As long as this does not involve a state of denial – which is what the Note suggests – and a failure to learn from current events.
7. No Reversals
Half-Truth n.7. “Governments should avoid short-term reform reversals that have not been properly assessed and that may come at a high price for future retirees” (from the “Note” cited). In the unlikely event that current contributions, instead of accumulating in individual accounts, were simply diverted towards the payment of current pensions, this would be highway robbery, of course. But let us suppose a 100%, 180 degree reversal of the pension reforms implemented in the last twenty years, from fully-funded back to PAYG.
During this reversal, or re-transition, current employees would keep their entitlement the pension they have already matured corresponding to their cumulative investments up to the time of reversal. Their ailing, undervalued if not toxic investments would be transferred to the state, and for the rest of their working life they would mature an entitlement to a full PAYG pension minus what they would have matured in the years before reversal. The reversal would raise over time the virtual, implicit pension debt of the state (negligible in the literal sense that it can be neglected in a continuously operating system, as long as the system is balanced or its possible imbalance is affordable) but would decrease the explicit state debt by the value of pension funds transferred to the state. It would also eliminate completely pensioners’ exposure to financial markets risk.
State bankruptcy and Armageddon would remain uncovered, but the first presumably would affect also financial markets and funded pensions, and its impact would be temporary (see Russia in the 1990s); while the second would not be a problem but a solution.
Half-Truth n.3. “The current crisis strengthens the need for diversified multi-pillar system” (from the World Bank “Note” cited above). Next to a first pillar of PAYG or anyway a defined benefits system, a second “fully funded” pillar of defined contributions, a third pillar of voluntary savings, in that “Note” the World Bank now advocates as well even a “zero pillar” (sic), of non-contributory public pensions to take care of poverty among the aged. Which is fine, there is nothing to prevent individuals from saving or governments from making transfers to the poor. Except that diversification of pension systems is only needed to reduce the riskiness of the second and the third “fully funded” pillars, for both the first and the zero pillar do not depend on the price of financial assets.
If anything diversification is needed within the second pillar (and the third, but that is a matter for the individual saver not for public policy other than for tax incentives). So much so that the Bank advocates a “life-cycle” approach reducing the share of equities and raising that of government bonds in individual portfolios with the nearing of retirement age, and “the development of phased transitions to the payout of benefits that limit the impact of short term financial volatility” (Holzman, quoted above). Which is also fine, except that one wonders what has become of the presumed advantages of funded systems in terms of “choice”, reliance on stock markets rather than the state, and the enhancement of financial markets. What difference do pension funds make if they just intermediate between pensioners and the state?
4. Smoothing
Half-Truth n. 4. Governments should reconsider “the valuation rules applicable to pension fund assets in the context of the extreme current volatility in financial markets”, namely relaxing mark-to-market rules and allowing some “smoothing” valuation in order to “more accurately reflect the true underlying values and avoid the possible adverse reactions to large changes that prove to be very short run” (the “Note” cited). This of course would be beneficial to pension funds valuation but at the cost of the associated loss of transparency and disclosure. We know that banks have often abused of the relaxation of accounting rules in the valuation of their toxic assets; why tempt pension funds? It would be a high price to pay for a mostly cosmetic improvement.
5. Black Swans
Half-Truth n.5. “The current financial crisis is a rare “extreme” event” (from the World Bank “Note” cited above). Robert Holzman (in the presentation cited above) sticks his neck out further: “the current financial crisis is an extremely rare event, similar to those that have taken place every 50, 80, or 100 years in the past”. Well, 1929 was eighty years ago; even a single major crisis every eighty years means that everybody will be affected, either directly or through their parents or children. Nassim Nicholas Taleb’s bestseller, The Black Swan – The Impact of the Highly Improbable, (Random House, 2007) should be mandatory reading for the World Bank “Human Development Network” officials.
6. No Shocks
Half-Truth n.6. “Abrupt policy changes in response to the immediate circumstances should be avoided”. Compared with World Bank advocacy of shock therapy in post-socialist economies in the 1990s, this call for gradualism, experimentation and reflection is only to be welcomed. As long as this does not involve a state of denial – which is what the Note suggests – and a failure to learn from current events.
7. No Reversals
Half-Truth n.7. “Governments should avoid short-term reform reversals that have not been properly assessed and that may come at a high price for future retirees” (from the “Note” cited). In the unlikely event that current contributions, instead of accumulating in individual accounts, were simply diverted towards the payment of current pensions, this would be highway robbery, of course. But let us suppose a 100%, 180 degree reversal of the pension reforms implemented in the last twenty years, from fully-funded back to PAYG.
During this reversal, or re-transition, current employees would keep their entitlement the pension they have already matured corresponding to their cumulative investments up to the time of reversal. Their ailing, undervalued if not toxic investments would be transferred to the state, and for the rest of their working life they would mature an entitlement to a full PAYG pension minus what they would have matured in the years before reversal. The reversal would raise over time the virtual, implicit pension debt of the state (negligible in the literal sense that it can be neglected in a continuously operating system, as long as the system is balanced or its possible imbalance is affordable) but would decrease the explicit state debt by the value of pension funds transferred to the state. It would also eliminate completely pensioners’ exposure to financial markets risk.
State bankruptcy and Armageddon would remain uncovered, but the first presumably would affect also financial markets and funded pensions, and its impact would be temporary (see Russia in the 1990s); while the second would not be a problem but a solution.
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4 comments:
My Rome colleague Roberto Felice Pizzuti reminds me that a pioneering contribution to the critique of funded pension systems was provided by the great Italian applied mathematician Bruno De Finetti (1906-1995), in his paper "Sicurezza sociale e obiettivi sociali" [Social security and social objectives], presented at the Conference on actuarial and statistical problems of social security (Rome, 18-21 June 1956), published in Conference Proceedings, Edizioni Ordine Nazionale degli Attuari, Rome 1956; reprinted in Un matematico e l'economia, Franco Angeli Editore, Milan 1969.
Roberto Pizzuti’s own contributions to this critique are exemplified by: 1) “Notes on a Political Economy Approach to Pension Financing”, conference paper, Munster 13-14 June 1996, in Pensions in the European Union - Adapting to Economic and Social Change, Conference Proceedings, Koln, GVG, 1996; 2) A Political Economy Approach to Pension Financing, in: Hughes, G. and J. Stewart (Eds), Pensions in the European Union: Adapting to Economic and Social Change, Kluwer Acedemic Publishers, Boston 2000; as well as by earlier writings in Italian.
Both De Finetti and Pizzuti argue that funded and unfunded systems are equivalent forms of intergenerational transfers. I cannot agree with this view, as funded systems are financed by a share of total profits appropriated by pensioners in virtue of their earlier investments and as such are not an intergenerational charge/transfer.
Nick Barr, of LSE, in a recent e-mail exchange about this post points to the advantages of “notional” individual accounts in certain circumstances. A team of experts (including Nick Barr and Peter Diamond) advising the Chinese government on pension reform in 2004 suggested that funded individual accounts (adopted by China in 1998 on World Bank advice) were premature in China's current circumstances; instead the government should replace funded individual accounts with notional individual accounts. Advantages include:
* Simple from the point of view of the worker
* Centrally administered, hence low administrative costs
* Avoids much of the risk of funded individual accounts, since avoids volatility of capital markets
* Does not require the institutional capacity to manage funded schemes
* Saving may be the wrong policy (China needs more saving like it needs a hole in the head)
* NDC can be the basis for a future move to partial or full funding
Nick Barr also points out that the World Bank “Note” simply reiterates its current position on pensions. It does not step back to consider fundamental issues such as how risks should be shared (a) during the financial crisis, (b) more generally. It does not say 'the financial crisis demonstrates the extent to which pensioners in some types of pension system face more risks than in others'. Instead it says things like 'if you are a young worker, don't worry, because the value of the assets in your individual funded account will bounce back.'
Finally, Nick Barr compares and contrasts two basic propositions in the “Note”: (1) "The international financial crisis has severely affected the value of pension fund assets worldwide. The unfolding global recession will also impose pressures on public pension schemes ... , while limiting the capacity of governments to mitigate both of these effects."
(2) "The current crisis strengthens the need for diversified multi-pillar systems. These allow for better diversification of risks and thus provide better protection to individuals who may be vulnerable to the kind of economic shocks now being experienced." .
The two quotes (from p.1 of the World Bank "Note", top of column 1 and the top of column 2, respectively), appear to be directly contradictory. Diversification between equally vulnerable systems cannot bring any benefit.
I found the ‘rarity of Black Swans’ comment particularly bizarre. It is an integral element to the overall ‘fully funded is better than PAYG’ argument because extreme volatility of share prices would cause both uncertainty and, probably, lower returns for savers. If it were to be illustrated that share prices are extremely volatile, then the desirability of the fully funded approach would presumably be called into question. Here, I think the evidence suggests that volatility in share prices is: (a) quite normal; and (b) getting worse. The comprehensive argument that Black Swans are much more common than is often acknowledged would take longer than I have here. So, I will merely point out the volatility of stock performance in two advanced economies
If one examines trends in the performance of both the New York and London stock indices (I have tried to attach a chart with the historical performance – it may not have made its way onto the post), we can see that between 1945-1980, the level of volatility was relatively low, although greater fluctuations were becoming more evident after the early 1970s. Clearly the reduction of capital controls as time progressed helped result in greater volatility. This trend then becomes much more evident after 1980. As well as the higher frequency of small-sigma events (i.e. fluctuations of 1-2 percent), there were at least two large-sigma events (1987 and Sept 2008), as well as the cumulatively significant bear market from 2000-2003 (or 09?). Prices are now at 1997 levels. Of course, this discounts dividends, etc, but it does show that the ‘prices only go up’ argument to be true only in the very long run. Thus, the argument that Black Swans only occur every 50-80 years is clearly spurious, and evidence of sample bias. If we widen our sample to go back to, say, 1900, we can see the period 1945-80 is actually the aberration, largely explained by the presence of capital controls that were not present prior to WW1 and that were gradually dismantled after the 1960s. Black Swans occurred in 1907, 1914 and 1929, to name only the most obvious. And this observation covers only the ‘advanced’ economies of the USA and the UK. Throw Japan (1989-?) into the mix, and the sales pitch is even less persuasive.
If we look at the frequency of financial crises and the volatility of stock market performance, we see that are more prevalent in emerging market economies. Again, the correlation with increased international capital flows is clear. Since the 1980s, crises of some form or another have hit nearly every emerging economy, from South Korea and Argentina, to Russia and Brazil (again, see my chart which may or may not make it onto the screen). Only China seems to have avoided being hit by the storm of global finance, no doubt due to a resistance to low capital controls. Even here, stock market volatility is high (see the last year). Again, the frequency of these crises appears to be increasing.
In short, the Black Swans that concern funded pension systems are not Black Swans at all, i.e. low probability, high impact events. Instead, they are high probability, high impact events, and pension systems that hope to ensure some level of stability and certainty would be best served by factoring
Thanks, Richard. As you can see your graphs were not uploaded. I have learned how to upload graphs into the text of the post, but it does not seem to work in comments. If you e-mail me the graphs (dmarionuti@gmail.com) and tell me where to place them I will turn your comment into a new post including your graphs. Also, your comment appears to have been cut short, but that can be easily remedied in the same way (or you can add another comment with the missing bit).
On the question of substance I feel that fully funded schemes are vulnerable to black swans (=events that are rare, extreme, unpredictable ex-ante though explainable ex-post) even in the absence of other kinds of volatility. Conversely, you seem to say that black swans are not so rare and are getting more frequent (which is what Taleb says in his book) and regardless of black swans there is enough volatility in asset values to make trouble for a fully funded system. Which is fine with me, but I may have misunderstood.
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