The World Bank on Funded Pensions in the Crisis: Feeble, Defensive, Obfuscating

In his “Remarks by the President On 21st Century Financial Regulatory Reform” (17 June 2009), Barak Obama recalls “the terrible pain in the lives of ordinary Americans” inflicted by the “historic economic crisis” and acknowledges that, next to the jobless and the bankrupts, “there are retirees who've lost much of their life savings”.

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.

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.