PG/Eco408: Public

Economics
Optional Course Offered by Dr. Vikas Dixit
Need for an Effective Formal
Pension System
• Pressures of global population aging.
• The erosion of informal and traditional family support
systems.
• Changes in work and family patterns, including the
increasing participation of women in formal
employment, rising divorce rates, diminishing job
stability and increases in local and international labour
migration.
• Weaknesses in the governance and administration of
existing pension systems.
Issues in Traditional Pension
Systems
• Adverse fiscal consequences.
• Financially unsustainable over the long term.
• Fail to fully deliver on their social objectives of poverty
alleviation and income smoothing.
• Create significant distortions in the market economies.
• Bias redistribution in favour of higher income groups.
• Poor coverage.
World Bank’s Approach for
Strengthening Pension Systems
• World Bank’s proposed framework incorporates
assessment of initial conditions and capacities in
relation to a multi-pillar model of the potential
modalities for pension systems that establish a broad
but defined range of potential reform designs.
• These possible designs are then evaluated against a set
of primary and secondary evaluation criteria in an
attempt to reach an outcome that is contoured to
country-specific conditions, needs and objectives.
Assessment of Initial Conditions –
Inherited Systems
• Existing mandatory and voluntary pension systems;
• The acquired rights of workers and retirees;
• Related social security schemes;
• Existing family and community support of retirees; and
• Old age vulnerability and poverty prevalence in
absolute terms and relative to other age groups.
Assessment of Initial Conditions –
the Reform Needs of Such Systems
• Reforms needs are such as modifying existing schemes
in the face of fiscal unsustainability, coverage gaps,
aging and socio-economic changes assessed against a
combination of primary and secondary evaluation
criteria.
Continued: Primary Criterion –
Adequacy
• An adequate system is one that provides benefits
sufficient to prevent old-age poverty (at a country-
specific absolute level) to the full breadth of the
population in addition to providing a reliable means to
smooth lifetime consumption for the vast majority of the
population.
Continued: Primary Criterion –
Affordability
• An affordable system is one that is within the financing
capacity of individuals and the society, and does not
unduly displace other social or economic imperatives or
have untenable fiscal consequences.
Continued: Primary Criterion –
Sustainability
• A sustainable system is one that is financially sound and
can be maintained over a foreseeable horizon under a
broad set of reasonable assumptions.
Continued: Primary Criterion –
Equity
• An equitable system is one that provides the income
redistribution from the lifetime rich to the lifetime poor
consistent with the societal preferences in a way that
does not tax the rest of society external to the system;
and one that provides the same benefit for the same
contribution.
Continued: Primary Criterion –
Predictability
• A predictable benefit is provided by a system where
• (i) the benefit formula is specified by law and not
subject to the discretion of policymakers or
administrators;
• (ii) the defined formula is designed to insulate the
individual from inflation and wage adjustments prior to
retirement or the defined contribution investment policy
can insulate the beneficiary from material effects on
benefits from asset price adjustments prior to
retirement; and
• (iii) the benefit is automatically indexed during
retirement so as to shield the worker from effects of
Continued: Primary Criterion –
Robustness
• A robust system is one that has the capacity to
withstand major shocks, including those coming from
economic, demographic and political volatility.
Continued: Secondary Evaluation
Criteria
• I. Minimisation of labour market distortions;
• II. Contribution to savings mobilisation; and
• III. Contribution to financial market development.
Assessment of Initial Conditions –
Enabling Environment for a Reform
Design and Process
• Demographic profile;
• The macroeconomic environment;
• The capacity of administrative, regulatory and
supervisory institutions; and
• The breadth, depth and efficiency of financial markets,
particularly with respect to long term instruments.
Core Objectives of Pension Systems
• Protection against the risk of poverty in old age.
• Consumption smoothing from work to retirement.
Modalities for Achieving Objectives:
the Multi-Pillar Model
Zero Pillar
• Comprises of non-contributory basic benefits like demogrant,
social pension, or general social assistance, which are typically
financed by the local, regional or the national government, fiscal
conditions permitting, to deal explicitly with the poverty alleviation
objective in order to provide all of the elderly with a minimal level
of protection.
• This ensures that people with low lifetime incomes are provided
with basic protection in old age, including those who only
participate marginally in the formal economy.
• Whether this is viable-and the specific form, level, eligibility and
disbursement of benefits depends upon the prevalence and need
of other vulnerable groups, availability of budgetary resources and
the design of complementary elements of the pension system.
First Pillar
• Corresponds to mandatory with contributions linked to
varying degrees to earnings with the objective of
replacing some portion of lifetime pre-retirement
income.
• This pillar addresses, among others, the risks of
individual myopia, low earnings, and inappropriate
planning horizons due to the uncertainty of life
expectancies, and the lack or risks of financial markets.
• They are typically financed on a pay-as-you-go basis
and thus are, in particular, subject to demographic and
political risks.
Second Pillar
• Constitutes mandatory defined contribution plans with independent
investment management.
• It is typically an individual savings account with a wide set of design
options, including active or passive investment management, choice
parameters for selecting investments and investment managers, and
options for the withdrawal phase.
• DC plans establish a clear linkage between contributions, investment
performance and benefits.
• They support enforceable property rights, and may be supportive of
financial market development.
• When compared to DB plans, they can subject participants to financial and
agency risks as a result of private asset management, the risk of high
transaction and administrative costs, and longevity risks unless they require
mandatory annuitization.
Third Pillar
• Corresponds to voluntary contributions taking many
forms, e.g., individual savings for retirement, disability
or death; employer sponsored; defined benefit or
defined contribution.
• It is essentially flexible and discretionary in nature.
• It compensates for rigidities in the design of other
systems but includes similar risks as second pillar.
Fourth Pillar
• Represents a non-financial informal support (such as
family support), other formal social programmes (such
as healthcare and/or housing), and other individual
financial and non-financial assets (such as home
ownership and reverse mortgages where available).
• The availability and type of such support for the aged
has a major bearing on the design and implementation
of the other pillars, including target benefit levels.
Key Considerations for Determining
Country-Specific Strategy
• Should scarce fiscal resources be devoted towards
providing old-age poverty protection in those societies
where data suggest that there are other groups, such as
children that may face greater poverty prevalence or
vulnerability?
• How much should a society aim to redistribute income
through the pension system and how can it ensure that
this redistribution is made transparent and progressive?
• What measures should be taken to strengthen the
enabling environment that are conducive to reform
options best satisfying the core objectives?
Some General Guiding Design
Principles for Determining the
Reform Choices
• Prefunding of future pension commitments.
• Mandatory and fully funded.
• Small, simple and universal.
• A carefully thought process of pension reform, based on
a long-term, credible commitment by the government;
local buy-in and leadership; and sufficient capacity-
building and support for implementation arrangements.