Building a new pension system

The term `pension' conjures up an image in India of the pension programs for government employees (this includes railways, defence, etc). Here, employees obtain a fairly generous pension after retirement without having ever had to plan for it or make payments for it. To many people in India, the term `pension system' conveys something of this flavour: a mechanism through which people can obtain a monthly pension in old age which is a pure subsidy from the government.

This is infeasible on any sensible scale. Let us make some conservative assumptions: Assume (1) we seek to deliver a pension of Rs.500/month to each of 5 crore people above age 60, and (2) leakages and administrative overheads amount to 50%. In this case, a pension program which is based on a pure subsidy from the government would cost 2.25% of GDP. Given our fiscal crisis, such a program (which would add 2.25 percentage points to the fiscal deficit as percent of GDP) appears infeasible.

Further, even if such a pension program were created today, it would lead to an excruciating crisis in the years to come, owing to a great increase in the number of the elderly. Demographic projections suggest the number of the elderly will rise to 11.3 crore in 2016 and further to 17.9 crore in 2026. A pension program that appears infeasible with 5 crore old people today is even more infeasible with the ageing of the population that we are set to experience.

Hence, the only strategy that can be adopted for a formal pension system is one where individuals save while they are working, and derive benefits from their assets in old age. Remarkably enough, daily pension contributions of as low as Rs.3 to Rs.5 prove to be adequate to escape the poverty line in old age; hence accumulating pension wealth on a scale that wards off poverty is actually possible for a large fraction of India today.

If we imagine a pension system based on making contributions into the pension system when young, and deriving benefits when old, then the two central questions are about political risk and rates of return.

Rates of return matter in a simple and direct fashion. For a typical person, each one percentage point improvement in the rate of return yields a 20% increase in the final pension wealth. With conventional rates of return, the minimum contribution that is required in order to avoid poverty in old age is around Rs.10 per day. With improved rates of return, this number comes down to Rs.3 to Rs.5 per day, a difference which would make the pension system accessible to tens of millions of additional people.

Political risk pertains to the dangers of the pension system being hijacked by special interest groups. A large stock of pension assets is a dangerous thing. There will be a host of special interest groups who would seek to obtain ``minor'' alterations of the pension system in order to benefit themselves -- this could range from winning votes, buying shares of PSUs, financing the government debt, transferring resources to states, financing infrastructure, subsidising inefficient financial sector entities, etc. Regardless of the merits of any of these claims, the only goal that the pension system should serve is the well--being in old age of participants.

How can we obtain a pension system that is relatively insulated from political risk and is able to deliver high rates of return? There are four fundamental questions in pension system design which matter greatly.

1. Funded versus unfunded A funded pension program is one where future pension liabilities are clearly matched by securities in hand. An unfunded program will meet future liabilities using government taxes. Unfunded programs are vulnerable to irresponsible political decisions. With unfunded programs, contribution rates and benefit rates can be arbitrarily set by government. There is always a possibility of a political decision to increase benefits or reduce required contributions into an unfunded program. International experiences with pension policies are quite gloomy in this regard; governments have routinely abused the flexibility that unfunded programs give them.

2. Government securities versus private securities While funded versus unfunded matters greatly in the extent of political risk, a funded program which invests in government securities is no better than an unfunded program when it comes to the rate of return. An unfunded pension system depends on future taxes; but a funded pension system which owns government bonds also depends on future taxes for obtaining repayment on the bonds. The ability of the government to obtain tax revenues can only grow at the rate of wage growth in the economy. Hence the rate of return on pension savings in unfunded programs, or in funded programs which buy government bonds, is the wage growth rate. In contrast, investments in private securities (bonds or equities) gives a rate of return which is the marginal product of capital. This is always substantially higher than the wage growth rate. Hence, a pension system should be funded (in order to reduce the political risk) and invested in private securities (in order to obtain a higher rate of return).

3. Individual accounts versus collectivist programs A pension system where each individual makes contributions into an individual account is desirable since the individual interprets the pension assets as personal wealth and watches over the assets closely. This makes it harder for special interest groups to hijack pension assets. In contrast, collectivist programs, where an individual does not have a passbook and does not see assets which are personal wealth, are vulnerable to a free rider problem: each individual has an incentive to ignore political problems of the pension system in the hope that others will take care of them.

4. Defined benefits or not In a defined benefit program, the individual is guaranteed that a certain pension will be paid in old age. The moment this is done, the political risks are amplified, since the individual has no interest in ensuring that pension assets are not hijacked by special interest groups. Once benefits are defined, governments are free to set contribution rates to "required" levels, and there is the risk that governments will choose irresponsibly low contribution rates. These political risks are very real: Even in an advanced country such as Germany, the government pressurises actuaries to say that the liability of the pension program is 50% below the truth. Since voters have been promised a defined benefit, they do not care about the problems of the pension system, and only support the politicians who promise the lowest contribution rates.

These four arguments suggest that a sound course for building a pension system will be based on the following ingredients: (a) Individual pension accounts, (b) Benefits in old age that are purely determined by contributions into the individual account in preceding years and the asset returns that were experienced, and (c) as little investment in government securities as possible, subject to minimum limits that flow from prudential regulation. A pension system that walks along these three routes will face low political risks and offer high rates of return.

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