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Organisation for Economic Co-operation and Development



Publication sponsored by

the Japanese Government

INSURANCE AND PRIVATE PENSIONS

COMPENDIUM

FOR EMERGING ECONOMIES


Book 2

Part 2:2)c


PUBLIC-PRIVATE INTERACTION IN THE STRUCTURAL PENSION REFORM IN EASTERN EUROPE AND LATIN AMERICA

Katherine Mueller

2001



This report is part of the OECD Insurance and Private Pensions Compendium, available on the OECD Web site at www.oecd.org/daf/insurance-pensions/ The Compendium brings together a wide range of policy issues, comparative surveys and reports on insurance and private pensions activities. Book 1 deals with insurance issues and Book 2 is devoted to Private Pensions. The Compendium seeks to facilitate an exchange of experience on market developments and promote "best practices" in the regulation and supervision of insurance and private pensions activities in emerging economies.

The views expressed in these documents do not necessarily reflect those of the OECD, or the governments of its Members or non-Member economies.


Insurance and Private Pensions Unit

Financial Affairs Division

Directorate for Financial, Fiscal and Enterprise Affairs



I. Introduction


The past few years have witnessed structural pension reform in many countries of the world, with a particular reform dynamics in Latin America and Eastern Europe (for an overview see Müller 2000a, 2000b). This type of pension reform was mainly intended to change the public-private mix in the provision of old-age security, and to strengthen individual responsibility for old-age pensions. Under this reform approach, funds are independent financial entities and each worker chooses his or her own pension fund  a “worker-choice model“ (Lindeman, Rutkowski and Sluchynskyy 2000: 32).

Before structural pension reform was implemented, many of the countries used to have a monolithic public pension scheme; in others voluntary private pension funds were offering supplementary benefits. Structural pension reform, as we have come to know it in recent years, introduces private old-age provision on a mandatory basis, while at the same time downsizing the public tier. Much of the concomitant policy discourse has been marked by a public-private dichotomy. Contrary to this, I will stress here that in the new multipillar schemes the government’s role is not limited to the public tier. Rather, the state plays an important role in all tiers of the new pension systems: “It is not possible to get government out of the pensions business“ (Barr 2000: 48).

Not only public old-age benefits, but also private pensions are vulnerable to the absence of an efficient government. There are public sector prerequisites for pension privatisation, minimally sufficient conditions both in terms of administrative and supervisory capacities, and in terms of fiscal leeway. At the same time, there may be feedback mechanisms from the private tier to the public sector.

II. The public-private mix in Latin American and East European pension reforms


There have been various types of structural pension reforms, differing with regard to the public-private mix and the functions allocated to the private and public tiers, respectively. Latin American reforms are usually divided into three main groups (Mesa-Lago 1998, Müller 2000a):

The substitutive reform path implies that the former public system is closed down, being replaced by a private funded scheme. Under the parallel model, a private funded scheme is introduced as an alternative to the public one, resulting in the coexistence and competition of two parallel systems. The mixed reform path adds a new private funded component on a mandatory basis complements the reformed public system. The common feature in all three models is the introduction of a mandatory private pension fund tier, that either competes with, substitutes or complements the public PAYG scheme. Annex Table 1 shows that the substitutive model is the dominant reform type in Latin America, having been adopted by Chile (1981), Bolivia (1997), El Salvador (1997) and Mexico (1997). Nicaragua has legislated a similar reform. The other countries have either chosen the parallel model  such as Peru (1993) and Colombia (1994)  or the mixed model, such as Argentina (1994), Uruguay (1996) and Costa Rica (2001).

In the Eastern transition countries (see Annex Table 2), there is more diversity in terms of first tier design, but basic reform types are less heterogeneous. So far, the parallel approach has not been adopted in the region, and only one country  Kazakhstan  has opted for the ”Chilean model“. The predominant type of structural pension reform is the mixed model, that was implemented in Poland and Hungary, and legislated in Croatia, Bulgaria, Macedonia and Latvia (for details see Fultz and Ruck 2000, Lindeman, Rutkowski and Sluchynskyy 2000, Müller 2000b).

This paper will discuss public-private interactions in structural pension reform. “Classical“ state functions in mandatory private schemes include (1) the design and implementation of the new pension scheme, (2) the regulation and supervision of the funded tier, (3) the financing of the fiscal costs of the transition, and (4) the provision of an implicit “pension guarantee of last resort“. Additional functions allocated to the state in some countries include (5) a clearinghouse approach, (6) the state as sponsor of pension funds, and (7) the provision of disability and survivors’ pensions. Finally, (8) the general context conditions, on which the government has a major influence, also matter, notably the provision of a sound macroeconomic and political environment.


III. The role of the state in pension privatisation


(1) Design and implementation of the new pension scheme: The state sets the “rules of the game“ by writing the laws for the establishment of the private pension fund tier, making important design choices. In the light of classical welfare state research, it may seem paradoxical that the state could possibly be handing over a part of its own responsibilities to the private sector (but see Müller 1999, 2001). Most notably, the size of the funded tier, relative to the public tier, is determined by the government. This includes the decision about the level of contributions to be diverted to the funded tier, as well as the participation requirements in the private tier and default rules for the allocation of undecided participants. In the case of mixed or parallel systems, the state also sets the incentives for a fair or biased public-private competition.

(2) Regulation and supervision of the funded tier: There is a strong case for an efficient supervision and monitoring of a mandatory funded tier by the state, in order to reduce management and investment risks. This can be done either through a separate supervisory entity or as part of existing financial sector agencies. Many transition countries went through banking crises in the past decade, hence the public should be assured of a special supervisory effort made for their old-age provisions. Regulation should not be maximized, yet made as efficient as possible, for reasons of consumer protection. An example for the need for a strong supervisory agency is granted by the case of Bolivia: when the Spanish owners of the only two existing pension funds merged, turning Bolivian old-age protection into a private monopoly, the superintendency was there to negotiate with the newly created company, BBVA, obliging it to sell one of the pension funds. However, the corporate structure of the private pension funds may limit the state’s ability to monitor the mandatory private scheme, as in the case of Hungary with its cooperative-like entities, that create de facto (as opposed to formal) ownership structures, difficult to supervise.

If there is an element of choice between the public and private mandatory components, the government has an obligation to provide independent counselling and advice, which is lacking in many countries. Individuals should be assisted in making informed switching decisions and to choose among funds, especially given the high potential cost of mistaken choice. It should not just be left to private pension funds to provide information to the public. The importance of informed choice is highlighted by the misselling scandal in Britain. Increased choice is desirable only where consumers are sufficiently well-informed to make choices. The basic information provided should include a standardisation of rentability calculations, to enable a meaningful comparison of the funds’ performance, as well as periodic information on individual contribution payments.



(3) The financing of the fiscal costs of the transition: Boiling down to the most significant feedback effect from any newly introduced private tier to the public sector, the costs of the transition to funding are borne by the public system. As the private mandatory tier is not created in a institutional vacuum, the contributions that are diverted to the private funds are likely to worsen the financial situation of the public tier. This effect has been particularly pronounced when the number of people who switched exceeded the original estimates (such as in Argentina, Hungary and Poland). These costs are not only likely to affect pensioners that rely on the public scheme, but may also crowd out other public expenditure items. Excessive reliance on deficit financing can lead to an increase in macroeconomic risks. When implicit pension debt is made explicit, this can have an impact in other areas of public policy, e.g. compliance with Maastricht criteria. Pension privatisation does not solve problems of short-run fiscal imbalances.

To address these financing needs, in several countries a huge part of the private funds’ portfolio is in government bonds. This may be the result of a deliberate government policy, such as in Bolivia, where private funds are obliged to invest in public instruments. In the short run, this policy may effectively prevent a dynamization of the local capital market. On the other hand, a portfolio structure biased towards government bonds may also reflect the scarcity of other titles with a suitable risk-return profile.



(4) The provision of an implicit “pension guarantee of last resort“: If the private tier underperforms and guarantees are insufficient, the government may find itself obliged to supplement the retirement income (albeit certainly more so in Europe than in Latin America). Hence, ultimately the risk of old-age poverty is borne by the state, even when the system is formally DC. In the context of an overall strengthening of earnings-related elements, a trend extending to the existing PAYG schemes, this may result in sizeable contingent liabilities for the state.

(5) Clearinghouse approaches: There is a recent trend to allocate additional functions to the state in pension privatisation. Some countries have opted for public collection of second-tier contributions, by the tax authority or the first-tier agency (e.g. Sweden, Argentina, Poland). The emergence of private schemes may thus be one of the driving forces to improve registering in the public tier, as well as increasing the need for electronic archives and substantial investment in IT. An information clearinghouse approach, that has proved particularly popular in mixed schemes, also implies using a state-agency as a record-keeper. Sweden has gone particularly far in limiting the funds’ interaction with the public. The following reasons are quoted for this design choice (Lindeman, Rutkowski and Sluchynskyy 2000: 34-35): economies of scale if there is a single transfer agent; a reduction of the burden on employers when dealing only with one collection agency; the creation of an information barrier between employer and pension fund, to avoid pressure on the insured that may limit his/her choice; the creation of an information barrier between the pension fund and the insured, to lower marketing costs.

If employers are supposed to pass contributions on to private pension funds, it is necessary to create checks and balances. Transparency should exist both with regard to the insured and to the state. This includes the collection and disclosure of statistics on contribution evasion (currently unavailable in Hungary). Otherwise, incentives may be counterproductive: there is evidence from many countries that employers deduct contributions from wages but fail to pass them on to private funds. More effective revenue collection and compliance remains a major issue to be solved in private schemes; otherwise workers may lose part of their contributions, as the recent Polish and Hungarian experiences show.



(6) State-sponsored pension funds: In some countries, the state is even one of the players in the pension fund arena. In Kazakhstan, the state sponsored pension fund still has the largest market share. In Argentina and Uruguay, a state bank runs its own pension fund, with an important market share in the Uruguayan case. This design feature may be an important tool to win political support for a change in the public-private mix in pension provision, but should be handled with care. There should be enough leeway for investment decisions of all pension funds, as there is clearly a tradeoff between fiscal needs and the interest of the insured in profitable investment.

(7) The provision of disability and survivors’ pensions: Notably in the Eastern transition countries, disability and survivors benefits have been kept in the public tier, even after pension privatisation. At the same time, second-tier funds are not always required to pass the accumulated capital on to the first tier in the case of disability and death of the insured. Hence the state is still covering two important risks, with a decreasing revenue base.

(8) The general context conditions: Finally, it is obvious that without a sound macroeconomic environment, the private pensions industry will have a hard time. If the state cannot ensure macroeconomic stability, then private pensions are also endangered. When inflation is high, private pensions tend to be even more vulnerable to depreciation than public benefits. Political risk is another issue that affects not only public, but also private pension provision, as some Latin American cases have shown (notably Peru). This effect is particularly pronounced if most assets are invested domestically and, hence, the insured bear the full country risk.

IV. Concluding remarks


There are significant public-private interactions in the recent waves of structural pension reforms. Setting up a private funded tier results in feedback mechanisms towards the public tier, most notably with regard to the revenue side. It should be noted that in pension privatisation, not only private sector capacity matters, but also government capacity. Consequently, countries that opt for structural pension reform should be encouraged to make sizeable ex ante investments in human capital and IT in the public sector. As noted by Barr (2000: 23): „If government is ineffective, any pension scheme will be at risk.“

BIBLIOGRAPHY


Barr, Nicholas (2000): Reforming Pensions: Myths, Truths, and Policy Choices. IMF Working Paper WP/007139, Washington, DC: IMF

Fultz, Elaine and Markus Ruck (2000): Pension Reform in Central and Eastern Europe: An Update on the Restructuring of National Pension Schemes in Selected Countries. ILO-CEET Report No. 25. Budapest: ILO-CEET.

Lindeman, David, Michal Rutkowski and Oleksiy Sluchynskyy (2000): The Evolution of Pension Systems in Eastern Europe and Central Asia: Opportunities, Constraints, Dilemmas and Emerging Practices. Washington, DC: World Bank.

Mesa-Lago, Carmelo (1998): Comparative Features and Performance of Structural Pension Reforms in Latin America, Brooklyn Law Review, 64 (3), pp. 771-793.

Müller, Katharina (1999): The Political Economy of Pension Reform in Central-Eastern Europe. Cheltenham, UK and Northampton, MA, USA: Edward Elgar.

Müller, Katharina (2000a): Pension Privatization in Latin America, Journal of International Development, 12, 2000, pp. 507-518.

Müller, Katharina (2000b): Ten Years After: Pension Reforms in Central and Eastern Europe & the Former Soviet Union, WIIW Monthly Report 2000/1, pp. 20-29.

Müller, Katharina (2001): The Making of Pension Privatisation in Latin America and Eastern Europe – A Cross-Regional Comparison. Paper prepared for the joint IIASA World Bank Workshop on “The Political Economy of Pension Reform”, Laxenburg, Austria, 5 April 2001.


Annex 1

A comparison of Latin American pension privatisations


Characte-ristics

Implemented


Legislated




Chile

Peru

Argentina

Colombia

Uruguay

Bolivia

Mexico

El Salvador

Costa Rica

Nicaragua

Public mandatory tier

Phased out

Traditional PAYG scheme; alternative to private tier

Traditional PAYG scheme; private tier complemen-tary

Traditional PAYG scheme; alternative to private tier

Traditional PAYG scheme; private tier complemen-tary

Closed down

Closed down

Phased out

Traditional PAYG scheme; private tier complemen-tary

Phased out




Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Private mandatory

tier

Mandatory for new entrants to labour market. Other workers may opt to switch from the public tier.

Membership in either the private or the public tier is mandatory for all workers.

All workers may redirect their contri-bution to the private tier.

Membership in either the private or the public tier is mandatory for all workers.

Mandatory for workers earning over US$ 800, optional for those earn-ing less and those above age 39 to re-direct part of contribution to private tier.

Mandatory for all workers.

Mandatory for all workers.

Madatory for new entrants to labour market and affiliates up to age 35. Older work-ers up to age 50 (women) / age 55 (men) may opt to switch from public tier.

Mandatory for all workers.

Mandatory for all workers up to age 43.




Individual contribution rate: 10%

Individual contribution rate: 8%

Individual contribution rate: 7.5%

Individual contribution rate: 10%

Individual contribution rate: 7.5%

Individual contribution rate: 10%

Individual contribution rate: 6.5% + state subsidy

Individual contribution rate to be gradually increased to 10%

Individual contribution rate: 1% + employers’ contribution rate: 3.25%

Individual contribution rate: 4% + employers’ contribution rate: 6.5%




from 1981

from 1993

from 1994

from 1994

from 1996

from 1997

from 1997

from 1998

from 2001

*

Reform type

substitutive

parallel

mixed

parallel

mixed

substitutive

substitutive

substitutive

mixed

substitutive

* In Nicaragua, pension privatisation was legislated in March 2000. Prior to implementation, the law creating the superintendency has yet to be approved.

** In this table, individual contribution rates to the private tier exclude commissions and disability and survivors’ insurance. It should be noted that although the



IFF tier is dominated by private pension administrators, some countries also admit publicly run pension funds.

Annex 2

A comparison of post-socialist pension privatisations

Characte-ristics

Implemented


Legislated




Kazakhstan

Hungary

Poland

Latvia

Macedonia

Bulgaria

Croatia

Public mandatory tier

Closed down

Traditional PAYG scheme; private tier complementary

NDC* scheme; private tier complementary

NDC* scheme; private tier complementary

Traditional PAYG scheme; private tier complementary

PAYG scheme with pension points; private tier complementary

PAYG scheme with pension points; private tier complementary




Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Individually fully funded

Private mandatory

tier

Mandatory for all workers.

Mandatory for new entrants to labour market and optional for other workers to redirect part of their contri-bution to the private tier.

Mandatory for workers below 30 years of age and optional between ages 30 and 49 to redirect part of their contri-bution to the private tier.

Mandatory for workers below 30 years of age and optional between ages 30 and 49 to redirect part of their contri-bution to the private tier.

Mandatory for new entrants to labour market and optional for other workers to redirect part of their contri-bution to the private tier.

Mandatory for all workers up to 42 years of age to redirect part of their contribution to the private tier.

Mandatory for workers below 40 years of age and optional between ages 40 and 49 to redirect their contribution to the private tier.




Individual contribution rate: 10%

Individual contribution rate: 8%

Individual contribution rate: 9%

Individual contribution rate to be gradually increased to 10%

Individual contribution rate: 7%

Individual contribution rate yet to be defined (2-5%)

Individual contribution rate: 2.5% + employer’s contribution rate: 2.5%




from 1998

from 1998

from 1999

from 2001**

from 2001**

from 2002

from 2002

Reform type

substitutive

mixed

mixed

mixed

mixed

mixed

mixed

* NDC = Notional Defined Contribution.

** Latvian starting date: July 2001; Macedonian starting date: September 2001.



*** In this table, individual contribution rates to the private tier exclude commissions and disability and survivors’ insurance. It should be noted that although the IFF tier is dominated by private pension administrators, some countries also admit publicly run pension funds.


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