Pension reform: what choices do we have?
In the after-math of the Great Recession, governments in the western world are grappling with how to reform the pension system (aka social security in the U.S.). The particular issue is that in most plans current funding would not adequately pay out those retiring or would pay out those retiring in the immediate future but with declining benefits succeeding recipients. In England, there has been a back-lash against proposals to push back the eligible age for state pensions to 70.
Canada’s more modest reform would consist of raising Canada Pension Plan (CPP) premiums from either a modest increase to fully funded which has elicited a mini-generational war over pension benefits to a larger discussion on whether the issue is not the pension system but our saving patterns during our earning years.
There’s a common theme about pension reform- government knows best, the taxpayer- only the people who fund the plans- should take a passive role and that, in most cases, pension reform should be government centric.
Are these are only choices? Do can we, as taxpayers, legitimately contribute to the debate?
HOW PENSION SYSTEMS WORK
At its core, the pension system is easily understandable. There are really only two fundamental systems a county can use in constructing a pension plan. A “pay as you go” or a “paygo” uses the current contributions of taxpayers to pay current recipients of pension benefits. In order words, there is no money being saved (known as reserves) in the plan- it is money in and money out. A “fully funded plan” is, as the name implies, a plan that can pay out both the current pension recipients and the future recipients (taken as a reserve) based on actuarial calculations on investment returns and future payouts; a crude analogy would be a household that has cash on hand to pay before this month’s fixed expenses and the rest of the years.
Given our aging demographic, a fully funded plan would require extensive contributions from employees and employers. Thus, most countries now run hybrid, paygo-fully funded plan such as CPP. There is enough money to pay current recipients and enough reserve to cap any increase in current pension contributions.
A move to a fully funded plan, while ideal, would be political suicide. It would require steep increases in pension contributions from both the employee and employer. Most countries have moved away from fully-funded plans in the mid-1990′s for this reason. A paygo system would be equally unpalatable. While it may buy the senior’s vote, how could a political party sell a plan where money contribute would be used 100% to pay others to voters in their prime earning years?
Thus, a hybrid system tends to balance the competing needs of different generations while ensuring job security for politicians. However, the policy question has rapidly becomes how does the government balance the needs of those being paid out against those contributing without damaging the economy in the meantime?
HOW MUCH MONEY DO YOU GET?
Here is where things get slightly more complicated. How much pension money do you receive? Again, there are two primary ways to administer how much to pay out. The first is to pay based on the taxpayer’s earnings history; for example, the U.S. Social Security system looks at the average of 35 years of average earnings in determining payout. The other systems, such as used by CPP, is to pay out based on contributions into the plan.
In order to stem payment out, when you get your pension benefits is as important a question as how much. In Canada, reduced contributions are available as early as 60. In the U.S., the earliest age is 62. Sweden, which has arguably the most comprehensive systems of pension benefits, a taxpayer has 3 milestones to consider, taking their benefits at 61, 65 or 67.
Obviously, the longer a pension plan can wait to pay the recipients, the longer it can cap premium increases. Thus, as we see in Europe, the debate has become soon can anyone be eligible for early pension payouts and what age can anybody receive pension benefits without an early withdrawal penalty. The easy political solution will be to eliminate early application for pensions or to reduce the amount payable if people apply for pension benefits early.
DOES IT HAVE TO BE ALL PUBLICLY ADMINISTRATED?
This is where many governments are omitting a viable option. Pensions do not all have to be publicly administered. In fact, Sweden, socialist Sweden of all places, has a partial privatized option. Although their pension contributions are a staggering 18.5% of payroll, 2.5% of this contribution is directed into a self-administered account. The taxpayer can pick various products within this fund or, in the absence of any choice, there is a default fund. The government does not manage the money (I wrote about this pension option previously at length).
The larger policy argument for privatization surrounds what the government does with pension reserves. In the U.S., social security reserves (which, again, is money that does not need to be paid out today) are stored in nominal trust account but the funds themselves have been loaned back to the government for operating needs with treasury bonds given back in return as security. In other words, a portion of pension contributions are backed by a IOU of a government with a large debt and deficit.
This raises the larger question about entrusting one’s pension to institutions that predominantly do not have good track records of managing money, using funds properly, or have any consequences from failing to manage the money properly.
…I have no special insight into pension reform. However, the point of this post is not to persuade readers that one position is better than another but to educate on a very preliminary overview of how pension systems work so that a more educated and informed dialogue can occur to replace the top-down one-sided conversation occurring now.