Karnit Flug: Challenges in the field of pension savings
Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Pensions, Insurance and
Financial Literacy Research Center, Ben-Gurion University, Beer-Sheva, 20 November 2014.
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Good morning,
The festive opening of this institute is a very important event, and its work plan seems
promising. There is tremendous importance to raising awareness and research on the
matter, and action in this direction is to be welcomed. It is also important to improve the
public's ability to make an informed decision in this field as this is one of the most important
financial decisions a household makes. I therefore see tremendous importance in working on
financial literacy.
I would like to briefly touch upon a number of facts and trends that point to the challenges in
the field of pension savings, and then to present a series of questions that I believe are
proper to deal with in an institute such as this.
Projected demographic trends
As we know, life expectancy is increasing, and if we look at the past 40 years, the life
expectancy of those reaching age 65 increased from 80 years to 86 years for women, and
from 79 years to 84 years for men. This fact, together with the fact that the retirement age
increased by only two years, means that men are expected to live an average of 17 years
after retirement and women are expected to live 24 years after retirement. This leads to the
question of whether, during the working period, the public is saving enough to ensure a
proper income at retirement age.
Another way of looking at the demographic change is to look at what is happening to the ratio
between the working-age population and the retirement-age population. The trend in Israel is
similar to the trend in other countries in the world, although with some lag. As of today, there
are 5 working-age people for each person over age 65 in Israel, while the ratio in 2050 is
expected to narrow to 3:1. This change obviously has serious implications for the labor
market, the dependency ratio, and various aspects of policy.
An international comparison of retirement arrangements shows that in Israel, the retirement
age for women is relatively low, and even after it is raised to 64, as is supposed to happen in
2017, it will be significantly lower than in most European countries, some of which are also in
a gradual process of raising it. The retirement age for men in Israel was raised to 67, and is
similar to the retirement age among European countries that have already raised it, and is at
the upper threshold. The large gap between men and women in Israel is prominent, and
raises a question regarding the ability of women to save enough for retirement. The more the
decision on an additional increase in the retirement age for women is delayed, the more it will
be necessary later on to do so more rapidly, which will be more problematic.
And what is happening to long-term savings?
There has been a significant increase in the volume of assets under management by
longterm savings plans in the past 14 years, from about 57 percent of GDP to about 90 percent
of GDP. One of the significant processes behind this increase is the enactment of the
Mandatory Pension Law in 2008, which requires workers and employers to set aside a
significant percentage of their income for pension. In addition, during this period, there was a
gradual transition in the public sector from defined benefit pensions to defined contribution
pensions, with all employees who began working in the public sector from 2004 onwards
contributing to defined contribution pensions. The volume of assets increased, although it is
volatile: for instance, the decline during the financial crisis, such that someone who retired at
that time saw lower accumulated savings that he had expected.
Looking at the distribution of main assets in the investment portfolios of the long-term
savings plans, we can see a gradual and continuing decline in the share of designated
bonds, together with an increase in the weight of stocks, corporate bonds and investments
abroad in the portfolio, so that the share of the components that are more sensitive to
developments in the financial markets is expanding over time. In terms of the composition of
investment portfolios by type of plan, we see that the in plans in which more veteran
members save (old pension plans and plans that ensure a yield), the weight of designated
bonds is relatively high, and the weight of the assets that are sensitive to the financial
markets is relatively low. In contrast, in the investment portfolios of the plans in which new
members are saving (new pension funds, and profit-sharing funds), there is a much higher
weight given to investments abroad, stocks, and corporate bonds, which leads to higher
exposure to developments in the financial markets. These investments finance economic
activity and development, but are also exposed to higher volatility.
The impact of the trends on the replacement ratio
In view of the trends I have presented to this point, the interesting question is what will
happen to the level of the pension payout at retirement age. The commonly accepted
variable to look at in this context is the replacement rate - what will the retiree's income be
compared to his pre-retirement salary. In a simulation of the net replacement rates including
defined benefit pensions and old-age pensions, we focus first on women with a relatively low
income of NIS 7500 a month. Women who retire at age 62, whose pension savings have
generated an average real yield of 2 percent per year, and whose pension contributions are
17.5 percent of their monthly salary, will have a replacement rate of 54 percent. In contrast, if
the yield is 4 percent per year and pension contributions are 19.5 percent of monthly salary,
the replacement rate will be 76 percent. Men who retire at age 67 and earn NIS 7500 a
month at retirement age, whose pension savings have generated an average real yield of
4 percent per year and whose pension contributions are 19.5 percent, will have a
replacement of almost 100 percent. In contrast, if the average real yield is 2 percent and the
contributions are 17.5 percent, the replacement rate will be just 66 percent. The replacement
rate will be significantly impacted by both the retirement age and the amount of contributions
to savings. This situation, which is similar among those with higher salaries, raises questions
on both the individual level and the policy level. These are the issues that the institute being
launched now should deal with.
I will also present a number of questions, on the individual level, on the policy level, and a
number of questions for research:
Size of the payout:
- What is a reasonable replacement rate?
- How do we deal with the increase in life expectancy?
- How do we deal with the ramifications of the low interest rate environment on the
yields of pension savings?
- How do we deal with the ramifications of high volatility on the yields of pension
savings?
- What are far management fees that also allow for the quality management of
pension savings?
The efficient allocation of public resources:
- How do we use and allocate the designated bonds among the various long-term
savings plans and instruments in the best possible manner?
- What is a fair and efficient allocation of tax benefits?
- What is the proper way to handle the population that will be retiring in the next few
years without sufficient pension savings?
Questions relating to the investment portfolio of the institutional investors?
- What is the optimal composition of the investment portfolio in the context of the
transition from classic investment channels to other channels (direct credit, real
estate), and in the context of the diversification of investments abroad?
- What effect does the tension between the short-term measurement method of the
plans' achievements and the need to create long-term yields and repayment
abilities, which is what is relevant to the saver, have? Does the method of
measurement not create short-term competition, which is not necessarily optimal?
- What is the proper extent of the investment portfolio's exposure to investments
abroad and to foreign currency?
Financial education:
- What is the proper balance between the decisions of the individual and regulatory
intervention?
- What are the tools that need to be provided to the public in order for them to make
informed decisions about their pension savings?
Questions for research:
- Can we estimate the effect of savings enforced by the Mandatory Pension Law on
developments in various markets (household credit, and so forth)?
- How does mandatory pension affect total savings?
- How can we balance the need to direct long-term savings to support for business
sector growth and the maintenance of a reasonable level of certainty for retirement
age?
In summation, the institute currently being launched has a great deal to do, both in the field
of broad empirical research and in the field of research on questions of policy. The activity to
increase the public's financial literacy will help all of us make informed decisions regarding
the question that is perhaps the most important in the area of household financial decisions. I
wish the people of this institute success in your important endeavors, and I await the
opportunity to learn from the fruits of your labor.