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# **Box 9. Designing Mandatory Pension Schemes**

# Excerpts from **_Dimitri Vittas,_** "Viewpoint," Financial Sector Development Department, World Bank, February 1996.

In many countries, participation in a public pension system involving some kind of redistribution is compulsory. But there are growing fears that the value of these pensions will not be sustained. As many public pensions fail, the case for compulsory private pension schemes become stronger. The state has an obligation to ensure that the system works well, is simple and will deliver the targeted benefits.

_Defined Contribution or Benefit?_ Increasingly, compulsory schemes are of the defined contribution variety with individual capitalization accounts. These schemes tend to be fully funded, fully vested, and fully portable, although the performance risk of pension investments is transferred to workers.

_Size of Contribution?_ Experience suggests that a contribution of 5 percent is inadequate for longterm capital accumulation and for an appropriate pension level. An additional 2 to 3 percent is required to cover operating costs and premiums for term life insurance and disability insurance. Basic contribution rates, including insurance, are 13 percent in Chile, 11 percent in Argentina, and 23 percent in Malaysia.

_Who Should Manage the Funds?_ Experience in both developed and developing countries shows that decentralized, competitive private management has achieved higher real returns, net of expenses and fees, than public centralized management.

_What Types of Regulation?_ The main focus of regulation should be prudential norms and fiduciary standards. Rules for separating pension assets from those of the sponsoring company and against self investment are essential. Detailed investment rules setting upper limits on different assets by type and by issuer may also be necessary to ensure diversification in less developed capital markets. But reliance on the "prudent man" rule should provide adequate protection.

_What State Guarantee?_ State guarantee can take many forms. If not properly formulated, these provisions can create moral hazard and increase the cost of entry. A minimum pension guarantee is often used. Chs'e, for instance, offers a guarantee of 25 percent of the average wage of the workers who have contributed for at least 25 years.

_Individual Choice and Competition_ Individual choice is essential even in a compulsory pension scheme. In Malaysia and Singapore, workers can decide how to invest part of their own balances, provided that they choose from a menu of approved assets. In many Latin American countries, workers can choose their fund management companies and can switch from one company to another.

_How to Offer Tax Incentives?_ Tax incentives should be used to ensure compliance. Two regimes are commonly used. One exempts contributions and investment income from taxes, but taxes pensions - the EET regime. The other taxes contributions, but exempts investment income and pensions - the TEE regime.

This shortfall may be attributable to a variety of factors, including under-reporting by employers, failure to make contributions for the full year, or inadequacies in the posting and accounting of member contributions. In addition, Jamsostek does not require contributions based on overtime pay, which for some companies represents a large proportion of workers' compensation. Such collection lapses are not unique to Indonesia, but appear to be a universal