metadata: authors: 0: author: Price,William Joseph
count: World
docna: 0: docna: Designing pension systems with coherent
            funded private pillars including issues for notional defined
            contribution schemes
docty: Policy Research Working Paper
subtopic: Rural Labor Markets,Labor Markets,Pensions & Retirement Systems,Population & Development,Social Funds and Pensions,Non Bank Financial Institutions,Capital Flows,Capital Markets and Capital Flows,Urban Housing and Land Settlements,Urban Housing,Municipal Management and Reform,Urban Governance and Management
teratopic: Communities and Human Settlements,Social Protections and Labor,Rural Development,Public Sector Development,Urban Development,Finance and Financial Sector Development,International Economics and Trade,Health, Nutrition and Population
abstracts: cdata!: This paper reviews the factors that
            should guide the design of private funded pensions to create
            a complete pension system alongside a notional defined
            contribution -- or public -- component. It argues that a mix
            of public and private pensions is the most effective option
            to deliver the best combination of pension outcomes. Pension
            design should start with a vision for five core outcomes:
            coverage, adequacy, sustainability, efficiency, and
            security. Thinking through these outcomes helps guide
            choices for market structure, benefit type, contributions,
            investment strategy, and other factors. As well as technical
            design, the governance, scale, and expertise of pension
            funds are critical for good investment and other outcomes.
            Regulators and supervisors should also focus on these
            outcomes and then work out how best to mitigate the risks to
            achieving them over time. These issues are relevant in
            relation to any public pillar, but notional defined
            contribution (NDC) systems bring clarity and transparency to
            policy makers in the benefit formula. The NDC payout formula
            can offer insights for how to improve the payout options in
            funded pillars. The clarity on the NDC formula also means
            that the joint distribution of public and private pensions
            can be modeled.  This is important because the precise NDC
            formula may have implications for optimal investment
            strategies for private pensions, given, for example, the
            negative correlation between real per capita GDP growth and
            equity market returns over long periods.
repnme: repnme: Designing pension systems with coherent
            funded private pillars including issues for notional defined
            contribution schemes
display_title: Designing pension systems with
            coherent funded private pillars including issues for
            notional defined contribution schemes
listing_relative_url: /research/2018/04/29851454/designing-pension-systems-coherent-funded-private-pillars-including-issues-notional-defined-contribution-schemes
topicv3: Pension Funds m1326066 611,Labor Markets m1326488 855,Aging Population m1327275 643,Land and Housing m1327648 817,Retirement m1504007 2896
publishtoextweb_dt: 2018-04-30T00:00:00Z
historic_topic: Communities and Human Settlements,Social Protections and Labor,Rural Development,Public Sector Development,Urban Development,Finance and Financial Sector Development,International Economics and Trade,Health, Nutrition and Population
no_of_pages: 28
author_keys: 0: author_key: 1181806
model_extractions: WPS8420 Policy Research Working Paper 8420 Designing Pension Systems with Coherent Funded Private Pillars Including Issues for Notional Defined Contribution Schemes _William Price_ Finance, Competitiveness and Innovation Global Practice April 2018
Policy Research Working Paper 8420

# **Abstract**

This paper reviews the factors that should guide the design of private funded pensions to create a complete pension system alongside a notional defined contribution—or public—component. It argues that a mix of public and private pensions is the most effective option to deliver the best combination of pension outcomes. Pension design should start with a vision for five core outcomes: coverage, adequacy, sustainability, efficiency, and security. Thinking through these outcomes helps guide choices for market structure, benefit type, contributions, investment strategy, and other factors. As well as technical design, the governance, scale, and expertise of pension funds are critical for good investment and other outcomes. Regulators and supervisors should also focus on these outcomes and then work out how best to mitigate the risks to achieving them over time. These issues are relevant in relation to any public pillar, but notional defined contribution (NDC) systems bring clarity and transparency to policy makers in the benefit formula. The NDC payout formula can offer insights for how to improve the payout options in funded pillars. The clarity on the NDC formula also means that the joint distribution of public and private pensions can be modeled. This is important because the precise NDC formula may have implications for optimal investment strategies for private pensions, given, for example, the negative correlation between real per capita GDP growth and equity market returns over long periods.

This paper is a product of the Finance, Competitiveness and Innovation Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/research. The author may be contacted at willprice@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Designing pension systems with coherent funded private pillars including issues for NDC schemes

William Price<sup>1</sup> JEL Code: C63; D15; G11; G17; G18; G23; J11; J26; J46 Keywords: pensions, pension funds, retirement income, forecasting, simulations, stock market, bond market, government bonds, equity markets, annuities 1 This Working Paper was developed as part of a wider project on Notional Defined Contribution (NDC) pensions, where the final results will be published as a chapter in a book titled “NDC Schemes: Facing the Challenges of Marginalization and Polarization in Economy and Society“, edited by Professor Robert Holzmann, Professor Edward Palmer and Professor Stefano Sacchi. The author is very grateful for comments received on earlier drafts by the editors and participants at the ‘NDC III” conference in October 2017 and particularly to Professor Nick Barr, and to comments received from World Bank colleagues, in particular, Fiona Stewart and Mitchell Weiner. All errors and omissions remain the responsibility of the author.
# **1. Introduction**

This paper reviews the factors that should guide the design of private funded pensions to create a complete pension system alongside a Notional Defined Contribution (NDC) component. It argues that a mix of public and private pensions is most effective to deliver the best combination of pension outcomes. Corner solutions that rely solely on public pensions (whether NDC or not) or just private pensions (whether Defined Benefit, Defined Contribution or hybrid) have no obvious examples of sustainable success in either developed or developing countries. This paper provides references to current and past practice in different regions and globally so that the interested reader can see the different mixes of pension solutions in countries across the world. But documenting in detail who has done what tends to crowd‐out a focus on how and why different approaches are implemented. The design principles set out below are for some well‐known in theory but are often not followed in practice. So, the paper aims to (re)state them succinctly and clearly to (re)establish some simple but powerful principles for the benefit of pension policy makers.

The paper first sets out the criteria by which to judge success or failure of a pensions system ‐ coverage, adequacy and sustainability alongside its efficiency and security. It then highlights the wide range of (overlapping) risks to which pension pillars are subject. Evaluating the success of a system is difficult if there are no metrics of success against which to judge it (including the distribution of outcomes by income and gender). The next section then considers the design of a private pension pillar across two dimensions. The first design question looks at the way in which private pensions will need to be delivered – using the concept of the pension value chain or market structure to highlight the key issues and options. This approach is particularly important to tailor best practice to different country and labor market contexts – particularly levels of formality and informality. The value chain also helps to draw out the importance of the governance of private pensions – and helps to craft solutions that can work with different levels of governance in the public and private sectors. Finally, the process helps to tailor pension system design to the level of development of an economy and the financial market – and whether it meets the ‘pre‐ conditions’ for the successful delivery of private pensions. In some cases, the first‐best theoretical option may need to be replaced by a second‐best option that will be more effective.

The second set of design questions then look at the more ‘traditional’ elements of benefit design, contribution levels, eligibility and payout phase. In an ideal world, the future income to be delivered by a pension system would look at the joint distribution from the combined NDC and private pillar. There are many modeling tools that focus on a single pillar, but the joint distribution can be overlooked. NDC systems allow a clearer identification of potential outcomes in that they are (in theory) less prone to ad‐ hoc adjustments and pre‐election changes than traditional defined benefit public pension pillars. The precise NDC rule may have important implications for optimal investment strategies in private pensions – something that governing bodies of pension funds and pension regulators should consider in their approaches. For example, in many countries real per capita GDP growth (which can feature in NDC rules) is negatively correlated with the real growth of equity markets. So, an NDC rule linked to per capita GDP, sitting alongside a private pension pillar in which there are equity investments, may combine uncorrelated forms of risk. The policy maker needs to think through whether these correlations, negative or positive, are desirable or not. Finally, it is important that design coherence flows to the regulatory and supervisory approach so that they can also focus on how best to achieve the long‐run outcomes. Although not discussed in detail, creating the institutional framework early in the process is obviously important to ensure that the regulator and supervisor can be up and running before the first contributions are paid. A 2
robust program management or ‘Mission Office’ greatly assists the delivery of the reforms, so that great designs are not lost by poor implementation.

# **2. Using long‐run pension outcomes to guide decision‐making on private pensions**

Before introducing the key outcomes, it is necessary to identify the different parts of a pension system and highlight the parts or pillars and the risks to which they are exposed. Public pension provision comes broadly in the form of ‘zero pillars’ ‐ poverty alleviating payments paid out of government revenues that do not require contributions ‐ and ‘first’ pillars that are typically mandatory and can have the full range of benefit options but are often Defined Benefit. Many first pillars are Pay‐As‐You‐Go where current contributions fund current pensions, but there are a number that are at least part funded. Examples range from the CCSS in Costa Rica,<sup>2</sup> the Social Security and National Insurance Trust in Ghana, and Vietnam Social Security (VSS). Such arrangements are very rare in Europe – where many countries are very reliant on large Pay As You Go (PAYG) public pillars with systems that are in great need of diversification (EU White Paper 2012). The NDC debate focusses on this ‘first pillar’. It introduces a mechanism that does not fund the benefits in advance but aims to avoid the build‐up of unsustainable Defined Benefit promises by altering pensions in payment with changes in factors such as longevity (if politics do not intervene).

**Figure 1: Different pensions pillars have different functions and face common and unique risks**

|**Sources of retirement**<br>**consumption**|**Risks affecting payout size**|
|---|---|
|Zero Pillar –poverty prevention|Fiscal,Intergenerational,Longevity|
|First Pillar – public contributory –<br>consumption smoothing|Fiscal, Intergenerational / Political,<br>Longevity, Labor Market, GDP|
|Second Pillar– mandatory private<br>contributoryDB,DC or hybrid|Capital Market (Inv returns/costs),<br>Laborparticipation,Longevity|
|Third Pillar- private contributory<br>DB,DC or hybrid|Capital Market: Investment/Costs<br>Labor market/individual myopia|
|Fourth Pillar: Financial assets|Economic Growth, Instability|
|Fourth Pillar: Familytransfers|Familysize/wealth/culture/location|
|Fourth Pillar: Housing / Physical|Housing market, labor income|
|Labor Income & Own-<br>consumption|Labor Market, Agricultural market|
|Longevityand infl|ation risk ispervasive|

## **Source: Author**

> 2 Caja Costarricense de Seguro Social.

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Decisions on private pensions typically focus on the second and third pillars. Terminology varies globally where many European countries characterize the second pillar as employer provided, and the third pillar as individual pensions. In the World Bank framework, the key dividing line is whether the pensions are mandatory (second pillar) or voluntary (third pillar). In this framework, an employer could be involved in the second pillar or the third pillar. The boundary line between mandatory and voluntary pensions is blurring with the use of auto‐enrollment ‐ as introduced in the UK, New Zealand and Turkey ‐ where it is typically mandatory for an employer to offer a pension and place workers into the pension, but employees can opt out. A common feature across all such pensions is that they involve the investment of assets. There are many ways in which these assets can be invested – from in‐house investment, full outsourcing to fund managers, or a mix of the two. This is discussed in more detail in Section 3. Moreover, there are a range of organizations that control the contribution collection and investment strategy decisions. These range from public sector institutions, arms‐length not‐for profits such as provident funds or employer‐ sponsored trusts to fully private pension fund management companies. Section 3 outlines the pros and cons of these arrangements and provides some guidance for making the best choice in different contexts.

However, the terminology can sometimes get in the way. Many of the issues identified in this paper in terms of good design for ‘private’ pensions would apply equally to a ‘public’ pension fund that was investing assets to meet either a Defined Benefit liability or with a Defined Contribution structure. A country that had an NDC pillar plus a funded ‘public’ pension plan is still effectively bringing together notional and real assets to jointly provide retirement income. The only real difference is the institutional setup, where the choice of ‘public’ or ‘private’ should depend on which arrangements are likely to be secure strong governance, scale and expertise – as discussed in more detail below.

Deciding on the ‘best’ or ‘optimal’ make up of private pensions in combination with a given NDC (or other form) of public pension provision requires criteria against which to judge various options. This paper uses five key outcomes – as set out in work on Outcomes Based Assessments (Price, Ashcroft and Hafeman 2016) which builds on earlier work such as International Patterns of Pension Provision II (World Bank 2012) and Holzmann and Hinz (2005). The five outcomes are<sup>3</sup> :

- **Efficiency** – relating to costs, investment returns and labor market impact of pensions design. Pension provision faces numerous market failures. This means the ‘competitive’ market can deliver sub‐ optimal outcomes (Impavido, Lasagabaster and Huitron, 2010). Failures relate to the ability of consumers to understand the products and make informed decisions (Benartzi and Thaler, 2007), to the quasi‐utility nature of pension delivery given the huge economies of scale in administration and investment management, through to the well‐documented examples of mis‐selling scandals in multiple jurisdictions (UK, Financial Services Authority and Financial Conduct Authority, India Insurance, Mexico, Chile). These factors make it important to think clearly about the full pension value chain and the role of government, providers, employers and members. Transparency is an important element of any good system, but a simple focus on disclosure will not be sufficient to ensure members get the best outcomes. Good governance is profoundly important to ensure members get the best net of fee returns they can – and indeed good governance is relevant to all the outcomes in one form or another (Ashcroft and Franzen, 2017).

3 There are other ways to break down the outcomes – for example as in the work of the Melbourne‐Mercer Global Index (ACFS and Mercer 2013) and the Global Aging Institute (Jackson and others 2013), or work by the American Academy of Actuaries (Forward‐Thinking Task Force. 2014).

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A critical feature for effective pension systems that is often ignored is an explicit focus on reducing the total cost of delivery, including a clear target for total costs that do not enhance returns. In a world where real returns are likely to be only 3%‐4% in the long‐run, having a fee level of 1% means that total fees are taking 25%‐33% of returns. This is not only a question of the level of profits made by private providers, since high sales and marketing costs and wasted setup costs with high rates of switching can mean that high fees co‐exist with low profits. But best practice should be to work from a long‐run objective of delivering high net of fee returns including through rigorous cost and fee control and use this to drive system design. The objective is not low fees on their own, but to minimize costs and fees that do not increase coverage, contributions or investment returns. As discussed in Section 3 there are many attractions to a central clearing house model with centralized administration and investment management contracted at scale – however, there are cases where the governance or the technology or delivery capacity make such arrangements difficult.

- **Sustainability** – relating to the funding of public or private defined benefit promises, but also the affordability of given contributions by employers and employees. Private pensions that involve Defined Benefit promises underwritten by employers clearly add another dimension to sustainability. Payout phases delivered by insurance companies mean that a pension policy maker needs to have confidence in the sustainability of the insurance regime. Where this confidence is lacking, or annuity markets are not well developed, other pension payouts can help deliver income. Political sustainability should also be a central focus since pension systems need to be maintained across multiple electoral cycles. This places a premium on using cross‐party pension reviews to build consensus. Clarity on what each pillar of the system can and cannot deliver is critical to anchor expectations and help avoid unrealistic expectations – supported by simple clear messages, rather than attempting to turn people into pension experts.

- **Adequacy** – relating to the level of pension income – both at the point of retirement (or drawdown) as well as at later ages. A pension pillar should deliver in its own right, but ultimately it operates in combination with other sources of retirement income. Governments directly impact the level of income either through direct contributions or through providing incentives such as tax relief or matching. The distribution by income and by gender is especially important for assessing outcomes – particularly if scarce tax resources are used to provide incentives which can often benefit higher income workers if not well‐targeted. The rules for a ‘zero’ pillar, if it exists, or any base level of income guaranteed to all in old‐age by virtue of citizenship is also clearly important in considering the size and shape of a private pension pillar.

- **Coverage** – relating to the percentage of the relevant populations that are contributing and receiving pensions – with coverage of informal workers possibly the single biggest challenge in global pensions (Bosch and others, 2013).  Again, the distribution by income and gender is important to understand so that projections for the ‘average’ worker do not mask large inequalities in future outcomes that will call into question the success and legitimacy of the pension system. In the past many countries with occupational Defined Benefit pensions had long ‘vesting’ rules where workers had to work for 5 or even 10 years to receive pension rights. This leads to lower pensions for women who tend to have shorter and more broken career histories. Hence an ambition for broad coverage with gender equality would then lead to a need for low or no vesting periods – which is a natural feature of most Defined Contribution pension arrangements. Likewise, rules on annuitization of income, or the sharing of pension rights on death or divorce will also affect gender equality ‐ since again in most countries female labor market participation tends to be lower than for men and pension contributions reflect

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this labor market experience. This gender inequality is particularly stark in some regions – e.g. the Middle East and North Africa region (Price, Pallares‐Miralles, DeMarco and Attia, 2017).

- **Security** – relating to the security of assets, the reliability of promised pensions and the central role of a regulator and supervisor. This is critical for all private pensions, but consideration should also be given to whether an NDC system should be subject to external scrutiny as well. It is essential that public confidence is created and maintained for: the robustness of the formula for the notional returns; assurance that the inputs (such as changes in mortality or wage rates) are accurate; and that there is effective management of other issues such as cost control. It is important in the sequencing of private pension reforms that sufficient time is given to create or improve the regulator and supervisor and ensure it is effective before the first contributions are made. Failure to allow enough time to get the regulator up and running can lead to significant problems for new pension pillars – for example as seen in the reforms in Ghana from 2008 which have taken years to correct. It can also contribute to the implosion of reforms, as in Mexico’s 1992 ‘SAR’ reforms which failed initially and then had to be revisited in 1997. Section 4 includes a discussion of some key supervisory issues.

The 5 outcomes presented above clearly interact. A country could aim for a higher level of adequacy simply by increasing contribution rates to DC private pensions or the contribution amount credited to the notional account. But in combination with contributions to public sector pensions this could make the labor market inefficient as employers and workers try to avoid contributions. It can make the system unsustainable because contributions take too large a share of employer profits, or government revenue. A country may be aiming to rapidly expand coverage of private pensions but will need to target incentives more effectively. It could use matching or a tax credit rather than simple tax relief but with a cap on total incentives so that broad coverage is not unaffordable. This effect has been seen for example in the UK where tax relief for private pensions was available for up to GBP1.8 million before the financial crisis, but has been progressively scaled back as governments had to take decisions about the best use of scarce public resources.

The policy development process should focus on making viable and consistent choices. There is no point in setting a goal for adequacy as 50% of average earnings, but then having a contribution rate of 3%. It is not viable to have a goal for coverage of 80% of the labor force if the formal sector is only 20% and the proposed delivery of private pensions is via employers, or only via institutions with links to the formal economy. Similarly, a goal for 80% coverage is not plausible if policy makers will only introduce a voluntary pension pillar, rather than a mandatory or quasi‐mandatory pillar (see Figure 2 for a description of different pension pillars). Similarly, there is no credibility in asserting that all assets in private pensions are secure from fraud and error if there is no regulator and supervisor and no requirement to use a custodian. The discussion about what a country may want to achieve and the logical impact of that ambition for policy design can highlight unrealistic ambitions. This is important in relation to political sustainability and whether the intended outcomes are realistic. There is a danger that policy makers (or providers) can over‐ promise on potential outcomes to sell reforms or encourage people to join a system, and then face the consequences of disappointment when those promises do not materialize.

A focus on multiple pension pillars is not simply to provide a menu of options from which to choose the ‘best’ pillar. The focus is because relying on a single pillar is a very risky strategy – not least because the 6
the workers were effectively nationalized by governments in Poland, Hungary and Argentina – who used the assets for governmental purposes while maintaining promises for future pension income (Price and Rudolph, 2013). As far as the author is aware there were no examples of employer sponsored (trust‐ based) pensions that were appropriated by governments – although in Ireland the government did impose a small levy on the assets of occupational pensions – akin to a limited form of `wealth tax – and governments do make changes to the regulatory, legal and tax environment that can impact benefit levels. Pension policy needs to deliver over a 40‐80‐year period. Given the certainly of shocks and changes over such a period, a diversified approach to delivering retirement income is a sound policy.

For the reader interested in which choices different countries have made, a good global survey is provided by International Patterns of Pension Provision II (Pallares‐Miralles and Whitehouse 2012), and, for a smaller set of countries, by the OECD’s Pensions At A Glance. International comparisons of saving for old age have been developed by the ‘FINDEX’ index and can be found in work by Demirguc‐Kunt and others (2015, 2016). Recent in‐depth regional reviews of history and current practice include: The Inverting Pyramid for Europe and Central Asia (Arias and Schwarz, 2013); Live Long and Prosper for East Asia Pacific (O’Keefe and others, 2016); Pension Systems in Southeast Asia (ADB 2013); Pensions at a Glance Latin America and Caribbean (2014); Pension Patterns and Challenges in Sub Saharan Africa (Dorfman, 2015); and for the 22 members of the Arab League, a review of Trends and Policy Reforms (Price and others, 2017). For longevity comparisons, there is the UN’s World Population Prospects (UNDESA, 2015), and for long‐run international comparisons of asset returns in 22 countries since 1900, the London Business School, Credit Suisse Global Investment Year Book (Dimson, Marsh and Staunton, 2016).

There are many organizations that provide regular international comparisons in the form of a league table that can provide some comparative information, such as the Melbourne Mercer Global Pension Index (Mercer, 2016) or the Global Aging Index (2013, 2015). Reducing a pension system to a single number is obviously aimed at creating debate and discussion – but the reports are perhaps even more useful for the in‐depth discussion of the characteristics of each country. In recent years, the World Bank has partnered with the OECD and IOPS annual pension statistics exercise with the aim of making its coverage increasingly comprehensive. It is worth highlighting a note of caution with any regional or international comparison of pension systems. It is a heroic effort to keep up with the number of changes in a typical pension system, to be sure that administrative data sources are accurate, the latest surveys are representative, or to do full justice to the complexities and nuances below broadly comparable descriptions. So, they can and should be used to look at big picture trends and areas for development, but it is important to validate the data and conclusions with a thorough technical review of a country when developing reforms.

# **3. The first design question for how to deliver private pensions**

Before getting to questions of contribution rates, accruals, investment strategy and payout phases it is important to have a rigorous focus on each part of the pension value chain. How will individuals and employers be identified, enrolled, make contributions, have their accounts created and managed, their investment strategies developed and executed and finally their pension income distributed? This is important because pension markets – particularly those that cover most people in a country – are created deliberately and by policy action rather than emerging spontaneously. It is certainly the case that there are forms of voluntary provision in many countries at all stages of development that are the outcome of 8
individual decisions – usually resulting from the decisions of (large) individual firms and often due to union bargaining. But even in these cases the coverage very rarely extends beyond 10% of the labor market and is often far lower. Those countries that do have coverage above 10% from purely voluntary occupational pensions (e.g. the UK, Canada, the US) have very active political debates about the need to expand private pension coverage. Therefore, if the answer to the question on the desired coverage level is for something above 10%, then the policy maker will need to do far more than create legislation to allow the sale of pensions with some form of tax‐preferred status and rules that lock in assets until a person reaches a certain age.

Individual voluntary pension provision – or the ‘third pillar’ ‐ is very often structured as a product purchased by individuals from a private provider as a ‘normal’ financial product. Providers are often insurance companies, or dedicated pension fund management companies – and are often themselves part of larger financial services groups. This can be a sensible and important first step in a journey to building all the necessary pillars of pension provision. Albania, for example, founded its third pillar in 2009 at a time when there were certainly not the pre‐conditions for a move to a mass market second pillar, whether via compulsion or auto‐enrollment. Turkey in 2003 is a similar example.

This third pillar model certainly allows pension products to be rapidly and freely available. However, translating availability into coverage can be very tough. These third pillar pensions have a value‐chain that is more akin to the sales of insurance products – relying on a network of sales agents and competition between many vertically‐integrated providers.<sup>4</sup> Interestingly, a new survey by the International Association of Insurance Supervisors (IAIS) and International Organization of Pension Supervisors (IOPS) has shown that around 50% of the value of insurance company life insurance business comes directly from pension markets, where in many cases the large size of the business in the first place is due to a government mandate.<sup>5</sup> Moreover, when a country wants to expand coverage, the market structure of the ‘many firms‐many buyers’ vertically integrated financial group does not translate well to delivering the best outcomes for a mass market product. This need not matter if there is a clear understanding of the issue and a commitment to start a mass market approach using a different market structure. But once the third pillar is well‐established policy makers face the problem of politically influential incumbent providers who may well resist the development of a different approach – particularly one that might break the link between provider and individual customer that can be an important part of improving outcomes as set out below. New approaches can be developed, but the experience of the UK in developing auto‐enrollment reforms shows that even well‐developed proposals by an effective pension commission that generated broad political consensus faced very strong resistance from many incumbents. This led to 2 separate reviews into the proposals made for auto‐enrollment in 2007 and 2010, both of which had the potential to derail or significantly undermine the reforms that have now added an extra 7 million savers (out of some 30

> 4 Insurance provision is almost never compulsory in the way that pension contributions are often mandated or quasi‐ mandated – except for car insurance, some forms of personal liability insurance, and in the case of Turkey mandatory earthquake insurance. Rules set by mortgage lenders can sometimes make home insurance effectively compulsory as well as some form of life cover, but this is not universally the case, and there is typically no check once a mortgage is provided that the cover remains in place.

> 5 IAIS and IOPS 2017 forthcoming.

9
million workers) and significantly cut costs for the median saver. A more effective approach to developing the right pension market structure for a country is to use the pension value chain (see Figure 3) to think through each stage of the delivery of a pension product and to match the design of the private pension market to the vision for the outcomes to achieve and the role of other pillars as set out in Section 2 above.

**Figure 3: Stages of the Pension Value Chain**

<!-- Start of picture text --> 2. Recordkeeping<br>1. Membership and 3. Governance and 4. Investment<br>and account 5. Pay‐out phase<br>payment channels investment management<br>management<br><!-- End of picture text -->

# **3.1 Membership and payment channels**

A central question is how members will join a pension plan and how they will make their payments. The key message here is to make it as simple as possible for a member to join a pension and to make their payments, and to ensure that there is a segmented strategy that matches the enrollment channel to the nature of the labor market. If the labor market is highly formal, then using the employer as an administrative channel to enroll members and make payments is a natural (and efficient) initial option. This does not mean the employer should necessarily be the entity choosing the pension provider – which is discussed below. But it does mean that if there is already a functional mechanism whereby employers already pay social security contributions for the workers and deduct tax and social security contributions from the workers’ gross wage then adding an extra requirement to channel a flow of income to a pension provider can be effective. Informal labor markets are typically viewed as a feature of developing economies – where a lot of innovation is taking place as outlined below – but the development of the ‘gig economy’ or the ‘uberization’ of the labor market mean that many developed country policy makers would be well‐advised to study how to maintain coverage in the face of these challenges (Secunda, 2017) – or indeed how to use new approaches to extend coverage to the self‐employed who are often excluded.

Such structures work for an NDC model too. However, in labor markets that are highly informal, this route does not exist for many workers. There are no labor contracts, regular income and no tax and social security payments. In these circumstances, it makes sense to have many channels through which a person can join a pension and make payments. This may be through a self‐help group or micro‐finance institution or a professional group. Modern Identification (ID) and Information Technology (IT) mean that there are now more options – and even traditional options can be more efficient in terms of costs, fraud and error (Bhardwaj and Khanna, 2017).<sup>6</sup> 6 In Mexico, for example, the government and regulator have partnered with 7,000 retail companies to allow workers to make direct payments to their pension provider at the point of sale by providing their unique national ID and biometric confirmation via a finger print (Brodersohn and Palacios, 2017). The process is fully digital and paperless. In India, the National Pension System can be accessed digitally and paperlessly online, via providers in branches and in recent pilots via village‐level point of sale systems (also used to distribute the small state pension in some states), again with the provision of a unique ID and biometric confirmation (Saksena, 2017).

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# **3.2 Record Keeping and Account Management**

Once a person is enrolled into a pension system and making payments, there is a need to keep records for all payments and maintain their account balance (Barr and Diamond, 2009). In Defined Benefit (DB) systems the record keeping can be simpler than Defined Contribution (DC) systems because a DB system is organized around a benefit formula focused on wages and years of service. Even this can be challenging for many countries – particularly those that developed systems in the pre‐digital era. NDC models need to have more robust arrangements still. Finally, DC systems need to keep track of each contribution, the assets into which they were invested and the returns to be allocated to the individual. As highlighted below, some DC systems essentially run a single strategy for all workers, which is the simplest approach administratively, whereas others have potentially hundreds of choices at the individual level – which is the most complex administratively (as well as having other drawbacks in terms of the ability of an individual to make good choices when faced with so many options).

The key message of the first design choice in terms of enrollment and payments is to make it as simple and as ubiquitous as possible to join and contribute. The message of this section on administration is perhaps the opposite. The ability to manage records and accounts for 40 years (or 60 if the payout phase is included) is very unlikely to be widely distributed in an economy. The ‘traditional’<sup>7</sup> employer sponsored pension plan can have many advantages, particularly with large employers, if there are resources for good governance, delivering expertise and having a long‐term horizon that is focused on the members’ best interest. But many employers, particularly those that are small and medium sized, do not have the time, inclination or expertise to deliver this additional value. Moreover, many workers will have multiple jobs over their working life so the question of how to ensure that their pension contributions can be aggregated and not lost in multiple small pots remains, whether they move to or from a small or a large employer.

In addition to the logistical and technical challenges to running a pension administration operation in many different institutions, the profound economies of scale in pension administration (Bikker, 2013) mean that many small‐scale providers will add to the cost without providing additional benefit. For this reason, the notion of a single administrative clearinghouse has gained popularity – particularly since the successful reforms in Sweden since 1992 (Palmer, 2000). There are many ways to deliver such a system. Some countries, including Sweden and New Zealand, use their tax authorities to act as the collection and administration agency. Others, such as India, run a competitive tender for a private company to deliver the services of a Central Record Agency (CRA). A critical feature is not just the technical specifications and the achievement of economies of scale in costs – but also the control on the fees paid. In Mexico, the different pension fund management companies have established a clearinghouse among themselves 7 Traditional is in quotes because not all countries or indeed regions share the concept of large‐scale employer provision. That said, in many countries not thought of as having an employer tradition – e.g. Mexico or Turkey ‐ there are in fact many large employers both public and private that do provide pensions. That said, for any large‐scale mass enrollment employers are important, even if not following the approach seen in some of the best‐known pension systems such as the Netherlands, Australia, UK and Canada. The key question is whether the employer or group of employers is large enough to provide the economies of scale and resources to have high quality governance and expertise needed to deliver good outcomes. In these cases, a hybrid model might be preferred with a centralized or limited number of administrators, or enforced inter‐operability, alongside the continuation of large scale employer providers. Multiple institutions can add some useful diversity to the investment market and allow greater tailoring of pension provision to particular groups of workers.

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known as PROCESAR. But this does not feed automatically to lower prices because the companies control the entity. In the case of India, the regulator PFRDA recently tendered for a second CRA because the long‐ term contract with the initial provider locked in higher prices than were currently feasible. While it did undoubtedly save costs, and lead to a more efficient solution, the regulator needs to be proactive to ensure that this is true continually. A critical feature of this option is that the public‐sector tax provider is able to operate at low cost (e.g. around 10 basis points a year for administration in Sweden). There are very many countries where this is not the case – as documented for example in Sluchynskyy (2014). His analysis shows that some of the public‐sector providers deliver good value, but many do not – and do not provide anywhere near the level of fees that should be acceptable in a well‐run pension system.

While these issues of administration are always critical in deciding on private pensions, the existence of an NDC public pillar implies that there needs to be an individualized account identification and tracking system. To the extent that this has already been set up and is working successfully it obviously provides an infrastructure that could be used for the administration of private pension accounts – albeit with additional requirements such as the custody of assets and (typically) daily valuations of individual accounts. There is a spectrum of administrative complexity from a pure final salary DB plan, through to a career average plan that requires annual salary data though to a pure DC individual account. The NDC infrastructure though could be leveraged to exploit economies of scale and synergies, particularly in countries with scarce capacity. As well as efficiency gains, there are also likely to be transparency and clarity gains for those designing the system as it makes it much easier to show combined pension accounts and forecasts of combined retirement income. That said, modern DB systems now have more of the capabilities of an individual account system compared to their predecessors where benefit calculations may have waited for retirement or another form of exit. Transparency for members from NDC may be more theoretical given that many will find it very difficult to really understand issues such as indexing and longevity factors – and may not even appreciate that there are genuinely no assets backing their account.

However, the clearinghouse model may not be preferred in a situation with concerns over governance since it presents a single point of failure in the pension regime. It may also not be preferred if the government and regulator have doubts about the ability to deliver a major IT reform. However, in either of these scenarios one might question whether the country has achieved the pre‐conditions necessary for the launch of a major new pension reform (Holzmann, 2009). That said, in the UK’s auto‐enrollment reforms the task of checking that employers were fulfilling their duties – which is performed by the tax office in Sweden and New Zealand ‐ was given to the UK Pension Regulator who outsourced the IT component to a private provider. This was due to a lack of capacity in the tax authorities at the time of the development of the reforms. If the reforms had started now, then a different decision might have been taken. The key point is that the very large economies of scale that exist can be secured by a number of internal and external routes – mirroring the picture on asset management, as discussed below.

The final objection to some form of centralization of accounts so that a unique account can follow a worker throughout their life ‐ and ensure that all contributions are aggregated in a single pot – is that it is either anti‐competitive or is an unfair policy for existing pension providers who offer such services. It is certainly the case that moving account administration from current pension providers can break the link between them and the customer, which is something about which the private providers will be very worried. An intermediate position, which avoids stripping out all the administration functions from the current 12
providers is to require interoperability between systems and the maintenance of a single account to ensure lowest costs and reduce the chance of lost or orphan assets. It is worth noting that the benefits of the ‘blind account’ system in Sweden are also due to fee reductions imposed on 2<sup>nd</sup> pillar providers.

# **3.3 Governance and Investment Strategy**

Governance and organizational design is one of the most important elements in delivering good pensions (Clark and Urwin, 2008, Ambachtsheer, 2016). The key issues relate to the legal structure of the pension fund including issues such as the separation between a governing body that focuses on long‐run strategy (including investment strategy) and an (expert) management team that has the freedom to take decisions to implement the strategy. In relation to investment, the full board would be involved in agreeing on the long‐run investment strategy as set out in the Statement of Investment Principles (along with a Statement of Investment beliefs). This will include issues such as the long run objective for the strategy and strategic asset allocation. There will be clear differences between a Defined Benefit and a Defined Contribution pension fund – but perhaps not as much as in the past as techniques like asset‐liability management used in DB funds are seen to help create a more disciplined approach in DC funds so that they focus on their long‐run retirement income function rather than shorter‐term investment returns. For the reader interested in the background to the governance debate, Franzen and Ashcroft (2017) is a useful overview.

There are a very wide range of institutional designs that have been used internationally, particularly in relation to the investment strategy for the member contributions. Options range from control by a public sector body (Norway’s Pension Fund Global for example which is a department of the Ministry of Finance); an arms‐length institution such as a Social Security Agency, Provident Fund or a specific pension delivery body (for example the Kosovo Pension Saving Trust, Malaysia’s Employees Provident Fund or the UK’s National Employment Saving Trust or NEST); private fund managers and employer‐sponsored pension funds with very strict investment regulations (e.g. India’s NPS particularly for the public sector workers in the early years of the system, or Mexico’s AFOREs<sup>8</sup> in the early years when there were very restrictive investment limits and almost 100% allocation to government bonds, or Turkey’s Pension Foundations); and finally private fund managers and employer‐sponsored funds with either no quantitative limits or much looser ones e.g. Chile, Mexico’s AFOREs now with greater latitude in the investment regulations, or India’s NPS now with similarly greater latitude after successive relaxation of the investment limits or most UK, US private providers). The latter category includes countries with ‘prudent person’ style investment regulations which give the governing body broad authority to make decisions on investment allocations.<sup>9</sup>

# **3.3.1 Individual choice of asset allocation**

Sitting alongside these decisions on who decides the investment strategy in general is the issue of whether individual choice is allowed. Some countries have a single strategy for all members (in the same way the NDC formula offers only one option). In other countries there is choice for additional voluntary contributions. Default option with some limited additional choices, or a default strategy with potentially hundreds of choices are also common. In the individual pension market there is often a process whereby a potential client will be taken through options by an adviser who recommends an asset allocation that

> 8 Administradora de Fondos para el Retiro.

> 9 The OECD carries out a useful annual survey of global investment regulations for pension funds.

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matches the members’ attitude to risk. However, there is not much evidence to support the view that the typical member can really understand the options (Clark 2018, forthcoming) or that levels of financial education are in general sufficient in any country to give confidence that members can navigate the choices in relation to pensions (Mitchell and Lusardi, various). This is an area where the sales agent can have a great influence – and can make members ‘choose’ the product that benefits the agent, not the member (Halan and Sane, 2016). Some countries have effectively removed sales agents from the process or banned the payment of commissions to agents because it skews their recommendations and behavior (e.g. UK following the Retail Distribution Review).

For all these reasons, as well as well documented behavioral barriers to ‘optimal’ decision making, modern pension policy is very focused on developing good default options for members. Sweden is a good example of a country that invested very significant resources in the early years of the Premium Pension System (the 2.5% Defined Contribution pillar that sits on top of the NDC pillar) to encourage members to make individual decisions about their preferred pension provider and strategy. Ultimately these efforts were not judged to be effective and the quasi‐government / not‐for‐profit default fund known originally as AP7 (referring to the ‘AP’ range of institutions involved in the investment management of different elements of the Swedish pensions system) gained greater prominence. Over 90% of people now ‘choose’ the default fund. In the UK, the default fund offered by NEST (the new not‐for‐profit provider created as part of the auto‐enrolment reforms) has seen over 99% of members move into the default fund and 90%+ is common in many different types of pension funds.

The literature on pension performance highlights that governance of the fund is often a highly significant factor in determining the performance – along with the scale and cost effectiveness of the institution (CommonWealth Partners and World Bank, 2017 forthcoming). Perhaps uniquely in global markets, it is the not‐for‐profit providers (such as HOOPP in Canada) who tend to come out as the most effective in rigorous comparisons of different providers (Impavido and others, 2010; Murray Review, 2014; Heale and Martiniello, 2017).

However, as with the discussion on administration, centralization and the clearinghouse model, it is important to be sure that a country has enough independence from political interference to allow independent governance to sustain the benefits of the model. Politics may always have some influence on institutions, but the key is whether there is sufficient independence to allow a focus on the best long‐ run interests of members to be the main driver of the pension fund. If the law mandates that 100% of assets are invested domestically then a pension fund that was otherwise governed independently is obviously constrained by politics relative to the unconstrained asset allocation it may otherwise choose. This is not a static issue – since countries are able to move from extensive political involvement to a model of independent governance over time. Political interference can be through directed investment in certain firms all the way through to nationalization of the assets of private pension funds. Reversals in pension reforms seen after the Global Financial Crisis highlight that the most **efficient** approach can fail to create the most **secure** option because quasi‐government structures may be more easily unpicked or even nationalized (Hungary, Poland) than those that are more separated – particularly if contributions to social security are partly diverted to private pensions but other sources of funding do not replace the consequential gap (Price and Rudolph, 2013). As far as we know there were no examples of employer sponsored pensions run as separate entities that were ‘reversed’ in the crisis. Recent reforms to introduce 14
auto‐enrollment in Turkey for example, maintained a greater role for existing private pension providers partly to keep a clear separation between the public and private pillars. The market structure was still changed importantly by introducing auto‐enrollment, routing decisions via the employers to reduce the role of sales agents and switching at the individual level and enhancing the role and effectiveness of default employment strategies.

# **3.3.2 Investment strategy in private pensions and the potential impact of the NDC rule**

This section has so far identified a range of important considerations for developing private pension pillars that are relevant whatever the form of the public pension pillars. But the creation of an NDC pillar requires the creation of the NDC formula that will create the return on the notional capita. There are many options – and this section highlights the importance of modeling the likely **joint** distribution of outcomes between the NDC and funded pillars. If the NDC system is based on a GDP growth rate, or has a wage indexation or price indexation formula, how is that correlated with likely returns from different investment strategies? Are asset prices positively or negatively correlated with the formula driving the NDC payout? This is relevant both to the accumulation phase of private pensions but also to the decumulation phase. How do the payout rules for private pensions (annuity, re‐pricing or variable annuity, phased withdrawal or lump sum) interact with the NDC income formula – and other pension pillars – such as ‘Social Pensions’ providing minimum income for all?

This issue is highlighted by the fact that a well‐established, but often forgotten, feature of real equity market returns is that they tend to be negatively correlated with real per capita GDP growth. The result was established in Dimson, Marsh and Staunton’s “Triumph of the Optimists” using data from 1900 to 2000 and subsequent updates of their Global Investment Returns Year Book. This result goes against simple intuition for many people, but as explored in detail in Ritter (2005, 2012) there are in fact sound reasons for the result. They help to shed light on the nature of equity market returns – and the importance of good corporate governance in helping to ensure that companies return cashflows to shareholders if they do not have rigorously evaluated investment projects that will yield a positive net present value.

The result for 19 developed countries between 1900 and 2011 is a correlation between real returns on equities and growth of real per capita GDP that is minus 0.39. That is, if someone was seeking the highest real returns on equities when choosing between a sample of countries in 1900 they would have done best if they had chosen the countries that subsequently had the lowest growth in per capita GDP rather than those that had the highest growth. This result is shown in Figure 4. The ‐0.39 correlation is for real equity returns in local prices. If US dollars are used then the correlation is still negative at ‐0.32 (Ritter, 2012).

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However, if one takes aggregate GDP growth rather than per capita GDP growth, then the correlation is positive. Aggregate GDP growth however, does not abstract from the impact of population growth, with the intuition for the positive correlation being in simple terms that the growth of population is akin to existing owners of capital getting extra customers. Per capita GDP growth, by adjusting for population growth, focuses on growth driven by productivity. The development of new and better ways to produce goods and services is as likely to come from new entrants, which may even harm the profits of existing owners of capital. In addition, over time in a broadly competitive market, the gains from productivity were competed away (Ritter, 2012).

So, determining the ‘right’ investment strategy for the private pension pillar in an NDC system should take into account whether there was a per capita GDP term or just an aggregate GDP term in the NDC formula. Likewise, but not shown here for space, where there are NDC formulas that use the growth of wages it is important to investigate the correlations between the growth of the notional assets and the real assets in the funded pillars to determine likely future retirement income. A key takeaway is that these issues should be investigated during the design phase of an NDC pillar. But even for countries where the NDC formula is already set, the regulator of private pension funds and the governing bodies of those funds should both be taking an interest in how the precise NDC formula might impact the optimal investment strategy for their members. It would be an interesting exercise for a future paper to see if current NDC countries see any systematic differences in the investment allocations of their private pension pillars, to the extent that the issue has been internalized by any major fund. This regular investigation of how to create improved investment allocations mirrors the importance of ensuring that pension funds invest in assets with the best expected contribution to the long‐run retirement income of their members. Pension regulators can sometimes encourage the opposite (through guarantees, relative and short‐term return measures and allowing excessive switching).

# **3.4 Investment Execution**

Once an investment strategy has been determined the issue is then to execute it. The range of options here mirror those above with the investment strategy – from wholly in‐house public‐sector or not‐for‐ profit options to fully outsourced private fund managers. The governance of the overall process and the monitoring of the implementation remains critical to deliver good value for money for the members. Moreover, the political environment can also play a key role in determining the ‘right’ approach.

The US’s Thrift Savings Plan delivers Defined Contribution pension benefits for Federal Government workers. It is probably the world’s most efficient fund, with total costs to members for administration and investment of under 5 basis points a year. This is partly driven by huge economies of scale in administration. But it is also driven by the entirely passive investment execution that is a requirement of its legal provisions. This requirement was imposed by the US Congress as a way of preventing any form of political control over the direction of its investments (Long, 2018 forthcoming). A very different country and context has identified a similar type of mechanism. The Kosovo Pension Saving Trust (KPST) was established as a funded DC pillar to provide the major source of retirement income for future Kosovan Pensioners. It was founded in a post‐conflict environment, with no domestic capital market to speak of. The governing board of the KPST includes three foreign members as a way of bringing international expertise, but also helping to reduce the impact of any domestic political interference. The board of the 17
KPST determines the investment strategy and is then required to execute via external fund managers selected by competitive tender. The fund managers deliver the mandates at scale for the KPST rather than having any relationship with the individual members. Finally, and importantly, the KPST has a requirement to keep costs to a minimum and a target to progressively reach 50 basis points a year as a share of assets under management (Zalli, 2018 forthcoming). These options are useful examples for countries who may have fears that in‐house investment management by public sector or arms‐length bodies such as provident funds may be susceptible to political control.

However, the most robust internationally benchmarked evidence tends to suggest that the best net‐of‐ fee returns come from the in‐house management and execution of investment by very large not‐for‐profit funds of the type found in Canada, the Netherlands and in Australia’s superannuation funds (Heale and Martiniello, 2017). As highlighted above, these structures cannot be replicated in all places. But they do appear to be able to deliver an enhanced alignment of interests between the pension fund and the investment managers, and can save significant costs. The longer the investment chain, the higher the costs and the higher the potential for weaker alignment. Heale and Martiniello (2017) show that a fund of hedge funds structure can cost over 400 basis points a year **extra** compared with the in‐house execution of similar structures – and lead to significant under‐performance in real returns net of fees. A recent case study on major Canadian providers showed how their approach developed over the past 20‐30 years. There was often an initial reliance on outsourcing investment, or unsatisfactory experiences with in‐house management. As governance and expertise increased, in‐house capabilities improved, and a number of funds set about to successfully bring in (previously outsourced) management in‐house, with an enhanced net of fee performance as a result (CommonWealth partners, 2017). So even if this is the desired long‐ term structure it may be necessary to build slowly towards it.

# **3.5 Payout phase – administrative arrangements**

A pension system is only complete when it has started to pay out an income in retirement.<sup>10</sup> To do this requires good quality account administration (see above) so that accumulated balances can be returned to the members. It also requires the basic administrative capability to ensure proof of (continuing) life and the minimization of fraud and error – which is sometimes performed by the pension fund if it pays the pension and sometimes by an insurance company if pension payouts are transferred to an insurance company. There is perhaps too little attention on the administrative requirements of the payout phase compared to the accumulation phase. An NDC pillar by design integrates the two phases and can provide useful insights for private pensions. When administrative systems are not well‐developed, the process to choose and receive a pension can take many months and even longer. In many countries it will be simple to make payments directly into bank accounts electronically and automatically. There is substantial merit in using the most effective payments channel so that it is simple and low cost for a person to receive pension payments in old age. Low cost is partly determined by any bank charges for transferring funds.

> 10 The term “annuity” is not used in the same way in every country. Note that the terminology around payouts and annuities can be very confusing. In some countries products are marketed as annuities that provide a way to accumulate assets to be taken as a lump sum when the person retires. In other countries the lump sum payout would indicate the opposite of an annuity which is thought of as a stream of income payments not a one‐off cash distribution. In this paper we aim to link the payout category to the income stream it creates – hence an annuity pays an income until death in the standard form and a phased or systematic withdrawal allows periodic payments but no guarantee of income until death.

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But it is also important in terms of the ‘shoe‐leather’ costs of find access to an ATM or a financial provider. The financial inclusion revolution is making these issues simpler to solve – and can also help to reduce fraud and error. Issues relating to the type of payout product are covered in Section 4.

# **4. The second set of design questions – what type of pension to deliver**

Once a country is clear about what it wants private pensions to achieve in terms of additional outcomes to public pensions and has thought through the most effective market structure and governance to deliver pensions, it also needs to consider ‘traditional’ issues of benefit design, eligibility and payout rules. These areas are clearly not all mutually exclusive. A good policy design and public consultation process will allow iteration and adaptation in design. But a central message of this paper is that the process should be coherent and logically consistent. A country should not promise its people no risk, certain outcomes and high benefits and then choose a Defined Contribution private pension pillar with limited expertise and weak governance over investments. Equally, a country should not follow a global trend – for example choosing ‘pure DC’ private pensions with all the risk taken by individual members – if there are viable risk‐ sharing options that might have been discarded in the rush to avoid the implications of final salary Defined Benefit plans with fully guaranteed benefits.

In terms of benefit structure, the best way to think about the suitability for the private pension pillar is to include the existing provision on the public‐sector side. Many countries that are described as having ‘moved from DB to DC’ in truth have only seen this trend among private pensions. The UK and US, for example, who have both seen a 30‐year process of most employer sponsored Defined Benefit plans (particularly in the private sector) close first to new entrants and then to future accruals from existing participants. However, both retain substantial Defined Benefit public sector pillars. The US first pillar being particularly important for the vast majority of workers in retirement (Burtless, 2014) – whereas the UK has a relatively modest first pillar by international standards (OECD, 2016).

Another element in determining the ‘right’ benefit structure is to be very precise on the actual terms of the pension. A DB pension can mean a formula based on total years of work, with a long vesting period, calculated on final salary and guaranteed against wage inflation for deferred members and then against price inflation for pensions in payment. This is very expensive to deliver, has negative impacts on gender equality through the vesting rules and greatly enhances the impact of wage inequality. Moreover, anchoring to inflation and wages makes it very difficult to adjust to shocks in the return on investments. However, a Defined Benefit formula can also be much more flexible – focusing on career average salary to deal with inequality, have low or no vesting rules to aid gender equality, and only allow indexation of benefits if there are sufficient funds to pay for it. Likewise, a pure DC formula that places all the risk on the member can lead to very large differences in retirement income purely by virtue of the start and end year of a person’s contributions (Canon and Tonks, 2004). This can easily be modified to improve its risk‐ sharing properties. As above, nominal or real capital guarantees can be considered – with best practice to use a backstop fund for the guaranteed elements (Antolin, 2012).

Contribution levels are of course central to the final pension outcome for defined contribution plans, as is the ‘density of contributions’ e.g. the total number of payments made over a working life. In developed 19
economies with formal labor markets the density of contributions tends to be close to 100% for each year of employment and then lower due to periods out of the labor market. But in countries with greater informality, and with workers in seasonal employment everywhere, they may find it very difficult to contribute 12 months a year. Hence modeling the likely payout from a 5% contribution as a share of wages should build in scenarios for likely payouts for those with less than 100% contribution record. The current debates about the performance of the Chilean system are partly driven by the realization that many workers have far less than ‘official’ projections – because many simple projections assume a worker will contribute the whole time. Even if there are many other variants presented, the full implications may be lost on workers – whether the implications of a failure to contribute should be obvious or not. Working out the ‘right’ level of contributions can be greatly assisted by models to project pension payouts from private pensions (OECD 2012, IOPS 2014, Dowd and Blake, 2013, Sane and Price, 2018). They provide useful tools for how much to contribute and the implications of different investment strategies. As highlighted above, a useful development if these models are used in the context of an NDC system, is to model the joint distribution of outcomes from the investment strategy in the private pensions and the NDC formula.

The final issue in this brief overview of the nature of the pension product relates to the payout phase.<sup>11</sup> Without specifying the payout phase, it is not possible to state clearly the outcomes that the pension system is seeking to achieve. Many private pension systems are better described as saving accumulation systems rather than retirement income systems. This is because they allow members to withdraw money from the pension pot for other purposes such as health, education and housing, and then withdraw the full amount of money at retirement in a lump sum. A multi‐purpose accumulation vehicle can be well‐ designed – as in the Malaysia and Singaporean examples with some assets permanently identified for retirement and some proportion allocated for access to health, housing or education if needed. But early access is often not well‐designed and can lead to significant leakage. The Society of Actuaries in the US for example has estimated that some 40% of US retirement assets leak before retirement – principally because workers can take the full accumulated pot when they change employer.

However, the potentially attractive benefit design in Malaysia during the accumulation phase has traditionally been followed by a tendency to take 100% of the money as a lump sum at ‘retirement’. While practice is changing, one survey showed that 70% of people had used all their retirement assets within 10 years of retirement (EPF, 2004). Clearly this is not ideal. There is no guarantee that this will happen given the experience of Australia which allows 100% lump sums to be taken and where most workers do not spend all the money within 10 years of retirement (ASIC, 2017). But for all the reasons that mechanisms like mandatory or auto‐enrollment pensions and investment defaults work – it is prudent to mandate that a percentage of pension assets go into an income generating product.

> 11 This section does not go into great detail on all the different annuity options which can be found in a range of publications – for example Rocha and others (2011), or Brown, J. R., O. Mitchell, J. Poterba, and M. Warshawsky. 2001. “The Role of Annuity Markets in Financing Retirement”. MIT Press, Cambridge.

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# **4.1 Adapting the NDC payout formula for use in the funded pillars**

The NDC formula used to generate the retirement income in Sweden in fact provides an attractive way for countries to deliver income guaranteed until death for their citizens without the need for well‐ functioning annuity markets (Price and Inglis, 2017). An adapted form is used in Sweden’s second pillar to provide a second stream of income until death in addition to the NDC pillar. The periodic repricing of the income paid from the accumulated assets as investment returns are known and mortality forecasts updated removes the need for the regulatory capital to back the promised income in a traditional single premium annuity. It also overcomes the psychological barrier people face when spending 40 years building their assets and then having to pass them all to an insurance company in one block to gain an annuity. This issue is compounded by the insurance companies often not exploiting the illiquidity premium that comes from having access to a source of capital that cannot be withdrawn (Rocha and Thorburn, 2007). Another recent and innovative example in the payout space is UK NEST’s initiative to combine a phased withdrawal with a deferred annuity.

An NDC pillar by providing an income until death (along with any basic minimum pension) may mean that the absence of annuity‐like options in the private pillar is less serious for old‐age poverty. It may also allow a simplification of the task for private pensions by focusing on the first 10 or 15 years of retirement that gives a fixed, and potentially manageable, target for many people, with the public pillar and NDC increasingly taking over as people age. One way to increase the coherence of this type of arrangement is for public pensions to start at a relatively low level in the early years of retirement as people rely more on private savings, but for the public component to ramp up in the latter stages of old age when private assets have been drawn down and there are fewer people to cover and hence potentially lower costs. Since the wealthy are more likely to reach old age, the higher public pension would need to be taxed to ensure equity. This would further enhance the cost savings relative to the standard model of a payout that is anchored by the income paid at retirement (see Price and Inglis, 2017 for a more detailed investigation of this idea).

Other forms of payout outside a traditional annuity include phased or systematic withdrawal options. These do not provide the guarantee of income until death, but can be a simple and effective way to move beyond a ‘lump sum’ pension system to one that focusses on delivering income. Moreover, in systems such as Australia which deliver a relatively high level of income from the public pillar, there is an argument that there is less of a need for an additional source of income until death, particularly if there is universal public health provision. However, even in Australia the government itself has taken the view that the current arrangements do not maximize potential outcomes and is developing a comprehensive retirement income product or ‘MyRetirement’ option (Murray Review, 2014, Productivity Commission, 2016).

# **4.2 Regulation and Supervision**

A final area in this survey of issues to consider when developing a private pension pillar relates to regulatory and supervisory arrangements. The argument for the power of coherence made throughout this paper is important here too. In many discussions the case would be made that regulators should be risk‐based – and implement risk‐based supervision (RBS). The central idea is that an entity needs to focus their resources on the areas that create the greatest risks rather than spend time on areas that do not reduce risk. The checking of daily investment limits in regulations is an example of a low‐value added task 21
since most are likely to be resolved by the systems in the investment manager which will leave only persistent breaches needing to be fixed.

Many regulators have adopted risk‐based supervision (IOPS, 2014), and there are many useful techniques for off‐site and on‐site supervision. But before starting to use the techniques of RBS it is vital to set out the aim or objective to which the risks are relevant to avoid the process of risk‐based supervision potentially being driven by the techniques, or second‐order issues rather than always being rooted in how the regulator can best contribute to the achievement of the long‐run outcomes set out for pensions. Bringing these concepts together is important because the risks that should be focused upon are those that risk the achievement of the long‐run outcomes. The choices between inherently different activities within a regulator from on‐site supervision through to communication and education can be more coherently decided within a framework which considers their contribution to the long‐run outcomes – even if the measures of success are sometimes focused on intermediate indicators. A methodology that unites the outcomes with risk based supervision, knowns as Outcomes and Risk Based Supervision, has been developed by Price, Hafeman and Ashcroft (2016). The recently revised OECD Core Principles of Private Pension Regulation (2016) now have as the first line the clear statement that the focus of regulation should be on achieving the 5 long‐run outcomes highlighted above.

The focus on risk based supervision is sometimes applied too narrowly to mean just the work of off‐site and on‐site supervision. It is more helpful for RBS to be understood as how to organize the combined focus of (secondary) regulation and supervision. With this clarification, the best approach is one where the regulator and supervisor use the choice of instruments that will best reduce the risks. For the risk of fraud that will reduce assets and hence reduce adequacy there are few measures as important as mandating the use of custodians – as well as a focus on the overall governance of an organization. In other areas, particularly with large, well‐run organizations, greater flexibility can be given so that the regulator can focus on the weakest institutions. A key insight of risk based supervision is that a focus on what is strictly in the law can lead to wasted effort on some areas and a failure to be proactive to address emerging risks in other areas. In some ways, the concepts mirror a theme within the International Social Security Association’s (ISSA) principles for good governance of social security institutions – namely that those running such institutions need to be ‘dynamic’ in terms of identifying and addressing emerging problems. NDC arrangements could benefit from being included in supervisory scope to enhance accountability, transparency and trust.

The issues discussed above are far more important than a focus on structures – whether a supervisor is specialized or integrated with other sectors such as insurance and securities – where there is no clear pattern globally in terms of integrated, hybrid, specialized or functional regulators.<sup>12</sup> The Global Financial Crisis highlighted that structure did not dominate outcomes, since all models had examples of successes and failures. Rather than structure, the key to dealing successfully with the challenges of regulation had more to do with the ‘ability to act’ in terms of having the legal powers and resources, and the ‘willingness to act’ in terms of having the independence, quality of staff and behavioral characteristics needed to take tough but proportionate decisions necessary for an effective regulator (Vinals and Fiechter, 2010).

> 12 Masciandaro and Quintyn, CEPR Policy Insights No 30, 2009.

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A final note is worth adding on the importance of getting the implementation of policy right. The approach outlined above deliberately places a high priority on understanding the ‘nuts and bolts’ of the way in which a pension system works. These are central, rather than incidental, to good outcomes. Policy makers should ensure their teams have sufficient understanding of operational issues, including on ID and IT, and on the program management skills to implement major policy and operational change. Taking this broad and deep view can be an important way to mitigate the risks of project failure (OGC, 2012). Moreover, the implementation of major pension reforms should be seen as major program of work – and run accordingly. The role of the program or mission office in pension reforms in the UK and New Zealand’s auto‐enrollment reforms and in India’s world record setting financial inclusion initiatives is instructive for potential reformers (Ryder and Pande, 2017).

# **5. Conclusions**

The role of private pensions in a country with an NDC pillar is important, as in all systems. No single pillar can bear the full weight of delivering retirement income. Diversification in pension pillars is a more robust strategy than a single pillar approach for both economic and political reasons. The first stage of pension design should be to consider the long‐run outcomes a policy maker is seeking to achieve. This is an iterative process – since not all levels of income (or adequacy) will be possible with a given level of contributions depending on the benefits formula employed. There are 5 core outcomes that should be considered at this stage – namely coverage, adequacy, sustainability, efficiency and security. Thinking through these outcomes also helps to clarify and hone down the possibilities for the design of the market structure and other parameters such as benefit type, contributions, investment strategy and supervisory arrangements. The governance, scale and expertise of pension funds of all types are critical to good investment strategy and execution. The outcomes that drive overall system design should then flow through to the regulator and supervisor. Their risk based approach should be driven by reducing the risks to achieving the long‐run outcomes to which they can contribute. All these issues are relevant in relation to any public pillar, but NDC systems bring the benefit of clarity and transparency in the benefit formula with automatic adjustments that mean they are more likely to be sustainable over time than typical defined benefit rules for public pensions – if of course they are enforced. The NDC formulas may be usefully explored to provide lifetime income products for the private sector that may be easier to deliver than traditional single‐priced life annuities. The NDC formula also potentially makes it possible to model the joint distribution of public and private pensions with greater precision. Such modeling is important because small differences in NDC formulas may have significant impacts on the optimal investment strategy in private pensions. One example of this is the negative correlation in the long run between real per capita GDP growth and real equity markets, as opposed to a positive (or no) correlation between aggregate GDP and equity markets. As in all elements of pension design, long‐run outcomes and coherence matter. In countries where the NDC formula is based on average wages or the wage bill, it will be correlations between these metrics and potential investment portfolios that need to be modeled – something that could be the subject of future work.

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