The Case For Pension Reform

 September 11, 2011 |  Administrator

The following article is a chapter in the text: Workable Pension Systems; Reforms in the Caribbean. It appears here with permission; the authors are Olivia S. Mitchell and Derek M. Osborne.

Costs and Challenges
One factor that has contributed to the unsustainability of old age schemes in the English-speaking Caribbean is the high cost of plan administration. In many countries more than 15 percent of contributions goes toward administrative costs, representing 1-2 percent of insurable wages. The programs involved include old age, invalid, and survivor programs, and sometimes include non-contributory benefit schemes for people fail to qualify for contributory pensions and who pass means tests.

Most pensions in the English-speaking Caribbean are based on a defined benefit structure, with monthly pensions usually based on the number of contributions and on the highest average wage over the three to five years before retirement. However, Trinidad & Tobago provides a nonindexed pension based on career earnings, while Jamaica provides a flat rate plus earnings-related benefits. In most English-speaking Caribbean countries the normal retirement age is 60, but it is as high as 65 in a few cases. In addition, many people can apply for old age benefits even if they have not fully withdrawn from the labour force.

Relative to U.S. and Canadian social security schemes, the pensions offered by English-speaking Caribbean countries tend to be quite generous in an earnings replacement sense. The maximum benefit is generally about 60 percent of participants' average insurable earnings in the final three to five years of employment, and this maximum can often be achieved after 30-35 years of contributions. In addition, benefits accrue quickly early in life, usually totalling 30-40 percent of earnings after 10 years of contributions, with 1 percent added each year thereafter. In the United States, by contrast, the social security system replacement rate averages 40 percent of preretirement pay after a typical working life of 40 years.

Unlike in many industrial countries, in the English-speaking Caribbean ceilings on insurable earnings and benefits are not necessarily related to average wages. At the same time, tax and contribution ceilings are typically not increased automatically in the English-speaking Caribbean. For this reason periodic government interventions have been required to ensure that tax bases rise with earnings. Due to political pressures, contribution ceilings have often gone for as many as 15 years without being increased, making the programs less appealing to middle and high-income workers. On the other hand, benefit increases for pensioners have occurred more frequently and tend to compensate for inflation. Indeed, some benefit increases have exceeded changes in cost of living, adding extra long-term costs to the schemes. As a result the imbalance between increases in benefits and tax ceilings raises questions about the systems' long-term financial viability.

In the near term, however, many old age schemes in the English-speaking Caribbean are cash-flow solvent, having accumulated large pools of reserves due to contribution income exceeding spending in most years since they were established. Most pension fund reserves range from 4 to 20 times annual spending, and are more than 30 times spending in the British Virgin Islands. Though these schemes are nowhere near fully funded on an actual basis, their substantial reserves represent an important source of anticipated financing that will be important when system expenditures begin to exceed contributions and investment earnings.

One challenge facing English-speaking Caribbean schemes with large reserves is a lack of suitable investment opportunities. Until recently most schemes invested all their funds locally. Increasingly, however, some have devoted small portions of their assets to regional investments, with a few having small international portfolios. In general, the region's social security funds have been managed conservatively and passively. With few other investment vehicles available, many are highly concentrated in government securities or in fixed deposits at commercial banks with majority government ownership.

For schemes heavily invested in government securities, the financing challenge will begin long before reserves are exhausted. When cash-flow deficits first occur, sponsoring governments will have to choose between boosting general taxes or cutting spending, in order to redeem these bonds. Social security schemes could also raise their taxes-boosting contribution rates-to meet current expenditure needs. Since the population that pays general tax overlaps extensively with social security contributors, the economic effect of increasing general taxes or contribution rates could be similar.

By law, every social security fund in the English-Speaking Caribbean undergoes an actuarial review every three to five years. In addition to financial and demographic projections, actuaries must provide policy advice on scheme designs, benefit provisions, and future operations. Only recently have some English-speaking Caribbean countries undertaken projections beyond 30 years. Accordingly, the extent of the long-term financial challenges confronting these schemes typically not been revealed to sponsoring governments or future retirees.

U.S. social security actuaries recently adopted explicit long-term financial measures to reveal the actuarial status of the fund in perpetuity (Trustees of the Social Security Administration 2003). By contrast, actuaries in the English-speaking Caribbean are usually able to report that a scheme is adequately funded for the short term, but are not asked to evaluate its sustainability in perpetuity. Their reports do indicate when a fund is unsustainable for the long term at current contribution rates. They also indicate when cash-flow deficits are expected to begin, when a fund is likely to become exhausted, and projected pay-as-you-go rates to maintain solvency on a cash-flow basis. Unlike in the United States, the reports do not give the alternative view- that is, illustrating how benefits would have to be cut to bring the system info financial balance.

Based on the best information, given current contribution rates and pension provisions as well as projected demographic changes, all the English-speaking Caribbean schemes reviewed here are at likely to be unsustainable over the long term. While most countries in the region have relatively young populations, substantial declines in fertility over the past two decades- to near or below replacement rates- and improvements in life expectancy will produce dependency ratios like those in industrial countries over the next 50 years. Recent actuarial projections suggest that cash-flow deficits could begin within 20 years, and program funds could be exhausted in 25-35 years if reforms are not made.

The projected timing of these events and the growth pattern of expenditures depend on factors related to the schemes themselves- years of existence, contribution rates, current funding levels, eligibility for and benefit levels of pensions, investment returns, and administrative costs. While future economic growth and migration will have a major impact on the long-term viability of these schemes, depletion of reserves is expected due to contribution rates being below the average long-term cost of benefit promises, along with an expected drop in the number of contributions per pensioner.

For most schemes in the English-speaking Caribbean, contribution rates were initially established under the scaled premium method of financing for an initial period of equilibrium. Thus the framers anticipated that contributed rates would have to be raised in the future. Most of the region's schemes have not reached the point where expenditures exceed contributions, so no tax increases have been needed thus far. Among countries that have had to use portions of their investments to cover expenditures, only Guyana has made a small rate adjustment, while Barbados has adjusted contribution rates five times as well as changed the benefit formula to help cover growing expenditures.

If governments in the English-speaking Caribbean want to maintain the defined benefit structure and bring long-term sustainability to pension programs, further reforms are needed to increase system revenues, reduce expenditures, or both. Such changes could include:

  • Cutting promised benefits
  • Reducing administrative costs
  • Increasing investment returns
  • Raising contributions.

The first three changes require reviewing current systems, eventually leading to refined programs that offer reasonable, equitable, and affordable benefits, are operated efficiently, and maximize investment returns. Increasing contributions could then be seen as a final step toward strengthening programs for future generations. One nonfinancial reform that is also required is removing most political intervention, so that schemes keep up with the changing socioeconomic conditions.

Specifically, governments currently decide on the timing and magnitude of increases in earnings ceilings and pension payments. When such changes are made- or avoided-the decisions are often politically motivated. Moreover, there is often not a sound basis for whatever adjustments are made. For pensions especially, underfinanced benefit increases tend to occur with depressing regularity during election campaigns. If the rules governing such adjustments were guided by regulations, social security scheme coverage and benefits would more likely be affordable.