Alternative Financing

This section has been taken from the World Bank Policy Research Report: "Averting the Old Age Crisis: Policies to Protect the old and promote growth". Minor modifications have been made for this document. Since it is not an exact reproduction, the section is not within quotation marks.

Three different financing and managerial arrangements for old age security are most common. They are: (1) public pay-as-you-go programs, (2) employer-sponsored plans, and (3) personal saving and annuity plans. Public pay-as-you-go plans. This is by far the most common formal system. Coverage is almost universal in high-income countries and widespread in middle income countries. As its name suggests, it places the greatest responsibility on government, which mandates, finances, manages, and insures public pensions. It offers defined benefits that are not actuarially tied to contributions and usually finances them out of a payroll on active workers (sometimes supplemented from general government revenues) and pays the older members of society simultaneously. The problems facing public pension plans stem partly from poor design features such as early retirement and overgenerous wage replacement rates that favor high-income group. But more basic problems stem from the separation of benefits from contributions that induces evasion, labor and capital market distortions, wasteful use of pension reserves and political pressures for poor design features. Even if the governments desire to pay a small sum as a pension to each person, the numbers of older people is so large that the total budget becomes huge. For example, of the Government of India decided to pay INR 100 each month to each older person by year 2005, the monthly budget should be INR 8,840 million. Such a sum is unimaginable for any country. Moreover, the INR 100 pension is not even enough for 1 meal a day. In developing countries there is no organized collection of pension from younger people which can help pay for the elderly of today. Such schemes are termed "pay-as-you-go" schemes. These are bankrupt in all developed countries where they have been implemented. Developing countries will do much better to think of alternate forms of funding pension plans (e.g. fully-paid-up pension plans). Occupational plans.

These are privately managed pensions offered by employers to attract and retain workers. Often facilitated by tax concessions and increasingly regulated by governments, these plans tended to have defined benefits and be partially funded in the past. But the number of defined contribution plan (in which contributions are specified and benefits depend on contributions plus investment returns) and the degree of funding have been increasing in recent years and these have quite different effects. More than 40 percent of workers are covered by occupational schemes in Germany, Japan, the Netherlands, Switzerland, the United Kingdom and the United States - but far fewer in developing countries. In developing and transitional economies, this move toward occupational plans is at an early stage. In most cases, employer-sponsored pension plans cover public sector workers, and the coverage of private sector workers has been growing in such countries as Brazil, India, Indonesia, Mexico, South Africa, and Zimbabwe. Personal saving and annuity plans. These are fully funded defined contribution plan. Workers save when young to support themselves when they are old. Since benefit are not defined in advance, workers and retirees bear the investment risk on their savings. Voluntary personal saving is found in every country, often encouraged by tax incentives, but some countries have recently made it mandatory. A key distinction is between mandatory saving plans managed by the government (as in Malaysia, Singapore, and several African countries) and those managed by multiple private companies on a competitive basis (as in Chile and soon in Argentina, Colombia, and Peru). Like funded occupational plans, mandatory saving schemes can foster long-term saving and capital market development. But unlike defined benefit occupational schemes, they are fully funded by nature rather than by regulation. Their coverage can be broad. They do not have portability problems or inhibit labor mobility. They permit workers to diversify risk. And unlike defined contribution occupational schemes, they allow workers, who bear the investment risk, to choose the investment manager. Mandatory saving nevertheless creates a new set of problems. Most notably, privately managed schemes fail to insure workers against poor investment performance of the funds, a problem especially great where many workers have had little financial experience or information. In addition, they do not assist workers with low lifetime incomes or provide adequate pensions in the start-up years of the plan.