Interview with Robert Holzmann on Pensions

The scarcer the resources in an economy, the more one has to choose between different goals. This is particularly the case in a country with high absolute poverty and massive unemployment. In such a country, one has to look very carefully at who is the most vulnerable population, and only to this population can resources be spent. As a result, the elderly may or may not be the most vulnerable in the country, and thus a universal pension system may or may not be the best solution. The World Bank is currently undertaking studies which try to establish which group of the population is the most vulnerable, in particular, whether households with elderly or households headed by elderly are more vulnerable to poverty compared to the others.

As regards the issue of index-linked pensions in high inflation and low growth environments, this is again a question of allocation of resources, but the Bank proposes that pensions should, in principle, be guaranteed in real terms, or adjusted for inflation as much as possible because retirees are the least capable of dealing with inflation and, for example, increasing their labor force participation to cope with high inflation.

The World Bank proposes a multi-pension system which is geared toward different groups in society and the main groups the Bank identifies are the life-long poor, the informal sector and the formal sector.

For the case of India, it means that only some 20 percent of the population are directly covered by pensions. 10 percent is the formal sector. 10 percent are the relatives. Some 30 percent are the life-long poor and some 50 percent are the informal sector, who are not currently poor but risk to become poor if they don't have assets to invest.

What this suggests is a different kind of layers which are important for the different groups. For the life-long poor, a formal pension system, our first or second pillar is important. They also don't have the resources to save for their old age. For them what matters is the existence of social pension. They exist, in principle, in the Indian states and it is well functioning in a number of them.

For the informal sector what matters is the access to savings instruments which allow them to take money from now for the future. The alternative is to invest in property, which is not always the best risk management instrument. For the formal sector, what matters is an instrument which, on the one hand, which shields them against poverty and, on the other hand, allows them to smooth consumption. So the World Bank model is very much adjusted to the differences in the countries and depends on the existence and the size of the different groups, on the existing programs but also on the enabling environment, for example, financial market, this determines then the choice which the country has to make. We provide the analytics and the knowledge for that.

The question starts with the level of illiterate employment in Africa.

The World Bank doesn't have a model -- doesn't have a blue print. It has a proposal how to think about pensions, what objectives exist with regard to pension systems and what criteria should be used when reforming the pensions. In the case of Africa, with this level of unemployment and illiteracy, quite likely social pensions, if justified by the level of vulnerability, plus a voluntary pension, work best for most of the countries, because formal systems, as the experience has shown, are prone to less-than-perfect management, and also may not be able to deliver on their promises. In some countries they have been able to reform the pension systems according to a more modern approach. In others, it is still in a shambles. Overall, frankly speaking, what we have, there are a number of countries inside and outside Africa where we have an actual dilemma. What do you do if the public sector cannot deliver, they are not able to run a public program appropriately, raise the resources -- for example, 50 percent of revenues, this makes it difficult.

Another problem is if there is no financial market which can allow individuals voluntarily to participate. What do you do in such a case? We are still looking for a good answer.

First counter-question is whether the OECD should be a benchmark for other countries. The reason why this may be asked is that the high level of benefits, the high level of coverage, may be only a historical episode. Because what we can see now is that in these countries the overall generosity to the pension system is decreasing, less people are covered and also the benefits are decreasing.

The reason is that some of those countries may have moved too far in what people want and so they want to step out of the current system. What this suggests is, and including the political process in the discussions about it, it is difficult to pass decisions, whether the decisions are for funded system or unfunded system, so one of the first conclusions is: Think very carefully what kind of decisions you are making. This decision will have an impact for a long time in your country because of this past dependency, this allows quick or painless reversal in the future.

A second conclusion one may wish to draw out of those countries is keep things small and simple. Don't try to place too much income through public hands because then it becomes too expensive. Don't try to make the system too complicated because this makes it open and vulnerable to political exploitation, and number three is, if you look at a system, it is by definition, because of the social environment, the economic environment, the political environment changes, it must be able to be reformed, to be adjusted to new challenges coming up. To make the last point a bit clearer, think about the pension system as it still exists in most countries: you have old-age pensions, disability pensions, survivor pensions, and survivor pensions are larger because it reflected the older model, where the husband was working and the women was taking care of the children. Now most women are working and the rate of divorce is 50 percent. In this case, traditional systems become obsolete and need to be reformed. Allowing this kind of adjustment is crucial for any system and must be taken into account when you start a new system in a country which still has a chance to do so.

The high level of costs and fees in a funded system is an irritation for those who support funded systems and it is a main reason for people who dislike funded system. The question is: What are the kinds of instruments for dealing with it? I think the first thing to say is that in order to charge the level of costs and fees, they have to be compared in a kind of life cycle framework. If you only take current or instantaneous costs and fees, you compare apples and pears. You are not able to compare them.

Secondly, what we see in the countries, and in America also, is that once a system is starting out, they have high fees, but they are decreasing over time but always at the same speed; but if you take Chile or Mexico, they have decreased by one-third of what they were in the beginning.

The third part is we have some ideas but not strong evidence of what is the best in order to decrease them. Quite clearly what matters is that one has a lot of information about it, so publicity, information about the costs and the fees, is crucial, because otherwise you won't get the competition.

The second part, what it is, competition helps but only so far. By itself it is not the solution to the problem.

The third thing that is important to understand is that regulation is crucial but by itself is not a solution. One of the things which a few countries have started to experiment with is to use innovative solutions, and I quote here, the highly industrialized countries which may or may not be transferred to other countries. In Sweden, the reduction of a small funded pillar a couple of years ago, they specialized the pension funds in what they are, whereas issues of contribution collection, recordkeeping, disbursements, et cetera, is done by a clearinghouse. The clearinghouse passes on the money to the investment funds in an anonymous manner in so-called planned accounts. So pension funds can only compete at the level of rate of returns they should but not individual clients because they don't know who their own clients are and this has allowed to bring the costs down to a very low level. So sharing this information and finding out what the alternatives are, for example, using the payment of other things that we are engaged we hope will lead to the reduction of costs and fees.

Latin America has been in the forefront of pension reform. They started out early and made early mistakes from which other regions or countries have been learning. We think there has been major progress to make the system more stable but the progress was not linear through all countries, and we think there is room for improvement. There are three main areas for Latin America which I think also the countries, the people in the countries, agree with.

Number one is coverage. The reforms have been accompanied by the hope that it will lead to an explosion in coverage. This has not happened. Where the reform was well done there was some slight increase in coverage but not a major one, which means there are still many parts of the population which remain outside. They remain outside because they deliberately want to do so because even a reform system is not a good deal or because they are too poor to participate. So for those two groups it is important to provide voluntary assistance, but also to think about social pensions which can be afforded by the country, and my understanding is that it is in those areas that a number of countries are thinking about. But what it means is you can only afford social pensions. To be able to afford the system, you need to be able to shoulder the costs.

The second area of concern has to do with reduction of costs, both in unfunded as well as funded systems, and here progress again has been made, but I think everybody agrees that much more needs to be done.

The last part and the last main challenge has received much less attention so far. This has to do with disbursement of the accumulated money, disbursement through phased withdrawal or through annuities. In this area of annuities, Chile, with the longest history, has made important progress, but not all the problems could be solved, and this will be an area where a lot of things need still to be done in the future.

A good way to think about how to structure pension system is to think about what is the reform pressure, what to do with the system, introduce it or reform it. What is the current system, because current systems have a long schedule, and what is the enabling environment in order to do it. No country, or only few countries have no pension system. Starting out a new one has to make assumptions about what is the environment in which this pension system is operating.

If you had to choose a type of environment with no existing pension system, then quite likely one wouldn't need a public pension system because otherwise it would already exist, which means in such an environment you would be able to focus on the very elderly. You would be able to focus on voluntary system and perhaps choose a lighter mandated system of perhaps a funded type. If you start out with a pension system in a low-income environment, in which a country barely makes it to fulfill the conditions to choose a funded system, in such a circumstance you would quite likely have the choice between moving toward a funded pillar, a small one, or choosing an unfunded pillar, which may have problems in the future. What will quite likely be able is you will think of a defined contribution system as compared to an unfunded system because this creates problems of mobility and this creates problem of incentives, and creates problems of dealing with the aging part of it and quite likely you would think about funding compared to an unfunded system.

So starting out anew will not lead to the same answer, it will lead to different answers depending on the enabling environment and what kind of legacy you have come up with in the country.

The objective of social security is to provide social risk management against risks. The question is when thinking about an expansion, what are the kind of risks which are the most important ones for individuals. There may or may not be the ones which are typically aligned under the pension system, let's say, of the ILO. There may be more pressing risks which determine the welfare of individuals. This can be drought, flooding, this can be earthquake, this can be specific sicknesses. The first answer is if we are thinking of an expansion we have to think about what are the priorities for the country given its financial capacity.

Staying within the framework of the typical social conventions is -- I think one thing for Cameroon is to think how much is needed in order to expand the coverage. Understand there is an old-age pension, there is account insurance and there is also maternity, but this applies only to the formal sector, perhaps only 20 percent or so of the population. What happens with the other -- do they need this kind of insurance, and if they need it, how can this be provided before thinking about other risks?

The third one is to see what has happened to other countries where one has experimented with extensions of social security in the area of, let's say, social safety nets because social safety nets are there to help people out, or once the risk occurs, to protect the investment. In addition, the investment in health, for example, dealing with areas of child labor or with prenatal health, and what countries find out, there are two targeted instruments which have been applied now with a lot of success. One is conditional cash transfer so you get not only money because you need it, but you get the money to do certain things with it, for example, keep a child in school, go to the doctor with your newborn, or simply to certain health check ups which otherwise would not do. And this has been experimented in Mexico and Brazil. It is now under implementation in many other countries, and many countries are looking at it.

The second part which was also undertaken in Africa is also a dealing with macroeconomic problems or cyclical fluctuations on the public work side. The problem is while they can be decided in an ideal manner, many have failed in implementation. But they are good help in order to deal with the unemployment part of it.

The last part is I think what people started to realize inside and outside the bank, and here we are in full sync with the IL, that decent jobs is the best social security. If people have access to jobs, it helps them, and the rest of the economy works well and that is the best way to deal with social security.

Indeed, thinking about choosing a pension system or reforming pension system in a sequential manner is a very good way of doing it. So in many countries in which there is no system at all, it is useful to think about is there a need for social pensions, is there the capacity to introduce a voluntary pillar, and have them first before you move toward an unfunded pillar, if this is required at all. This is, for example, what happened in South Africa, which has an old-age pension, and a very well funded pillar. Sequencing is also a way of thinking about reform. For example, for countries in Eastern Europe which wanted to move from their monopillar to a multi-pillar, in a number of countries it was useful to reform the first pillar so the old unfunded type of system, and in parallel introduce a voluntary pillar and use this as a way to test the capacity of the market, and once this was tested only to introduce a second pillar as a partial offset against the first pillar. For this reason the multi-pillar framework is important because it allows this flexibility.

Indeed, in order to deal with aging, funding of pension systems, whether pay as you go or through capitalization, matters little, because at the end of the day all pensions are paid out of output which needs to be produced. But it doesn't mean that funding is totally irrelevant. The form of funding is a kind of collateral, how to have it, it is the collateral, your future contributions or is the collateral future assets. Both of them are backed by GDP.

What to do with regard to aging? Well, if it is only aging, then the best way of dealing with it is to split the gains in life expectancy between a bit more work and a bit more leisure. If life expectancy increases from 80 to 90, then it would be useful for people to think about -- to work a bit more, five years, and stay five years longer in retirement. Where does funding come in? Well, in order to allow for individual flexibility, some would like to work more, some would like to retire earlier, but financed out of their own pocket, not out of the particular pocket of the next generation. What matters then is to give them the capacity to finance an early retirement or ignore it and retire later, and here a pension system which allows this kind of flexibility, and which provides the security through diversity, is important. Here funding a support mechanism and not a guaranteed system in a pension system is a crucial element.

The second thing is, if it is not the aging per se as people get older, but it is a question if there are fewer people around because the birth rate has decreased. This requires a slightly different approach. It requires also in an individual decision which becomes a macroeconomic equilibrium more and higher retirement age, but it is also likely to require higher contribution rate in order to be optimal.

Frankly speaking, I don't have the full number of countries. I had asked staff to provide it to me but it was a short time. What I can say is that currently still the majority of the countries rely on unfunded mandated systems and normal pillars, but what has happened is that multi-pillars so mandated as well as unfunded pillars have increased substantially over these years. There are, as you know, some 12 countries that have implemented the reform since the beginning of the 90s, and there are 12 countries in Europe and Central Asia that have introduced a partially funded system, and you also have this kind of reform outside Latin America, outside Europe, and there is movement in Africa, and also in Asia. For example, India introduced last year a funded pillar for those entering the labor force. China has a kind of system which has funding in at least three pilot provinces. So overall the majority of the countries have unfunded pillar but there has been a main movement toward funded pillar not fully but at least partially in the last 10 to 15 years.

To initiate pension reform and to make it successful is a difficult undertaking. There are, overall, political economies and areas where we made some progress over the last decade or so without being a full expert--nobody is. What emerged from it is that you need to have an understanding what makes countries think about pension reform. Here what emerged is, it is important to have uncontested calculation which shows you the unsustainability of the existing system. If you don't have that, it is difficult to convince the population at large.

The second thing that emerged is it is important to tell the country, the people, that there are alternatives out there, and the alternatives succeeded in reforming the system. So pass on the message that pension reform can be done.

The third part which emerged is that in order to push for pension reform, it is important to have a champion, to have somebody who is able to take pension and run with it. If you don't have a reform champion, pension reforms are not done. This champion then has to find coalitions to come up with a proposal which finds support from parliament, trade unions, to make it happen.

The last part is to take a lot of care with the implementation because having the law is only 10 percent of the work. 90 percent of the work is still outstanding once you have the law. This quite often is not fully understood.

So with this kind of element of transparency, of knowledge, one is able to engage in a pension reform, but these are necessary but not sufficient. We are still trying to find out.

Indeed, there are different policy stands between the World Bank and the ILO, and there are a number of answers to this one.

Number one is the differences have been reduced over the last decade as a result of an intensive dialogue at all levels, but also on an individual bilateral level, to understand better the position of the others and to understand good arguments. The differences are currently more at the level of decree rather than level of substance. The ILO recognizes the importance of funding but sees the overall benefits perhaps less strongly than the World Bank sees them. This may have to do that the Bank is a development institution, and sees the importance of financial markets, and the contributions to financial market developments which well done pension reforms can provide. What we know from own research is that financial markets are an important element for sustainable and high growth prospects for countries which cannot be ignored, in particular against a background that any kind of pensions need to be paid out of future higher households.

The second thing is that the existing differences, it is good to have them because it should allow the joint client countries to hear both sides, perhaps also the side from the IMF or from other development banks to form its own opinion. It would be tragic if there were not a plurality of opinions about it, and of different views and the possibility for the client to be more informed about products. Intellectual competition is good also in the area of pension reform.

The last point to say is that there are institutions, like the Bank, like the ILO, like the IMF, that argue the point of view from their mission, which the ILO is linked very much to to the formal labor market, and the area of the Bank has to do with the poverty mission, the area of the IMF has to do with macroeconomic stability. So given this different mandate, different objective, it is clear that different opinions must emerge but these opinions and the differences have been reduced.

Old age security is another social protection instrument that has to be seen against a background of social risk management, what are the kind of risks that matter to a country and the result of which, which are the ones where you find priority. As a result, you have a lot of emphasis in highly industrialized countries which are aging, which have little background and a larger family which takes care of the elderly. So you need to have a mechanism which coddles toward the elderly, but in highly industrialized countries you have market-based instruments which can be used under good government regulations, mandated or not mandated is a different question, which are able to provide the services toward the elderly. This is different in a country which has, let's say, a very young population. Only a small share of the elderly which are accounted for by the family, in this case saving for old age is simply not a priority. In this case perhaps sickness is more important. They don't want to invest in something which has a rare probability to happen which is far in the future.

This kind of considerations are borne out if one looks into risk and vulnerability assessments which ask individuals in countries, rural areas as well as urban areas, what are your most important threats to your livelihood. This risk assessment shows quite clearly differences between countries, high income and low income, and rural and urban sectors, and as a result the social protection programs need to be geared toward it, and not simply a template coming from elsewhere to be applied.

Europe is one of the most aging regions in the world, rivalling with Japan. This aging puts a burden on the pension system from two ends.

The first has to do with people getting older. This can be rather easily solved by simply letting people work a bit longer. Nowadays people are much more healthy than, say, 20 years ago. A more difficult issue has to do with the fall in the birth rate, which makes the population and the labor force shrink. This shrinking, which is expected to be to the tune of half a percent a year from now to the year 2050, has an important bearing on the internal rate of return of an unfunded system. The internal rate of return of an unfunded system is productivity grows as population grows. Productivity growth is likely to be reduced by an aging population. In an IMF study of last September, the World Economic Outlook, a cross-country estimate showed that due to aging there will be a fall of half a percent of productivity due to aging, over the next 50 years. Add to this the fall in labor force, it leads to a fall in the real rate of return of 1 percent, which is quite substantial. If you add to this the change in the relative prices dealing with long-term care, the problem is that there may be essentially no positive rate of return for an unfunded system in the future, which means that in order to achieve the same level of replacement rate, even if you increase your retirement age, people will have to have worked more or contribute more.

Put differently, in order to deal with aging, people will have to increase their retirement age by, let's say, five years, from now until they retire. In order to deal with the fall in labor force participation, another five years may be required to balance the system. I think against this background the issue of migration needs to be seen. Migration is not an instrument of dealing with an increase in life expectancy because also the migrants get older. So in order to keep a constant retirement age, migration will have to grow exponentially, which is economically and politically unfeasible, but it may help stabilize the work force and generate the necessary support to keep the economy more vibrant.

How much do we need? If you take Europe between now and 2050, labor force participation will fall by 50 billion, and the labor force in the Middle East and northern Africa region at the same moment will increase by 170 billion. Which creates a disequilibrium, and as economists may say, if there is disequilibrium, there is room for arbitrage. What are the conditions for arbitrage to make it a win-win-win situation, winning for the migrants, winning for the sending country, and winning for the receiving countries? If you look on the Bank's website, you'll find a little booklet on this which will provide some answers.

The proposal has two elements to it which are intermingled. The first one has to do with putting the system on a sustainable basis. This needs to be done whether it is funded or not funded, and this can be done through increasing retirement age or increasing contributions or cuts in benefits. This is the first question, because the current system as it is would show a deficit which at the end of the day has to be covered.

The other part of the proposal is to move partially from the current largely unfunded to a funded system. What the latter does is to essentially partially undo the original distribution toward the start-up generation. The start-up generation which received much more than anticipated to the system because there was no contribution accumulated and interest received.

Moving now from unfunded to a partially funded individualized system makes this debt implicit than explicit. And this is the deficit which may or may not emerge if this proposal is introduced so the overall debt is not increased. It is only made from an implicit to an explicit one. But what likely needs to happen is that this explicit debt needs to be repaid which requires a contribution from the current and future generations to make this happen.