international pension reforms implications for china's pension systems

How can China relate pension lessons to its specific development challenges, such as an expanding aging population, underdeveloped capital markets, and To shed some light on these questi

International pension reforms: Implications for China's pension systems

Tao, Sunning

ProQuest Dissertations and Theses; 2008; ProQuest Central

pg n/a

INTERNATIONAL PENSION REFORMS:

IMPLICATIONS FOR CHINA’S PENSION SYSTEMS

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TABLE OF CONTENTS

LIST OF TABLES 00 eeesesecseessssssssnceeessseceecarseesesesseesscessessesssssusesssssevscescesseseassseass Vili

LIST OF FIGURES oceccccccssssssssssssssscscccssssssssssssssossssssessesssssssuanansasssnsasssesesareseeseeeeeeisen ix

LIST OF ABBREVIATION DUSEID, L1 3n nh ng ngưng ng xi ACKNOWLEDGMENTS 0 cecccccssssseesecssessesseneeesssessecersvseessessessscvaecssscaseesseascasesscees xii CHAPTER ONE: Introduction óc nh HH TH TH nh ni 1

CHAPTER TWO: A Brief History of Pension System Developmeii 5 2.1 Traditional Approaches for Growing Old ccccscsssscssssesssssssssessssssessassessassaceees 5

2.2 Institutional Cares .cccsesesssssssecssssscscsssssvsssssvsvesssessscscacssscacasssssaceeacsesvavacsesececes 6

2.2.1 Pension Systems Development in Some Coumtries cccscsessssecseeseesseseees 6 2.2.2 Pension Systems in China cccccscsccsssssssccsseseesecssseeecssseeessesseserevsessassanees 10 CHAPTER THREE: Literature Review on Pension ŠYS{€INS sen 13 3.1 Annuifl©§ -c re Hee HH K9 9 kg vệ 14 3.1.1 Annuity PTICINE sàn HH HH 1001010101 7x 14

3.1.2 The Demand of Annuify css 2 S2EE21111111121211122311111101222212211eexee 15

VI 0c 0n 17

3.3 Individual Savings HH rên 21

3.4 Employer-sponsored Pension Systems .:scssssssessssesssessssessssescssssesseessensseeses 23 3.4.1 Defined Benefit (DB) Plans Ăn HH ng ng 1n neo 24 3.4.2 Defined Contribution (DC) PÏans - Ặ GS n 1n ng ng ng kho 25 3.4.3 Which to Choose: DB or DC Planns2 - G SG 1v ng reka 26 3.5 Public Pension SVSÍ€rm§ - G HH HH HH HH HH kg 27

3.5.1 Contributory Pension SyS(€Ims - cưng xe 28

3.5.1.1 The Pay-As-You-Go (PAYGO) System nen, 28 3.5.1.2 The Fully Funded Pension System ee KH Ki n0 n1 06 29

-3.5.1,3 The Notional Defined Contribution (NDC) System - 30

3.5.2 Noncontributory Pension SYSf€ITNS HH ng ng 2215 1 krre 31

CHAPTER FOUR: Pension Challenges in Developed Countries KH HT ng 33 4d Background cesesessssssesssssessssvssvsessesscsesussesersussvsnssesacsesucaesussesurssecaesscaesessesscaeeanes 33

4.2 The Demographic Change and Its Impact on the Traditional Pension System 34

4.3 Assessing Pension Reforms .:ssssssesssssssessessesesssessescesscsssscessssesneseessesseesscesens 39 4.3.1 The Incremental Changes .ccccccssssssesseessessecsssessecsssesescseeenseessecesessseneens 40 -_4.3,1,1 Raising Retirement À©S ng ng ng ve 40 4.3.1.2 Reducing Pension BenefiS - sc Ăn n HH HH HH HH dư, 44 4.3.1.3 Increasing PayrolÏ 'TaX€S§ -ĩ c1 HH ngư ưa 45 l7 ẻ 47

4.3.2.1 DB versus DC LH HH HH HH rrrerirrrrid HT vn key 48 “10.06 009 ố.ốố.ố 49

4.4 Portfolio Diversification .ce.ssssscssessssessssesccsesssssessseeesseesssvecssesesscessaccasvesssseces 53 4.4.1 Why PortfolioS? cv 53 4.4.2 Diversification: Finance Theories and Development Facfs 34

4.4.3 Portfolio Choices mm —- 4.4.3.1 Portfolio Choices with Government-organized Individual Accounts 55

4.4.3.2 Portfolio Choices with Privately-organized Individual Accounts 55

AS Regulations hố ốố ố.ố e 56

4.5.1 Structure of Management and Supervision 56

4.5.2 TaxatiOnS — 57

4.5.3 Regulation of Portfolio Management - HH HH, 58 "ho an 39

CHAPTER FIVE: Pension Reforms in China .s- 2Á S11 xe, 62 5.1 Background án TH TT Tư TH HT ng ng ưg2 63 5.2 Demographic Change and Economic Shift se Hee 64 5.2.1 An Aging POPUlafiOT 5 555 tt s3 vn ng ng ngưng so 64 5.2.2 The Economic Shift: Rural-to-Urban Migration .- -cccc<sssss«e 68 h9) 060x208) ae 71 3.3.1 The Framework of Pension SYSÍ€INS c con HH ng ng ng ngưyệt xã 5.3.1.1 The Mandatory Public Pension SysStem « «+ HH khe, 72 5.3.1.2 The Employer-sponsored Pension System KH 01611011 t0 73 5.3.1.3 Individual SŠaVITỠS - - Go TH 904 1g 900 kh 74 5.3.2 Challenges of Mandatory Pension SySf€ImãS cv 75

` 6o 0ì 80 5.4 Assessing Pension Ñ€ÍOrIS có ch ng TH nà ng ng ng ng rà °ÖŠ 83 5.4.1 Rising Retiremenf Àøe che TH kg kg ng 84 5.4.2 Reducing the Payroll Tax - ¬ 85 5.4.3 Extending Pension Coverage ¬ 86

5.4.4 Establishing NDC System in Individual ACCOUNUS c ccccssssssecessesseeseesees 88

5.5 Fostering Caprtal Markets 90 5.5.1 Accelerating Financing InnoVafIOTS, cv x3 n9 xxx, 91 5.5.2 Portfolio DiversificafiOn ong ng — 91 5.6 Government Regulations and Pension Funds Management - 92 5.6.1 Unifying Fragmentary Pension System Management ‹ -«- 92 3.6.2 Providing Taxation ÍncenifÏV€S ong ng ng vrg 93 5.6.3 Relaxing Investment Re€striCfÏOTIS ng 0 re, 94 5.6.4 Improving Pension Funds Management and Supervision - - 95 CHAPTER SIX: Conclusions 101107 96

REFERENCES 11171ẼẺ77 7 100

LIST OF TABLES

Table 2.1: History of the Public Pension Systems ki ¬— 8 Table 4.1: Demographic Background in Some OECD Countries -ccs-csc 38 Table 5.]: Contribution Rates for Urban Enterprises and Individuals 82

LIST OF FIGURES

Figure 2.1: The Three-Pillar Pension Model so ch ng n0 0t 10 Figure 4.1: Life Expectancy at Birth, Canada, 1990-2004 - Hee 35 Figure 4.2: Fertility Rate, Canada, 1926-2002 .sescsssscssscsssecsssecssrecessessecsssesesnssseeeees 36

Figure 4.3: Population Pyramid, Canada, 2000 — Tnhh 37

Figure 4.4: Population Pyramid, Canada, 205 HH HH HH HH g 37

Figure 4.5: Average Retirement Age, Canada, 1976-2006 .s-cccccccreereee -.42

Figure 5.1: Average Life Expectancy at Birth, China, 1981-2007 vsessnsseneee 65

Figure 5.2: Fertility Rate, China, 1949-2007 cocscsssesccssssssssssssesssccsesessesssssssessesseessse _ 65

Figure 5.3: Populatlon Pyramid, China, 2000 - Ặ cà "HH ng tp 67

Figure 5.5: Proportion of Urban and Rural Populations, China, 1978-2005 70 Figure 5.6; China’s Current Pension System " 7l

ABSTRACT

Pension systems were widely introduced in most developed countries after the Second World War China, however, did not aggressively advance its modern pension system until the 1990s What can China learn from other countries in improving its pension system? How can China relate pension lessons to its specific development challenges, such as an expanding aging population, underdeveloped capital markets, and

To shed some light on these questions, this thesis first reviews a brief history of pension systems and their underpinning economic theories, and then it explores the challenges and opportunities in implementing pension systems facing governments in: some developed countries Finally, it addresses how China can learn from pension lessons in other countries, The purpose of this thesis is to draw the attention of scholars and policy makers to the challenges of implementing a pension system in China

AFP AGI CIA CPP CPPIB CRA CRRA

DB

DC

EA ERISA FDC GDP GIC GIS HRDC IPD IRA ISP MOLSS NDC NSSF NSSFC OAS OECD PAYGO PBGC RPPs RRIF RRSPs WTO

LIST OF ABBREVIATION USED

Administradora de Fondos de Pensions

Adjusted Gross Income

Central Intelligence Agency Canada Pension Plan

Canadian Pension Plan Investment Board

Canada Revenue Agency Constant Relative Risk Aversion Defined Benefit

Individual Retirement Account Income Security Programs Ministry of Labor and Social Security Notional Defined Contribution National Social Security Fund National Social Security Fund Council

Organization for Economic Co-operation and Development

ACKNOWLEDGMENTS

I would like to express my deep and sincere gratitude to my supervisor, Professor Kuan Xu for his excellent guidance, simulating advices and encouragement while undertaking this thesis writing I also would like to thank Professor Swapan Dasgupta and Professor Ian McAllister for their insightful suggestions and valuable corrections Furthermore, I would like to thank all faculty members, staff and my classmates of Department of Economics Their kindness and professionalism made my time in the department a really enjoyable one

CHAPTER ONE Introduction

One of the greatest socioeconomic successes in the western world has been the establishment of social insurance programs in the last century Pension systems, perhaps the most important component of social insurance, were developed to ensure individuals have a stable income in their ‘retirement’ years, so that they can live decently and with dignity China, however, did not have any modern pension system in the sense of those in the western world until 1991 In an attempt to implement a sound pension system, China has been exploring its own way and also trying to learn from the experiences of other countries Many questions have been raised in this regard:

(1) What are the pension challenges facing governments in developed and developing countries? How are the governments dealing with those challenges?

(2) What is China’s traditional pension system like? How well does the new modern pension system work in China?

(3) Can successful pension reforms in developed and developing countries be employed in China? What can China learn from these countries in improving its modem pension systems?

(4) What are the challenges and opportunities in implementing a successful pension plan system in China?

This thesis will try to provide some answers to these questions based on the research

In most developed countries, modern pension systems were not adopted until the Second World War At the beginning of pension systems’ establishment, the number of retirees was only a small fraction of the total population in the most countries The pension benefits payout was relatively low in the government budget To date, however, the elderly population has increased considerably at a rate which is much faster than that

of the working-age population Therefore, the benefits paid to the elderly are imposing a great fiscal burden on the working-age population across most countries Moreover, the traditional way of financing pension benefits from payroll taxes makes the labor markets inefficient (Mackenzie et al, 1997) Asa consequence, governments in those countries are facing significant challenges in financing the public pay-as-you-go (PAYGO) pension system, which transfers the contributions from the working-age population directly to the elderly population —

_ This has led to the reform of pension systems in many countries In particular, the governments have taken a significant step towards the transition from the traditional PAYGO pension system to a funded pension system Although it is expected that some generations will suffer from an increased financial burden of this transition, this nevertheless ensures stable and sufficient benefits payout in the long run In addition, governments are actively encouraging individual workers to reduce their dependence on public mandatory pension systems Because of this, private pension plans and annuity markets have become essential for compensating the reduced benefits from the public pension system

Cases which are of particular interests in the pension reforms are Chile and Sweden

In 1981, Chile successfully conducted a pension reform by replacing the traditional: public PAYGO pension plan with an individual accounts system Sweden established a Notional Defined Contribution (NDC) public pension system in the beginning of 1990s These reforms draw considerable inspirations for researchers and governments alike

Unlike other countries, China currently employs two separate pension systems that mainly serve two different social groups: (1) a traditional pension system, established in

| the 1950s, which covers employees who work in education services, military, governments and state-owned enterprises, and (2) a modern pension system, explored in

1991, which covers enterprises workers in urban areas However, workers in rural areas are not covered by any of the mandatory pension plans and most of them have to rely on their own and their family in retirement

Up to now, a modern pension system has been successfully adopted in China Rules _ and regulations have been carefully established However, the Chinese government faces broader challenges in improving and providing a sound pension system Population aging, ongoing urbanization and undeveloped economic transformation are placing an increasing pressure on financing the current pension system (Holzmann, Arthur and Sin, 2000) It is important to learn from pension lessons of other pioneering countries

This thesis has two purposes The first purpose is to review the literatures on pension system development, relevant economic theories, challenges and opportunities facing governments in some developed and developing countries

The second purpose is to analyze other countries’ lessons and experiences in pension systems that will help in improving China’s pension system Given that pension systems | vary widely among countries with different political ambitions, diverse cultural and historical background, this thesis studies how the experiences from other countries can be applied to China

This thesis is organized as follows Chapter two reviews a brief history of pension

‘systems with a focus on some successful countries and China Chapter three introduces the relevant economic theories and framework of pension plan systems Chapter four discusses the challenges and opportunities in implementing pension system reforms facing governments in some developed and developing countries Chapter five will address the debates on improving pension reforms in China and the lessons from other countries that are relevant to China, Chapter six draws concluding remarks and suggests future research

CHAPTER TWO

A Brief History of Pension System Development

To maintain an adequate standard of living, and a decent lifestyle in retirement, retirees must have sufficient resources As Midwinter (1997) indicated the basic question here is: who provides the resources for retirees, individuals themselves or governments? This question can be answered from the historical perspective

2.1 Traditional Approaches for Growing Old

How did people in the past live through ‘retirement’? Before answering this question,

it is necessary to know the actuarial life expectancy in the old days In the industrial era, the average age of death was about 17 in Liverpool (an industrial city in eastern England) In the 1750s, the life expectancy at birth was about 37 years The birthrate was about 35 per 1000 of the population as late as 1860s, and only about 30 per 1000 a century ago Therefore, the higher death incidence and lower birth rate ensured that only

a small number of people would survive into old age (Midwinter, 1997)

In the traditional societies, it has been common that family and close relatives were the primary caregivers for their elderly family members For example, in China, “raising sons to support people in older age” was the motto for caring the elderly This motto also emphasizes the responsibility that male offspring have Because of this, for centuries, the

elderly without sons often lived in fear of poverty and neglect This is still the case in some areas in the world today

In addition to family support, charity existed as a form of economic security in Europe in the Middle Age (DeWitt, 2003) However, this service was not sufficient enough to support old people’s needs at that time The reason is that the donation depended on the givers not the receivers Also the social problems could not be solved by the spontaneity of givers’ voluntary efforts alone (Midwinter, 1997)

When the economy grew more commercialized, where the trading and commercial activities were prominent, people tended to move into urban areas and became less dependent on land However, urban life was not as self-sufficient as life in agriculture It was a separation of the home and the workplace (Midwinter, 1997) This demographic change finally led to the shift from family and charity support to institutional cares

2.2 Institutional Cares

2.2.1 Pension Systems Development in Some Countries

In 1601, England enacted the English Poor Law which was the first systematic codification to assume responsibility and to provide some economic security for its underprivileged citizens Under the law, the government provided taxation to fund relief activities and established almshouses to house those on relief (DeWitt, 2003) This law was sustained for 300 years However, it mainly focused on people who were poor, and it

was not a real pension system that protected people from the uncertainty of getting old (Midwinter, 1997)

Pension systems were first established in some developed countries between 1880s and 1920s, including Germany, Britain, the United States and Canada Chile was the first Latin American country that adopted a systematic social security system (see Table 2.1) Most scholars agree that the earliest pension system was instituted in Germany in 1889 The system was a funded and mandatory program for workers, especially in large companies where people were, most influenced by socialist movements (The World Bank,

| 2006) Britain started its pension system in 1908 by issuing the “Old Age Pension Act’ Under the Act, the government paid a non-contributory amount to people over 70 (“Pension Schemes: A Brief History,” 2007) The United States established its social security system in 1935 (Apfel, 2000) Canada commenced a pension system in 1924, but the system did not come into effect until 1954 (Treasury Board of Canada Secretariat,

2007)

Table 2.1 History of Public Pension Systems

History of the Public Pension Systems

Otto von Bismarck, the first chancellor, proposed a pension Germany ~ 1gg9 | system for all workers in trade, industry, and agriculture from

the age of 70 years In 1913, the pension age was reduced from

70 to 65 years

Britain 1908 The “Old Age Pension Act’ was approved to pay a non-

contributory amount to people over 70 | The “Civil Service Superannuation Ác?” was passed by Parliament with the aim of providing public servants with suitable income upon retiring from the public service It came into effect in 1954

A pay-as-you-go system was established on as early as 1924 It Chile 1924 | made Chile the first Latin American Country to adopt a social

The “Social Security Act” was signed by President Franklin

The United Delano Roosevelt on Aug 14, 1935 It was designed to pay

States _ | retired workers age 65 or older a continuing income after

Sources: Germany’s information from the World Bank, 2006 Britain’s information from

the British Broadcasting Corporation Canada’s information from the Treasury Board of Canada Secretariat, 2007 Chile’s information from the World Bank,

2006, The United States’ information from the Social Security Administration,

2000

Countries listed in Table 2.1 are the pioneers in developing pension systems However, most countries established a modern pay-as-you-go pension system after the _ Second World War Following the War, a strong need for welfare provision increased rapidly when large numbers of veterans returned to their home country (“Pension History: International,” 2007) Providing a stable financial support to those veterans and retired military personnel became an inescapable responsibility of various governments - Asa consequence, pension plans were initially established for retired military personnel Later, pension plans extended their coverage to workers who worked for governments, or

large bureaucratic organizations, such as railroads and banks (“Pension History: International,” 2007) Overtime, pension plans were developed into an earned right by, and for workers, no longer limiting to the civil servants and war veterans (Perotti and Schwienbacher, 2007) Governments started to establish pension systems and to formulate laws and programs to provide retirement benefits to retirees

Programs that governments have established for their senior citizens are called public pension systems Currently, most governments in developed countries employ the pay-as- you-go system However, many public pension systems are moving gradually to funded pension systems A fully funded pension system ensures at 100 percent of present value

of all pension liabilities are owed to the current members (The World Bank, 2006) Besides public pension systems, there are also employer-sponsored pension systems They have two main kinds: defined benefit (DB) plans and defined contribution (DC) plans, which have different risk distributions between employees and employers (Davis, 1993), The DB plan is a plan in which the pension agency guarantees that pension is paid based on a prescribed formula and benefits may not be tied actuarially to contributions The DC plan is a plan in which contributions are prescribed and the benefits depend on contributions plus the investment returns (The World Bank, 2006)

Based on the World Bank’s classification, there are three pillars of pensions: the publicly managed system with mandatory participation, the private by managed saving system and voluntary savings (The World Bank, 2006) The first pillar, the public pension system, is typically considered as a “safety net” It protects pensioners from

poverty through some minimum guarantees The second pillar, the employer-sponsored pension system is considered as the responsibility of both employers and employees

~401(k) in the United States, lock-in RRSP (Registered Retirement Saving Plans) in Canada, and other employer-sponsored private pension plans are examples The third pillar, voluntary saving is voluntary in nature, and sometimes, has preferential tax treatment in developed countries Examples include Individual Retirement Account (IRA) in the U.S and Registered Retirement Saving Plans (RRSP) in Canada (See Figure 2.1)

Figure 2.1 The Three-Pillar Pension Model:

Source: The World Bank, 2006

2.2.2 Pension Systems in China

Over the last 60 years, China’s social and economic system has experienced dramatic changes, which has significantly influenced how to fund old people’s needs After the Sino-Japanese War of 1937-1945 (part of the Second World War), China finally ended

partial colonial governance, but it got into the Chinese Civil War from 1945 to 1949 With the victory in the Chinese Civil War, the Communist Party established the People’s Republic of China in 1949, Since then, China has been governed by a one-party system (“History of China,” 2007) However, the society was financially drained after the many | years of wars and chaos During that time, survival was people’s preoccupation It is understandable, therefore, no systematic pension system ever existed

The traditional pension system in China was instituted in the 1950s This system was designed for employees who worked for governments, state-owned enterprises, military and educational sectors It had defined benefits, providing old age pensions that represented 50% to 70% of workers’ wages (Holzmann, Arthur and Sin, 2000) |

During the Cultural Revolution (a period of social movements in 1966-1976), the government transferred the responsibility of pension supervision to provincial labor bureaus This led to the termination of the practice of the social pooling on the national level Furthermore, the pension funds that had accumulated before were embezzled in the Cultural Revolution, effectively eliminating the pre-funding' reserves that had built up for years (Holamann, Arthur and Sin, 2000)

During the economic reform from the central planning to a market-oriented system (1978-present), the State Council of China reaffirmed certain pension rights and granted new and higher benefits to pensioners Throughout the 1980s and 1990s, the Chinese

* The role of pre-funding policy is a means of smoothing the intergenerational incidence of aging cost (Lassila and Valkonen, 2001)

government initiated pension reform pilots in selected provinces (Holamann, Arthur and Sin, 2000) Holzmann, et al (2000) described detailed regulations of the pilots:

“These focused primarily on: (i) shifting from enterprise insurance to social insurance by setting up social pooling systems for industries in urban areas; (ii) requiring individual contributions in order to distribute the pension cost burden; (iii) establishing voluntary occupational pension schemes and individual savings plans to supplement pensions; and (iv) partially pre-funding future pension debt by setting a higher contribution rate” (Holzmann, Arthur and Sin, 2000)

In these regulations, individual accounts and the social pooling were emphasized This helped in building a two-pillar contributions system from individuals and enterprises

in urban areas In 1997, the State Council of China unified the system Hence, a modern pay-as-you-go pension system was established in China In this system, the employer contributes funds equal to 20 percent of employees’ incomes, and individuals contribute funds equals to 8 percent of their incomes (Zheng, Silin, 2005)

The establishment of the Chinese traditional and modern pension systems was deeply influenced by the socioeconomic changes Before the economic reform in 1978, the Chinese government collectivized agriculture to speed up industrialization, which unavoidably divided economic functions of urban and rural areas Unfortunately, the division became more pronounced after the reform of the 1990s (Bottelier, 2002) Asa consequence, the modern pension system is largely urban-based, and covers only the enterprises workers in urban areas Rural labor force, who now accounts for about 60% of the total population, does not participate in this mandatory system Instead, they continue

to rely on their own savings and family support in their old age

CHAPTER THREE Literature Review on Pension Systems

Generally, a pension system has two essential objectives: (1) to allow an individual

to smooth his consumption between working years and retirement years (Diamond, 2005), and (2) from a government perspective, the public pension system should also prevent poverty among the elderly (Government of Canada, 1982) To understand how to achieve these objectives, this chapter discusses analytical approaches that are relevant to pensions and reviews some basic features of different pension systems

This chapter begins with an introduction to annuities, since public pensions and _ employer-sponsored pensions typically provide benefits to retirees following the principle of annuities with regular monthly payments Then the chapter uses a two-period model to demonstrate the first objective of consumption smoothing in the life cycle Later, this chapter presents the basic features on three retirement pension systems: individual! savings, employer-sponsored pension systems and public pension systems and discusses how these three systems help individual workers allocate their assets to achieve the pension objectives The goal of this chapter is to lay a conceptual framework for the

- discussion in the following chapters

3.1 Annuities

An annuity is a contract in which an insurer promises to pay the investors a stream of payments on a regular (often monthly) basis The size and number of these payments depend on the funds invested in the insurance company and the annuitant’s age and the annuity options that the annuitant chooses (Sharpe et al 1997, p.729) In many countries, the principle retirement income vehicle is a life annuity (Blake, Gairns and Dowd, 2003)

It is a financial instrument where payments are provided regularly as long as a retiree lives Consequently, a life annuity is optimal for an annuitant since it protects the annuitant from outliving his pension savings The life annuity that public pension system offers also provides inflation insurance (Mackenzie, 2006, p.5)

3.1.1 Annuity Pricing

To determine the price of an annuity, the insurer should devise both interest rate and mortality rate Assume there is a cohort of all 65-year old women that no one of the cohort will survive past age 100 Furthermore, we assume the interest rate is a constant and each one of them receives an annuity payment ($1) annually (although monthly is _ more common), starting from year one to year thirty-five

We denote the interest rate as, and the probability of survival to year ¢ after -annuitization as SP,, then the present value of the expected stream of one dollar annuity payment P to each one of this cohort can be expressed as:

SP

P= wit Gant - G1)

Equation (3.1) indicates the present value on the life annuity As we can see from Equation (3.1), the present value falls as the interest rate increases Moreover, the lower the survival probability (or the higher the mortality risk), the cheaper the present value of the life annuity is (Mackenzie 2006, pp 43-44)

3.1.2 The Demand of Annuity

Aside from public pensions and employer-sponsored pensions, very few individuals voluntarily purchase life annuities The private annuity market is relatively small in comparison to markets for other financial instruments in most countries (Mackenzie

2006, p.23)

However, a life annuity should be the optimal financial vehicle to the risk averse individuals with uncertain lifetimes Yaari (1965) presents that a life-cycle individual will always choose to purchase a life annuity without bequest motives The reason for his result is that a life annuity will always provide a higher return than a regular note for an individual without bequest motives, and the cost of the annuity would be automatically equal to zero after the individual dies

But why is the individual annuity market so small in reality? Many economists try to explain individuals’ annuitization intentions The intentions vary greatly across individuals based on the different economic and behavioral parameters

First, financial markets do not offer life annuities on very favorable terms (Mackenzie, Gerson and Cuevas, 1997) Friedman and Warshawasky (1990) indicate that after allowing adverse selection, the differential between the implicit expected yield on

an annuity and the available yield on alternative forms of wealth holding accounts for the reluctance of most individuals to buy life annuities Furthermore, they explain that individuals have information that leads them to know their life expectancy In contrast, insurers typically charge a uniform premium to all individuals of the same age and sex Individuals who expect longer (shorter) lifespan will perceive that the life annuities have higher (lower) expected yields Therefore, the annuity premium charged on various individuals would be different with that charged based on the whole population

~ Second, bequest motives and household behaviors affect individuals’ annuitization decisions Bernheim (1991) finds that social security annuity benefits significantly depress private annuity holdings among the elderly individuals, since many elderly have strong bequest motives that reduce their desire to annuitize their wealth, even if insurance markets are perfect Brown (1999) presents that individuals’ health and marital status are correlated with individuals’ annuitization behavior Individuals with very poor health are less likely to annuitize Married couples are less likely to annuitize than are single individuals due to the ability to pool mortality risk

The study of annuities provides important insights for studying the potential impact

of introducing individual accounts to traditional public pension systems and partial substitute for the current pension systems (Brown, 1999)

3.2 The Two-Period Model

To analyze how to achieve the first objective of consumption smoothing, we introduce a two-period life cycle model following Romer (2001) and Mackenzie (2006)

In this two-period model, we assume individuals live for only two periods We define the first period as working years, and the second period as retirement years Each individual lives for at least one period, but some of them may die before the second period starts In the first period, individuals earn incomes, and in the second period,

| individuals consume the saving from the working years, if they are still alive To further simplify the analysis, the model assumes that individuals only save to buy annuities and

do not have any bequest motives

We can choose one individual as the representative agent In the first period, this individual chooses his consumption level for period one, and then allocates the rest of his income to purchase an annuity, in the amount of A With this assumption, the annuity the individual purchases will pay him a gross return of 1 +7, where r is the interest rate of

an annuity, if he survives to the second period, and the annuity will not pay if he dies We denote this individual’s total wealth by W His consumption in the first period is C,, the -

potential consumption in the second period is C, Therefore, his consumption in the second period will subject to the following budget constraint:

We further assume that this individual’s preference over consumption-at-retirement

as described by a constant relative risk aversion (CRRA) utility function

probability Furthermore, the utility he gains from consumption in period two will also be discounted by a factor 6 (0 < 6 < 1) The closer P is to zero, the greater the future will

be discounted Therefore, we modify (3.5) and allow for the consumption in the second | period: ©

he purchased must be equal Therefore, we substitute C, by using equation (3.4), then we can re-express equation (3.6) as:

cr + sp-8-[—C;)(1+r)]1*

Max U(C,,C2) = ox Ta — Q7)

After differentiating equation (3.7) with respect to C, and setting the equation equal

to zero, we can derive:

We can see that a decrease in the consumption in the first period increases the value

of the equation (3.8) on the left-hand side When « and r stay constant, increases in

survival probability and discount factor ổ on the right-hand side could increase the total value of the equation It is understandable that the greater the probability of survival to period two, the greater needs for saving in period one Also, when & is greater than 1, the second-period consumption falls as the interest rate increases When « is smaller than 1, the second-period consumption increases as the interest rate increases Furthermore, if we re-arrange the right-hand side of equation (3.8), the equation can be rewritten as:

- consumption to vary over time (Romer 2001, p.48-49) Therefore, Equation (3.9) implies that when sp: B - (1 +17) > 1, the smaller « is, the individual is more willing to shift his consumption from period one to period two, and the greater « is, the individual would like to shift his consumption back from period two to period one Hence, the coefficient

of risk aversion, «x, determines how much individuals’ consumption varies between

| working years and retirement years (Romer 2001, pp.48-49, Mackenzie 2006, pp.194-

197)

The two-period model demonstrates the first.objective of consumption smoothing from a theoretical perspective In the following paragraphs, we introduce how the

different pension systems help individuals allocate their assets for consumption smoothing

3.3 Individual Savings

Individual saving is one of the primary ways of financing retirement, in particular, in the absence of a public pension system As shown in the two-period model, in order to achieve consumption smoothing, individuals work and earn incomes when they are young, and live off their savings when they cease working and take up retirement

Even with a public pension system, individual saving is still an indispensable way of protecting the elderly in the rainy days In developed countries, governments provide preferential tax treatment to encourage individual savings for retirement that can ease the pressure of financing public pension systems Examples include Registered Retirement Savings Plan (RRSP) in Canada, and Individual Retirement Account (IRA) in the United States

In RRSPs, the contributions are tax deductible and assets can grow tax-free until they are taken out of RRSP plans Individuals are allowed to contribute as much as 18 percent

of their previous year’s earned income, up to a maximum amount of $18,000 in 2006 Individuals may contribute to an RRSP until they reach age 69 After that, individuals have to convert their RRSP to Registered Retirement Income Fund (RRIF) The funds can be used to purchase an annuity or be withdrawn in a lump sum Withdrawals from

RRSP funds are taxed The objective of RRSP is to encourage individual savings for retirement (Human Resources Development Canada, 2001)

The IRAs are accounts which allow qualifying individuals to save and invest for their retirement in the United States Generally, the IRAs include Roth and traditional IRA The eligibility requirements for the two types of IRAs are different with individuals’ ages, type of income and amount of adjusted gross income (AGI), participation in an employer-sponsored plans, rate of return on investment, personal/family long term plans etc The contributions to a traditional IRA are tax free before withdrawal, but contributions to a Roth IRA are not tax deductible The contribution limits for an IRA were $3,000 per year per person from 2002 to 2004 and with an additional $500 for individuals who are 50 years and older Between 2005 and 2007, the contribution limits are $4,000 and with an additional $1,000 for individual aged 50 and older The contributions can be invested in stocks, bonds, certificates of deposit, or mutual funds Therefore, benefits can be varied by individuals with different personal experiences, goals and risk tolerance (Bard, 2007)

In addition, individual savings can be held in many different ways For example, individuals can deposit their savings in a bank, or invest them in financial markets In primitive economies, most investments are of real variety, such as buying a house or purchasing a land In today’s modern world, investments can be made in purchasing financial instruments, such as treasury bills, long-term bonds, common shares etc (Sharpe 1997, pp.1-8) But the performance of these investments can be affected by a

range of factors In addition, the annuity products provided in the insurance markets protect individuals from outliving their savings

However, even with the existence of government incentives and perfect financial markets, individuals may be too “myopic” to make adequate reserves when they are young and healthy For example, it is fairly difficult for an individual who are 20 or 30 years old to anticipate their needs when they approach 80 Therefore, in the long run, they may suffer from insufficient resources for their retirement years

| Moreover, individuals may suffer from “moral hazard” problems They would consume to the point that no savings are available when they are young and expect the society would take care of them when they are older (Schwarz, 2006) Because of these, the involvements of other pension systems become necessary to protect individuals from finding themselves in poverty and help them achieve consumption smoothing when they are in retirement Other pension systems include employer-sponsored pension systems and public pension systems

3.4 Employer-sponsored Pension Systems

An employer-sponsored pension system is established by employers and considered

as a responsibility of both employers and employees In some countries, employer- sponsored pension systems are established on an industry-wide basis, such as France and Italy (Davis, 1993) In some countries such as Canada and the United States, they are built up with active government involvement in regulations and supervision of

investment policies (Mackenzie, Gerson and Cuevas, 1997) In some countries such as Demark and Sweden, they have largely defined contribution plans (OECD, 2005) Moreover, the coverage of the pension systems differs across countries For example, 40 percent of the Canadian workers are covered by the current employer-sponsored pension system (Statistics Canada, 2006) In the United States, the coverage is about 56%, and in Denmark, the coverage is almost universal (OECD, 2005)

- Within a country, employer-sponsored pension plans vary across different sectors, types of workers, and occupations For example, pension benefits paid to workers in the public sectors are more generous than those in the private sectors (Poterba et al 2006) Workers who have higher education levels are more likely to have pension plans than those who have lower education levels (Bodie, Marcus and Merton, 1985) Union workers are more likely to have pension plans than nonunion workers (Bloom and Freeman, 1992)

Generally, there are two types of employer-sponsored pension plans: defined benefit (DB) plans and defined contribution (DC) plans

-_ 3.4.1 Defined Benefit (DB) Plans

DB plans specify to receive contributions from both employers and employees and to pay the annual flow of pension benefits according to the employee’s years of service and earings The DB plans benefits can be expressed as:

Pz = ONX (3.10)

where P, is the annual pension benefits, @ is a percent figure, N is years of services and

X is an average salary, which can be defined as the average salary earned over any period, or most typically over the last five to ten years of employment (Ashenfelter and Layard, 1986, p 331)

The major advantage of DB plans is that the benefits are defined based on the employee’s average wage and years of services Workers under DB plans tend to get a stable replacement rate of their final incomes, where a replacement rate is the proportion

of a worker’s average wage that a pension plan replaces after retirement (Bloom et al 2002) Usually, pension funds under DB plans are invested long-term in the capital markets, and employers would manage the funds and keep them in an actuarial balance (Davis, 1993) Therefore, the employers have the full responsibility if the pension fund investment goes deficits

3.4.2 Defined Contribution (DC) Plans

In DC plans, the employee and employer make regular contributions into the employee’s retirement account The contributions are typically invested in financial assets selected among different financial instruments, such as stocks and bonds (Williamson and Williams, 2005) After the employee retires, he can then receive his total assets plus the investment return in his retirement account in the form of a lump sum, or more often, of an annuity (Ashenfelter and Layard, 1986) Therefore, the benefits

under DC plans depend on the employee’s contributions and the return on the financial assets In DC plans, no specific benefits are promised In contrast to DB plans, employees will bear the investment risks in DC plans

The advantages of DC plans to employees are: (1) DC plans offer sufficient flexibility for the employee to select financial assets based on his own preferences, for example, the employee could invest his funds in some inflation-hedged portfolios to avoid inflation uncertainty, and (2) the employee has a direct control over the financial assets in his retirement accounts at any point in his working career (Bodie, Marcus and Merton, 1985) Therefore, DC plans are more self-managed

3.4.3 Which to Choose: DB or DC Plans?

DB plans once dominated the employer-sponsored pension systems In last two decades, there has been a shift from DB plans to DC plans (Poterba et al 2006) The reasons for this shift can be explained from both employers and employees’ perspectives: (1) For employers, they tend to bear fewer administrative costs and less investment risks

in DC plans, since they do not need to meet the actuarial funding obligations which were required of DB plans, (2) For employees, DC plans are more flexible DC plans entitle employees with more responsibility in managing their pension funds Employees can choose different financial assets based on their own preferences (Kruse, 1995) (3) DC plans may be more favorable in term of portability than that of DB plans Under DB plans, employees may forfeit future indexation of the benefits already accrued, while

under DC plans the benefits are fully funded and the job turnover makes no difference to the investment in DC plans (Bodie et al 1985) -

However, the shift does not necessarily mean that DC plans are more likely to improve employees’ welfare Poterba et al (2006) compare the average value of retirement wealth among individuals holding DB and DC plans They find that the individuals in DC plans who make various equity investments will usually achieve higher benefits than in public sector DB plans However, risk adverse individuals tend to attain higher levels of the expected utility in DB plans than in DC plans

Because of the above differences, employers in different sectors have different preferences for employer-sponsored pension plans, DB or DC plans DB plans are more | sensitive to a worker’s employment history, such as years of service, wages and job turnover, while DC plans are more sensitive to the investment risks in financial markets

3.5 Public Pension Systems

Individual savings and employer-sponsored pension systems are also called private pension systems, which differ from the public pension system The main objective of these private pension systems is more focus on consumption smoothing However, a public pension system is typically mandatory, aiming not only at consumption smoothing " but also poverty reduction Therefore, the public pension system usually has two basic categories; the contributory pension system and the noncontributory pension system

Different countries vary their focuses on these two objectives Some countries such

as Australia, Canada and the United States, place emphasis on poverty reduction more than consumption smoothing It is estimated that in the United States, high-income individuals contribute 40% of their wages but only receive as little as 20% of their contributions, while low-income individuals can receive 100% of their previous contributions, However, some other countries such as Sweden and Austria focus more on consumption smoothing (Schwarz, 2006)

3.5.1 Contributory Pension Systems

In today’s society, contributory pension systems normally include pay-as-you-go (PAYGO) system, fully funded system and notional defined contribution (NDC) systems

3.5.1.1 The Pay-As-You-Go (PAYGO) System

The PAYGO pension system, also called pay-as-you-go defined benefit (PAYGO DB) system, was first established in Germany in 1889 It is funded through payroll tax on the current workers and their employers It collects the contributions from the working population to cover the administrative costs and the benefits that are paid out to the retiree population in that year The contributions are based on workers’ current earnings, and the benefits will be calculated based on their contributions in their working years However, their final pension payments are actually disproportional to their contributions That is, there is a redistributive mechanism in the PAYGO through which the contributions of the higher-income workers are redistributed to the lower-income workers