Pensions market: the evolving scenario

Dramatic changes in the demographic profile have forced countries to undertake pension reforms as it has been found that state funded pension and health care have become too expensive, says Abhijit Roy

"My only fear is that I may live too long. This would be a subject of read to me.''

- Thomas Jefferson, 1801

AFTER THE opening up of the insurance market in India, the Government appears keen to open up the pensions market to new players. The life insurance business, the asset management business and the pensions business are closely related to each other. While life insurance business deals with the fear of "dying too soon", the pensions business deals with the fear of `living too long'. The asset management business deals with management of the funds accumulated in an efficient manner, so that the life insurance policyholder and the pensioner get a decent return on the funds invested. It is thus logical that the Insurance Regulatory and Development Authority (IRDA) has been asked by the Government to submit recommendations relating to the pensions market.

As in many other countries, Indians also face the prospect of increased longevity. Even though this is a happy scenario, it is not unadulterated joy. Living longer after retirement means that provisions have to be made for higher expenses for a longer time including proper health care. For example, in India, it is estimated that life expectation at birth has risen from 45.6 years in 1971 to more than 62 years now. In fact, the life expectation of the average pensioner is substantially more than this figure and increasing quite rapidly. The number of pensioners is also rising rapidly. The number of people above 60 years in 2001 is estimated at 71 million, forming about 7 per cent of the total population. By 2016, this number is expected to rise to 113 million, forming nearly 9 per cent of the population.

World Bank suggested structure

Dramatic changes in the demographic profile have forced countries to undertake pension reforms as it has been found that state funded pension and health care have become too expensive. In fact a number of developed countries are rapidly running out of funds for old age pensions. In order to arrive at some kind of solution to this serious problem, the World Bank suggested the following structure that breaks up the possible pension provisions into three pillars:

The first pillar consists of publicly funded schemes providing modest benefits or social security schemes;

The second pillar consists of occupational schemes sponsored by employers for the benefit of employees or private mandatory pension programmes;

The third pillar consists of additional voluntary contributions to meet retirement needs.

In many developed countries, social security schemes are operated by the government on a `pay as you go' basis. Even though employers and employees may have to contribute to these schemes, basically current employees are contributing to pay the pensioners. Demographic changes are introducing severe strain on the system, with the number of retired persons increasing rapidly as compared to the number of working employees. Developed countries are therefore revisiting the assumptions made in providing extensive social security benefits, and are proposing more and more private initiatives to meet the old age requirements. Briefly, this would mean that the state would provide a basic minimum amount of pension benefits, while the remaining amounts will have to be accumulated by the people themselves during their working life through occupational or personal pension plans.

Defined benefit v defined contribution schemes

It is appropriate here to clarify the two main types of occupational pension plans in existence. The first type is the Defined Benefit (DB) Scheme. Under this scheme, the employee becomes eligible for a certain level of benefit depending on his final wage or salary. Sometimes, a commuted amount in the form of lumpsum is also paid to the employee at the time of retirement. The other main type is the `Defined Contribution (DC) Scheme wherein the contributions of the employer as well as employee are accumulated over his working years. The corpus formed out of this accumulated amount is then used to buy an annuity for the pensioner. It is obvious that for the employee the DB plan is the better one, but it is expensive for the Government and the society to maintain. Given the three pillars talked about earlier, experts recommend that the first pillar of basic social security should be a DB plan, while the other two pillars should be of the DC type.

The main difference between DB and DC schemes is about who bears the investment risk in the pension plan. In a DB scheme, the investment risk is largely borne by the employer; and consequently his contribution depends on the rate of return on the pension fund. In a DC plan, the investment risk is borne by the employee. The level of eventual retirement benefit is thus dependent on the contributions paid, the investment performance of the fund and various expenses incurred.

The payment of pensions can be interpreted as transfer of assets from one generation to another. DC schemes can be interpreted to mean that the bulk of the savings has to be done by the pensioners themselves, hence the transfer from the young to the old is minimal. Sociologists will have a field day in explaining the pros and cons of such intergenerational transfers, but the fact is that active workers beyond a certain point will find working for others and not for themselves burdensome. Factors affecting there is longevity are also changing; on one side there is the HIV/AIDS syndrome, on the other is the genome project that is expected to increase longevity substantially in the coming decades.

The Indian Government is facing serious budgetary constraints due to its obligation to pay the DB type of pensions to its employees. State governments and some public sector organisations are also in the same boat. The Government has announced that employees recruited after October 1 this year will not be eligible for the old type of pension and will have to move over to a new DC type of scheme. The good news for India is that as the overall pension coverage in India is low, it can still get out of the trap of high liability towards pensions. A number of West European countries like Italy, France, Spain and Germany as well as countries like China and Japan have `Pay-as-you-go' DB type of pension plan for a large percentage of the population. On the other hand countries such as Australia, Chile and Malaysia have moved over to a fully funded DC type of pension plan. Further, increased mobility of the workforce is also encouraging DC plans; many workers like `portable' schemes, they carry their accrued retirement benefits as they hop from job to job.

Regulatory issues

The regulatory framework has to keep in mind the concerns relating to various aspects of the two types of schemes, especially security of accrued benefits and formulating an appropriate investment policy. In the case of DB schemes, security of accrued benefits would imply that the scheme's assets are maintained separately from that of the employer and also that the employer is held responsible for the adequacy of benefits that the employee is eligible for. Actuaries play an important role in advising the regulator and the beneficiaries regarding the adequacy of the provisions; otherwise the employer has an obligation to pay the difference. In the case of DC schemes, the investment risks are borne by the employees, which implies that the retirement income of the employee is at risk.

During the accumulation phase or during the time pension contributions are made, a number of agencies may be involved: the employer may administer the fund, or outside agencies such as mutual funds, banks or life insurance companies may administer the fund. However, at the time of buying the annuity on retirement of the worker, a life company becomes involved. This is because the annuity payable to the pensioner is a level amount and this entails a guarantee in the form of `mortality risk' and `investment risk'. With rising longevity and often falling interest rates, insurance companies sometimes find themselves in a bind.

An important point to remember about the pensions market is that because of their long term nature, the funds collected are ideal for long term investments so that there are no asset-liability mismatches. Such long term investments are mainly in infrastructure industries and this makes such funds important for building nations. The importance of such investments in a developing country like India cannot be overemphasised. Pension funds such as insurance funds also play an important role for the development of capital markets, especially the long term debt market.

(To be concluded)

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