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The public pension system is under stress, thanks to global ageing

LiveMint logoLiveMint 26-02-2017 Lisa Pallavi Barbora

Rene Schaaf, senior vice president and chief operating officer, Principal International, Inc., is responsible for global business development, strategy and operations of the company in Latin America and Asia. She met Mint during a recent visit to India and discussed global trends in the pension industry. She also elaborated how India is in a unique position when it comes to the retirement market, thanks to the relatively younger population. Schaaf stresses the importance of defined contribution plans for sustainable evolution of the pension industry. Edited excerpts:

Many countries have adopted the defined benefit format for pension contributions; however, this hasn’t worked well for government finances. How do you see the situation progressing?

When we think about pension systems, there are two critical elements. First, what is the replacement rate it provides in terms of adequacy of income? And, how sustainable is the whole system? What’s happening, not just in developed markets but globally—with any pay-as-you-go government-sponsored pension plan—is that as populations age, the ratio of people who are retired to those who are working continues to increase. This puts stress on the system, to be able to sustain it financially. Governments are realizing they have to do one of two things to sustain this: they can either increase taxes or decrease benefits or do both. For example, in the US, our public pay-as-you-go (Social Security) system reserve is inadequate for future liabilities. In order to deal with that we have already seen a reduction in future benefits and the way that’s happened is by increasing the retirement age. This is happening both in developed and emerging markets. The public pension system is under stress because of financial sustainability issues, thanks to global ageing.

The situation in India seems slightly different—it has a growing young population and there isn’t any government-sponsored pension for all. There is a voluntary scheme for the organized sector and now a small pension scheme for the poor in the unorganized segment. What else could we put in place?

India is unique. You have a very young population, with 45% under the age of 16 years. Your dependency ratio—which compares those in working age to those who are not—is around 10%. What I can tell you from working with emerging markets throughout the world is that even though India is young and your economy is growing rapidly, it will be well served to consider that if you are going to move towards some sort of a mandatory public pension system, to make it a fully funded personal account system. This is sustainable in the long term. Eventually, it may be years down the line, but it simply reduces the burden on the government to fund that through taxes.

The other unique thing about India is the big informal workforce, which makes it difficult to put in a pay-as-you-go or even a mandatory work-based system.

For India as well as for many markets, trying to determine ways to encourage a voluntary pension systems is important. It needs to be a combination.

What would it require for a system to be completely based on a funded personal account?

Fully funded personal account systems can still accept contributions from the employer as well as take deductions from the employees’ pay cheques. There are various examples where it is a mix of both—like in Mexico and Hong Kong—but in Chile it is 100% funded from the employees. So, it could be either way. What makes a fully funded personal account system different is that the employee can see what is in the account, the investment and the return. Ultimately, that money belongs to you and it helps to see how its growing. Unless the government nationalizes that plan, you have a greater assurance of how much will be there at retirement. The source of the funding is flexible. Its uniqueness lies in the fact that it is identifiable to a person.

Globally, is there a lot of choice for products and providers or do people settle for what the employer recommends?

For voluntary pension plans, we see a lot of variety. If you look at markets like the US, the UK, Australia and parts of Scandinavia, the voluntary market is characterized by employer-sponsored plans or occupational voluntary plans. Usually, there is some contribution by the employer, and they are almost always payroll deductions. Within that, the employer will often choose the universe available to the employee and further choice can be made by the employee.

What’s become more popular is the target-date or the target-risk fund. These are types of asset allocation funds that take away the responsibility of allocating to asset classes from the individual investor—most people have no idea about this. It depends on the country and how the particular market will work. The employer will choose the kinds of investments and the employee can choose the specific investment.

But what’s being noticed, for example in the US, is that people are not very good at making their own asset allocation; instead the default investment option is some sort of a solution.

The reason that employer plans are popular and effective is because they are really good at reaching the middle-class saver. When an employer sponsors it, it helps with education and makes it very easy to save and most countries offer some financial incentive to put money into the defined contribution plans.

Traditionally, in India one’s retirement wealth comprises of physical assets like property and gold. The situation is now changing and people are starting to consider financial investments for retirement. How does one make this shift more widespread?

It has to be a combination of financial education and literacy, as well as the right kind of incentives for people to save for retirement. The issue that perhaps gets faced with physical assets is that you forgo some of the advantages of compounding, some of the advantages of equity markets and liquidity. If you look at mutual funds, for example, which I think are a popular product to save for retirement, they offer all those benefits. That’s not to say that there is no space for buying your own home. People need to understand the benefits of having a diversified asset portfolio in the long term. Education and financial literacy has to be one part of it.

In order to really promote investing and to incentivize people to save for the future, most countries have opted for some sort of tax-preferred vehicle. Some countries have actually gone for a government match or a government contribution, especially for lower income. Anything that the government can do to encourage people to save and invest in the long term, that is what we see as being the best practice for countries.

Annuity as a retirement solution hasn’t picked up well. What trends are prevalent globally for this segment?

Globally, the low interest rate environment makes annuities expensive and a tough business. They play an important role in retirement because of the guaranteed income but they also have some concrete disadvantages. If you die early, your family may not get the money back. There is an important place for annuities.

Taking what you have as a retirement nest egg and turning it into an income stream is important, be it through an annuity or through programmed withdrawals using mutual funds where you can determine how much you need to withdraw and you invest in more income-oriented schemes. Also, rising longevity makes annuities more expensive.

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