Colombo Telegraph

Prime Minister Questions The Viability Of Unfunded Pensions

By Hema Senanayake

Hema Senanayake

Prime Minister is of the view that unfunded-liability pensions cannot prevail. But trade unions want to keep intact the present non-contributory pension for public sector employees who would be recruited from January 2016 onwards too. This still is an unresolved budgetary proposal.

However, the government has agreed not to go ahead with that particular budgetary proposal until the proposal is renegotiated with trade unions and agreed upon. Trade unions do oppose to the contributory system. Trade union leaders vowed to launch nation-wide strike again if the government would not withdraw the proposal.

Addressing this particular issue in his special speech made to parliament on 14th December, P.M. pointed out that the present pension system is a system of unfunded-liability and the government has proposed to change it to a system of funded-liability system only for the new recruiters. If this is the theory behind this proposal then unfortunately I am not agreeable with it. Why?

Before, I explain it let us just have a look about the system available for private sector employees in order to ensure their old-age income security. The system is very peculiar. There is no pension for them. Instead they are paid back their own savings in EPF and ETF together with accrued interest when they retire. EPF and ETF are just saving programs not pension programs. Out of the money they get from EPF and ETF they can deposit up to Rs. 1.0 million in a bank and would receive 15% rate of interest per annum, whereas the market rate of interest is around mid-single digit. The difference between the market rate and the mandatory 15% interest is reimbursed to the bank by the Treasury and this too is unfunded liability on the part of the Treasury in ensuring an income for senior citizens.

Then again, the government previously told in parliament and outside the parliament that the government wanted to completely do away with the private placements in issuing government bonds, because EPF and ETF are benefitted by securing higher rate of interest when the bonds are issued through auctions. Formerly, in issuing bonds the Central Bank used public auctions and the mechanism of private placements in order to keep the rates within the macro economically desired levels and as a result low rates of interest became the new normal towards the end of 2014. Low rates of interest are good for the growth of the economy but bad for the EPF and ETF. Now, what would you do? Would you keep the rates low to promote economic growth or would you let the rates to go up to save EPF and ETF?

In view of above you may easily understand that all prevailing mechanisms to prevent the old-age income insecurity of retirees are economically wrong no matter those mechanisms are funded or unfunded.

Therefore, what the country now needs is a national pension program. It should be a program in which all employees in the private sector, self-employed sector and public sector could participate. Without a national pension program, having even a funded pension program for public sector employees is not prudent because even the funded part of the pension of public sector employees have to be paid ultimately by tax payers and when it is unfunded still pension liabilities are paid by tax payer money. So, what is the difference, if the government does not intend to reduce the present disposable income of public sector employees? Absolutely, there is no difference.

If we agree that the country needs a national pension program, the next point that trade unions must understand is that employees have to contribute to it. For a moment let us assume that trade unions prefer to have an unfunded-liability system. Then, it means that the government has to finance it. How the government gets money? It is through taxes paid by the people. The difference is that one system is funded by contributions and the other is funded by taxes. Hence, I think, trade unions will understand this point. They would agree to a contributory pension program if it is a national program.

I strongly feel that pension reform is not a bitter pill to swallow if a national pension frame work is designed properly. In this regard looking at other countries experiences might be useful. But what is more prudent is to investigate experiences of other countries under the light of economic fundamentals. I previously wrote on this subject, yet let us investigate about it briefly.

Many people believe that you can save for your retirement. But the first economic truth in regard to an efficient pension scheme is that, you can’t save for your retirement. Even some economists still believe that “the best social security is for the young to save for the future.” The notion that you can save for your retirement and by investing those savings “wisely” you can have a rich retiree life is a big illusion.

The reason is that the modern economic system does require, time to time, to deflate systemic debt through wage increase bound moderate inflation. If we did not do it proactively, the economic system would crash wiping off most of the savings in pension funds. I am going to discuss this point in a separate article. For the time being let us assume that “wage increase bound moderate inflation” is a systemic need. Therefore inflation is an unavoidable phenomenon in any economy. On the other hand the productivity of the economy will ever be increased. Therefore, there are two important parameters namely inflation and ever-increasing-productivity, which are needed to be incorporated in designing any successful pension scheme.

Further, these two parameters must automatically be adjusted in calculating present-day retiree benefits during the continuing economic evolution. These two adjustments do not happen automatically in “save-for-your-pension” programs. Therefore this type of pension schemes cannot be successful even they are funded.

Accordingly, the solution must be to have a pension program under which the above said two parameters are automatically adjusted. Therefore we need to develop a basis/principle for such a pension scheme. The best basis is that “you pay for the pension of current retirees and in turn, your pension will be paid by the future generations of the work force.” Under this principle the above said two parameters are automatically adjusted. Basically, this is the principle used in designing the United States’ social security administration system but they made an adjustment in order to incorporate better social policy too. Accordingly, those persons with lower contributions (contribution is related to earnings) would receive a relatively higher benefit than those with higher contributions. Let me quote it from the official website of U.S. Social Security Administration.

“Social insurance provides a method for addressing the problem of economic security in the context of modern industrial societies. The concept of social insurance is that individuals contribute to a central fund managed by governments, and this fund is then used to provide income to individuals when they become unable to support themselves through their own labors. Social insurance differs from private insurance in that governments employ elements of social policy beyond strict actuarial principles, with an emphasis on the social adequacy of benefits as well as concerns of strict equity for participants. Thus, in the U.S. Social Security system, for example, benefits are weighted such that those persons with lower past earnings receive a proportionately higher benefit than those with higher earnings; this is one way in which the system provides progressivity in its benefits. Such elements of social policy would generally not be permissible in private insurance plans.” (U.S. SSA website)

Why the government and trade unions cannot agree to this kind of national pension program?

However, I prefer if Prime Minister sticks to true facts. During the same special speech made by Prime Minister on 14th December, he said that unfunded pension schemes cannot prevail and bound to fail and in this regard the best example is the U.S. Social Security System. Firstly, the U.S. social security system is not an unfunded system. You may easily verify it from the above quote. It is a well-funded national program managed by the government even though there are a few minor issues arising by 2034. Mostly those issues are surfacing due to an unexpected retiree boom and due to the reduction of contributions after 2008 financial crisis for a few years. If the government erroneously thinks that the U.S. system is a failure then they might miss possibly the best pension scheme which can be justified by economic theory. You may listen to the relevant part of P.M’s speech from 10.50th minute onwards by clicking on the following video clip.

I think, we can prevent the next nation-wide strike if the government designs a proper national pension scheme based on true facts. I do not see any reason for trade unions to reject such a program. Rests of the things are just implementation details, including transition.

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