IV Private Pension Plans and Saving
- Alfredo Cuevas, George Mackenzie, and Philip Gerson
- Published Date:
- September 1997
The design of public pension plans has the potential to affect the saving rate, as Section III has made clear. The same could be true of private pension plans, and the question arises as to whether the regulatory framework for the private pension industry can be manipulated to increase the saving rate. A related, though distinct, question is whether the private pension industry can replace public schemes without reducing saving or jeopardizing the income security of the elderly.
There may also be scope for raising voluntary (noncontractual) saving. Apart from using macro-economic policy—for example, by changing the general level of interest rates—governments can conceivably affect the rate of voluntary saving through a number of channels. These include the treatment of saving by the tax system and regulations that affect the perceived soundness of the financial system. Voluntary saving also depends on the extent to which risks to capital and income may be diversified—which in turn depends on the level of development of the financial system—and on the comparative attractiveness of contractual schemes.
There is fairly strong evidence, at least for the United States, that increases in private pension plan saving are not fully offset by declines in voluntary saving (Gale, 1995; and Appendix II). Consequently, there is some reason to believe that an expansion in the patchwork quilt of private pensions could raise the private sector saving rate.
Basic Features of Private Pension Regimes
Because of the tremendous variety in private pension regimes across countries, it is hard to characterize their commonalities and differences. However, the second tier of most countries’ pension systems (after the public plan) is the occupational, or employer, pension plan. In some countries, plans can be set up on an industrywide basis, as in France. Sometimes they are established with active government involvement—not only in regulation and prudential supervision of investment procedures and policies, but also in basic design issues, such as rates and benefits—as in Israel. The second tier can in some cases be only semiprivate, given the government’s role as a tacit guarantor of contributors’ rights. The coverage of the second tier varies a great deal as well; for example, it is broad in Canada, Switzerland, the United Kingdom, and the United States, and comparatively narrow in Germany.
Private pension plans are typically defined-benefits rather than defined-contributions plans, although the relative importance of the two types does vary across countries. Changes in the tax laws and regulatory frameworks have stimulated increases in the share of defined-contributions plans recently in both the United Kingdom and the United States. The post-retirement indexation of benefits is a rarity, although in most countries where the private regime has broad coverage, the pension takes the form of an annuity.
The legal and regulatory frameworks also vary greatly. A framework normally encompasses the areas of governance, insurance, plan design, and tax status (Box 3).
The quality of pension plan governance has important implications for participants’ confidence in their plan and thus for the plans’ attractiveness as an alternative to voluntary private saving. So too do insurance requirements, given that company pension plans have been notoriously vulnerable to the company’s fortunes. The regulations that apply to plan design, except possibly those governing funding, may not have the same impact on confidence, but can definitely affect the perceived attractiveness of employer pension plans. This is particularly true of the regulations governing vesting and portability. The extent to which private plans are vested or portable varies greatly across countries. Whereas public pension schemes are by definition portable—the plan follows the contributor from job to job, even from job to no job—private pension schemes are typically characterized by little or no portability. Vesting requirements vary substantially, being more strict in some countries than in others.28
Box 3.Legal and Regulatory Framework of Private Pension Plans
- Legal status of fund
- Qualifications of administrators
- Reporting requirements
- To regulatory authority
- To fund participants
- Actuarial valuation procedures and assumptions
- Insurance requirements
- Plan design
- Participation requirements
- Benefit structure
- Vesting requirements
- Responsibility for contributions
- Funding requirements
- Tax status
Funding requirements also vary greatly. In Japan, for example, the rules applying to the annuity plans (tax-qualified pension plans) offered by smaller firms result in less than full funding, because the employers are not required to take account of likely future wage increases in calculating their required reserve. The effective degree of funding is also influenced by the latitude permitted in the selection of actuarial assumptions. Studies of the United States have shown that the actuarial assumptions used for state and local government plans can vary with the financial condition of the employer.29 The same is likely true of private sector plans.
The tax treatment of private pension regimes is of critical importance for their design, and possibly for their relative size. It is standard practice to exempt contributions from tax, at least up to some ceiling. In this respect, contractual saving is treated more favorably than most forms of purely voluntary saving, although some countries give similarly favorable treatment to contributions made to qualifying individual retirement plans—for example, the individual retirement account (IRA) in the United States, and the registered retirement savings plan (RRSP) in Canada. Some countries also offer at least a limited tax exemption to pension income (Australia), although pensions are generally taxed. In the United States, changes in the tax treatment of defined-contributions plans offered by employers following the 1974 ERISA Act are thought to have contributed to the decline in the share of defined-benefits plans—from 87 percent of all plans in 1975 to 71 percent in 1985.
Regulation and Its Effect on Saving
Clearly, if changes in the regulatory framework are, through their impact on contractual saving, to increase total saving, the increase in saving from that source must not be entirely at the expense of voluntary saving. In a world governed by the LCH, but tempered by some degree of myopia and capital market imperfections, the most obvious way to increase contractual saving is to require higher contribution rates. However, government intervention in the private pension market would then have to go well beyond regulation as such. It would entail two significant problems.
(1) The lack of universal coverage of employer pension plans means that the take-home pay of plan participants would fall relative to that of nonparticipants, which could be perceived as inequitable. Moreover, if plan participants deemed that their real compensation had, on the whole, fallen, the attractiveness of employment at companies or in industries offering pension plans might be reduced. The perceived fall in real compensation would be more likely for contributors to plans with little vesting or portability. If employers were not required to offer pension plans to their employees to begin with, a legal requirement entailing higher contribution rates would simply discourage the plans’ creation.
(2) It is not clear how a required contribution rate would work with defined-benefits plans. Presumably, the benefit would be redefined and the replacement ratio would be increased if the required rate exceeded the contribution rate for an existing plan. However, a change in actuarial assumptions could mean that, even with more generous benefits, the contribution rate appropriate for the plan would fall below the rate required by law.
For these and other reasons, the imposition of an obligatory high contribution rate would be problematic for the private pension system. The Chilean system largely avoids these problems, because it is a defined-contributions plan that is compulsory for all but the self-employed and because portability is automatic and vesting is 100 percent.30
Compulsion not being the strategy of choice, perhaps fiscal incentives are the way to go. There is good evidence that the tax treatment of pensions and other savings vehicles does affect the allocation of saving. It is not clear, however, that it affects total saving (Bovenberg, 1989; Smith, 1990; and Feldstein, 1994). More favorable tax treatment of pension saving is thus likely to be largely—although, the evidence suggests, not fully—financed by a reduction in voluntary saving. Even if it is not, the tax incentives directly reduce public sector saving. Munnell (1992) finds that deferring tax on the accrued benefits of participants in private pension plans in the United States has probably had no impact on national saving. Some recent research on the growth of IRAs and 401(k) plans—two forms of saving favored by the U.S. tax system—has nonetheless concluded that most of it did not come at the expense of other forms of saving (Poterba, Venti, and Wise, 1993).31
Another option is measures that affect the riskiness of pension plans and the confidence their contributors have in them. Unfortunately, evidence on the links between the regulatory environment and the coverage of the private pension regime is scanty. A more fundamental point is that, even if pension plans become more attractive (less risky), it is not obvious that the total quantity of saving will grow as a result.
Measures that strengthen the regulatory environment could certainly make contractual saving more attractive relative to voluntary saving, because the effective risk-adjusted return on the former savings vehicle would be increased. However, a large number of studies of the impact of changes in the rate of return to saving on the quantity of saving in the aggregate do not find that the positive impact, if there is one, is large (Savastano, 1995). Moreover, because financial markets-do not typically offer life annuities on very favorable terms, the paradoxical effect of measures to promote pension plans could conceivably be a net reduction in private saving. When a company undertakes to provide its employees with life annuities, the amount of money employees save may fall by more than their contributions to the plan if they no longer have to worry about accumulating enough capital to shield themselves from the risk that their returns to investment may be below average and their post-working life longer than normal.32
Sound regulatory practices and prudential requirements may entail large welfare gains, promote the development of the private pension industry, and improve financial intermediation. But it is not obvious that they will contribute to an increase in the saving rate. A compulsory defined-contributions system might do so if its contribution rate is high enough, although such a system would have to be properly integrated with existing public and private schemes, which it might at least partially replace.
For example, U.S. pension legislation (the ERISA Act of 1974) provides that plan participants should in general become vested (i.e., have a right to a pension of some size) after 10 years of participation. In Switzerland, the law requires immediate vesting of employee contributions; employer contributions are partially vested after a few years, but not fully vested until 30 years of plan service. In Japan, there is no legal requirement to vest. In practice, all Japanese plans offer some type of vesting, although it can take 20–30 years to become fully vested. Early leavers are penalized quite heavily.
A Chilean-style plan need not be optional for the self-employed, although the regulatory and administrative requirements of a defined-contributions plan that is compulsory for all are much more substantial than those for one confined to wage and salary earners.
The increase in saving induced by tax incentives or reforms could have feedback effects on interest rates that could depress saving.
People who are risk averse will seek to accumulate a stock of savings whose value will exceed the expected present value of the post-retirement consumption stream they want to finance, at least when the present value is calculated at a rate of interest close to the market rate. By the same token, shortsighted people—those who, were they not members of a company pension plan, would not save enough—will have their saving rate increased. See Auer-bach and Kotlikoff (1995) for a discussion of this issue.