Retiring around the world
There is much to be learnt from studying global best practice as the UK follows the rest of the world towards a defined contribution pensions system
Defined contribution pensions appear to be the future. As states seek to reduce their pension liabilities in the face of demographic pressures and employers retreat from balance sheet risk, a world where individuals bear the risks of investment looms large. In a new edited collection the two of us asked leading scholars from around the world to offer a window into the experience of different pension systems which have transitioned from defined benefit (DB) to defined contribution (DC), or are set to do so (Ireland). Three tests were set: how far each DC system offers adequate incomes in retirement; how inclusive the system is (i.e. does it encompass the self-employed, unemployed, carers) and how much it costs the taxpayer and/or employers. What did we find? Here are five quick takeaways.
First, all systems combine to some degree state, employer and private pension savings – the three pillars that the World Bank famously described as the foundation of a decent pension system. But the strength of the pillars varies by country. Chile’s defined contribution system involves no employer contribution; a major weakness. Hong Kong has no state pension pillar as such, although there is a means-tested supplement available to the elderly. At the other end of the spectrum, the high-quality Danish and New Zealand systems are built on a generous, universal state pension. For example a couple in New Zealand receive a state pension of 2/3 average earnings. The US’s social security in old age is relatively generous too (compared at least to the UK). The Singapore system is perhaps the exception to the three-pillar rule. A mandatory provident fund managed efficiently by the state dominates the landscape.
Following on from this, the next point to note is that differences in system design reflect the way in which a nation’s politics, economics and culture shape pensions provision. This matters for policymakers. The shift towards defined contribution is a global trend but the best parts of one system cannot simply be replicated by another. Pension systems have their own ecology. Each is more than the sum of its parts.
Denmark’s political economy, defined by high levels of social cohesion, trust and income tax, provides fertile ground for a successful pension system built on high contribution rates, a large role for government provision, and a long-term perspective (see, for example, the recent decision to raise state pension age steeply over the long term), agreed between the representatives of workers, employers and the state. In New Zealand, the political economy is more Anglo-Saxon in style, featuring lower taxes and less government, but its society is characterised by similarly high levels of national cohesion. It is possible that smaller countries are more easily able to build up trust between and among citizens and that this is reflected in healthy pension institutions. On the other hand, under examination, the country overall has weaker pensions provision.
Inclusion is an issue in the defined contribution pillars of Mexico, Chile and the US. This matters even more than it might otherwise because their state pension entitlements are less generous. In Latin America the large informal economy is a huge challenge to defined contribution coverage. In the US, and other developed economies, the growth of self-employment makes comprehensive coverage more difficult. However, in the US the biggest barrier to coverage by far is the unwillingness of employers to offer pensions in the voluntary second pillar. For the tens of millions of Americans who work in SMEs, a pension plan is a rarity.
Finally, on the investment side, the challenge for second pillar pension funds is also about scaling up. Pensions is not a cottage industry. Scale makes the accruing of necessary expertise easier. In private (i.e. unlisted) markets, which are currently receiving a giant wave of pension fund money, this is particularly notable. Harnessing the illiquidity premium is increasingly an objective of pension schemes, but private markets are complex and increasingly costly to access and understand. Funds large enough and expert enough to invest directly, co-invest with their peers, and ensure their external mandates are appropriately priced with scale discounts, can expect better returns over the long term. As the price of unlisted investments is bid-up this matters all the more. In the UK, DC funds simply aren’t in the private markets space. They need to get there fast.