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					     Rethinking Pension Reform:
     Late Prof. Franco Modigliani
                   &
           Arun Muralidhar

www.mcubeit.com        Dr. Arun Muralidhar
Franco Tribute




                         New Yorker, June 1999

                 The New Yorker
Agenda
   U.S. Social Security and current problems

   Case for funding (and investing in equities)

   Privatization - European & South American experience

   A swap ensures DB and no manipulation of assets

   The impact of these proposals on market efficiency

   The impact of reform on the budget and the asset
    management industry
                                                         3
The Pension Fund Balance Sheet
                Funded ratio = assets/liabilities

           Current
           Assets



            Future
         Contributions      =              PENSION
                                           BENEFITS



           Future
           Returns



     Can be funded completely, partially or PAYGO
                                                      4
Background on U.S. Social Security
    Pay 12.4% of salary as contribution (w. caps at $87,900)

    Contributions split equally between employer and employee

    Average benefit = 50% of average of 35 best years of salary

    Defined benefit, but redistribution (top earnings bracket may
     get only 35%; lowest can get 70%)

    “Pay-As-You-Go”: Some funding thanks to Alan Greenspan

    For many, SS accounts for 90% of retirement income!!

    Inflation adjusted pensions

                                                                     5
Background on U.S. Social Security
    Receipts = $630 bn; Payments = $480 bn

    Trust Fund = $1.5 trillion

    47 mn people receive benefits; 154 mn people covered

    Trust Fund projected to grow to $4 trillion by 2013

    Current surpluses are invested in “government debt” – earned
     6% in 2003

    Problems not immediate – can go on for 40 years



                                                                    6
PAYGO Formula

       Taxable Wages* SS tax = Pension Benefits


   Taxable Wages depends on Rate of Growth of Real
    Income (Labor Force + Productivity Growth)
   Increasing longevity increases pension benefits
   Often, no incentive to control pension promise
   Ratio of contributing worker to pensioner dropped
    from 9 to 2-3
   A “Ponzi” Scheme and the Bjorn Borg solution……..    7
Need for Reform – Social Security Crisis
   Pay-as-you-go (PAYGO) systems face a crisis
   Caused by low population and productivity growth
   Contributions will need to rise dramatically or
    benefits will need to be cut to be sustainable
   Often, there is a poor link between contributions and
    benefits; benefits are often too generous
   Many countries do not have budget cushions to bail
    out these systems – Maastricht Criteria!!
   Two different issues: (1) Best System; (2) Transition
                                                            8
Need for Reform - The U.S. Case
                                                                                                     Contribution rates without reform




                                     25.00%
 Percentage of total wages payable




                                     20.00%



                                                                    Effective Cost Ratio
                                     15.00%                                                                                     Contributions without Reform


                                     12.4%
                                                                              Current contribution
                                     10.00%
                                                                                                                                                 Current contributions




                                     5.00%




                                     0.00%
                                              2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074
                                                                                                               Year




Problems are much worse in Europe, Emerging Mkts!!
Latin America and Europe

   In many European cases, current contributions are as
    high as 30% of salaries – projected to rise further!!
   Benefits very generous – often 100% of final salary
   Pension cost can be as high as 6-10% of GDP
   Rates of return in the 1980s of governmental systems
    often very negative (-37% p.a. in Peru)
   Projected rate of growth of labor force +
    productivity < rate of return on assets

                                                            10
PAYGO versus Funding
   Long term, Funding = lower contributions (r >
    population growth + productivity growth)
   Volatility of contribution under PAYGO is very high
   No savings – contributions finance dissaving of the
    elderly
   Cannot just transition immediately, as Funding
    dominates because funds were set aside
   Funded systems can impact capital markets
   Funding implies some investment in equities
                                                          11
When Funding Dominates….
                         Cost and Contribution Rates for Alternative Systems and Selected Scenarios
                         Assumptions: Working Life = 40 Years; Average Salary = 50% Replacement


                        Cost Ratio = Pay-as-you-go Scheme Contribution Rates for Different Scenarios
                              Retired Life - 16 Years                 Retired Life - 18 Years

                              Real Productivity Growth                Real Productivity Growth
                            0%     1.00%      1.40%    2.00%        0%     1.00%      1.40%    2.00%
  Population Growth
       0%               20.00%    15.40%    13.40%    11.90%    22.50%     17.20%    N/A        N/A
       1%               15.05%    11.70%    10.40%     9.00%    16.77%     N/A       N/A        N/A
       2%               11.24%     8.80%     7.00%    N/A       12.41%     N/A       N/A        N/A


                                          Table 3.1B
                           Cost Ratio = Funded Scheme Contribution Rates for Different Scenarios
                              Retired Life - 16 Years                Retired Life - 18 Years

                                              Real Productivity Growth
                            0%     1.00%     1.40%        2%        0%      1.00%     1.40%           2%
   Return on Assets
        0%              20.00%    20.11%    20.15%    20.23%    22.50%     22.62%    22.67%    22.75%
        1%              15.05%    15.33%    15.45%    15.63%    16.77%     17.08%    17.21%    17.41%
        2%              11.24%    11.60%    11.75%    11.97%    12.41%     12.81%    12.97%    13.22%
        3%               8.33%     8.70%     8.86%     9.10%     9.12%      9.53%     9.70%     9.96%
        4%               6.13%     6.48%     6.63%     6.86%     6.66%      7.04%     7.21%     7.46%
        5%               4.49%     4.80%     4.93%     5.14%     4.84%      5.17%     5.32%     5.54%
        6%               3.26%     3.53%     3.64%     3.82%     3.50%      3.78%     3.90%     4.09%

  Approx. replacement     50%        41%       38%       34%       50%       41%        38%        34%
  on final salary




                                                                                                           12
The Golden SS Funding Rule
                    c* + (r-)At-1*= p*
    c* is the contribution rate, r is the nominal return on
    investments,  is the growth of income = population
    growth + productivity growth (r- is the net return
    defined as the gross rate of return from investments
    and reduced by adjustments for productivity growth
    and population growth)
    A* is the steady state asset ratio to wages, and p* is
    pension cost relative to the wage bill or cost ratio.

                                                               13
DB versus DC – can look similar
   DB: Inter and intragenerational risk sharing
   DB: sponsor bears the risk; pooling lowers cost
   DC: Offers choice to individuals who bear the risk
   DC: Allows for bequeathing assets

                   KEY EQUATION
 Contributions, compounded at the expected return on
  assets (with or without volatility) = Expected final
wealth at retirement = Expected present value of desired
            annuity as of the retirement date
                                                           14
The 3-Pillar Approach (World Bank)

   Pillar 1: PAYGO; DB; Government; Mandatory
   Pillar 2: Funded; DC; Private; Mandatory
   Pillar 3: Funded; DC; Private; Voluntary




 Because Pillar 1 was struggling – changed all aspects.
   Bush Administration favors creation of Pillar 2.
         Privatization only privatizes risk!!
                                                          15
Problems with Privatization Model
     The key problem is only a financing problem
     Was meant to keep government away from funds
     Individuals are gambling with retirement funds
     Private accounts = high fees = lower pensions
     Can lead to unpredictable pensions
     Value of choice overrated – e.g., Sweden, Australia
     U.S.: Shift 2% of contributions from SS – how??
    Governments and individuals will pay a lot to ensure
              that elderly do not retire poor
                                                            16
Problems with Privatization Model
                           Contributions
                       Gross                   Net                  Fees              "Seepage"
                   (% of wages)          (% of wages)         (% of wages)        =Fees/Gross
 Argentina             7.5%                  5.0%                      2.5%          33.3%
 Chile                10.0%                  7.7%                      2.3%          23.0%
 Columbia             10.0%                  8.4%                      1.6%          16.0%
 Mexico               11.5%                  8.8%                      2.8%          23.9%
 Peru                  8.0%                  6.7%                      1.3%          16.3%
 Uruguay               7.5%                  5.5%                      2.1%          27.3%


                       Gross           Gross            Gross            Gross           Loss on
                    Replacement     Replacement      Replacement      Replacement      Replacement
                    Final Salary   Average Salary    Final Salary    Average Salary    Final Salary
                         (1)             (2)              (3)              (4)          (5) = (1)-(3)
       Argentina       70.0%           222%            47.00%            148%               23%
       Chile           93.0%           296%            72.00%            228%               21%
       Columbia        93.0%           296%            79.00%            249%               14%
       Mexico         112.0%           356%            86.00%            274%               26%
       Peru            75.0%           238%            63.00%            199%               12%
       Uruguay         70.0%           222%            51.00%            162%               19%


              Fees take a huge chunk out of pensions
                                                                                                        17
Will Chile Get Pickled? Hidden Debt
    Table 4.8: Results with 40 different participants in the plan

    INVESTMENT POLICY:      EXPECTED RETURN      6.5 PERCENT,   VOLATILITY     5.2 PERCENT

                  Probability That     Expected Amount by       Downside Risk          Expected
                  Participant Will     Which the Participant    When the Participant   Debt of the
                  Not Meet Their       is Below Her Target      is Below Her Target    Plan
                  Target Wealth        Wealth                   Wealth



    DC            53.6 percent        36,562                    8.8 percent            6,236,624

    CFDB          53.3 percent        23,590                    5.7 percent            4,670,100

    Welfare gains of CFDB (i.e., the difference between DC & CFDB)

    Absolute      0.3 percent         12,972                    3.1 percent            1,566,525

    Relative      0.6 percent         55.0 percent              54.4 percent           33.5 percent




Mandatory participation = DB will lead to lowest debt
                                                                                                      18
Problems with Transitions

   Need to get the funded system going with money
   Debt financed transitions risky – a big leverage play
   Surplus financed transitions are best
   Problem: President Bush blew the surplus
   Tax rebates will come to roost in higher
    contributions or consumption taxes
   Intergenerational issues are key – who pays?

    Transition does not require “double contributions”
                                                            19
Transition to Partial or Fully Funded?

   Full funding implies the Golden SS rules applies
   To get to full funding, transition cost is very high
   Asset-wage ratio = 3.5X (or 2.3X national income)
   Partial funding requires smaller cost
   In the US case, assumed 1.1% extra contributions;
    asset-wage ratio = 1.6X (or 1.1X national income)
   Full funding would crowd out private investors
   Some argue that a 1.9% increase could keep PAYGO
                                                           20
Even Australia/Sweden will Struggle

   Australia: Mandatory participation (driven by Labor)
   Some company DB schemes, but largely DC
   Pooled people into industry schemes – lower cost
   Problems: Too many small schemes – cost is high
   Not sophisticated: consultants used = additional fees
   Potential conflicts – trustees can represent AM firms
   Where choice offered – not used!!
   Estimated reduction in pensions 10-15% (Bateman)
                                                            21
Our Solution – Only Two Pillars

    Pillar 1: Funded (Partially or Fully); DB; Public
     Governance/Private Management; Mandatory
    Pillar 2: Funded; DC; Private; Voluntary (Pillar 3)


        DB = Guaranteed Return on Contributions
            Assets Pooled to Minimize Costs
    Swap between Treasury and SS to Guarantee Return
       Blue Ribbon Board like Canada and Ireland
     Variable Contribution to Minimize Risk to Govt.
                                                           22
How Does the Swap Work?
   SSA pays Treasury return on invested portfolio;
    Treasury pays SSA guaranteed real rate + inflation
   Long term swap rate = 5% real
   Invested in mkt cap weighted index (stocks + bonds)
   Prevents manipulation of funds = shows up in the
    budget as payment in the swap
   SS is always whole; smoothes returns over decades
   Government (best risk taker) bears risk
   Create a sinking fund; allow variable contributions
                                                          23
Why Our Solution Is Better?
   Contributions are Lower and More Predictable
   Benefits are Protected (and Minimizes Cost to
    Governments and Participants)
   Lower Asset Management Costs
   Better For Unsophisticated Participants
   Access to DB and DC Leads to Optimal Choice
   Choice is not really exercised: Australia, Sweden
   Transition cost borne equally by all generations
                                                        24
Explaining the Transition – Zero Growth
                                                                                                       Zero Grow th Scenario:
                                                                                                     Transition from PAYG to Funding
                                                                                                             (% Taxable Payroll)


 30.00%



 27.34%



 25.00%
                  Transition Cost
                                                                                                                    Pensions (CR)

 22.5%


                                                                                                                                                 NF Pensions
 20.00%


                                                    Required Contribution (ex Transition
                                                    Cost)

                                                                                                                                                                                            Interest on TF
 15.00%




 10.00%




                                                                                                                                         NF Contributions

  5.00%
 4.84%




  0.00%
          2000   2002   2004   2006   2008   2010   2012   2014   2016   2018   2020   2022   2024    2026   2028   2030   2032   2034    2036    2038   2040   2042   2044   2046   2048   2050   2052   2054   2056   2058   2060
Transition to New System - The U.S. Case
                                                                                                  Comparison of Contribution Rates
                                                                                     under Different Reform Scenarios - Smoothing Contributions


                                    20.00%


                                                            Effective Cost Ratio


                                                                                                                                                            M Contributions

                                     14.4%
                                    15.00%
Percentage of total wages payable




                                                                                                                        Household Contributions with Proposed Plan
                                    13.5%
                                    12.4%

                                                                                   Current contribution


                                    10.00%




                                                                                                                           Interest from Trust Fund
                                    5.00%




                                                                                                      Transition Cost


                                    0.00%
                                             2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074
                                                                                                                    Year
Investment Issues
   Should portfolio be U.S. only or global?
    Initially U.S., but ideally global return on capital
   Should assets be managed passively or actively?
    Initially passive, but ETFs can allow active
   Role of alternative assets?
    Canada has already invested in alternatives
   Internal or external? No strong bias
   Too much passive – implications for voting &
    valuation                                               27
The Appropriate Rate of Return…..
   Average return on equity has been remarkably
    stable - around 7% (Siegel 1994 and 1999).
   The return on equity corresponds to profit; profit is
    not a satisfactory measure of the return on capital
    when the firm is financed partly by debt
   Investing in an indexed portfolio of an share of the
    market portfolio of stock and bonds (70:30).
   Estimate of the real interest rate =3%
   Equals an estimate of return on capital of 6% --
    (Bosworth (1996) arrives at an estimate of 6.2%)    28
The Appropriate Rate of Return….
 Must look at pre-tax value as that is relevant to Treasury
 6% return on total corporate capital after corporate tax.
 Corporate income tax = 30% on the levered profit, plus a 30%
  debt at a real interest around 3.3%, results in an estimated
  8% of the pre-tax return on total capital,
 1% for interest, 7% for equity before tax, of which 2% is
  attributable to the tax
 This estimate of a pre-tax return on the unlevered market
  portfolio is close to a well-known estimate of Poterba (1998)
 Gives the Treasury a premium of 3% for bearing risk

                                                                  29
How To Achieve Retirement Objectives –
The Two Pension Fund Theorem
        Replacement
        Rates (%)
  100



   80
                                     Market
                                     Portfolio-M
                                                               Markowitz Efficient
   60                                                          Frontier
                           B
              A


   40
        Guaranteed
        Replacement Rate


   20

                                                                                     Probability of not
                                                                                     achieiving a
    0                                                                                replacement rate



                           A’s Investments :70
                                      %          DB, 30% Market Portfolio

                           B’s Investments: 50% DB, 50% Market Portfolio
Pillar “3” is No Breeze
   Average sophistication is low
   Poor advice on asset allocation (strategic & tactical)
   Too much focus on manager selection
   Rating schemes are poor – Morningstar, IR tells you
    little about risk-adjusted performance, skill etc.
 Measures that do (M2, M3, SHARAD, Q-sum)
    beyond reach of most individuals
 Fees can be mitigated through ETFs etc.

                                                             31
Conclusions
 Do not fix what is not broken (DB)

 Do not transfer risk and choice to those least
  capable of bearing or using it

 Invest in the market with guarantee structure

 A combination of DB and DC are critical

 Variable contributions to manage risks

    Longer the delay to reform, the higher the cost
                                                      32
Appendix
Arun Muralidhar - Bio
   Chairman of Mcube Investment Technologies, LLC and
    Managing Director at FX Concepts, Inc.

   Author of “Innovations in Pension Fund Management”

   Head of Investment Research and Member of Investment
    Management Committee, World Bank Investment Department,
    1995-1999

   Derivatives and Liability Management, World Bank Funding
    Department, 1992-1995

   Managing Director and Head of Currency Research, JPMIM,
    1999-2001

   BA, Wabash College (1988); PhD, MIT Sloan (1992)
                                                               34

				
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