Can Guyana manage the transition to a defined contribution social security system?
Stabroek News
January 21, 2007
Contribution rates for typical Caribbean social security scheme Source: 2006 Caribbean Actuarial Association conference
Introduction
Last year this publication ran a story regarding a potential reform being considered by the National Insurance Scheme (NIS) to replace the current pay as you go system with a system whereby benefits are set with reference to the amount of contributions paid into the scheme ('NIS eyes contribution-based pensions proposal as part of reform,' Sunday Stabroek, November 5, 2006). This is a topic of great interest to me, and one that I had wanted to return to cover in more detail. My interest was sparked largely due to an incident at a pension fund management workshop in Barbados in 2005 where I gave a presentation, 'The Actuary's Perspective.'
Although the seminar was entirely aimed at private sector provision, in the panel discussion at the end a heated debate ensued on whether a defined benefit or defined contribution approach was more suitable for social security benefits. I was put on the spot at the time as the question was posed directed at me! It should be noted that Barbados recently had a substantial overhaul of its social security system, including increasing retirement ages and contributions - now with the highest contribution rate of any scheme in the Caribbean at 18% - well above the next highest which happens to be Guyana at 13% - hence the interest in other possibilities from the delegates.
At the time I advocated a basic minimum provision provided by the state with substantial proportion of provision provided by the private sector and individual. This is in sharp contrast to the current situation in most of the Caribbean where the state scheme provides the majority of benefits. The main problem I highlighted was the one of making private provision affordable given that a substantial contribution is being paid into the current social security scheme. One option that was put forward by a delegate was to replace the defined benefits based on years of contributions and salary with benefits defined by the contributions paid in. All well and good, I argued, but then who pays for the existing defined benefit promises that have already been made given that contributions are now being diverted away from the old scheme?
Now such a move is being put forward as one potential reform for the NIS, I decided to revisit this problem and see if a move to a defined contribution social security scheme can be managed in Guyana. This process is often referred to as 'privatising' social security which is a bit of a misnomer, since if contributions are compulsory it is still a state scheme - more accurately the process should be described as the investment of social security funds in private funds.
The Chilean system
Chile is often pointed out as the poster child for the move to a defined contribution scheme. Anyone interested in how they managed to tackle the thorny issue of transition can read the journal of José Piñera who was Secretary of Labour and Social Security and oversaw the change, published by the Cato Institute. (http://www.cato.org/pubs/journal/cj15n2-3-1.html). Something I did not realise until I read this was that the reform took place earlier than I had thought, in fact under the dictatorship regime. I thus suspect that many of the less popular aspects of the reform which may not sit well with a democracy could have been forced through under duress. Having said that many other South American countries made similar transitions in the nineties perhaps justified by the success of the Chilean system.
In a nutshell, the government closed the old scheme to new members. The state guaranteed to make provision to those pensioners in payment in the old scheme. Anyone currently contributing to the old scheme was eligible to transfer to the new scheme and in doing so received a credit for their service, which was a government guaranteed 'recognition bond,' index-linked and carrying a real yield of 4 per cent, payable at retirement age but tradable on the secondary market to facilitate early retirement. Any new entrants to the labour force were required to join the new scheme.
Arguing that social security contributions were priced into wages, a redefinition of what constituted gross wages to include employer's contributions to the old scheme was mandated - effectively leading to an 18% increase in salaries (but not to the employment cost). "In that way, we ended the illusion that both the employer and the worker contribute to social security, a device that allows political manipulation of those rates. From an economic standpoint, workers bear nearly the full burden of the payroll tax because the aggregate supply of labour is highly inelastic." Combined with the fact employee contributions were lower in the new the scheme than the old, "net salaries for those who moved to the new system increased by around 5 per cent."
The transition was not without its costs, and estimates indicate the combined effect of meeting the unfunded pay as you go benefits and honouring the recognition bonds was some 80% of GDP. However, Chile saw a huge increase in GDP growth following the advent of the new scheme (which also coincided with the privatisations of a large number of state entities). Piñera attributes this to "virtuous sequence."
"It gave workers the possibility of benefiting handsomely from the enormous increase in productivity of the privatized companies by allowing workers, through higher stock prices that increased the yield of their PSAs [Pension Savings Account], to capture a large share of the wealth created by the privatization process." Others argue that Chile's economy has improved because of economic reforms accompanying privatisation.
Cost of transition in Guyana?
Recognising the cost of unfunded promises is nothing new for private schemes run by companies reporting in compliance with IAS19. The International Accounting Standards Board (IASB) took a dim view of the practice of representing cost simply as the amount being paid in, particularly when this was considerably less than the value of the benefits being promised accruing in the scheme. Instead, a method largely driven by balance sheet values was adopted, where the value of benefits promised to date is reflected in the balance sheet of the company, offset by any assets held to meet those benefits.
Alas there is no compulsion for state schemes or entities of the state to report the present value of their obligations so we do not know the cost of the unfunded benefits in Guyana. An idea can be garnered from the following chart which is typical of contributions being paid and was presented at last years's Caribbean Actuarial Association conference.
The value of the benefits is essentially the pay as you go rate (PAYG) -which increases up to 25% of insurable earnings over time. Thus substantial burden would have to born by the state. Note the PAYG rate decreases if those in the old scheme are encouraged to join the new scheme.
Investments?
Chile introduced its new scheme and then privatised a large number of state run entities. Guyana's privatisations have largely taken place already and ended up in the hands of strategic investors or majority shareholders. If liquidity on the local stock market is anything to go by there would simply be insufficient assets in which to invest, unless investing overseas was permitted, which would negate the benefits of large capital investment in the economy. Guyana even lacks a government bond market as an alternative investment medium (though one could be developed if the cost of transition was financed by bond issues).
Conclusion
The only way such a scheme could conceivably work in Guyana is if the last bastion of state ownership, sugar, is at least partly privatised. In this way Guyanese will begin to feel they have a stake in the economy and a culture of share ownership can be encouraged. I think Piñera says it very eloquently: "the new pension system gives Chileans a personal stake in the economy. A typical Chilean worker is not indifferent to the behaviour of the stock market or interest rates. Intuitively he knows that a bad minister of finance can reduce the value of his pension rights. When workers feel that they own a part of the country, not through party bosses or a Politburo, they are much more attached to the free market and a free society."