Peru : reforming the pension system

69 7 rESP Discussion Paper Series Peru: Reforming the Pension System Cheikh T. Kane June 1995 Education and Social Policy Department Human Resources Development and Operations Policy The World Bank  ESP Discussion Papers reflect work in progress. They are internded to make lessons emerging from the current work program available to operational staff quickly and easily, as well as to stimulate discussion and comment. They also serve as the building blocks for subse,quent policy and best practice papers. The views expressed here are those of the authors and should not be attributed to the World Bank or its Board of Executive Directors or the countries they represent.  Abstract This paper identifies the main areas of pension reform that Peru should address in order to complement its optional capitalization scheme introduced in 1992. The guiding principle of the remaining changes is the need to adopt a unified pension regime. Such unification is desirable for both equity and efficiency reasons. A central theme of the paper is therefore to provide a framework for selecting a unified pension system . This framework allows a critical assessment of the new draft law for private pensions. In addition, an estimate of pension liabilities is provided to highlight the importance of moving towards a defined-contribution regime, but also to quantify the fiscal effect of some of the policy reforms that are being discussed in Peru, such as adopting a minimum pension guarantee.  CONTENTS 1. INTRODUCTION .1 II. WEAKNESSES OF THE CURRENT SYSTEM ......................................................... 1 III. THREE OPTIONS FOR A UNIFIED PENSION SYSTEM ................ ........................... 2 Pure Capitalization System: .............................................................. 2 Capitalization with Minimum Pension Guarantee: .......................................................... 3 Multipillar with Public Provision: ...................... ........................................ 3 IV CRITICAL ASSESSMENT OF THE NEW DRAFT PENSION LAW: .......... ................... 4 Affiliation: .............................................................. 4 Minimum Pension Guarantee: .............................................................. 4 Taxation: .............................................................. 5 Contribution: .............................................................. 6 Investment Regulations and Minimum Return: ............................................................. 7 V. OVERALL UNFUNDED PENSION LIABILITIES AND CASH FLOW ISSUES ................ 7 Consolidated Implicit Debt: .............................................................. 7 Consolidated Cash-flow Accounts: ....................... ....................................... 9 VI. SUMMARY OF RECOMMENDATIONS AND TRANSITION ISSUES ......... ................ 9 Adopt a Unified Pension System: .............................................................. 10 Accelerate the phasing-out of the civil servant regime: ........................ ......................... 10 Fiscal Incentives and Labor Taxation: ............................................................... 11 Contribution Level and Structure: .......................... .................................... 11 Appropriate Budgetary Allocations: . .............................................................. 11 STATISTICAL ANNEX: .............................................................. 13 REFERENCES: .............................................................. 14  POLICY NOTE: REFORMING THE PERUVIAN PENSION SYSTEM I. Introduction As an integral component of the structural reforms implemented since 1990, Peru introduced a fully-funded private pension system in 1992.1 This was undoubtedly a major step towards improving income security for the elderly and addressing the well known structural problems associated with dominant pay-as-you-go pension schemes. In many respects, however, this reform needs to be consolidated and extended to other important sectors. Today in Peru there are five main pension regimes, of which the newly created private pension fund is the only defined- contribution and fully funded regime. The functioning of these five regimes is summarized in Table 1. The marked differences between these regimes in terms of financing, eligibility criterion, and benefit level create obvious distortions in net marginal tax rates. The underlying premise of this paper is that for both equity and efficiency reasons a move towards a uniform pension regime should be considered. The purpose of this paper is therefore to provide a framework for selecting a unified pension regime and assessing the fiscal implications of the transition from the current combination of regimes. Among the existing five pension regimes, the focus will be on the national pension system, the civil servant pension system (i.e., cedula viva), and the capitalization regime (i.e., AFPs). The rest of the paper is organized as follows. Section II summarizes the main problems associated with the current combination of regimes. These limitations provide the background for Section III, which lays down three options of unified pension system. Section IV gives an assessment of the new draft law for private pensions that is being discussed in Peru today. This new law provides a window of opportunity for strengthening the earlier pension reform. Section V contains estimates of unfunded liabilities associated with existing pension schemes and explores ways of financing them. Finally, Section VI summarizes the main policy recommendations. 1I. Weaknesses of the Current System The current system has at least five major drawbacks. First, except for the private pension regime, which covers 13 percent of the labor force, most pension schemes are unfunded 2 and fiscally non-sustainable. As shown in section IV, the magnitude of these unfunded liabilities is very significant. This is particularly true for the civil servant pension system, which is financed out of general revenue. Second, the different pension regimes give rise to different contributions and benefits to individuals with the same socioeconomic profile, hence violating horizontal equity (see Table 1). For instance, workers affiliated with the civil servant pension system can draw a pension after 30-25 years of service and irrespective of their age, whereas workers affiliated with the national public pension system receive a less generous pension and are subject to a minimum age for retirement of 60 (men) and 55 (women). Third, there are still strong disincentives for workers to join the private pension scheme because of its higher contribution rate (15 percent, including commissions and disability insurance) compared to that of the national pension scheme (9 percent). This bias is reinforced by the fact that in many companies, for administrative simplicity, 1/The law was adopted in 1992 and the system started operating in 1993. 2 / The coverage rate of 13 percent is based on total affiliates and therefore overestimates actual number of contributors because of multiple accounts and inactive affiliates.  2 the one-time salary increase of 13.5 percent that is supposed to be granted to workers shifting to the private pension fund is often applied to all workers. An additional disincentive to opt for the private pension scheme is due to the fact that workers who decide to do so would face a statutory retirement age that is 5 years older for men and 10 years older for women. Clearly, these disincentives are not consistent with moving away from a pension system with a dominant pay-as-you-go pillar. Indeed, today there are still twice more contributors in the national pension system than in the private pension system. Fourth, in addition to generating significant unfunded liabilities, the civil servant pension system is holding captive any genuine reform of the state because of its indexation to public wages. These wages are particularly low in the social sectors. But because of the indexing mechanism, any extra US$1 spent on wages translates into a 30-cents increase in pension payments. The civil servant pension system is also hindering the privatization process because a funding mechanism for pension liabilities has not been put in place. It is therefore important to quantify the cedula viva pension liabilities, devise a funding mechanism, and phase out the regime. Fifth, payroll taxes financing pensions contribute to the very high marginal effective tax on labor, which hinders competitiveness and is conducive to informalization. The combined taxes on labor funding pension schemes, health, and the housing fund (FONAVI) reach 18 percent for workers affiliated with the national pension system and 27 percent for workers affiliated with the private pension regime. It is important to emphasize that for a small open economy such as that of Peru, prices on tradable goods are internationally set and higher taxes therefore lead to higher labor cost because taxes ',4 cannot be "pushed forward". III. Three Options for a Unified Pension System Pure Capitalization System: As shown in the previous section retaining the combination of pension systems as they operate today is not a viable option. An alternative arrangement would be to move totally to a capitalization scheme without any Government involvement in the provision or the guarantee of pensions. This option therefore entails phasing out both the civil servant and public pension systems. The attractiveness of a capitalization regime is that it removes the fiscal instability associated with pay-as-you-go systems. Furthermore, such regime makes contributions more a deferred compensation than a tax, hence reducing distortions. There are, however, two limitations to adopting a pure capitalization regime. First, to the extent that redistribution remains an objective of the pension system, a pure capitalization will not be satisfactory since individual pensions would be determined by contributions and the average return on investments. Second, the principle of risk diversification across pillars is also absent since there is no mechanism to offset the investment risk factor. One must remember that the way the savings pillar works today, and despite the existence of a fluctuation reserve, negative returns are not precluded. It would be preferable to have a pension system that, at least partially and for the most vulnerable groups, insulates pensions from investment risk. 3 /Apparently this was done by the Central Bank. 4r/This holds unless labor supply is perfecdy inelastic and labor unions are absent. There is empirical evidence for OECD countries supporting the view that increased transfers financed by distortionary taxation lead to a loss of competitiveness and a decrease in employment in all sectors of the domestic economy (see Alesina and Perotti NBER 4810, July 1994).  3 Capitalization with Minimum Pension Guarantee: In order to add redistribution to a defined-contribution scheme, the Government could provide a minimum pension guarantee that is financed out of general revenue. It should be emphasized that this option would also imply phasing out the public pension scheme as well as the civil servant pension system. In the case of Chile, the minimum pension guarantee is set at US$70 per month and requires 20 years of contribution. More recent Latin American reformers such as Colombia and Argentina also have a minimum pension that requires 20 and 30 years of contribution, respectively. It is therefore not surprising that Peru is considering following suit by inserting a minimum pension guarantee in the new draft pension law. Cost estimates of the minimum pension guarantee are provided in Tables 2.1 and 2.2 for an average real return of 5 percent and 3 percent, respectively. The costs shown are for each eligible retiree and expressed as a multiple of the monthly average wage prevailing at retirement. It should be noted that the cost is the difference between the funds accumulated by a worker at retirement and the level that would be required to receive an annuity equal to the minimum pension. By design, the unit cost of the minimum pension guarantee is higher for low income workers.5 However, even with an equal starting salary, women receive a higher subsidy because it is assumed that, on average, they have a lower contribution density (i.e., propensity to contribute during working age). The fiscal burden of the minimum pension insurance also rises as the average return of the pension fund decreases. 6 Section IV provides an estimate of the annual cost of a minimum pension guarantee and its associated implicit debt. By adopting a minimum pension guarantee that requires 20 years of contribution payments would start only 18 years from now, as the first contributions to the capitalization system took place two years ago. If the Government decided to have the guarantee applied earlier, the required years of contribution could be increased gradually to its target. Multipillar with Public Provision: In many countries the option of phasing out the public pension pillar either runs against considerable resistance or is simply politically unfeasible. In the case of Argentina, for instance, the original draft made the savings pillar mandatory to new entrants into the labor market. By the time of final approval, the capitalization scheme was made optional. Thus, it would be wise to devise a strategy in response to a constraint of keeping the public pension system. Such strategy should ensure that the public pension system neither becomes a source of fiscal instability nor hinders the performance of the savings pillar. For instance, the need to correct the difference in contribution rates between the savings and public pension systems becomes even more pressing if new entrants into the labor market are allowed to opt between these two regimes. 5/ With a minimum pension guarantee of 20 percent of the average wage and an average real return of 3 percent, per- capita cost of the minimum pension guarantee would be roughly 22 times the monthly average wage for a typical worker with an average starting salary of 15 percent of the average salary. The corresponding cost for a worker with a starting salary of 42 percent of the average wage falls to 11-12 average wages. 6/ As shown in Tables 2.1 and 2.2, when the average return goes down from 5 to 3 percent, the subsidy to workers with a starting salary of 15 percent of the average wage is increased by 22 percent for men and 19 percent for women. The methodology that we use to estimate the fiscal burden of a minimum pension guarantee does not take into account the variability of the return. This variability would have been taken into account by using an option-pricing method. For an illustration of this approach applied to Chile see Zurita (1994).  4 A more fundamental question, however, is whether it would be desirable to retain some form of public provision even after adding a minimum pension guarantee to a mandatory capitalization scheme for new entrants. Militating in favor of such provision is the need to protect uninsured workers that remain outside the formal sector. One way of meeting this need would be to transform the national pension scheme into a social assistance scheme. Indeed, in a country such as Peru where a large fraction of the population is outside the formal sector, the minimum pension guarantee alone becomes a less effective tool for redistribution. Today, both the national pay-as-you-go scheme and the capitalization regime cover less than 40 percent of the labor force. By contrast, in Chile affiliates to the capitalization regime represent 94 percent of the labor force. It is unlikely that such a broad coverage would take place in Peru in the near future. For this reason, Peru could consider providing a social assistance pension to the elderly in a context of a broader poverty alleviation strategy. In addition to an obvious vertical equity argument, the minimum pension guarantee might be politically easier to adopt in tandem with a social assistance pension. Of course, just like the minimum pension guarantee, the flat social assistance pension would be financed out of general revenue. It should be noted that the social assistance pension would have to be set at the level that is more or less equal to the subsidy that is implicit in the minimum pension guarantee.8 IV. A Critical Assessment of the Draft Pension Law for Private Pension Funds The Government of Peru has recognized the need to correct some of the weaknesses of the current private pension system. As a result, a draft law modifying the original one was put together in April 1995.9 The new law contemplates changes in virtually all aspects of the functioning of pension funds. The importance of this law lies in the fact that in choosing a suitable uniform pension system, Peru seems ready to make the private pension scheme the most important pillar. This is confirmed by the proposed change in affiliation policy. Affiliation: The draft law suggests making it mandatory for new entrants into the labor market to join the private pension system. This would certainly contribute to moving towards a unified pension system, but should be complemented by other measures discussed above, such as closing the civil servant pension system. Minimum Pension Guarantee: This would be an important addition to the private pension fund, in particular given that affiliation to these funds would be made mandatory for new entrants. The draft does not specify the level at which the minimum pension guarantee would be set. As far as eligibility is concerned, it is proposed that to qualify workers would need to have contributed a minimum of 5 years in the private pension system, and a total of 30 years in the combined private pension and public pension systems. This implies that payments arising from the minimum pension guarantee could start as early as 1998 for workers who joined the private pension system in 1993 and have contributed 25 years to the old system. 7/Vittas and Iglesias (1992) estimate the ratio of affiliates to the labor force at 79 percent in 1991. A more recent estimate by Powers and Terrin (1995) is 94 percent. 8/ The social pension would have to be below the minimum pension guarantee itself since the subsidy element is the difference between this minimum and the annuity arising from the worker's savings. In Chile, for instance, there is a social assistance pension that represents 50 percent of the minitnum pension guarantee. 9/ Propuesta de Reforma Reglamentaria del Sistema Privado de Pensiones Decreto Ley No.25897, April 1995.  5 There is a growing consensus that when setting a minimum pension guarantee a principle of proportionality should be adopted. According to this principle, for workers who fail to meet the minimum years of contribution, the level of the minimum pension guarantee would be pro-rated by the number of years of contribution. At this stage, such proportionality is not included in the Peruvian reform proposal.1