Topic 4: The Pension Design Framework

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Learning Objectives

      After reading this topic, you should be able to answer these questions:

  • What is the implication of classical, bounded, and ecological rationality?
  • How does ecological rationality explain national pension system design?
  • What explains the variations in national pension system design?

What do we Mean by Design?

Kumaragamage (2011) broadly defines design as

“a roadmap or a strategic approach for someone to achieve a unique expectation. It defines the specifications, plans, parameters, costs, activities, processes and how and what to do within legal, political, social, environmental, safety and economic constraints in achieving that objective.” (as cited in Schwittay, 2014)

Pension system vary considerably in their emphasis on the ‘five pillars’ in different countries. Individual countries have pension systems that have design features and emphasis that are specific to them. However, these national pension systems also have design features that are common across countries. How can we explain this common but differentiated framework of national pension systems across countries?  This is the focus of the discussion in this topic.  The goal is to identify an approach that integrates our understanding of rationality and social contracts developed in the previous topics and explains not only the common attributes but also the relative emphasis on the pillars that constitute the national pension systems.

The identification of a framework of pension design is important, as it helps national pension systems respond to challenges like increases in longevity, changes in the labor market brought about by technology and globalization,  in an analytical and consistent manner.Without understanding the common framework underpinning pension design and its different characteristics, expediency and adhocism is characteristic of the policy response to challenges to sustainability of pensions and old age security. An example of expediency and adhocism,  often driven by asymmetrical vested interests  is the popularisation of the defined contribution plans by the financial services industry and policy makers. The defined contribution plans are set as the default and only alternative to the “failing” defined benefit plans. The evidence from the 401(k) plans in the United States, the only large-scale implementation of defined contribution pension plan design, show that such plans have been unsuccessful in securing the retirement finance for the majority of workers (EBRI, 2016, 2017). Nonetheless, such defined contribution plans continue to be adopted as the default alternative to the withdrawal of defined benefit plans in occupational pensions.

Perspectives on Rationality & Pension Design

The alternative perspectives of intertemporal choice and decision behavior that emerge from the three different approaches to rationality discussed earlier, have implications for design governance and investment of pensions. Classic or economic rationality leads to the advocacy of a non interventionist policy intervention in pension decisions amongst the working population who have the disposable income to save for their retirement. Homo economicus, with its assumption of perfect foresight and capacity to incorporate all available information, can effectively make the intertemporal choices to financially provide for their retirement. Under this assumption of classical rationality, the area of policy focus is on transfers amongst those who cannot save (poor/ low wage earners) or the pay as you go component of the five-pillar framework of pensions because of the lack of disposable income in this population group. Under this framework the asset management and investment responsibility of pension planning can be decentralised with little or no requirements for governance and institutional investments in  infrastructure.

The bounded rationality framework accepts the classical rationality assumption of self-interest as the motivation but disagrees with the assumption of optimizing as the objective of the of the decision maker. As discussed in the topic on intertemporal choices, our decisions are guided by self-interest as in classical rationality but given our cognitive limits we are unable to choose the best possible outcome that utilises all available information. Hence we are unable to optimize but do pursue self-interest maximising behaviour. Thus, given the bounded rationality and the pursuit of satisficing behavior, the behavioral view calls for ‘nudges’ or the creation of an incentives and institutional infrastructure that helps people into a band of behavior that ensures intertemporal decisions promoting pensions and financial security into old age. An example of these nudges or design features in pension and retirement schemes would be commitment devices like automatic enrollment into occupational contributory pension plans which aids in intertemporal choices that promote financial security in retirement.

The bounded rationality framework points to the creation of an incentive and institutional pension infrastructure that promotes intertemporal pension choices. In Canada, an example of such an incentive is the tax break for Registered Retirement Savings Plan (RRSP). Another design feature of the institutional infrastructure is the compulsory enrollment and payroll deduction and contribution by both employers and employees under the Canada Pension Plan. Bounded rationality, while recognizing the limits of individual capability/responsibility, still calls for a decentralized framework of pension design that promotes an individual’s satisficing behaviour . The emphasis in bounded rationality is on creating an institutional  structure that simplifies the demands on an individual’s cognition and decision-making capacity for taking intertemporal decisions.

Ecological rationality also points to a greater role for institutions and social contracts in the design governance and investments of pensions. Ecological rationality and the social contract that allows for the determination of what is every person’s due provides the rationale for the five pillars of the pension system.The emphasis in ecological rationality is on the role of the environment in promoting superior intertemporal choices. Decisions are process driven and not goal driven. Thus, pension policies require an institutional framework that is sensitive to the environment in which it is embedded. The most important component of the environment for an intertemporal pension policy framework is the social contract. The social contract is an environment that will decide the emphasis on the five pillars in the nation’s pension plans and the design governance and investment attributes of its national pension system. As discussed in the topic on social contracts, the emphasis on the five pillars in pension design will depend on the  country’s socio political systems location in the individualism/collection spectrum.

The role of different interpretations of rationality in our decision behaviour and in the design of pension systems and the individual pension plans should not be seen as mutually exclusive. Classical and bounded  interpretations of rational decision behaviour will have greater relevance in the design of pensions at the plan level while ecological rationality will be relevant in the design of pension systems.

Ecological Rationality Social Contracts and the Pension System Design

The specific design of a country’s pension system is the outcome of a process of negotiation between different stakeholders. The negotiation terms are set by the society’s emphasis or location on the individualism collectivism scale. The negotiated design must be periodically renewed as necessitated by the changes in longevity and in the labour market.

A nation’s choice of pension system will be the outcome of the negotiation by various stakeholders about their society’s relative emphasis on the three precepts of the (bio) social contract: equality (E), equity (Q), and reciprocity (R). Every society will decide for itself to what extent it is obligated to support people in retirement based on its history, culture, and level of economic development. Is the right to financial assistance in old age unconditional, or are such entitlements contingent on obligations, including work and savings?  What should be the extent of inequality in potential pension benefits in pension design as an acknowledgment of differing human talent and merit?

Variations and choices in pension design in the social contract space may be country specific. However, we can identify some broad classification or typology to explain the emphasis these countries may place on the three tenets of a social contract. At the risk of oversimplifying the underlying complexities of the choices regarding E, Q & R, such a typology, would be beneficial to understanding the variations in pension design across countries and provide us with a comparative framework for analysing the changes in pension design. In the absence of such a framework, proposals for pension design and reform become subject to ad hoc influences of vested interest.

Dixon and Hyde (2003) propose a typology of welfare ideologies to apply to changes in pension design in many countries. This typology or classification can also be used to interpret and understand the location of pension design within the social contract space. The location on the social contract space reflects the society or the country’s emphasis on E, Q & R in the design of its pensions. It also indicates the changes it proposes in response to longevity increases and labor market changes due to technology or globalization.

The four categories expressed in Dixon & Hyde (2003) are displayed in Table 6 below:

Table 6
The Welfare Ideology Spectrum

Anti-Collectivism Reluctant Collectivism Reluctant Individualism Social Reformism
  • Competitive markets for pension products;
  • no mandatory pension requirement;
  • pension financing individual responsibility;
  • administration and investment fund management by the private sector and market;
  • no role of public policy beyond the provision of means (personal or family unable to provide) tested survival needs;
  • selling of pension products only by the financial services industry;
  • no regulation of providers; fund managers;
  • existing consumer laws deemed sufficient
  • Competitive markets for pension products;
  • mandatory pension requirement;
  • role for public policy as a social insurance to maintain social stability and not just survival because of market’s inability to ensure full employment always;
  • role of public policy also in incentivizing financing of pensions through tax breaks;
  • selling of pension products by the financial services industry;
  • but role of non-profit sector possible;
  • industry-specific regulation by state
  • Competition between non-profits with freedom for exit and entry;
  • mandatory pension requirement;
  • greater role for non-profit collective ownership by beneficiaries in pensions;
  • public policy role only in promotion of labor force participation;
  • making pension participation mandatory;
  • Regulated pension management to non-profit, industry, employer, unions or community-based partner organizations;
  • mandatory pension requirement;
  • individual responsibility for financing with state subsidies for those outside the workforce or those on low wages;
  • sale of pension products by partner organizations;
  • extensive state regulation in all areas: selling, service, product provision, investment decisions

Note. Adapted from Dixon & Hyde (2003)

A mapping of the Dixon and Hyde (2003) typology in the E, Q & R social contract space shown in Table 7 below, gives us a common framework to evaluate pension design in different countries. The common framework is not an idiosyncratic arrangement, but rather contain consistent features with variations that can be explained by the identification of the social contract, on the welfare ideology spectrum which in turn is a function of the societal interpretation of the roles for individualism and collectivism.

 

Table 7
Mapping  E, Q, and R Social Contract Components in the Welfare Ideology Spectrum 

Anti-collectivism Reluctant Collectivism Reluctant Individualism Social Reformism

Greatest emphasis on Q; minimal emphasis on E, and little or no consideration for R

A greater emphasis on Q and a moderate emphasis on R, and then on E in that order A greater or near equal emphasis on R and Q, and then on E A greater or near equal emphasis on R and E, and then on Q

There is no evidence that any national pension system belongs to the anti-collectivism category. Despite the popular perception that individual responsibility and market should be the response to rising longevity and labor market changes because of technology and globalization, no country or society chooses to adopt anti-collectivism as their framework for pension design. Defined contribution plans are popularized by the financial services industry, and by policy makers on grounds of expediency, but not as a negotiated outcome of pension design. Neo-classical economics and its emphasis on anti-collectivism has influenced pension redesign, but these values are inconsistent with the social contract. Modern states are committed to the fairness principle and some mix of the E, Q & R components as outlined above in Table 7.

The relative emphasis on E, Q & R lies in the society’s interpretation of the social contract. The interpretation will depend on the society’s location on the welfare ideology spectrum as outlined by Dixon & Hyde (2003). National consultations can inform a country about its location on the welfare ideology spectrum and its relative emphasis on E, Q & R.  In Canada the document that informs us about our location on the Welfare ideology Spectrum and our social contract is the Canadian Charter of Rights and Freedoms. The interpretation and our location on the Welfare Ideology Spectrum is the subject of ongoing consultation and negotiation and informs our society and country of our emphasis on E, Q & R. An example of such ongoing consultation is the Citizens’ Dialogue on Canada’s Future: A 21st Century Social Contract (most recent changes by Fletcher, 2017).

Table 8
Mapping Pension Plans in Canada onto the Five Pillars

CAPITAL FUNDED PAY AS YOU GO (PAYGO)
PUBLIC Canada Pension Plan (CPP) – (Pillar 2)

 

Old Age Security (OAS) – (Pillar 1)

Guaranteed Income Supplement (GIS) (Pillar 0)

Guaranteed Annual Income System (GAINS) – Specific to Ontarians (Pillar 0)

PRIVATE Individual (Employee)

  • Registered Retirement Savings Plan (RRSP) – (Pillar 3)
  • Tax Free Savings Plans (TFSA) – (Pillar 3)

Occupational (Employer/Employee)

  • Defined Benefit (DB) – (Pillar 2)
  • Defined Contribution (DC)  – (Pillar 2)
  • Pooled Registered Pension Plan (PRPP) – (Pillar 2)

The second design feature of these programs is that they all have an income threshold, beyond which they are either progressively reduced due to higher income or not available at all. Thus, Old Age Security (OAS) in 2017 begins to be clawed back when pension income exceeds $74, 788 per year (Yih, 2017).  If annual income including OAS is less than $17, 599.99 per year, the Guaranteed Income Supplement (GIS) is available on a sliding scale. For example, GIS is $804 dollars for those reporting no pension income from any source and declines with a rising income and is $0 when annual income reaches $17, 599.99 (Government of Canada, 2018) . Similar considerations apply to the level of allocations for Guaranteed Annual Income System (GAINS) payments for seniors, which is a provincial program available to all Ontarians (Government of Ontario, 2013).

What is the rationale for these design features? Why does the pension design provide for a guaranteed minimum income for all Ontarians 65 years and above? Why is the availability of these benefits related to pension income from other sources available to an Ontarian in retirement?  The concept of ecological rationality provides the rationale for these programs. Ecological rationality requires that our decisions promote co-operation between members of the group or society ads this has been the basis of our success as a species. The environment in the public policy decision context is the social contracts specific emphasis on E, Q & R as conditioned by the welfare ideology spectrum.

This social contract comes under strain and its continuation becomes unsustainable if what Corning (2005) describes as “equality” (E) is not available to all people in a society. Equality implies a collective obligation to provide for the common needs of all people, which includes the elderly and retired. In the specific case of pension design, the preservation of the social contract requires that incidence of old age poverty is minimized to the extent possible; depending upon the level of economic development. In the case of a developed country like Canada, this means that we cannot have retirees in poverty without shelter and receiving income that does not ensure that their basic needs such as healthcare, food, and clothing are met.  Typically, in most countries, pension programs aimed at financing the equality component of the social contract are not funded, but rather are on a PAYGO basis. Given the expected average longevity, it is considered part of the intergenerational contract that the young would take care of the old. Therefore, these pension programs are funded by the current tax revenue of the government. In effect, the current workers will pay for the equality component of the social contract in this pension design.

All countries with viable PAYGO pension programs seek to minimize the dependence of the population on this form of financing retirement. Failure to do so can lead to unsustainable fiscal deficits, reduced investments in infrastructure, and, a diminished capability to fund the PAYGO systems in the future. National pension systems try to reduce the dependence on PAYGO programs by encouraging current workers to save for their retirement. In the top left quadrant is the publicly funded and governed pension plan. In Canada such a national pension program, is the Canada Pension Plan  (CPP). The CPP is financed by mandatory contributions from employees and employers (including self-employed) who have income above $3,500 and are of 18 years or older. The province of Quebec has its own variant of the CPP called the Québec Pension Plan (QPP). In the social contract environment, the CPP represents the reciprocity component of the bio social contract. Reciprocity (R) requires that each of us contribute proportionately to the viability of the pension design according to our abilities.

In the bottom left quadrant are the merit or equity (Q) component of pensions in the social contract space. The Registered Retirement Savings Plan (RRSP) and the Tax Free Savings  Plan (TFSA) pension programs are voluntary, and left up to individual choice. Employees may also have access to workplace or occupational pensions. There are different kinds of occupational pension plans. Some of the more popular ones are the Defined Benefit Plan (DB), Defined Contribution Plan (DC), and  Pooled Registered Pension Plan (PRP). Some of the newer formulations of the occupational pension plans are the Target Benefit Plan (TB), and the Defined Ambition Plan (DA).  The ability to contribute to these programs is a recognition of merit or the superior economic capabilities of the individual in the social contract framework.

The effectiveness of these capital-funded programs to reduce the dependence on PAYGO pension plans has come under growing scrutiny. Capital-funded, public and private pension plans face complex challenges because of rising longevity, healthcare costs, and the changes due to globalization and technology, impacting the labor market.

THE CHANGING SOCIAL CONTRACT ENVIRONMENT

Rick Wartzman, a senior advisor at the Drucker Institute, traces the changes in the social contract between companies and employees in The End of Loyalty: The Rise and Fall of Good Jobs in America

Listen to his interview (25:19) on National Public Radio
http://www.npr.org/books/titles/535626741/the-end-of-loyalty-the-rise-and-fall-of-good-jobs-in-america

For six out of 10 Canadian pensioners, the amount of pension available in retirement will be a combination of capital funded public pensions, or the CPP that they have contributed to during their working years, and the PAYGO component that is funded by the current tax revenue of the government. The reliance on the privately managed and  funded pension plans is on the decline (Office of Superintendent of Financial Institutions Canada, 2015).  Amongst those who have occupational plans, coverage in the private sector has declined. Furthermore, within the private sector, the percentage of employees who have defined benefit plans have gone down from 53% to 28% between 2003 & 2013.

The individual private-funded and managed pension plans like the Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) are being subscribed to by fewer active workers and by those in higher income groups. A recent Statistics Canada study noted (Messacar, 2017):

 

  1. The number of contributors into RRSP declined gradually by approximately 16% over this period, from 5 million in 2000 to 4.2 million in 2013.
  2. The number of RRSPwithdrawers (total withdrawers) increased over the period, from approximately 0.9 million in 2000 to 1.3 million in 2013.
  3. Consistent with the downward trend in the frequency of contributing, the total value of RRSPcontributions also declined steadily over the period among 25- to 54-year-olds, from approximately $30.6 billion to $22.5 billion between 2003 & 2013

 

What about the tax-free savings account (TFSA)? The same study also shows that a slight decline in RRSP use over the last few years coincided with an increase in the number of individuals aged 25 to 54 who contributed to a TFSA, from 2.0 million in 2009 to 3.0 million in 2013. However, while the number of TFSA contributors has risen, so has the number of withdrawers. In 2013, there were approximately 1.6 million TFSA withdrawers, slightly more than one-half the number of contributors in that year. However, the value of TFSA withdrawals also increased, from $1.3 billion in 2009 to $7.4 billion in 2013. Both the frequency and magnitude of TFSA withdrawals are significantly larger than for RRSPs. Figure 3 provides further insights into the profile of the RRSP and TFSA subscribers.

bar graph showing income quartiles and types of accounts

Figure 3. Chart 4:  Incidence of contributing to an RRSP or TFSA (or either) across income groups for 25- to 54-year-olds, 2009 to 2013.

Note. Reproduced and distributed on an “as is” basis with the permission (Statistics Canada, February 13, 2017).

With rising longevity, the challenge for most national pension systems across the world is the sustainability of the PAYGO quadrant that ensures the continuation of the social contract. The data on occupational pension plans and individual savings plans like the RRSP and TFSA cited above shows that the bottom left quadrant comprised of privately funded and privately managed quadrant of pension design is failing in its overall objective of minimizing the dependence on PAYGO pension plans. Defined benefit plans are available to only a very small percentage of Canadians outside the government or publicly funded organizations. Only high-income households partake in sustained individual savings through RRSP and TFSA.  This is a source of considerable concern in public policy on pensions and in proposed changes in pension design.  Identifying and understanding these challenges is the prerequisite for an intelligent and informed discussion about changes in pension design.

 

Exercises

TOPICS FOR REVIEW

  1. The Welfare Ideology Spectrum
  2. Anti Collectivism
  3. Reluctant Collectivism
  4. Reluctant Individualism
  5. Social Reformism

Exercises

REVIEW QUESTIONS

  1. What are the implications for pension system design under different interpretations of rationality?
  2. Describe the characteristics of national pension systems in the different categories of the Welfare Ideology Spectrum.
  3. Discuss the emphasis of the national pension in the Welfare Ideology Spectrum on the different components of the Bio social contract.
  4. Map the Canadian Pension system into the four pillars using the two by two matrix based on management and funding and discuss the individual pension plans in each pillar.

 

Exercises

APPLICATION EXERCISE

Research the national pension system design of one other country than Canada. Map the country’s pension plan design using the World five pillars as shown in Table 8.

Using the criteria of the bio social contract and Dixon and Hyde’s (2003) Welfare Ideology Spectrum (as shown in Tables 6, 7), evaluate the country’s location of their national pension system in the social contract space.

You can use the following table template to identify the country’s national pension system’s location in the Welfare Ideology Spectrum.

 

 

Template to identify a national pension system in the Welfare Ideology Spectrum (Dixon and Hyde, 2003)

Country

[Name of Country]

 

Complementary

Pensions


Program


[Reluctant Collectivism

, or

Social Reformism]

Statutory earnings related to pension plans

a. Collectivist orientation

Labor engagement

Monopoly supervision

State subsidies

Specified benefit entitlements

Universal employment coverage

b. Market orientation

 

Employer contributions

Commercial provision

Individual only contributions

Unspecified benefit entitlements

 

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