The recalibration of the pensions privatisation debate

It is a natural tendency of human beings, especially as a social collective, to seek out simple solutions to complex public policy problems. What if there are no simple solutions to complex public policy initiatives?

Consider the example of pension schemes. The conventional wisdom since the early eighties has been that pension plans are best administered by private fund managers. As part of the Reagan-Thatcher axis and later the Washington Consensus, countries were encouraged to move from defined benefit to defined contribution schemes as well as privatise the management of their pension funds. Chile was cited as the poster child of such reforms.

Now, three decades later, Chile is revisiting its pension model. The Times has a nice article,

The options being considered include creating a state-run pension administrator, raising the retirement age, instituting a 5 percent contribution from employers and adopting stronger regulations for the pension fund administrators. “After going from a totally public system to the other extreme in 1981, now we are moving towards a middle ground that combines individual savings, state spending and contributions from employers,” said Mr. Bravo, of the Catholic University of Chile. “Another option is tearing down the A.F.P. system, but it’s too costly. We don’t have the privilege of starting from zero anymore.”

Clearly, the privatised pension model overlooked the messy realities of managing a system with too many moving parts, which cannot always be either regulated or incentivised into conformity. It also mistook a certain demographic and global development moment to be representative of all times to come. 

A pension account requires contributions to be made into individual accounts with a defined periodicity. It is no surprise that poor people, suffering from real financial constraints and amplified behavioural biases, struggle to meet this requirement. The example of unutilized bank accounts from India is an example of such serious last mile gaps. And now, there is growing evidence from everywhere that employers, more due to fiscal and unscrupulous reasons, too renege on contributions.  The article mentions that in Chile, a study found that only a quarter of those who retired last year had paid into the pension scheme for more than 25 years and 62% of women contributed for less than 15 years. So, it appears that the private providers are not well positioned to bear these risk all by themselves. 

Then there are structural issues. The demographic pyramid has slowly changed shape, leaving an increasing share of subscribers exiting the labor market. The age of double-digit or high single digit returns on portfolios looks most likely a thing of the past as we peer into a long period of low interest rates. In fact, as the management and other fees extracted by fund managers rise as a proportion of net returns, pension funds are left clutching at the straws. This has naturally re-iginted the debate on whether the contributions of the workers are in the first place adequate enough to sustain a pension scheme which can give reasonable payouts at the time of retirement. 

All this naturally questions the priors about the neat outsourcing of pensions management responsibilities to private providers. At a more fundamental level, this should be one more in the long list of reminders that the quest for simple, neat, outsourced, start-up driven solutions to complex problems is most likely to be futile.

Update 1 (18.09.2016)

Times has a nice story on the calculation of pension liabilities. The actuarial measurement, which uses a discount rate of 7-8 per cent (the expected investment return), vastly understates the actual liabilities. In contrast, if the risk free rate is taken as the discount rate, the net present value of the liabilities would have to be discounted by closer to 2-3 per cent, which would in turn be a much larger liability. Pension funds prefer to state the former and keep the latter confidential.