The case for GCC pension reform from sinking to sustainable

Published December 20th, 2009 - 08:25 GMT

Pension systems in the Gulf Cooperation Council (GCC) are remarkably generous. People in the region retire well and they retire early. To the extent that the region’s pension systems are intended to provide social welfare, they are certainly fulfilling their role. However, the overemphasis on social welfare is at odds with the region’s movement away from a pure welfare state model toward one that relies on steady diversification of the economy and growth of the private sector. Existing pension systems are also unstable and unsustainable. Successful reform will gradually shift responsibility toward workers and private fund managers, and thereby help grow the GCC’s financial markets and significantly reduce the role of government, finds a new study by Booz & Company.


The GCC’s slowly sinking pension reforms

Pension systems can confer three benefits. The social benefit allows retirees to maintain their pre-retirement consumption, or provides a safety net against poverty. The second is the financial benefit - pensions involve decades-long liabilities and long-term invest­ments, which can decrease the volatility of financial markets and deepen a country’s capital markets. The third benefit is economic - giving people an incentive to work, thus bolster­ing the labor market and making the country more competitive.


“In the GCC, pension reforms mainly work toward a social goal, doing little to further the region’s economic and financial goals,” stated Richard Shediac, a partner at Booz & Company. Although the systems are currently sustainable with 25 working people contribut­ing to pension funds for everyone who pulls money out of them, by 2050 this dynamic will change to approximately three-to-one in some countries. “Pension reforms are required to strengthen the financial underpin­nings of these funds, preserve their role as safety nets for citizens, develop the region’s capital markets, and deepen the efficiency of regional labor markets,” he added.


Pension plans in the GCC are generous and use much shorter averag­ing periods, often the last one to three years of a worker’s career. Income replacement rates in retirement also tend to be high - around 80 percent on average and in many coun­tries, the 80 percent level is available to 40-year-olds.


Accrual rates—the percentages by which GCC workers’ expected retire­ment incomes rise each year - are constant and the same regardless of income level—resulting in the same replacement rate. “Depending on a country’s pension reform goals; there are several options to investigate aside from constant accrual rates. A pro­gressive accrual rate by years of work for instance, rises as workers age, and gives workers an incentive to remain in the workforce,” said Samer Bohsali, a principal at Booz & Company. A regressive accrual rate is another option, where accrual rates decrease by income level.


Currently, GCC workers are incentivized to retire early rather than stay engaged in the workforce. Roughly nine in 10 male workers in the region have retired by age 60, versus only one in 10 male workers in Organisation for Economic Co-operation and Development (OECD) countries.


Another reform issue is the creation of savings vehicles to help deepen the region’s financial markets. “GCC workers are not encouraged to save for their retire­ments and there is no equivalent of the voluntary retirement mechanisms that exist in more mature economies,” explained Shediac. High spreads at banks also discourage savings, and life insurance is not widely owned in the GCC. A lack of sophistication in investment knowledge and a high con­sumption rate (a recent study put Abu Dhabi among the nations with the highest consumption rates in the world), highlights the reluctance by workers to move from a welfare mentality.


A clear improvement opportunity for GCC pension programs is the inclusion of productive non-national labor - especially considering three-quarters of GCC employees are expatriates. In the UAE and Kuwait, this is even higher - at 83 and 82 percent, respectively.


“While other countries with large percentages of foreign workers have looked for ways to include them in their pension sys­tems, the governments of the GCC have avoided such concessions, thus limiting their coun­tries’ attractiveness as destinations for workers,” Bohsali stated. Some companies have addressed this issue, setting up private pension schemes to keep prized international managers. By excluding foreign workers from pension systems, GCC countries miss a significant opportunity to strengthen their finan­cial markets: pension coverage of non-nationals means the contribution fund would in some countries be more than three times larger than now.


Finally, the GCC’s approach to its pension funding is almost certain to prove unsustainable in the long run. Its pension systems are partially funded, meaning some benefits are paid out of investments made with excess contributions, backed by a pay-as-you-go system, where retirees’ income comes out of the tax contributions of current workers. “This approach is necessary because assets are not enough to cover long-term liabilities. Ideally the region’s pension systems should become fully funded, where assets would cover long-term liabilities so that benefits would primarily come out of an invested pool of contributed money,” said Shediac.


The pension systems’ partial funding does not currently pose a problem, but as the region’s demographics change - there won’t be enough workers supporting retirees. The old age dependency ratio - the ratio of people working to those in retirement - will drop steadily as the population ages.


Reform objectives, what the GCC’s pension systems require

All these weaknesses will drive GCC nations to overhaul their pension systems. It makes sense to initiate pension reform now when, demographically speaking, the pressure is less intense and changes can be made purposefully.


Among the most important reforms is opening the GCC’s pension systems to foreign-born workers and the self-employed. A second fundamental reform is reducing governments’ roles in administering pensions and taking care of workers in their retirement. A third critical reform is the introduction of voluntary retirement savings, so workers have the option of saving money above and beyond that allotted for them. A fourth reform would be to make workers’ retirement accounts portable, so they wouldn’t face the prospect of losing pensions if they switched jobs or left the country.


“Other tactical changes that GCC countries should consider include fine-tuning accrual rates to better redistribute wealth; lowering the guaranteed income replacement rate to levels more in line with highly developed countries; indexing pension increases to inflation; and reducing companies’ mandatory pension contributions,” Bohsali commented.


Existing routes to pension reform

Most countries that have reformed their pension systems have gone about it via either parametric reform or systemic reform. Parametric/ retrenchment reform involves changing the parameters of a country’s pension system to ensure financial stability such as retirement age or mandatory contribution rates. Systemic reform is more complex, involving the introduction of multiple pension “tiers”; a retirement income that is guaranteed by publicly administered pension funds often supplemented with a benefit provided by privately administered funds. A tier 1 system is a government-sponsored, mandatory pension fund (like Social Security in the U.S.); a tier 2 system is a mandatory employer-administered fund in which there are defined benefits (like General Electric’s pension benefit). A tier 3 system is underpinned by defined contributions, in which workers voluntarily save an amount of their choosing and invest it as they please, over and above what the state and their employers are putting away for them (like an IRA or 401(k) in the U.S.).


The World Bank is a strong proponent of multi-tiering as a route to systemic reform, which eventually makes pension systems more robust. When governments introduce nonpublic pension tiers, they typically do so with the goal of shifting responsibility to the worker and private fund managers, and lessening their own roles.


“Parametric reforms alone may not be sufficient in the GCC but systemic reforms do not guarantee success either,” Shediac said. The right socioeconomic conditions must be in place for it to work. A government undertaking systemic pension reform is less likely to succeed if it has a high deficit. Second, a country undertaking systemic reform is less likely to succeed if its underlying income inequality is high and its financial markets or financial-services industries are not yet well developed. Income inequalities are accentuated by a system that emphasizes the market returns from worker contributions or a system oriented toward privately administered tiers. And less developed financial markets make the success of such reform efforts debatable—there is no one to administer the private tiers.


Three tiers, managed by government

The region needs a model of pension reform that uses the three tiers of systemic reforms and embeds them in the individual public funds already being administered by governments. Governments should run all three tiers and spin them off as employers get proficient at running corporate retirement funds (Tier 2) and as capa­ble financial-services companies arise to handle the employee-contributed funds (Tier 3). Because such financial-services companies aren’t well developed in most of the GCC, it isn’t realistic for govern­ments to hand off the burden of administering their pensions.


“Instead, governments should move forward with the “one fund/three tiers” concept, and give financial players time to lay down infrastructure and begin developing services,” stated Bohsali. The long-term objective would be to have the governments’ parts of the funds serv­ing mainly the social welfare function, ensuring that retirees meet a desig­nated standard of living, while the corporate- and employee-funded areas contribute financial and economic benefits, such as deepening financial markets.


Parametric reforms should also be part of the prescription. Changes parametric policies would go a long way toward ensuring the financial stability of these one-fund/ three tiers entities, allowing many to wean themselves off partially funded or pay-as-you-go schemes and move toward being fully funded. Embedding the voluntary portion of the program in the existing public fund would help jump-start the third tier; making workers more secure about putting “extra” money into retirement savings in a public fund they know and trust. “As money pours into this third tier, it would create the condi­tions for capital markets to thrive, leading to a stage when defined con­tribution funds can be spun out in the GCC, and run by private companies,” Shediac explained.



Without question, there will be some beneficiaries of the current GCC pension systems who will be unhappy with changes to the benefits structure they are counting on. But those changes should be phased in over a period of years, giving people who are still in the workforce time to adjust their thinking and modify their financial behavior. There is real opportunity for GCC countries to make reforms to their pension systems now, that would strengthen the financial underpinnings of those systems, preserve their role as financial safety nets, and allow low-income workers to maintain their con­sumption habits. The reforms could also contribute to the development of regional capital markets and deepen the efficiency of labor markets. Done right, these reforms could help the GCC’s pension systems advance to become among the best in the world.

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