Fragmentation produces administrative, economic inefficiencies
This is the fourth part of Arab Monetary Fund and World Bank Group report on pension systems in the Arab Region: Trends, challenges and options for reforms.
— Editor
There are several reasons why people do not contribute, including mistrust of the institutions and designs of pension schemes. For instance, most schemes in the region do not have a formal pension indexation mechanism, so inflation and discretionary adjustments affect real benefits. This increases the level of uncertainty about the real value of future pensions and can induce workers to view contributions as an additional tax rather than savings, thus promoting evasion.
Given that coverage has not been expanding, the support ratio (number of contributors per beneficiary) has been decreasing. Although demographic characteristics in the Arab region remain favorable, the system demographics of social insurance (mostly pensions) schemes are rapidly aging. Short vesting periods and low retirement ages and weak penalties on early retirement also contribute to higher dependency ratios.
Countries such as Libya, Tunisia, Egypt, and Jordan have the highest coverage rates in the region, although careful consideration should be given to the definition of pension coverage for active workers. This active coverage rate refers to active contributors (of the labor force) to a mandatory social insurance pension scheme. Many people contributing are perhaps benefiting from various social insurance programs (e.g., work injury, sickness, maternity). However, they will not be able to qualify for a pension if they do not comply with the minimum number of years of contribution, so coverage of pensioners can be much lower than active member coverage. Comparison of contribution densities and labor mobility of the formal and informal sectors is important to consider in assessing coverage rates properly. The social security institutions that cover private sector workers often have a considerable number of “dormant accounts” — people who have been affiliated in the system and have contributed at some point but do not necessarily contribute at present.
Only an average of approximately 10 percent of people aged 60 and older receive a pension in the Arab region. Most of the older population in the region must rely on family and other types of informal care or state transfers. With falling birth rates, rising life expectancies, changes in urbanization, migration, and family structures the reach and scope of these informal arrangements have been weakening in recent years and will weaken further unless new policies to protect older adults are implemented.
A distinctive feature of labor markets in certain Arab countries is the large number of foreign-born resident workers — up to 90 percent of the labor market in some countries. These workers will predominantly retire in their home countries rather than the host countries where they are employed. The percentage who stay in the host country is perhaps larger than might be expected, but coverage is needed for these foreign resident workers, which is a particular priority for the WBG, given the importance of these workers to countries particularly in South Asia and East Asia Pacific. As set out in the policy recommendations section, improvements in pension systems in the home countries that could allow workers to contribute directly to their home country pension system and send remittances for other family members to pension accounts so that the windfall of temporarily much higher wages not only boosts short-term consumption, but also helps secure their old-age income security and that of their families, are creating some exciting potential opportunities.
This solution may be preferable for host country governments, employers, and providers, too, because they do not need to enroll many workers who may be only temporarily in the host country pension system, although the assets will be leaving the region, so there will be a lower level of growth in domestic capital markets. A mix of solutions may be useful so that some workers can be included in host country saving and pension vehicles, but the large number of foreign resident workers, many of whom have no coverage, are now potentially much more easily directed into pension schemes in a way that will cost much less for host country governments and employers than before (figure 19).
Most countries in the region have fragmented pension systems, with more than one scheme covering different type of employees (mostly private sector workers and civil servants but also other special schemes). Most countries have more than one compulsory pension scheme. Different types of schemes, with different qualifying conditions, different benefit formulas, and other different characteristics, cover different types of employees. Some countries in the region have been integrating (or have been trying to) their different schemes gradually into a unified national scheme, with the objective of having the same social insurance system cover all employees in the country. Bahrain and Iraq have integrated administratively, but civil servants and private sector employees are still subject to different rules. Jordan has accomplished pension scheme integration reform. Civil servants hired before 1995 and military staff hired before 2003 are still covered under the old civil and military pension laws, but civil servants and military hired after such dates are already covered under the same national pension law (which covers all other employees in the private sector as well). Palestine has also effectively integrated its schemes, although effective parametric reforms have not been implemented, and the integration included not schemes for civil servants and private sector employees but only schemes that cover geographically different civil servants and security service personnel.
Some Arab countries have special schemes for civil servants and other special schemes for armed forces and other type of employees. Selfemployed and casual workers are not covered under social insurance programs in most Arab countries, although self-employed workers in Algeria, for instance, have their own fund (called Caisse d’Assurance Sociale des Non- Salariés), according to law, although in practice, fewer than 30 percent of self-employed workers are effectively covered. In Egypt, Tunisia, and Yemen, the same scheme that covers all private sector employees also covers selfemployed workers (according to law). In practice, a high percentage of them are not covered either.
As mentioned above, this fragmentation of pension systems in the region produces considerable administrative and economic inefficiencies. Transparent, efficient rules to transfer rights across schemes are rarely in place, so the mobility of the labor force is restricted, preventing efficient allocation of resources. Fragmentation also increases administrative costs and is a source of inequities, with some segments of the labor force receiving preferential treatment from the public pension system. This is an area where data are particularly lacking, hence the suggestion for a regional cost-benchmarking exercise in the recommendations, which could be useful for all who run funds in the public and private sectors.
Other aspects of the current design of many of the social insurance (mostly pension) schemes in the Arab region unnecessarily distort the economy and are a source of adverse distributional transfers and behavioral incentives. Beyond the problem of fragmentation, the current designs of many of the pension schemes in the region create economic inefficiencies and income inequalities (usually favoring middleand high-income workers at the expense of low-income workers, and favoring current beneficiaries at the expense of future generations).
The problems related to fragmentation in the broader pension system risk being re-created in private pension funds if there is not an active policy to create a market structure that can deliver the benefits of economies of scale that are so powerful in pension markets. There is not much evidence that an individualchoice model that relies on ordinary people actively choosing to join a pension plan and then being able to choose their investment strategy and negotiate or shop around for low fees is the optimal way deliver mass market pension coverage.
A recent example of the benefits of improving the market structure in conjunction with sensible regulations is a reform in Turkey that introduced auto-enrollment into pension plans via employers. This has cut costs from the existing individually based private pension market (known as the BES) by more than 50 percent. The weighted average of total costs in the new auto-enrollment system is approximately 0.75 percent per year (75 basis points) for administration and investment management, compared with 1.7 percent (170 basis points) in the individual market (and even higher in previous years despite the system having been set up in 2003). In the first 6 months of the new policy, over 2.5 million workers were added to the system — all of whom could have chosen to take out a pension before — for which there had been a generous 25 percent government match of contributions (up to a limit). This shows how important it is to have a proactive policy to expand coverage rather than relying on individuals being able to navigate the options without assistance.
Turkey is another good example of the need to improve the demand and supply dynamics in the pension market. On the supply side, it is important to develop a model that does not rely on large sales forces chasing individual subscribers because this is expensive for companies to operate and can lead to “churning” of accounts from one provider to another, which increases costs and forces more-liquid investment strategies because companies face high levels of redemptions to transfer assets to alternative providers (Stewart et al. forthcoming). It can also be tempting to mis-sell because sales agents paid up-front commissions push products inappropriately, with scandals being seen in countries such as the United Kingdom, the United States, and India. The demand side is equally important because there is a large body of evidence showing that it is difficult to understand the choices involved in creating a goodquality pension product. There need to be high-quality default funds for the accumulation and decumulation phase so that members do not need to become investment experts. Improving both elements can be beneficial because providers can deal at scale and gain scale without having large sales forces, which increases competition in asset management from companies that do not rely on traditionally dominant bank-based distribution models.
The section below on potential policy reforms explores how some of these challenges can be avoided as pension markets are developed in the region. One additional benefit is that if scale providers of pensions are created, an economy more quickly reaches the point where it can have large, long-term providers who can invest successfully in longer-term and illiquid investments from real estate to private equity to infrastructure that many countries in the region are desperate to fund.
The fragmentation outlined in the previous section as a common feature in the pension schemes of Arab countries is one of the clearest challenges to address. Most countries in the region have more than one pension scheme, with schemes covering public and private sector workers typically separated. The separation of the schemes responds to historical legacy rather than to a rational justification for different treatment of private and public sector workers. Bringing these elements together and using common platforms will deliver important benefits because this will tackle (i) Diseconomies of scale, resulting in high costs associated with duplication of administrative processes (collection, investment) and management of separate databases in parallel; (ii) Unfair treatment of workers in different sectors, with high returns on contributions in one sector (usually public servants) and very low benefits/low coverage (private salaries) or simply no coverage (self-employed); (iii) Lack of central databases limits supervision and law enforcement capacity, resulting in important groups of the population excluded from pension benefits because employers evade social security contributions; (iv) Lack of portability of pension benefits, resulting in limited flexibility to move between jobs.
In spite of strong arguments for the merger of different schemes, Arab countries face several difficulties before they can consolidate their pension schemes. From the experience of countries that have merged, some of the challenges to address include
Administrative barriers: Different organizations have different procedures, organizational structures, and technologies to perform the same administrative processes.
Consolidation of records: Centralizing information is essential as part of the consolidation process, but it may be complex if there are different types and sources of data or IT.
Organizational cultural barriers: In addition to written administrative manuals and organizational structures, different organizations have generally accepted and usually unwritten codes of practices; integrating these common practices is sometimes more complex than adopting unified manuals of procedures.
Asymmetries: Organizations to be merged are normally different, and although the merger process may improve synergies and complementarity, it is also possible that the consolidated institution will inherit the weaknesses of both organizations. There may also be asymmetries in definitions of key problems and priorities; although increasing administrative capacity is a common need of pension schemes, public pension schemes in some Arab countries face critical challenges of sustainability, and the top priority for the schemes for private sector workers is usually extension of coverage and greater compliance.
Rights of individuals that the merger will affect: Consolidation would require significant changes to define the rules of the new merged institution, affecting the rights (or expectations) of individuals in one or both of the schemes. This adds to the difficulties of ongoing reform processes in each of the schemes separately.
Resistance to change: Mergers are usually perceived as major changes and therefore encounter resistance, particularly in existing institutions, whose staff members perceive change as risk of losing their jobs or the power they have in their respective organizations.
These challenges are stronger obstacles to merger if the schemes to be consolidated are similarly developed and strong. In this case, both public and private sector schemes would resist the merger.
In addition to these challenges, as in any reform process, two critical aspects are of paramount importance and should not be disregarded: the need for a strong, proactive reform champion to lead the process, educate and bring together the political groups, and push the process forward and an effective public information campaign, particularly targeted at private sector workers and employers, to raise awareness of the importance of enrolling in pensions and making regular contributions to the scheme.
Other common challenges facing social insurance and pension systems in the Arab region are related to weak institutional capacity to monitor expected revenues and expenditures and to manage reserves. In many cases, social insurance systems have been used as mechanisms to finance and provide social assistance services. In general, benefits are not in line with contributions, leading to actuarial imbalances. Also, the systems are often financed through high payroll taxes that contribute to the distortion of labor markets, and as mentioned earlier, their financial position is deteriorating or expected to deteriorate in the near future.
The Arab region faces a compelling challenge in improving governance and management outcomes for public pension schemes. There is a serious gap between governance structures and management of public pension systems in the Arab region and the best international standards and practices for good governance and sustainable management.
Other structural constraints include a legal framework that makes it difficult to apply bestpractice models, governance problems at the macro level, limited administrative and institutional capacity in many of the countries in the region, and the level of financial sector development. There are major shortcomings in governance (particularly financial governance) and administrative structures.
Lack of appropriate information systems to monitor and track contributions encourages evasion. Inappropriate governance structures also lead to discretionary adjustments of contributions and benefits, which are often arbitrary and driven by political pressures that compromise the financial sustainability of the systems.
Improving governance and investment of social security funds, but also of other public and private pension funds, is a critical part of the future success of pensions in the region. This is addressed in section V on how to improve overall performance of the capital market and pensions. There is a high degree of overlap in governance between good practices for social security funds — as highlighted for example in the Governance Principles of the International Social Security Institution and the standards of the OECD for Private Pensions — and assessment frameworks that aim to bring together the core lessons of these and other attempts to improve governance, such as Outcomes-Based Assessments for private pensions.
The long-term nature of pensions means that safeguarding benefit promises or the assets backing those promises over many decades is of critical importance. This is not a problem simply for Arab countries but for any country seeking to build a multi-pillar or diversified pension system that will combine public and private pensions, pay as you go with funded pensions and Defined Benefit type pensions with savings and Defined Contribution pensions.
The area of regulation and supervision has grown in importance over the years as more countries have developed this multifaceted way of delivering pensions. Some countries in the region have wellestablished regulators and supervisors. Some have them for part of the pension system but not all parts — for example the Egyptian Financial Supervisory Authority, which supervises voluntary private plans but not public pension schemes. It is an open question whether a pension supervisor should cover both public and private pensions, but it is perhaps an emerging trend to give supervisors broader scope as the costs of lack of transparency in public pensions and social security institutions become clearer. For example, in the United States, private employer based pensions are regulated by the Department of Labor and have to follow a set of regulations aiming to increase the likelihood of full funding in the case of Defined Benefit plans, or achieving good standards in the case of Defined Contribution plans. Public or state pension plans are governed by different (and weaker) rules and many are now very significantly underfunded. Over the course of many decades many of these plans at state level have accumulated deficits, that if measured on the same basis as the private pension plans, would often by 5 times higher than the explicit debt of the states.
The potential to create very large deficits in public pension plans which will ultimately be extremely difficult to fund can be partially avoided by having greater scrutiny by an independent regulator who can monitor the assumptions and the funding situation greater scrutiny even if the government retains the policy role to determine the right level of contributions and benefits. This arrangement is broadly what has recently happened in the UK where many public service pension plans have now been transferred under the supervision of The Pension Regulator.
For regulation and supervision to be effective it is important that the supervisors have the necessary degree of independence and resources to do their job. The resources are: the legal powers to take action in the case of problems; the number and quality of the staff; and the willingness of the staff to take action, which is the ability to deal with difficult decisions and the experience and insight to know that problems can and do emerge in the delivery of pensions — in both the public and private sector. These behavioral characteristics are best supported by effective design of the pension market value chain — so that those investing assets do so for example using a custodian, which is a way of hard-wiring anti-fraud protection into a system.
Security of the pension benefits also relates to avoiding assets being reduced by market volatility just before someone retires and needs to use the assets. So, this means that investment plans are needed that can move away from riskier assets as someone approaches retirement. One option is to focus on matching the asset allocation used by insurers providing annuities so that members will not suffer from volatility. Another element of security is trying to move to a situation where benefits are paid until someone dies so that people do not outlive their pension assets or promises and face poverty in old age (or relative poverty). Many defined benefit plans aim to deliver an income until death — but not all — see for example the case of Egypt where plans pay out lump sums from Defined Benefit plans. But some plans only guarantee a nominal level of income which can be quickly eaten up by inflation. This can make an initially adequate pension become increasingly inadequate if a person lives for many years — though correspondingly it is a way in which under-funded plans can re-achieve sustainability.