This post discusses how to design a pension system. In this post, you will understand the meaning of pension, types of pension plans, and pension design principles.

WHAT IS A PENSION SYSTEM? 

A pension scheme consists of plans, patterns, and legal processes of securing and setting aside funds to meet the social obligation of care employers owe their employees after retirement or in case of death and disability. It is a planned pattern involving economic security for a retiree who cannot support himself. A sound pension system ensures that a worker’s benefit is paid appropriately based on the pension plan rules.

Hence, a pension system boosts the beneficiaries’ confidence that the promised benefits are secure and will be appropriately paid. According to the World Bank (1994) classification, three vital criteria explain the pension system model. They are:

1. The primary form of the promised pension benefits.
2. How the pension benefits are funded.
3. Whether public or private institutions manage the system.

Pension systems can be widely categorised based on the promised benefits, how they are managed, and how they will be financed. The choice is usually between two types of pension plans: 

1. Defined benefit pension plans, and 

2. Defined contribution pension plans.

DEFINED BENEFIT PENSION PLAN

Defined benefit pension plan, also known as a ‘Pay As You Go’ (PAYG) system, provides a “defined benefit”, a pre-specified amount or annuity – either in absolute currency or as a fraction of a measure of past earnings and years of employment. The guaranteed pension benefit could be in either natural or nominal terms.

DEFINED CONTRIBUTION PENSION PLAN

A defined contribution plan specifies the proportion or extent of the contribution of participants and sponsors. These contributions may be partially or voluntarily. In a defined contribution pension scheme, participants, sponsors, or both make pre-specified contributions either in absolute currency or as a fraction of a salary measure. Participants invest contributions in financial and non-financial assets.

PENSION DESIGN PRINCIPLES

A good pension design should focus on human behaviour to meet members’ pension needs at retirement and support risk sharing based on country-specific pension regulations. Hence, good pensions should be developed based on trade-offs between design principles. Hence, the need to adopt sound principles to foster an effective pension design.

There are three universal principles of pension design: 

1. Behavioural principles, 

2. Adequacy principles, and 

3. Risk-sharing principles

HOW TO DESIGN A PENSION SYSTEM

It is essential to have a governance structure to ensure overall legal compliance and protection of members’ interests. The pension designer should set the design’s criteria as a guide for the intended pension system. These criteria will vary between countries due to cultural influences and the historical path along which the retirement system has evolved. For instance, a paternalistic perspective may be applied in designing a pension system. Depending on cultures and ethics, pension design trade-offs would vary from country to country.

There are six basic steps involved in designing a pension system, including:

1) Understand members’ needs,

2) Identify members’ primary risks,

3) Design the default,

4) Design the choice architecture based on the default,

5) Monitor outcomes, and

6) Implementation.

Let us briefly discuss the six steps of a pension system design.

DESIGN STEP 1: UNDERSTANDING MEMBERS’ NEEDS

All individuals are different, but there are everyday needs at different stages of an individual’s life. In designing a sound pension system, typical individuals’ general needs (including young workers, old workers, young retirees, and old retirees) should be considered. A young worker is mainly looking for a return above inflation to preserve the purchasing power of the contributions made and earn a risk premium. An old worker aims for a real return but with some focus on capital preservation.

DESIGN STEP 2: IDENTIFY MEMBERS’ BASIC RISKS

Technology allows pension designers to tailor a package that suits the objectives and needs of employers and employees. The members’ needs can be integrated into a pension system, including financial, biometric, insurance, and non-traded needs. At different stages of the life cycle, blocks can easily be added or taken away. Members basic risks include financial risk, diversifiable life-related risk, systemic life-related risk.

DESIGN STEP 3: DESIGN A DEFAULT

If a company has distinct groups of scheme members with different needs, consider introducing other default solutions based on representative sets of employees. The default choice can be developed using four age categories (young workers, old workers, young retirees, and old retirees) to ensure a smooth transition between the different categories by introducing an automatic life cycle for the member. In their younger years, the member will have exposure towards growth assets in a return-seeking portfolio. As the member grows old, the risk is gradually reduced, and in the pay-out phase, the member still has some exposure to growth assets, and the longevity is pooled.

DESIGN STEP 4: DESIGN A CHOICE ARCHITECTURE BASED ON THE DEFAULT

Once equipped with a robust default solution, the next question is to what extent are choices provided to members? An extreme paternalistic decision is to offer no choice to members. This is a decision that the pension designer will make together with employers’ and employees’ representatives. A more realistic view is to offer them only a few but relevant choices.

DESIGN STEP 5: MONITOR OUTCOMES

The member should have access to information to understand the appropriate (acceptable, affordable, and relatively stable) income level at retirement. This significantly depends on the level of pensions the social security pension system grants. Suppose retirement income relies mainly on the level of occupational-defined contribution schemes. In that case, the first thing that needs to be monitored is the potential gap between savings and the acceptable level of retirement income. This will help the member plan while still active in the labour market.

DESIGN STEP 6: IMPLEMENTATION

From an implementation perspective, collective and individual defined-contribution approaches have advantages and disadvantages. A collective approach might be helpful if the owner’s rights are clearly stated, reducing implementation costs. Hence, it is possible to identify an individual life-cycle path that generates the same economic outcomes as the collectively defined contribution solution. There are minimal welfare improvements from a financial perspective in the collective model compared to a model with clear individual ownership rights.

A pension design steps discussed above may differ between countries depending on the generosity and long-term sustainability of the state pension. However, several factors influence a pension design, including local labour market structures, fiscal and pension laws. The critical decision in developing a choice pension architecture is to determine what choices the sponsor or pension provider makes and what options are made by the members.

See the full video on How to Design a Pension System: https://youtu.be/FvtYMa5krdM