Assessment of Pension Schemes from a Financial Sector Perspective

A pension plan is a long-term financial contract that promises to pay a retiring worker a sum of money intended to support old age consumption (Mitchell 2002, p. 2). Pension plans are generally classified as either a defined contribution (DC) plan or a defined benefit (DB) plan. Those two plans have significantly different characteristics. In a DC plan, the sponsor promises to periodically deposit a specified contribution into the plan (e. g., per pay period), which is then invested in capital market instruments of various risk levels. An individual’s total pension is based on amount contributed, length of employ­ment, and investment return. By contrast, a DB plan is based on a promise by the sponsor to pay the retiree a specified benefit, usually based on the employee’s wage plus the length of service. In that case, the market risk associated with the investment returns is borne by the employer (sponsor), who must set aside sufficient funds to pay the promised benefits. In a DC scheme, market risk is borne by the employee.

Hybrid pension schemes that have the features of a DB plan but require a greater sharing of risks by beneficiaries (as in DC schemes) are emerging in several countries, partly in response to rising costs of DB plans in an environment of increasing longevity of retirees. Similar to traditional DB plans, the employer or trustee invests the plan assets and typically bears some of the investment risk. At the same time, the employee has an individual account—a notional account maintained for record-keeping purposes—and receives the account balance at separation as a lump sum or annuity, thereby assuming more longevity risk.1

Pension plans can be either funded or unfunded. In funded plans, pension liabilities are paid out from the accumulated assets. Essentially, benefits are paid out from a fund built over a period of years from the contributions of its members (i. e., on the basis of accumulation of financial assets), plus investment income. Most DC plans are funded.

Unfunded pensions also are financed directly from the contributions of the plan pro­vider or sponsor, the plan’s participant, or both, but unlike funded schemes, they are not fully backed by assets to pay the future promised benefits, although they may still have associated reserves to cover immediate expenses (Yermo 2002). Generally, in unfunded schemes, resources are transferred directly from the currently working generation to the retired generation. For example, in pay-as-you-go (PAYG) schemes, contributions by pres­ent workers through payroll deductions are used to pay the current benefits of retirees.

National pension systems are usually represented by a multi-pillar structure, whereby the sources of retirement benefits are a mixture of government, employment, and indi­vidual savings. Although there are various definitions, the three pillars can be identified by their sources of savings as follows: Pillar I is the government, usually a combination of a universal entitlement and an earnings-related component; Pillar II is occupational (employer) pension funds, increasingly funded; and Pillar III is private savings and indi­vidual plans, often tax advantaged.2

The assessment of pensions from the perspective of financial sector stability focuses on the financial management and financial markets aspects. The assessment process cannot follow a strict framework, in part because pension systems vary greatly across countries and are marked by different contribution and payout characteristics. Accordingly, each assessment is guided by the individual country’s level of pension system development. The process is further complicated by the fact that pensions are intrinsically complex forms of long-term savings linked to capital markets, insurance, and social security (Whitehouse 2002).

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