Topic of Discussion: How Can Insurers Drive Pension Reforms (Mr. Sunil Mehta, American International Group, Inc-India Co. Ltd.)
Source:
Mr.Sunil Mehta, American International Group, Inc-India
Abstract:
The Need for Pension Reform
The issue of pension reforms has attracted enormous interest not just in the developing world but also in countries of the developed world. The issue gains importance on account of the wide-ranging social implications that pension reforms can deliver and the impact it can have on the structure of financial markets. Ageing population, lower mortality rates, dynamic and often unpredictable interest rate markets have all combined to make the business of managing pensions difficult. Developing countries face a bigger challenge. Typically these countries lack a social security framework, having largely depended on extended families and other informal means to provide old age social security. The problem is further compounded by the absence of a vibrant financial market, which can provide instruments and investment opportunities for the investment of long-term contractual savings. This circular logic can lead to a virtuous cycle if the pension system is reformed in a sustainable manner. Long-term investments by pension funds can provide much needed resources for the infrastructure and other long gestation projects. Insurance companies can play a critical role in this process of reform.
Countries that have implemented pension reform have witnessed a sharp rise in gross output. While the increase in GDP cannot be directly attributed to the development of a private pension system, nevertheless there are some linkages due to the introduction of private pensions. The obvious link between pensions reforms and GDP growth is through the accumulation of savings. However, a greater savings level only begins to appear years after the introduction of pension reforms. At the beginning of the pension reform, costs of the pension system are high and the apparent benefits not easily identifiable. As long-term savings grow structural changes become more evident. In a country like India with a high rate of savings, the economic impact will be more discernible with wide spread social security and deployment of resources in building much required infrastructure. Another significant factor affecting savings level is the decrease in the extent of budgetary support for government managed pension funds. This causes indirect financial effects in the economy as a result of more efficient use of capital. New financial institutions appear, offering new instruments, making financial markets more competitive and ultimately lowering the cost of funds.
Important Stages of a Pension Plan
While the specific form of pension reform depends on the social and economic characteristics of the country, insurance companies have typically played a significant role in the evolution of pension reforms in many countries.
Accumulation Stage
A pension program is characterized by two distinct stages.
The first is the accumulation stage wherein the pension fund receives contributions from the participants. At this stage the expertise required is in the areas of asset gathering and fund management. The skills required are widespread distribution of points of presence and sustained investment management performance. In the Indian context the large banking network and postal savings system can act as a conduit for gathering contributions into the pension system. The use of technology lower costs associated with the asset gathering and data maintenance process. Although the burden of investor education is usually shared by the industry, it is important that individual players are encouraged to undertake investor awareness campaigns. Governments and regulatory agencies can play a key role in disseminating information and educating investors. While there can be no guarantees on minimum fund performance, investor risk can be mitigated through carefully drafted regulations and investment guidelines. It is also essential to communicate the risks inherent in different asset classes with investors in a clear and comprehensive manner.
Annuitization Stage
The second stage of a pension system is the annuitization stage. The purpose of an annuity is to safeguard against the eventuality of living beyond ones earning age. Insurance companies in exchange for a one-time payment of a lump sum amount sell annuities. Annuities are therefore normally used to provide a regular income after retirement and are financed with the current savings or with funds from the accumulated balance of a defined contribution pension plan. Annuities can be structured in various forms to meet the needs of individual savers. For instance, annuity payments can be made with reference to two or more lives (e.g. husband and wife). In pension systems that rely on defined contribution plans, the importance of annuities cannot be overstated. Governments in many countries have mandated that the accumulated balance at retirement in an individual pension account be used to purchase an annuity.
Annuities, by their design, have assumptions of life expectancy and investment returns embedded in their pricing and these two factors have a critical bearing on the success of an annuity program. In general, insurance companies selling annuity products have to insure against the cost of an improvement in longevity. A good understanding of the actuarial profile of populations is therefore essential to the pricing of annuity products. In India there is a dearth of qualified actuaries and the introduction of pension reforms must take note of this reality.
Insurance companies also run the risk of the investment returns falling short of the defined payouts in an annuity. This can arise due to a variety of reasons; the most usual of which is the absence of financial instruments of sufficiently long maturity. In theory, life insurance companies can use some of their other policies to hedge against the above-mentioned risks embedded in annuities. Life insurance policies have a payout profile which is the inverse of an annuity and the two can be used to net out investment risk to a certain extent. The real extent of hedging will vary depending on the expected mortality rates of the population buying annuities and that which buys life insurance.
The degree of protection offered by an annuity against longevity and investment risk depends on the nature of the product. Nominal annuities offer no protection against inflation, while inflation indexed annuities can afford real rates of return. However for insurance companies to offer indexed annuities, it is essential that the financial markets provide similar investment opportunities. Governments therefore can play a key role through the introduction of inflation indexed bonds.
Pension System in India - Current Stage & proposed reforms
The current pension and provident fund system in India is inadequate to provide old age social and income security. The system suffers from many ills, not the least of which is poor investment performance. There has been wide spread media coverage of the potential short fall and the liability that the government may have to bear. The magnitude of the problem is large enough for government and regulators to seek reforms in this sector. However, the government is yet to come up with coherent regulatory proposals for allowing participation of private sector players. Attempts at introducing a new regulatory structure for private pensions will however have to be reconciled with the existing treatment of exempt funds. The key in undertaking pension reforms is to be able to manage the transition from the existing government sponsored system to a private system. This will require a sound technical plan that takes into consideration the realities in the fiscal account and financial sectors. We are yet to see the emergence of a consensus among government and regulators on the structure of this technical framework. The appointment of a pensions regulator has been delayed for long and should receive immediate attention.
China initiated reforms in the pensions sector with the introduction of the New Unified Pension System in 1999. The new system in broadly in line with the three-pillar structure advocated by the World Bank. The third pillar envisages the participation of private sector pension fund managers. Many foreign fund management companies have entered into technical agreements with Chinese partners in anticipation of the opening up of the private pension fund management sector. China has also set up a National Social Security Fund (NSSF) to make good any shortfalls in the government managed pension funds. The NSSF receives 10% of the proceeds of disinvestment of state owned enterprises as income.
In India, one area where insurance companies have already started to make an impact is in managing superannuation and gratuity funds of corporates. Current regulations provide for life insurance companies to provide fund management and administration services to companies for their superannuation and gratuity funds. The investment pattern mandated for insurance companies in this activity creates an opportunity that corporates can benefit from. For instance insurance companies can invest upto 60% in corporate bonds. The comparable allocation to corporate bonds for self managed superannuation funds is upto 10%. In addition insurance companies can also invest in equities to the extent of 30% within the overall allocation to corporate bonds. Self-managed funds are not permitted this investment option. This gives rise to the possibility that insurance companies can deliver higher rates of return on these funds.
Some life insurance companies have started to offer unit linked funds to which employees can make regular defined contributions. On the vesting date, the accumulated balance is used to purchase an annuity. Further employees can chose between funds of varying risk - return profiles, ranging from funds investing only in government bonds to funds having exposure to equities. This affords employees the opportunity to accumulate capital in a manner, which appeals to their risk appetite. The practice is similar to what is being envisaged under the OASIS. Recommendations for the individual investors, especially the self-- employed section of the working population.
Conclusion
There has been much debate over the past few years on the need to reform the pension system in India. A government appointed task force has also submitted a conceptual blueprint for this reform. However there have been no concrete amendments or regulatory initiatives to give shape and direction to pension reforms. Further delays will aggravate the problems current facing the country.
Insurance companies have been at the forefront of pensions reforms in countries like Poland and in Latin America. In India too, life insurance firms can play a pioneering role in offering pension products to individuals. Widespread distribution network, fund management skills and understanding of mortality rates of populations make life insurance companies uniquely positioned to offer pension products. While in the longer term, composite players and asset management companies can complement the structure of the industry, it is essential that a start is made with the existing life insurance companies.
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