Pension schemes and undersaving for retirement: the case of Latin America
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Swiss Re Institute economists Fernando Casanova Aizpún and Caroline Cabral recently published the study "Pension schemes in Latin America: addressing the challenges of longevity". In addition to providing an overview of the existing pension schemes in the region, the authors define and measure the pension gap in the six largest economies and set forth recommendations to close the gap.
One of the most important challenges in personal finance is to secure a post-retirement income. Most people in retirement require less income to maintain their standard of living, since by that time, mortgages tend to be repaid, children are independent, and as retirees, they no longer need to contribute to a pension scheme. However, other expenses remain, medical care costs increase, and the need for long-term care arises. Although retirement income can come from the state, family, personal savings and/or an insurance product, it is usually a combination of all, and the weighting of each depends on the type of pension scheme available. Ultimately, the purpose of a pension system is to provide workers with a reliable post-retirement income and to prevent poverty in old age.
Pension systems around the globe are coming under pressure due to changes in demographics, low investment returns and shrinking national budgets. In Latin America and the Caribbean (LAC), the ageing of the population is more pronounced than for the global aggregate. Current estimations show that the old-age dependency ratio (the number of people aged 65+ as a share of those aged 15-64) in LAC is expected to rise from 11.4% in 2015 to 58% in 2050, while for the global aggregate the increase would be from 12.6% to 38.1%.
In LAC, many countries have long relied on defined benefit schemes, where the contributions of current workers fund the benefits of current retirees. However, due to the ageing of the population, some countries had to react to the funding challenges by reforming their pension systems to make them more fiscally sustainable. Chile was the first, in 1981, to shift the responsibility of retirement saving from the government to individuals (with the introduction of a defined contribution scheme). Chile was also the first to transfer individual longevity risks to the life insurance industry. In the 1990s, Mexico, Colombia and Peru followed suit, although the last two remain hybrid systems that include elements of defined benefit and defined contribution schemes. Argentina and Brazil remain purely dependent on defined benefit schemes.
The Swiss Re Institute study shows that in a sample of LAC countries, the pension gap is now USD 2.2 trillion. Brazil’s gap is by far the largest, at USD 1.2 trillion, followed by Argentina with USD 475 billion. As a share of their income, Argentinians need to save the most – ie, 16.6% of their earnings on top of what is already mandatory – to ensure that their savings meet the capital required to afford a post-retirement income equivalent to 65% of their salary at the age of retirement. Workers in Mexico and Peru would need to increase their current retirement savings the least (by 6.9% and 4.3% of their earnings) since they have, on average, more years until retirement and their life expectancies are shorter. The study emphasizes that if no measures are introduced to address the problem, then defined benefit schemes will likely become unsustainable. Given the current retirement benefits in the Brazilian defined benefit scheme, the pension deficit is projected to rise from 1.4% of GDP to 8.4% in 2041. For defined contribution schemes, the risks of undersaving for retirement will ultimately be borne by individual retirees, unless pensions, for example, are transferred to a life insurer and paid out as an annuity.
The authors point out that a shift to more sustainable models is needed since savings rates in LAC are historically low due to periods of hyperinflation and/or expropriation that have depleted savings and resulted in mistrust towards public sector management and financial institutions. Savings rates are also low due to the culture of family support in which younger relatives are expected to provide financial support to the elders, underdeveloped domestic financial systems and low financial inclusion, as well as high economic informality.
The pension gap can be closed in multiple ways. Difficulties arise when there are attempts to introduce unpopular measures. Once retirement benefits – or any other entitlements – have been established, it is very difficult to withdraw or modify them. Regardless of the pension system in place, in order to reduce the political backlash of eliminating previously acquired benefits, the most feasible solution would be to implement changes gradually.
Given the heterogeneity of countries, one size does not fit all. The solution to the pension gap requires a joint effort from the public and private sectors. Here, the insurance industry can play an important role. To help close the gap, countries can raise the retirement age, increase the mandatory contribution rate and reduce investment restrictions. They can also increase competitiveness and transparency in the pension fund management industry, incentivize voluntary savings, lower the informality in the economy and work closely with the insurance industry to embed life insurance into the pension system.