Social Security and Pension Reform: International Perspectives

12 - The Efficiency of Defined Contribution Pension Plans in the Americas, Denise Gomez-Hernandez and Alberto M. Ramirez de Jurado Frias

269 12 The Efficiency of Defined Contribution Pension Plans in the Americas Denise Gómez-Hernández Autonomous University of Querétaro Alberto M. Ramírez de Jurado Frías Conference of Consulting Actuaries, American Academy of Actuaries, and Colegio Actuarial Mexicano Defined contribution pension plans are widespread among the Americas. Pension actuaries use the pension replacement rate as a benchmark to measure how much a worker’s preretirement income is replaced by its pension. Although this measure is intended to make the system efficient, the postretirement challenge for workers is to be able to purchase at least the basic market basket. Income projections used in pension replacement benchmark rates do not capture this because workers ’ incomes are not efficiently linked to macroeconomic variables in Latin America. This chapter proposes the use of macroeconomic variables such as the Consumer Price Index and the basic market basket to develop a benchmark indicator of basic income replacement as an alternative to the replacement rate. This indicator is calculated along with the replacement rate by country and compared to illustrate the efficiency level of their current defined contribution plans. REPLACEMENT RATES Apension is intended to replace a worker’s income after his working lifetime. Because of this replacement objective, the pension serves the In order to view this proof accurately, the Overprint Preview Option must be checked in Acrobat Professional or Adobe Reader. Please contact your Customer Service Representative if you have questions about finding the option. Job Name: -- /356308t 270 Gómez-Hernández and Ramírez de Jurad Frías same purpose as the worker’s preretirement salary, that is, to purchase goods like the basic market basket, health care, housing, entertainment, and other needs or goods. Upon retirement, the pension amount is often the only source of income for retirees; this is the main reason why the pension amount is compared with the salary, defined as the Traditional Replacement Rate (TRR), which is the ratio of the pension amount and salary upon retirement TRRt = ft äy (12) St , where ƒt is the amount in the fund at the end of the accumulation period, (t) is the worker’s individual account under the defined contribution plan, ӓ is the annuity factor used to convert a lump sum to an annuity , and St is the projected salary for the accumulation period (t). The traditional replacement rate is affected by the contribution rate to the pension plan, the fees charged, the rate of return received, and the starting salary. In the Americas—North, Central, and South—the race between inflation and salary is often lost by the salary, that is, salaries are often adjusted by employers at a rate below the inflation increase. Therefore, the salary is not an item that is necessarily linked to macroeconomic variables. For this reason, the authors believe the current replacement rate approach underestimates the future effectiveness of pension income due to price increases in the set of goods. Three aspects are affected when salary and macroeconomic variables are unlinked: 1) country-wise comparison between different geographies, economies , and currencies, 2) determination of money purchase levels for goods upon in and out of work lifetime periods, and 3) notion of pension plan efficiency and retiree satisfaction levels. The authors identified the basic market basket variable as a candidate to benchmark a defined contribution plan, particularly because this is a standard measurement performed by most if not all of the central banks in the Americas. The minimum satisfaction level or replacement In order to view this proof accurately, the Overprint Preview Option must be checked in Acrobat Professional or Adobe Reader. Please contact your Customer Service Representative if you have questions about finding the option. Job Name: -- /356308t The Efficiency of Defined Contribution Pension Plans 271 rate under this measure is when the pension amount is sufficient to purchase the basic market basket. LITERATURE REVIEW Since the implementation and growth of defined contribution plans, many authors have tried to model and project the final amount in the individual accounts at retirement. Vigna and Haberman (2001) analyze the financial risk in defined contribution plans using dynamic programming through a model that incorporates a regime of fixed and variable income. The main conclusion of this research is the sensitivity of the projected amounts in the fund to the returns during the accumulation period. Gómez-Hernández, Vidal, and Enrique (2009) compare the competitiveness of the defined contribution plans in...