National versus privatized pensions

There are advantages of the nationalized system over the current privatized one.

By SHLOMO YITZHAKI
Money [illustrative] (photo credit: REUTERS)
Money [illustrative]
(photo credit: REUTERS)
Israel’s current privatized pension savings system should be replaced with a nationalized pension system, similar to the one in the United States, concludes a recent Taub Center policy paper authored by researcher Daniel Premysler and myself.
The government has justifiably recognized that in order to prevent senior citizens from becoming a burden on society, it’s important that people have pension insurance. However, the government has erred in backing a private system, which requires citizens to manage their savings on their own, even though a large share of the population is unable to monitor capital markets and to understand the complexities of financial investment. The solution lies in transitioning to a nationalized pension system, which would lead to a more effective mechanism for contribution and oversight of pension fund money, a reduction in management fees, and more generous benefits.
Similar to the United States, contributions to the national pension system should be capped and any contributions based on an amount beyond this maximum would be managed as they are today. A cap that is equal to the average salary would mean that 70 percent of Israel’s employees would have their entire pension savings with the state. Unlike in the American system where savings are not invested in the market, the savings should be invested in the capital markets through a tender process carried out under the supervision of a committee of experts.
The advantages of the nationalized system over the current privatized one are as follows: (a) More effective regulation and enforcement.
The pension contribution system is currently in the hands of private companies that manage the funds. In contrast, the state maintains responsibility for pension regulation and oversight, which includes ensuring that employers and workers contribute the required amounts to pensions as set by law. This separation of responsibilities makes it challenging for the state to regulate the contributions collected by private companies.
This problem would likely be solved if the state itself deducted pension contributions from the employees’ salaries, as it does for health insurance. Since such a payment system and records of life-time salaries are already in place for the National Insurance Institute (NII), inclusion of the pension contribution would simply entail an increase in the total sum deducted by the NII.
(b) Lower pension management fees.
In 2013, the Knesset Finance Committee decided to cap the fees charged by two types of pension funds (provident and insurance funds) as of January 2014, with fees permitted up to 1.05% of the total assets (i.e., the accrued savings plus return) and up to 4% of the contribution amount. This law was intended to benefit savers, because the previous law allowed a 2% fee on total assets.
It is generally assumed based on actuarial calculations that the average return stands at 4% per year. This implies that the law up until 2013 allowed pension companies to eat up 50% of the return in fees without carrying any risk, while the saver carried the risk and received the remainder.
Even with the new law beginning in 2014, calculations show that management fees are still 1% higher than returns in the first year. This means that the saver pays more in fees than he gains in profit, even before he begins to realize any return on his savings. In subsequent years, the results change as savings and returns accumulate so that in the second year, 50% of the return is lost to management fees, while in the fifth year, some 40% is lost. Even in the long term, nearly 30% of the return goes toward management fees.
Along with the need for complex calculations, there are a number of other disadvantages of management fees in private pension funds. Firstly, the current method of fee collection reduces social justice because it is regressive – that is, an individual’s bargaining power with regard to fees grows as his salary increases. Secondly, fees are transferred from the general public to the private hands of fund managers and owners, instead of to the state to serve the public at large. Thirdly, the current fees are inflated relative to acceptable levels elsewhere (e.g., in the US, fees rarely exceed 0.5% of total savings).
(c ) More generous pension benefits for savers. Private pension funds must remain balanced at all times (i.e., without actuarial deficit), since rumors of a deficit could cause large numbers of savers to withdraw their money and lead the fund to collapse. In contrast, there can be no mass exodus from a nationalized pension system, because there is no alternative.
A nationalized pension system in Israel could thus take advantage of this flexibility to provide more generous benefits than private pensions. Such benefits would be based on Israel’s high population growth rate (a rate of 1.5% per year that is expected to remain unchanged in the future).
This high growth rate in the labor force translates into growth in pension contributions.
A national pension system, which would not require actuarial balancing, can rely on the expected growth in contributions to provide current pensioners with a return that is at least 1% higher than the current 4% return on private pensions.
Recommendations for improving the pension system: Several key changes should include placing fund management in government hands while leaving the money itself in the private market, allocating a portion of the investment funds toward profitable public works, and making positive changes for current senior citizen beneficiaries.
In order to maintain the savings in the capital markets, a committee of experts should be established, charged with supervising the allocation of funds to private firms with investment expertise. The firms managing the pension funds would be chosen by tender. This process would disperse investments and limit the shock to pension companies and the capital markets that moving to a national pension system could create.
Today, workers who have already reached pension age are required to continue making pension contributions. In order to create a more fair pension system and address this nonsensical situation, it is recommended that senior citizens (over age 70) who continue to work should not be required to make pension contributions (as is already the policy for the National Insurance Institute system).
Finally it is worth mentioning that economic theory does not say that private firms are more efficient than public institutions.
Instead, economic theory says that competition leads to efficiency. However, the returns to scale in the capital markets mean the dominance of a few larger firms rather than the prevailing of competition, which thus leads to inefficiency.
Hence, there is a need for state intervention in the pension system.
The writer is a professor at the Hebrew University, the former Director of and Chief Statistician at the Israeli Central Bureau of Statistics, and performed this research at the Taub Center for Social Policy Studies in Israel.