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The first approach is for savers to choose the sum they wish to withhold from their monthly wage, thus accumulating, with interest, a sum of money that determines their level of retirement income. The second approach is for savers to choose a desired standard of living upon retirement, which determines the required level of monthly saving. The first method is termed "defined contributions;" the second is "defined entitlements." Both approaches require that the value of individuals’ savings and pension entitlements should be kept in constant equilibrium in order to avoid a deficit.

Most of Israel’s pension funds are owned by the Histadrut (the General Federation of Labor, a nationwide umbrella trade-union organization). These funds, which have large deficits, register approximately 700,000 members, whereas the non-Histadrut funds, which do not run deficits, have only about 30,000 members.1

According to actuarial calculations, the Histadrut funds face an actuarial deficit, i.e., the value of all the funds’ income and assets falls short of their future liabilities. Consequently, the funds will suffer a liquidity crisis at some future time and fail to meet their liabilities. The size of the deficit and the timing of the crisis depend on assumptions about interest rates, the influx and outflows of members, wage levels, and other factors. The higher the interest earned on bonds owned by the funds, the more valuable their total assets will become and, therefore, the lower their deficit. When the funds gain new members, they take in additional money, which reduces the likelihood of an imminent liquidity crisis.

According to the most stringent assumptions, the funds’ deficit is estimated at NIS 35.6 billion, 2 28 percent of their liabilities. (As of December 1993, US$1 = NIS 2.97.) Because the crisis is not likely to occur until 2013, there is still time to take corrective action. Although the pension funds are under government supervision, through the Insurance and Capital Market Division of the Ministry of Finance, the government has no legal obligation toward members of the Histadrut pension funds. But political realities are such that no Israeli government is likely to let the Histadrut pension funds default on their retirement payments.

Pension Arrangements in Israel and Abroad

Pension arrangements fall into three levels of coverage. The first aims to assure a minimum income upon retirement. The second is meant to ensure a retirement income similar to that earned before retirement. The third level is private savings for pension purposes; this accrual, unlike that in the second category, is not entitled to government benefits.

In Israel, the National Insurance Institute provides the first level of coverage. By law, any citizen of Israel is insured from the age of eighteen. Compulsory contributions are made, respectively, by both employees and employers at 4.9 percent and 1.93 percent of wages. Wage components such as car expenses, health benefits, and transportation allowances were exempted from social security payments in the past. As of 1995, the wage base for social security payments includes all fringe benefits. The maximum income liable to National Insurance contributions is four times the national average wage. The pension is calculated as a percentage of the national average wage, accrued on the basis of seniority to a maximum of 48 percent of the national average wage. Approximately 540,000 people, 9 percent of the population, receive old-age pensions and survivors’ benefits from National Insurance today. Outlays on these payments in 1995 came to $2.8 billion.

Israel’s program under National Insurance resembles schemes that provide the first level of coverage in other countries. Most countries give benefits for old age, survivors, and disability, and entitlements accrue with seniority in all schemes. Some programs, such as those of Israel and the Netherlands, award a fixed-sum pension; those of the United States and France link pensions to previous income. In New Zealand, all programs are funded with general income-tax revenue--there are no social-insurance contributions--and are based on current funding, in which today’s working citizens pay the pensions of retirees. Under this method, the pension is a function of the ratio of the number and income of working people and the number of pensioners.

Even in cases where the program deposits some of the revenues in a "sinking fund," such as the National Insurance Institute reserves in Israel and the Social Security trust fund in the United States, the sums involved are usually small relative to the actuarial liabilities of the programs. Because in both cases the "funds" serve to finance government spending, these "funds" cannot be considered savings.

Current funding is one of two ways to fund a pension. The other method is accrual funding, in which the pension fund invests savers’ money in assets that generate yields from which the pensions are paid. Under this system, the size of members’ pensions depends on the yield. The second method is preferred by most economists today.

The increase in life expectancy in the past half-century and the downtrend in population growth have lowered the ratio of working people to pensioners. This decrease in the dependency ratio, which is expected to continue, should be reflected in reduced pension entitlements. Unsurprisingly, many countries are reassessing their social programs in view of these demographic changes.

The demographic changes, however, are not the only reason for the reassessment of programs based on current funding. The pension system is a very convenient vehicle for government benefits that aggravate deficits, because it allows politicians to hand out benefits today and pay for them later. Evidence of this is the swift accrual of pension entitlements by senior employees in municipal authorities and the central government. In Israel, government ministers and judges accrue pension entitlements at the rate of 7 percent per year, members of the Knesset at 4 percent, and rank-and-file workers at only 2 percent.3

A conventional argument against the current-funding method is that it converts a smaller portion of savings into yield-generating investments, thus reducing the total output available to the economy in the future. This argument applies if we assume that the first generation receives its pension without saving anything. Theoretically, if the political considerations which favor that first generation were to be neutralized so that it would be forced to pay for its pensions, we would build a capital stock that continues to accrue income until the pension fund would begin paying its members. If the pension fund pays its members according to its rate of return--according to the ratio of the number of working persons and their income to the number of pensioners--the capital stock will grow commensurate with the rate of yield that it attains. In this case, the current-funding method has no substantial effect on capital inventory or future economic output. Even if both methods of funding were to theoretically yield the same return on savings, the accrual funding would still be preferable because it creates a base for private property rights not subject to government interference.

We shall examine Chile’s social-insurance reform in the light of this critique. Chile was one of the first countries to introduce social insurance, having done so in 1924. 4 The system in Chile, as in other countries, suffered from a government tendency to raise pension entitlements whenever cash flow was abundant. The increase in pension entitlements without a corresponding increase in contributions led to escalating government support, which, by 1975, accounted for 20.5 percent of all government expenditure. The reform was planned back in the 1970s under General Pinochet, but was not implemented until 1981, when the accrued budget surplus sufficed to begin narrowing the deficit of the old system. In the transition to the new system, the current-funding method was replaced by accrued funding and employees were required to deposit 10 percent of wages in a personal account kept with one of the funds that complied with government regulations. These funds invested the employees’ money in stock, commercial bonds, and government bonds.

Remittances to the fund and yields on investments were made tax-free. Employees were allowed to switch funds, meaning that the funds competed to earn high yields. Employees were also allowed to contribute another 10 percent of their post-tax wage to their account with the fund. Thus far, the privatization of social insurance in Chile has succeeded at both the micro and the macro levels. Since 1981, the Chilean pension funds have attained an average annual yield of 14 percent. In the past twenty years, the Chilean economy has gone from zero-percent savings to total accrual of $23 billion, approximately 41 percent of the gross national product.5

The main criticism of the reform in Chile concerns the pension funds’ high administrative expenses, which resemble those of American private pension funds 6 but exceed those of a government-operated fund. This criticism ignores the fact that the relevant measure is the total net return of the fund, not the percentage spent on administration. The difference between the levels of administrative expenditure is attributable to the private funds’ marketing outlays. In general, high administrative expenses may be the price to pay for a reform of the Chilean type, but government controlled pensions also have their price. Under a system of government controlled pensions, the economy’s savings are directed to the government rather than the capital market, and therefore the price of this system is a centralized market. A centralized market reflecting the decisions and expectations of a limited number of participants impinges upon the efficiency of the market. It reduces competitiveness and the possibility that the price of a company’s stock will reflect its true market value.

The success of the reform in Chile inspired similar reforms in other Latin American countries such as Argentina, Mexico, Peru, and Colombia. In Mexico, for example, one may choose between governmental and private insurance. In Europe, too, the United Kingdom and Italy have begun modifying their social-insurance programs. Parts of the Italian program have been privatized, and the terms of the British plan have been softened so that people may save more than in the past.7

Current funding is the method most often used in first-level coverage. Most programs at the second level are based on accrued funding. In this respect, Israel’s civil-service pension is an anomaly. This pension system has no sinking fund, and its pension outlays are funded by state outlays.

In 1995, the civil service pension system has total liabilities of NIS 120 billion. (US$1 = NIS 3.15 in August 1996.) According to the government's pronouncements, new civil-service employees will henceforth be referred to private pension plans that operate on an accrual basis.

The second level in Israel is covered by the Histadrut pension funds, private pension funds, and provident funds (including comprehensive pension plans). The number of members in provident funds is estimated at 200,000. A provident fund is a savings plan redeemed at one point in time, whereas a pension fund combines savings and insurance payments to create a monthly payment.

A typical feature of this second level is a government benefit in the form of a tax exemption. In Israel, the government provides a further benefit by assuring the funds a higher interest rate than the market rate. Government regulations require pension funds to invest at least 9 percent of their assets in non-negotiable government bonds which earn real (CPI-indexed) interest of 6.3 percent. The provident funds are "worse off" than the pension funds, because provident funds invest in earmarked government bonds that pay only 5.2 percent, indexed.

The government granted the pension funds superior terms in order to encourage citizens to join them. The reason for this, in turn, was its wish to keep the pension funds from collapsing. Because the pension funds have given their members pension entitlements that exceed their savings, they are constantly in need of new members in order to fill the gap.

The only way an Israeli citizen can qualify for government benefits is by joining a pension or provident fund. In the United States, savers have had an additional option since 1974: the possibility of managing their own tax-exempt pension savings by depositing money in an Individual Retirement Account (IRA). Such an account, in the saver’s name, is meant for employees who have no other pension plan. A contribution of up to $2,000 per year may be made to this account. (There are also joint employer-employee plans, such as the 401(k), in which the employer contributes fifty cents for every dollar contributed by the employee, up to 6 percent of wages.)

If money is drawn from the account before age 59.5, a ten-percent fine is imposed. After age 70.5, savers must withdraw their money and pay any taxes due. In the United States, the tax benefit is that the interest earnings compound on a tax-deferred basis, until they are withdrawn at retirement. In Israel, individuals are exempt from taxes on interest, and therefore the tax benefit results because people have a lower marginal tax rate upon retirement than during their working years. Savers may manage their accounts through portfolio managers, provident funds, trust funds, or by themselves.

The great advantage of this method is the full control that it gives savers in the management of their savings. If Israel were to introduce such a system, competition in long-term savings would be stimulated. It would also solve another problem: In Israel, the large banks own provident and mutual funds and have a large stake in some of the country's largest business enterprises (e.g., Koor and Clal). This creates a conflict of interest for the mutual and provident funds. Activation of an IRA system would mitigate this problem.

The availability of third-level coverage depends on the outcome of the public debate on the tax base. A transition to a consumption-tax base would eliminate today’s discrimination among types of savings and thereby make the "third level" definition meaningless.

Source of Israel’s Pension-Fund Deficit

Pension contributions in Israel are inadequate for several reasons:

1. Historically, Israel is a country of immigrants. Over the years, immigrants who reached Israel at a relatively advanced age have been given pension entitlements in excess of the level that their contributions would warrant. The Histadrut pension funds were founded in 1950-1954, a time of mass immigration of elderly Jews from Eastern European countries. The Histadrut, regarding itself as part of the state leadership and vice-versa, chose to bestow superior pension terms on these members.

   The political echelon of the Histadrut sometimes took these decisions against the staunch objections of its own pension professionals. (Of particular note in this context is the resignation of Histadrut actuary Yitzhak Blass in 1978, after the Histadrut Social Security Center and Coordinating Committee decided to give a special grant to persons who retired after more than 35 years on the job.) In one such decision at that time, (in the early 1950s) anyone who joined the Mivtahim pension fund at age 55 was assured a 40 percent pension at age 65.8 Naturally, granting such high pension percentages created an actuarial loss for the fund. For ten years, Mivtahim received 16 percent of employees’ wages and paid out 40 percent of their wages for 14.3 years (the average life expectancy of a man at age 65).

2. In the past, the pension funds were mismanaged. Fund managers placed much of their discretionary assets in Histadrut-owned companies. In 1970-1983, the money was invested in nonindexed bonds of Hevrat Ha’ovdim (an Histadrut holding company) at interest rates substantially lower than inflation, thereby subsidizing the Histadrut industrial empire. The value of the bonds at redemption was negligible in comparison with actual outlays. The State Comptroller remarked that no reasonable person would have made such an investment. But Histadrut was governed by political, not economic, considerations. The size of the investment was estimated at approximately $60 million 9 and the size of the loss at approximately $127 million in January 1996 prices.10

   Further evidence of inefficient management of the pension funds is bloated administrative expenses, which, in certain cases in the past, verged on 15 percent of current contributions.11 For the purpose of comparison, pension funds today are not allowed to charge more than 8 percent of current revenue in management fees.

   Another indicator of the funds’ mismanagement is conflict of interests on the part of the funds’ board members. For example, members of the secretariat of the Farm Workers’ Union sit on the board of their workers' pension fund. A similar situation pertains at the construction workers’ fund. Until a short time ago, the secretary-general of the White Collar Union served as board chairman of the 80,000-member Makefet pension fund.12 These conflicts of interest made it easy for works committees and trade unions to demand preferential retirement terms or to delay forwarding employees’ withheld contributions to the pension funds.

3. Fund rules encouraged deficits. The pension funds’ regulations, which spell out savers’ entitlements and stipulate their contributions, are the main cause of the deficit. Contributions are set at a percentage of wages and are termed "pension fees." Because no individual may receive more than the value of his savings in an accrual-type pension plan, the fund regulations should stipulate that members’ entitlements are equal to the sum accrued.

   In a fund that operates on the basis of economic considerations, the size of the member's benefit is a function of the amount of savings accrued, life expectancy, and interest rate. Savers receive an annual pension in such a manner that if their life expectancy approximates the average for the population, the flow of pension money paid out will be equal to the sum saved. In practice, however, the funds entitle savers to a pension set at a certain proportion of the determining wage. By defining pension entitlements in this fashion, the funds effectively destroy the correlation between members’ savings and pension entitlements, thereby allowing a deficit to form.

   Because pension entitlements are a function of seniority, savers are entitled to a certain percentage of their determining wage for each year of membership. Savers must belong to a pension fund for at least ten years, for which they are entitled to 35 percent of the determining wage. For every additional year of membership, they accrue another 2 percent of the determining wage, to a maximum of 70 percent.

   Pension at Retirement Age, Central Pension Fund 13

   Years of membership determining wage	Pension entitlement as percent of
   10	35
   11	37
   12	39
   13	41
   14	43
   15	45
   16	47
   17	49
   18	51
   19	53
   20	55
   21	56
   22	57
   23	58
   24	59
   25	60
   26	61
   27	62
   28	63
   29	65.52
   30	67.50
   31	69.75
   32	70

   By manipulating the definition of pension entitlement as a percentage of the determining wage, the pension funds have been able to award financial bonuses. For example, instead of saying that John Doe received a gift of NIS 10,000, one could say that he received a 4 percent entitlement of the determining wage for each year of membership. The way the determining wage is set may also be used to provide certain members with entitlements in excess of those they are due.

   The determining wage is defined in two ways. The first definition is the last wage earned. If this definition is used, employees who receive a large wage increase near the end of their working life automatically obtain larger pension entitlements, but the effect of the raise on their contributions is negligible because of the short time remaining until retirement. This expansion of entitlements without a corresponding increase in contributions results in a deficit. The second definition uses an averaging method, in which the member's annual wage is multiplied by the percent increase in the national average wage for that year until the year of retirement. This multiplication process generates a series of figures, the average of which is the determining wage.

   Calculation of Pension Entitlements by the Averaging Method 14

   
   Si -- Wage during period i
   A65 -- Average national wage in year of retirement S (0.02Si*A65)/Ai
   Ai--Average national wage in year of retirement.

   This method, too, inevitably leads to a deficit. The entitlements are a percentage of the determining wage, which is computed only when the member retires. Therefore, the fund is committed to an unknown sum. However, this method is less conducive to deficits than the "last-wage" method. Most of the deficit is caused not by the way the determining wage is computed but by the way pension entitlements are accrued.

   Pension entitlements expand in a linear fashion, an increment of 2 percent of the determining wage for each year of membership. The accrual of contributions, however, does not increase linearly, because earlier contributions account for a larger percentage of the accrued contribution. This creates an incentive to join a pension fund at a later age, because the contributions avoided in one’s early years are larger than the value of the entitlements lost, and late-joining members thus pay less for the entitlements they obtain.

   This creates a deficit. The deficit is covered with some of the pension contributions. The fact that some contributions are used to cover the pension funds’ liabilities rather than to purchase bonds causes the deficit to mount swiftly.

   Any discussion of pension-fund reform has to recommend amendment of the regulations in order to prevent the formation of further deficits in the future. The pension funds’ regulations create not only deficits but a disincentive to save, because money contributed at age 64 purchases the same entitlements as money allocated at age 25, even though money contributed at age 25 is worth much more at age 65 than money contributed at age 64 because it has so many more years to earn interest. The effect of this regulation is to instruct citizens not to begin saving before age 30 under any circumstances!

   Practically speaking, anyone who joins a pension fund before the age of 33 subsidizes those who join later on.15 Contrary to appearances, this is not a case of the young supporting the elderly, but those joining the pension fund at an early age supporting their contemporaries who join later on.

   Pension Funds and Methods of Calculating Determining Wage 16

   Fund	Method of Determining wage
   Makefet	Averaging
   Nativ	Last three years
   Construction Workers	Last three years
   Egged	Last wage
   Dan	Last wage
   Hadassah	Last wage
   Gilead	Averaging
   Central Pension Fund	Averaging
   Mivtahim	Averaging/last three years

   Changing the Regulations

   To avoid deficits in the future, the pension funds’ regulations should be changed to stipulate the linkage between members' contributions and entitlements. When the individual level is in actuarial balance, deficits cannot arise and there is no need to check every person who joins the fund. The meaning of actuarial balance on the individual level is that members have personal savings accounts that they may keep with the pension fund or switch to any other fund as they wish. This mobility is essential in ensuring competitiveness in the pension industry.

   In the absence of actuarial balance at the individual level, it is necessary to examine how new members affect the fund’s balance. Because this examination is not always carried out, the funds accept new members who tend to aggravate their deficits for reasons of cash flow (i.e., shortage of cash). The great advantage of a changeover to personal actuarial balance is that the individual’s entitlements in such a fund depend on his contributions; therefore, the younger the member, the greater the return on his savings, which means "more benefits for the buck." When greater entitlements are granted for savings begun at an early age, young adults are given an incentive to save. Thus, without applying coercion, the country would acquire a broader savings base.

   Part II

   
   

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