Public Discussion of the Pension-Fund Crisis
The public has been discussing the pension-fund crisis for a decade. The subject surfaced on the agenda mainly at the government’s initiative. Over the years, the prevalent attitude was that, in order to save the pension funds from collapse, there was no alternative but to reduce the members’ entitlements. Although the government has no legal obligation to the funds, government decisions affect the size of the actuarial deficit of the funds. The funds are monitored by the Insurance and Capital-Market Division of the Ministry of Finance. The Division could and should have ordered the pension funds to take action to reduce their deficits. For political reasons, the order was never given: No government was willing to confront an electorate of half a million people and their families.
The government can also affect the size of the deficit by adjusting the interest rate on its earmarked bonds. To raise the interest rate on these bonds, however, would have clashed with the intention of reducing government intervention in the capital market. This intent, a consequence of the 1985 Economic Stabilization Plan, led to a decline in the real interest rate on earmarked bonds from 6.3 percent to 5.7 percent for pension funds, and from 5.2 percent to 4 percent for provident funds. For these reasons, the government confined its response to the formation of committees to examine the condition of the funds.
An interdivisional Finance Ministry team under Micha Winter released its report in early 1986. The report was meant to help formulate the Finance Ministry's proposal on pension insurance. The committee examined the burden to the economy caused by pensions irrespective of the pension funds’ deficits. According to the report, the cost of pension insurance may climb to 18 percent of national income or 26 percent of the wage base. The committee urged the government to reduce pension entitlements retroactively by raising women's retirement age, creating an entitlement scale that diminishes with age, and reducing current members' entitlements. The recommendations in the report were never applied.
In 1986, in the spirit of the Winter report, the government rejected a Histadrut demand to raise contributions from 16 percent to 17.5 percent. On January 1, 1987, as a result of Histadrut pressure, the government reversed this decision and approved an increase in contributions to 17.5 percent. (Employees may contribute 17.5 percent from whatever portion of the salary they choose, in which case that will constitute the wage base for calculating the pension.) This inconsistency has been recurrent.
Eleven of the 14 funds were given an increase of half a percent on 20-year bonds as compensation for previous reductions in the interest rate on these bonds.18 In September 1986, the government decided to limit the proportion of earmarked bonds that the funds might hold to 68 percent. In January 1988, the Income Tax Ordinance was amended to empower the state to require the pension funds to keep at least 93 percent of their assets in (non-negotiable) earmarked bonds.
Under a government resolution of September 8, 1992, another committee was set up, this time headed by Finance Ministry Director-General Aharon Fogel. In its report, released in June 1994, the committee presented its recommendations on two subjects: overall policy and a solution to the pension funds’ actuarial deficit. The committee limited its recommendations to ten years.
The committee recommended leaving the first level of pension coverage, that provided by National Insurance, unchanged. As for the second level, the committee recommended the following principal reforms:
To contend with the pension funds’ actuarial deficit, the committee recommended increasing the contributions from 17.5 to 21 percent of wages. Another recommendation was to base the pension on a 2 percent annual increase in the national average wage, rather than the actual increase. The committee also recommended NIS 4.4 billion in special assistance for the weaker funds and the possibility of NIS 1.8 billion in additional assistance to the Dan and Egged funds (the public bus companies). According to the committee, these measures would reduce the deficit by NIS 20 billion.
Significance of the Fogel Commission’s Proposed Reforms
The Fogel Commission report contended with the deficit-conducive regulations by redefining the way entitlements are accrued and stipulating higher pension contributions. However, it did not establish the required connection between individuals’ contributions and entitlements. The report makes no attempt to assure a pension as a fixed proportion of wage--an attempt which, according to many, has failed.
To understand how difficult it is to award such a pension, we need to recall the origins of the pension funds. When they were founded forty years ago, a man who retired at age 65 had an average life expectancy of seven years. Today, he may expect to live an additional 14.3 years. Life expectancy, however, is only one of many parameters that affects a pension fund’s ability to guarantee, for given contributions, a pension at a fixed rate. Because the probability of no long-term change in these parameters is virtually zero, a pension fund that wishes to maintain actuarial balance must, over the years, modify either the rate of contributions or the rate of entitlement.
According to the Fogel report, the connection between contribution and entitlements exists under certain assumptions. In an actuarially balanced pension fund, in contrast, the relationship between contribution and entitlements exists by definition: entitlements can never exceed the value of the contributions and the yield they generate. The report recommended a change in the way in which the determining wage is set.
Instead of multiplying each wage by the increase in the average national wage from year one of contributions to the year of retirement, the fund should assume an annual increase of 2 percent. This would neutralize the built-in uncertainty of the averaging method with respect to the level of the determining wage. This uncertainty contributes significantly to the pension funds’ deficits, because when the determining wage is unknown, the entitlements are also unknown. When a fund cannot possibly compute the entitlements it has assured, the probability of its keeping entitlements and contributions in balance is virtually impossible.
Although the Fogel Report does not favor a mandatory pension, it does aspire to preserve a fixed level of entitlements by denying the individual the right to choose the rate of pension contributions. The report recommended raising the share of wages for remittance to the fund to 21 percent, in order to create actuarial balance between contributions and entitlements, assuming an interest rate of 4 percent. The contributions would remain dual-participatory, made by employees and employers.
The increase in contribution rate would apply to both sides, the employee's share rising from 5.5 percent to 6 percent and the employer's share from 12 percent to 12.7 percent, plus the transfer of severance-pay contributions (2.3 percent) to the pension funds. This would be detrimental to the current Severance Payment Law, for employees would receive less severance pay under the new regime. It would be better to leave the rate of contributions unchanged, even though this would mean lower pension rates. Those who wish to expand their pension entitlements should set aside a higher proportion of their wages.
In March 1995, the government decided to adopt a new pension arrangement. The government arrangement effectively adopts three principles of the Fogel report: reduction of the subsidized interest rate, limiting the rate of pension-applicable wage increases, and modifying the scale of entitlement accrual. The arrangement does not apply these recommendations in full.
According to the new plan, the following rules will apply to new members of pension funds:
With respect to the existing pension funds, the following decisions were made:
The government’s scheme has many opponents. Ora Namir, former minister of labor and social affairs, has demanded the legislation of a state pension law, arguing that a situation in which 500,000 people have no pension insurance is intolerable. Another supporter of a state pension law is Professor Avia Spivak, dean of the social sciences faculty at Ben-Gurion University of the Negev. According to him, such a law is needed to ensure a broader savings base. A joint study by Spivak and Professor Ya’akov Lavie of the Bank of Israel Research Department found that the introduction of a compulsory pension system would raise the savings rate by 0.7-1.5 percent of GDP. Raising the savings rate is a desirable goal, without which, in the long run, the rate of investments cannot be increased. While a compulsory national pension system would apparently raise the savings rate, the danger is that the government will use the additional savings to increase government debt and not investment.
Other opponents of the arrangement, including the Bank of Israel, argue that the type and extent of the subsidy will adversely affect the capital market, retard economic growth, and impose a heavy burden on taxpayers. The most extensive protest concerned the injustice of the settlement. Why should 850,000 of Israel's 1,350,000 working people subsidize the other 500,000? If this is an injustice, how much more unjust is the plan’s principle of transfers between people with similar income levels and assets?
Implications of the Government Pension Arrangement
Before examining the government arrangement, we should explore its legal status. The arrangement was adopted in a decision of the government without any legislative amendments or discussions in the Knesset Finance Committee. The question of legal status will be answered when the High Court of Justice issues a decision on the matter. In September 1995, the High Court served the government with an order nisi instructing it to explain why it would not issue earmarked bonds to provident funds, too. In another petition to the High Court yet to be heard, private individuals are asking the state to show why the pension arrangement should not be revoked. The petitioners are seeking the appointment of a state commission of inquiry to probe the actuarial deficits of the Histadrut pension funds.19
The government pension settlement should be examined in view of its impact on individuals and the economy. From the point of view of the economy, we shall examine the effects of expanding the subsidy and modifying its method. From an individual’s point of view, we shall examine how the arrangement will affect their pensions and competition in the pension industry.
Effects of the Arrangement on the Economy
The government’s support of pension funds by means of bonds is paid for by the taxpayer. Subsidies for current members of the Histadrut pension funds cost the government NIS 1 billion per year. The future subsidization of current members 20 --not taking into account the cost of subsidizing members of new pension funds and new members of the Histadrut funds--will cost taxpayers NIS 3 billion per year. The size of the giveaway in the earmarked bonds is a function of the interest rate. If we assume a sustained real market interest rate over the lifetime of current fund members (most of whom will have retired by 2015) in the vicinity of 3.3 percent, the value of the taxpayers’ subsidy is NIS 60 billion. If the market interest rate is sustained over time at 2.5 percent, then the value of the subsidy for current members, over time, will be NIS 135 billion!21
According to Zvi Lieber, a member of the Fogel Committee, the total cost of the government arrangement may climb, over time, to NIS 250 billion: NIS 100 billion in subsidies for current members over the course of their membership and NIS 150 billion for new members throughout their term of savings in the pension funds.22 By implication, the government's undertaking will double Israel's national debt. Current public expenditure on pensions, even before the government arrangement goes into effect, is about 10 percent of GDP.
The government that chose this arrangement has no intention of covering the pension funds' deficit from its own budget. From its point of view, the contributions of members of new funds will cover the pension liabilities of the old funds, thus "recycling" the deficit. In the future, when the population stops growing and ages to an extent that new members' contributions will no longer suffice to cover the deficit, the future government will have to keep the current government's promise. Because social expenditure rises commensurately with aging of the population, the government that will have to pay the debt will be the government least able to do so. In this respect, the current government's decision is a definition of irresponsible government.
If the government wishes to subsidize pension-fund members and cover the funds' deficit, it should follow the example of the government of Chile, which reduced spending and used the savings to eliminate the deficit of its social-insurance system. By saving in order to support the pension funds the government would be able to subsidize savers directly. Direct government support of savers would prevent a chasm from opening between the pension funds and the capital market. When the support is given to the funds by means of non-tradeable, guaranteed interest government bonds, the pension funds are no longer relevant as players in the capital market. If the pension funds were active in the capital market, they would provide a counterbalance to the dominance of the banks. The effect of locking the pension funds out of the capital market will deprive the market not only of a "player" but also of much of its magnitude, because vast sums of money will be channeled to pension funds instead of the capital market.
The shrinkage of the capital market will aggravate the problems that beset this market today. In due course, the proponents of the government subsidy will cite the deterioration of the capital market as proof that the funds should not have been referred to this market. Some argue that the diversion of pension money to the capital market will inflate the market artificially and lead to its future collapse. There is a perverse truth in this since the government does not allow citizens to invest in capital markets overseas. If restraints on capital flows are eliminated, there will be no reason to fear an artificial inflation of the market.
Even though subsidization by means of earmarked bonds is economically inefficient, a different political decision cannot be expected. Hardly any politician in Israel would wish to confront half a million people and reduce the entitlements of pension-fund members. Similarly, however, almost no politician would wish to tax the public heavily or reduce public expenditure in order to finance the pension-fund members. The way politicians may resolve such a conflict is by issuing bonds that bear higher interest than the market offers. The government thus attracts new members to the pension funds. In this fashion, the deficit in the Histadrut pension funds may be covered with the contributions of members of new funds. In this case, the deficit is not eliminated but rather postponed to some future date.
Effects of the Arrangement on the Saver
A saver's pension entitlements depend on two parameters: the determining wage and the percent of this wage paid out as a pension. The determining wage depends on the rate of increase of the national average wage. In the last 13 years, the national average wage has risen by an annual average of about 3 percent. The recent arrangement stipulates a rate of increase of 1.75 percent instead of the actual rate of increase. If future wages rise at an average pace of 2.5 percent per year, the government's recent decision will result in a lower determining wage and lower pension entitlements. For example, a 50-year-old pension-fund member would have a determining wage 6 percent lower than that warranted by the actual increase in the national average wage. This decision was actuarially warranted but came about in the context of struggle with organized labor--a struggle that illustrates the danger of mixing pension funds with politics. A measure that should have been taken automatically (because no one should receive more than the value of his her savings) turned into a political struggle.
An equitable pension plan should give all members proprietary rights in their personal fund, thus empowering them to manage their assets through whomever they choose. The state has an interest in assuring that people save for retirement, but this is no reason to force them to belong to a certain fund. Aware that it is thwarting competition in the pension industry, the government has limited management fees to 8 percent of contributions. Thus, the first government interference brings in its wake more government interference!
A fund that invests its 30 percent of discretionary assets (those not invested in the purchase of earmarked bonds) in ordinary government bonds will be assured a minimum 3 percent yield on this investment. Under such conditions, it is reasonable to assume that no fund will invest its members’ money in shares or other instruments up to the permitted limits. If all the members’ money is deposited with the government, why is an 8 percent management fee necessary? Why should a third party profit from the "benefit" that the government is handing out to its citizens? If the government’s true concern were the citizens’ well-being, it could guarantee a 4.4 percent yield 23 on every shekel that savers voluntarily deposit with National Insurance. By administering pension funds through members’ personal accounts with National Insurance, it would be possible to slash management expenses drastically, thus facilitating a larger pension or smaller contributions for a given pension.
The government arrangement allows the old funds to continue granting pensions as a percentage of the determining wage. Since there is no justification for bestowing an additional gift upon people who are already being subsidized, there is good reason to revoke the determining-wage method in the old funds, as in the new funds, and instead to derive pension entitlements from the value of members’ savings.
Summing up, the great advantage of the government arrangement is the way in which it was adopted, i.e., as a government decision without any accompanying legislation. This makes the situation reversible, at least from the legal point of view.
Basic Contours of a Pension-Fund Arrangement
In handling the pension-fund crisis, the following questions should be answered: What should be done in order to avoid further deficits in the future? How should the government intervene in the current crisis? Since the pension funds benefit from tax relief and subsidized bonds irrespective of their deficits, should these benefits be given at all?
What should be done in order to avoid further deficits in the future?
To ensure that pension entitlements will not be allowed to exceed pension contributions in the future, the regulations of each pension fund should define each member’s entitlement as equal to his contribution. The government’s pension arrangement indeed stipulates this kind of actuarial balance for new members.
How should the government intervene in the current crisis?
In eliminating past deficits, it is worth noting that a substantial percentage of pension-fund members earn above the national average wage, and quite a few own property (a dwelling) worth hundreds of thousands of dollars.24 Notwithstanding this, they have benefited from subsidized bonds for all these years. There is no reason why, in addition to this benefit, all citizens--particularly younger ones who own no property as yet--should finance the deficits of the Histadrut pension funds. Because the deficit constitutes 28 percent of guaranteed pension entitlements, the effect of such a policy would be to reduce members’ entitlements by this rate.
One argument against doing this is that it would prevent pension-fund members from aging with dignity. Dignity is a subjective concept that can be interpreted in many ways: as a function of standard of living, or as a function of maintaining values. Under the latter definition, financing a high standard of living at the expense of the entire population does not enhance dignity. One may argue, on the other hand, that what is being financed here is not a high standard of living but a minimum income. A minimum income is also a subjective concept, but in this case there is a law that defines minimum income. According to the Income Maintenance Law, an individual’s minimum income is 25 percent of the national average wage.25 Income maintenance is the province of National Insurance. Those who believe that National Insurance is failing to achieve this aim should attempt to amend the National Insurance Law instead of granting a benefit to a specific group.
Although the government has no legal obligation to the pension funds, the funds are monitored by the Capital Market Division of the Finance Ministry. Pension-fund members may argue that they had relied on the government’s supervision and that the government should compensate them on this account. On the basis of this argument--without delving into the legal aspects--the government may be presented with several demands. A pension-fund member may argue that, as a result of government supervision, the government should meet all commitments made by the pension funds.
Government supervision is meant to prevent squandering of the saver’s money. Therefore, the presence of such supervision cannot be invoked as justification for government funding of assurances that a third party made and cannot honor.
Another possible demand is for the government to assure that pension-fund members receive the value of the opportunity cost of their savings. In such a case, the real interest rate in the market has to be verified. The rate of return that pension-fund members would receive according to this approach would be equal to this interest rate. One may argue that government supervision does not absolve the pension-fund member of liability. Therefore, the government should ensure that pension-fund members receive the value of their savings in the best case, and not even this in the worst case.
If we assume a constant real interest rate of 3 percent, the pension entitlements derived from this interest rate would be 45 percent smaller than the insured pension entitlements.26 Thus, if we reduce the entitlement by 45 percent, pension fund members would still enjoy a real interest rate of 3 percent. Because it is necessary to reduce pension entitlements by only 28 percent in order to bring the funds into balance, one may say that all pension-fund members would in any case receive a real return of at least 3 percent on their savings. Under such circumstances, additional government funding is not needed. For the sake of comparison, in the United States, which has a more powerful economy than Israel's, pension funds have achieved a real annual yield of 1.5 percent over the past two decades.27
Should pension funds be given benefits at all?
In the past, subsidized bonds were used as a way to grant benefits to certain groups. Today, when it is possible to establish private pension funds, the main argument in favor of continued subsidization of the old funds is that such a subsidy increases total saving. Although this argument is valid in the intermediate term, when the government pays subsidized interest in the long term, government expenditure will rise and savings will decrease. The only way to ensure a long-term increase in savings through the use of subsidized bonds is by reducing future government expenditure. If the government wishes to encourage savings, it should slash its expenditure now instead of selling citizens a promise to do so in the future.
As for tax benefits, in order to encourage and promote savings fairly and efficiently, a transition to a consumption-tax base is recommended. Under a consumption-tax base, all savings are tax-free. This approach would do away with today’s discrimination among different types of savings. By eliminating this discrimination, individuals may choose their own savings rates instead of having to contribute, forcibly, 17.5 percent of their wages in order to benefit from a tax deferral.
Today, the subsidy applies to all levels of pension. At each level, a subsidy is given to a different cross-section of the population. At the first level, that assured by National Insurance, the disadvantaged are subsidized by the more affluent. At the second level, that of pension and provident funds, the more affluent are subsidized by earmarked bonds. As stated, this subsidy effectively destroys the capital market.
Irrespective of income distribution, abolition of the subsidy should be considered at all pension levels. Government support for the income-redistribution purposes can be done directly and overtly, if it should be done at all.
Yishai Ashlag is a Koret Fellow in the Institute for Advanced Strategic and Political Studies in Jerusalem and Washington, D.C. He has served as an Institute Economics Intern in the Knesset for two years and in House Majority Leader Dick Armey’s office in Washington, D.C. in May 1995.
IASPS Policy Studies are published by the Institute for Advanced Strategic and Political Studies, Jerusalem and Washington, D.C. Nothing written here is to be taken as necessarily representing the views of IASPS or as an attempt to aid or hinder legislation in Israel or the U.S.
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