(Reprinted from HKCER Letters, Vol. 26, March-July 1994)
The Arithmetic of Old Age Pension
Is It Good Investment?
Since the Government released details of the proposed Old Age Pension Scheme (OPS) in July, discussions have focused on the possible social and economic effects of the scheme and on alternative financial arrangements. Many observers have rightly pointed out that the scheme amounts to a social welfare program rather than a pension system. To an average worker, however, the question of the most immediate concern is still: How attractive is the OPS as a pension investment?
Newspapers have published calculations which show that total pension payouts exceed total contributions for all but those earning more than 50,000 dollars per month. Such calculations are simply wrong. They are based on three erroneous assumptions: (1) there is no wage growth; (2) employers do not pass the burden of the tax to employees; and (3) future benefits are as valuable as present benefits. To correctly evaluate the pension scheme as an investment, economists use the concept of the internal rate of return. The calculation of internal rates of return requires nothing more sophisticated than a spreadsheet, and the interested reader can do some home computations on his own.
As an illustration, consider a worker who earns $11,869 per month in 1994 (the average monthly earnings in Hong Kong). I use the government's figures which project a real wage growth of 4.33 percent in 1995, decreasing gradually to 2.0 percent in 2011, and remaining at 2.0 percent thereafter. While employers' contributions may not be immediately passed on to their workers, employees will ultimately have to pay in the form of reduced wage growth or reduced benefits. The worker is assumed to start paying 3 percent of his earnings at age 20 and to collect a benefit of $2,300 per month for 15 years after retirement at age 65. With these assumptions, the implied rate of return is found to be 0.5 percent. This return probably beats investing money in a passbook account, but nothing else. In Hong Kong, a major part of personal savings are invested in children's education and in housing. The rate of return from investment in education has been estimated to be around 10 percent, while historically investment in housing yielded a real return of over 15 percent. It is difficult to find a private pension plan that gives a return as low as 0.5 percent.
Table 1 shows the internal rates of return from the OPS for workers with different monthly earnings. For example, the median monthly earnings in Hong Kong is about $8,000 in 1994. Thus, half of the workers in Hong Kong will get a return better than 1.9 percent, and the other half will get a return worse than 1.9 percent. For people earning more than $15,000 a month, the rate of return is negative. These estimated rates of return can be made more precise by incorporating more realistic age-earnings profiles and age-specific mortality rates, but the adjustments are quite small.
Rates of Return from the Old Age Pension Scheme
Monthly earnings in 1994 Internal rate of return
$5,000 +3.5% $8,000 +1.9% $10,000 +1.1% $15,000 -0.4% $20,000 -1.6%
One should also bear in mind that the proposed scheme is an extremely illiquid form of investment. People are virtually locked into the system for their entire working life. There is no way to withdraw or to claim any benefits before retirement age. In a period of economic and political uncertainties surrounding the change of sovereignty, the lack of liquidity makes the OPS even more unattractive than its meager rate of return suggests.
Another way of evaluating the proposed pension scheme is to see if you can do it better than the government. Suppose you start saving 3 percent of your earnings every month starting at age 20. Can you count on getting $2,300 a month from your accumulated savings when you retire at 65? Among other things, the answer will depend on the real rate of return from your investments and on your life expectancy. In Hong Kong, the life expectancy for men is 75 years, and for women it is 80 years. For simplicity's sake, assume your life expectancy to be 80 years so that you will draw on the pension for 15 years. The real rate of return from investments varies, but a benchmark figure commonly used by economists is 4 percent. Conservative investments such as contracts offered by life insurance companies usually yield a return of near 2 percent. On the other hand, one can easily get a return of above 10 percent from investment in housing and in children's education. Table 2 shows the size of the monthly pension a worker can expect to get if he invests on his own. The calculations are based on the projected wage growth contained in the government's consultancy report. The median worker in Hong Kong, who earns $8,000 a month, will do much better by investing on his own than by participating in the government's pension plan. At an interest rate of 4 percent, even a worker making $5,000 a month will gain more from his private pension than from the proposed pension.
Monthly Benefits from Do-It-Yourself Pension
Monthly income in 1994 Return from pension investments $5,000 $8,000 $10,000
2% $1,480 $2,370 $2,960 3% $1,980 $3,170 $3,960 4% $2,680 $4,290 $5,360 5% $3,660 $5,860 $7,320 6% $5,050 $8,080 $10,100
To be sure, investing in a do-it-yourself pension requires foresight and discipline. But a lot of Hong Kong people are doing it. The savings rate in Hong Kong is around 28 percent---lower than in Singapore, but higher than most other countries. Many young people are saving as much as they can for the down payment of a flat or for the mortgage. To most people in Hong Kong, the security of owning a home is more important than the security offered by a pension of $2,300 a month. Housing prices and mortgage restrictions have already denied or delayed homeownership to a large segment of the population. Forced saving into an unremunerative pension plan would only make things more difficult for aspiring homeowners.
The Tough Arithmetic of Social Security
The poor return from the OPS may seem surprising, but it is part of the tough reality of any social security system. To tie benefits to wage growth rather than to inflation, for example, would raise the amount of pension payments. However, doing so also necessitates raising contributions, and the final rate of return would not be much altered. Similarly, to increase the government's contributions will require raising taxes. The truth of the matter is, a pay-as-you-go system only redistributes wealth. It involves no investments and hence cannot create wealth (except for the 1,660 professionals to be hired by the OPS administration). To the extent that private savings are channelled away from productive investments to this unproductive redistribution system, society will be made worse off.
Relying entirely on private savings, however, is not a practical solution. Although the majority of the population still prepare for their retirement with foresight and diligence, there will always be some less fortunate individuals who fail to save enough for the future. A live-and-let-live attitude is becoming increasingly untenable as society becomes more affluent. What then is to be done to cope with the problem?
One alternative that has been ignored is the original compulsory pension scheme as outlined in the government's consultation paper on "A Community-wide Retirement Protection System" in October 1992. For reasons still not made known to the public, the government took a 180 degree turn from its original proposal of a contributory pension system to the current proposal of a pay-as-you-go welfare system. Companies which already have a pension scheme in place would not be affected by a compulsory pension system, whereas everybody would have to participate in the OPS. Therefore the current proposal is certainly no less compulsory than a compulsory pension system. Moreover, as former Chief Economist of the World Bank Lawrence Summers points out, compulsory pension contributions are less inefficient than a social security tax, although they are often viewed as equivalent. Under a social security system, benefits are not tied to contributions. Social security contributions therefore represent a pure tax on employment and will discourage work. Under a compulsory pension system, on the other hand, workers who contribute more also expect to receive more in the future. Thus compulsory contributions will have a much smaller work disincentive effect.
Perhaps more importantly, money in compulsory pension systems can be used to finance real investments. Money in a pay-as-you-go system is, however, immediately redistributed to the elderly population. Without real investments to create wealth, it will be rather difficult for a redistributive program to break the tough arithmetic of poor returns.
Dr. Wing Suen is a lecturer in the School of Economics and Finance at the The University of Hong Kong.