Guest Article

Extending Private Pension Coverage in a Middle Income Country: The Case of Brazil

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John A. Turner
Public Policy Institute
AARP

November 1, 2000

Though social security reform debates have captured more attention, many countries are also considering changes to strengthen their voluntary private pension systems. Important reasons occur for doing so. By providing an alternative source of retirement income, private pension systems reduce the need for government spending for the elderly. Funded private pensions may aid in the development of capital markets. They create a demand for financial assets as well as for financial market regulations that protect investors. They provide a source of long term savings for investors. Private pensions provide greater flexibility than do social security programs because private pension plans can have features that address the particular needs of small groups of workers.

Government policy can play an important role in the development of pensions. This article examines policies that governments in middle income countries could adopt to increase the number of workers covered by voluntary private pensions.

While the policies discussed are generally applicable for middle income countries, the economic and legal environment for pensions differs in different countries, and the article focuses in particular on the situation in Brazil, but with lessons drawn from the experience of other countries. In Brazil in the year 2000, the coverage rate of private sector employees was less than 10 percent. Pensions in Brazil are categorized as either closed pensions, which are provided by a single employer, or open pensions, which are provided by a pension service provider and are open to any employer or individual. The two types of pensions are subject to different government restrictions.

The article discusses three types of government policy that can be used to encourage voluntary private pension coverage in middle income countries. First, it discusses major policies that can provide a favorable economic and legal environment for private pensions. These policies are essential for the development of a strong private pension system Second, given the environment provided by the first policies, the article discusses a set of policies that can be used to encourage the development of private pensions. Third, the article discusses policies that address criticisms or weakness of private pension systems that may discourage their development. The division of particular policies into these three categories is somewhat subjective. The main point, however, is that an effort to raise pension coverage should include a variety of types of policies .

Primary Government Policies Affecting Pension Coverage Rates

Some of the policies that high income countries have pursued to reach high levels of pension coverage may also be successful in middle income countries. However, pension policy to extend coverage in high income countries is focused on employees in the lower half of the income distribution because a high proportion of middle and upper income workers are already covered. Because of the low level of income and precariousness of employment for many workers in the informal sector in middle income countries, pension coverage will necessarily be very low for those workers. Thus, this article focuses on extending coverage to upper and middle income workers. It considers voluntary employment-based pension arrangements or individual account plans connected with the worker's private sector employment. While there are important differences between defined benefit plans, where the benefit is based on a benefit formula and the investment risk is borne by the employer, and defined contribution plans, where the benefit is based on the accumulated account balance and the investment risk is borne by workers, this policies discussed here would generally be favorable for the development of either type of pension.

In considering policies to raise voluntary pension coverage, social security policy should be examined first. The age at which workers may receive social security old-age benefits affects the need for private pensions. If social security provides benefits at a relatively young age, it will be expensive for private pensions to provide benefits starting at the same age. If the age at which social security provides benefits is relatively old, private pension plans will develop in part to provide retirement benefits before that age. In Brazil, workers are eligible for social security benefits after 35 years of work for men and 30 years for women, regardless of age, and thus women could retire before age 50 and men before age 55. In the United Kingdom, by contrast, the eligibility age is 65, and private pensions are used by workers to provide benefits for retirement at a younger age.

The level of social security benefits provided to middle and upper income employees affects their need for supplemental private pensions. While low pension coverage rates are commonly thought to reflect the weakness of private pension systems, in some countries, such as Italy and Austria, they result from social security providing a high replacement rate for most employees, so that workers do not need a supplementary private pension. If social security benefits replace 70 percent or more of pre-retirement earnings for a group of workers, those workers have little need for voluntary pensions. A social security system with a moderate replacement rate of pre-retirement earnings of 50 percent or less for middle and upper income employees will encourage the development of private pensions.

Second, in countries where social security benefits provide moderate replacement rates and thus leave room for the development of private pensions, private pension coverage will not develop to a significant extent unless the government provides adequate incentives through the tax system. Tax preferences are designed to encourage private pensions. They are provided in the belief that lacking such an incentive, individuals would otherwise not save enough for retirement. To encourage savings through pensions a tax preference is needed to offset the disadvantage of saving through pension due to their illiquidity. In the absence of adequate tax incentives for pensions, to the extent that employees save, they will prefer to save for retirement through other more liquid forms of savings, such as financial market investments, or through other forms of savings that receive tax advantages, such as investing in their homes or self-employed workers investing in their businesses.

Governments provide tax preferences for private pensions in all countries with strong private pension systems. For firms, pension contributions are tax deductible just as are wage payments to employees. For employees, compensation received in the form of pension contributions by employers or the accrual of future pension benefit rights in defined benefit plans are not taxable as current compensation. Usually, contributions by employees are deducted from their taxable income. Also, the investment income earned by the pension fund is not taxable. Pensions are then taxed as income whey they are received as benefits. This approach is used in Canada, the United Kingdom, the United States and elsewhere. Different countries have used different variants of that approach, but that is the basic approach used by most countries with substantial voluntary private pension coverage.

The extent that tax preferences encourage pension coverage depends in part on the tax treatment of other assets. In Brazil, dividends on corporate stock are not taxed, and capital gains are taxed only when realized. This favorable tax treatment of corporate stock held privately, combined with the threat by the government that the investment earnings of closed pension funds will be taxed, and the prohibition of pension funds investing in foreign stocks, provides little tax or financial incentive for saving through pensions.

For tax preferences to be effective in encouraging pensions, they must allow an adequate amount to be saved through pensions. The experience in New Zealand, where preferential tax treatment for private pension funds was ended during the 1990s, indicates that preferential tax treatment can have a large effect on pension coverage. Tax deductions for pension contributions, however, only affect employees that pay income taxes. In Brazil and many other middle income countries, many workers have earnings below the level at which they are required to pay income taxes.

Tax evasion plays an important role in the motivations workers have for participating in pensions. Workers who evade taxes and effectively reduce their marginal tax rate have a reduced incentive for participating in pensions. Conversely, because of widespread tax evasion in Brazil, pension funds are a relatively attractive target of the government for taxation. Tax evasion by other taxpayers may be an important reason why the Brazilian tax collecting authority has expressed the desire to tax the investment earnings on closed pension funds. Thus, dealing effectively with tax evasion may reduce the pressure on the government to tax pension investment earnings.

Third, private pension funds require reasonably stable prices and reasonably stable asset markets in which to invest. Private pension funds have difficulty maintaining the real value of their investments in hyperinflation where the real value of their accumulated assets may be greatly reduced. If wages keep up with the rate of inflation but some asset prices do not adjust, defined benefit pension funds may have serious financing problems during hyperinflation. In the past, some firms have been reluctant to operate funded pensions in Brazil because of the risk of hyperinflation. The government providing inflation-indexed bonds in Brazil may reduce this problem. Allowing firms to use book reserve financing may also reduce the problem. With book reserve financing, the firm records the pension liability on its books as an accounting entry, and it legally obligates itself to pay future pension benefits, but no separate fund is set aside to finance the pension benefits. During the past century, both France and Germany experienced periods of hyperinflation. Those periods appear to have had a long run effect on their pension systems, with both countries relying primarily on unfunded pension plans.

Fourth, private pension funds require reasonably favorable regulations concerning the investments they may hold in their portfolios. If the regulation of pension funds places them at a disadvantage relative to other forms of savings, employees will prefer to save in other ways. The change in pension regulations in Brazil in the year 2000 which permits a greater percentage of pension fund assets to be invested in corporate equities provides an example of a change in regulations that will make pension funds a more attractive form of savings.

Government Policies to Encourage the Development of Pensions

In addition to these primary policies that provide a favorable environment, governments have a number of policies that they can use to encourage the development of private pensions.

1. Influence public opinion.

The government can lead by example, both through its own pension plans for its employees and through the pension plans of state owned enterprises. By serving as a model employer in the way that it treats its own employees, by providing them a sensible, economically feasible pension plan, the government can serve as an example for other employers. When government and state owned enterprises provide pension benefits after few years of work, at young ages, and at excessively high levels, as is the case in Brazil, they not only place an expensive burden on taxpayers, they provide a bad example of how pension plans should be structured, and may discourage the development of pension plans in the private sector because such plans are viewed as being too costly. When governments and state-owned businesses provide reasonable pension plans for their employees, some private sector employers may be induced to do so because of competition for employees in the labor market

Government also can try to increase pension coverage through public education and advertising. Such activities inform workers about their need to save for retirement.

2. Prohibit pre-retirement cashouts.

In some countries, workers can cash out their pension benefit before retirement age, which effectively reduces the coverage provided to workers in the pension system. In other countries, such as Canada, workers' pension benefits are locked in until they reach retirement age.

In Brazil and other countries in Latin America, many workers have savings or severance pay plans that are cashed out when they quit work or change jobs. One way to extend pension coverage would be to require that these plans could only be cashed out at age 62 or older, or at retirement. Such a change, however, would make these plans less attractive to some workers.

3. Increase options.

Governments can increase the desirability of pensions by expanding the options available. Pensions can be provided that have features not currently provided. For example, in cases where employee contributions are not tax deductible, tax law can be changed so that employee contributions are tax deductible. The amount of contributions by employers and employees that are tax deductible may need to be increased.

In some cases, employees and employers find hybrid plans desirable, where a single plan contains features of both a defined contribution and defined benefit plan An example of a hybrid plan is a guaranteed defined contribution plan, where the employer guarantees a minimum rate of return for the defined contribution plan (Turner 2000). In this type of plan, the employer matches the employee contributions only when the rate of return on the plan falls below the guaranteed level, and only to the extent required to raise the rate of return to the required level. Such a type of plan may be considered by some employees to combine the best aspects of defined benefit and defined contribution plans.

4. Target incentives.

The government may try targeting incentives towards particular groups of workers or firms that typically have low coverage rates. Government expenditures relating to targeting of incentives are most effective when targeted towards employees and firms that are on the borderline in the decision whether to participate in or to offer a pension plan. Recognizing that small firms are much less likely to provide a pension than large firms, government policy is sometimes oriented towards especially encouraging pension provision by small firms. This is done mainly by reducing their costs by exempting them from some government reporting requirements. Similarly, government policy may grant middle and lower income workers special options or tax preferences not available to upper income workers as a way of targeting groups less likely to have pension coverage.

Employers have some fixed start-up costs when first establishing a pension plan. Government might provide a subsidy to small employers in the first year or two of a pension plan to help cover the start-up costs.

CRITICISMS OF PRIVATE PENSIONS

While retirement income policy discussions often focus on the problems of social security, the criticisms of private pension have received less attention. Weaknesses of private pensions may inhibit the growth in their coverage. The criticisms divide into those affecting the role of pensions in capital markets and in labor markets (Turner and Rajnes 1995).

Capital Markets

First, because pension systems accumulate large sums of money, they attract criminals who try to steal the money. The most famous example is Robert Maxwell in the United Kingdom, who stole $600 million from pension funds of companies he controlled.

The risk of fraud can be reduced through pension law and regulations concerning the behavior of pension fiduciaries, pension enforcement, and required disclosure of financial information. Since the Maxwell case, pension law has been considerably strengthened in the United Kingdom. Strengthening pension law, however, is only the first step. The regulatory authority needs to have adequate staff in terms of numbers and qualifications, which is an issue in Brazil and other middle income countries (Kane 1998).

Second, even in the absence of criminal activity, private defined benefit pensions may default on their promised benefit payments if they are underfunded. When firms are not required to fully fund their defined benefit pension plans, the plans may be highly underfunded. When a firm has financial difficulties, it will tend to contribute as little as it can to its pension plans. If such a firm becomes bankrupt, employees may lose both their jobs and their pension plan. This problem can be greatly mitigated by requiring firms to fully fund their pension plans. An alternate approach is to require that firms insure their pension plans.

Third, private pension systems generally do not provide post-retirement inflation protection. In no country where such protection is voluntary do many pension plans provide it. However, many social security systems do not provide post-retirement inflation protection either

Labor Markets

The role of pensions in labor markets has also been criticized. First, because of the pattern of coverage rates, governmental tax subsidies (tax expenditures) for pensions, that occur because of the preferential tax treatment pensions receive, primarily benefit middle and upper class workers. This pattern of redistribution counters the pattern desired in all major religious traditions, which is to redistribute resources to the poor. Further, much of the savings that occurs through pensions may have occurred in their absence, with the tax expenditure merely subsidizing workers rather than increasing net savings.

This criticism of pension systems takes a limited view of governmental transfers. It is not necessary nor desirable that every governmental program favor the poor. In examining transfers, it is more appropriate to examine the tax benefits through both social security and the private pension system.

Second, private pension systems do not promote social solidarity through social risk sharing. Social security systems may provide social solidarity by allowing for risk sharing across broad income groups. It has been argued, however, that a funded private pension system can increase social solidarity by turning workers into capitalists. To the extent that employees have a stake in the ownership of capital, they do not view the interests of capital and labor as antagonistic.

Third, private pension systems may not do a good job of protecting the benefit rights of workers who change jobs. Pension plans may require many years of work before workers have any benefit rights through plan requirements concerning vesting. Thus, transient workers are penalized. These problems can be reduced through government regulation concerning maximum years for vesting.

In sum, while private pension systems have inherent weaknesses, steps can be taken to address most of them.

Reasonable Expectations for Coverage Rates

Though private pensions may be viewed as an answer to the problems of social security systems, voluntary private pensions play an important role in providing retirement income in only about a dozen high income countries. These countries include Canada, Germany, Ireland, Japan, Norway, United States, and United Kingdom. Even in these countries, however, it is rare that a voluntary private pension system covers more than half of the labor force. Only in countries where most of the labor force either belongs to a union or is bound by collective bargaining agreements--for example, Sweden and the Netherlands, respectively--are substantially all of the labor force covered (Dailey and Turner 1992).

CONCLUSIONS

Private pensions may relieve the strain on social security, aid the development of capital markets, and enhance flexibility for workers and employers. While private pension systems have weaknesses, government policies can be established that would encourage the expansion of those systems and address their weaknesses. These policies can be divided into three groups: 1) policies that are essential to providing a favorable economic environment for pensions, 2) policies that encourage the development of private pensions, given that a favorable economic environment for them exists, and 3) policies that deal with weaknesses of private pension systems. With population aging increasing the burden on social security systems, inevitably many countries will expect private pensions to play an increased role in providing retirement income.

References

Dailey, Lorna M. and Turner, John A., "U.S. Pensions in World Perspective, 1970-89." In Trends in Pensions 1992, edited by John A. Turner and Daniel J. Beller. Washington, DC: US Government Printing Office, 1992, pp. 11-34.

Hinz, Richard and Turner, John A., "Pension Coverage Initiatives-- Why Don't Workers Participate?" In Living with Defined Contribution Plans, edited by Olivia S. Mitchell and Sylvester J. Schieber. Philadelphia: University of Pennsylvania Press, 1998, pp. 17-37.

Kane, Cheikh T., "Reforming the Brazilian Pension System." In Do Options Exist? The Reform of Pension and Health Care Systems in Latin America. Edited by María Amparo Cruz-Saco and Carmelo Mesa-Lago. Pittsburgh, PA: University of Pittsburgh Press, 1998, pp. 293-309.

Turner, John A., "The Best of Both Worlds?" The Actuary, August 2000, pp. 20-21.

Turner, John A. and Rajnes, David M., "Can Private Pensions Fill the Gap?" Ageing International 22 (June 1995): 38-43.

Reprinted with permission, ©American Association of Retired Persons, 2000. All rights reserved.

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