Perspective Unlimited

Tuesday, August 21, 2007

A Right Step Towards Risk Pooling

A couple of months ago, I suggested here (not wholly originally) that the major problem of the CPF system was not that returns were low, but the lack of risk-pooling to guard against "longevity risk".

First on the issue of returns. Based on the sketchy information that has been brought to the public in the two days since N-Day rally, CPF returns would indeed be boosted by giving members a higher "expected" rate that would fluctuate according to market conditions. Obviously, higher expected returns would be accompanied by some risk. The interesting question is - if an individual is more risk averse, can he opt for a fixed 4% interest instead?

The bolder proposal being discussed is the "longevity insurance" - citizens contributing towards a national pot, from which senior citizens aged 85 and above would be paid from. The idea of this is simple enough but it represents a key shift for it is the first time a form of national insurance for retirement (either cross sectionally or inter-generationally) is introduced. When my mother-in-law (a youngish 52) heard the proposal as it rolled out at the 10 o'clock news, her first reaction was, "Why should I be paying for others above 85". As Singaporeans are brought up with the idea that CPF account belongs to the individual, it may be difficult to accept that setting aside a small fraction into a common pot for insurance is in fact beneficial to every one.

From an economic point of view, the proposed policy is indeed a right step forward - and a very smart one in fact. First, the scheme is likely to be mandatory. Otherwise, since an individual is most aware of his own health status, only those who think they can outlive 85 will participate in the scheme (averse selection) making it less sustainable. Some critics however argue that mandatory participation would in fact disadvantage the poor since they have a lower life expectancy and the scheme would be actuarially unfair to them. But my sense is that this problem is small compared to old age destitution when retirement funds run out.

Second, notice that the pay out age of 85 is also set above the average life expectancy. Suppose a worker stops working at 65, he would have to live on his own retirement funds for another 20 years before he could dip his finger into the common pot. In other words, the worker would still have to save up for his own retirement (of 20 years at least) before the insurance element kicks in.

In economic parlance, the 20 years is the "excess" - like how we often have to pay for the first $500 of damage when we file a car insurance claim. The purpose of this "excess" is to reduce the moral hazard problem that always occurs with insurance. Because he still have to worry about 20 years of his retirement, the worker still has strong incentives to build up his personal retirement account even though he is insured past 85.

As expected, the loss of control of a portion of retirement fund has given rise to some unease ("coerced annuity"). Rather than seeing it as coercion, a better way would be to understand the true nature of this proposal, which is essentially a social safety net for the advanced old. But the nature of having a social safety net is as such - there must be contributions by all to support and sustain this safety net. In principle therefore, building in some element of risk-pooling into our CPF system is the right step forward. The proposal also cleverly reduces the moral hazard problem. The government should be given some credit for creative thinking.

13 Comments:

  • Why couldn't it be funded via normal budget since it is basically a state pension scheme?

    If they want to risk pool might as well risk-pool from whole Singapore right?

    Or why not leave the interest rate alone and use the 700 million to fund the scheme?

    Anyway, this annuity thing is really an admission by the govt that CPF has failed as a reliable pension plan for Singaporeans.

    By Anonymous Anonymous, at 4:04 am  

  • Helping 85 year olds who were not 'prudent' enough to anticipate their longevity causes a moral hazard?

    If they apply their strict standards across the board we may be somewhat sympathetic, but they bail out that loser of a company Chartered Semi with several billion $ cash infusions....do they scrutinise spending on defense as tightly as they do aid to 85 yr-olds. Do heads roll for debacle in UNSW, John Hopkins etc.?
    ....the billions they lost in Shin Corp can be used to help 85 year olds for decades....do the reserves belong to us?

    This annuity thing is yet another tweak...ever since they liberalised CPF for every thing besides retirement, we had this problem. The HDB has huge surpluses thanks to changes in CPF usage. Risk pooling?...I think the biggest risk for Singaporeans is they voted for a govt that makes sure they will never see a single cent from vast reserves even in the moment of greatest need.

    I've not seen a single person speak positively about this annuity thing - expect for you. They are generally bewildered how a govt can make $10 billions in upgrading promises before general elections finds it so hard to give the small number of 85 year olds $200 per month.

    By Blogger LuckySingaporean, at 4:27 am  

  • Hi Anon and Lucky,

    I agree that in principle, this insurance can come out of budget. But taxes may have to go up. Chinese saying goes - wool comes from sheep. On way or another, the citizen has to contribute to this pool.

    The increase in interest rate is probably to answer the many critics that say that CPF interest is low. So the government says, yes we can give a higher "expected" rate, but it will have to fluctuate according to market conditions. I did ask in the original post if one could choose a fixed lower rate since not every one likes risks.

    I think we have to be fair to the government on this issue. Many countries around the world do suffer pension problem. It surely is an exaggeration to suggest CPF failed. The fact that it may not be enough for 100 per cent of the citizens does not mean it fail. The recent proposal is simply to recognise the longevity risk and to tweak the system to make it more fail-safe.

    There is always moral hazard with insurance. I explained that the 20 years (between 65-85) act as excess to reduce the moral hazard. If the policy is done well, moral hazard can be contained.

    Lucky, I think we must be careful not to link so many issues together. Upgrading, investment etc are discretionary items. The government can or cannot do depending on how economy is doing, whether there is budgetary slack. But the CPF reforms we are talking about here are not about discretionary spending. Annuity payment are recurring, and pretty permanent. It is therefore prudent in my opinion for the longetivity insurance to acturially fund itself over the long run, and not rely on extra top ups from other parts of the budget or from dilution of investment.

    I know people are uncomfortable with the annuity scheme. I am trying to show the economics of it. My larger point is that it is fundamentally inconsistent to argue to more social security net (which advance old age annuity is part of) and not want to pay for it at the same time.

    By Blogger Bart JP, at 5:29 am  

  • hi bart

    "I agree that in principle, this insurance can come out of budget. But taxes may have to go up. Chinese saying goes - wool comes from sheep. On way or another, the citizen has to contribute to this pool.

    The increase in interest rate is probably to answer the many critics that say that CPF interest is low. So the government says, yes we can give a higher "expected" rate, but it will have to fluctuate according to market conditions. I did ask in the original post if one could choose a fixed lower rate since not every one likes risks."

    It is highly likely that Singaporeans will much happier if the govt juz implement the annuity scheme using the 700m earmark for higher interest rate and forget about increasing the rate...

    "I know people are uncomfortable with the annuity scheme. I am trying to show the economics of it. My larger point is that it is fundamentally inconsistent to argue to more social security net (which advance old age annuity is part of) and not want to pay for it at the same time."

    Well I believe that is not true. If the govt can promise Singaporeans that any increase in taxes are used 100% to fund social security schemes like state pension, the policy can be sold.

    The payouts from the scheme need not be fixed, it can be limited to the taxes collected solely for the purpose. Say GST increase by 0.5% to the scheme, then the payout be limited to the $ raised by this tax.

    By Blogger at82, at 5:56 am  

  • I think you guys are looking at things too microscopically. An annuity scheme that pools risk to take care of "extreme" longevity ....I think the issue is not whether it will work or not ..whether it is just or not ...but how did the No.1 workforce in the world for 2 decades end up without sufficient funds to retire comfortably vs a govt that accumulated the highest reserves per capita in the world.

    I have no intention of going down to debate the merits of this annuity scheme. It is a small matter that is given too much attention - the amount we are talking about is not even the round off figure our defense budgets to its nearest billion. The question is whether the govt is uniformly prudent in all areas or only when it comes to helping Singaporeans in need.

    That's all I have to say about this annuity thing. I leave the debate to the rest of you guys.

    By Blogger LuckySingaporean, at 2:21 am  

  • AT,

    I dunno, maybe it is a balancing act. You know, when govt gives rebates, it will send you the original bill showing exactly how much cost is incurred before showing the rebate amount.

    Maybe it is the same here. The govt giving everyone higher interest rate, then deduct some away for the longevity insurance, to let people keep the mental account that they are paying for their own insurance rather than riding on the state. I am not sure if this is the best way to present it, or if it is the best strategy to get people to accept the idea.

    But I accept your point (and others) that there are many ways to fund the new initiative. But however you dice it, the citizen has to pay in the end.

    By Blogger Bart JP, at 2:23 am  

  • Wait, assuming if such a scheme is funded based on a co-payment by the government to a tune of 1 -2 billion dollars, on top of the 'compulsory' premium payments by us all. Would you say this would also need an increase in tax payments?

    And let's say that the Defence budget needs an additional 2 billion a year from next year or maybe a few years later. Would you say this would have that an increase in tax is similarly needed?

    By the way, have you actually looked at the demographics where the risk of Xtreme longevity takes place?

    By Anonymous ted, at 2:43 pm  

  • Hi Ted,

    I don't know how to answer your hypothetical question. If there is a new recurring spendin item that cost 1-2 billion year after year, it must be funded from somewhere (assuming no budgetary slackness).

    I have not looked at how much of the population will hit Xtreme old age. Two of my four grandparents hit 85 (still going strong). My wife also has two of four grandparents past 80 (also going strong).

    In any case, I think 85 is set such that the number of people collecting the insurance cannot be very high, nor should they be expected to live for very long past 85 (the very idea of insurance is to cover less likely event). Otherwise premiums will be quite costly.

    By Blogger Bart JP, at 3:13 pm  

  • Lucky,

    I disagree with your line of reasoning completely.

    There is really no point in your assertion that the number one workforce has not enough to retire on. Working from 25-65, and retire from 65-85. It is 1 retirement year for every 2 work, not even mentioning housing, misc expenses, and education for children. Now this is onerous even for a high rate of saving isn't it?

    The question is always how long the retirement is going to be? If you don't even know how long the retirement is, what constitute CPF-adequacy?

    Risk-pooling means that workers worry about 20 years of retirement, let the (possibly state managed) annuity take care of the rest.

    The longevity insurance is not a microscopic point, it is the first time there is a national insurance scheme for old age. It is not trivial in my opinion.

    By Blogger Bart JP, at 8:19 am  

  • Bart,

    Well said. The KTM also thought this compulsory annuity thing pretty innovative. Took him a while to figure out what was really going on. :-)

    Packaging was however poor -- as usual. :-P

    By Blogger kwayteowman, at 1:16 pm  

  • Thanks KTM. I think the packaging is always going to be difficult because the policy is essentially a nationalisation of a part of CPF, a form of taxes to pay for a social security net for the advanced old. Nobody likes their assets nationalised or pay higher taxes even though they all want more social safety net.

    By Blogger Bart JP, at 7:59 am  

  • I find it interesting that annuities (something that not everyone will need) will cover everyone, whereas medical insurance (which you are far more likely to require) does not. If risk pooling is the aim, then universal medical insurance, without any person or condition being excluded should be primary on the list. Instead, there appears to be lots of cherry picking on the types of "risk" that we pool - maximum profits anyone?

    By Anonymous Anonymous, at 4:17 am  

  • There is a difference. Compulsory annuity - you know exactly how much you are paying out, you fix the rate. Universal medical coverage is a little more difficult, since cost pressures keep mounting over time. The amount of moral hazard is probably higher.

    By Blogger Bart JP, at 3:25 am  

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