How to build financial security

Asia’s demographic trajectory points to a pensions conundrum within the next 20-40 years. To build financial security among the elderly, the region needs a multi-faceted approach: Investment, social policy, health care, fiduciary structures and regulatory frameworks.

In ostensibly affluent Singapore, a rather incongruous routine occurs in the public housing estates on a daily basis. Elderly people in their late 60s and 70s, often women, rummage in the trash bins for cans, bottles and discarded publications to sell for one or two Singapore cents apiece. This is their livelihood in old age without the proverbial financial security.

As Asia’s demographic trajectory heads towards a greyer population in the next 20 to 40 years, this scene may become more common throughout the region if the infrastructure for old-age financial adequacy is not built in the near future.

Consider four demographic developments. First, Asia’s populations will be living longer. Life expectancy at age 65 in India is about 77 for men and 78 for women; in China, about 78 for men and 81 for women; in Singapore, 82 for men and 85 for women; in Japan, 84 for men and almost 90 for women, according to the Organisation for Economic Co-operation and Development (OECD).

Second, Asia’s elderly population is going to grow far more rapidly than in developed nations elsewhere. By 2090, the proportion of people aged 65 or older will be five times the 2005 level in Malaysia, Pakistan and the Philippines. In China, the number of people 65 and older is projected to treble by 2090 and 90% of this rise will occur by 2040. The elderly population in the OECD, on the other hand, will only grow by 200% over this period.

Third, the younger generation of Asians are less inclined to look after aged parents and grandparents, unlike previous generations. In fact, there are anecdotes of offspring in India, upon inheriting the family home, throwing their elderly parents out onto the streets to fend for themselves.

Fourth, the cost of living is likely to rise in the future. The cost of medical care is escalating, especially for older people who tend to have more complications. The cost of food, water and energy will also ascend in response to scarcity.

Yet, there is currently no known pension infrastructure that adequately addresses these issues. The Singapore Central Provident Fund (CPF) has a new scheme that offers lifetime payouts after retirement, but these are unlikely to sufficiently cover all of an elderly person’s expenses.

Currently, the pension net replacement rates — pension benefit divided by net pre-retirement earnings, after personal income tax and social security contributions from workers and pensioners — tends to be lower in developed Asian economies than in the West, among average income earners.

Among all OECD economies, the average replacement rate is 71.6% for men and 63.6% for women, according to Pensions At A Glance 2009’s Asia Pacific edition, a joint study by The World Bank and the OECD.

Among Asian countries, the Philippines, Pakistan and Vietnam have the highest rate of 82.7%,76.2% and 75.2% respectively while Indonesia and Singapore take the rear at 16.3% and 16.6% respectively.

In between are China with 73.5%, Taiwan 73.2%, Korea 49.2%, India 46.4%, Hong Kong 40.9% and Japan 38.9%. These rates are for male average income earners. 

Bruce Pflaum, President and CEO of Russell Investments in Japan and the firm’s managing director for Asia, has been mulling these multi-faceted issues for years. Russell has been developing financial security models for some time, but has yet to find a solution that adequately meets the beneficiary’s desire for guaranteed returns that grow in line with inflation, or more, for 30-plus years while not being exposed to the risk of investment loss during that time.  

Pflaum concludes that these complex issues cannot be solved via financial instruments alone. He suggests a holistic approach involving multiple disciplines and agencies: Investment, social policy, health care, fiduciary structures and regulatory frameworks.

Although Asia’s pension situation differs vastly from one jurisdiction to another, there are four threads of similarity, Pflaum observes.

First, even in economies with well-defined pension regimes, such as Hong Kong, Korea, Singapore and Malaysia, the schemes are the lone providers of pension benefits. “A sole provider cannot achieve the entire objective of financial security in old age for most people. Many of these systems need refinement or supplementation by other agencies such as individual or corporate retirement accounts. One example would be 401K-type plans used in the US, which creates a significant tax impetus to save. Corporate pension plans are rare in Asia, and even if they exist, they typically don’t pay well or offer wide employee coverage. If the scheme is a PAYG (pay-as-you-go) lump sum pension scheme and the company goes bankrupt or if you switch jobs in your 40s, you won’t have any real level of financial security,” Pflaum says.

Second, pension plans in Asia tend to invest conservatively and hence deliver relatively low returns, he observes.

It is impossible to make a fair comparison of returns, as regulatory environments, reporting standards, valuation methodologies and other variables differ among economies. But as a rough gauge, annual real returns among all combined actuarial performance services (CAPS) pension funds was 2.48% over the five years to end 2008; the 10-year period returned 0.69%; and over 20 years, 4.79%, according to the consulting firm Watson Wyatt.

Real returns among private pensions have varied from 14.7% since 1997 in Uruguay to 1% since 1995 in the Czech Republic, according to Pension Fund Performance, an OECD paper published in 2008.

Asia’s returns tended to be in the lower end: Hong Kong delivered real returns of 2.1% since 2000; Japan, 3.4% since 1990; and Australia 8.9% since 1990.

The report’s author and principal economist of the OECD’s private pension unit, Pablo Antonin, remarked: “It is interesting to notice that by assessing average rate of return in the last five years (2000 to 2005), for which there is data for all countries, against the volatility of these returns as measured by the standard deviation, most countries have had relative low average returns and relative low volatility… Hong Kong, Japan, the United Kingdom and the United States had very low average returns over the five-year period and relatively high volatility.”

During the 2000-2005 period he refers to, average returns for Australia were 4.9%; Hong Kong, 1.7%; Japan 4.8 %; and the US 1.5% for defined benefit plans and 0.7% for defined contributions.

Pablo concluded that “pension funds have generally underperformed with respect to the hypothetical portfolio with the highest (mean) return for a given level of risk (i.e. an ex-post efficient frontier. Interestingly, the analysis suggests that in several countries investment restrictions have had a negative impact on performance.”

Pflaum suggests real returns of 3% to 4% over the long term “would be great and is eminently achievable.”

Part of the solution lies in improving Asia’s fiduciary framework, Pflaum says. “In 1974, the whole idea of retirement changed in the US with the Employee Retirement Income Security Act (ERISA), which says a fiduciary acts on behalf of the pensioner, not the company, state or other entity. It sets out standards and processes for private-sector companies offering pension benefits and legal recourse for the beneficiary. The bill made significant changes to transparency and responsibility in retirement plans. There might be some lessons here for Asian countries.”

In Asia, pension trustees are a rare, or nonexistent, breed. The few employers who offer a pension plan rely primarily on custodians such as banks or insurance companies for execution.

Dr Khoo Guan Seng, a senior risk officer and an advisor to Hapitalist, a Singapore-based organization devising practical ways to fix broken parts of the economic system, advocates sharper risk management in the areas of longevity risk, investment risk and lifestyle risk. He says: “We need a research and development centre for pension risk and insurance, examining the entire value chain. For instance, defined benefits versus defined contribution, dynamic asset class rebalancing, proportions of the fund managed by institutions and the individual, retirement wealth advisors and so on. Outside of these frameworks, it’s also important to have social networks that the elderly can turn to for financial, economic and emotional sustenance. These might include employment structures and agencies for the elderly.”