According to the report, Governments are being advised to pay close attention to their schemes which are projected to run significant deficits, with a possible depletion of the assets over the coming decades raising the possibility of government intervention. The report has highlighted a number of factors including unfavourable demographic trends, slow economic growth, rising employment, widening fiscal deficits, and increasing public debt levels since the onset of the 2008 global financial crisis. The report adds that the economic downturn has impacted the schemes as declines in growth rates coupled with significant increases in unemployment rates have contributed to lower pension contributions to the schemes.
Most social security institutions in the Caribbean have been in existence for over four decades. In the case of Barbados, the NIS (National Insurance Scheme) is over 50 years old. These schemes are generally financed under what can be described as a “scaled premium” system, whereby the contribution rate is fixed at such a level that the income from contributions and investments is expected to exceed the expenditures on benefits and administration for a period of years, referred to as the period of equilibrium.
During this period of equilibrium, the excess of income over expenditure is accumulated in a reserve. This reserve constitutes the resources available for investment.
The investment challenge for social security institutions was to maximise the growth of these reserves during the period of equilibrium by achieving the best possible rate of return taking into consideration the basic principles that apply to the investment of social security funds of safety, yield, liquidity, and social and economic utility.
The pension reform exercise undertaken in Barbados during the first half of the last decade was to address the long-term financial sustainability of the NIS. The actuarial projections for the Barbados scheme reflected that there would have been net positive contributions which should prevail for a period of time. Following that period of positive contribution, investment income would be expected to meet any shortfall in contribution, without the capital having to be impacted.
For social security institutions, there are three main inflection points to consider. The first inflection point is when overall expenditure exceeds contribution income. In this case the scheme must draw on its investment income to meet expenditure payments.
The second inflection point is when expenditure exceeds total income (contribution income and investment income), and at this point the scheme should start drawing down its reserves to meet expenditure payments, and the third critical point is when the reserves are exhausted.
As outlined in the IMF report, many Caribbean schemes have already crossed the first inflection point, with expenditure expected to exceed contribution income in Barbados and St Lucia within the next two years.
In Barbados’ case this point is supported by the 14th Actuarial Review of the NIS Fund at December 31, 2011, where it was projected that the expenditure on benefits would exceed the contribution income during 2017.
Must be revised
When the NIS was initially established, the idea was that current contributors would pay part of their cost and they would depend on generations that came after them to meet part of the expenditure of their pensions. And so, it was known from the beginning that the contribution rate or even the benefit provisions would have to be revised at a later point in time.
In the Caribbean, there have been significant demographic changes over the past 50 years. In the case of Barbados, it is quickly entering a period where the oldest members of its population will very soon outnumber the youngest.
Population ageing results from decreasing mortality, higher life expectancy and declining fertility.
This combination has led to a relative reduction in the proportion of young people (aged from birth to 14 years) and to an increase of older persons in the population (aged 65 years or over).
In Barbados, the percentage of older persons has increased from 7.5 per cent in 1990 to 9.1 per cent in 2010 and will continue to grow, based on projections. The number of older persons is expected to more than double the 2010 level by 2040, with older persons in Barbados projected to exceed the number of young people for the first time by 2025.
The old-age support ratio (number of working-age adults per older person in the population) is already low and is expected to continue to fall.
This will create, or possibly exacerbate, fiscal pressures on existing support systems for older persons. The impact of an increased life expectancy, which is one of the highest in the region, is that pensions are expected to be paid for a longer period.
The IMF Report has identified actuarial deficits calculated as the present values of net future benefit expenditure ranging from 0.7 per cent of GDP in Barbados to 92 per cent of GDP in Jamaica. This is reflective of the potential cash flow deficits which are expected to emerge in coming decades and which become contingent liabilities on governments in the event that scheme is unable to meet their obligations and get to be a major source of fiscal risk.
Persons may argue that with approximately $4.5 billion worth of reserves that the NIS has right now, there should be no cause for concern, as reserves as a percentage of GDP was more than 40 per cent, which was one of the highest in the region. Those reserves are on hand so that when pension payments come due, they can be met.
Per the Actuarial Report, you can expect to see increasing reserves for another few years but down the road these reserves would decline and ultimately be totally depleted (third inflection point).
With a low actuarial deficit and high reserves to GDP, this should not be an opportunity to congratulate ourselves. Our reserves-to-annual benefit expenditure ratio is sufficient to cover 8 years of benefit payments without additional revenue, compared to approximately 30 in St Lucia and Guyana at 2.5 years.
The performance of the investment portfolio can have a significant impact on the long-term financing of the social security institution. A good rate of return on the investment portfolio can reduce the extent of increases in the contribution rate necessary to fund the social security institution, beyond the period of equilibrium.
At the outset of pension reform, it was also recognised that the reserves must increase substantially to meet future expenditure. This was necessary as contributions would be coming from a shrinking workforce. The growth of reserves meant that avenues had to be available for the investment of NIS funds, which would either be alternative effective channels of investment in substantially increased productive capacity at home supplemented by substantial foreign investments, to add to the investment returns obtained at home.
Economic growth
It can be argued that investments in the productive sector of the economy can contribute to economic growth and improvements in the standard of living, by generating employment and providing further investment opportunities.
The contention is that increased employment and economic growth will inevitably lead to an increase in contribution income. Unfortunately, we have not observed this economic growth and increased employment for most of the last decade.
For social security institutions, the concept of “long-term” involves a horizon that is generally measured in decades. With a long-term investment horizon, social security institutions should be able to invest in less liquid, higher yielding investments, such as infrastructure and real estate, as well as increasing investment in equities.
The currently challenge facing the NIS, is that having crossed the first inflection point the investment focus of the NIS may now not be long-term, but on a shorter time horizon as the investment portfolio should now be structured to provide an increasing cash investment return to supplement the contribution income to meet expenditure and to prepare for the second inflection point, which based on the IMF report can be as early as 2024.
The IMF report indicates that the Barbados NIS has one of the highest exposure to Government securities, including those issued by state-owned enterprises, at 68 per cent of the fund supporting their concerns that “investment of pension funds may lead to high exposures to government securities.”
This anxiety was also raised by the actuary in the 14th Actuarial Review, where it was noted that “the heavy concentration of investments in Barbados Government and other public sector securities presents growing concerns for the fund’s long-term sustainability.
The key risk factor here is whether the fund will receive cash when debentures and treasury notes will have to be liquidated to meet current expenditure”.
The pay-as-you-go system used by the NIS and several social security pension systems in the Caribbean region have had to undergo significant structural changes in the face of population ageing to ensure their long-term sustainability.
Some of these changes include increasing contribution rates, and the raising of the retirement age when members would be eligible for a pension.
More pressure
Population ageing will increase pressure on governments to balance two priorities. First there is the need to reduce government budget deficits and debt levels especially in the face of lower economic growth, and secondly the need to sustain public spending on public health care, pensions and other social programmes for ageing population.
This has been compounded by the economic impact of the global financial crisis and natural disasters, which have resulted in higher unemployment and severe strains on government budgets.
It should be noted that none of the concerns expressed in the IMF paper are necessarily new, as most schemes have advanced various reforms efforts, but in general most Governments have elected to take a “kick the can down the road” approach when it comes to changes that will ensure the long-term viability of the social security system.
Ensuring the long-term sustainability of the NIS is just one of the challenges that Government will have to face over the coming decades. Government will need to address elements like tourism, education, housing, transportation and crime, as well as finding ways to improve the country’s productivity performance in order to address the challenge of producing the goods and services the entire population will require. These are all taking place at a time when Government is fiscally challenged with the prospect in coming years of lower NIS reserves to draw on.
• Gregory Hinkson is Managing Director and Principal Consultant of SAMDOR Services Ltd Limited
