December 20, 2009

The Case for GCC Pension Reform from Sinking to Sustainable

With the ratio of workers to pensioners likely to decrease from 25:1 to 3:1 by 2050, the region has ‎an opportunity for pension reform now, while the pressure is still low.

Pension systems in the Gulf Cooperation Council (GCC) are remarkably generous. People in the ‎region retire well and they retire early. To the extent that the region’s pension systems are ‎intended to provide social welfare, they are certainly fulfilling their role. However, the ‎overemphasis on social welfare is at odds with the region’s movement away from a pure welfare ‎state model toward one that relies on steady diversification of the economy and growth of the ‎private sector. Existing pension systems are also unstable and unsustainable. Successful reform ‎will gradually shift responsibility toward workers and private fund managers, and thereby help ‎grow the GCC’s financial markets and significantly reduce the role of government, finds a new ‎study by Booz & Company.‎

The GCC’s Slowly Sinking Pension Reforms

Pension systems can confer three benefits. The social benefit allows retirees to maintain their ‎pre-retirement consumption, or provides a safety net against poverty. The second is the financial ‎benefit—pensions involve decades-long liabilities and long-term investments, which can decrease ‎the volatility of financial markets and deepen a country’s capital markets. The third benefit is ‎economic—giving people an incentive to work, thus bolstering the labor market and making the ‎country more competitive.‎

“In the GCC, pension reforms mainly work toward a social goal, doing little to further the region’s ‎economic and financial goals,” stated Richard Shediac, a partner at Booz & Company. Although ‎the systems are currently sustainable with 25 working people contributing to pension funds for ‎every one who pulls money out of them, by 2050 this dynamic will change to approximately three-‎to-one in some countries. “Pension reforms are required to strengthen the financial underpinnings ‎of these funds, preserve their role as safety nets for citizens, develop the region’s capital markets, ‎and deepen the efficiency of regional labor markets,” he added. ‎

Pension plans in the GCC are generous and use much shorter averaging periods, often the last ‎one to three years of a worker’s career. Income replacement rates in retirement also tend to be ‎high—around 80 percent on average and in many countries, the 80 percent level is available to ‎‎40-year-olds. ‎

Accrual rates—the percentages by which GCC workers’ expected retirement incomes rise each ‎year—are constant and the same regardless of income level—resulting in the same replacement ‎rate. “Depending on a country’s pension reform goals; there are several options to investigate ‎aside from constant accrual rates. A progressive accrual rate by years of work for instance, rises ‎as workers age, and gives workers an incentive to remain in the workforce,” said Samer Bohsali, ‎a principal at Booz & Company. A regressive accrual rate is another option, where accrual rates ‎decrease by income level.‎

Currently, GCC workers are incentivized to retire early rather than stay engaged in the workforce. ‎Roughly nine in 10 male workers in the region have retired by age 60, versus only one in 10 male ‎workers in Organisation for Economic Co-operation and Development (OECD) countries. ‎

Another reform issue is the creation of savings vehicles to help deepen the region’s financial ‎markets. “GCC workers are not encouraged to save for their retirements and there is no ‎equivalent of the voluntary retirement mechanisms that exist in more mature economies,” ‎explained Shediac. High spreads at banks also discourage savings, and life insurance is not ‎widely owned in the GCC. A lack of sophistication in investment knowledge and a high consumption rate (a recent study put Abu Dhabi among the nations with the highest consumption ‎rates in the world), highlights the reluctance by workers to move from a welfare mentality. ‎

A clear improvement opportunity for GCC pension programs is the inclusion of productive non-‎national labor—especially considering three-quarters of GCC employees are expatriates. In the ‎UAE and Kuwait, this is even higher—at 83 and 82 percent, respectively. ‎

“While other countries with large percentages of foreign workers have looked for ways to include ‎them in their pension systems, the governments of the GCC have avoided such concessions, ‎thus limiting their countries’ attractiveness as destinations for workers,” Bohsali stated. Some ‎companies have addressed this issue, setting up private pension schemes to keep prized ‎international managers. By excluding foreign workers from pension systems, GCC countries miss ‎a significant opportunity to strengthen their financial markets: pension coverage of non-nationals ‎means the contribution fund would in some countries be more than three times larger than now. ‎

Finally, the GCC’s approach to its pension funding is almost certain to prove unsustainable in the ‎long run. Its pension systems are partially funded, meaning some benefits are paid out of ‎investments made with excess contributions, backed by a pay-as-you-go system, where retirees’ ‎income comes out of the tax contributions of current workers. “This approach is necessary ‎because assets are not enough to cover long-term liabilities. Ideally the region’s pension systems ‎should become fully funded, where assets would cover long-term liabilities so that benefits would ‎primarily come out of an invested pool of contributed money,” said Shediac. ‎

The pension systems’ partial funding does not currently pose a problem, but as the region’s ‎demographics change—there won’t be enough workers supporting retirees. The old age ‎dependency ratio—the ratio of people working to those in retirement - will drop steadily as the ‎population ages.‎

Reform Objectives, What the GCC’s Pension Systems Require

All these weaknesses will drive GCC nations to overhaul their pension systems. It makes sense ‎to initiate pension reform now when, demographically speaking, the pressure is less intense and ‎changes can be made purposefully.‎

Among the most important reforms is opening the GCC’s pension systems to foreign-born ‎workers and the self-employed. A second fundamental reform is reducing governments’ roles in ‎administering pensions and taking care of workers in their retirement. A third critical reform is the ‎introduction of voluntary retirement savings, so workers have the option of saving money above ‎and beyond that allotted for them. A fourth reform would be to make workers’ retirement accounts ‎portable, so they wouldn’t face the prospect of losing pensions if they switched jobs or left the ‎country. ‎

‎“Other tactical changes that GCC countries should consider include fine-tuning accrual rates to ‎better redistribute wealth; lowering the guaranteed income replacement rate to levels more in line ‎with highly developed countries; indexing pension increases to inflation; and reducing companies’ ‎mandatory pension contributions,” Bohsali commented. ‎

Existing Routes to Pension Reform

Most countries that have reformed their pension systems have gone about it via either parametric ‎reform or systemic reform. Parametric/ retrenchment reform involves changing the parameters of ‎a country’s pension system to ensure financial stability such as retirement age or mandatory ‎contribution rates. Systemic reform is more complex, involving the introduction of multiple pension ‎‎“tiers”; a retirement income that is guaranteed by publicly administered pension funds often ‎supplemented with a benefit provided by privately administered funds. A tier 1 system is a ‎government-sponsored, mandatory pension fund (like Social Security in the U.S.); a tier 2 system ‎is a mandatory employer-administered fund in which there are defined benefits (like General ‎Electric’s pension benefit). A tier 3 system is underpinned by defined contributions, in which ‎workers voluntarily save an amount of their choosing and invest it as they please, over and above ‎what the state and their employers are putting away for them (like an IRA or 401(k) in the U.S.).‎

The World Bank is a strong proponent of multi-tiering as a route to systemic reform, which ‎eventually makes pension systems more robust. When governments introduce nonpublic pension ‎tiers, they typically do so with the goal of shifting responsibility to the worker and private fund ‎managers, and lessening their own roles. ‎

‎“Parametric reforms alone may not be sufficient in the GCC but systemic reforms do not ‎guarantee success either,” Shediac said. The right socioeconomic conditions must be in place for ‎it to work. A government undertaking systemic pension reform is less likely to succeed if it has a ‎high deficit. Second, a country undertaking systemic reform is less likely to succeed if its ‎underlying income inequality is high and its financial markets or financial-services industries are ‎not yet well developed. Income inequalities are accentuated by a system that emphasizes the ‎market returns from worker contributions or a system oriented toward privately administered tiers. ‎And less developed financial markets make the success of such reform efforts debatable—there ‎is no one to administer the private tiers.‎

Three Tiers, Managed by Government

The region needs a model of pension reform that uses the three tiers of systemic reforms and ‎embeds them in the individual public funds already being administered by governments. ‎Governments should run all three tiers and spin them off as employers get proficient at running ‎corporate retirement funds (Tier 2) and as capable financial-services companies arise to handle ‎the employee-contributed funds (Tier 3). Because such financial-services companies aren’t well ‎developed in most of the GCC, it isn’t realistic for governments to hand off the burden of ‎administering their pensions. ‎

“Instead, governments should move forward with the “one fund/three tiers” concept, and give ‎financial players time to lay down infrastructure and begin developing services,” stated Bohsali. ‎The long-term objective would be to have the governments’ parts of the funds serving mainly the ‎social welfare function, ensuring that retirees meet a designated standard of living, while the ‎corporate- and employee-funded areas contribute financial and economic benefits, such as ‎deepening financial markets.‎

Parametric reforms should also be part of the prescription. Changes parametric policies would go ‎a long way toward ensuring the financial stability of these one-fund/ three tiers entities, allowing ‎many to wean themselves off partially funded or pay-as-you-go schemes and move toward being ‎fully funded. Embedding the voluntary portion of the program in the existing public fund would ‎help jump-start the third tier; making workers more secure about putting “extra” money into ‎retirement savings in a public fund they know and trust. “As money pours into this third tier, it ‎would create the conditions for capital markets to thrive, leading to a stage when defined contribution funds can be spun out in the GCC, and run by private companies,” Shediac explained.‎


Without question, there will be some beneficiaries of the current GCC pension systems who will ‎be unhappy with changes to the benefits structure they are counting on. But those changes ‎should be phased in over a period of years, giving people who are still in the workforce time to ‎adjust their thinking and modify their financial behavior. There is real opportunity for GCC ‎countries to make reforms to their pension systems now, that would strengthen the financial ‎underpinnings of those systems, preserve their role as financial safety nets, and allow low-income ‎workers to maintain their consumption habits. The reforms could also contribute to the ‎development of regional capital markets and deepen the efficiency of labor markets. Done right, ‎these reforms could help the GCC’s pension systems advance to become among the best in the ‎world.‎