The pressing need for GCC pension reform

People in the region retire well and they retire early. Ninety per cent of men and effectively all women have retired in the GCC by the time they are 60.

Pension systems in the GCC are remarkably generous, particularly in the public sector. People in the region retire well and they retire early. Ninety per cent of men and effectively all women have retired in the GCC by the time they are 60, with their state pensions paying, on average, 80 per cent of what they were earning before their retirement. But the pension systems are inherently unstable. In the next 25 to 40 years, pension schemes will be unable to meet their obligations unless there are changes. GCC policy makers will need to undertake reforms that will make their pension systems sustainable for the long term. Furthermore, by excluding non-nationals, who make up three quarters of the region’s workforce, GCC countries also miss a significant opportunity to strengthen their financial markets. If the GCC expanded pension coverage to non-nationals, the contribution fund would in some countries be more than three times larger than it is now.

Pension systems, in any country, confer three potential benefits. One is the social benefit that allows well-to-do retirees to maintain their consumption and saving habits and, for the less well-off, provides a safety net against poverty. The second is the financial benefit. Pensions, after all, involve liabilities that accrue over decades and require long-term investments, which in turn can decrease the volatility of financial markets and deepen a country’s capital markets.

The third benefit of a pension system is economic, giving people another incentive to work and thus bolstering the labour market and making the country more competitive. In effect, a country with a strong pension system signals that it supports the rights of labourers, and as a result attracts workers for the long term. Pension systems in highly developed countries tend to provide benefits in all three areas but in the GCC they work primarily towards a social goal and do little to further the economic and financial goals of the region.

The structure of incentives in the GCC encourages workers to retire early rather than stay engaged in the workforce and in the economic development of the region. And although the systems are fully sustainable, with 25 working people contributing to pension funds for every one person who pulls money out of them, by 2050 this dynamic will change dramatically. The ratio of contributing workers to retirees will drop to about three to one in some countries. The GCC’s pension funds will not be solvent if changes are not made.

There are two ways in which pension reforms can come about: parametric reform and systemic reform. Parametric reform involves changing things such as retirement age, mandatory contribution rates and averaging periods to ensure the system’s financial stability. Bahrain’s lowering of mandatory employer pension-contribution rates to 15 per cent from 21 per cent is an example of a parametric reform. Systemic reform is the more complex way to change pension systems. This often involves the introduction of multiple pension “tiers” involving 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 (such as Social Security in the US); and a tier 2 system is a mandatory employer-administered fund in which there are defined benefits (such as 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.

What is needed in the GCC is an alternative model of pension reform, one that uses the three tiers of systemic reforms and embeds them in the individual public funds already being administered by each government. Due to the difficulty of moving to a three-tier structure, the government should initially run all three tiers. These can be spun off as employers become proficient at running corporate retirement funds (tier 2) and as capable financial services companies arise to handle the employee-contributed funds (tier 3).

But because such financial services companies are not yet well developed in the GCC, it is not realistic for the region’s governments to hand off any of the burden of administering their pensions at this point. Instead, those governments should give financial players the time they need to lay down infrastructure and begin developing services. 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 the financial and economic benefits, such as deepening financial markets.

Parametric reforms should also be part of the prescription. Governments should take a fresh look at things such as income replacement levels, averaging formulas, accrual rates, and enrolment criteria (especially regarding the exclusion of non-nationals). Without question, there will be some beneficiaries of the 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 behaviour.

Done right, these reforms could help the GCC’s pension systems advance to become among the best in the world. Richard Shediac is a partner and Samer Bohsali a principal at Booz and Co