A pension is a type of employer-sponsored retirement plan that provides monthly income to retired employees of companies or governments that offer such plans. Two primary types of pension plans include defined-benefit plans and defined-contribution plans.
With defined-benefit plans, the employer guarantees that the employee will receive a definite benefit amount of upon retirement, regardless of how well the underlying investment pool performs. With defined-contribution plans, the employer makes predefined contributions for the employee, but the final amount of benefit that the employee receives depends on the investments' performance.
The amount that an individual's pension provides is typically based on the number of years the employee has worked for the company or government offering the plan, the employee's age at retirement, and the employee's compensation, either at retirement or over some other period determined by the plan.
Worldwide, the quality of pension systems available to workers varies greatly. The Australian Centre for Financial Studies recently released the Melbourne Mercer Global Pension Index, which examines the pension systems of 20 countries across the Americas, Europe and Asia Pacific, covering more than 55% of the world's population. The Index compares retirement income systems and rates each based on its adequacy, sustainability and integrity. Here, we take a look at the results of the fifth edition of the annual Melbourne Mercer Global Pension Index.
The Melbourne Mercer Global Pension Index is calculated using the weighted average of three sub-indices:
- Adequacy sub-index. The adequacy sub-index, which represents 40% of a country's overall index value, looks at how a country's pension system benefits poor and median-income earners. Additionally, the adequacy measure considers the system's efficacy and the country's household savings rate and rate of home ownership.
- Integrity sub-index. The integrity sub-index, which represents 25% of a country's overall index value, examines the communication, costs, governance, regulation and protection of pension plans within that country. It also considers the quality of the country's private sector pensions because, without them, the government becomes the only pension provider.
- Sustainability sub-index. The sustainability index, which represents 35% of a country's overall index value, considers factors that can affect how sustainable a country's retirement fund is, such as the level of coverage of private pension plans, the level of pension assets compared with GDP, government debt and the projected demographic factors.
The Top Pension Systems
The index value for each country is represented by a value between zero and 100, with higher value signifying more favorable pension systems. The average score for the 20 countries included in the 2013 index was 60.0 (the average sub-index scores were 61.2 for adequacy, 69.4 for integrity and 51.9 for sustainability). The top three countries with the highest overall index grade were:
1. Denmark. With an index value of 80.2, Denmark received the highest score for 2013 of the 20 countries included in the index. As the world's leading pension provider, Denmark has a public basic pension scheme, a supplementary pension benefit tied to income, a fully funded defined-contribution plan, and mandatory occupational schemes.The index noted that Denmark's score could be improved by:
· Raising household savings
· Increasing workforce participation among older workers
· Introducing measures to protect the interests of both parties in a divorce
· Providing increased member protection in the event of fraud, mismanagement or provider insolvency
2. Netherlands. The Netherlands ranked number two, with an overall index value of 78.3 for 2013. Its retirement income system uses a flat-rate public pension and a semi-mandatory occupational pension linked to earnings and industrial agreements. Most of the Netherlands' employees are members of these occupational plans, which are industry-wide defined-benefit plans; earnings are based on lifetime average earnings.The index found that the overall index value could improve with:
· Implementation of a minimum access age to preserve benefits for retirement
· Increased household savings
· Increased workforce participation among older workers
· Increased member protection in the event of fraud, mismanagement or provider insolvency
3. Australia. Australia ranked third in the Index, with an overall index value of 77.8. Its pension system is comprised of an income-tied, aged-based pension funded by the government, a mandatory contribution from employers into a private fund and voluntary contributions into a private retirement fund. Although Australia's score improved several points over 2012, the index noted that its pension system could improve by:
· Introducing a requirement that part of the retirement benefit be taken as an income stream
· Increased workforce participation among older workers
· Increasing the pension age as life expectancy increases
· Increasing the minimum access age to receive benefits from private pension plans
The United States and Canada
Canada received an overall index grade of 67.9, ranking 6th out of 20, while the U.S. was at 58.2, putting it in 11th place. Canada's retirement income system uses a universal flat-rate pension combined with an income-tied pension, an earnings-related pension derived from lifetime earnings, voluntary occupational pension schemes, as well as voluntary individual retirement savings plans. The index noted the overall index value for Canada could improve with:
· Increased coverage of employees in occupational pension plans
· Increased household savings.
The U.S. retirement income system includes a Social Security program that has a progressive benefit formula based on lifetime earnings, and also has voluntary private pensions, which can be occupational or personal. Here's what the U.S. system could do to improve its overall index value:
· Raise the minimum pension for low-income retirees
· Adjust the level of mandatory contribution for median-income earners
· Improve the vesting of benefits
· Limit access to funds before retirement
· Require that part of the retirement benefit be taken as an income stream
Here's how the 20 countries in the Index rank:.
Pension systems as ranked by the Melbourne Mercer Global Pension Index.
The Bottom Line
Worldwide, pension systems are under more pressure than ever before because of rising life expectancies, increased government debt, uncertain economic conditions, inflation risk, and a shift towards defined-contribution plans. The Melbourne Mercer Global Pension Index includes recommendations to improve each country's retirement income systems, acknowledging that no universal solution exists because each system has evolved from unique economic, social, cultural, political and historical circumstances.
Common challenges in pension systems around the world include the need to increase the pension and/or retirement age to reflect increasing life expectancy; promote increased workforce participation at older ages to increase retirement savings and limit the length of retirement; encourage increased levels of savings; increase the coverage of employees and the self-employed in the private pension system; and increase the governance of private pension plans to improve member confidence.