Pensions in the middle sectors: formal and informal
Defining pension coverage is not as straightforward as it seems. The most direct measure is affiliation24 rates (the number of members of the pension system divided by a measure of the potential universe of members, be it working-age population, economically active population or employed workers). However, this point measure does nothing to capture the main outcomes of the system, such as the savings a member can expect to have accumulated at retirement or expected total years of contributions. The optimal definition is probably the ratio of the total months of contributions over the total months affiliated to the pension system. An intermediate one, used in this chapter because of data availability, is the ratio of contributors to workers.
It is important that any measure be dynamic. Workers tend to shuttle frequently in and out of the labour force, between work and unemployment, and between formal and informal jobs (see Box 2.1). A cross-sectional analysis of the data may therefore be misleading. Proper analysis should instead seek to evaluate coverage from a life-cycle perspective, taking into account the effect of demographic change. It should also take into account the different contribution patterns revealed in the microdata, since there is significant variation across income levels, work status and gender.
Broadly speaking, an individual needs to be contributing for at least 60% of their working life to get an adequate pension. Over a stylised 40-year labour career this corresponds to 24 years of contributions, although in practice the timing of pension gaps and the worker’s wage profile matter as well. As a first approximation then, where a country’s overall coverage rates are below 60% it is likely that many if not most current workers are failing to accumulate enough to cover their retirement.
Box 2.1. There and back again: mobility between formal
Recent evidence from Latin American countries suggests that there is high mobility between formal and informal work. Using data from the first two waves of the Mexican Family Life Survey, changes in status between 2002 and 2005 can be examined for different categories of workers. Overall mobility for men and women is high and the probability of remaining in any particular employment sector is relatively low – the highest value is 63% for self-employed males (Table 2.1).
Table 2.1. Mobility between formal and informal work in Mexico (percentage of individuals aged 20 to 60, 2002-05)
International comparisons of mobility are complicated by differences in methods and data. Bosch and Maloney (2005 and 2010) used mobility-intensity matrices (the continuous-time equivalent of the transition matrices in the table) to compare Argentina, Brazil and Mexico. They found Mexico to have the highest level of mobility, followed by Brazil and then Argentina. Mobility is certainly higher when large economic shifts are underway, such as in the transition countries during the late 1990s (Pages and Stampini, 2007).
Moreover, the rate of movement from formal to informal work is comparable to movement in the opposite direction. This impression derived from these simple transition matrices is confirmed when controlling for the effects of different rates of job separation and job creation across sectors (Bosch and Maloney, 2010).
This evidence on labour dynamics in Latin America has two key implications for labour-market and social-protection policy. First, at least part of the informal workforce – especially among the self-employed – is not rationed out of formal salaried jobs. Instruments to integrate them into health and pension systems will therefore need to consider their incentives and the ability of the state to harness their saving capacity and demand for social insurance. Second, a number of individuals transit from informality to formality and back. This may be evidence of effective allocation of labour if demands are similar, but creates a challenge in ensuring coverage particularly in pensions which typically have lengthy eligibility periods.
Who is covered and who is not?
Despite the reforms we discussed earlier, pension coverage rates in Latin America have remained low – below 30% on average. This is low enough to suggest major funding issues in future decades.
Among a sample of 18 countries from the region, coverage of the labour force is positively correlated with income level (Figure 2.4).25 Within these four sub-groups can be distinguished:
- Paraguay, Nicaragua, Honduras, Dominican Republic and Bolivia where the coverage ranges from a maximum of 40% for the highest quintiles to values close to zero for the lowest ones. In Bolivia from the 1990s to 2000s the gap actually widened, coverage increasing for the highest quintile, while falling for the fourth quintile.
- Peru, Ecuador, Guatemala and El Salvador, where coverage peaks at around 60% for the highest quintiles while lower quintiles have values ranging from below 5% to 20%. Except in Ecuador, this group sees significant variation in coverage between quintiles. This is particularly notable in Guatemala, where the difference in coverage of the first and the fifth quintiles is around 60%.
- Colombia, Venezuela, Mexico, Argentina and Panama have similar overall coverage rates (from 5% to 60%), but lower dispersion between income levels.
- Brazil, Uruguay, Costa Rica and Chile show the highest coverage rates for all income levels, with the highest quintiles reaching 80% (Uruguay), and even the lowest above 20% (Brazil).
Figure 2.4. Pension coverage rate by income quintiles in Latin America (percentage covered out of the economically active population over 20 years old)
Perhaps surprisingly, coverage is particularly low in the middle three quintiles. This group can be taken as an approximation to our middle sectors. Rates for these workers in the first group of countries are around 15% in the 2000s (ranging from 10% in Bolivia to 20% in Dominican Republic). Coverage is a little over 20% in all countries in the second group other than Peru where it is only around 10%. In the third group, coverage is around 40% (ranging from 41% in Argentina and Panama to around 35% in Colombia). Coverage is higher in the fourth group at above 50% on average for all countries included – though this still falls short of the 60% minimum coverage identified earlier as necessary. Extending the analysis back in time finds no clear or reassuring pattern: between the 1990s and 2000s, coverage of these middle quintiles increased in about half of the countries of the region, but decreased in the other half.
Focus on the formal and informal middle class
Given the extent and persistence of informality in the region’s middle sectors, no analysis of their coverage rates would be complete without an examination of this dimension. The data are drawn from household surveys in Bolivia, Brazil, Chile and Mexico, from the mid-1990s to 2006.26 As noted above, these four countries cover both different levels of informality and a range of approaches to pension provision.
We define an individual as "covered" according to their answers to questions in the relevant household survey regarding contributions to or enrolment in a public or private pension scheme.27 The universe is the working population, taken here as those individuals aged 14 to 64 years, a span which adequately captures a typical labour career.
We assign respondents to the middle sectors (or the disadvantaged or the affluent) according to our 50-150 definition.
Coverage rates unsurprisingly increase with income, though the extent to which this extends up the income distribution is noticeable (Figure 2.5). Although lack of coverage for the disadvantaged is the usual focus of analysis and comment, it is apparent that this is also a middle-sector problem. The difference in coverage between the middle sectors and the affluent is never lower than around 6 percentage points (in Chile) and rises to around 20 points in Brazil and Mexico. The consequence is that many people currently in the middle sectors are very likely fall into poverty in old age.
There were no significant changes in the coverage of these workers of those four countries during the period studied (1996-2006; see Tables 2.A1 to 2.A4 in the annex).
Figure 2.5. Pension coverage rate by income level (percentage of workers covered)
Another feature of middle-sector coverage is the extent to which "unexpected" combinations occur: formal workers who are not covered, and informal workers who are (Table 2.2). Bolivia has the highest percentage of informal middle-sector individuals among the covered (27.2%), and Chile the lowest (10.1%).
Table 2.2. Coverage rate and formality, by level of income (percentage of workers covered)
The issues arising from informality therefore extend even to individuals who in principle would be considered "protected". This highlights the importance of considering mobility between formality and informality during an individual’s working life. Workers who make such transitions risk falling into poverty in old age since they will not have contributed sufficiently. How bad is this problem?
Pension coverage among formal employees is high (Figure 2.6) – above 80%, except in Bolivia and among the disadvantaged in Mexico (where coverage drops dramatically at low incomes, although these cases are not numerous). Despite differences across income groups and certain heterogeneity across countries, pension coverage among formal employees, at all income levels, is broadly adequate in three of the four countries analysed when measured against our 60% coverage threshold.
Figure 2.6. Pension coverage rate of formal workers by income level (percentage of workers covered)
All three income groups (disadvantaged, middle sectors and affluent) have similar coverage levels in Brazil and Chile; in Mexico, middle-sectors coverage is similar to the coverage of the affluent, although coverage for the disadvantaged is lower. The picture is more worrying in Bolivia. Coverage there rises with income level – itself evidence of inequality among formal workers – but absolute levels remain low. Even formal employees in the affluent income group barely reach the 60% standard.
This generally adequate coverage of formal workers means that the persistent shortfall in coverage in the region is concentrated among the self-employed and informal employees. Coverage rates of informal workers are very low, and strongly linked to income level in all four countries (Figure 2.7). The informal middle sectors in Chile secure the highest level of coverage (14%), followed by Brazil and Mexico (11%) and Bolivia (2%). These coverage levels put the informal middle sectors closer to the disadvantaged than the affluent.
Figure 2.7. Pension coverage rate of informal workers by income level (percentage of workers covered)
Among the informal group, pension coverage is highest for professionals (self-employed with tertiary education) in all countries other than Mexico (Figure 2.8). There – surprisingly – coverage of professionals is lower than that of non-agricultural informal employees.[i] Coverage rates for professionals are U-shaped (with the exception again of Mexico), being lower for the middle class than the income groups either side. This contrasts with the rest of the self-employed where coverage in all countries rises with income level.
[i] Table 2.A4 in the statistical annex shows the evolution of coverage for this group from 1994 to 2006. It has increased only for the affluent.
Figure 2.8. Pension coverage rate of informal workers (percentage covered)
Brazil is noteworthy because compulsory affiliation there extends to self-employed workers – it is voluntary in Bolivia and Mexico, and will be in Chile until 2012. Coverage as a result is indeed relatively high. However compulsion has not succeeded in breaking the link with income: the level of coverage of the less-educated self-employed is low, and coverage rises markedly from one income group to the next (from 12% for the middle sectors to 38% for the affluent). This points both to the limited effect of compulsion on the one hand and, probably, to low and irregular savings among middle-sector independent workers on the other. It certainly suggests that legal compulsion by itself is not enough to secure extended coverage.
Finally, coverage among informal employees is higher than coverage among the self-employed (except for the self-employed with tertiary education completed).at all income levels in Chile, and more so in Mexico – the highest for any informal group. Any explanation based solely on this descriptive analysis must remain somewhat speculative; however it is possible that capitalisation provides incentives to remain in the system even after a transition to an informal job.
Figure 2.9 recasts these data by occupational class. Brazil has the highest coverage rate for professionals (around 40%), followed by Chile (around 20%). Non-agricultural informal employees are best covered in Mexico (around 17%), as noted above. Chile has the highest coverage rates for the non-professional self-employed, in both agricultural (around 14%) and non-agricultural (around 10%) occupations.
Summing up, the data presented confirm that informality reduces pension coverage for all income groups. Moreover, the link between coverage and income levels is much clearer among informal workers than formal, meaning that poverty in old age is likely to reproduce, or even exacerbate inequality.
Figure 2.9. Pension coverage rate for the informal middle sectors (percentage covered)
A look at those already retired
Calculating coverage rates for the elderly (over 65) is straightforward, since this is the group currently receiving benefits. The coverage of the elderly in Latin America is extremely low, and only in a few countries – Argentina, Bolivia, Brazil, Chile, Costa Rica and Uruguay – are rates above 60%.29 The range is huge: from 85% in Uruguay to only 5% in Honduras.
As in the case of workers, coverage rates for contributory pensions are low – the exception is Brazil, where they are above 85% on average, and 87% among the middle sectors. Coverage rates are also positively correlated with income (Figure 2.10). Non-contributory pension schemes help to offset this regressive pattern (reaching up to 90% in Bolivia, and around two-thirds in Chile). These pensions are small however and significant regressivity remains.
Figure 2.10. Pension coverage rate of the elderly by income level (percentage covered)
Covering the Uncovered
The main goal of pension reform is to achieve "adequate, affordable, sustainable and robust pensions, while at the same time contributing to economic development".30 Many of the countries in Latin American that were at the forefront of structural pension reform seem to have achieved some of these goals (affordability and sustainability), but run the risk of failing in others (adequacy and robustness). These challenges are shared by countries, such as Brazil, that did not participate in the reforms. In addition, informality severely limits the coverage of pension systems – even those based on individual capitalisation accounts, where the incentives to contribute are in principle the greatest.
Pension reform in Latin America will therefore need to be underpinned by appropriate social, labour and macroeconomic mechanisms. It cannot be seen as the "silver bullet" to reduce informality, as was hoped by the pension reformers of the 1990s. Instead, reform needs to take into account this reality. While reducing informality can be retained as a goal – and incentives aligned with this end – changes should focus on assuring adequate and sustainable pensions across the population.31
Mechanisms to guarantee pension coverage can be categorised as being of two types: those that act at the moment of retirement, called ex post interventions; or those that act ex ante during the working career.32 Ex post interventions are themselves of two main types: transfers that are not linked to contribution histories, often referred to as "social pensions"; and transfers which guarantee a minimum pension within mandatory-contributory pension schemes (conditional on a given contribution history). Social pensions can be universal, paid to all individuals who reach eligibility age, sometimes with residency restrictions; this is the case in Bolivia and Chile. Or they can be means-tested as is the case in Argentina, Brazil,
Chile, Costa Rica and Uruguay.
Given that informality is pervasive in Latin America, reliance on this solidarity pillar seems almost inevitable. Indeed calls to strengthen it have been made by the Inter-American Development Bank (to be financed by consumption taxes)33 and by the Economic Commission for Latin America and the Caribbean.34 One way of doing so would be to reduce the years of contributions required for a minimum contributory pension. This currently stands at over 20 years in many countries, compared with 15 in Spain for instance. Another option would be to introduce social pensions. This would be more expensive, but could have a significant impact on poverty reduction.35
Unfortunately, a large fiscal commitment to a non-contributory basic pension can act as a strong disincentive to formalisation. The design of such a scheme must therefore be careful. A minimum pension which rises with contributions up to a certain level may address this risk at least in part – as has been done in Chile.36 However, such reform will never be cheap, and estimates put the cost at the order of 1% of GDP.37 These costs will not be immediate however, since all pension reforms include a transition period during which those who enter the new system accumulate resources or entitlement well before they begin to retire. Only after this, given that there are generally generous transition rules, is a social-pillar protection mechanism necessary.
In contrast to the ex post situation, there is little doubt that governments need to act now for workers in the active phase. Also with these ex ante policies there seems to be the greater scope for pension reforms benefitting the middle sectors.
The most direct policy option is to make affiliation compulsory for the self-employed. This is not currently the case in many countries (among our sample Bolivia, Mexico, and Chile at least until 2012). However the patchy coverage figures for Brazil, which does have compulsion, demonstrate that the effective implementation of such policy is not simply a matter of passing the necessary legislation. By definition, it is not evident how to enforce compulsory contributions for those in the informal sector. Furthermore, some informal workers can afford only to save to cover basic needs, so compulsory saving may not be optimal for low- or even middle-income households – unfortunately, household survey data are not adequate to answer this question, and estimates from alternative databases are not accurate either.
Several countries have been considering alternative hybrid approaches, such as "semi-compulsion". Under these programmes, workers are automatically enrolled, but are able to opt out. Modifications that would particularly respond to the needs of informal workers could accompany this. Greater flexibility on both the amount and timing of contributions is one example; permitting payment withdrawals in limited circumstances, such as long-term unemployment or health problems, is another.38
Finally, in recent years the debate has started to focus on "matching contributions" – transfers made by the state into an individual’s defined-contribution pension plan conditional on their own voluntary contributions. In contrast to minimum and social pensions, matching contributions provide incentives for long-term saving by workers themselves. This may be particularly relevant for informal individuals with some savings capacity – a group that covers much of our middle sectors.
Matching contributions are still in the experimental design stage, and few countries have implemented them. In Latin America, the Colombian Solidarity Pension Fund subsidises the contribution of low-income self-employed workers, and the Mexican government partially matches the contributions of workers affiliated to the private defined-contribution system. Brazil does some matching within its rural pension scheme. Finally, Peru has recently introduced a matching-contribution scheme for informal workers of small firms, by which the government matches 100% of the worker’s contribution. Though they have the support of the World Bank,39 it is still early days for these schemes and research assessing them is awaited.