18 - Financing and funding Flashcards
Define Unfunded financing and describe its three main types.
Unfunded financing occurs when an alternative financing option may have already been encountered under the term pay-as-you-go (PAYG). The three main types of unfunded financing are:
* Pure PAYG: This involves absolutely no funds set aside.
* Smoothed PAYG: This arrangement maintains a small working balance which is in no way linked to the benefit promise.
* Equalised PAYG: This arrangement charges a stable contribution rate over a control period. Surpluses in a small fund created at the start of the control period are intended to be fully exhausted by the end of the control period. The purpose of the asset pool is not to cover the benefit promise in part or full but merely to stabilise the contribution rate.
Explain the concept of the funding level in the context of financing.
The funding level is the ratio of the asset value to the liability in respect of the benefit promises. In some financing flows, the size of the asset level relative to the liability in respect of the benefit promise is targeted.
What are the key differences between pure PAYG and funded financing with respect to how future benefits are paid for?
- Under pure PAYG, current contributions from current workers and their employers pay for the pensions of current retirees, promising that future generations will pay for their pensions. Borrowing money on capital markets to fund public projects is common.
- Funded financing collects contributions from current workers and employers and sets them aside to pay for the benefits of current generations in the future. This creates a debt-like public sector liability and an asset in the private sector.
Describe the general average premium (GAP) method for advance funding.
The general average premium (GAP) method calculates a contribution rate (CR) such that a level rate will be payable throughout the lifetime of the scheme. This means that a relatively high rate will be payable when the scheme is first established, compared to the equivalent CR in a PAYG system. The CR at any point in time is given by:
CR = (EPV(future benefit expenditure incl future new entrants) - fund) / EPV(future covered earnings of contributing population incl future new contributors).
Explain terminal funding and in what situations it is most meaningful.
Terminal funding means that the funds are set aside in advance, each of which will cover the once-off cost for each individual beneficiary. No funds are built up to provide the expected stream of benefit payments. This method is most meaningful for annuity-type benefits like retirement pensions, disability income benefits, and unemployment benefits where there is a delay between when the benefit starts and the actual payments are made. This method is very useful in cases where beneficiaries can choose between lump-sum and income benefits as both can be financed from the fund created.
Describe the scaled premium (SP) method and how its contribution rate (CR) changes over time.
The scaled premium (SP) method involves choosing a control period and calculating a level contribution rate sufficient to provide for the expected benefits during the control period. Unlike the equalised PAYG, the SP is applied over a shorter control period, at which point the CR is recalculated. Many benefit systems face rising costs over time, and in an equalised PAYG, a fund is built up during the early period that will be drawn down later. By contrast, under the SP method, if a fund builds at the end of the control period, the level would be zero or relatively low, and another control period is then assessed. This approach generally requires a non-decreasing fund and the fund itself must be invested to meet expenditure and not the fund itself.
What are the main categories of advance funding options?
The main categories of advance funding options for sponsors in general include:
* Lump sum in advance: A lump-sum payment is made when a member joins a fund.
* Terminal funding: Funds are built up to meet the cost of the benefit as soon as the benefit promise is made.
* Regular contributions: Contributions are paid regularly to meet the future benefit payments.
* Just-in-time funding: Payment is made at the last possible moment that distinguishes it from terminal funding, as there is generally not a benefit event which jeopardises the security of the fund.
List and briefly describe the criteria for choosing a financing method.
The following criteria for choosing a financing method:
* Security: The ability to meet benefit expectations in all circumstances.
* Stability: A financing method that produces a contribution rate that is not unduly distorted by fluctuations in experience.
* Affordability and sustainability: The chosen method should involve both current and future contributions that are affordable and acceptable to those paying them.
* Realism: The financing method should give a realistic measure on a year-to-year basis of the long-term costs of the benefits.
* Accounting: Accounting standards should regulate the truthfulness of the reported financial position of the fund.
* Liquidity: The liquidity of a PAYG system depends on the contributions or source of income.
* Flexibility: The ability to offer significant flexibility for different types of contributors.
* Opportunity cost: There may be an opportunity cost involved in setting aside funds now to meet future benefit payments.
* Regulation: All types of non-state provision have regulations restricting the method of financing which will be allowed to be observed.
* Taxation: Restrictions linked to any incentives provided by the state to encourage benefit provision.
What are some potential advantages and disadvantages of a state adopting a funded approach to financing social security benefits instead of a PAYG system?
Potential advantages:
* Potentially more resilient to demographic shifts (e.g., ageing population) if the fund is sufficiently large and well-managed.
* Savings and investment may lead to higher economic growth.
Potential disadvantages:
* Requires significant upfront capital and investment management expertise.
* Investment returns are not guaranteed and involve risk.
* Can be complex and may exceed the investment capacity of the country.
* Savings may be redirected from other productive investments.
Explain the concept of contribution rate (CR) in a Pure PAYG system and how it is influenced by demographic factors.
In a pure PAYG system, the contribution rate (CR) is expressed as a percentage of covered earnings. One way of interpreting it is:
CR = (Number of recipients / Number of covered workers) * (Average benefit / Average covered earnings)
This can be further broken down into the dependency ratio (DR), the eligibility ratio (EL), and the replacement rate (RR):
CR = (Working age population / Number of covered workers) * (Benefit-eligible population / Working age population) * (Recipients / Benefit-eligible population) * (Average benefit / Average covered earnings)
Or simplified as:
CR ≈ DR * EL * RR / (CovR / Pop) where CovR is covered workers and Pop is total population.
