Can Pension Reform lead to an increase in Gross Saving?

Objectives of pension reform

The primary objective of a comprehensive pension system is to ensure that individuals across the income spectrum have adequate income in retirement. Their pension savings are intended to replace enough of their income so that they can enjoy a standard of living not drastically lower than when they were working. In the case of South Africa, proposals to achieve this include mandatory pension contributions and compulsory preservation of accumulated savings. A secondary yet important objective of pension reform is to increase the gross savings rate. For South Africa, this objective is of great significance given the substantial deterioration in the gross saving rate that has taken place over the last three decades (see Figure 1).

It is instructive to recall the three components of gross saving, namely, household saving, corporate saving and government saving. Given that pension reform targets household behaviour, much of the expected impact on gross saving will come through household saving. However, due to the relationships that exist between households on the one hand, the corporate sector (for example, as employer) and the government (for example, as receiver of tax revenue) on the other, pension reform could also have an impact on the other two components of gross saving.

Figure 1: Gross saving (% of GDP)

(Click on image to enlarge)

Source: South African Reserve Bank

There is strong agreement amongst stakeholders in the public and private sectors that increasing South Africa’s saving rate is critical for higher economic growth. This article examines some of the channels through which pension reform can be expected to reverse the downward trend in saving, and whether these channels would be effective in the South African context.

Channels through which pension reform could increase gross saving

Under the current proposals, households will be forced to redirect at least part of their existing retirement and other savings towards mandatory retirement plans. Pension reformers looking to promote savings expect that the resulting decline in current saving will be less than the increase in saving brought by mandatory pension arrangements. Because South Africans are generally saving a relatively small proportion of their income, pension reform is likely to require saving that is greater than the low level of saving that currently takes place. Total saving is expected to increase as households save more.

Households have a precautionary motive for saving (e.g. for unexpected health costs). The level of saving that households require for precautionary reasons is fairly independent of pension savings. This is because pension savings are relatively illiquid and hence a poor substitute for precautionary savings. As a result, households will attempt to maintain their precautionary savings at a similar level to what was the case prior to mandatory pension savings. Consequently, overall saving will increase when a mandatory pension system is introduced.

The desire to leave an inheritance for children means that households will continue working towards a certain level of saving over and above their mandatory pension savings. Pension savings cannot easily substitute for bequeaths, especially if life expectancy is increasing. As in the case with precautionary saving, total saving is expected to increase when this motive is taken into account.

If a mandatory pension system makes a clearer link between contributions and benefits for a wider segment of the labour force, then total savings could increase. The argument is that individuals are induced to work harder and longer in order to attain a benefit level that meets their needs in retirement. Greater productivity and a longer working life can contribute positively to household and corporate saving. The resulting higher income will also affect government saving positively as taxes paid by individuals and companies increase.

Pension reform could also increase gross saving by reducing pressure on fiscal resources. There are currently 2.5 million beneficiaries receiving the State Old Age Grant (SOAG). This is almost 70% of all people aged 60 and over. If pension reform is able to increase the number of individuals saving for their retirement, then there could be less dependency on the SOAG as a source of old age income. This could in turn have a positive effect on gross saving through an increase in government saving.

Why pension reform may not increase gross saving

There are several factors that may undermine the potential of pension reform to increase gross saving. The expectation that introducing a mandatory pension system will lead to a higher saving rate hinges on the assumption that households have sufficient income to save over and above their pension contributions. The South African reality however, is that a significant percentage of the population is struggling to live from day to day and saving for precautionary reasons is difficult while saving for their children’s inheritance is close to impossible.

High debt levels mean that South Africans are poorly prepared for compulsory saving. Figure 2 shows that between June 2007 and March 2010 consumers with impaired credit records increased from 36.4% of all consumers to a staggering 46.0% of all consumers. This means that about 1 in every two 2 consumers is struggling to pay their debt. By placing further pressure on incomes that are already stretched, a mandatory pension system could lead households to borrow even more in order to meet their consumption needs. Better management of household debt will increase the likelihood of a successful mandatory pension arrangement.

Figure 2: Consumers with impaired credit records (% of total consumers)
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Source: National Credit Regulator

There is a real danger that individuals will take measures to evade this new system. For example, they could evade it by moving out of the formal sector into the informal sector. This holds true particularly for low income individuals with low life expectancies. In their case, there is very little money to save for retirement, and a high likelihood that they will not reach retirement.

Without a clear understanding of the needs to save for retirement, individuals could choose to evade mandatory pension contributions. Financial literacy is critical if these channels are to work. More generally, these channels require some level of financial planning whereby individuals understand the need to save not only for retirement but for other needs as well. Saving for retirement is likely to be more successful in an environment where there is a broader understanding of saving.

Conclusion

Under the current saving environment, pension reform may not lead to a higher gross saving rate. This does not mean a mandatory pension system should not be introduced. The primary objective of providing adequate retirement income remains important even if the gross saving rate does not increase. Nevertheless, a holistic approach towards pension reform that incorporates the need for a higher gross saving rate should be encouraged.