- N. Barr
- Published Date:
- April 2002
© 2002 International Monetary Fund
IMF External Relations Department
Cover design and composition Massoud Etemadi, Jack Federici, and the IMF Graphics Section
Published March 2002
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The Economic Issues series aims to make available to a broad readership of nonspecialists some of the economic research being produced on topical issues by IMF staff. The series draws mainly from IMF Working Papers, which are technical papers produced by IMF staff members and visiting scholars, as well as from policy-related research papers. This pamphlet was prepared by Charles Gardner.
This Economic Issue draws on material originally contained in IMF Working Paper 00/139, Reforming Pensions: Myths, Truths, and Policy Choices. Citations for the studies reviewed are provided in the original paper, which readers can purchase ($10.00) from the IMF Publication Services, or download from the IMF’s website: www.imf.org.
Funded Pensions. These schemes make pension payments from a fund that is an accumulation of financial assets built up over a period of years from the contributions of its members. These plans may be either private or government run.
Pay-as-you-go (PAYG) Systems. In contrast to funded pensions, these systems pay pensions out of current contributions or taxes. They are usually run by governments from current tax revenues, and the amounts of the benefits are based on commitments, or promises, made by the governments.
Defined Contribution Plans. These plans are funded accounts in the names of individuals. The contribution rate is fixed. The individual’s pension is an annuity whose size—at a given life expectancy and rate of interest—is determined only by the size of his or her lifetime pension accumulation. Members of these schemes face the uncertainties associated with varying real rates of return to the pension assets.
Defined Benefit Plans. Often run at the level of firms or industries, defined benefit plans pay an annuity based on the employee’s wage and length of service. In older schemes, the pension was often based on the employee’s wage in his or her last year, or last few years, of service. The recent trend has been to base benefits on a person’s real wages averaged over an extended period. Either way, a person’s annuity is, in effect, wage indexed until retirement.
In these schemes, the employer, not the employee, bears the primary risk of a fall in the return on plan assets, but also gets the benefit of any higher-than-required return. In reality, these risks (or gains) to the employer are shared more broadly, rippling through to current workers (whose wages may be more or less depending on the cost of the scheme to the employer), to shareholders and taxpayers (through effects on profits), to customers (through effects on prices), and even to past or future workers, if the company uses surpluses from some periods to boost pensions in others.
Social Insurance. These are typically government-run pay-as-you-go plans. Risk is shared even more broadly than in private defined benefit plans. The costs of adverse outcomes can be borne by the retiree (through reduced benefits), by current workers (through higher contributions), by the taxpayer (through tax-funded subsidies), and by future taxpayers (through subsidies financed by government borrowing).