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Pension Schemes: Trade-Offs Between Redistribution and Saving

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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MANY countries’ single-pillar public pension systems seek to both generate savings for workers’ old age and alleviate poverty among older persons. Since these objectives are inherently contradictory, however, better results may be obtained by shifting to a multipillar system in which each pillar focuses on a single objective.

Public pension programs are intended to fulfill two primary objectives: to provide a compulsory saving mechanism and to alleviate poverty among the old. The compulsory saving mechanism forces individuals who might be myopic with regard to their future needs or who might expect to rely on charity in their old age to save for themselves. Financial institutions offering long-run contracts—60 or more years in duration—may not exist today in some developing countries, nor did they exist early in this century in the major industrial countries. In such circumstances, a public pension system might be the only means of accumulating long-term savings.

Poverty alleviation for the old can be achieved directly by forcing those individuals who can save to do so. However, there will always be individuals whose incomes are low throughout their lives and who are unable to save at all or to save enough to avoid facing poverty when they are old. A public pension system that collects contributions from workers can redistribute some of the contributions received to the poor.

Anita M. Schwarz,

a US citizen, is a Hutman Resources Economist with the Labor Markets and Social Insurance Group of the World Bank’s Education and Social Policy Department.

Unfortunately, these two objectives—saving and poverty alleviation—are inherently contradictory. A good saving mechanism establishes a tight link between contributions and benefits, with the value of the saving mechanism measured by the rate of return received on contributions. Poverty alleviation objectives, however, would suggest a much looser link between contributions and benefits, since some of the contributions from the rich are diverted to benefit the poor.

Most pension systems around the world attempt to achieve both of these objectives through a single system, but many of them end up doing neither very well. By shifting to a multipillar system, with one pillar devoted to providing a saving mechanism and the other to alleviating poverty, pension systems can achieve both objectives at a lower total cost.

Pension benefits and finance

Pension benefits can be provided as either defined benefits or defined contributions. Under a defined-contribution system, individuals and employers know how much has been contributed, but the benefit received by each individual is uncertain, since it is determined by the investment return on the contributions. Under a defined-benefit system, the benefit is specified in advance, but the cost to the pension system of providing that benefit is uncertain.

Defined-benefit schemes are generally financed on a pay-as-you-go or partially funded basis. Pay-as-you-go schemes take contributions from today’s workers and use them to pay pensions to current retirees. They neither add to the stock of natural savings nor provide savings accounts for contributing workers. Instead, their contributions purchase an “entitlement” to future benefits at some predetermined rate. As the number of retirees rises relative to the number of workers, owing to the aging of the population, contribution rates have to increase if the same benefit rate is to be maintained; if contribution rates remain unchanged, benefits will have to decrease.

Initial contribution rates are set higher under partially funded systems than under pay-as-you-go systems, allowing the accumulation of a fund which, with its investment return, limits the need for future contribution rate increases. It does not, however, completely eliminate this need. Furthermore, in many countries, the fund accumulations have been squandered by governments seeking additional revenue or used to augment current benefits. As a result, many countries that started with partially funded systems eventually reverted to pay-as-you-go financing.

Full funding, by contrast, results in an accumulation of funds today that match expected future liabilities. Contribution rates need not increase unless the expected investment return decreases or liabilities unexpectedly increase. While full funding of occupational defined-benefit plans is sometimes required by regulators, there are no examples of full funding in public defined-benefit schemes—perhaps owing to the same pressures that converted many partially funded systems into pay-as-you-go systems.

Chart 1Contribution rates required by alternative pension systems

(Percentage of average wage)

Source: Anita M. Schwarz, “Trade-Offs Between Redistribution and Savings in Alternative Pension Schemes,” forthcoming in the ESP Discussion Series (Education and Social Policy Department, World Bank).

Defined-contribution pension systems are, by definition, fully funded. Contributions from current workers are invested and used to pay pensions of those same workers upon their retirement. The fund itself carries no additional liability.

Defined benefits

Using the demographic profile of China as an example, the pay-as-you-go line in Chart 1 simulates the increasing costs of providing the elderly with an average pension worth 40 percent of the average wage in the economy. This is a modest replacement rate, yet it quickly becomes expensive. The simulations assume that the system begins in 1995 with a minimum 10-year contribution period required to receive a pension. Workers are assumed to enter the labor force at age 20 and retire at age 60. In the earliest years, few beneficiaries qualify for a pension, so the required contribution rate is less than 1 percent. But the required rate rises as the system matures and the population ages. By 2025, the payroll tax is 15 percent, and by 2075 it is 25 percent. Adding essential administrative costs, as well as survivors’ and disability insurance (included in most plans), would increase the required contribution rates another 3-6 percentage points. While China’s population is aging especially rapidly, all countries are undergoing a similar process and can expect similar cost increases.

Intragenerational redistribution. Although in practice little redistribution seems to take place, in theory it is possible for defined-benefit plans to transfer income from the rich to the poor. Suppose a country’s population consists of three categories—the poor, the middle class, and the rich—with the poor earning half as much, and the rich earning twice as much, as the middle class. Suppose further that real economy-wide wages grow 2 percent annually and that individual wages grow another 1 percent annually as workers age and gain experience. Chart 2 shows the results of a progressive benefit structure in which each individual receives 20 percent of the economy-wide average wage plus 20 percent of his own average lifetime wage, indexed for inflation and economy-wide wage growth. While the poor receive a lower pension than the rich, they get a higher percentage of their own average lifetime wage, enabling them to stay above the poverty line when they are old. Clearly, substantial redistribution and poverty alleviation are possible under pay-as-you-go, defined-benefit schemes.

Average lifetime benefits provided under:

Chart 2Pay-as-you-go, defined-benefit-plan

(percent)

Chart 3Pay-as-you-go, defined-benefit-plan

(percent)

Chart 4Defined-contribution plan

(percent)

Rates of return under:

Chart 5Defined-contribution plan

(percent)

Chart 6Mature multipillar system

(percent)

Chart 7Multipillar system

(percent)
(percent)

Source: Anita M. Schwarz, “Trade-Offs Between Redistribution and Savings in Alternative Pension Schemes,” forthcoming in the ESP Discussion Series (Education and Social Policy Department, World Bank).

Intergenerational redistribution. Because, in the early years of the plan, retirees who have contributed for only part of their working lives receive full benefits, and because the contribution rate rises gradually while the benefit rate is unchanged, the rate of return on contributions falls over time for all income groups (Chart 3). By 2050, when today’s children are about to retire, the rate of return for the average worker will be less than the market rate. While there is some redistribution between rich and poor, the bulk of the redistribution is from the young to the old, irrespective of the income earned by either. Thus, income will be redistributed from the young poor to the rich old (Chart 3). And even though the poor retiring in 2050 have lower lifetime incomes than the rich who retired in 2015, the former get a below-market return and lose real income while the latter get an above-market return and gain real income. The pay-as-you-go pension system is obviously not a good long-run saving vehicle.

Except during the early years of the plan, all participants would do better by saving on their own at market rates of return.

Defined contributions

The defined-contribution system, by contrast, has constant costs (). Initially, benefits are lower under the defined contribution plan than under the defined-benefit plan, because retiring workers have only a partial buildup in their pension accounts. But, once the plan has been in effect for 40 years, the average individual with a full working career gets benefits equivalent to those in the defined-benefit plan, and the cost of these plans can be directly compared (Chart 1). When the pension systems first begin, costs are lower in the pay-as-you-go plan, which has no beneficiaries in 1995. But, by 2025, when a generation of beneficiaries exists, the defined- contribution system is considerably cheaper.

A defined-contribution system does not redistribute income, since it essentially does not change market outcomes. Individuals with similar work experience get pensions that are equivalent to similar percentages of the wages they earned during their final year of employment, but they get very different percentages of the economy-wide average wage. Poor individuals get one third less per year than they would under the defined-benefit plan, while the rich get roughly one third more (Chart 4). Furthermore, the rate of return remains constant for all income groups in the defined-contribution plan and is equivalent to the market rate of return, indicating that the value of the saving mechanism remains high (Chart 5).

Plans compared. While the defined-contribution plan results in lower costs in the long run and provides a good long-term saving vehicle, it does not provide any mechanism for income redistribution or poverty alleviation. The defined-benefit plan, in contrast, has the capacity to alleviate poverty in the short run, but the expense involved becomes prohibitive over the long run. The 25 percent payroll tax rate required by 2075 is far higher than in developed countries today and will have a negative effect on employment. If even fewer workers have to support retirees, the payroll tax rate required to maintain fiscal balance will have to be even higher, which will have further negative effects on employment. The major redistribution of income in defined-benefit plans is from the young to the old rather than from the rich to the poor.

Multipillar system

Suppose a multipillar system is established that combines a pay-as-you-go, defined-benefit plan that is targeted toward the poor with a fully funded defined-contribution scheme for all. Together, these two pillars are set to provide a 40 percent benefit rate to the average worker. The pay-as-you-go benefits provide 20 percent of the economy-wide average wage to the poor and 10 percent to the middle class, with the rich left to rely on their defined-contribution benefits.

The multipillar system will have increasing costs over time because of the pay-as-you-go defined benefit, but, because this is blended with the defined contribution, which does not change over time, cost increases will be smaller and more gradual than in a purely pay-as-you-go system. By 2075, the costs of the multipillar plan are about 30 percent higher than the defined-contribution plan but only 60 percent of the defined-benefit plan (Chart 1). The benefit structure in the multipillar system is better targeted toward the poor who, in 2060, continue to get a positive redistribution; their pension is higher than under the defined-benefit plan, while the rich and the middle class get a little less. (Compare Chart 6 with Chart 2.) Thus, in the long run, the multipillar plan is more effective in alleviating poverty than either the pay-as-you-go, defined-benefit plan or the fully funded, defined-contribution plan.

Further, much of the redistribution is within, rather than between, generations. (Compare Chart 7 with Chart 3.) Essentially, the middle-class young and the rich of all ages transfer income to the middle-class old and the poor of all ages. The rate of return for all workers remains closer to the market rate than it did under the pay-as-you-go plan, so the pension system continues to be a good saving vehicle, even in 2075.

Which system?

While public pension systems aim to provide a saving vehicle and alleviate poverty for the elderly, the pay-as-you-go, defined-benefit systems found in most countries end up achieving neither of these objectives over the long term. The aging of the population results in income transfers from future generations to the first few groups of retirees under the system, irrespective of their income levels, but poverty alleviation for the old becomes less and less feasible over time as costs rise. The defined-contribution pension system provides a good saving vehicle, but cannot alleviate poverty for old people who were poor during their working years. The multipillar pension system with a defined benefit targeted toward low-income groups provides a reasonable saving vehicle, keeps costs down, and successfully alleviates poverty in both the short and the long term.

Furthermore, the capital accumulated under the funded part of the system should generate increased productivity and higher wages for the economy, raising the overall rate of return. The experience of many countries suggests that the effect will be greater if the funded part is privately and competitively managed, which is the basic reason why the system should have two pillars—one publicly managed, the other privately managed—rather than one.

This article is based on a longer paper, “Trade-Offs Between Redistribution and Savings in Alternative Pension Schemes,” forthcoming in the ESP Discussion Series (Education and Social Policy Department, World Bank).

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