XVII. Pensions

Ke-young Chu, and Richard Hemming
Published Date:
September 1991
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What is the appropriate structure of public pensions?

Does pension provision have adverse effects on the labor market and national savings?

How should public pensions be financed?

What is the likely impact of population aging on pension costs?

The large and rising share of GDP devoted to public pension programs, amounting at present to some 10 percent in industrial countries and about 5 percent in a number of middle-income countries, renders the control of program outlays an important public expenditure policy objective in these countries. However, pension reform has proven to be difficult. Radical restructuring is rare, and reforms have for the most part been limited to modifying existing pension schemes. The reason for this difficulty is that current pension provisions tend to be structured in a way that confers rights which governments have been reluctant to deny. This note explains why programs have developed in this way, describes some of the problems with which they are associated, and discusses the issues that arise in designing new programs and reforming old ones.

Institutional Aspects of Public Pension Programs

Rationale for public provision

Three arguments are generally advanced to explain government intervention in the provision of pension benefits. The first argument emphasizes the absence of efficient private provisions due to market failure. In countries with rudimentary financial systems, this relates to the lack of saving instruments that offer a guaranteed real return. An adequate annuity market would help insure against the uncertainty of an individual’s life expectancy; therefore, inefficient or limited annuity markets justify public intervention. The pooling of all risk groups in one mandatory public pension scheme overcomes problems associated with adverse selection, where a private market will inevitably collapse because only people who anticipate an above-average life span will want to purchase insurance. The second argument is based upon paternalism; even if actuarially fair annuities are offered by private insurance markets, individuals may be myopic about saving and therefore not save enough for retirement. This saving shortfall may be due to a short planning horizon or to a high individual intertemporal discount rate. The third argument contends that even in the absence of market failure and myopic behavior, a public pension program can be used as a welfare-enhancing instrument of income redistribution over individual life cycles, between individuals and across generations.

Public pension systems

The two main objectives of pension arrangements are poverty alleviation and income replacement. The former guarantees that retirees maintain a level of income that enables them to achieve at least a minimum standard of living; the latter ensures that, on and through retirement, there is a link between their pre-retirement and post-retirement standards of living. The first objective is addressed by flat-rate benefits; the second objective is met by earnings-related benefits. These two objectives correspond closely to two alternative models of pension provision: the universal model and the social insurance model.

In the universal model, flat-rate benefits are provided either to all residents or citizens above a certain age, irrespective of income and employment status, or else as flat-rate benefits at means-tested minimum levels. The benefits are typically financed by general government revenue. The universal model has been adopted in only a few high-income countries and is often supplemented by an earnings-related pension scheme. In the social insurance model, benefits are related to former earnings and contribution periods. This system is mandatory for some or all occupational groups and the benefits are usually financed by contributions from the earnings of the insured. Earnings-related schemes remain the prevailing system for providing retirement income in industrial countries. This system can also be found in some Latin American countries, with varying degrees of coverage, and in most developing countries for government employees, including military personnel. In a number of developing countries (in particular, the francophone countries in North Africa), salaried employees in the formal sector are often covered by a public pension scheme of the social insurance type. In the anglophone developing countries of Africa and Asia, pension provision is more likely to reflect a voluntary agreement between employers and employees, usually set up as a provident fund arrangement, whereby pensions reflect accumulated contributions that are invested by the provident fund administration, usually in government bonds, housing loans, or other loans to public sector agencies. However, the majority of employees in developing countries are not covered by a pension plan, and rely instead on their own savings, the extended family and community support during retirement (see the note on Poverty and Social Security for further discussion of safety nets in developing countries).

Economic Aspects of Public Pension Programs

Effects on labor markets

It has been suggested that the provision of public pensions has a significant impact on labor supply. However, for the younger age groups it is difficult to separate the effects of pensions from those of other taxes and transfers. If contributions are viewed as a tax (because workers are short-sighted and ignore accumulated entitlements) or if benefits are unrelated to current taxes (as in universal schemes), they should affect labor supply in exactly the same way as do taxes and transfers. But, if workers recognize the value of accumulated future entitlements, these effects are reduced. The tax-benefit link is often cited as an advantage of the insurance approach to pension provision, and is used as an argument for a closer relation between contributions and benefits. A close tax-benefit link should also lead to fairly orderly retirement decisions of elderly workers. However, actual programs differ as a result of varying eligibility rules, replacement rate formulas, and indexation provisions that yield diverse financial implications of working an extra year at close to retirement age. Empirical studies show that these financial implications have a significant impact on labor force participation of the elderly.

Effects on savings

Public pension programs operate essentially on a pay-as-you-go (PAYG) basis; that is, a working generation directly finances the benefits of the contemporaneous retired generation. This contrasts with the funded provision common in the private sector, under which each active generation builds up its own stock of assets that it then draws down after retirement. The establishment of a PAYG system could affect the saving and dissaving rates of active and retired generations respectively. The active generation could reduce its saving rate, because the presence of the system implies a reduced need to save for retirement, while the retired generation might reduce its dissaving to reflect the benefit received from the pension system. The net effect is likely to be negative because, as the pension system matures, it will transfer income from the working generation, with a high propensity to save, to the retired generation, with a lower propensity to save. However, the effect is also likely to be small, and only temporary during the growth phase of the program. In the long run, the national saving rate should return to close to its pre-pension level.

Selected Policy Issues

Pension financing

The financing of public pension programs raises three interrelated but distinct issues: (i) the choice between contributions and general revenue financing; (ii) the split in the contribution burden between employees and employers; and (iii) the role of reserve funds. The first issue relates to the type of benefits provided. Flat-rate benefits are not linked to previous income levels, and it is therefore argued that financing should be provided from general revenues. Earnings-related benefits, on the other hand, require earnings-related contributions, as in the case of private pensions. However, since the link between contributions and benefits in public pension programs is usually not very precise, it is often argued that the implied welfare component should be financed from general government revenue. Further arguments for partial budgetary financing take into account that the low level of earnings of many of those insured prevents a full contribution burden and that the costs of shifts in demographic structure, and in particular population aging, should not be borne only by the insured.

The second issue is more political than economic. There is in principle little difference whether employers or employees are formally responsible for paying pension contributions. Total labor costs are the same in either case. But if labor markets are inflexible, the distinction may matter, at least in the short run. The higher employers’ contributions that are a common feature of pension programs result primarily from voter-oriented political behavior that anticipates less resistance to an increase in employers’ contributions. However, the resulting misperception of the true costs of public pension provision may be partly responsible for unsustainable extensions of benefits and coverage that have been demanded in some countries (see below).

The third issue is linked with the choice between PAYG and funded systems. Almost all public pension programs started out as fully or at least partially funded systems, accumulating reserves during the start-up period. However, the reserve funds rapidly grew to levels that brought forth demands for additional benefit increases or delays in contribution rate increases. Most public pension programs now operate on a pure PAYG basis with a small liquidity reserve of one to three months’ outlays that serves only to cover the time lag between outlays and revenue collection and short-term cyclical factors. However, in some cases there is still a build up of sizable financial reserves—such as those in the United States (accumulated to provide for the retirement of the baby-boom generation) or in some developing countries (accumulated during the start-up phase)—that are as a rule used to finance deficits on the nonpension operations of the government.

As indicated above, public pension funds are usually invested in government bonds. Pension contributions then become a source of captive financing for the government budget. Moreover, since these contributions are forced savings, the government can pay below-market interest rates. Such arrangements have a number of implications. They often encourage governments to spend more than can be justified by reference to the taxable and borrowing capacities of the economy. While this is a criticism more often leveled at PAYG programs, a pension fund invested in government bonds is indistinguishable from a PAYG program, since future pension payments will require higher contributions or taxes. The low interest rate is also distortionary and inhibits the progress of financial liberalization. Ideally, the government should use temporary reserves of pension plans either to create assets, reduce debt, or lower taxes, and thereby provide room to accommodate increased pension expenditure in future years.

Inflation and indexation

An inflationary environment has a substantial impact on public pension programs, and indexation policies can play an important role in sustaining or generating inflationary pressures. Inflation combined with collection lags reduces effective contribution rates and provides strong incentives for employers to delay contribution remittances in the absence of appropriate penalties. If pensions are not indexed to inflation, the living standards of the retired deteriorate. Moreover, adjusting benefits to reflect inflation can combine with collection lags to widen the deficit of the pension program, which in turn can fuel inflation. This phenomenon has been observed in a number of high-inflation countries. Indexation also implies that pensioners receive special protection from the adverse effects of inflation. While the elderly are one of the most vulnerable groups in the population, a more targeted approach to protecting their well being—for example, a flat-rate increase which compensates only the poorest segment fully for the price level change—may be preferable.

Pensions and labor market adjustment

Increasing labor market disequilibria, pressing youth unemployment problems, and employment adjustments in declining industries are issues that are frequently addressed by special early retirement provisions, relaxed rules on eligibility for disability pensions, and a selective lowering of retirement age. Although these measures may mitigate the unemployment problem and related political pressures, they also have a number of drawbacks. First, they are costly. The few available studies indicate that unemployment compensation and retraining schemes, and other specially tailored temporary programs targeted at displaced workers, are more cost effective. Second, these measures may have longer-term financial consequences; for example, early retirees with low initial pensions will have a high poverty risk, requiring further government protection. Third, the measures are difficult to reverse even if the unemployment situation improves.

Population Aging and Long-Term Pension Costs

The cost implications of existing pension programs have become an issue in many industrial countries. In particular, it is now evident that extensions to benefits made in the 1960s and 1970s, when the baby-boom generation was swelling the work force and could absorb the additional taxes and contributions needed to finance them, will be unsustainable when this unusually large age cohort is retired. In a number of countries, benefits have been cut back so as to limit projected tax/contribution increases. It remains to be seen whether more extensive retrenchment will be needed in the future. This experience points to the need for a careful assessment of the long-term cost implications of pension reform. With a PAYG system, these costs are often not evident, since they do not materialize until long after commitments are made. This feature of PAYG can be used to pursue short-term political goals, which in turn exacerbates long-term financing problems. One of the principal advantages of funding is that program costs reflect benefits that are being accrued even if they do not become payable until long into the future; funding therefore embodies financial discipline inherently lacking with PAYG. However, as indicated above, imposing this discipline is a different matter. But there can be no justification for introducing new pension programs—either PAYG or funded—and changing existing programs without taking into account the long-run cost implications of so doing.

Country Illustration

Pension reform in Uruguay

Uruguay’s pension plan underwent significant reform in 1979. At the time, it was part of a larger social security system comprising 10 pension funds, 6 unemployment funds, and numerous maternity programs. Social security expenditure amounted to over 10 percent of GDP, one of the highest spending levels in Latin America. Expenditure had grown fairly rapidly over the preceding decade, as the coverage of the social security system in general was extended, and the pension scheme in particular was maturing in the sense that people were retiring with increasingly larger pension rights because of longer service. At the same time, the population was aging and the dependency ratio, as a consequence, increasing.

The principal objectives of the 1979 reforms were to unify the system with a view to rationalizing pension administration, to contain benefit growth, and to broaden the base of the system’s finances. The reforms did not achieve full unification, although 75 percent of pension expenditure is now undertaken by three plans managed by the central government. Benefit changes were modest; despite increases in retirement age and the elimination of early retirement provisions, the benefit structure remains highly variable across plans, average pensions are high, and retirement age is still low (60 for men, 55 for women in general, but lower for certain professional groups).

Before 1979, the social security system was financed from a payroll tax levied on employees and employers. Reserves were accumulated only to smooth short-term fluctuations in income and expenditure. Reflecting the level and pattern of expenditure, payroll tax rates were, on average, high and in some cases reached levels (up to 65 percent) that promoted capital-intensive economic activity and generated unemployment. Both the level and dispersion of rates were reduced in 1979, with additional revenue from a broadening of the value-added tax base being transferred to the social security funds. However, during the early 1980s, continued expenditure growth—compounded by rising unemployment and extensive tax evasion, which reduced the payroll tax base—required increases in payroll tax rates that largely reversed the 1979 reductions but without reducing claims on general revenue.


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