Equitable and Sustainable Pensions
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Chapter 2. Public Pension Spending in Advanced and Emerging Market Economies: Past Trends and Projected Outcomes

Author(s):
Benedict Clements, Frank Eich, and Sanjeev Gupta
Published Date:
March 2014
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Author(s)
Frank Eich, Mauricio Soto and Csaba Feher 

Introduction

This chapter presents historical trends in and long-term projections of public pension spending in advanced and emerging market economies.1 It finds that public pension spending increased from 5 percent of GDP in 1970 to about 9 percent in 2010 in advanced economies, with the four drivers behind the increase being population aging, changes in eligibility, the income replacement rate, and labor force participation rates. During the period 1970–90, increases in spending reflected a combination of higher replacement rates, aging, and increased eligibility. Pension spending growth has been more contained since 1990, helped by both tighter pension eligibility rules and increases in labor force participation rates. Public spending increases have been larger in emerging market economies, than in advanced economies during the past two decades, but from a much lower starting level in emerging market economies outside Europe. Between 1990 and 2010, spending in all emerging market economies increased, on average, by 2 percentage points of GDP. In emerging Europe, spending increased from about 7½ percent of GDP in 1990 to 10½ percent in 2010, reflecting mainly higher replacement rates and population aging. In other emerging market economies, spending increased from 2¼ to 3¼ percent of GDP during the same period, owing to increases in replacement rates, albeit from relatively low initial levels.

Looking forward, the chapter provides projections for public pension spending to both 2030 and 2050, incorporating the impacts of recent pension reforms. Public pension spending is projected to increase by about 1½ percentage points of GDP by 2030 in advanced economies. The projected public pension spending increases would be significantly higher had reforms not already been enacted: in the absence of these reforms, public pension spending would increase by 4¼ percentage points of GDP. Among emerging market economies, spending increases are projected to average ¾ percentage point of GDP by 2030.

The chapter is structured as follows: Historical trends of public pension spending and the factors driving them are presented in the next section, followed by a section discussing public pension projections out to 2030 and 2050 based on current policies. Population aging will accelerate markedly in advanced and emerging market economies during the coming decades, putting additional pressure on age-related spending for years to come. The next section discusses the numerous risks to the projections, including those relating to long-term demographic developments and macroeconomic assumptions. The final section assesses the need for pension reform. It finds that this need varies by country but that reforms could be considered in the majority of advanced economies and in a few emerging market economies, particularly those in which the projected increases in age-related spending for 2010–30 are relatively high.

Historical Trends in Public Pension Expenditures

The historical trends in public pension expenditure must be observed against the backdrop of gradual population aging. During 1970–2010, the old-age dependency ratio—the number of people ages 65 and older divided by the number of people ages 16 to 64 (the working-age population)—increased from 17 percent to close to 25 percent in advanced economies and from 10 percent to nearly 14 percent in emerging market economies (see Chapter 1). In other words, for every person 65 and older there are currently four working-age people in advanced economies and slightly more than six in emerging market economies. In most countries, the gradual increase in the old-age dependency ratio reflects, in part, increases in life expectancy but mainly the decline in fertility rates since the 1950s. As a result of declining fertility, the working-age population has been growing less rapidly. Migration is the other key demographic variable that can affect the old-age dependency ratio. In many countries, though, its impact on the overall population structure, and hence the age distribution, is not significant.

Public Pension Spending Trends in Advanced Economies

In advanced economies, although public pension spending has increased sharply during the past 40 years, reforms enacted since 1990 have helped slow spending growth. Expenditures increased from 5 percent of GDP in 1970 to 9¼ percent in 2010 (Figure 2.1, left panel).

Figure 2.1Advanced Economies: Evolution of Public Pension Expenditures and Main Contributors

Sources: Eurostat (2011); International Labor Organization (1997, 2011); Organization for Economic Cooperation and Development (2013b); and IMF staff estimates.

Note: The averages for these figures are calculated including only economies with consistent data for 1970–2010.

Figure 2.1, right panel, shows that the four drivers behind the change in public pension spending as a share of GDP are aging, eligibility rates (the number of pensioners as a proportion of the population 65 and older), replacement rates (the ratio of average pension to average wages), and labor force participation rates:

  • During 1970–90, increases in spending in advanced economies reflected a combination of higher replacement rates, aging, and increased eligibility—the average statutory retirement age declined by one year in this period. This increased generosity of systems that occurred during 1960–80 reflects, in part, the more general expansion of the welfare state (Lindert, 2004; Tanzi and Schuknecht, 2000). Increased female labor force participation offset some of the increase in spending.

  • Pension spending growth has been more contained since 1990. The impact of aging and benefit increases was partly offset by both tighter pension eligibility rules (including a higher retirement age in the Czech Republic, France, Germany, Italy, Korea, New Zealand, the Slovak Republic, and the United States) and further increases in labor force participation rates.

Public Pension Spending Trends in Emerging Market Economies

During the past two decades, increases in public pension spending in emerging market economies have been larger than those in advanced economies, but from a much lower starting level in emerging market economies outside Europe. Between 1990 and 2010, spending in all emerging market economies increased, on average, by 2 percentage points of GDP (Figure 2.2, left panel).2 In emerging Europe, spending increased from about 7½ percent of GDP in 1990 to 10½ percent in 2010 with rapid increases during the 1990s in Poland, Romania, Turkey, and Ukraine. This increase has been mainly due to higher replacement rates (average pensions increased relative to wages during the 1990s) and population aging. Declining labor force participation rates have also played a role (Figure 2.2, right panel). In other emerging market economies, spending has increased from 2¼ to 3¼ percent of GDP over the same period, owing to increases in replacement rates and population aging, albeit from relatively low initial levels.

Figure 2.2.Emerging Market Economies: Evolution of Public Pension Expenditures and Main Contributors

Sources: Eurostat (2011); International Labor Organization (1997, 2011); Organization for Economic Cooperation and Development (2013b); United Nations (2012); and IMF staff estimates.

Note: The averages for these figures are calculated including only economies with consistent data for 1990–2010.

On average, spending is lower in advanced economies than in emerging Europe—at 9¼ percent and 10½ percent of GDP, respectively—but is substantially lower in other emerging market economies, at 3¼ percent. However, the variation in spending among advanced economies is considerable, ranging from less than 5 percent of GDP in countries with relatively young populations and low replacement rates (Australia, Canada, Iceland, and Korea) to more than 12 percent in countries with relatively high replacement rates and older populations (Austria, Finland, France, Greece, Italy, and Portugal; see Figure 2.3). In contrast, no European emerging market economy spends less than 6 percent of GDP. Most European advanced and emerging market economies have replacement rates of between 40 and 60 percent, old-age dependency ratios greater than 20 percent, and nearly universal coverage. The relatively low spending in emerging market economies outside Europe reflects a combination of relatively low coverage (generally only those in the formal sector are eligible and receive pensions that are high relative to the average wage) and younger populations.

Figure 2.3.Pension Spending, Replacement Rates, and Aging, 2010

Sources: Eurostat (2011); International Labor Organization (2011); Organization for Economic Cooperation and Development (2013b); United Nations (2012); and IMF staff estimates.

Note: The size and shading of the bubbles represent aging—larger and darker bubbles indicate higher old-age dependency ratios. Advanced countries are AUS = Australia, AUT = Austria, BEL = Belgium, CAN = Canada, CHE = Switzerland, CZE = Czech Republic, DNK = Denmark, ESP = Spain, FIN = Finland, FRA = France, GBR = United Kingdom, GER = Germany, GRC = Greece, ISL = Iceland, IRL = Ireland, ITA = Italy, JPN = Japan, KOR = Korea, LUX = Luxembourg, NLD = Netherlands, NZL = New Zealand, NOR = Norway, PRT = Portugal, SVK = Slovakia, SVN = Slovenia, SWE = Sweden, and USA = United States. Emerging market economies are ARG = Argentina, BRA = Brazil, BUL = Bulgaria, CHN = China, CHL = Chile, COL = Colombia, EGY = Egypt, EST = Estonia, HUN = Hungary, IND = India, IDN = Indonesia, JOR = Jordan, LVA = Latvia, LIT = Lithuania, MYS = Malaysia, MEX = Mexico, PAK = Pakistan, PHL = the Philippines, POL = Poland, ROM = Romania, RUS = Russia, SAU = Saudi Arabia, ZAF = South Africa, THA = Thailand, TUR = Turkey, and UKR = Ukraine.

The Outlook for Public Pension Spending

Increased Spending in Advanced and Emerging Market Economies

Pension spending in advanced and emerging market economies is projected to increase by 1½ and ¾ percentage point of GDP, respectively, between 2010 and 2030, with substantial variation across countries (Figure 2.4). Among advanced economies, increases in spending of at least 2 percentage points of GDP are projected in Austria, Belgium, Finland, Korea, Luxembourg, the Netherlands, New Zealand, Norway, Slovenia, and Switzerland, while spending is projected to decrease in the Czech Republic, Italy, and Japan. Among emerging market economies, spending increases are projected of at least 3 percentage points of GDP in Egypt and Turkey and decreases in Bulgaria, Chile, Colombia, Estonia, Hungary, Latvia, Lithuania, Poland, and Ukraine. Box 2.1 summarizes the projection methodology.

Pension spending is projected to increase further beyond 2030. In advanced and emerging market economies, pension spending is projected to increase by 1.2 and 1.4 percentage points of GDP, respectively, between 2030 and 2050, taking the overall increase between 2010 and 2050 to nearly 3 and more than 2 percentage points of GDP, respectively.

Box 2.1Projecting Public Pension Spending

The projections presented in this chapter are based on official estimates where available, which are also subjected to “stress tests” to identify upside risks. For the advanced economies, initial spending levels include cash benefits for old-age, survivor, and disability pensions from the Organization for Economic Cooperation and Development (OECD) Social Expenditure database. The baseline projections are adjusted to reflect differences in spending levels between OECD and national authorities’ estimates (for most countries this discrepancy was less than 0.5 percent of GDP in 2007) using the framework outlined in Appendix 2A. For example, U.S. official projections include only social security pensions, whereas the projections in this chapter include social security and public pensions for state and local government employees. The baseline projections assume that the share of these state and local programs in total pension spending remains constant over time. For countries without readily available projections—mostly emerging market economies outside Europe—the calculations reflect the impact of changing demographics and labor force participation and are adjusted to account for reforms that would affect eligibility ratios and replacement rates.

For emerging market economies, initial spending is based on national authorities’ estimates. This chapter presents spending projections and calculates the eligibility ratios and replacement rates based on these projections, given the data on demographics, labor force participation projections, and legislated increases in the retirement age. Although the methodologies used for projecting pension spending may be straightforward, the assumptions underlying these projections are critical to their validity. Thus, the analysis also stress tests the demographic and macroeconomic assumptions underlying these projections to identify upside risks. In addition, the implementation challenges associated with the reforms underlying these projections are highlighted.

Enacted Reforms Help to Dampen Future Spending Increases

In advanced economies, old-age dependency ratios are projected to double between 2010 and 2050, in part because of increasing longevity—life expectancy at age 60 is projected to increase by about one year a decade—but mainly because of the past decline in fertility from about three children per woman in the 1950s to fewer than two in the 1990s (Goss, 2010). In emerging market economies, increases in the old-age dependency ratio are projected to be even more dramatic, particularly after 2030, owing to the rapid decline in fertility rates of the past few decades. In the absence of reform, demographic changes up to 2030 will increase public pension spending by 4¼ and 3¾ percentage points of GDP in the advanced economies and emerging Europe, respectively, and 2 percentage points in other emerging market economies (Figure 2.5). If implemented as planned, enacted reforms will lower average pension spending in 2030 by 2¾ percentage points in the advanced economies, 3¾ percentage points in emerging Europe, and 2 percentage points in other emerging market economies.

Figure 2.5.Projected Evolution of Public Pension Expenditures, 2010–30

The cumulative fiscal cost of projected spending increases is large. For the 20 years of 2010–30, the average present discounted value of pension spending increases is 12½ percent of 2010 GDP in the advanced economies and 3¼ percent in emerging market economies (Figure 2.6).3 The cumulative present discounted value of increases in pension spending during 2010–50 is 44¼ percent of 2010 GDP for advanced economies and 22¼ percent for emerging market economies.

Figure 2.6.Cumulative Cost of Pension Spending Increases

Risks to the Projections

Uncertainty of demographic projections

Although the consensus holds that life expectancy at birth and at age 65 will increase in the coming decades, the exact amount of those increases is uncertain. Unanticipated increases can result from misjudging the continuing upward trend in life expectancy or from sudden changes, for example, as a result of medical breakthroughs. Figure 2.7 illustrates the inaccuracy of assumptions about life expectancy at birth for the United Kingdom. Past official population projections consistently underestimated the expansion of life expectancy, requiring regular upward revisions. In response, the projections have, since 2006, assumed more rapid increases in life expectancy. Whether the more recent projections are more realistic than earlier forecasts remains to be seen.

Figure 2.7.Projected Life Expectancy at Birth for Males, 1966–2031

(Years)

Source: Shaw (2007).

The uncertainty of the population projections is also illustrated by the United Nations’ revisions themselves. Figure 2.8 (panel 1) shows the total fertility rate (TFR) in Germany projected in the 1992 and 2012 UN population revisions. For 2010, the 1992 population revision projected a TFR of 1.78; the actual number was 1.36. Starting with a much lower base in 2010, the 2012 revision now projects a much lower TFR in 2020 than was projected in 1992. The projections for the old-age dependency ratio in Latvia (Figure 2.8, panel 2) show a similar discrepancy, with the ratio projected to rise to 25 percent and 29 percent by 2020 in the 1992 and 2012 population revisions, respectively. Even small misjudgments in the underlying developments translate into significant deviations from the actual trend over the time horizons relevant for pension system design and policies.

Figure 2.8.Differences in Demographic Projections

Sources: United Nations (1992, 2012).

Figure 2.9 illustrates the uncertainty of the life expectancy at birth projection using India and Japan as example. The figure shows that revisions do not always have to go in the same direction: whereas life expectancy has been revised upward significantly for Japan, the opposite is true for India.

Figure 2.9.Differences in Projected Life Expectancies, Japan and India

Sources: United Nations (1992, 2012).

In addition to these demographic risks, public pension expenditure projections are subject to a number of other risks.

Macroeconomic risks

Macroeconomic assumptions also affect pension spending projections. For example, lower-than-expected productivity results in lower wages and—to the extent that pension payments are indexed to prices rather than wages—could result in higher replacement rates than under the baseline scenario.4 Under a low-productivity scenario (productivity growth lower by 0.25 percent, or set at the 2000–07 average if lower), pension spending in 2030 would increase by 0.3 percentage point of GDP in advanced economies and by 0.1 percentage point in emerging market economies more than in the baseline scenario.

Projections are also sensitive to labor force participation assumptions: unchanged labor force participation rates would raise 2030 spending by at least ½ percentage point of GDP in Brazil, the Czech Republic, Estonia, Hungary, Japan, Ukraine, and the United Kingdom.5

Risk of reform reversal

Official projections are also subject to the risk of reform reversal. In response to substantial aging challenges, legislated reforms often seek ambitious reductions in pension spending. Relative to a no-reform scenario enacted reforms are expected to reduce 2030 spending by at least 5 percentage points of GDP in Brazil, Chile, Colombia, the Czech Republic, Estonia, France, Italy, Latvia, and Poland and by at least 3 percentage points in Austria, Finland, Germany, Greece, Hungary, Japan, Lithuania, Portugal, the Slovak Republic, Slovenia, Spain, and Ukraine. Between 2010 and 2030, these reforms should lead to relatively large reductions in projected replacement rates in Canada, France, Germany, Iceland, Ireland, the Netherlands, Portugal, Slovenia, and Sweden and in eligibility ratios in the Czech Republic, Italy, the Slovak Republic, and the United Kingdom (Figure 2.10). For the period 2030 to 2050, large reductions in replacement rates are projected for Iceland, Ireland, Portugal, and the Slovak Republic. Eligibility ratios largely stabilize after 2030, when most of the legislated increases in the retirement age will have taken effect.

Figure 2.10.Current and Projected Replacement Rates and Pension Eligibility in Advanced Economies, 2010 and 2030

Sources: European Commission (2012); International Labor Organization (2011); Organization for Economic Cooperation and Development (2013b); United Nations (2012); and IMF staff estimates.

Note: AUS = Australia, AUT = Austria, BEL = Belgium, CAN = Canada, CHE = Switzerland, CZE = Czech Republic, DNK = Denmark, ESP = Spain, FIN = Finland, FRA = France, GBR = United Kingdom, GER = Germany, GRC = Greece, ISL = Iceland, IRL = Ireland, ITA = Italy, JPN = Japan, KOR = Korea, LUX = Luxembourg, NLD = Netherlands, NZL = New Zealand, NOR = Norway, PRT = Portugal, SVK = Slovakia, SVN = Slovenia, SWE = Sweden, and USA = United States,

As these reforms take effect, political pressure to reverse them could mount. In Sweden, for example, automatic adjustments (such as increasing contribution rates and freezing benefits to respond to funding shortfalls) designed to ensure sustainability of its pension system were delayed, and benefits were cut by less than suggested by automatic adjustment rules (Sundén, 2009). Similarly in Germany, indexation rules were modified during the 2008–09 global economic crisis to prevent pensions from falling in nominal terms (Börsch-Supan, Gasche, and Wilke, 2010). To reduce the impact of reform reversal, replacement rate reductions should not undermine the ability of public pension systems to alleviate poverty among the elderly. For example, in Greece and Italy, reforms reduced benefits while protecting low-income pensioners. In addition, achieving the spending reductions associated with lower eligibility ratios—such as by increasing the retirement age (as legislated in Australia, the Czech Republic, Denmark, Estonia, France, Greece, Hungary, Ireland, Italy, Japan, Korea, Romania, Spain, Ukraine, the United Kingdom, and the United States)—means that older workers should not exit the labor force through other routes, such as by claiming disability pensions.

Risks from the transition to multipillar structures

In emerging market economies in Latin America and Europe, specific risks arise from the transition to multipillar structures. In these countries, pension reforms that led to the introduction of mandatory private pensions improved the long-term sustainability of public finances. However, the large transition costs arising from diverting contributions to mandatory private pensions have widened budget deficits and increased near-term borrowing requirements. These deficits led a number of countries to reverse or slow this transition to address short-term fiscal constraints as captured by traditional deficit and debt indicators (Estonia, Hungary, Latvia, Lithuania, Poland, Romania), at times with adverse implications for long-term balances (Soto, Clements, and Eich, 2011). These reversals or slowdowns highlight the need to account for pension reforms transparently.

Shortfalls in the funding of defined-benefit private pension plans could also impose a burden on public sector finances. Governments may have to support participants covered by private pension plans if the private plans fail to deliver promised benefits. Because defined-benefit pension plans guarantee a certain pension income based on contribution years and earnings, funding shortfalls could be regarded as a contingent government liability (Figure 2.11). The degree of under-funding is considerable in some plans, but subject to wide fluctuations. In the United Kingdom, for example, the funding position of corporate defined-benefit plans fluctuated between balance and a shortfall of 20 percent of GDP during 2009 alone. The funding position was then in small surplus in early 2010 and early 2011. In mid-2013, the funding ratio was about 80 percent, equivalent to about 15 percent of GDP (PPF, 2013). In the United States, the 100 largest defined-benefit corporate pension plans were, on aggregate, fully funded in 2008 but the funding ratio fluctuated between 70 and 80 percent (equivalent to 2½ percent of GDP in 2012) in the following years (Erhardt, Perry, and Wadia, 2013). Insurance plans have been set up to protect defined-benefit pension program participants in case of corporate bankruptcies (Germany, Sweden, the United Kingdom, the United States). Although these insurance plans reduce government exposure to individual corporate failures, they are not designed to absorb the more widespread closure of private defined-benefit pension plans. Thus, government exposure to these risks is likely to be accentuated during times of crisis (IMF, 2009).

Figure 2.11.Funding of Private Defined-Benefit Pension Schemes, 2009

(Percent of pension plan liabilities)

Source: Organization for Economic Cooperation and Development (2011).

Note: Estimated median percentage surplus or deficit of 2,100 exchange-listed companies’ aggregate defined-benefit obligations.

Inadequate replacement rates are also a risk in private defined-contribution plans, which would lead to pressure for higher social pension spending. Governments in most countries will have no legal obligation to step in, but a contingent liability could arise from an implicit social obligation to ensure adequate income in retirement, especially for low-income groups. Although estimating the adequacy of future retirement incomes and making cross-country comparisons is generally difficult, these risks are likely to be more pronounced the larger the role of defined-contribution plans in providing old-age income. In Mexico, South Africa, Switzerland, and much of emerging Europe, more than three-quarters of pension fund assets are in defined-contribution plans (OECD, 2013a).

The limited cross-country evidence suggests that these risks could be particularly challenging in some countries. For example, the ratio of elderly to non-elderly incomes (on a posttax basis) is projected to fall between 2010 and 2040 in several advanced economies (Canada, France, Italy, and Switzerland), remain stable in some (Japan, Spain, and Sweden), and rise in others (Australia, Germany, the Netherlands, the United Kingdom, and the United States) (Jackson, Howe, and Peter, 2013). In several countries, median replacement rates are projected to be substantially lower than the average, which supports the evidence that some people—especially those with low to modest incomes—are not making adequate voluntary contributions to pension plans (U.S. Government Accountability Office, 2007; Pensions Commission, 2004). It has been calculated that 50-year-old Britons must save an additional $9,400 a year until retirement at age 65 to reach a benchmark replacement rate of 70 percent; the corresponding figures for Ireland and Spain are $8,800 and $7,300, respectively (Aviva, 2010).

Conclusion

The need for pension reform varies by country. Table 2.1 provides guidance on the need for reform and the main risks to the projections. Reforms could be considered in the majority of advanced economies and in a few emerging market economies, particularly those in which the projected increases in age-related spending (health and pensions) during 2010–30 are relatively high. In addition, the large size of pension spending in government budgets in several advanced and emerging market economies suggests that fiscal adjustment plans will need to include pension reforms, particularly in countries with large consolidation needs. If the underlying demographic assumptions do not materialize, reforms may be needed to stabilize spending—this risk is particularly marked for the high longevity assumption in six advanced and eight emerging market economies. Projections for a few advanced economies are vulnerable to macroeconomic assumptions, and those for emerging market economies face risks with respect to projected increases in labor force participation. Countries with low retirement ages and high eligibility ratios may also wish to prioritize pension reform to boost growth, especially if the gap between increases in life expectancy and the retirement age is high.

Table 2.1Summary of Pension Issues and Potential Reform Options
Cause for ReformMain Risks to ProjectionsMain Areas for Reform
PensionPension spending as
Age-relatedspending as aa percent of primaryShare of privateHighLowLow labor forceEligibilityReplacementTaxEfficiency of
spending increases1percent of GDP2spending3pensions4longevity5productivity5participation5rate6rate7wedge8contributions9
Advanced economies
AustraliaXXX
AustriaXXXXXX
BelgiumXXXXXX
CanadaXXXX
Czech RepublicXX
DenmarkXXXX
FinlandXXXXXXX
FranceXXXX
GermanyXXXX
GreeceXXXXXXX
IcelandXXX
IrelandXXXX
ItalyXXXX
JapanXXX
KoreaXXXXX
LuxembourgXXXX
NetherlandsXXX
New ZealandXX
NorwayXX
PortugalXXXXXXX
Slovak RepublicXXXXXX
SloveniaXXXX
SpainXXX
SwedenXXXX
SwitzerlandXXXXX
United KingdomXXX
United StatesXXXXX
Emerging market economies
ArgentinaX
BrazilXXX
BulgariaXXX
ChinaX
ChileXX
EgyptXXX
EstoniaXX
HungaryXXXXX
IndiaX
Indonesia
JordanXX
LatviaXX
LithuaniaXX
MalaysiaXX
MexicoXX
Pakistan
Philippines
PolandXXXX
RomaniaXX
RussiaXXXXX
Saudi ArabiaX
South AfricaXXX
Thailand
TurkeyXXXXXX
UkraineXXXXX
Note: Tax wedge and payroll tax yield available only for OECD economies.

Although the appropriate mix of reforms depends on country circumstances, increasing the retirement age has many advantages. Table 2.1 identifies potential reform options that could be considered by each country if additional reforms are required, including eligibility rates (which are affected by the retirement age and the coverage of the pension system), replacement rates, and measures to raise additional revenues:

  • Raising the retirement age further and curtailing eligibility for early retirement may be needed in most advanced economies projected to have high eligibility ratios in 2030, including Austria, Belgium, Canada, Finland, France, Germany, Greece, Korea, Luxembourg, the Netherlands, Portugal, the Slovak Republic, Slovenia, and Switzerland. Raising the retirement age could avert the need for further cuts in replacement rates beyond those already legislated and would limit the burden of higher payroll taxes. Some countries could also focus on reducing replacement rates—Ireland and Italy, for example, are projected to have relatively high replacement rates in 2030. However, cuts in pensions should be sufficiently progressive to keep the elderly out of poverty. The relatively low tax wedges in Australia, Ireland, Korea, New Zealand, Switzerland, and the United States suggest that revenue measures could complement efforts to tighten eligibility or reduce replacement rates. In addition, Austria, Canada, Greece, Ireland, Korea, the Slovak Republic, Sweden, Switzerland, and the United Kingdom seem to have room to raise collection efficiency.

  • Many emerging market economies, particularly Brazil, South Africa, and some in eastern Europe, are projected to have relatively high eligibility ratios in 2030. These countries could focus on equalizing the retirement ages of men and women and tightening access to disability pensions. Egypt and Turkey are projected to have comparatively generous plans that generally cover only a small portion of the population. In these countries, parametric reform is a prerequisite to expanding coverage. A few countries (including India, Indonesia, and Pakistan) are projected to have low replacement rates and low eligibility rates. For these countries, the main challenge will be to expand the retirement systems in a fiscally sustainable manner.

Appendix 2A. Public Pension Expenditure Details

Public Pension Expenditure Identity

Population aging is typically measured by the old-age dependency ratio (the ratio of the population age 65 and older to the population ages 15–64). Eligibility refers to the number of pensioners as a proportion of the population 65 years and older; this factor depends on the qualifying conditions for a pension, particularly the statutory retirement age and the possibility of early retirement. Replacement rates—the ratio of average pensions to average wages—capture the generosity of pension benefits. Finally, changes in labor force participation rates affect both the numerator—increases in labor force participation today can affect future eligibility and replacement rates—and the denominator—higher labor force participation implies higher GDP. The equations define the public pension expenditure identity. This simple identity can be used to calculate the change in pension spending as a share of GDP between two years (t1 and t2). For any year t, let O(t) be the old-age dependency ratio, E(t) be the eligibility ratio, G(t) be the replacement rate, and L(t) be the inverse of the employment ratio. Assuming a constant total compensation share in GDP over time, the following calculations can be made:

Data Sources and Calculations

For OECD economies (Australia, Austria, Belgium, Canada, Chile, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, the United States) 1980–2007 data are from the OECD Social Expenditure Statistics database (www.oecd-ilibrary.org/content/data/data-00167-en). This spending includes cash benefits for old-age, survivor, and disability pensions.

For some countries, public spending includes spending on special pension plans for public employees, including civil servants, subnational government employees, teachers, and members of the armed forces, which often follow special rules (including in Austria, Belgium, France, Germany, Greece, Portugal, and the United States). For Canada, these figures do not include teachers’ pension plans. For Mexico, the OECD data do not include state government plans. Earlier data (1970–79) for the majority of these countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States) come from Holzmann (1988). For the other OECD countries (Chile, Hungary, Iceland, Luxembourg, Mexico, Poland, Turkey), data for 1970–79 are imputed based on data from the International Labor Organization’s (ILO’s) “The Cost of Social Security” (1979, 1981, 1985, 1996). For years without observations, spending figures are estimated using a linear interpolation between the two observed points.

For Bulgaria, Latvia, Lithuania, and Romania, the primary source of data for 1990–2008 is the European System of Integrated Social Protection Statistics from Eurostat. For these countries, data for 1970–89 are imputed based on data from the ILO’s The Cost of Social Security. For years without observations, spending levels are estimated using a linear interpolation between the two observed points.

For other emerging market economies, the most recent spending as a share of GDP comes from IMF documents (Colombia, Egypt, Jordan, Saudi Arabia), country authorities’ estimates (Argentina, Brazil, China, India, Indonesia, Pakistan, the Philippines, Russia, South Africa, Thailand, Ukraine), or the ILO’s World Social Security Report 2010/11 (Malaysia). For some countries, these data might include social security spending other than pensions (Brazil). Because these data provide few data points, the years before 2010 are imputed based on demographics.

For cases in which data for 1990 and beyond are not available for these countries, they are imputed based on data from the ILO’s “The Cost of Social Security.” For years without observations, spending figures are estimated using a linear interpolation between the two observed points.

Projected Pension Spending, 2010–50

The latest available number (from the OECD, European Commission, Eurostat, ILO, IMF, World Bank documents, or country authorities’ estimates, as explained above) is the starting point for the projections. Spending is projected based on the authorities’ estimates when available. For most European economies, the authorities’ projections are available in their Stability and Convergence Programmes. These reflect, in part, efforts by the European Commission and the EU Economic Policy Committee to construct consistent projections for many European economies (European Commission, 2012). The methodology applies the rate of increase of the share of GDP in the authorities’ estimates to the initial spending point. For example, for countries for which the latest data point available is from the OECD for 2007, and for which the authorities’ estimates for 2007, 2010, and 2030 are available, the projections for 2010 and 2030 are calculated as follows:

For cases in which the authorities’ estimates start after the latest observed figure, the spending figure is projected forward using demographic changes only. For example, if the last actual observed year of spending is 2007, and the authorities’ estimates start in 2008, then

Of course, this methodology suggests that the spending figures may not always match the authorities’ figures because of the use of a different base—OECD pension spending might differ from official estimates because of broader coverage of pension spending. For example, for the United States, OECD pension spending includes spending in state and local plans, whereas the authorities’ estimates include only the national social security plan. Nevertheless, the advantage of this methodology is that it provides a relatively similar definition of spending (the OECD definition) that allows for cross-country comparisons.

For countries without readily available projections—mostly the emerging market economies outside Europe—projected spending reflects the impact of changing demographics and is adjusted to account for reforms that would affect replacement rates and eligibility ratios (Brazil, Chile, Colombia, Egypt, Jordan, Mexico). When no information about reforms is available (Argentina, China, Indonesia, Malaysia, Pakistan, the Philippines, Russia, Saudi Arabia, South Africa, Thailand, Ukraine), the following assumptions are made: (1) the coverage ratio (pensioners as a share of the population 65 and older) is constant, as is the replacement rate; and (2) changes are driven by the employment ratio and the old-age dependency ratio:

For China, a key assumption is the evolution of the funded component (the second pillar) of the system. Sin (2005) assumes full implementation of the second pillar and finds declining public spending on pensions as a share of GDP over time. In contrast, the baseline projections included in this chapter are closer to those from Oksanen (2010), which project substantial increases in pension spending during 2010–30, assuming the generosity of the unfunded state pension (first pillar) remains at its current level.

Population, 1970–2050

Population estimates, which affect the old-age dependency, eligibility, and inverse of the employment ratios in the identity, are from United Nations (2012).

Number of Workers

The number of workers is defined as the population ages 15 and older that is economically active. For every country in the sample the economically active share of the population is identified for each five-year age group (15–19, 20–24,…, 75–79, and 80+) separately for men and women for 1970–2050.

The share of the population that is economically active combines the fourth (data for 1950–2010) and sixth (data from 1990–2020) editions of the ILO’s Economically Active Population database. A consistent series for 1970–2020 is obtained by combining these two series—using the latest edition as the base and interpolating employment activity from 1990 to 1970 using the observed changes in the earlier data. Data for 2025–50 are projected using a fixed-effects regression on a five-year cohort (c) for every five-year period (t) during 1950–2020 (EAc,t = αEAc−1,t + βEAc-1, t γEAc, t-2 + γYEAR). In other words, the projections assume that the economic activity rate in year t for cohort c depends on the economic activity of the group five years younger than cohort c in 2020, and on the observed economic activity rate of cohort c in 2015, 2010, and 2005. This regression is performed for all countries in the ILO database. The result is a consistent series of economic activity for men and women by five-year age groups during 1970–2050.

Number of Pensioners

All individuals older than the statutory retirement age are considered “retired.” In addition, to account for early retirement, the share of the population ages 50–64 that was economically active at ages 45–49 but is no longer active is added to the “retired” pool—this calculation follows three different cohorts, 50–54, 55–59, and 60–64, separately for men and women. Finally, the total number of “retired” is multiplied by pension coverage (percent of those above the statutory age of retirement receiving a public pension) from ILO (2010) to obtain the number of pensioners. This adjustment is made to public pension coverage to reflect that not all retirees receive public pensions.

Compensation to GDP

Total employee compensation as a share of GDP (the last ratio in the pension expenditure identity) comes from the UN System of National Accounts 1993. The latest observed share of compensation in GDP is used, and it is assumed to remain constant throughout 1970–2050.

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Advanced economies comprise Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, the United Kingdom, and the United States. Emerging market economies comprise Argentina, Brazil, Bulgaria, China, Chile, Colombia, Egypt, Estonia, Hungary, India, Indonesia, Jordan, Latvia, Lithuania, Malaysia, Mexico, Pakistan, the Philippines, Poland, Romania, Russia, Saudi Arabia, South Africa, Thailand, Turkey, and Ukraine.

Not enough data are available to conduct the analysis for 1970–90.

The calculation uses a discount rate of 1 percent, equivalent to assuming a 1 percentage point differential between the interest rate and rate of economic growth. A similar assumption is made for longer-term projections in the IMF’s Fiscal Monitor (IMF, 2011). Over an infinite horizon, the present discounted value of pension spending increases is 235 percent of 2010 GDP in advanced economies and 190 percent in emerging market economies.

The impact is likely to decline over time because a permanent slowdown in productivity growth gradually lowers lifetime earnings, which, in turn, will eventually lower replacement rates.

Another related consideration is the impact of the 2008–09 global financial crisis and its aftermath on potential growth. The crisis would lead to a step increase in pension spending as a share of GDP, at least in the near term because benefit levels, which are tied to historical wage growth, adjust gradually and with a substantial lag. Some of this effect will be permanent, reflecting permanent losses in potential output, but some would be unwound as the output gap closes. Nevertheless, the overall effect of the crisis on spending is relatively modest, with little impact on the magnitude of the projected increases: closing the 2010 output gap would reduce 2010 pension spending by an average of 0.3 percent of GDP.

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