Chapter

IV Pensions

Author(s):
Edgardo Ruggiero, Peter Heller, Menachem Katz, Robert Feldman, Richard Hemming, Peter Kohnert, Ziba Farhadian, Donogh McDonald, Ahsan Mansur, and Bernard Nivollet
Published Date:
September 1986
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The largest single item of social expenditure in most of the seven major industrial countries is pensions; Canada and Japan are the only exceptions (Chart 3 and Table 15). Of the three major government social programs, the pension program has also been the fastest growing.34 As Table 1 shows, demographic factors, improved program coverage, and benefit increases have all contributed significantly to the growth of real pension expenditure. Benefit increases have tended to be the principal influence on expenditure growth, although demographic changes have had a strong effect, particularly in Japan. As long as populations continue to age, the demographic factor will exert considerable influence on pension expenditure.

Demography and Pension Expenditure

As Chapter III shows, the absolute number of elderly people—those aged 65 and over—is expected to increase in each of the seven major industrial countries. However, changes in the numbers of elderly do not necessarily correspond to changes in the numbers of pensioners. First, the eligibility age for pensions is not 65 in each country; 65 is the maximum “normal” pension age. Appendix II contains a summary of the principal features of the major public pension programs in each of the seven countries, including normal pension age and average benefit levels (Table 33). The evolution of the numbers of people of pension age can be derived from the demographic projections described in Chapter III (see upper half of Table 4). For the most part, the growth in the number of people of pension age and the growth in the number of elderly are the same. One exception is France, where the number of people aged 60–64 is projected to grow faster than the number of people aged 65 and over. The other exception is Japan, where the number of people aged 60–64 is projected to grow more slowly than the number of people aged 65 and over.

Table 4.Growth in the Number of People of Pension Age and. Numbers of Pensioners, as Projected in the Baseline Scenarios, 1980–2025(Index 1980 = l00)
Country1980200020102025
(Index of number of people of pension age)1
Canada100142169272
France100118128l47
Germany, Fed. Rep. of100112128138
Italy100123132148
Japan100178226238
United Kingdom100103109130
United States100136153230
(Index of number of retirement pensioners)
Canada100142169272
France100122132150
Germany, Fed. Rep. of100134155170
Italy100122130144
Japan100172206215
United Kingdom100l03109130
United States100136150215
Source: Fund staff estimates.

Pension ages (men/women) are assumed to be: Canada–65/65; France–60/60; Federal Republic of Germany–63/63; Italy–60/55: Japan–60/60: United Kingdom–65/60: and United States–65/65.

Source: Fund staff estimates.

Pension ages (men/women) are assumed to be: Canada–65/65; France–60/60; Federal Republic of Germany–63/63; Italy–60/55: Japan–60/60: United Kingdom–65/60: and United States–65/65.

Second, changes in the number of elderly (or changes in the number of people of pension age) do not correspond to changes in the number of pensioners because pension programs typically permit some flexibility in actual retirement age (with a corresponding adjustment to pensions). The lower half of Table 4 reflects the actual patterns of retirement age.35 For most countries, the two halves of the table differ little. In the Federal Republic of Germany, the somewhat faster growth in the number of pensioners reflects past increases in labor force participation, particularly among females, and a continuing trend toward early retirement. In the United States, an allowance has been made for a phased increase in the pension age from 65 to 67 between 2000 and 2025. In Japan, the number of pensioners is roughly equal to the number of people aged 55 and over, rather than the number of people aged 60 and over, and for the purposes of the projection this is treated as a long-term equality. This age group (55 and over) will, in turn, grow more slowly than the number of people aged 60 and over. Third, the number of pensioners is not only affected by retirement but also by the number of people who receive general non-retirement pensions (e.g., disability pensions).

Across countries, considerable variation is seen in the growth of the numbers of pensioners. At the extremes, the growth rate in Canada is more than twice that of the United Kingdom, Japan and the United States exhibit the same long-term growth rate, which is exceeded only, and substantially, in Canada. But the patterns of growth are markedly different. In Japan, 63 percent of the total increase occurs before 2000; in the United States, 56 percent of the total increase occurs after 2010. In Canada, 61 percent of the total increase occurs after 2010: the corresponding figure is 70 percent in the United Kingdom. Elsewhere, the growth in the number of pensioners is moderate and steady.

Given prospective numbers of pensioners, future pension expenditure is determined by the average pension that each one receives. If this latter factor is held constant, then an index of the number of pensioners would also be an index of real pension expenditure. Indeed, in that it shows how real pension expenditure changes as a result of increases in the number of pensioners alone, it represents a pure demographic effect. However, average pensions are unlikely to remain constant in real terms.

Pension Expenditure Projections, 1980–2025

There are a number of reasons why average pensions will increase in real terms over time. First, in some countries full pension rights are conferred only on people who retire after having spent a considerable part, if not all, of their working life in a program. If newly retired pensioners benefit, relative to their predecessors, from having been in a program for a greater part of their working life—because longer membership necessarily implies a bigger pension—then that program can still be viewed as immature. The more immature a program, the greater the difference or the longer it will take to close the gap between current and long-term real pension levels for newly retired pensioners.36 Second, initial pensions are often related directly to past earnings, and to the extent that real earnings grow over time, so do initial pension levels, And third, there are generally provisions for regular post-retirement pension increases. Often these provisions do no more than compensate for increases in the cost of living, so that real pensions remain constant. But in some countries pensions are indexed to earnings even after retirement, and an increase in real earnings will again imply an increase in real pension levels.

In each of the seven major industrial countries, the principal social security programs pay earnings-related pensions, or a combination of flat-rate and earnings-related pensions (Canada, Japan, and the United Kingdom). Post-retirement increases are related to gross earnings in France, net-of-tax earnings in the Federal Republic of Germany, a combination of earnings and cost of living in Italy, and prices or cost of living elsewhere. The programs in Canada, Italy, Japan, the United Kingdom, and the United States are, to varying degrees, immature.

Intercountry differences in the structure of social security programs have to be modeled in order to project average real pension benefits. The indices of real pension expenditure reported in Table 5 reflect these differences, which are described in more detail in Appendix II. They also incorporate expenditure on survivors’ and disability pensions and, in some cases, pensions paid to public sector employees (see Appendix II for details). In comparison with the index numbers reflecting the pure demographic effect (Table 4), those in Canada and the United States increase least, as there is no significant maturation effect and pensions are adjusted in line only with prices after retirement (i.e., they are fixed in real terms).37 Pensions of the newly retired in these two countries are adjusted in line with earnings (except the flat-rate component in Canada), which are assumed to grow with average productivity, and that is why the index numbers increase faster than those reflecting pure demographic changes.

Table 5.Indices of the Growth in Real Pension Expenditure and the Ratio of Pension Expenditure to GDP, as Projected in the Baseline Scenarios, 1980–2025(index 1980 = 100)
Country1980200020102025
(Index of real pension expenditure)
Canada100154189317
France100175230325
Germany, Fed. Rep. of100180218300
Italy100198285498
Japan1004307871,314
United Kingdom100159199290
United States100145178306
(Index of the ratio of pension expenditure to GDP)
Canada1008989123
France100110115130
Germany, Fed. Rep. of100129140154
Italy100121138171
Japan100229307319
United Kingdom100115124144
United States1009290110
Source: Fund staff estimates.
Source: Fund staff estimates.

More immature programs are found in Italy. Japan, and the United Kingdom. In Italy, pensions are assumed to increase with earnings, plus an additional 0.5 percent to reflect immaturity. Since post-retirement indexation reflects a combination of earnings and price changes, the excess of growth in line with earnings plus 0.5 percent over expected pre-retirement and post-retirement growth reflects the impact of increasing maturity on average pension levels. In Japan and the United Kingdom, earnings-related pensions increase in line with prices after retirement and flat-rate pensions increase in line with prices. However, for Japan, it is assumed that the average pension grows at 1.5 percentage points more than the growth in GDP per capita up until 2010, by which time the average replacement rate should be close to its maximum level under the recently enacted pension law.38

For the United Kingdom, the development of the State Earnings Related Pension Scheme (SERPS) has been modeled explicitly in the official United Kingdom projections which underlie the indices in Table 5; however, in this projection both flat-rate and earnings-related pensions, after retirement, are assumed to increase at the same rate as GDP per capita and the projections have been amended to reflect the impact of recent reforms.39 In these three countries, average real benefits are set to grow most rapidly, and considerably more so in Japan than elsewhere.

In France and the Federal Republic of Germany, the pre-retirement pension base and post-retirement pension increases are kept in line with earnings. In the Federal Republic of Germany, increases after retirement have recently been switched from a gross to a net earnings basis. This change is reflected in the projections.

While real pension expenditure is increasing, the real income of the working population may be increasing at the same time. The pension burden—the proportion of its income the working population must give up to pay pensions to the retired—need not increase. In Chapter III it is shown that, with the exception of the Federal Republic of Germany, the population of working age is going to increase. Naturally, not everybody of working age is employed. Chapter II describes the participation rate and unemployment rate assumptions used in the study for projections of future employment. It also reports the productivity growth assumptions that combine with the employment projections to yield the estimates of future GDP. Comparisons of future pension expenditure and future GDP reveal whether the pension burden will increase or decrease.

Table 5 reports indices of the ratio of pension expenditure to GDP, which take into account projected GDP growth in the baseline scenario, as indicated in Table 3. The offset this provides to real expenditure growth is clearly greatest in Japan, of a lesser but still considerable order of magnitude in Canada. France, Italy, and the United States, and significant even in the slow-growing countries (the Federal Republic of Germany and the United Kingdom). Thus, across countries, pension ratios will more than triple in Japan, increase between 50 percent and 100 percent in the Federal Republic of Germany and Italy, and increase by less than 50 percent in Canada, France, the United Kingdom, and the United States. In Canada and the United States, the ratio will fall before 2010 and increase after 2010. The increase in the pension ratio will also occur more strongly after 2010 in France, Italy, and the United Kingdom, and it will be steadier in the Federal Republic of Germany and Japan, although it should be noted that in Japan the pension ratio more than doubles before 2000.

It is interesting to compare these prospective developments with those of the past (Table 6). In Chapter III, it is pointed out that the number of elderly people will grow more slowly in the future than it has in the past, and the same is true of real pension expenditure. Indeed, the lowest growth rate recorded over the 1960–80 period (4.8 percent in the United kingdom) is only slightly over 1 percentage point lower than the highest growth rate projected over the 1980–2025 period (5.9 percent in Japan). The growth in the pension ratio is also much lower than it has been in the past, despite assumed GDP growth rates that are also low by historical standards. The problem is, of course, at least in some countries, that the ratio of pension expenditure to GDP is already high, and it may be heading toward a level which future working generations will judge unacceptable.

Table 6.Annual Growth Rate of Real Pension Expenditure and of the Ratio of Government Pension Expenditure to GDP in Historical Perspective, 196080 and 1980–2025
Annual Growth Rate of:
Real pension expenditureRatio of pension expenditure to GDP
Country1960–801980–20251960–801980–2025
Canada7.22.62.40.5
France8.22.73.40.6
Germany. Fed. Rep. of4.92.51.21.0
Italy8.53.64.31.2
Japan14.15.96.02.6
United Kingdom4.82.42.90.8
United States6.22.52.70.2
Sources: OECD, Social Expenditure: 1960–1990. Problems of Growth and Control (1985); and Fund staff estimates.
Sources: OECD, Social Expenditure: 1960–1990. Problems of Growth and Control (1985); and Fund staff estimates.

Thus far the projections have been presented in the form of index numbers. Therefore, this discussion of population aging, future pension expenditure, and the pension ratio has not been influenced by differences between countries in the ratio of pension expenditure to GDP. These differences have been very wide in the past (Chart 11 and Table 14). In part, this reflects definitional variations, although the differences are still wide even with a much larger measure of international comparability (Table 16). They will also remain so in the future, as Chart II shows. This chart has been derived by applying the index numbers describing the growth of the pension ratio in Table 5 to the 1980 expenditure ratios (see Table 14 for precise statistics).

Chart 11.Government Pension Expenditure as Percentage of GDP, 1980–2025

Across the seven major industrial countries, the pension expenditure implications of population aging in Canada and the United States—with low expenditure ratios increasing very modestly—are not serious. In France and the United Kingdom, the outlook is worse; in the first case, because the expenditure ratio is already high, and in the second case, because expenditure will increase significantly. In Japan, the expenditure ratio is currently low, but it will be among the highest by 2025. However, the outlook is clearly bleakest in the Federal Republic of Germany and Italy, where the combination of high initial expenditure ratios and relatively rapid growth will produce ratios of expenditure to GDP of over 20 percent by 2025.

Alternative Demographic and Economic Scenarios

Alternative scenarios described in earlier chapters focus on what happens if the demographic situation and/or the economy are less favorable than in the baseline scenario. Chart 11 indicates the effect of combining the “greater aging” demographic scenario with the baseline economic scenario (see also Table 14). In all countries, final expenditure ratios are higher, although in some countries there is either no difference before 2000 or the expenditure ratios are initially lower (France). In no country is the “greater aging” scenario so much more unfavorable than the baseline scenario that the final expenditure ratio increases markedly. However, the differences reflect 1 percentage point or more as found in France (2.6), Italy (2.4), Japan (2.1), the United Kingdom (1.0), and the United States (1.0).

The pessimistic economic scenarios differ from the baseline scenarios by assuming lower productivity growth and, in most cases, higher unemployment. Where pensions are increased in line with earnings (or in effect productivity growth). an assumption of slower growth in productivity does not affect the results of the projections. However, higher unemployment does affect them, since the expenditure ratio is inversely proportional to the employment rate. Where pensions are held constant in real terms during retirement, as in Canada and the United States, an assumption of lower productivity growth will imply a higher expenditure ratio. Where pensions are increased in line with net earnings, as in the Federal Republic of Germany, the outcome is indeterminate. In the case of the United Kingdom, the pessimistic economic scenario is characterized by a lower GDP growth rate than in the baseline scenario, but by the same unemployment rate. Since pensions are assumed to increase with GDP per capita, the projections remain unaffected. Chart 11 also shows the impact of combining the “greater aging” demographic scenario with the productivity growth rates and unemployment rates that characterize the pessimistic economic scenarios in Tables 2 and 3. Because the pessimistic scenario’s unemployment rates differ only slightly from those in the baseline scenario, the pessimistic economic scenario shows little impact on the expenditure ratios in France, Italy, and Japan. And even in Canada and the United States, the combination of more pessimistic unemployment rates and productivity growth rates does not have an enormous impact on expenditure ratios. In the Federal Republic of Germany, the combination of reduced productivity growth and increased unemployment causes the final expenditure ratio to fall slightly.

Policy Issues

What are the policy implications of these projections? The answers to this question are not at all obvious from the numbers appearing in the tables. Certainly, the prospect of the growing and ultimately large share of national income that some countries will have to spend in order to provide the pensions now being promised has been a source of concern. This has been a major issue in the Federal Republic of Germany, Japan, the United Kingdom, and the United States, but it has been less of an issue elsewhere. For example, in Canada, an official report, although recognizing that an aging population would create some additional fiscal pressure, concluded that the high incidence of poverty among pensioners called for an increase in the real level of pensions and that Canada would have the capacity to provide it.40 And in France, the financial pressures created by population aging are recognized, although recent concern has been with short-term rather than long-term financial imbalances. This concern is reflected in the sort of policy responses being discussed, which revolve around making some attempt to increase the fertility, savings, and participation rates, rather than to reform the pension system. Population aging does not yet seem to be viewed as a pressing issue. In Italy, there is widespread recognition of the need to reform the pension system and a pension reform bill is currently before the Italian Parliament.

Even in the United States, pension reform appears to be less of an issue because a number of measures have already been introduced to counteract the demographic factors that would otherwise force pension expenditure to rise. The projections in Table 6 take account of these measures, which include: the 1977 Social Security Amendment, changing the method of calculation of pensions for those reaching 62 after 1982 so that replacement rates would fall from their 1981 peak until they stabilize in 1990;41 and the 1983 Social Security Amendment, which legislated an increase in the retirement age from 65 to 67 between 2000 and 2027, introduced changes in early retirement benefits and delayed the retirement credit to be phased in from the beginning of 1986, and subjected to tax half of the pensions of people with high incomes.

Recently, the policy debate has been most active in the Federal Republic of Germany, Japan, and the United Kingdom. Indeed, in the Federal Republic of Germany there has just been a significant change in the pension system, switching the basis of pension increases from gross to net earnings, with the intention that demographically induced increases in social security contribution rates would feed back into smaller pension increases. This switch has been incorporated into the study’s projections, Without it, the projected 2025 expenditure ratio would increase to more than double the 1980 ratio of 13.3 percent of GDP as compared with the 20.5 percent now projected.

In Japan, the ratio of pension expenditure to GDP is projected to grow to the level currently found in the Federal Republic of Germany. But that is more than three times the 1980 level, and would have been substantially higher were it not for the 1985 Pension Reform Act, which reduced the benefit level by up to 37 percent by lowering the replacement rate and eliminating multiple benefits. The reform was motivated by the concern over the long-term viability of the pension scheme; while the large funds now accumulated in the system would have allowed higher pension payments with the current contribution rate to be maintained until the end of this century, the contribution rate would ultimately have had to rise almost fourfold when the accumulated funds ran out. The reform lowered the long-run replacement rate from 83 percent to 68 percent, which effectively freezes the replacement rate at the average level for current new recipients, who have about 32 years of enrollment in the system. Thus, the reform did not have to involve lowering the benefits of current recipients, which helped alleviate controversy over benefit reduction. The reform also unified the Koosei, Kokumin, and Seamen’s pension schemes, and pension provisions for spouses have been unified and extended. These measures will rule out the possibility of individuals or households receiving excessive pensions through eligibility under multiple pensions. There is a view that the expenditure ratio anticipated under the revised system is too high, and raising the standard eligibility age from 60 to 65 is under consideration, associated with an extension of the retirement age in general. This could reduce the ratio by about 3 percentage points of GDP.

The United Kingdom has perhaps been taking the most radical look at its pension system in light of the long-term cost implications of SERPS. Its reform strategy has recently been outlined in a policy document.42 The more expensive elements of SERPS are to be modified: SERPS pensions are to based on lifetime earnings rather than the best 20 years, and calculated on 20 percent of earnings rather than 25 percent. Spouse’s rights to inherit SERPS entitlements have been reduced, and greater responsibility has been placed on occupational pension schemes for inflation-proofing guaranteed minimum pensions. Financial incentives are to be introduced for firms setting up occupational schemes and individuals taking out personal pensions. The U.K. Government estimates are that the annual cost of SERPS will be nearly halved by 2033.

The nature of the trade-off currently facing, or which faced, policymakers in each of the seven countries is clear. If projected contribution rates rise too quickly or to unacceptable levels, then future pension expenditure has to be reduced (relative to the projected total), either through a reduction in pension benefits (again relative to their projected level) or an increase in pension age, or a combination of both. The United States has emphasized a phased increase in pension and retirement age while the Federal Republic of Germany, by linking pensions to net earnings rather than gross earnings, will systematically reduce the growth rate of pension expenditure as demographic pressures build up, although contribution rates will remain relatively high. In the United Kingdom, the cost of earnings-related pensions—the principal source of increasing pension expenditure—has been halved, leaving the main structure of SERPS intact. Japan will freeze replacement rates, but this will only partly offset a marked increase in contribution rates. However, because the pension program is immature, there is scope for the contribution rate to increase more than in other countries. Ultimately, France and Italy will respond to demographic pressures, and the Federal Republic of Germany may have to take further measures to control the growth in pension expenditure.

One policy issue that has not yet been mentioned, but has certainly featured in discussions of pension reform, is financing. This paper focuses on expenditure, and the method of financing cannot affect the size of the transfers to the elderly, although it can affect the resources available to meet the pension bill. Most programs are now financed on a pay-as-you-go basis, whereby pensioners are paid out of the current income of the working population. There has been some discussion, especially in the United States, of introducing an element of funding into social security financing—that is, setting aside funds in advance for a pension liability that has to be met. Only Canada and Japan fund part of their social security pension liability, and the trend appears to be toward funding even less.

Both pay-as-you-go and funding have merits, but the proponents of funding highlight its positive impact on saving, capital accumulation, and growth.43 In fact, research has revealed that the impact of a switch from pay-as-you-go to funding is difficult to determine, although it most likely would lead to more saving.44 If this in turn leads to higher growth through increased capital accumulation, then this would make the future pension burden easier to bear. However, a number of issues arise. First, it is not all clear that social security is the most efficient policy instrument available to a government wishing to increase an economy’s savings rate. Second, there is no guarantee that a higher government savings rate will lead to higher rates of capital accumulation and growth. And third, the creation of funds large enough to have any significant impact on the future burden of pensions may create problems of monetary management that far outweigh any benefits derived from funding social security.

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