Chapter

II. Background

Author(s):
Sheetal Chand, and Albert Jaeger
Published Date:
December 1996
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Demographic Trends

Projections of demographic trends reflect assumptions about future variations in fertility, life expectancy, and immigration flows.2 Present rates of fertility (the number of children born to an average woman during her lifetime) differ considerably across the selected industrial countries, ranging from historically low values of 1.3 (Germany, Italy) to highs of 2.1 (United States, Sweden). Over the next four decades, the demographic scenarios assume, perhaps optimistically, that the fertility rate in all countries will converge to the level needed to maintain a stable population, that is, about 2.1. However, trends in fertility rates are notoriously difficult to predict.3 Although deviations from the fertility assumptions underlying the projections will not affect the projected number of elderly persons, they could nevertheless have sizable effects on the projected number of persons of young and working age. Life expectancy at birth of both sexes is projected to increase by some five years until 2050, with most of the added longevity occurring before 2020. In light of present political realities, net immigration flows in most of the industrial countries are assumed to taper off quickly from observed levels during the early 1990s, falling to zero in most countries after 2005. Only Canada and the United States are assumed to have positive (but declining) net immigration beyond 2005.

Given the assumptions about fertility, life expectancies, and immigration flows, the age structure of populations in the seven major industrial countries and Sweden is projected to change significantly (Table 1). In particular, elderly dependency ratios— defined as the ratio of the population aged 65 and over to the population aged 15 to 64—are expected to increase sharply, although the pace of aging differs across countries.4 While elderly dependency ratios in 1995 cluster around 20 percent for most industrial countries, by the year 2030 the ratios are projected to more than double in Japan, Germany, Italy, and Canada. In the United States and France, elderly dependency ratios are projected to almost double by 2030. Population aging in the United Kingdom and Sweden, while it starts in 1995 at a relatively advanced level, is projected to be less pronounced, but elderly dependency ratios will nevertheless reach almost 40 percent by 2030. Beyond 2030, elderly dependency ratios are projected to stabilize in all countries except in Japan and Italy, where further increases of more than 10 percentage points are expected to occur.

Table 1.Demographic Trends(1995 Population = 100)
Country199520002010202020302050
United States
Population100.0104.8113.0119.8124.7127.2
Elderly dependency ratio19.219.020.427.636.838.4
Very elderly ratio42.746.345.840.545.855.6
Total dependency ratio52.752.050.557.468.068.8
Japan
Population100.0101.3102.2100.697.691.6
Elderly dependency ratio20.324.333.043.044.554.0
Very elderly ratio37.838.344.547.256.358.1
Total dependency ratio43.947.256.767.870.584.0
Germany
Population100.0100.097.294.290.681.2
Elderly dependency ratio22.323.830.335.449.251.9
Very elderly ratio40.742.741.848.344.159.7
Total dependency ratio46.346.750.057.375.181.3
France
Population100.0102.2104.9106.9107.8106.1
Elderly dependency ratio22.123.624.632.339.143.5
Very elderly ratio39.243.449.641.948.856.6
Total dependency ratio52.252.851.259.667.973.6
Italy
Population100.0100.198.295.391.982.6
Elderly dependency ratio23.826.531.237.548.360.0
Very elderly ratio38.542.847.948.448.060.9
Total dependency ratio45.647.851.558.872.789.6
United Kingdom
Population100.0101.0102.2103.5103.9102.0
Elderly dependency ratio24.324.425.831.238.741.2
Very elderly ratio42.946.346.344.545.857.2
Total dependency ratio54.354.052.358.368.071.2
Canada
Population100.0105.0113.2119.7123.1122.7
Elderly dependency ratio17.518.220.428.439.141.8
Very elderly ratio39.943.344.640.244.455.8
Total dependency ratio48.648.347.556.369.071.9
Sweden
Population100.0101.8103.8105.7107.0107.0
Elderly dependency ratio27.426.929.135.639.438.6
Very elderly ratio46.650.846.745.852.258.8
Total dependency ratio56.957.958.565.170.468.8
Source: Bos and others (1994).Notes: The elderly dependency ratio is defined as population aged 65 and over as a percent of the population aged 15–64. The very elderly ratio is defined as the population aged 75 and over as a percent of the population aged 65 and over. The total dependency ratio is defined as the population aged 0–14 and 65 and over as a percent of the population aged 15–64.
Source: Bos and others (1994).Notes: The elderly dependency ratio is defined as population aged 65 and over as a percent of the population aged 15–64. The very elderly ratio is defined as the population aged 75 and over as a percent of the population aged 65 and over. The total dependency ratio is defined as the population aged 0–14 and 65 and over as a percent of the population aged 15–64.

Chart 1 plots elderly dependency ratios for the selected industrial countries during 1950–2050, providing a historical perspective on projected aging patterns. While elderly dependency ratios in all countries have been rising steadily since the 1950s, Chart 1 also shows that projected dependency ratios in most countries will increase at a historically unusual pace starting around 2010, reflecting the passage of the postwar baby-boom generation into retirement.

Chart 1.Elderly Dependency Ratios

(In percent)

Sources: OECD (1979); Bos and others (1994).

The elderly population itself is projected to age considerably over the projection horizon, as indicated by the projected long-term increases in the very elderly ratio—defined as the ratio of the population aged 75 and over to the population aged 65 and over. However, the occurrence of “double aging” in most countries is erratic rather than continuous and, except in Japan, where life expectancies are particularly high, is not expected to become pronounced before 2030. Total dependency ratios—defined as the population aged 0 to 14 and 65 and over to the population aged 15 to 64—are projected to rise significantly less than elderly dependency ratios, indicating that the relative size of the young dependent population is expected to decline over the projection horizon.

Although there is considerable uncertainty about long-term demographic change, the short-term demographic outlook is relatively certain. For example, barring significant migration flows, labor force growth in the next two decades is largely given by past fertility experience and, absent significant unexpected changes in life expectancies, the number of elderly persons can be projected with confidence as far out as the middle of the next century.

Public Pension Arrangements

The main pillar of the old-age security system in most industrial countries is a mandatory public pension plan, which, however, is often complemented by private pension schemes. Mandatory public pension plans are generally based on the defined-benefit principle, according to which the benefit received by the individual is specified in advance, usually as a function of the person’s earnings history and the number of contribution years. Pension plans can alternatively be based on the defined-contribution principle, according to which the annual contribution paid by the individual is specified, usually as a proportion of gross salary, and benefits depend on accumulated contributions and the realized rates of return on their past investments.

Public pension expenditures in the major industrial countries and Sweden have increased sharply since 1960, reflecting the rise in the elderly dependency ratios depicted in Chart 1, an increase in the generosity of per capita pensions, and the maturation of public pension schemes.5 At the same time, estimates of total public pension expenditures at the beginning of the 1990s indicate that public pension expenditures (as a percent of GDP) vary widely across the countries considered in this study, being significantly higher in the selected continental European countries than in the other countries (Table 2). In addition, public pension systems often comprise a wide range of different pension schemes including pension plans for civil servants and particular professions (miners, agricultural workers).6Table 2 also provides estimates of the amount of such public pension expenditures covered by the projections of the present study. As the coverage for most countries is significantly less than 100 percent, mainly reflecting data availability, the projections of the study are likely to understate the actual size of net pension liabilities.

Table 2.Public Pension Expenditure(In percent of GDP)
Of Which:
CountryPublic Pension Expenditure in 19901Covered by projections of this studyNot covered by projections of this study
United States6.94.52.4
Japan5.75.00.7
Germany212.38.93.4
France213.311.91.4
Italy14.213.90.3
United Kingdom6.44.22.2
Canada6.03.82.2
Sweden11.37.04.3
Sources: OECD; and IMF staff estimates.

Defined as spending by all public sector pension schemes including civil service pensions and schemes for specific professions (miners, agricultural workers).

1992.

Sources: OECD; and IMF staff estimates.

Defined as spending by all public sector pension schemes including civil service pensions and schemes for specific professions (miners, agricultural workers).

1992.

Table 3 summarizes selected characteristics of the main public pension schemes in the major industrial countries and Sweden. As regards financing, pension plans can be classified into fully funded, partially funded, or PAYG schemes. In a fully funded scheme, the contribution rate is chosen so as to accumulate a stock of capital that, at any point in time, should equal the present discounted value of future benefits minus future contributions of those currently in the scheme. In a PAYG scheme, benefits accruing to the current beneficiaries are financed by current contributions or budget transfers. A partially funded scheme combines features of a fully funded and a PAYG scheme (but where reserves do not fully meet the aforementioned financial condition). A defined-contribution plan is usually fully funded. Recent pension reform proposals in some countries including Sweden and Latvia seek to mimic the close link between contributions and benefits associated with defined-contribution plans without, however, building up a fund (so-called notional funding). Defined-benefit plans, on the other hand, are most often organized as either PAYG or partially funded. Public pension schemes in many industrial countries, including Germany, France, Italy, the United Kingdom, and Canada, are financed on a PAYG basis, whereas the United States, Japan, and Sweden have adopted partially funded schemes.7 Systems financed exclusively or partially on a PAYG basis are particularly vulnerable to population aging.

Table 3.Public Pension Schemes
CountryFinancing1Retirement Ages2 (Men/Women)Contribution Period for Full PensionBenefit Accrual Factor3Assessed EarningsMaximum Replacement RateIndexation of Benefits
United StatesPF65/65354Career41.0Prices
JapanPF60/55400.75Career30.0Net wages
GermanyPAYG65/65401.50Career60.0Net wages
France5PAYG60/60381.75Best 12 years50.0Prices/Gross wages
ItalyPAYG62/57402.00Last 5 years80.0Prices
United KingdomPAYG65/60500.40Career20.0Prices
Canada6PAYG65/65400.50Career25.0Prices
Sweden6PF65/65307Best 15 years60.0Prices
Source: Van den Noord and Herd (l993), Table 1.1; and IMF staff estimates.

PAYG = Pay-As-You-Go. PF = Partially Funded.

Statutory retirement ages as of 1995.

Benefit accrual factor per year of contributions, in percent of assessed earnings.

Benefit accrual factor increases as assessed earnings decline.

The basic scheme is indexed to prices, while the earnings-related schemes are indexed to gross wages.

For earnings-related scheme only.

Benefit accrual factor declines as number of contribution years increases.

Source: Van den Noord and Herd (l993), Table 1.1; and IMF staff estimates.

PAYG = Pay-As-You-Go. PF = Partially Funded.

Statutory retirement ages as of 1995.

Benefit accrual factor per year of contributions, in percent of assessed earnings.

Benefit accrual factor increases as assessed earnings decline.

The basic scheme is indexed to prices, while the earnings-related schemes are indexed to gross wages.

For earnings-related scheme only.

Benefit accrual factor declines as number of contribution years increases.

The main financing source of public pension schemes is social security contributions levied on gross wage earnings, at statutory rates ranging from 5 percent in Canada to over 27 percent in Italy. In some countries, the contribution is shared equally by the employer and the employee, whereas in others the employer bears more than half of the burden.8 Most public pension schemes also stipulate that contributions on earnings are only paid up to a specified limit.9 To the extent that social security contributions fall short of pension expenditure, PAYG systems necessitate transfers from other budgets to cover the shortfall.

Eligibility for pension benefits is typically determined by a statutory retirement age and a minimum contribution period. The United States, Germany, Canada, and Sweden have statutory retirement ages of 65 years for both sexes, while the other countries maintain differentiated statutory retirement ages for men and women. At the same time, most public pension schemes contain provisions for early retirement, implying that effective retirement ages are often significantly below statutory ones. Some countries, including the United States and Germany, allow for flexible retirement. In particular, an individual can retire before reaching the statutory retirement age, provided that he has reached a minimum pensionable age and paid contributions for a minimum period, and at the cost of a reduction in the benefits proportional to the difference between the individual’s age and the statutory retirement age.

In defined-benefit plans, benefits can be earnings related, flat rate, or means tested. Earnings-related benefits are computed on the basis of (1) determination of assessed income: the initial benefit for new retirees is usually computed as a percentage of average wage income assessed over a period that can vary from a few years to the entire career; (2) accrual rate: in most defined-benefit plans, the initial pension is calculated by applying to the assessed income an accrual rate multiplied by the number of years in which the person has contributed to the plan. Accrual rates vary from 0.4 percent in the United Kingdom to 2 percent in Italy. A ceiling is often imposed in the form of a maximum replacement rate, that is, a maximum ratio of the pension benefit to the assessed income. In flat-rate schemes, the benefit is independent of past earnings, but can be tied to other characteristics of beneficiaries. For example, social security arrangements in Japan, the United Kingdom, and Sweden combine earnings-related and flat-rate schemes.

Another important feature of a pension scheme is the type of indexation mechanism for existing pension benefits. In most industrial countries, pension benefits are indexed to the inflation rate, as measured by the consumer price index (CPI). Among the selected industrial countries, only Japan and Germany use indexation schemes that link existing pensions to the growth rate of net wages, which in the case of Germany is defined as net of payroll and income taxes. In France, the earnings-related pension scheme is indexed to gross wages.

In many industrial countries, private pension schemes complement mandatory public pension plans. However, estimates of the size of accumulated assets of private pension funds at the of end of 1991 differed significantly across the selected industrial countries, ranging from over 70 percent of GDP in the United Kingdom to less than 5 percent of GDP in Germany and France (Table 4). While these estimates are subject to measurement problems, reflecting primarily issues of how to treat life insurance savings and book reserve provisions on companies’ balance sheets, available data on asset size nevertheless indicate that countries with relatively low public pension replacement ratios—for example, as measured by the maximum replacement ratios listed in Table 3—have developed sizable private pension schemes.

Table 4.Assets and Workforce Coverage of Private Pension Funds
Assets (In percent of GDP)1
CountryNarrowly defined2Broadly defined3Workforce Coverage (In percent)
United States51.066.046.0
Japan45.08.050.0
Germany43.04.042.0
France2.05.0
Italy6.05.0
United Kingdom60.073.050.0
Canada32.035.041.0
Source: Davis (1993), Tables 3.1 and 3.4.

At the end of 1991.

Funded pension schemes.

Funded pension schemes and pension resources of life insurers.

In Japan and Germany, large funded pension plans are held directly on firms’ balance sheet.

Source: Davis (1993), Tables 3.1 and 3.4.

At the end of 1991.

Funded pension schemes.

Funded pension schemes and pension resources of life insurers.

In Japan and Germany, large funded pension plans are held directly on firms’ balance sheet.

Pension Reform Debates

At least since the early 1980s, the anticipation of adverse demographic trends has increasingly shaped pension reform debates in industrial countries.10 In this context, it is useful to distinguish between two stylized approaches to pension reforms: the “parametric reform approach” and the “systemic reform approach,” with some scope for mixing the two.

Parametric Reform Approach

The most widespread reform approach to the aging problem consists in identifying corrective measures that change the parameters of the existing public pension system. A first option is to act on the revenue side. In the past, significant increases in contribution rates have been part of the reforms in many industrial countries, including the United States, Japan, Germany, and Italy. However, as the contribution rates required to restore financial balance have already reached very high levels in some countries, expenditure-reducing measures have increasingly been considered.

Many countries, such as the United States, Japan, Germany, and Italy, have legislated increases in the statutory retirement age to be phased in over a number of years so as to slow down the growth in the number of beneficiaries. In some countries, such as Italy, this has been supplemented by tightening eligibility criteria for early retirement and disability pensions. Other expenditure-reducing measures aim at lowering the level of per capita benefits by modifying either the mechanism determining the initial benefit for new pensioners, or the indexation of benefits of existing pensioners. The initial pension benefit in an earnings-related system can be modified in several ways: (1) extending the period of a worker’s earning history used for establishing the assessed income for determining the initial pension; (2) adopting partial rather than full grossing up of past earnings in computing the assessed income for determining initial pension levels; (3) reducing the accrual rate; and (4) imposing, or lowering, a maximum replacement rate. The subsequent evolution of the initial pension benefit is affected by whether pension benefits are indexed to prices or to wages (net or gross). The debate on the choice between price and wage indexation is usually centered on the issue of whether or not pensioners should also enjoy the benefits of growth in labor productivity taking place after they have left the labor force. Indexation to net wages ensures that the growth of pension benefits takes account of the impact of higher contribution rates. In order to limit pension expenditures, in 1992, Italy adopted indexation to prices, in place of gross wages, whereas Germany in 1992 and Japan in 1994 shifted to indexation of net rather than gross wage growth.

Systemic Reform Approach

A second approach to the aging problem has involved an increase in the extent to which a PAYG, defined-benefit system is established as a partially or fully funded system; more systemic reforms have involved either the adoption of a more significant defined-contribution element in the pension system, or a full-scale replacement of the defined-benefit approach with a defined-contribution system.11

Proposals in favor of a shift to a partially or a fully funded public pension system generally arise from the beliefs that it is the financing mechanism of a PAYG system that lies at the root of the imbalance, and that the development of financial reserves (through partial or full funding) would reduce the need for unsustainable increases in payroll tax or contribution rates. The validity of this approach is not without controversy. If the financial reserves of a public pension system are heavily invested in government securities and there is some bunching in the rate of investment of these securities to pay for annuities, some fiscal strains may be generated, as future taxpayers may have to bear higher tax rates to service the government’s debt. In addition, the provision of government-guaranteed minimum rates of return could give rise to contingent government liabilities.

Another argument sometimes made in favor of partially or fully funded schemes is that reserves accumulated under these schemes could constitute a net addition to overall savings in the economy. The empirical issue of the extent to which public pension schemes affect the national savings rate is, however, controversial, as is the issue of the optimal appropriate use of such funds in the general economic context. These issues are discussed in greater detail in Section IV.

A more fundamental systemic reform of the public pension system consists in reallocating responsibilities to the private sector and individuals. “Privatization of social security” is often proposed as a way to mitigate labor market distortions owing to a potentially loose link between benefits and contributions under public pension schemes, to take advantage of the conceivably better rate-of-return characteristics of privatized fully funded schemes, to increase savings and the capital stock of the economy, and to reduce the risk of political mismanagement.12 Whether the wholesale transition from a PAYG system to a privatized fully funded defined-contribution system would indeed result in sizable net welfare gains for existing or future generations has been examined in several recent theoretical contributions and simulation studies.13 Using a stylized dynamic life-cycle model, the study by Kotlikoff (1995) in particular has concluded that the size and even sign of net welfare gains from the transition to a privatized pension system depend sensitively on the existing contribution structure, the link between benefits and contributions under the existing system, and the financing of the transition cost.

The role of private provision of retirement income may also be enhanced by reforms that do not necessarily aim at a wholesale transition to a private fully funded system. In the United Kingdom, for example, members of occupational pension schemes may contract out of the state earnings-related additional pension scheme, thereby reducing the importance of the public pension component. Individual retirement accounts, already a familiar feature of the U.S. and Canadian systems, have recently been introduced in France. And recent social security reform proposals in the United States advocate putting a portion of the contributions of insured workers into mandatory individual or personal retirement accounts to take advantage of higher rates of returns in equity markets.14

In those cases where the reform has involved a major structural shift from a defined benefit to a defined contribution approach (such as in Chile), many important transition issues arise, including the treatment of the pension rights already accrued to existing pensioners and current members of the labor force. The solution that is most often proposed is to convert the accrued rights into a bond (so-called recognition bonds) to be issued to qualifying beneficiaries. These rights may, however, be quite sizable, as is indicated subsequently by the results of this study, so that their conversion into financial instruments would raise a number of rather complex issues.

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