Chapter

Overview

Author(s):
Benedict Clements, David Coady, Frank Eich, Sanjeev Gupta, Alvar Kangur, Baoping Shang, and Mauricio Soto
Published Date:
January 2013
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This volume examines the outlook for pension spending over the coming decades, and options for reform. In advanced economies major rationalization of public spending, including on pensions, will in many cases be required to achieve significant fiscal consolidation (IMF, 2010, 2011a). In emerging market economies, especially outside emerging Europe, the challenges are different. There, the key challenge will be to expand coverage in a fiscally sustainable manner.

Fortunately, the extensive pension reforms enacted by many countries in the past two decades offer valuable insight for the design of future pension reforms. It is therefore opportune to evaluate their likely impact on pension spending, assess associated risks, and consider options for deeper reforms should these be necessary. In many countries, it will also be a priority to ensure that reforms do not undermine the ability of public pension systems to alleviate poverty among the elderly. Finally, because these reforms can affect labor force participation rates and private saving—and thus long-term growth—pension reform will be an important component of countries’ structural reform agenda to bolster long-term growth.

To provide context for the discussion of reform options, this volume starts by surveying the current design of public pension systems in 27 advanced and 26 emerging market economies.1Chapter 2 shows that old-age benefits account for about three-quarters of total public pension spending. The remainder is accounted for by survivor benefits and disability pensions. The importance of each of these programs varies across countries, to a large extent reflecting both the degree to which disability pensions are used as a pathway to retirement and the relative generosity of disability and old-age pensions (OECD, 2006).

More than three-quarters of public pension systems link benefits to lifetime earnings. These plans can be “defined benefit” (DB, with pension benefits typically dependent on the number of years of contributions and the average of covered earnings) or “defined contribution” (DC, with benefits dependent on the contribution history and the returns on these contributions). Some countries also offer a flat-rate component that does not depend on previous earnings, while others provide only a means-tested or flat-rate universal public pension. Access to means-tested benefits for the elderly (regardless of contribution history) is more common among advanced than emerging market economies.

Whereas nearly all emerging market economies in Europe and Latin America supplement their public pension systems with some type of mandatory private plan (mostly through systems of individual accounts), such arrangements are rare in advanced economies. Instead, some advanced economies have mandatory occupational pensions, with participation linked to employment in firms or professional or trade-associated membership. Moreover, advanced economies often complement their public systems with voluntary private plans, including voluntary occupational plans. However, the contribution of voluntary plans to retirement income varies widely across countries.

To understand current arrangements and spending commitments, it is useful to look at historical developments. In other words, how did we arrive at the systems in place today? Chapter 3 reviews past trends in public pension spending and the factors underlying them. In advanced economies, public pension spending increased from 5 percent of GDP in 1970 to about 9 percent in 2010. 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 the average pension to average wages), and labor force participation rates. During the period 1970 to 1990, increases in spending reflected a combination of higher replacement rates, aging, and increased eligibility. Increased female labor force participation offset some of the increase in spending. Pension spending growth was more contained over the past two decades. The impact of aging and benefit increases was partly offset by both tighter pension eligibility rules (including increasing retirement ages) and further increases in labor force participation rates.

Over the past two decades, increases in public pension spending in emerging market economies have been larger than in advanced economies, but from a much lower 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 has increased from about 7½ percent of GDP in 1990 to 10½ percent today, reflecting higher replacement rates and population aging. Declining labor force participation rates also played a role. In other emerging market economies, spending increased from 2½ to 3½ percent of GDP over the same period, owing to increases in replacement rates, albeit from relatively low initial levels.

Chapter 4 provides an overview of the main public pension reforms implemented in advanced and emerging market economies over the past decade. With the share of public pension spending in total government expenditures and GDP edging up, and policymakers recognizing the fiscal challenges arising from an aging population in the future, many countries have initiated significant pension reforms over the past decade. In advanced economies these reforms were often of a parametric nature—that is, they involved changes, within existing systems, in the numerical parameters that determine the financial viability of a pension system. These include changes in the legal retirement age and adjustments to the benefit formula. Elsewhere (including in emerging Europe), there were also systemic changes in the pension system involving the introduction of funded private systems.

The financial and economic crisis has spurred a new round of reforms. In some countries, it has led to deeper parametric reforms, for example, by accelerating the increase in the retirement age (Greece, Italy, United Kingdom). In parts of emerging Europe, policymakers responded to the crisis by slowing the transition to funded private pensions through a reduction in pension contributions to private accounts rather than through the government budget.

Chapter 5 provides projections for public pension spending to both 2030 and 2050, incorporating the impacts of recent pension reforms discussed in the previous chapter and highlighting the key assumptions underlying these projections and associated risks.

Based on public projections, where available, pension spending is projected to increase by about 1½ percentage points of GDP over the next two decades in advanced economies, but there is substantial variation. Increases in spending in excess of 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.

The projected public pension spending increases would be significantly higher had reforms not already been enacted over the past two decades to deal with the challenge arising from population aging. In advanced economies, old-age dependency ratios are projected to double between 2010 and 2050, partly because of increasing longevity, but mainly because of the past decline in fertility rates (Goss, 2010). In the absence of reform, public pension spending would increase by 4½ percentage points of GDP.

Among emerging market economies, spending increases are projected to exceed 3 percentage points of GDP in China, Egypt, Russia, and Turkey and to decrease in Bulgaria, Chile, Colombia, Estonia, Hungary, Latvia, Lithuania, and Poland.

Chapter 5 also acknowledges that there is considerable uncertainty with respect to these projections, which could actually understate the expected additional strain on public finances in a number of countries. First, the impact of aging is directly related to demographic assumptions—fertility rates and longevity—for which past projections have proven relatively optimistic in terms of their impact on spending as a share of GDP. Second, projected spending in some countries is based on relatively optimistic macroeconomic assumptions. Third, official projections are subject to the risk of reform reversal. In response to substantial aging challenges, legislated reforms often imply ambitious reductions in pension spending. As these reforms take effect, political pressure to reverse them could mount. To reduce the risk 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, recent reforms have reduced benefits while protecting low-income pensioners.

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 sustain-ability of public finances. However, the considerable transition costs arising from diverting contributions to mandatory private pensions have widened budget deficits and increased borrowing requirements in the near term. This has recently led to a number of countries reversing or slowing this transition to address short-term fiscal constraints as captured by traditional deficit and debt indicators, 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.

Potential risks also arise from the interaction between public and private sector pensions. For example, shortfalls in the funding of DB private pension systems could impose a burden on public sector finances; the degree of underfunding is considerable in some systems. Insurance plans have been set up to protect DB pension program participants in the event of corporate bankruptcies (Germany, Sweden, United Kingdom, United States). While these insurance plans reduce the exposure of government to individual corporate failure, they have not been designed to absorb more widespread private DB pension plan closures. As such, governments’ exposure to these risks is likely to be accentuated during times of crisis (IMF, 2009). Similarly, there is also the risk that replacement rates in private DC plans are inadequate, which could create pressure for higher social pension spending. In most countries there will be no legal obligation for the government to step in, but a contingent liability could arise from the pension system’s implicit social obligation to ensure adequate income in retirement. These risks are likely to be more pronounced the larger the role of DC plans in providing retirement income. In Australia, Chile, Denmark, Mexico, South Africa, Switzerland, and much of emerging Europe, more than three-quarters of pension fund assets are in DC plans (OECD, 2011).

Chapter 6 discusses the considerations that should guide pension reform. First, the basic objective of public pensions is to provide retirement income security within the context of a sustainable fiscal framework. Many economies will need to achieve significant fiscal consolidation to lower their debt-to-GDP ratios over the next two decades (IMF, 2010, 2011a). Similarly, countries could consider strengthening their overall fiscal positions and reducing public debt in anticipation of age-related spending pressure. Pension reform could potentially play an important role in this. Second, the importance of providing income security, especially for low-income groups, suggests that equity should be a key concern in pension reform. Third, the design of public pensions could potentially affect economic growth through its impact on the functioning of labor markets and national saving.

Chapter 7 presents pension reform options. In advanced economies, pension reforms that curtail eligibility (for example, by increasing the retirement age), reduce benefits, or increase contributions can help countries address fiscal challenges. Beyond what is already legislated, with no increases in payroll taxes and no cuts in benefits, the average statutory retirement age would have to increase by about another 2½ years to keep spending constant in relation to GDP over the next 20 years. Relying only on benefit reductions would require an average 16 percent across-the-board cut in pensions. Relying only on increased contributions would require an average payroll rate hike of 3½ percentage points. To keep pension spending as a share of GDP from rising after 2030, additional reforms would be needed: for each decade, the retirement age would have to increase by about one year, benefits would have to be cut by about 6 percent, or contribution rates would have to increase by about 1 percentage point.

The appropriate combination of reforms depends on each country’s circumstances. Nevertheless, raising the statutory retirement age has clear advantages. First, it would promote higher employment levels and economic growth, while increases in social security contribution rates could decrease the labor supply. By increasing lifetime working periods and earnings, raising the retirement age can also boost the growth of real consumption, even in the short term (Karam and others, 2010). Second, raising the retirement age would help avoid even larger cuts in replacement rates than those already legislated, thus reducing the impact of reforms on elderly poverty. Third, increases in the retirement age could also be easier for the public to understand in light of increasing life expectancy. Many countries have room for more ambitious increases in retirement ages. In advanced economies, the number of years men are expected to live beyond age 60 is expected to increase by an average of five years between 1990 and 2030. In contrast, the average statutory retirement age is being increased by only one year over this period. To better address increases in longevity, statutory ages could be gradually raised to 67 by 2030 (as already legislated in a number of countries) and indexed to life expectancy afterward.

Increases in the statutory retirement age would need to be accompanied by steps to limit early retirement—for example, by decreasing (financial) incentives to do so (Queisser and Whitehouse, 2006) and by controlling alternative pathways to retirement such as disability pensions (OECD, 2006). Currently individuals claim pensions, on average, about four years earlier than the statutory age. Furthermore, reform should be accompanied by measures that protect the income of those who cannot continue to work. In the United States, for example, about a quarter of all workers in their sixties may find continued work difficult on account of disability or poor health (Munnell, Soto, and Golub-Sass, 2008). Older workers should be protected fully by disability pensions, where appropriate, and social assistance programs to ensure that increases in the retirement age do not raise poverty rates. To ensure that higher life expectancy does not erode the progressivity of pension systems, consideration could be given to offsetting measures, such as reducing replacement rates for upper-income households.

Another reform option is to reduce the replacement rate further. This could be appropriate in countries with relatively high projected replacement rates in 2030, such as Austria, Finland, Greece, Ireland, Italy, and Norway, and could be achieved by freezing pensions for a period of time or reducing the indexation for those receiving high pension benefits—in most advanced economies, pensions are indexed to inflation. Alternatively, benefits could be linked to demographic and economic variables so that they are reduced to respond to changes in these variables (Austria, Canada, Germany, Italy, Japan, and Sweden have some type of automatic adjustment mechanism).

Increasing revenues could also help offset increases in pension spending. This is particularly true in countries where there may still be room to raise payroll contribution rates or introduce payroll taxation (for example, Australia, Ireland, Korea, New Zealand, Switzerland, and the United States). In some cases it may be appropriate to lift the ceiling on earnings subject to contributions. Similarly, some countries should also aim to increase the efficiency of contribution collections—for example, by unifying revenue administration for tax and social security collection (Barrand, Ross, and Harrison, 2004). Another option is to equalize the taxation of pensions and other forms of income—many advanced economies tax pensions at a lower rate. Where increasing revenue is desirable, alternative revenue sources such as consumption taxes could also be considered, particularly to finance the redistributive components of pension systems. Similarly, countries that subsidize private pensions, either through tax relief or matching contributions, could consider scaling back these subsidies, which often have very little impact on national saving and benefit mostly higher-income households (European Commission, 2008).

Looking at emerging Europe, the challenges are not dissimilar to those in advanced economies. Priority should be given to putting public pensions on a sound financial footing. One strategy would be to set the same retirement age for men and women, increase the retirement age in line with life expectancy, and tighten eligibility criteria for early retirement plans. At age 60, life expectancy for women is four years higher than for men. However, in eastern European economies, the retirement age for women is still lower than for men (particularly in Poland and Russia). In addition, further increases in the retirement age could better match longer life spans—during 1990–2030 average life expectancy at age 60 is projected to increase by three years, but the average retirement age will increase by only one year.

Replacement rates could also be reduced by indexing pensions to prices and increasing the pensionable base to capture lifetime earnings. In eastern Europe, it is still common to index pensions at least partially to wages. Benefits for future retirees can also be limited by modifying benefit formulas, typically by reducing accrual rates and changing the base of pensionable income. Last but not least, additional parametric reforms might be required in countries that scaled back mandatory private pensions.

The challenges are different in emerging market economies outside Europe, where increasing pension coverage in an affordable way remains a key challenge. On average, coverage rates are particularly low in emerging Asia, somewhat higher in Latin America, and still higher in Middle Eastern and African economies. This reflects in part these countries’ highly informal economies. Promoting greater formalization of the economy would help close the coverage gap. A larger proportion of the workforce contributing to existing pension systems would reduce the ratio between pensioners and contributors, which is already high in many emerging market economies despite young populations.

For countries with very low coverage rates, “social pensions” that provide a flat pension aimed at poverty reduction could be considered. The long time horizon required for the expansion of formal pension systems means that tax-financed social pensions could be the most promising tools to address old-age poverty in the medium term. To contain fiscal costs, these plans should be means tested to target only the needy. In addition, the design of such programs should aim for benefits that are sufficient to alleviate poverty but low enough to minimize incentives to remain outside the formal pension system.

Chapter 8 provides some concluding comments and is followed by a number of appendixes. Appendix 1 describes the methodology used to project public pension expenditures and lists the data sources used; Appendix 2 outlines the design of disability pensions and discusses potential reform options; Appendix 3 estimates the impact on poverty of lower replacement rates in select countries; and Appendix 4 analyzes the impact of public pension systems on labor market incentives. Finally, Appendix 5 contains additional tables that detail current and projected public pension expenditure, and the impact of pension reform on private savings.

1

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.

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