Chapter

The Outlook for Public Pension Spending

Author(s):
Benedict Clements, David Coady, Frank Eich, Sanjeev Gupta, Alvar Kangur, Baoping Shang, and Mauricio Soto
Published Date:
January 2013
Share
  • ShareShare
Show Summary Details

Population aging will accelerate markedly in advanced and emerging market economies over the coming decades and will put additional pressure on age-related spending for years to come. This chapter presents public pension projections out to 2030 based on current policies. Where available, the projections presented are based on official estimates; where these are not readily available, the projections 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.

The chapter then discusses the numerous risks to these projections, which stem from the uncertainties surrounding demographic and macroeconomic assumptions but are also of a political nature.

Projected Increases in Pension Spending Are Substantial in Many Advanced and Emerging Market Economies

Pension spending in both advanced and emerging market economies is projected to increase by 1½ and 1 percentage point of GDP, respectively, over the next two decades, with substantial variation across countries (Figure 5.1; Table A5.4). Among advanced economies, 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. 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. Box 5.1 summarizes the projection methodology.

Figure 5.1.Increase in Pension Spending, 2010–30

(Percent of GDP)

Sources: European Commission; International Labour Organization; Organisation for Economic Co-operation and Development; United Nations; and IMF staff estimates.

Enacted Reforms Hold Down the Impact of Population Aging on Spending

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 fall in fertility rates over the past few decades. In the absence of reform, these demographic changes will increase public pension spending by 4½ and 4 percentage points of GDP in the advanced economies and emerging Europe, respectively, and 2 percentage points in other emerging market economies (Figure 5.2). If implemented as planned, enacted reforms will lower average pension spending in 2030 by 2½ percentage points in the advanced economies, 3½ percentage points in emerging Europe, and 1 percentage point in other emerging market economies.

Figure 5.2.Projected Evolution of Public Pension Expenditures, 2010–30

Sources: European Commission; International Labour Organization; Organisation for Economic Co-operation and Development; United Nations; and IMF staff estimates.

The cumulative fiscal cost of projected spending increases is large. Over the next 20 years, the average present discounted value (PDV) of pension spending increases is 13½ percent of 2010 GDP in the advanced economies and 5 percent in emerging markets (Figure 5.3).1 The cumulative PDV of increases in pension spending over 2010–50 is 47 percent of 2010 GDP in advanced economies and 28 percent for emerging market economies.

Figure 5.3.Cumulative Cost of Pension Spending Increases

Sources: European Commission; International Labour Organization; Organisation for Economic Co-operation and Development; United Nations; and IMF staff estimates.

Numerous Risks to the Projections

There is considerable uncertainty with respect to these projections, which may actually understate the expected additional strain on public finances in a number of countries. The impact of aging is directly related to demographic assumptions—fertility rates and longevity—about which past projections have been relatively optimistic. In addition, projected spending in a number of countries is based on relatively optimistic macroeconomic assumptions.

First, there is uncertainty from the demographic projections themselves (Box 5.2). Over the past few decades, 20-year projections have overestimated fertility rates by an average of 0.3 children per woman across advanced and emerging market economies (National Research Council, 2000). Twenty-year projections have also underestimated life expectancy at birth by an average of three years in Australia, Canada, Japan, New Zealand, and the United States and by about one year elsewhere. Uncertainty surrounding demographic assumptions has an important impact on projections in some countries: under a low-fertility scenario (fertility rates lower by 0.5 children per woman) spending would increase by an additional 0.1 percentage point of GDP to 2030 in both advanced and emerging market economies (with additional increases of about 0.2 percentage point of GDP in Austria, Belgium, and Finland). Under a high-longevity scenario (life expectancy at age 65 increases in all countries to the highest level observed separately for advanced and emerging market economies in 2010) spending would increase by about 0.3 percentage point in advanced and 0.4 percentage point in emerging market economies (with additional increases of more than 1 percentage point of GDP in the Czech Republic, Russia, the Slovak Republic, Turkey, and Ukraine).2

Box 5.1.Projecting 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 Organisation for Economic Co-operation 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 1. For example, U.S. official projections include only social security pensions, whereas our projections 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—projections 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, the initial spending is based on national authorities’ estimates. This chapter presents spending projections and calculates the eligibility ratios and replacement rates implied by these projections, given the data on demographics, labor force participation projections, and legislated increases in the retirement age. While the methodologies used for projecting pension spending may be straightforward, the assumptions underlying these projections are critical to their validity. Thus, this chapter 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.

Second, macroeconomic assumptions also affect pension spending projections. For example, lower-than-expected productivity implies 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.3 Under a low-productivity scenario (productivity growth lower by 0.25 percent or set at the 2000–07 average if this is lower) pension spending in 2030 would increase by 0.26 percentage point in advanced and by 0.1 percentage point in emerging market economies. Productivity growth assumptions appear particularly optimistic relative to recent trends for a few advanced European economies. Under a low-productivity scenario, pension spending would increase by 1 percentage point of GDP in Italy and by ½ percentage point in Portugal and Spain.

Projections are also sensitive to labor force participation assumptions: assuming 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.4

Last but not least, official projections are also subject to the risk of reform reversal. In response to substantial aging challenges, legislated reforms often imply ambitious reductions in pension spending. Relative to a no-reform baseline, 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 imply relatively large reductions in projected replacement rates in Austria, Germany, Portugal, and Sweden and in eligibility ratios in the Czech Republic, Italy, the Slovak Republic, and the United Kingdom (Figure 5.4). Over the period 2030 to 2050, large reductions in replacement rates are projected in Italy, Portugal, the Slovak Republic, and Spain. Eligibility ratios largely stabilize after 2030, when most of the legislated increases in the retirement age will have taken effect.

Figure 5.4.Current and Projected Replacement Rates and Pension Eligibility in Advanced Economies

Sources: European Commission; International Labour Organization; Organisation for Economic Co-operation and Development; United Nations; and IMF staff estimates.

Note: See page xi for a list of country abbreviations.

Box 5.2.Key Demographic Trends up to 2050 and Uncertainty

According to the latest 2010-based UN population projections (United Nations, 2010), life expectancy at age 65 will increase from 18½ years in 2010 to 22 years by 2050 in advanced economies (Figure 5.2.1). In Japan, life expectancy at age 65 is expected to reach 24½ years by midcentury, the highest among the advanced economies under consideration. In emerging market economies, the extension in life span at age 65 is expected to be slightly less marked, with that life span rising from 15½ years now to 18½ years by 2050.

Figure 5.2.1Life Expectancy at Age 65 (Years)

The increase in life expectancy, in combination with below-replacement fertility rates, will lead to a doubling of the old-age dependency ratio over that period in advanced and emerging market economies, with that ratio reaching 50 percent and 30 percent, respectively (Figure 5.2.2). By contrast, over the period 1970 to 2010, the ratio increased by about half.

Figure 5.2.2Old-Age Dependency Ratio

(Percent)

These projections are subject to a high degree of uncertainty. In the case of Switzerland, for example, the United Nations now projects that the old-age dependency ratio will increase to 56 percent by 2050–11 percentage points higher than in the previous round of population projections in 2008 (United Nations, 2008). The latest projections for the old-age dependency ratio also differ significantly from previous estimates for Iceland and Luxembourg in the advanced economies and Indonesia, Jordan, Mexico, Saudi Arabia, and Thailand in emerging markets. In the case of Iceland and Jordan the rate has been revised downward.

Figure 5.2.3 illustrates how uncertain assumptions are about life expectancy at birth in the case of 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. It remains to be seen whether the more recent projections are more realistic than earlier forecasts.

Figure 5.2.3United Kingdom: Projected Life Expectancy at Birth, Males, 1966–2031

As these reforms take effect, political pressure to reverse them could mount. This happened in Sweden, where the implementation of automatic adjustments (such as increasing contribution rates or freezing benefits to respond to funding shortfalls) designed to ensure sustainability of its pension system was delayed and benefits were cut by less than suggested by automatic adjustment rules (Sundén, 2009). Similarly in Germany, indexation rules were modified during the recent crisis to prevent pensions from falling in nominal terms (Börsch-Supan, Gasche, and Wilke, 2010). 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 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 the elderly should not exit the labor force through other routes, such as by claiming disability pensions (Appendix 4).

Figure 5.5.Funding of Private Defined Benefit Pension Plans, 2009

(Percent of pension plan liabilities)

Source: Organisation for Economic Co-operation and Development (2011).

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

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 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 (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 (see Chapter 6).

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 these fail to deliver promised benefits. With defined benefit pension plans guaranteeing a certain pension income based on contribution years and earnings, funding shortfalls could be regarded as a contingent government liability (Figure 5.5). The degree of underfunding 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 (PPF, 2009).5 In the United States, the 100 largest defined benefit corporate pension plans reported a funding shortfall of 1½ percent of GDP (Ehrhardt and Morgan, 2011). Insurance plans have been set up to protect defined benefit pension program participants in the case of corporate bankruptcies (Germany, Sweden, the United Kingdom, the United States). While these insurance plans reduce the exposure of government to individual corporate failures, they have not been designed to absorb the more widespread closure of private defined benefit pension plans. As such, governments’ exposure to these risks is likely to be accentuated during times of crisis (IMF, 2009).

There is also a risk of inadequate replacement rates in private defined contribution plans, which would lead to pressure for higher social pension spending. While in most countries there will be no legal obligation for government to step in, a contingent liability could arise from an implicit social obligation of the pension system to ensure adequate income in retirement, especially for low-income groups. Although generally it is difficult to estimate the adequacy of future retirement incomes and to make cross-country comparisons, these risks are likely to be more pronounced the larger the role of defined contribution plans in providing retirement income.6 In Australia, Chile, Denmark, Mexico, South Africa, Switzerland, and much of emerging Europe, more than three-quarters of pension fund assets are in defined contribution plans (OECD, 2011).

The limited cross-country evidence suggests that these risks could be particularly pronounced in some countries. For example, the ratio of elderly to nonelderly incomes (on a posttax basis) is projected to fall between 2007 and 2040 in several advanced economies (Canada, France, Italy, Japan), remain stable in some (Germany, Spain, Sweden), and rise in others (Australia, Netherlands, the United Kingdom, the United States) (Jackson, Howe, and Nakashima, 2010). 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 in a number of countries (U.S. Government Accountability Office, 2007; Pensions Commission, 2004). For Europe, 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).

1

The calculation uses a discount rate of 1 percent, equivalent to assuming a 1 percentage point differential between the interest rate and rate of growth. A similar assumption is made for longer-term projections in the IMF’s Fiscal Monitor (IMF, 2011a). Over an infinite horizon, the PDV of pension spending increases is 235 percent of 2010 GDP in advanced and 190 percent in emerging market economies. See Table A5.4 for more details.

2

Another demographic dimension is immigration, which boosts pension system revenues in the short term but also increases pension spending in the long term once immigrant workers retire. The overall impact of changing immigration on spending as a share of GDP is likely to be moderate in the advanced economies. In the United States, for example, assuming about a 30 percent drop in baseline migration, the U.S. Social Security Administration (2011) estimates an increase in the average cost of the program of about 0.13 percent of payroll (less than 0.07 percent of GDP) over the next 25 years.

3

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

4

Another related consideration is the impact of the recent financial crisis on potential growth. This would imply a step increase in pension spending as a share of GDP, at least in the near term, as benefit levels, which are tied to historical wage growth, adjust only gradually 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

5

The funding position was in small surplus in early 2010 and early 2011, but declined sharply over the course of 2011. In mid-2012 the shortfall was equivalent to about 15 percent of GDP.

6

Projecting the role of private savings in providing future pensioner incomes is subject to a number of risks. For example, historical returns on assets may not provide a good guide for future returns in an environment of low interest rates. Similarly, pensions are subject to the risk of longer life spans (Antolín, 2006; IMF, 2012). Assessment of the adequacy of retirement income is further complicated by the greater role of nonfinancial assets such as housing in preparing for retirement in some countries (the United Kingdom, the United States) than in others (Germany, Switzerland). Differences in direct taxes paid on pension and labor income also make it difficult to compare the adequacy of certain (gross) replacement rates across countries.

    Other Resources Citing This Publication