Chapter

Considerations for Pension Reform

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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Pension reforms should (1) contribute to fiscal consolidation efforts, (2) address equity issues, and (3) support economic growth. The objective of public pensions is to provide retirement income security within the context of a sustainable fiscal framework. The importance of providing income security, especially for low-income groups, suggests that pension reform must also be equitable. Furthermore, the design of public pensions has the potential to affect economic growth through its impact on labor markets and national saving. These issues are discussed further below and provide the guiding principles behind the pension reform options outlined in Chapter 7 for advanced, emerging European, and other emerging market economies.

Fiscal Consolidation

Pension reform can potentially play an important role in countries’ fiscal adjustment strategies. Many economies will need to achieve significant fiscal consolidation to lower their debt-to-GDP ratios over the next two decades (IMF, 2010, 2011a). In addition, countries could consider strengthening their overall fiscal positions and reducing public debt in anticipation of age-related spending pressure.1 Given high levels of taxation in many economies, fiscal consolidation will need to focus primarily on the expenditure side (IMF, 2010). Because public pension spending comprises a significant share of total spending, efforts to contain these increases will be a necessary part of fiscal consolidation, particularly in advanced economies. Pension reforms are also needed to avoid even larger cuts in progrowth spending, such as public investment, and prevent increased intergenerational inequity as a result of rising life expectancy (at a pace faster than expected) and longer periods of retirement. Furthermore, some pension reforms, such as increases in the retirement age, can help boost growth. Thus, while the appropriate level of pension spending and the design of the pension system are ultimately matters of public preference, there are several potential benefits for countries that choose to undertake pension reform. It may be difficult to reduce public pension spending as a share of GDP in light of projected increases driven by population aging. However, at a minimum, stabilizing age-related spending (including pensions) as a share of GDP would avert the need for even larger cuts in other spending (IMF, 2010).

In this context, the design of pension reform should take into account the consequences for both current and future budgetary balances. This requires looking beyond traditional fiscal deficit and debt indicators, which focus on fiscal balances today but fail to capture the future impact of public programs. One approach involves looking at long-term fiscal balance projections. Another approach to capturing the long-term effect on public finances is to estimate a “pension-adjusted balance,” which takes into account the intertemporal pension balance rather than just the current balance of the pension system. The balance is calculated as the sum of the non-pension fiscal balance (calculated without taking into account the pension system) and the intertemporal pension balance (Soto, Clements, and Eich, 2011).2 The intertemporal pension balance term is based on the net present value of all the pension imbalances between today and a specified date in the future, say, 50 years from now. This approach would, for example, capture the effects of pension reforms that strengthen public finances over the longer term (such as raising the retirement age) but do not have an immediate effect on pension spending today. Similarly, pension reforms that strengthen the long-term fiscal outlook but have adverse effects on the budget balance and government debt in the near term, such as a transition to funded private pensions, should be assessed on a level playing field against other reform proposals.

Measures of the stock of pension liabilities can also help gauge the long-term fiscal burden posed by pensions and can guide pension reform. Pension obligations can be viewed as an implicit government debt, albeit one perhaps more easily repudiated than explicit debt. The net present value of future pension imbalances, as described above, is one such measure of this implicit debt. Other measures focus on pension benefits already accrued. It is useful to monitor such accrued benefits, because reform experiences suggest that governments find it harder to reduce spending on accrued liabilities for pension benefits already promised than that on future pension accruals.

Equity

Pension systems redistribute income within and across generations. Public pension systems often redistribute from those with high lifetime incomes to those with low lifetime incomes. For example, Australia, Canada, the Netherlands, and the United Kingdom offer flat-rate benefits unrelated to lifetime earnings. The United States uses a progressive benefit formula under which low-income earners receive a higher pension relative to their lifetime earnings than do high-income earners. These approaches reflect different policy objectives and approaches to targeting across countries (Barr and Diamond, 2008). However, the degree of redistribution may not always be as strong as it seems. In the United States, much of the redistribution between individuals occurs within households (from the high-earning spouse to the low-earning spouse) and not across households (Gustman, Steinmeier, and Tabatabai, 2011). Public systems also provide annuities on uniform terms for all individuals, a practice that inevitably favors the longer lived over the shorter lived. Pension systems can also redistribute income across generations (Box 6.1). By design, when most pension systems were introduced, individuals who were already near or past the retirement age received pensions although they made little or no contribution.

Such redistribution between generations has done much to alleviate poverty among the elderly. In Organisation for Economic Co-operation and Development (OECD) economies, the average ratio of poverty among the elderly to poverty among the entire population declined from 1.9 in the 1970s to 1.4 in the 2000s (Zaidi, 2009). This is partly explained by the redistributive components of pensions: today public pensions and means-tested benefits account for about 60 percent of the total income of the elderly in OECD economies. In the context of the United States, Engelhardt and Gruber (2004) show that the expansion of social security over the 1960s and 1970s explains the entire reduction in old-age poverty during this period. Furthermore, there is a clear association between replacement rates and old-age poverty. Controlling for other factors, regression analysis suggests that a 10 percentage point decline in replacement rates increases those at risk of poverty in old age by 0.9 percentage point (Appendix 3). This suggests that the projected reduction in replacement rates because of legislated reforms would have a moderate impact on the share of the elderly population at risk of poverty (Figure 6.1).

Figure 6.1.Projected Changes in Pension Replacement Rates and At-Risk Poverty Rates of the Elderly, 2010–50

Source: IMF staff calculations.

Note: “At risk of poverty” measures the share of people 65 and older with disposable income below 60 percent of the national median income (after social transfers). See page xi for a list of country abbreviations.

Economic Growth

The channel through which pension reform is most likely to affect economic growth is through its positive impact on the labor supply. In theory, pension reform could affect growth both by increasing the labor supply and through higher national (that is, public plus private) saving.3 However, empirical evidence suggests that the impact on the labor supply is most significant; reform’s effect on saving has been found to be ambiguous.

Raising the retirement age is likely to have the biggest impact on the labor supply. In the advanced economies, labor force participation rates of older men declined from about 80 percent in 1950 to about 40 percent in 2000. This decline is largely associated with the expanded coverage of public pensions, higher replacement rates, the introduction of early retirement provisions, and falling statutory retirement ages. Pension reforms, particularly increasing the retirement age and tightening access to early retirement, could reverse these trends and increase the size of the labor force, with potentially important macroeconomic effects. Although other parametric reforms—reducing benefits or increasing contributions—can improve fiscal balances, their impact on economic activity is less pronounced (and could even be negative). Reducing benefits lowers domestic demand, which offsets the growth benefits from lower interest rates due to healthier fiscal balances. Raising payroll tax rates can also reduce the labor supply—depending on the sensitivity of the labor supply to these taxes—and potentially result in lower output.4

Box 6.1.Pension Systems and Generational Imbalances

The generosity of a pension system for a given generation can be assessed in terms of how much it pays an individual in retirement relative to lifetime contributions. Building on Auerbach, Gokhale, and Kotlikoff (1994), Kashiwase and Rizza (2011) assess the net taxes (contributions minus benefits) attributable to pension systems for different generations in Italy, Japan, and the United States. Under its current pension system, the present generation of retirees in the United States receives benefits that are about 1.5 percent of lifetime earnings higher than what the current generation of workers will receive (Figure 6.1.1). The equivalent ratio for Italy is much higher, at just under 15 percent of lifetime earnings.1 In the case of Japan, this ratio is 6 percent.

Figure 6.1.1Generational Imbalance: Net Taxes

(Percent of lifetime earnings)

1Unlike the country projections for Italy reported in Table A5.4, this estimate does not incorporate the effect of the December 2011 pension reform.

The authors also evaluate impacts on generational imbalances from policy reform options, each of which restores the financial sustainability of a pension system. Among three reform options—raising contribution rates, reducing replacement rates, and increasing retirement ages—they find that raising contribution rates has the smallest effect on generational imbalances. In contrast, reducing replacement rates creates a much larger impact. This suggests that there can be a trade-off between the design of pension reforms that seek to share the burden of reforms equitably across generations and those that have more positive effects on labor supply and economic growth, such as increasing the retirement age.

Note: This box was prepared by Kenichiro Kashiwase.

Pension reforms can increase public saving, but governments need to resist the pressure to spend more or cut taxes to offset these gains. For example, Bosworth and Burtless (2004) find that 60 to 100 percent of the fiscal savings from pension reform is offset by higher public spending or lower revenues elsewhere in the budget for a sample of advanced economies (Austria, Canada, Denmark, Finland, Germany, Italy, Japan, the Netherlands, Portugal, Spain, Sweden, the United States). Similarly, Smetters (2003) and Nataraj and Shoven (2004) find that social security prefunding in the United States has been fully offset by lower public saving outside of social security. In many emerging market economies in Latin America and eastern Europe, pension reforms that introduced mandatory private pensions diverted contributions from the public system. This revenue loss has been generally offset by public borrowing instead of taxation or spending cuts, thus decreasing public saving.5

Evidence suggests that the impact of public pension reforms on private saving is ambiguous. The empirical evidence includes a wide range of estimates of how the private sector responds to the loss of public pension wealth (Table A5.5). In emerging market economies, pension reform had a positive impact on national saving in Chile and Kazakhstan but ambiguous effects in Colombia, Hungary, and Mexico (Aguila, 2011; Samwick, 2000; Villagómez and Hernández, 2010; World Bank, 2006).

In countries where decreased saving is part of a long-term growth strategy, expanded public pension systems could help achieve this objective. Precautionary motives explain much household saving and consumption behavior. Therefore, an expansion of pension coverage and higher public expenditures on pensions can help increase consumption. For China, Baldacci and others (2010) find that a 1 percent increase in public spending on pensions would raise consumption by 1½ percent. Cross-country econometric estimates in that study also imply that, for emerging Asian economies, an increase in public pension spending of 1 percent of GDP would result in an average increase in household consumption of about 1¼ percent of GDP.

1

Reducing debt as part of preparing for the fiscal consequences of an aging population has been an explicit policy objective in Australia, Finland, and Sweden (Australian Government Commonwealth Treasury, 2010; Finnish Ministry of Finance, 2001; Government Offices of Sweden, 2011). This approach is attractive because it contributes to greater fairness across different-size generations and allows for tax smoothing (Government Offices of Sweden, 2011).

2

The pension-adjusted budget balance builds on other approaches that capture the long-term budgetary position of the government, including intergenerational accounting (Auerbach, Gokhale, and Kotlikoff, 1994) and comprehensive public sector balance sheets (Buiter, 1983; Traa, 2009; Velculescu, 2010).

3

Numerous studies indicate a strong positive association between saving and growth (Levine and Renelt, 1992; Carroll and Weil, 1994; Aghion, Comin, and Howitt, 2006).

4

General equilibrium models have tended to emphasize the more favorable impact of raising the retirement age over reducing benefits or increasing contributions (Barrel, Hurst, and Kirby, 2009; Karam and others, 2010; Biggs, 2011).

5

Furthermore, relying on public borrowing to finance the transition can seriously undermine the fiscal position of countries with severe financing constraints (IMF, 2004).

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