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The author is grateful to Sheetal Chand, Luis Cubeddu, Philip Gerson, Sanjeev Gupta, Peter Heller, Martin Kaufman, George Mackenzie, Stephen Mathews, Alex Mourmouras, and Murray Petrie for their comments on an earlier draft.
Unless otherwise indicated, the term “public pensions” refers to national social security or social insurance pensions, as distinct from pensions for civil servants and other public sector employees.
The intuition here is that pension is accrued as salary increases and service is extended. With the pension contribution fixed, contribution income increases only with salary. It is therefore necessary to “pre-fund” future service and, with a final salary scheme, future salary growth. A formal proof is given in Appendix I.
There are finite-horizon models—Samuelson, Diamond, and Blanchard have produced variants—which suggest that the growth rate can exceed the interest rate in steady state, although this is not dynamically efficient. If reality reflected these models, PAYG would be preferable to funding.
In the G7 countries plus Denmark, the Netherlands, and Switzerland, real earnings growth in aggregate averaged about 2 percent during 1971–90 while the average real rate of return on a 50–50 portfolio of equities and government bonds was above 4 percent (Issue Brief 2, World Bank, 1994). However, the real rate of return on government bonds was only slightly above 1 percent, so portfolio choice—and in particular the risk that the public sector would be prepared to take in funding pensions—is critical to such an assessment.
This is sometimes referred to as the social insurance paradox.
It might be argued that concern about intergenerational fairness should properly be addressed in a more comprehensive way, through “generational accounting” which looks at the burden of fiscal policy more generally on successive generations.
There has been some mention in this regard of an “asset meltdown.” This is not likely to happen. Asset values will adjust gradually as national and global financial markets respond in a measured way to country-specific and worldwide population aging which is well understood and quite predictable.
Note that indexed assets do not guarantee a nonnegative real rate of return. The only requirement of an indexed asset is that the real rate of return is independent of the inflation rate.
Despite these advantages, notional funding is not widely practiced. The United Kingdom public sector makes some use of notional funding. Public pensions in Sweden are also partially funded on a notional basis.
The available studies report markedly different estimates of unfunded PAYG liabilities. Different estimates in Kuné (1996) vary by a factor of up to five for a single country, reflecting variations in the underlying assumptions.
It could be argued that contribution rate gaps provide more information since these reflect the equilibrium contribution rates required to balance a PAYG scheme on a year-to-year basis. An unfunded PAYG liability only provides an indication as to the sustainable contribution rate, which is the constant contribution rate required to balance a scheme over the longer term.
Hence the practice in the United States of investing social security surpluses in treasury bonds and then meeting future pension payments in part from the Trust Fund accumulated in the process is a means of smoothing the social security tax rate over time. The interest paid on the treasury bonds will reduce social security tax rates marginally over the long term compared to PAYG rates, but at the expense of higher federal tax rates, lower federal spending and/or a larger federal budget deficit.
See Leidy (1997) for a discussion of the impact of investing United States social security Trust Fund assets in private securities.
Results of a study by the Brookings Institution staff (reported by Henry Aaron at an IMF Economic Forum on “Aging Populations and Public Pension Schemes: Averting the Crisis”), show that when account is taken of the decline in pensions relative to incomes during retirement, the variation in replacement rates can be even larger than suggested here. For a defined-contribution scheme started in 1870, replacement rates would have varied in the range 30–100 percent between 1910 and the present day.
Another important lesson from Chile, related to the transition from PAYG to funding, is that to avoid the double burden on the transition generation, the government has to bear some of the transition costs. This was manageable in Chile because the government budget was in significant surplus prior to the reform.
Basic pensions fulfill the Pillar 1 role in the United Kingdom. There has been a concern that, because basic pensions are indexed to prices, they will continue to decline relative to earnings as in recent years and will thus fail to provide an adequate minimum. However, a further scaling back of SERPS should provide the scope to maintain basic pensions as an effective anti-poverty program.