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Re-tooling Retirement's Tools

By: Source: AARP.org Date Posted: 2004-11-30 00:00:00-05:00

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Re-tooling Retirement’s Tools

By Bert Rürup, Chairman, Rürup Commission, Germany

While many countries of South America, Africa and the Middle East have populations growing younger, Europe, Japan, and soon also China, have rapidly aging populations which will likely shrink in the medium to long term.

The economic costs and the real economic consequences of an aging population cannot be deleted by reforms.

Politics can try to accomplish the following three goals:

1. Distribute these real costs in a way that is as favorable for growth and employment as possible,
2. Distribute these costs as evenly as possible among all generations and
3. Achieve the highest possible level of financial sustainability. An old-age security system will be financed in a sustainable way if, on the basis of a given financing regime, the entitlements acquired may be fulfilled lastingly. In other words, no unplanned cuts of benefits will be required in the future to achieve the contribution goals and/or, starting out from an existing level of benefits, no unplanned increase in contributions will be necessary.

In general, a pension policy oriented towards sustainability in aging societies thus requires three things:

1. Reduction of labor costs—also by means of cuts in benefits—in the interest of employment and growth.
2. Compensation of the cuts in benefits by extension of fully-funded supplementary pension systems.
3. Prolonging the working career to place the burden of costs caused by increasing life expectancy—hence the increased period of pension receipt—on those persons who benefit from these additional years of pension payments (i.e., the future pensioners). Raising the statutory retirement age will reduce the pressure on contribution rates and render the pension level more stable.

There are no safe pensions which are guaranteed or the payment of which can be guaranteed. Pension claims are always claims on a future national product, and as such they are tainted with uncertainty just like the future of the economy.

The two principles which can be applied for structuring or financing an old-age security system, the pay-as-you-go system and the funded system, are both offering specific advantages and disadvantages and neither is a priori the basically superior financing system.

The pay-as-you-go system is largely inflation-proof and highly adaptable as it can be introduced and extended any time. If an old-age security system is introduced in a country, this can only be a pay-as-you-go system.

However, the pay-as-you-go system has the disadvantage of depending on the current employment situation and, in particular, of being sensitive towards the demographic shifts in the ratio of contributors to pensioners. In an aging society, pension systems on a pay-as-you-go basis regularly place the younger generation at a disadvantage. To this extent, they are unfair from an intergenerational point of view. Young people have to pay continuously increasing contributions to acquire the same entitlements as the elderly, or they have to content themselves with lesser benefits when contribution rates remain at the same level.

Whereas the pay-as-you-go system relies on the stability and productivity of national income from work, the funded system trusts in the stability and productivity of national and international income from capital. Probably the most important contrast to the pay-as-you-go system is the funded system’s reliance on international capital markets. Due to the possibility of investing assets for old-age provision abroad, it is possible to become independent of the national and demographic developments and also of labor market trends (within certain limits) and to use foreign real net output (expressed in capital gains and exchange profit) as an instrument for financing the domestic old-age income. However, this system has a cost of capital market and foreign exchange risks for pensions holders.

Due to the specific advantages and disadvantages of both financing systems and their different reactions to various kinds of economic and demographic changes, there are many arguments which support the view that—merely for reasons of risk heading—an "efficient" and thus also "safe" old-age security system should not only rely on one single financing principle, but should be a system based on mixed financing.

There is no "scientific" answer to the question about the right mix between pay-as-you-go and capital funding systems. The answer can only always be a political one. And this answer does not only depend on confidence in the long-term stability of capital markets, but also on assessment of "distributive acceptability" in connection with a partial transition from pay-as-you-go to a full funding system. Assuming that in the long term, interest rates will be higher than the national product growth or growth of total wages, there will be a permanent "yield advantage" for the capital funding system. Simulation studies of an even partial transition to the capital funding system, therefore, revealing that there will always be an additional burden on gainfully employed persons creating a "sandwich" generation. These additional expenditures for old-age provision during the introduction of the funded system will be the higher, the more far-reaching such a change is.

There can be no guarantee of a standard of living in the true sense of the word. Therefore, in these societies, the one-dimensional state pension systems must be replaced by multi-dimensional protection systems consisting of public and private elements which will then jointly guarantee this standard of living.

The social state approach of policy within the terms of an income-related protection of old age will then also no longer be reflected only by a stabilization of the state systems but, to an increasing extent, by the political organization, regulation and control of private and occupational supplementary pension systems. The active social state will more and more turn into an activating and regulatory social state.

Bert Rürup is an economist and pensions expert who heads a commission which is examining the German system of pensions.