International Comparisons
Getting Tough: Countries Tackle Pension Reforms
Speech
March 2004
Warren McGillivray, Chief
Studies and Operations Branch
International Social Security Association (ISSA)
A
Balancing Act: Achieving Adequacy and Sustainability in
Retirement Income Reform
Brussels, Belgium
The Secretary General of the ISSA, Dalmer Hoskins, has asked me to tell you how sorry he is that he cannot be here with you today. He has fallen ill, and while I am glad to report that his illness is not serious, it has nevertheless prevented him from travelling to Brussels.
I shall focus on two issues. The first concerns the sustainability of public pensions, and the wider implications of population ageing. The second deals with the adequacy - or rather implications of the inadequacy - of retirement benefits.
Clearly, we all agree that public pension schemes face the challenge of producing a continuing and adequate retirement income throughout a person’s retirement years and those of his or her dependants, and that this challenge becomes more difficult in the face of population ageing.
Similarly, we agree that public pensions are consumption allocation mechanisms - arrangements for transferring resources from workers to pensioners at the time the pensions are paid. Under the pay-as-you-go system the transfer is direct through contributions or taxes paid by workers. Under the funded system, pensioners liquidate assets which they have accumulated by selling their assets to workers. In both cases workers’ disposable income is reduced by the amount of resources transferred to retired persons.
Enormous attention has been focused on whether the challenge of providing sustainable retirement benefits through equitable transfers can be achieved by:
- defined benefit or defined contribution schemes,
- financing by pay-as-you-go or funding,
- public or private management, and
- pensions indexed to prices or wages.
Attention to these features of a public pension scheme has obscured the fundamental issue - how ageing societies will be able to produce the goods and services required by all segments of the population.
The effect of population ageing on pensions has attracted much attention, despite other implications of population ageing such as the demand for health care, possibly because robust projections of future expenditures to meet public pension promises can be made. And, unlike future health care expenditures, cutting future pensions is thought to be feasible.
The problem of supporting ageing populations is not solved by funding public pension schemes. In pay-as-you-go schemes it is uncertain whether declining relative proportions of active workers have the capacity and the will to pay the pensions of increasing numbers of pensioners. In funded schemes the uncertainty is whether there will be a systemic decline in asset values when pensioners seek to realize their assets by selling them to the declining relative proportions of active workers.
According to Barr (1998), the fundamental issue is not the financial system which is used to determine how output is divided between workers and pensioners. Rather, “The choice between PAYG and funding in the face of demographic change is [therefore] relevant only to the extent that funding … systematically causes output to be higher.” [emphasis in original]
Support of increasing numbers of retired persons is possible only if output grows - only if economic growth is sufficiently robust to generate the resources to be transferred to retired persons without unduly depriving active workers. It is held by some that if economic growth continues as it has since World War II, there will be sufficient output to distribute under pay-as-you-go systems. See, for example, Eisner (1995), Mullan (1999) and Baker and Weisbrot (1999).
Many have sought to demonstrate that increased saving through operating a funded scheme will stimulate economic growth. While this proposition is intuitively persuasive - a funded scheme should ultimately increase saving and the increased saving should result in increased investment and thereby increased output - given uncertain markets and the uncertain allocation of investments, convincing empirical evidence of the effect of a funded public scheme on saving has been elusive.
Sustainability: Labour market issues and retirement age
It is the potential labour market implications and consequent economic distributional and output issues arising from population ageing - not the the relative merits of different public pension arrangements - which are the key to designing sustainable public pension schemes.
The World Economic Forum Pension Readiness Initiative considers population ageing from the perspective of its potential macroeconomic effects on productivity and the standard of living of the entire population. Virtually everyone living in a society is a consumer and, in general, all consumers are dependent on workers in the society to produce the goods and services they consume. Hence the fundamental issue becomes labour supply - not simply how much a retired person’s pension costs - but how much output and general welfare is lost because the person is not working. Rather than focusing on reforms of existing public pension schemes, the focus should be on “potential policies that specifically target the deterioration of public budgets as a result of population aging and public pension schemes and [to explore] policies and institutional changes that would promote economic growth to ameliorate the aging burden problem”.
Economic output depends on the supply of workers, capital and technology. If current working patterns persist, the labour force growth which most industrialized countries have experienced over the last half-century is likely to be reversed in the near future. Slower growing or contracting workforces will create labour shortages which can lead to economic stagnation or decline. In turn, this would lead to lower rates of improvement or to decreases in living standards. Under this scenario the choice becomes (1) how to allocate diminishing output among different segments of society or (2) what policies should be pursued that will sustain economic growth and thereby allow all segments of society to benefit.
According to the Pension Readiness Initiative while increased capital investment can improve worker productivity, this cannot make up for the entire shortfall in labour supply. Rather, the policies required involve fundamental changes in current labour force patterns. In particular, labour force participation of younger retirees, women and young adults should be increased. Immigration at levels which would be required to sustain economic growth would generally be socially and politically unacceptable.
Whereas a half-century ago, in the industrialized countries, the typical retirement period was around one-third of the working period, now in some countries it is approaching two-thirds of this period. Increasingly, workers opt for early retirement which means the actual retirement age is significantly lower than the normal retirement age set for the public pension scheme. Raising the normal retirement age has proved to be a difficult political choice and it is a potential cause of ‘reform deadlock’. To avoid disturbing the plans of workers who are near retirement, increases in the retirement age must be phased in over long periods.
While changes in the normal retirement age in a defined benefit scheme are inevitably long-term projects, efforts can be made to discourage early retirement and encourage deferring retirement. Greater than actuarial reductions can be made to calculate early retirement pensions, and inducements can be offered for deferring retirement.
A probable, albeit perhaps unintended, result of replacing defined benefit by defined contribution schemes is that successive cohorts of contributors are apt to have to work longer than they would have had to under the defined benefit scheme in order to accumulate sufficient stocks of assets at retirement to purchase adequate pensions. Defined contribution schemes may indeed be more transparent than defined benefit schemes, but the uncertainty of the benefit means that workers risk having to work longer in order to have an adequate retirement benefit.
Hence, one means of helping to sustain productivity is a reform which has long been advocated - raising the actual retirement age in public pension schemes. But, now the reason is not only to maintain the sustainability of a public pension scheme, but the broader objective of maintaining or even improving the standard of living of the entire population.
Adequacy: Implications of inadequate retirement benefits
The focus on public retirement benefits is shifting from a preoccupation with their sustainability to a more balanced approach where greater account is taken of the potential adequacy of the benefits. It is widely held that a single public pension scheme can no longer provide all the income required by a retired person and his or her dependants. Generous public schemes must be trimmed, and three components: a mandatory public scheme, mandatory or voluntary occupational schemes and voluntary personal savings are now generally considered to be necessary to produce adequate retirement benefits. Much of the debate now concerns the relative shares of each of these components in the total retirement benefit ‘package’.
Voluntary personal savings and, increasingly, occupational schemes rely on the defined contribution approach. A mandatory public scheme may also be a defined contribution scheme.
In defined contribution schemes, the retirement benefit is uncertain, and the worker/contributor alone bears the risk that it will be inadequate. On the other hand, benefits under public defined benefit schemes are subject to continuous parametric changes which are considered to constitute a ‘political risk’ - the potential ‘repudiation’, or the even more pejorative term, ‘default’, of pension promises. In both cases, in contributory schemes non-compliance with contribution conditions - an important administrative issue which is little considered - can lead to inadequate benefits.
Political risk is cited as justification for distancing statutory schemes from the influence of governments. However, in democracies where civil society has a strong influence on public policy, political risk is not perceived to be so pernicious. In order to maintain the sustainability of national public pension schemes, parametric changes are implemented gradually after prolonged debate to reach a national consensus. This is where most industrialized countries find themselves today.
Agreeing on parametric changes involves another form of political risk - the risk that despite a manifest need for reform of the public scheme, since individual losses are readily identified and resisted, the body politic of a nation is unable to reach a consensus on an acceptable reform, thereby resulting in ‘reform deadlock’. This can lead to the adoption of a structural reform where winners and losers are uncertain or at least less obvious.
The political risk of parametric changes is cited as justification for distancing statutory schemes from the influence of governments by introducing private management of public pension benefits. But government must carefully supervise private managers. Indeed, removing governments from direct influence over social security protection is unlikely ever to happen. The social protection of retired persons is simply too important to expect that governments will not act should they decide that circumstances (including their political survival) warrant intervention.
Governments which are lauded for operating apparently sustainable public schemes, but which neglect the future adequacy of benefits produced by the components of their retirement benefit systems risk creating increasing populations of retired persons who perceive their standard of living - both absolutely and relative to the standard of living of workers - to be inadequate, or at worst who are living in poverty. Whatever the reason for their inadequate benefits - unsatisfactory investment choices or performance, widespread non-compliance, etc - even if they bore the risk, retired persons will blame their governments for their inadequate benefits. After all, they will claim, it was the government which set up the retirement benefit system and thereby implicitly promised them adequate benefits. Governments want to be re-elected and retired persons vote. It is inconceivable that future governments will not react to this situation by supplementing retirement benefits from general tax revenues, thereby vitiating the apparent sustainability of the public scheme.
In conclusion, first I suggest that we should regard future increases in retirement age as a necessary step to maintain living standards for the entire population, and not principally as a means of sustaining public pension schemes. Second, I suggest that despite the need to reform public schemes so that they are sustainable, reforms which jeopardize the adequacy of future benefits may simply defer problems to future governments.