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Public versus private old-age pensions in Europe
The modern idea of a ‘welfare state’ constitutes one of the most important achievements of European political thought. Old-age pensions, in turn, are a crucial feature of a modern welfare state and a modern social market economy. Pensions are the main tool to provide citizens, on a large-scale basis, with acceptable welfare levels at retirement.
In the face of this, demographic trends initiated in the past and now showing major effects are casting serious doubts on the future sustainability of national pension systems as they are organized today. Countries worldwide are dealing with increasing budgetary problems in paying out pensions due to population ageing and, especially in Europe, to a historical tendency towards early retirement. Awareness of this phenomenon has triggered a widespread debate in all Member States of the European Union and throughout the world about reforming national pensions systems. Currently , almost every OECD country and EU Member State is debating the pension problem and undertaking its own reforms.
However, pension system reform is a ‘sensitive target’, because of the very nature and importance of pensions. There are economic, demographic, social and political aspects that must be considered. Furthermore, from a technical point of view, there is controversy about the empirical magnitude of the pension problem and the underlying economic theory and, consequently, about best practices and policy advice for national governments. It is, therefore, no surprise that the debate on pension reform has grown intensively and now spans a variety of dimensions: from identifying appropriate actuarial formulae for computing benefits at retirement, to the general economic impact of different pension designs, to the more political issues of social consensus and implementation.
What is a pension scheme?
A pension is a contract under which an individual acquires the right to be transferred quotas of future output (the benefits) in exchange for quotas of his current output (the contributions). The contract establishes a point in time—retirement age—when this transfer starts.
In principle, an individual could ‘sign a contract with himself’; that is, he could store part of his own current production for future use. However, this is not viable for services and non-storable goods, for example health care and services for the elderly, clothing and food; these are precisely the basic kinds of good and services one is interested in after retirement.
In face of this physical constraint on individual actions, modern societies have coordinated individual pension contracts into a pension system, where individuals do not need to consume their own past production during their retirement time, but instead, consume output produced by the individuals working actively during that time. Every modern pension system constitutes essentially a transfer of output, in each period, from the current young generation—meaning here as those actively working—to the current old generation—those who are retired.
Pension systems fall theoretically into two broad categories.
In a pay-as-you-go system (PAYG), the current young generation contributes mandatory to the pension system through labor income taxes, whose revenues are partly transferred to the current old generation as pension benefits. In doing so, the young generation acquires the right to receive pension benefits when they grow old.
In a funded pension system, the members of the current young generation mandatory contribute part of their labor income to a pension fund, which invests in financial assets. When they retire, the fund pays out pension benefits in the form of lifetime annuities, which finance the pensioners’ consumption of goods and services produced by the current young generation.
Demographic change and public pension imbalances
This section discusses the problem of the current fiscal sustainability of public pension systems. A PAYG system is fiscally sustainable, or financially balanced,
when in each period, the total nominal contributions—given as the contribution rate times the average wage times the number of workers—equal the total pension expenses—given as the average pension times the number of pensioners.
In OECD countries, public spending for retirement pensions—that is, the right-hand side of the balancing formula—is expected to rise dramatically in the coming decades. Recent projections for the period 2000–2050 show that public age-related expenditures, as a percentage of GDP, may rise on average by about seven points. In particular, the proportion of GDP represented by public spending for retirement pension and early-retirement programmers is projected to increase by almost 10% in Norway, by 8% in Spain and Korea ,by 5% in Germany and by almost 4% in France.
For the European Union, ECOFIN projects an increase of the gross (before taxes) public spending in pensions of 2.3 and 2.2 percentage points of GDP, respectively, for the EU-15 and EU-25. This implies that by 2050, the EU-15 will spend almost 13% of its GDP to finance public pensions, while the EU-25 will spend 12.8%.
The projected increase in longevity, combined with a tendency towards early retirement, is responsible for the expected increase in the expenditure for retirement pensions. At the same time, projected pension contributions are expected to fall because of the decreasing fertility rates. Indeed, lower fertility rates tend to lead to a decrease in the working population and, under reasonable assumptions about productivity, to only a moderate expansion of GDP. As a result, given the current public pension formulae, the system will experience serious fiscal imbalances. Public versus private pension schemes
This section discusses how increasing the role of funded pension schemes can help to maintain fiscal sustainability in the presence of population ageing. It also elaborates on the effects on private pensions, savings and growth, financial markets and the protection of individuals against various types of risk, making comparisons with a PAYG system when necessary.
Funding allows the system to be kept financially balanced in the face of
population ageing. In a fully funded system each individual in a given generation, call it ‘generation A’, builds up her own ‘pile of financial activities’ during her working life. At retirement, the accumulated activities get transformed into a pension annuity whose actual value exactly equals the value of the accumulated assets for each individual. Under population ageing, during the retirement period of ‘generation A’ the working population will decrease. However, every individual in ‘generation A’ has already accumulated his pension fund before retirement. Hence, the pension system has by design enough ‘money’ to pay out A’s pensions. This argument is valid for each generation, and thus implies that a funded pension system, contrary to a PAYG, remains financially balanced in the presence of population ageing.
The fact that a funded system stays financially balanced does not mean that it can keep invariant the real levels of pension annuities in presence of ageing. The decrease of the working population implies—other things being equal—a decrease in output. Hence, when ‘generation A’s’ pensioners use their annuities to buy good and services, an excess of demand may arise, leading to an inflationary process which lowers the real value of A’s pension annuities.9
While this argument is correct, it is a somewhat minor concern. First, the funded pension system remains nominally balanced. Most importantly, financial imbalance may cause the system to break down. Second, the argument is essentially about economic growth. It is the lack of growth, due to the decrease in the working population, which lowers real pensions. But growth is a general problem that affects PAYG and funded systems, as well as the economy as a whole. Even if it is not known whether a funded system is always more effectual than a PAYG system in fostering economic growth, both PAYG and funded system are surely fragile in the presence of a lack of growth, but a funded system at least remains financially balanced. These arguments are seen as ones in favor of extending the role of funding in pension provision.
Towards private pensions: government regulation
This section discusses financial market regulation and identifies some specific directions of intervention. This article’s position is not one that calls for ‘more’
regulation. Rather, it favors a revision of current regulations in a direction that accounts for the peculiar characteristics of pension plans.
To start, consumer protection from contractual risk is important. It is precisely a regulatory system that should avoid a situation in which consumers bear ‘too much risk’, especially of a type they are often unable to value, as opposed as to risk transferred to intermediaries or financial institutions.
Regulation may mitigate these two common aspects of private pension schemes. The degree of liquidity of a pension scheme is partially due to the regulatory system, and can be increased. An example is the recent experience of mortgage contracts, which in some countries can be renegotiated at reasonable cost. For pension schemes, renegotiation may also include the possibility to switch funds and their providers. Clearly, this would call for a sufficiently high degree of standardization of pension plans. Regulatory interventions in the direction of higher standardization may also help to improve individuals’ knowledge of pension products, thereby reducing their uncertainty. Conclusions
This paper takes a cautious position towards a wider participation of the private sector in current pension systems. It argues that this may be a successful strategy provided that the transition is coupled by well-considered policy interventions fostering financial regulation. The position is not one that calls for more regulation, rather one that favors the revision of regulations in a direction.
Here, we want to point out that whenever a pension system has a strong redistribution objective. In this respect the public sector has more financing opportunities than any private institution.
Source: springer link/Filippo L. Calciano and Mario Tirelli/European View, 2008, Volume 7, Number 2, Pages 277-286
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