Prerequisites and Policy Choices in Pension Design
© 2002 International Monetary Fund
The Economic Issues series aims to make available to a broad readership of nonspecialists some of the economic research being produced on topical issues by IMF staff. The series draws mainly from IMF Working Papers, which are technical papers produced by IMF staff members and visiting scholars, as well as from policy-related research papers. This pamphlet was prepared by Charles Gardner.
This Economic Issue draws on material originally contained in IMF Working Paper 00/139, Reforming Pensions: Myths, Truths, and Policy Choices. Citations for the studies reviewed are provided in the original paper, which readers can purchase ($10.00) from the IMF Publication Services, or download from the IMF's website: www.imf.org.
Funded Pensions. These schemes make pension payments from a fund that is an accumulation of financial assets built up over a period of years from the contributions of its members. These plans may be either private or government run.
Pay-as-you-go (PAYG) Systems. In contrast to funded pensions, these systems pay pensions out of current contributions or taxes. They are usually run by governments from current tax revenues, and the amounts of the benefits are based on commitments, or promises, made by the governments.
Defined Contribution Plans. These plans are funded accounts in the names of individuals. The contribution rate is fixed. The individual's pension is an annuity whose size—at a given life expectancy and rate of interest—is determined only by the size of his or her lifetime pension accumulation. Members of these schemes face the uncertainties associated with varying real rates of return to the pension assets.
Defined Benefit Plans. Often run at the level of firms or industries, defined benefit plans pay an annuity based on the employee's wage and length of service. In older schemes, the pension was often based on the employee's wage in his or her last year, or last few years, of service. The recent trend has been to base benefits on a person's real wages averaged over an extended period. Either way, a person's annuity is, in effect, wage indexed until retirement.
In these schemes, the employer, not the employee, bears the primary risk of a fall in the return on plan assets, but also gets the benefit of any higher-than-required return. In reality, these risks (or gains) to the employer are shared more broadly, rippling through to current workers (whose wages may be more or less depending on the cost of the scheme to the employer), to shareholders and taxpayers (through effects on profits), to customers (through effects on prices), and even to past or future workers, if the company uses surpluses from some periods to boost pensions in others.
Social Insurance. These are typically government-run pay-as-you-go plans. Risk is shared even more broadly than in private defined benefit plans. The costs of adverse outcomes can be borne by the retiree (through reduced benefits), by current workers (through higher contributions), by the taxpayer (through tax-funded subsidies), and by future taxpayers (through subsidies financed by government borrowing).
All societies, in one way or another, try to meet people's needs as they age and can no longer provide for themselves. As developing countries grow, they face difficult issues about when and how to establish pension systems that their more complex economies require. Countries currently making the transition from central planning to more market-oriented approaches confront similar decisions. And in the industrial world, long-established pension systems that have sufficed for decades are now threatened by rapidly expanding populations of pensioners with a shrinking base of productive workers to provide for them.
This demographic time bomb has set off an intense debate about pension reform in general, and particularly about whether it is necessary or desirable to move away from government pay-as-you-go pensions toward private or publicly funded plans.
With so many countries now engaged with these issues, the time is right for reflective discussion of the simple economics of pensions and the prerequisites that economics suggests for establishing new systems as well as for adapting the mature, older ones.
Rational policy design begins by agreeing on objectives and then proceeds to discussion of instruments for achieving them. Broadly, the objectives of all pension systems are threefold:
In terms of these generally recognized objectives, pension systems have evolved in three distinct tiers that also serve to highlight the key choices countries make.
This pamphlet looks first at the economics of pensions, then at the prerequisites, and then at the policy choices. The simple economics of pensions provides perspective on the prerequisites that must be met if a pension system is to succeed, and also gives a basis for developing a separate checklist of issues that policymakers must decide in light of each country's capacity and preferences. A concluding section sums up how a country's stage of development affects its range of choices.
The main conclusions are threefold. First, all pension systems, no matter how financed, require strong and effective government to succeed. Most fundamentally, government must manage the economy effectively enough to provide adequate growth while establishing a strong regulatory environment.
Second, the much-debated choice between government pay-as-you-go and funded schemes (whether private or public) is of secondary importance. It matters much less than the capacity of the government to manage the economy effectively, to promote adequate growth of output, and to sustain a stable foundation for whatever pension system is adopted.
Finally, within the limits of the economic prerequisites, countries have a wide range of choice over pension design; if their pension systems are to succeed, they can and must make the choices in the context of their own cultures, histories, and national values.
Much discussion of pensions gets bogged down in arguments over what kinds of financial portfolios are safest or grow fastest, whether government promises are more secure than assets owned or held in the names of individuals, and which generation foots how much of the pension bill. Ideological strife heightens the confusion, and the economic fundamentals of all pensions—public or private, funded in advance or pay-as-you-go—get lost.
Several themes recur in any attempt to secure the resources needed for individuals at the ends of their lives, when they are no longer producing to meet their own needs. These themes are the central importance of national output to the viability of all pensions; the pervasive risks and uncertainties that all pension schemes face; and the imperfect information available for guiding a pension scheme, whether the manager is the government, a private firm, or the individual who ultimately expects to benefit.
Output Is the Key. Ultimately, the production and consumption of goods and services is essential to any effective pension plan.
There are two—and only two—ways to attain security in old age. The first is to store current production for future use. Robinson Crusoe, alone on his desert island, could provide for his old age only in this way, but it is a nonstarter today, being costly, taking no account of changing needs or tastes, and making no provision for many types of service, medical care being a vital example.
Instead, individuals must exchange current production for a claim on future production. They may either save part of their earnings to build up a pile of money to buy goods and services later from younger workers; or they may rely on a promise from children, an employer, or the government to provide adequate goods and services in their retirement years. These alternatives lead naturally to the two common forms of pensions. The first is funded schemes that pay pensions from financial assets built up over a period of years. The second is pensions based on promises, commonly pay-as-you-go schemes paid by governments out of current tax revenues.
Both funded and pay-as-you-go plans are claims on future output, and they are of no use to retirees if the country is not producing enough goods and services to meet those claims. Pensioners are not interested in currency as such, but in food, heating, medical services, seats at cinemas, and so on. Money is irrelevant unless the goods and services are available to buy.
Risk and Uncertainty. Both private funded plans and government pay-as-you-go systems are subject to risk and uncertainty. In the long term, risks include demographic changes such as the rapidly aging populations that now pose serious problems for most industrial country pension systems. Short term, they include the theft or mismanagement of privately held assets or the inability of governments, companies, or trade unions to make good on pension promises. More generally, uncertainty also includes unforeseeable political change, wars, and economic shocks, such as the stagflation (stagnation coupled with inflation) brought on by the oil price increases of the 1970s.
These uncertainties threaten the viability of all pension systems because they can undermine output, or generate price inflation, or both. Since many uncertainties arise from political risks, all pension systems are critically dependent on effective government, albeit in different ways. While governments may renege on pension promises, their pay-as-you-go systems are largely protected from inflation because the inflated pensions they pay are covered by the inflated currencies they take in through taxes.
Funded schemes, whether public or private, are more exposed to inflation risk. And private funded schemes face additional risks, including the incompetence or fraud of fund managers, market fluctuations in the value of pension accumulations held in equity markets, and the value of annuities, which depend on life expectancies and the validity of actuarial projections. Thus the argument that funded pensions diversify risk should not be overstated.
Imperfect Consumer Information. Since nobody can be well informed about the future, government pension administrators, private fund managers, and individuals all face the issue of imperfect information. For individuals dependent on defined contribution plans, however, the problem is worse because private pensions are complex and based on an array of financial institutions and instruments.
The workings of financial markets are poorly understood, even in the industrial countries with the most sophisticated systems and options. For example, a leading U.K. bank observed that most people do not grasp that invested pension assets are at risk if the assets fail to appreciate, and think of risk only in terms of theft or fraud. Even in the United States, where public knowledge of, and interest in, financial markets is exceptionally high, a survey found that over half of Americans do not know the difference between a bond and an equity.
Some consumer ignorance can be overcome with public education. But there is an irreducible minimum, because even financial sophisticates cannot necessarily be regarded as well-informed consumers, and some degree of consumer ignorance remains inherent. Given the high potential cost of mistaken choice, the problem of imperfect information requires the stringent regulation of pension management to protect consumers in an area where they are insufficiently informed to protect themselves, and where the least well-off tend to be the least well-informed.
Many arguments over pension design or reform can be simplified by separating issues requiring policymakers to make important choices from those where all pensions systems are subject to core prerequisites.
Facing the Demographic Dilemma. Looked at this way, even the difficult problem of aging populations that the industrial countries face is not insoluble. But until the underlying economic realities of these population pressures are addressed fully, solutions limited to different approaches to financing are likely to be inadequate.
A variety of policies are available for containing these population pressures. The most vital is increasing output, which is the only way of assuring that the financial claims on future output can be converted into enough goods and services to meet pensioner needs. The point is fundamental—the central variable is output; how the finance of pensions is organized is secondary. The argument that funding by itself resolves adverse demographics is a myth.
Policies are needed to raise the productivity of each worker, as well as to increase the number of workers. Promoting investment in more and better capital equipment and in training and education for workers can increase their productivity. Labor supply can be enlarged with better child care facilities, through tax policies that do not penalize part-time employment, by raising the age of retirement, by importing labor directly, and through importing labor indirectly by exporting capital to countries with a young population.
The evidence on whether a move to funded pensions increases savings and economic growth is mixed and controversial: a move to funding might not increase saving, because it may lead individuals to save less themselves; and if savings do rise, there is no certainty that the increase will be invested so as to increase output growth—the goal of individual accounts is asset growth, which is not the same thing as growth of output. In contrast, the evidence on labor market incentives is strong—all pensions should be designed with incentives that enhance labor supply. Badly designed schemes—whether public or private, funded or pay-as-you-go—can discourage work, both during working life and by encouraging premature retirement. Given today's demographic prospects, pensions should encourage later retirement and ensure that perceptions of the actuarial relationship between contributions and benefits accord with reality.
Policies also are required to address the fiscal burdens governments face with a rising proportion of retirees. One approach to reducing future spending is to cut average pensions; another is to reduce the number of pensioners. Cutting pensions, however, may worsen pensioner poverty as well as create political pressures. A more desirable approach is to reduce the number of pensioners by raising the age of retirement—a policy that helps for both fiscal and social policy reasons, particularly where longevity is rising generally. This approach aims to keep taxation broadly at its present level, at the price of imposing the burden of adjustment on pensioners.
For government pay-as-you-go-plans, what really matters is total public spending, not pension spending specifically. A second way to contain fiscal pressures, therefore, is to cut other public spending to increase funds available for paying pensions. The burden of adjusting to an aging population can be spread across generations by cutting public debt in the present and thus reducing future interest payments. This levels up tax rates between present and future requirements, while maintaining pension benefits.
A third approach is to set aside resources now to meet future pension spending. Building up pensions funds is one way—but not the only way. Examples include building up a surplus on the state pay-as-you-go scheme, as in the United States and Canada, or, as in Norway, creating a separate fund from oil revenues. The various approaches can, of course, be combined, for example by paying off some debt to allow some fiscal smoothing while raising the retirement age to share some of the burden with pensioners.
Public Sector Prerequisites. Before a country can establish or reform a pension scheme, whether public or private, funded or pay-as-you-go, it must have a strong and effective central government as well as a private sector that is mature enough for the chosen new system or the reform plans. The role of government is to assure both the fiscal and political sustainability of the pension system.
Fiscal stability is essential to foster economic growth and to assure the viability of pay-as-you-go finance. It is also fundamental to the success of private pensions, which can be undermined by unanticipated inflation.
Economic growth must be strong enough to provide for a central goal of government policy everywhere: to increase general living standards. Thus public spending—and, within that, public pension spending—must be held down to a level that allows enough private sector growth. Whatever the debates about the effects of taxation on growth, there is no doubt that beyond a certain point—which differs from country to country—the deleterious effects of high taxation are devastating. This was plain, for example, in the poor growth of the transition countries in the late days of communism.
While public pension spending must be sustainable in both the medium and long term, this does not imply that state pension spending in the long run should necessarily be minimized. Clearly, economies can function well with governments of very different relative size, but only so long as they remain within fiscally sustainable limits overall.
Public pensions require that the government be able to collect contributions; private schemes require that the government has the capacity to enforce contributions. A country that cannot implement even a simple payroll tax cannot run a pension scheme. The issue then becomes how to organize poverty relief in a context of limited fiscal and administrative capacity.
Political sustainability requires political will strong enough to support the long process of establishing or reforming a pension system and to maintain confidence in private plans. A large-scale reform of a national scheme, or the introduction of a new system of state or private pensions, is not a single event, finished when the legislation is passed. Instead, it is a process, requiring long-term government commitment, both for technical reasons, to ensure necessary adjustments to reform proposals as events unfold, and for political reasons, to sustain public support.
Preserving public confidence in private pension plans requires effective government regulation of financial markets to protect consumers in areas too complex for them to protect themselves. This requires tightly drawn up regulatory procedures and a body of people with the capacity and will to enforce those procedures. This task is particularly difficult because pensions are complex instruments, requiring highly skilled regulators whose abilities command a high price in the private sector.
Private Sector Prerequisites. Countries choosing to base their pensions systems on private financial markets and investments must first have well-established financial markets, as well as adequate public and government understanding of and trust in them. This may seem obvious, but in some developing and transforming economies, there is still the belief, even at high levels in government, that if a fund is "private" and the money "invested," a high real rate of return is inevitable.
Private schemes need financial assets for pension funds to hold and financial markets for channeling savings into their most productive use. If pension funds, whether public or private, hold only government bonds, this may appear to address the lack of other financial assets. However, these schemes are, in reality, pay-as-you-go, since both the interest payments and subsequent redemption depend on future taxpayers. Misunderstanding of this point is not limited to poorer countries, since it is widespread in the United States.
Private pensions that only use government bonds provide no real budgetary gain, no channeling of resources into productive investment, and considerable extra administrative cost. It is sometimes argued that schemes based on government debt will encourage development of private financial assets. In fact, the root of private financial assets is progress in the private real economy (competitive markets, effective corporate governance, effective regulation, and the like). Though the market for public debt can be a useful benchmark market for the private sector, the logical priority of developments in the real economy is ignored at policymakers' peril.
Another apparent solution is to use the pension savings of a poorer country to buy Western financial assets. Romanian savings would go, for example, into French firms, or Bolivian savings into U.S. firms, thus getting round the absence of domestic financial assets and financial markets. The argument against this approach is that it forgoes the growth of domestic investment and domestic employment. This is part of the argument used in favor of private pensions.
To get round this problem, it is argued that poor countries should buy low-risk Western assets, offset by an inflow of Western capital better able to accommodate high-risk investments. But would Western capital inflows be large enough to offset capital outflows? The evidence, not surprisingly, is that inflows are determined by real, not monetary, factors. The countries with the largest per capita foreign direct investment are those that are doing best, for example, Hungary and Poland. Western capital flows are dictated by expected profit, not by the unmet needs of a poor country's pension system. At best, the two are unrelated; more likely, they are inversely related.
None of this entirely rules out the investment swap approach. Certainly, if a country meets the prerequisites for private, funded pensions there is much to be said for at least partial international diversification of pension assets. But serious doubts surround the contention that a country can have a private pension system with virtually no domestic financial assets or financial markets.
Private sector capacity is also essential, given the heavy administrative demands of private pensions. A lack of capacity runs the risk that excessive administrative costs will erode the investment return to pensioners. Since there is a fixed cost to running an individual account, the issue is of particular concern for small pensions. At worst, deficient administrative capacity puts the viability of private funds at risk. Even if private sector capacity is adequate, is its deployment in administering private pensions its best use?
A further prerequisite in private financial markets is transparency. It is vital both for political reasons, to ensure the legitimacy and hence political sustainability of reform, and for economic reasons, as a necessary ingredient if pensions are to steer savings into their most productive use. Private pensions require transparency about the costs of tax relief, and through annual statements giving details of a person's pension accumulation, predicted pension, and administrative charges. Statements, furthermore, must be on uniform standards so consumers can make comparisons easily and accurately.
Although the basic requirements for all sound pension systems are extensive, countries must make a range of difficult, often controversial, choices to meet their varied capacities and needs. The following questions pose some of the key choices, but they far from exhaust the list.
How large should the first-tier pension be? A central question is whether the first tier should be a guarantee, available only (or mainly) to those who need it, or a base on which other pension income builds.
In ascending order, the first tier could take the form of a state guarantee to individuals in private schemes, as in Chile, under which only the least-well-off receive any state pension. Or the state pension could be awarded on the basis of an affluence test, as in Australia. An income test ensures that only the poor get benefits; thus benefits are scaled back rapidly as a person's income rises. An affluence test has a different purpose—to keep benefits out of the hands of the rich; thus benefits are scaled back less rapidly so that both poor and middle-income people receive benefits.
Somewhat less stringently, the first-tier pension could be flat-rate (hence going to all pensioners): it could be a flat-rate below the poverty line (as in many poorer countries just beginning to build pension systems), equal to the poverty line (broadly the case in the United Kingdom), or above the poverty line (as in New Zealand). Whatever the design of the first-tier pension, a minimum income in old age can be guaranteed through tax-funded social assistance for those whose income from all other sources leaves them in poverty.
To what extent should the first tier redistribute income? The smaller the pension and the greater the proportionality between contribution and benefit, the less redistribution there is. Pensions strictly proportional to contributions bring about no redistribution between rich and poor except to the extent that the rich may live longer. Such proportionality can be achieved either by financing flat-rate pensions with flat-rate contributions or by making both pension and contributions proportional to earnings. A flat-rate pension financed by a proportional contribution will be more redistributive, and a flat-rate pension financed from progressive general taxation more redistributive still.
A libertarian approach argues for mandatory membership only of the first tier, and then only to the extent of poverty relief. Though libertarians oppose compulsion, they can justify it to this limited extent because an individual's choice not to insure can generate costs for others—on taxpayers if the individual is bailed out by social assistance, on the family if they thereby face starvation, or on the wider society if the individual resorts to crime. This approach would comprise mandatory membership of a minimal first-tier pension plus a third-tier (voluntary) private pension.
Should there be a second-tier pension? The second-tier pension provides for spreading consumption more equally between working and retirement years. The argument for a mandatory second-tier pension can be couched in a number of ways: as justifiable paternalism; because imperfectly informed younger people will make poor choices from the perspective of their lifetime needs; to ensure insurance against unknowable events; or to avoid moral hazard in the presence of a generous first-tier pension (if there is a minimum guarantee, low-income people will have little incentive to make voluntary provision).
From an individualistic perspective the issue points toward a voluntary third-tier pension, while a paternalistic viewpoint favors mandatory consumption smoothing. If there is to be some compulsory consumption smoothing, a second question is whether compulsion should be applied only up to some ceiling and, if so, what ceiling.
Should a second-tier pension be pay-as-you-go or funded? In the United States, the first- and second-tier pensions are rolled into one, both tiers being run mainly on a pay-as-you-go basis. In Canada, a first-tier state pension provides poverty relief, and a mandatory, publicly organized, pay-as-you-go second-tier pension provides consumption smoothing. Other countries, including Australia and several in Latin America, have privately managed, funded, mandatory second-tier pensions. The United Kingdom has a mixed system: the basic state flat-rate pension is mandatory; beyond that it is mandatory to belong either to the state earnings-related pension scheme (which is pay-as-you-go) or to an approved occupational scheme (private, funded, frequently defined-benefit), or to contribute to an individual funded account.
Should the second tier be defined-contribution or defined-benefit? The issue here is how broadly risks should be shared. Individual funded accounts leave the individual facing most of the risk, in particular from differences in pension fund performance. The individual may also face inflation risk, though this can be shared partly or wholly with the taxpayer if the state provides indexation. Occupational schemes (frequently found in the United Kingdom) are often defined-benefit, thus sharing risks more broadly.
Should the second tier be managed publicly or privately? As just discussed, the second-tier pension is publicly managed in some countries, for example, the pay-as-you-go schemes in the United States and Canada. Singapore's Provident Fund, a form of compulsory saving scheme, is a publicly managed, funded scheme. Many other countries, including Australia and Chile, have privately managed second-tier pensions.
Should opting out of state arrangements be allowed? The first-tier pension, which is redistributive, is by definition mandatory. Beyond that, the question is whether people should be allowed to choose whether consumption smoothing should be through a state pension or through private arrangements. In the United Kingdom, people can opt out of the state earnings-related pension and instead join a private scheme. In the United States and Canada, in contrast, membership in the state earnings-related scheme is compulsory.
To what extent does the state assist with indexing pensions? Once a person has retired, pensions based on an annuity are vulnerable to unanticipated inflation. A major design question, therefore, is the extent to which government offers pensioners protection against inflation and through what mechanism. To the extent that government does participate, this introduces an unfunded element into funded schemes.
This list far from exhausts all the potential questions. What, for example, should be the tax treatment of contributions to the third tier: should such savings receive tax concessions; should those concessions be available only for savings for old age, or also for other purposes such as life insurance, house purchase, or education; and what form should any tax concessions take?
Pension design is controversial. Controversy swirls in particular round two sets of issues: should the first-tier, mandatory, state pay-as-you-go pension be minimal or substantial; and how should the second tier be organized—in particular should it be mandatory, private, funded, and defined-contribution?
The following conclusions emerge from examining the issues.
The key variable is effective government, a prerequisite for well-run pensions, however they are organized. It is not possible to get government out of the pensions business. Most fundamentally, government must manage the economy so as to facilitate the growth of output. Then, if pension systems are public, government must inspire confidence that the promises it makes will be kept. To the extent systems are private, government must sustain a regulatory framework that ensures high fiduciary standards and transparency in private capital markets. This last requires constant government vigilance, as the United States learned from the collapse of its energy giant Enron in late 2001.
From an economic perspective, the difference between pay-as-you-go and funding is secondary. There may be important political-economy differences, depending on country and historical context. Some argue, for example, that the political problems of raising the retirement age may be dealt with more easily with a private scheme. In contrast, others argue that a state scheme that combines poverty relief and the smoothing out of consumption, by embracing middle-class voters, will retain electoral support. Whatever the political arguments, the gains in terms of economic welfare of one pension arrangement as opposed to another are equivocal. Since pay-as-you-go and funding are simply different financial mechanisms for organizing claims on future output, this should not be surprising.
A given set of objectives can be achieved in different ways—there are many ways of skinning a cat. Thus there is no one-to-one relationship between instruments and objectives. Consider a scheme whose goals include mandatory consumption smoothing with some redistribution and risk pooling. The United States achieves this through a mandatory, publicly organized, pay-as-you-go pension embracing both poverty relief and consumption smoothing. The United Kingdom achieves a broadly similar objective for a significant fraction of pensioners through a combination of a flat-rate pay-as-you-go state pension broadly equal to the poverty line, together with privately organized, funded, defined-benefit occupational pensions.
Alternatively, consider a scheme the goals of which include mandatory consumption smoothing with a safety net provision. The aim in this case is to separate consumption smoothing and poverty relief fairly strictly. In such a scheme, redistribution occurs only through the poverty-relief component. Chile pursues this package of objectives through competitive, privately managed individual funded accounts, with a residual government guarantee. Sweden achieves broadly similar objectives through a publicly organized, pay-as-you-go defined-contribution scheme together with a safety net provision. The Swedish scheme introduces an element of solidarity in that years spent looking after children are counted as contribution years but, beyond that, is in major respects a public-sector analogue of arrangements in Chile.
The range of potential choice over pension design is wide. The key message is not merely that one size does not fit all, but that, provided government is effective, there is a considerable range of choice. For example, Poland and Hungary—well advanced in their transition from central planning—both have the capacity for the sort of sophisticated reforms they are proposing, and in Poland, the progress has been rapid.
That wide range of choice, however, does not mean that countries can pick and mix at will.