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O C C A S I O N A L   P A P E R     
Aging Populations and
Public Pension Schemes

Sheetal K. Chand and Albert Jaeger

I   Introduction and Summary
II   Background

Demographic Trends
Public Pension Arrangements
Pension Reform Debates
  Parametric Reform Approach
  Systemic Reform Approach
III   Identifying Fiscal Consequences

The Approach
Projected Fiscal Positions Under Present Arrangements
Sustainable Fiscal Stance and Projected Liabilities
Sensitivity Analysis
Delaying Reforms
IV   Reform Options

Fiscal Reforms Unrelated to Pensions
Parametric Reforms
  Reducing Average Replacement Rates
  Modifying Indexation Provisions
  Extending Retirement Ages
  Mix of Reforms
Systemic Reforms of Defined Contribution Type
  Shifting to a Defined Contribution System
  Transition Costs
Restructured Defined-Benefit System
Cost of Alternative Reforms
V   Conclusions
I   Analytical Framework and Data Sources for Public
Pension Projections
II   Bibliographic Notes
II   1.   Demographic Trends
   2.   Public Pension Expenditure
   3.   Public Pension Schemes
   4.   Assets and Workforce Coverage of Private Pension Funds
III   5.   Projections of Averages of Macroeconomic Variables, 1995­2050
   6.   Projections of Pension Replacement Rates, Support Ratios, and Pension Contribution Rates
   7.   Baseline Projections of Pension Expenditure, Balances, and Net Asset Positions
Net Pension Liabilities and Sustainability of Fiscal Stance
Sustainable Contribution Rates and Contribution Gaps
Sensitivity of Estimated Net Pension Liabilities and Contribution Gaps to Real GDP Growth and Interest Rate Assumptions
Effect of Postponement of Pension Reform
Effect of Changes in Pension Benefit Formulas on
Contribution Gaps
Effect of Different Indexation Schemes on Contribution Gaps
Effect of CPI Indexation on Pension Replacement Rates:
Illustrative Examples
Effect of Changes in Retirement Ages on Contribution Gaps
Decomposition of Gross Liabilities of Public Pension
Systems, 1995-2050
Fiscal Implications of a Gradual Transition to a Fully Funded
System, 1995-2050
Fiscal Implications of a Sudden Transition to a Fully Funded
System, 1995-2050
Sustainable Fiscal Stance Under Different Systemic Pension
Reform Options, 1995-2050
II   1.   Elderly Dependency Ratios
III   2.   Projected Pension Expenditure of Public Pension Funds
   3.   Projected Balances of Public Pension Funds
  4.   Projected Net Asset Positions of Public Pension Funds
  5.   Projected Public Pension Fund Contribution Rates
I.  Introduction and Summary

An aging society is characterized by a growing proportion of the retired to the active working population. Societies age either when fertility rates decline so that fewer children are born, or when longevity increases, or both. Aging affects virtually all societies today, but more so the industrial countries, which have generally experienced it over a longer period and for which further pronounced aging is projected over the next four decades, at the end of which a peak in the proportion of the elderly is likely to be attained. Concerns about the challenges posed by aging populations have moved to the forefront of the public policy debate in many countries. This paper attempts to respond to some of these concerns, focusing in particular on the fiscal sustainability of public pension schemes in industrial countries.

In the industrial countries, public schemes for providing for the retired are predominantly of a pay-as-you-go (PAYG) type, whose coverage is typically comprehensive, but which are frequently supplemented by funded schemes, mostly operated by the private sector. A standard PAYG system levies payroll taxes on the working population, while paying benefits to the retired, but usually without the close person-based relationship between individual contributions and benefits that characterizes fully funded schemes. In the early stages of a PAYG system, low contribution rates are sufficient to cover benefits of a relatively small number of beneficiaries, but as the scheme matures, benefits paid out tend to exceed contributions, requiring increases in payroll taxes or budget transfers. However, considerable additional fiscal stress is likely to emerge under a PAYG system as the proportion of the retired elderly rises. And if, as is typically the case, the PAYG scheme also involves various redistributive elements, there is further potential for fiscal stress, especially as the population ages. A failure to address the resulting fiscal stresses, coming on top of an already burdensome fiscal situation, could inflict serious macroeconomic and structural damage, both on the domestic economy and, in the case of large industrial countries through international linkages, on the world economy.

The potentially serious fiscal, economic, and social consequences of population aging raise complex issues, not least of which are political issues that arise whenever the distributional impact of a major public program is reconsidered. In principle, individuals should be responsible for making adequate provision for their own retirement. In practice, this has not been judged appropriate for a variety of reasons, necessitating publicly supported schemes. In fact, public pension schemes are widely credited with having led to significant reductions of poverty rates among the elderly. Nevertheless, the issue of how the burden of supporting the aged is to be distributed may become particularly contentious as the proportion of the working population declines, while at the same time the political strength of the elderly increases.

Four ways have been suggested to ameliorate fiscal stresses from the public pension arrangements: (1) through parametric adjustments of the structural characteristics of the pension system, such as the contribution rate, retirement ages, or pension benefit indexation formulas, possibly combined with building up financial reserves; (2) through systemic reforms, principally by developing a significant, defined-contribution, fully funded pillar inside or outside the existing public pension scheme; (3) by undertaking broader fiscal adjustments such as raising taxes and cutting expenditures not related to public pensions; and (4) by modifying the macroeconomic profile by changing such aspects as the size of the labor force through, for example, encouraging greater labor force participation, or immigration. While this study emphasizes approaches (1) and (2), it also considers aspects of approaches (3) and (4).

Growing recognition of the potential consequences of population aging has prompted widespread discussion of the problems and of what to do about them (see Appendix II). Among the most recent studies, a World Bank (1994) report forcefully advocates moving to a three-pillar system for providing old age security: a mandatory publicly managed pillar with the limited goal of reducing poverty among the elderly; a mandatory privately managed pillar providing fully funded pensions; and a voluntary savings pillar. In many industrial countries, adopting the proposed multi-pillar approach would amount to the effective dissolution of present public pension arrangements. Focusing on the need for pension reform in the major industrial countries, OECD studies by Van den Noord and Herd (1993 and 1994) and Leibfritz and others (1995) report estimates of unfunded public pension liabilities under present pension arrangements and discuss the effectiveness of selected parametric reforms. The OECD studies find that raising retirement ages would make a particularly significant contribution to reducing projected unfunded pension liabilities in the major industrial countries. Finally, Masson and Mussa (1995) review the implications of population aging for fiscal policy and conclude that restoring fiscal policy to a sustainable path would necessitate sizable cuts in the extensive commitments for social spending in many industrial countries.

This study examines the pension-related aging problem primarily from a fiscal perspective. The key questions asked are the following. How will prospective demographic developments that affect the proportion of the pensionable elderly affect pension outlays? What is the likely size of the fiscal burdens? What are the fiscal implications of alternative reform approaches for ameliorating the effects of aging on public pensions? The present study, employing a more disaggregated methodology than typically found in other studies, confirms that very serious fiscal stresses are in prospect for most industrial economies. Addressing such problems satisfactorily will require major actions early, given the long lead times involved in reforming a pension fund's financial position. In comparison with the mentioned OECD studies, the present paper seeks to provide a more detailed quantitative assessment of unfunded public pension liabilities and the fiscal implications of parametric reforms. As regards systemic reform proposals aimed at adoption of a fully funded system, this study attempts to evaluate quantitatively the fiscal implications of such reforms in the major industrial countries and in Sweden.1

The assessments show that a combination of parametric reductions in benefits, such as extending the retirement age and modifying indexation arrangements, would in most countries suffice to contain potentially adverse fiscal developments. An important implication is that if such reforms are combined with the implementation of a sustainable contribution rate (which the benefit-reducing reforms would bring closer to the actual contribution rate), the reformed public pension systems would be able to cope with the aging problem. In effect, such a system anticipates the demands associated with aging by making funding provisions in advance, thereby reproducing an essential aspect of the fully funded approach, but without requiring the close person-based relationship between individual contributions and benefits that characterizes a fully funded scheme. By levying a constant projected contribution rate through time--the sustainable contribution rate--this system preserves the compact between the generations that is at the core of a PAYG system, as it distributes equally the burden of meeting pensions across the generations. Advance funding has the further advantage of strengthening fiscal discipline if the publication of regular reports on the actuarial status of the pension system heightens awareness of the future cost implications of today's pension benefit promises.

The study also examines the alternative of a fully funded scheme and finds that the fiscal costs of undertaking such a shift may be very high. Meeting these costs may require, in many cases, an amount of fiscal adjustment substantially higher than what would be needed to fix the PAYG system. Hence, unless there are compensating gains, such as a stimulus to overall saving and superior equity implications, it may be preferable to fix the PAYG system instead of shifting to a fully funded system.

Although the focus of this study is primarily on the industrial countries, the examination of key fiscal issues pertains to other countries as well, for some of whom, especially the transition economies, the fiscal stresses have already become acute. It should also be noted that this study does not address the implications of aging for costs not related to pensions, such as on health care or education, which are also likely to be significant.

Before examining the fiscal consequences of public pension schemes, it is useful to review in more detail demographic trends, the nature of social security systems as they relate to pensions, and some of the conclusions reached in the ongoing debate on pension reform. This review is undertaken next in Section II. The approach in this study to identifying fiscal consequences of aging is set out in Section III, together with the results from its application. Section IV examines in detail the reform options noted above for reducing fiscal stress and discusses criteria that bear on the issue of which reform package to choose. Conclusions are presented in Section V. Appendix I describes the methodological framework and the data sources of the study, and Appendix II contains some bibliographical notes.

1The choice of Sweden as the representative of the smaller industrial countries was in part influenced by its traditional role as a pacesetter in promoting social welfare reforms and its earlier experiencing of the aging problem.