Major Pension Systems and Structural Reform Proposals
for PAYG Pension Systems

von: Christoph Henseleit und Verena Rosauer

Table of Contents

1. Introduction 3

2. Pension Systems 5

2.1. Traditional PAYG Pension Systems  5
2.2. Notional Accounts 6

2.2.1. General Description 6
2.2.2. Risks in Notional Accounts Pension Systems 8
2.2.3. Example Italy  9
2.2.4. Transition Problems  9

2.3. Funded Pension System  10

2.3.1. General Description 10
2.3.2. Risks in Funded Pension Systems 16
2.3.3. Example Chile  17
2.3.4. Transition Problems  18

3. One-Pillar- versus Multi-Pillar Pension Systems  19

3.1. General Description 19
3.2. Example Switzerland 21

4. Conclusion 21

References  25

Appendix  26

Abstract

Traditional pension systems continue facing major problems regarding their sustainability. Significant demographic changes in modern societies and antiquated attributes of pension systems result in increasing deficits in public budgets. Various proposals, trying to reform traditional pension systems via conservative reforms, failed to fix the emerging problems. This paper explores substantial opportunities to reform persisting pension systems structurally. By considering different theoretical approaches of reforms and actual implementations of structural pension reforms in practice, advantageous alternatives of designing pension schemes shall be assessed. Furthermore, the authors aim at stimulating discussions about structural pension reforms by introducing a profound reform proposal

1. Introduction

Numerous debates and ideas, concerning the pensions system and its reforms, have arisen during the last ten to 20 years all over the world. Moreover, in 1994, the World Bank published a book “Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth”. The diagnosis of this book, summarized by Michael Bruno, was that “systems providing financial security for the old are under increasing strain throughout the world”1. “As long as the number of retirees does not grow faster than total earnings of employees [in the current system], the tax receipts can continue to pay the benefits of retirees”2. But because of important changes in the demographic situation and mis-constructions in present systems, this condition does not hold true anymore: first, the birth rate in most countries of the Organization for Economic Co-operation and Development (OECD) decreases continuously. Thus the number of young employees decreases, too. Second, the people, born in the time of the baby boom (after World War II, the so-called “baby boomers”), will retire during the next decade. Additionally, due to the progress in medicine and high living standards, longevity increases. According to a prediction of the World Bank (1998), the portion of people over 60 in OECD-countries will rise from 19.9% in 2000 to 31.2% in 2050. Almost a tripling from 7.3% to 20.7% is expected in Asia within this period3. Moreover, in many countries the pension system provides incentives for early retirement. For many “Western countries” it holds true that the net present value of pension benefits is significantly higher for a person retiring earlier than the legal retirement age. Therefore we can conclude that there seems to be an implicit penalty on delaying retirement. Furthermore Gruber and Wise stress that “in many countries, disability and unemployment insurance programs effectively provide early retirement before the explicit social security early retirement age”4. Also generous pension benefits have been developing in many countries during the last decades.

All of the reasons above make the dependency ratio, defined as number of workers per pensioner, deteriorate: the ratio declined from 3.5 workers per pensioner in 1950 to 2.5 in 1990 and it is expected to decrease further. This ratio is the most important measure for the sustainability of the pay-as-you-go (PAYG) pension system. Thus it is getting harder for governments to maintain financial stability for current pension systems. The status quo is that future benefits are larger and growing stronger than future contributions, meaning that the public pension debt can not be amortized by future contributions without any pension reform. The current system is financially not sustainable. One more drawback within current PAYGsystems: internal rates of return for contributors are low or even negative.

Another aspect to consider is international pressure through increased globalization. As some countries (e.g. Sweden, UK etc.) have already reformed their pension systems successfully, taxes for companies and consumers in those countries are lower than in countries with “old” pension systems. Thus a difference in efficiency of the pension system can lead to differences in the competitiveness of countries, which should be a serious issue for any government. The problems mentioned above are most evident in OECD countries with PAYG pension systems. Other countries operating PAYG-systems with currently less severe demographic problems will experience similar problems, but at a later point in time. Due to the maturity and intensity of the problems in OECD countries (i.e. Germany or France), solving those problems can obviously not be done by devolving them to the following generations and have to be tackled in our days.

[...]

1 See Fox/Palmer “New Approaches to Multipillar Pension Systems: What in the World is Going On?”, page 90
2 See Gruber and Wise, “Different Approaches to Pension Reform from an Economic Point of View, page 50
3 See Fox and Palmer, table 3.2
4 See page 53 of their paper. For example, unemployed people can “retire” earlier than employees.