In what sense is there a pensions 'time bomb'?

Term Paper, 2002
11 Pages, Grade: 1,0


1. Introduction

This essay will work out the weaknesses of current pension systems and provide suggestion for improvements. It will focus on the question of how a public pension system could be shaped and therefore exclude a discussion of a possible shape of company pension systems.

2. The current shape of pension systems

The most common form of pension systems in the developed world is a pay-as-you-go (PAYG) pension system. Such systems are usually run by the state and tax the income of workers and transfer it to pensioners. From an aggregate viewpoint, the state is simply raising taxes from one group of individuals, and transferring the revenues thereby derived to another.

Thus, from this perspective, these schemes are no different from explicit income transfers like child benefit (Barr).

They rest on an implied but unenforceable contract between generations: the future pensions of those working today depend upon a future generation of workers.

The pensions are paid as defined benefits (DB), which means they are not expressly linked to what workers have paid in contributions. Instead, pensioners get a defined level of income, usually related to average pay (Wallace 2002).

Samuelson (1958) showed that with a PAYG scheme it is possible in principle for every generation to receive more in pensions that it paid in contributions, provided that real income rises steadily. This is dependent on the rate the economy can grow which in turn is dependent on the amount and utilisation of labour and capital resources available and the pace of technological progress (Gardiner 1999). A steady population growth can also lead to this phenomenon.

These systems were created after the Second World War. The overall aim was to avoid pensioners decline into poverty. Furthermore governments also intended to redistribute wealth between different groups of society.

Under the economic conditions after the Second World War these goals were achieved. The post-war generations of pensioners have profited from spectacular returns on their contributions, receiving far more in benefits than their due.

This is attributable to the prosperous development of western economies and the growth of the population until the end of the 1960’s (“baby boomers”).

3. The time bomb

As conditions for pension schemes have altered since the post-war period, they face new kinds of problems. These problems are listed and described in the following chapter. Moreover, the consequences for the society and the state itself are presented if pension systems are not adjusted to the changing conditions.

3.1 New problems are arising

Most of the industrialised world is subjected to a severe demographic transition. This transition process is characterized by rapidly ageing populations. This means that the working age population will drastically shrink and that the number of retirees will skyrocket after the heavy retirements, which will take place after 2010 (Barr; Banks and Emerson 2000; United Nations 1999). Even China has to struggle with this phenomenon (Pitsilis et al 2002).

The consequences of the change in the age structure (see table) of the population size of the workforce can be observed in the shift of the dependency ratio. The simple, but crucial variable is


where P is the number of pensioners and W the number of workers (Barr).

This ratio will double in the next thirty years in the western nations (Wallace 2002). In 2050, the World Bank expects a ratio of 60 % for the Euro area and for Japan, even more (aprox.70%).

Additionally, the continuous medical progress results in a 1 to 2 year increase in life expectancy every decade. Despite the increasing life expectancy there is a trend that workers retire earlier. The effective pension age is about 5 years lower than the official retirement age.

The problem of the strongly growing dependency ratio is magnified by high unemployment rates in the EU. According to Blake (2000), there is a “…potentially catastrophic combination in Europe, with dependency ratio increasing inexorably but unemployment at unprecedented levels and rising.”

In addition to this, Blake (2000) argues that the declining European competitiveness in high technology markets will lead to a decrease in productivity growth. So the shortfall caused by the declining population growth rates cannot be made up by labour productivity.

Another kind of problem stems from the inter-generational promise, which is a prerequisite for a PAYGO scheme. The promise “I will support you in the future” is a political claim and not a property right. Thus the future value of pensions is determined by unpredictable votes of future electorates.

3.2 Economic and social effects if adjustments do not take place

What has saved PAYG schemes so far is that demographic developments take a long time to work their way through the system. Nevertheless the first signs of the changing population age structure can be observed in the extremely high Social Security contribution rates. Americans worry about a contribution rate of 12.4 of pay, but Germans have to put up with 19.1% (Wallace 2002). However, these are also attributable to the over-generous increases in pension benefits in the last decades.

Another problem originates from the defined benefit schemes. As mentioned in the previous chapter, pensioner’s life expectancy raises constantly. This creates an extra financial burden for the state, because it means that they receive guaranteed sums every month, as long as they live.

Since a decreasing working population has to pay for an increasing number of retirees, the PAYGO schemes in their current forms are doomed to fail financially.

In order to prevent the PAYGO schemes to go “bankrupt” benefits either must halve in relation to average incomes; or contribution rates must double; or the retirement age must go up. This all results in drastically falling real returns for the current working force in the next 40 years (Wallace 2000). According to the Pension Provision Group, the state pensions in the UK are affordable, but that is because they are now so low (Blake 2000).

Whether pensioners are going to except lower pensions, or current workers oppressively high contribution rates is an open question. In modern democracies this is only dependent on the size and political voice of each group. Thus the unsolved question of pension systems creates a potential “political time bomb”, since the choices are essentially over who should gain and who should lose (Diamond 1996).

The unfair redistributive element in the pension schemes, that means, for example that wealth is shifted from poorer people to the better off (because poorer people tend to die earlier), also contributes to the politically unsustainable situation (Disney 2000).

The design of the current system also magnifies the problem of an ageing world by giving incentives to retire earlier (Boeri).


Excerpt out of 11 pages


In what sense is there a pensions 'time bomb'?
University of St Andrews  (Department of Economics)
Public Finance
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ISBN (eBook)
ISBN (Book)
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Rentensysteme Sozialsicherungssysteme Pensionssysteme, retirement, social security, pension system
Quote paper
Dipl. Kfm. Kristian Kanthak (Author), 2002, In what sense is there a pensions 'time bomb'?, Munich, GRIN Verlag,


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