Regardless of the type of pension, the working generation needs to share a part of the GDP it produces with the retirees. Pension systems still dominating today were devised at a time when each working generation was more numerous than the previous, which enabled easy and cheap financing of pension and other government expenditures out of rolled-over debt. In the 21st century, population aging has wiped out that way of financing. Policies cannot substantially alter demographic trends. Rather, institutions need to adapt to demographic developments. Demography rules in pensions.
Universal pension systems are kept solvent by increasing redistributions from the shrinking working-age population to retirees and/or by underfinancing other goals. Given population dynamics, other options are reducing benefits or raising the retirement age. Other options are negligible or non-existent; unfortunately, that sad fact is not apparent in public perceptions due to the non-transparency of most pension systems.
Initially, old-age pensions were financed through taxation of the economically active population. Taxation was politically convenient, and technology at the time did not allow for individualized participation. The social tax was fairly low, negative labor market externalities were negligible. Today individualization is both needed and possible (savings/insurance instead of taxation).
By paying contributions participants “buy” pension rights to participate in the GDP they will not produce. If that is not adjusted to population developments, inflated pension expectations generate large hidden and open debts left to the following working generations. Reforms are needed to reduce unrealistic expectations and to protect the interests of the young. The present value of contributions needs to equal the present value of benefits, so that the share of GDP going to finance pensions is constant, and remuneration of production factors is not affected.
Automatic adjustments provide information on the population-driven decline of benefits, which reduces pension expectations. Longer working activity is the most promising method to reduce the decline. Workers who work longer contribute more and take out less, since they will be receiving the benefits for a shorter period. Retiring later is less burdensome than either of its two components since it does not raise flows of monthly payments or reduce flows of monthly benefits.
Unable to change demographic trends, countries must adjust their institutional structures to the new situation. Waiting is an expensive error. Non-transparent institutions generate public unrest, making adaptation difficult. More transparency makes it easier to understand the trade-offs and to adapt to reality. The guiding principle behind pension reform should be recognizing participants’ interest in both phases of their life: economically active and retired. An optimal combination of the contribution rate and the wage replacement rate is crucial. That can be achieved when participation in the system is based on the individual accounts instead of political discretion.
Automatic adjustment based on rules can work properly in bad times as well as good, while discretionary adjustment works only in good times. Governments need to make pension systems more transparent and make adjustments to reduce the burden on workers, returning the pension system to its social role, which is helping the very old without overburdening the young. Pension solidarity should not be confused with political discretion. Transparency, fairness, and firm legal protection of individual accounts are the key preconditions when adjusting pension systems for the 21st century.
© Marek Góra
Read Marek Góra’s IZA World of Labor article: “Redesigning pension systems.”
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