EVEN AMONG the advanced welfare states of Europe, efforts to contain pension costs are now common. The United Kingdom, Sweden, Germany, and Italy have all enacted partial privatizations of their pension systems in recent years. Countries such as Spain and Greece will soon have to do so, with Greece making reforms in order to comply with European Union regulations that limit government borrowing. Hungary and Poland have both adopted hybrid systems, in which traditional plans are being phased out and replaced by mandatory savings requirements.
In part because of the need to bring their fiscal accounts closer to balance, some particularly highly indebted developing countries have been forced to make deep cuts in their public pension and social security systems that would be politically unthinkable in richer countries. These draconian fiscal efforts partly reflect a need to attract and retain foreign investment and partly a need to be seen to be following International Monetary Funds and World Bank reform programs.
Such developing countries as Argentina, Columbia, Uruguay, Mexico, El Salvador, and Croatia have all engaged in pension-reform efforts over the last ten years. Pension reform is often economically and politically painful. In China, there have been frequent street protests, and even riots, by pensioners who lost their benefits when state-sponsored industries failed. In both France and Italy, proposed pension reforms caused governments to fall during the 1990s. Argentina’s current political and financial instability is partly attributable to its costly efforts to reform its pension system. Nonetheless, most countries around the world will likely experience mounting pressure to reform or at least contain the cost of their pension systems for two fundamental reasons: (1) aging populations and (2) the pressures of globalization.
AGING POPULATIONS
The increase in the average age of the world’s citizens is a phenomenon most pronounced in the industrial countries of Europe and Asia. But it is also rapidly gathering momentum in many parts of the Third World as birthrates fall and life expectancy increases. In the Western Hemisphere, Barbados, Cuba, Trinidad, Martinique, and Guadeloupe are among the Caribbean locales with birthrates lower than that of the United States. Tunisia, Lebanon, Iran, and Sri Lanka have likewise joined the ranks of nations in which the number of births is no longer sufficient to keep the average age of citizens from increasing or even to prevent an absolute decline in the number of working-age individuals over time. Other developing countries with birthrates currently below replacement levels include China, Russia, Kazakhstan, Bosnia/Herzegovina, Thailand, Singapore, Macedonia, and Georgia. Even in relatively “young” countries, (for example, North Africa and some nations among the Persian Gulf states), birthrates are declining, and the relative burden of supporting the elderly is increasing.
Population aging is a product of many trends most people would view as positive, including improved sanitation and health-care delivery systems, which have cut infant mortality and boosted life expectancy in many countries, and the expanded roles available to women, which have reduced economic incentives to raise large families. And in many developing countries, this demographic transition is occurring at a much more rapid pace than it did in the industrial nations. In France, for example, it took 140 years for the proportion of the population aged sixty-five or older to double from 9 percent to 18 percent. In China, the same feat will take just thirty-four years; in Venezuela, twenty-two. Moreover, according to UN projections, developing regions will experience far larger growth in the absolute size of their elderly populations over the next half century than will developed regions. In less-developed countries, the population aged sixty and over is expected to quadruple, from 374 million in 2000 to 1.6 billion in 2050. The developed world at least got rich before it got old; the Third World is growing old before it gets rich.
Unfortunately, by reducing the number of workers available to support each retiree, population aging also puts great strains on social security systems. In 1955, for example, Chile’s social security system had 12 active contributors per retiree, but by 1979 there were only 2.5 contributors paying into the system for every retiree collecting a pension. As in many developing countries, the trend was exacerbated a growing underground economy that further reduced payroll tax receipts. By 1980, the system was running a deficit equal to 2.7 percent of gross domestic product, and the cost of honoring all its future pension promises exceeded the country’s total annual output. Because of these pressures, Chile became in 1981 the first country to privatize its social security system.
PRESSURES OF GLOBALIZATION
Globalization, or the increasing integration of the world economy, also continues to put pressure on both developed and developing nations to contain their pension costs. This can be seen in Eastern Europe, where countries hoping to join the European Union must contain their fiscal deficits and limit overall debt burdens—feats that necessitate reducing pension spending—before they will even be considered for admission. More generally, countries with inefficient industries that are suddenly exposed to global competition often find they can no longer afford to pay for generous pensions.
This has occurred most dramatically in China and the former Soviet Union. There, poverty among the elderly exploded during the 1990s following the failure of many state-sponsored industries to compete in a market-based economy after the collapse of communism. When state-run companies had to compete in the global marketplace, many went under and were unable to pay pensions. Globalization also coincided with a push to privatize state-owned enterprises. To ensure the success of privatization, governments needed to assure investors that they would not be saddled with massive pension liabilities. Finally, globalization has also been accompanied by large flows of immigrants moving from poor to rich countries—a trend that often exacerbates the challenge of population aging in the developing world. This is particularly a problem among Caribbean countries, which have both low birthrates and high rates of emigration, leaving fewer and fewer young people available to support the aged left behind.
POLICY PRESCRI PTIONS
Even the most committed advocates of social security, such as the International Labour Organization, now concede that population aging and globalization pose huge challenges to any system of collective provision for old age. But how individual nations should go about meeting that challenge is a subject of increasingly hot debate.
In 1994, the World Bank published an influential report, entitled “Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth,” which highlighted the bank’s deepening concern that the high and growing cost of pensions in many developing countries is a major drain on economic efficiency. In the bank’s analysis, the best way for countries to manage their pension cost is to create a three-tiered system.
The first tier, funded by payroll taxes or general government revenues, focuses on providing minimum benefits to the most needy—the so called “social safety net.” The second tier is a so-called prefunded system, in which workers must make contributions toward their future pensions. Under these plans, future retirement benefits are no longer defined and prescribed. Instead, contributions to the pension system become definedm with benefits depending on how well, or poorly, an individual manages his or her own retirement account. By fixing contributions but rendering benefits variable, this scheme ensures that the pension system never goes into deficit (hence the term “prefunded”).
The final tier asks employees to supplement their retirement incomes by relying on voluntary savings, which allow individuals to choose how to allocate their income over their lifetime.
In broad outline, this is the blueprint adopted by pension reformers around the world, although many variations in detail are possible. Today, World Bank staffers are engaged in pension-system reform work along these lines in some thirty countries.
KEY CONCEPTS
The record of pension reforms around the world shows, however, that they often impose huge hardships and economic dislocations—at least in the short term. Argentina, for example, attempted to follow the World Bank’s prescriptions for pension reforms by enacting a system of individual retirement accounts. But the cost of this transition reached 3 percent of gross domestic product by 2000—a cost the country could not bear given its other financial difficulties. Elsewhere, charges of corruption and high administrative costs have tarnished pension-reform efforts. In many of the poorer provinces of China, for example, money intended to help younger workers prefund their retirements was instead diverted to paying for current retirees, and pension fund withdrawals now exceed payments in twenty-five cities, up from just five in 1997. Journalists covering pension reform efforts need a clear understanding of the key concepts involved and also a shrewd eye for how theory may not be working out in practice.
“PAY-AS-YOU-GO” FINANCING
The rhetoric used to describe traditional social security systems often gives the impression that they operate like insurance schemes: workers make “contributions” and beneficiaries collect “earned benefits” that are paid out of “trust funds.” But in reality these systems function as devices for transferring income from one generation to another. Under the so-called pay-as-you-go system, the money today’s workers pay into these systems is used to pay for people who have already retired. If there is a surplus, the funds are sometimes also used to lend to other government operations, rendering future taxpayers liable for paying off these debts. The term “pay-as-you-go,” though, is a misnomer. In reality, each generation pays for its elders’ retirement, while in turn relying on the next generation for support in old age.
ADVANTAGES AND DISADVANTAGES The system works well so long as a country’s population and economy continue to grow robustly, but it breaks down when population aging and slower economic growth set in. Increases in productivity, or the rise in wages after accounting for inflation, can help sustain pay-as-you-go systems. But so long as there are consistently fewer workers available to support each retiree, such systems will inevitably come under strain. Reporters need to find out if the country in question has a pay-as-you-go system? If so, is the population growing, or growing older? What about the country’s productivity? If either of these rates are stagnant or negative, reporters should find out if any economists or institutions have calculated how long it will be before the pension system runs out of money. These same studies also calculate the present value of the future deficits, which typically represent a “contingent liability” that the government will eventually need to take over.
TRUST-FUND FINANCING
Some governments, such as that of the United States, use trust funds in their pension programs. Trust funds are best thought of as accounting exercises. Their statements of assets and liabilities are, in effect, estimates of the ratio of the future benefits the system has promised to pay to what it will take in from future taxes. This calculation enables policy makers to know whether their pension system has any long-term unfunded liabilities that will have to be paid through increases in taxes or cuts in benefits. Without going through this accounting exercise, policy makers would be hard pressed to know whether a pension system is solvent over the long term.
Unfortunately, the language used to describe trust funds can be highly misleading. Trust funds are said to contain assets and liabilities, to be in surplus or in deficit. To many people, this language makes trust funds seem analogous to bank accounts, and they imagine their contributions being safely stored up in an account that will later pay their own benefits. The reality is far different. With few exceptions, public pension plans do not have any actual assets, such as stocks or bonds, invested in wealth-producing enterprises. All the money they take in during any given year is spent in the same year, if not for pensions then for other government operations.
So what are these assets that trust funds show in their balance sheets? They are not, as one might think, funds set aside and invested or “in the bank.” Instead, these numbers are estimates of contributions to the pension system expected from future taxpayers or from other parts of the government. Just as a bank would count a loan you owe as part of its assets, governments count their claims on future taxpayers as assets as well, even though these “assets” represent a drain on the future wealth and income of the citizens themselves. From the point of view of taxpayers, therefore, the assets appearing in a trust fund report are really measures of the future payments that either they or their children and grandchildren are expected to make to the system.
SIDEBAR
During the Soviet era, Russia’s pension system was fully backed and guaranteed by the government—a cornerstone of a state policy guaranteeing citizens’ financial stability. But things began to change under former President Mikhail Gorbachev as economic controls were eased and inflation began to erode the value of the 120-ruble monthly pension. The sacred notions of safety and stability came to an abrupt end when the USSR collapsed in 1991 and radical market reforms brought on hyperinflation, which drove the purchasing power of pensions to rock bottom levels.
Some 40 million pensioners currently live on the system’s benefits, but many subsist in virtual poverty because of the inflation-led erosion of benefits. At the same time, an aging population, tax evasion, and other problems have yielded a deficit in the system that will leave it bereft of funds if not addressed.
The current system, in the process of ongoing reform, is funded by a 29 percent payroll tax and replenished from the budget if it falls short. Employees’ direct contributions are minimal, placing the burden almost entirely on the employer—for decades the government, but now more commonly the private sector. This structure encourages companies to underreport payroll expenses to avoid paying taxes, and the resulting shortfall has helped feed the deficit. Another burden is the growing pool of pensioners: the over-sixty age bracket doubled as a share of the population between 1959 and 1990, to some 20 percent. And despite rising life expectancy rates, Russian retirement ages are still fifty-five for women and sixty for men, lower than in comparable Eastern European countries.
Private pension schemes have been available since the mid-1990s, and there are now more than 250 licensed pension funds with some 21 billion rubles (approximately $700 million) under management. These funds are predominantly established under corporate sponsorship, but there are some open to the public. Still, private funds represent a mere fraction of the overall system, making the public scheme’s sustainability as critical as ever.
HISTORY OF REFORM
Russia has made several attempts to reform its pension system. After two initial steps that ended in failure, the government, in 1998, tried again, and the World Bank aided the effort with an $800 million loan. The project was designed to strengthen revenues through better collection and enforced compliance of larger companies. The reform was hindered by the August 1998 financial meltdown. In late 2000, the authorities again revived the pension reform, and a year later President Vladimir Putin approved three basic laws of a pension package previously approved by parliament.
This reform introduced a multipillar pension system that shifted from a defined benefit scheme to a defined contribution system comprising three levels. The first is a notional-defined contribution pay-as-you-go pension scheme in which benefits are determined by the sum of contributions paid into the plan, economic performance, and life expectancy at the time of retirement. A mandatory-funded second pillar, meanwhile, is managed by private institutions and allows individuals to direct their own investments. The final level is the basic benefit plan, which promises a specific monthly benefit that is usually based on factors like age, earnings, and years of service.
The reform aims to address several problems of the old system, including complex benefit formulas and generous eligibility conditions, such as early retirement in many occupations. It is also designed to tackle the growing financial burden produced by a sliding number of contributors and an increasing number of pensioners—the result of rising layoffs, tax avoidance, and an aging population. And the funded scheme endeavors to increase pension benefits while deepening the roots of capital markets and promoting economic growth.
LESSONS LEARNED
In spite of the reform efforts, a host of uncertainties and structural snags persist. One criticism is that the system fails to provide incentives for workers to increase contributions or to work longer, both of which are necessary to bolster the system’s funds and reduce costs. A solution would be to increase the retirement age, which would encourage Russians to continue working and continue paying into the system. Other disincentives include taxes, which eat up most of workers’ contributions, and a lack of inflation indexing. By law, pensions are linked to inflation, but in practice they are not increased accordingly, leaving many pensioners in poverty.
Beyond these structural issues, and even if reforms are successful, grave questions persist about the system’s fiscal sustainability. The World Bank has said that if economic growth falters, the system’s pay-as-you-go portion will likely fall into the red. While the basic benefit pillar is expected to post surpluses in coming years, the extra cash could not be used over the long run to offset the deficits.
The system’s effectiveness also hinges on stable, functioning markets. In order for workers to contribute, they must have confidence that their money will be invested safely. Banks too must be entrusted to safeguard assets, but this idea faces hurdles in a nation where citizens keep their savings far from banks. Given the absence of trust, it is difficult to imagine how other parts of the financial system vital for the funded pension system’s success—like capital market institutions—will prosper.
To bolster confidence in the system, the World Bank has recommended allowing pension funds to invest substantially in foreign assets. This would help ensure the population that its savings are not hostage to the whims of local markets, where infrastructure remains weak in spite of recent macroeconomic stability.
By the end of September 2003, the state pension fund had sent letters to millions of Russians advising them to decide whether to open new individual retirement accounts with the state-run system or with private pension funds. But it remains far from clear what kind of state-run system they would be buying into.
ADVANTAGES AND DISADVANTAGES “Trust-fund” financing forces governments to calculate long-term deficits in their social security systems, even if they do nothing to fund those deficits. The arrangement may also help build political support for social security systems by creating an impression that funds are being set aside in reserve to pay for future benefits. Yet talk of “surpluses” building up in trust funds can be highly misleading to the public and also provide governments with an excuse for spending more money than they actually have. Reporters should ask: what are the unfunded liabilities in the country’s pension system? Has the government issued debt to try to account for those liabilities? Does the government’s budget include this information? This information should be included when calculating the government’s performance in reducing national debt or balancing the budget.
PREFUNDING
Prefunding is where each worker must make contributions toward his or her future pension; under these so-called defined contribution plans, either individual retirement accounts are created, or the government directs the investments and uses the returns to pay promised social security benefits to workers in the future.
ADVANTAGES AND DISADVANTAGES In an aging society, making the transition from pay-as-you-go financing of social security to one in which each generation prefunds the costs of its own retirement will theoretically save money in the long run and defuse the ticking time bomb of implicit pension debt. That is because each generation gets the benefit of compound interest on its investments during its working years. Yet in any effort to move from a pay-as-you go to a prefunded system, there is a key challenge to be surmounted, namely the cost of financing the transition.
If benefits are to be preserved for the current generation of retirees, current workers will have to bear that cost plus pay for the prefunding of their own retirement. As the World Bank acknowledges in one of its publications, “Moving from a pay-as-you-go to funding means that current workers pay twice: for both their own (funded) pensions and current retirees’ (pay-as-you-go) pensions.”1 This transition cost, known as the “double burden” problem, bedevils all proposals to move toward prefunding of pension costs. In 2002, for example, the Croatian government announced it would borrow 150 million euros, at an interest rate of 6.875 percent, to finance the cost of changing its pay-as-you-go pension plans to a prefunded system. Is the country in question planning on making this change? Can it afford to make this investment without causing undue economic hardship in the short term?
KEY THINGS TO WATCH FOR
HIDDEN COSTS
Though a country’s current “pay-as-you go” pension scheme may be unsustainable, political leaders are often reluctant to communicate the true costs of reform. A frequent ploy is to suggest that government finance the cost of the transition by issuing new debt. Yet if the pension debt built into the old system is simply replaced by new bonds sold to the public, how will future generations of taxpayers benefit? In effect, the debt is still there. Reporters should be wary of claims that pension reform can be achieved without any group—current taxpayers and retirees or future taxpayers and retirees—sharing in some measure of sacrifice. The IMF, for example, has recently warned European nations that they will have to run budget surpluses for the next fifteen years to fund state pensions for today’s middle aged.2 What is the overall change in the nation’s savings rate and in the national debt level as a result of a change in the pension scheme? What are savings rates and debt levels doing in the short and long term? What does the government project for these levels? How much debt do independent economists think the country’s economy can stand to take on?
What is the cost involved in switching to a prefunded system? During the transition, workers may, for example, earn 10 percent annually on their retirement accounts, but the same generation will be responsible for paying all or much of the cost for honoring benefits promised to current retirees. An honest reckoning of the rate of return available to participants in the new, prefunded system must take this liability into account.
RATES OF RETURN
Pension reformers also sometimes make dubious claims about the rate of return individuals or governments are likely to make through investment of pension funds in private securities such as the stock market. Historically, the long-term return on stocks in developed countries has averaged 7 to 8 percent after inflation. In contrast, unless a country has a growing population, the returns that a pay-as-you-go system can offer each generation of participants (without any future increase in taxes) will be limited to the country’s underlying rate of productivity growth, or the amount wages increase after inflation, which rarely averages more than 2 to 3 percent annually. But claims that participants will get “a better deal” from a prefunded pension plan that invests in stocks than from a pay-as-you-go system can be misleading because money invested in private securities is inherently at risk and markets are volatile and past performance is no guarantee of future reward. Though pay-as-you-go systems are also vulnerable to economic depressions, losses are not born exclusively by individuals who made failed investments, as they are under defined-contribution plans, but are instead spread out across the entire pension system.
In small countries with underdeveloped capital markets, requiring citizens to invest their whole retirement nest egg in the domestic economy can be imprudent. The entire Russian stock market is worth less than a moderate-sized U.S. company, for example. A country may have a deep need for increased savings and investment, but individual savers need to hedge their risks by investing in a wide portfolio of holdings, which may not be possible so long as they are required to invest only in domestic companies. Unfortunately, this is precisely what the World Bank and many governments prescribe. Economist Laurence Kotlikoff notes: “In effect, the Bank is telling citizens of developing countries to do something it would never suggest to its own employees—namely, to invest their retirement assets in a single, small country that may default on its bonds and whose corporations do not meet western standards of accounting or corporate governance.”3 Does the country in question allow workers to invest pensions outside their own country? If not, what is the worth of the country’s stock market? What is its historical rate of return and how safe are investments there?
There is also good reason to believe that the return on capital will decline in the coming decades even in advanced countries. In the long run, interest rates paid to savers, as well as the value of stocks and bonds, are to a large extent a function of supply and demand. To the extent that both people and governments save more to prefund the cost of retirements, the world’s supply of financial capital should (all else being equal) increase. This rise in supply implies a decrease in price, and thus reduced premiums, or rates of return, paid to savers. At the same time, the slowing growth of the labor force should—again, all else being equal—lead to higher wages, leaving fewer resources available to compensate investors.
The cost of administering defined-contribution plans has to be taken into account. These costs are often substantial, particularly during the early years of a transition to a prefunded system. Has the government of the country in question said how much it is paying for the administration of the pension system? Is it being done by a department of the government, or was the contract given to a private company?
ALTERNATIVE REFORMS
Reporters should consider whether pension reform can be achieved by measures short of full privatization, especially if the country is likely to struggle with the costs of making a wholesale change in the pension system. Ask if the government has considered other options such as: Including a large underground or informal work force that escapes, or is excluded from, participation in the national pension scheme, as a potential new source of funding. The United States, for example, has helped preserve its social security system to date by expanding its coverage to occupations previously excluded, such as doctors, clergy, domestics, farm workers, and public employees, as well as by embracing a dramatic increase in the number of women working outside the home and therefore paying taxes into the system.
In countries where the labor force is shrinking, has the government done anything to encourage young workers to stay at home, rather than emigrate? What government policies, corruption, and so on are driving young workers away?
In some instances, the long-term solvency of pay-as-you-go systems may also be achieved through increases in productivity. Is the government giving priority to policies promoting productivity, including effective spending on education and other measures to improve the quality of the workforce?
In countries with below-replacement-level fertility rates, it may be appropriate for governments to look for ways to encourage more child-bearing. What is the cost of raising a child in the country? What programs could the government enact to ease the financial burden on parents and the strains of balancing work and family life?
NOTES
2. Heather Tomlinson, “Only 15 Years of Surplus Will Save Euro Pensions,” Independent on Sunday (London), 21 September 2003, 1.
3. Laurence Kotlikoff, “Look Abroad to Solve the Pensions Crisis: Developing Nations Should Ignore World Bank Advice to Invest for Retirement at Home,” Financial Times (London), 25 April 2000.