Older and Wiser

Economics of Public Pensions

Lawrence Thompson

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429827686
• Edition: 1
• Topic: Personal Development
• Subtopic: Personal Finance

First published in 1998, this volume was developed as part of the Stockholm Initiative and sets out to assess the situation of providing for retirement and pensions. In the wake of intense debate over pay-as-you-go pensions, Lawrence Thomson for the most part leaves social and cultural issues for subsequent analysis, instead examining the economic

Chapter One

Overview and Summary

During the past fifteen years, debate about and actual change in the scope and structure of national pension systems have grown to unprecedented levels. This intense focus on pension systems and institutions is occurring throughout the world, in fully developed and developing economies alike. It is being driven by a number of factors that vary in mix from one part of the globe to another. These include the need or desire to restructure entire economic systems, reinvigorate ineffective pension institutions, or improve social protection in concert with improving economic conditions. Debate is often occasioned by the hope that alternative pension structures will improve macroeconomic performance and help respond to changing demographics, or the desire to reflect changes in social philosophy about the relative importance of individual and collective provision for retirement.

One of the most prominent features of the current debate is sharp criticism of the pay-as-you-go, public pension programs that are the primary means of providing retirement income in many industrialized countries. For decades, these programs were widely viewed as valuable social and economic institutions. Today, they are often accused of costing too much, reflecting outmoded social philosophies, and having undesirable consequences for the economy. The previous consensus in support of these pay-as-you-go, public programs has broken down.

In the face of an increasingly polarized debate, the member organizations of the International Social Security Association (ISSA) asked the Association to help lead the search for a new consensus. The logical way to begin this search is with a careful review of the various arguments put forward by both critics and defenders of the traditional public pension arrangements. The review must examine the economic and social impacts of various pension approaches, assess how effective each is likely to be in ensuring adequate retirement incomes in an uncertain world, and identify the role that variations in social, cultural, and political traditions play in determining whether or not a particular kind of institution can prosper in a given environment. It should supply the foundation for an ongoing dialogue among the supporters of all approaches with the objective of developing a new consensus about the range of appropriate structures for national pension systems and the merits of following different approaches.

This volume is the initial step in the ISSA review process. It includes nine chapters that examine a variety of pension issues from an economic perspective. These chapters explore different aspects of the impact of pensions on the economy, the fiscal dynamics of different public pension approaches, and the challenges involved in ensuring that pensions provide adequate incomes. The review has begun with economic concerns because these are usually the basis for the strongest criticisms of existing pension systems and the major impetus for change in those systems.

The most common criticisms of pay-as-you-go pensions involve their economic impact, and that particular set of concerns is reviewed in the first five chapters of this volume. Pension systems, however, are not created because of the impact they might have on the macroeconomy. They are designed, first and foremost, to be mechanisms that provide retirement income to the aged population. This role is examined in detail in the issue briefs on the fiscal dynamics of public pension approaches and their adequacy as sources of retirement income.

For the most part, this volume leaves the social and cultural issues, which are also of great importance in the debate, for subsequent examination. These issues include the role of national pension programs as social institutions and the conditions under which different kinds of public and private institutions are likely to succeed or fail. These other topics are extremely important. The role that public pensions play in ensuring cohesion in a modern society is likely to be as important as any economic effect that they may have. In addition, history shows that serious problems with the operation of public pensions are frequently as much the result of institutional weaknesses as of design flaws. Designs that appear to work fairly effectively in one institutional setting can easily prove to be a disaster in another setting. These issues provide an agenda for future analyses as a part of this important ISSA initiative.

SUMMARY OF THE ISSUE BRIEFS

Chapter 2: Why Mandatory Retirement Programs Are Created

The logical starting point for this discussion is the question of why public pension programs exist at all. What purposes are they supposed to serve? What impact should we expect them to have? How should they be designed to achieve their purposes?

Both supporters and critics of the traditional pay-as-you-go pension systems agree that governments ought to require working-age people to make provisions for their retirement; they disagree about the most desirable mechanisms for achieving this. The agreement that some form of government intervention is necessary demonstrates a shared belief that free markets would not work properly to provide all citizens with adequate financial protection in retirement in the absence of government intervention.

One reason for government intervention is the desire to alleviate poverty, particularly among those no longer expected to work. As economies develop, extended family linkages weaken, and governments traditionally accept the responsibility of ensuring a minimum living standard for the aged. In many countries, public pension programs are the most important tool for discharging this responsibility, since they are effective in supplying at least a modest level of income to most aged and do so in a manner that preserves dignity and self-respect. Almost invariably, however, the scope and structure of the public pension program go far beyond the type of government effort that would be required just to provide a “safety net” to assure minimum living standards. It is this expanded scope that requires additional explanation.

The most common argument for this greater government role is that many working individuals who could adequately provide for their own retirement needs are myopic. In the absence of a government mandate, they would not have the foresight or discipline to save adequately for retirement. By the time they realized their mistake, it would be too late. In effect, the government acts paternalistically to enforce a mandate that people may resent when they are young but will grow to appreciate as they get older.

A second argument is that the government mandate is required to protect the prudent members of society from free-riders. If, in the end, people believe that the government will ensure that all of the aged have access to a minimum living standard, some may make a conscious decision not to save on their own. To avoid having to pay both for themselves and for any imprudent neighbors, the prudent members of society force everyone to contribute.

A third argument focuses on the possibility of reducing the uncertainty involved when each individual is required to make his or her own retirement arrangements. Government interventions can reduce the difficulty of preparing for retirement in the face of uncertainty about the pace of future economic activity, the path of future investment returns and inflation rates, and the length of one’s life.

Several observations about the structure of public pension plans flow from a review of these arguments. First, while the arguments suggest that some form of mandatory program is desirable, they do not suggest that the program must offer full earnings replacement for middle- and upper-income retirees.

Second, the arguments presume that many working-age people would not voluntarily make adequate provision for retirement. One key to successful implementation of a public pension program, therefore, is the willingness and ability of the government to enforce collections from reluctant individual and organizational contributors. One sometimes hears suggestions that compliance problems could be solved simply by linking benefits more closely to contributions. While such a change might have a beneficial impact, expecting it to produce a major increase in compliance would seem to ignore the basic assumptions about human behavior that motivated the creation of the pension program in the first place.

A third observation involves the likely impact of a public pension program on participant behavior. Public pension programs are designed to make it easier for people to retire at an “appropriate” age. The assumption is that, in their absence, people would have saved too little and thus been forced to work too long. It should be expected, then, that the implementation of a mandatory pension program will cause many participants to retire earlier than they otherwise would have, thereby reducing the labor force participation of the aged. To some degree, such an impact is the intended result.

Chapter 3: The Economic Cost of Pension Programs

The focus turns next to the fundamental economic issues underlying the public pension debate. Chapter 3 provides a careful examination of the factors that determine the actual economic cost of supporting the retired population. Chapters 4, 5, and 6 examine the likely impact of public pension systems on savings, labor force behavior, and international competitiveness.

One source of confusion about the economic impact of a public pension program can be traced to a failure to distinguish between the actual cost to the economy of the pension program and the social insurance contributions that are levied to finance those costs. Chapter 3 explores how changes in demography and public policies affect the economic cost of supporting the retired population. A later chapter explores how different economic and demographic environments cause the contribution rates required to finance pensions to rise or fall, even when the actual economic cost of supporting the retired has not changed.

The economic cost of supporting the retired population is best measured as the fraction of each year’s total national economic activity that is devoted to supplying the goods and services the retired consume. This assumes that whatever part of the economy’s capacity is used for this purpose cannot be used for some other purpose, such as producing consumer goods for the rest of the population or making new investments to increase future productivity.¹

This economic cost is financed through some combination of transfers from the labor earnings of those who are not retired (usually in the form of pension contributions) and allocations of a portion of each year’s returns to invested capital (usually in the form of earnings on assets owned by individual retirees or by pension funds). Different approaches to pension finance often involve different allocations of these costs between contributions and returns on assets. Confusion can occur when one approach appears to be cheaper than another because it involves lower pension contributions from earnings. If the lower charge to labor is offset by a higher charge to capital income, the total cost to the economy is the same even though it may be distributed differently.

The share of total economic activity devoted to the consumption of the retired—the actual economic cost of their support—is influenced by a variety of economic, demographic, and public policy developments. Perhaps the easiest way to understand how these various elements interact is to focus on the behavior of three key ratios: (1) the aggregate consumption ratio, which is the fraction of economic activity that is devoted to producing consumer goods and services for domestic use, (2) the retiree dependency ratio, which is the fraction of the population that is retired, and (3) the living standards ratio, which is the ratio of the average consumption of the retired population to the average consumption of all persons. When multiplied together, these three ratios will produce the ratio of retiree consumption to total economic activity, which is the economic cost of supporting the retired.

The relationship between changes in any of these three ratios and the corresponding change in the economic cost of the retired population is direct and proportional. Anything that causes one of these ratios to rise by a given percentage will increase the economic cost of supporting the retired by the same percentage. By the same token, the cost of supporting the retired can only be reduced if changes that reduce at least one of these key ratios are introduced.

As populations age, and if no other changes are made, the retiree dependency ratio will rise and the economic cost of supporting the retired will increase proportionately. The two most common adjustments that are discussed as ways of offsetting some of this cost increase are increasing the statutory retirement age, which would reduce the retiree dependency ratio, and reducing retirement benefits, which would lower the living standards ratio.

Shifting some or all of the responsibility for managing public pension plans from the public sector to the private sector has occasionally been advocated as a mechanism for reducing the cost of supporting the retired. Whether such a change has the desired effect depends entirely on whether it serves to decrease one of these key ratios. For example, if the shift is accompanied by changes that increase retirement ages or reduce the relative incomes of the retired population—or will be more effective at keeping retirement ages from drifting down or relative incomes from drifting up—it may well be an effective mechanism for reducing costs. If the shift is not accompanied by changes in dependency ratios or in the relative living standard of the retired, however, it will have no impact on the actual economic cost. Indeed, such a shift can actually increase the cost of supporting the retired if it produces higher retirement incomes. Higher incomes for the retired will most likely lead to an increase in their living standards relative to the rest of the population, causing the cost of supporting retired persons to rise.

Others advocate economic policies which they believe will accelerate economic growth as part of a strategy to deal with the rising cost of an aging population. While such policies may be desirable for other reasons, it is not at all clear that faster economic growth should be expected to reduce the economic cost of supporting the retired. If faster economic growth translates into more rapidly rising living standards of the working-age population without having the same impact on the living standards of the retired population, the relative cost of supporting the retired will drop. On the other hand, rising living standards among the working-age population may cause them to prefer earlier retirement and to offer less resistance to gradually rising pension contribution rates. Either reaction could mean that faster economic growth actually has the effect of increasing the cost of supporting the future retired population.

In summary, the economic cost of supporting the retired population is best measured by looking at the resources devoted to their consumption. Public pension benefit payments are a major source of support for the consumption of this population. For this reason, the best measure of the economic cost of a pension program is the benefits it provides. If it is important to prevent too great an increase in the costs of supporting the aged population, the evaluation of alternative policies to constrain these costs should focus on how effectively each will be in keeping pension benefit payments from rising.

PENSION IMPACTS ON THE ECONOMY

Even if the way that pension plans are financed is unlikely to have a significant impact on the share of national production devoted to supporting the retired, the financing approach may still have an important impact on everyone’s living standards if it influences saving behavior, labor force behavior, or international competitiveness. Each of these three possible effects is discussed widely in the popular press, often as if the linkages were obvious and all of the impacts significant. Serious students of economics have been able to establish some, but not all, of the linkages. Where linkages have been found, many of the impacts appear to be relatively modest. These topics are explored in the next three issue briefs.

Chapter 4: Pensions and Savings

The relationship between pension finance and saving behavior has attracted the attention of economists for several decades and has produced a considerable volume of statistical studies. The primary issue has been whet...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Acknowledgments
• Table of Contents
• Foreword
• Introduction
• 1 Overview and Summary
• 2 Reasons for Creating Mandatory Retirement Programs
• 3 The Economic Cost of Supporting the Retired
• 4 The Effect of Pensions on Saving and Investment
• 5 The Effect of Pensions on Labor Supply
• 6 Public Pensions and International Competitiveness
• 7 The Mathematics of Pension Contribution Rates
• 8 Choices of Pension Approaches and Transitions Between Approaches
• 9 Risks of Mid-Career Economic and Demographic Changes
• 10 Ensuring Income Adequacy Throughout Retirement
• Index
• About the Author