Almost all industrialized countries have established public pension programs that collect taxes from the current working population, often levied as a payroll tax, to provide benefits to the current retired population. An example of this approach is the Social Security program in the United States. This type of pension system is referred to as an unfunded pay-as-you-go (PAYG) pension, reflecting the fact that the contributions of current workers are not being invested in assets to be used to finance their own retirement. Rather, the current generation of workers is supporting current retirees, and the current generation will be dependent on contributions of future generations to support them in their old age. As currently designed, PAYG public pension programs in Europe, North America, and Japan will need to be altered significantly in order to achieve fiscal sustainability in coming decades (Disney 2000; World Bank 1994). An important reason why projections show that PAYG public pensions are headed toward fiscal imbalance is population aging.
The effect of population aging on PAYG pension systems is rather obvious, as can be seen by looking at the ratio of workers to pension beneficiaries. As a population ages, there is a decline in the relative number of workers available to support the expanding proportion of the population that is retired. The projected decrease in the support ratio over the first several decades of the 21st century is large for every developed country (see Table 5.5), creating fiscal imbalances in almost every public pension system. The challenge is greatest for nations that have the lowest projected support ratios (countries such as Japan and Italy), but is also substantial for the United States.
Problems in the long-term stability of PAYG pension systems as the demographic transition reached maturity might have been anticipated in their initial formulations (Disney 2000), but other developments have complicated the situation. First, across all developed countries the labor force participation rate of older men declined in the second half of the 20th century. Of course a major explanation for men leaving the labor force at younger ages over this time period was the growing availability of pensions (Wise 1997). The result, nevertheless, was to further reduce support ratios. Second, population forecasts available to those designing the major national pension schemes seriously underestimated the future decline in both death rates among the old and fertility rates among women. Consequently the pension programs as initially formulated did not anticipate the speed and extent of subsequent population aging. Third, for political reasons the generosity of pension benefits increased over time. Thus it is population aging, in combination with these other factors, that is forcing policy makers to decide among alternative reform options to stabilize public pensions in the near future.
Two basically different approaches to reforming public pensions are being debated (Disney 2000). The less radical approach, referred to as ''parametric'' reform (Chand and Jaeger 1996), argues that unfunded PAYG schemes can be brought into equilibrium by making changes in a few parameters. More money available for paying pension benefits could come from either increasing taxes on the workers or by increasing the proportion of the working age population that participates in the labor force. Pension expenditures could be reduced by decreasing benefits, either by directly cutting benefits or by increasing age for pension eligibility. The approach of increasing normal retirement age has received support from some demographers who point out that that increasing life expectancy and improving health of cohorts entering old age make a fixed retirement age (such as 60 or 65) increasingly obsolete (Chen 1994; Uhlenberg 1988). The general view of those favoring parametric reform is that by making moderate changes in several of the parameters (payroll tax, eligibility age, cost of living adjustment, means testing), existing public pension systems could be maintained as unfunded PAYG programs despite population aging (Kingson and Williamson 2001; Williamson 1997).
The alternative proposal argues that rather than "fixing" the existing programs, the required long-term solution is to move from unfunded to funded pensions. This approach is referred to as ''paradigmatic'' reform because it calls for a fundamental change away from the PAYG system. In a funded pension program the money collected from current workers and/or employers is invested in private sector equity markets (stocks, bonds), and these investment accounts are used to pay retiree benefits. This capital reserve-financing system could be operated as a public pension program. In the United States, for example, this would mean that the balance of funds in the Social Security Trust Fund would be invested in capital markets rather than in government bonds. Most often, however, plans for moving to funded pension plans expect that the transition would involve privatizing social security with a system of individual-based accounts. The most cited example of a country moving to a privatized social security plan is Chile (Edwards 1998), but there also are examples of partial privatization in several European countries (Feldstein and Siebert 2002).
The key difference between the two pension plans is that in a PAYG program retirees are dependent on current workers to support them, whereas in a funded program each generation funds its own retirement by accumulating capital. The relevance of this debate to population aging is obvious: population aging does not threaten the fiscal sustainability of funded pension plans. Other potential advantages of reforming public pension programs by moving to funded systems are often noted, such as the higher expected real rate of return on contributions and the contribution to development of financial markets (World Bank 1994). On the other hand, there are strong critics of paradigmatic pension reform who argue that this solution involves unfair transition costs, creates increasing inequality and greater individual risk, and threatens the viability of intergenerational solidarity in society (Walker 1999; Williamson 1997). Not surprisingly, many analysts suggest that a compromise of partial privatization of social security is a reasonable way to achieve the reform of public pensions required by population aging (Boldrin et al.1999).
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