Beyond Retirees

• Author: Philippe Karam, Dirk Muir, Joana Pereira, and Anita Tuladhar
• Position: Assistant to the Director in the IMF Institute, is a Senior Economist in the IMF’s Research Department, is an Economist in the IMF’s Western Hemisphere Department, and is a Senior Economist in the IMF’s European Department.

SINCE 1990, public pension spending has increased in an amount equal to 1¼ percent of gross domestic product (GDP) in the advanced economies in the Group of 20 (G-20). And a continuously aging population will cause further increases averaging about 1 percent of GDP in both advanced and emerging economies over the next 20 years (see Chart 1). Advanced economies that have not substantially changed their traditional pay-as-you-go pension systems are projected to experience larger spending increases than advanced economies that have legislated pension reform.

Among emerging economies, those with relatively high spending in 2010 are projected to experience the steepest increase in outlays over the next 20 years. In countries that do not cover a large segment of the elderly, such as China and India, the projected increase is much less severe, but could rise more rapidly if their systems expand to cover a larger share of the population. Moreover, advanced economies are experiencing sharp growth in the aged population now, but that will change after 2030, when emerging economies will experience a faster pace of aging.

A number of countries have already reformed their pension systems, and spending pressures seem sure to force more to do so. Globally, the number of people over 65 relative to the working-age population (the old-age dependency ratio) is projected to double between 2009 and 2050, putting enormous strains on public pension systems, largely pay-as-you-go plans that are financed by current workers, who expect future generations to fund their retirement.

Further reforms appear inevitable. How and when countries implement reforms, then, is not only a matter of fairness to current and future retirees. The choice will significantly affect economies—nationally and globally. Moreover, whether countries make those reforms individually or in coordination with other nations is also important to macroeconomic performance, given cross-border trade and investment linkages.

What can be done

There are three major ways countries can change pension systems to reduce costs:

• Raise the retirement age: Lifetime benefits paid to retirees are reduced. This encourages workers to remain in the labor force longer, which means they earn more over their lifetime. The increase in lifetime income could lead workers to save less and consume more during their working years. In addition, the increased fiscal savings from reduced pension payments will have long-term positive effects on GDP growth by lowering the cost of capital and encouraging investment.

• Reduce pension benefits: To avoid a sharp reduction in income and consumption in retirement, workers would likely boost savings. Consumption would fall in the short to medium term, but investment would increase over the long term.

• Increase workers’ contribution rates: Because higher rates reduce income, households might be less motivated to work, which could depress economic activity in both the short and long term.

We use the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) to quantify the effects of reforms to pay-as-you-go public pension systems worldwide. The model contains two types of households—those that are liquidity...