Can Europe Afford to Grow Old?

• Author: Albert Jaeger
• Position: Division Chief in the IMF's European Department
• Pages: 20-21

Page 20

Over the coming decades, an increasing share of the European Union's (EU's) population will turn elderly as baby boomers reach retirement age and life expectancy rises. This is true of both the 15 original members and the 10 new ones. Enlargement will, at best, have a brief rejuvenating effect, given the current, much younger age profile of the new members. Projections indicate that, by 2020, the share of older people in the EU-25 will approach that of the EU-15, reflecting a plunge in these new members' fertility rates over the past decade or so. In fact, the onset of serious population aging in the EU is no longer a distant event, as it will start as early as 2010.

Across major industrial countries, populations are aging.

[ SEE THE GRAPHIC AT THE ATTACHED PDF ]

In the European Union, the share of the elderly in the population will double by 2050 . . .

[ SEE THE GRAPHIC AT THE ATTACHED PDF ]

and the share of the employed in the population will decline sharply.

[ SEE THE GRAPHIC AT THE ATTACHED PDF ]

Page 21

For most EU countries, aging populations will cause major fiscal headaches-chief among them, fiscally unsound pension systems. Europe recognizes that dramatic pension reforms are urgently needed. Currently, public pensions financed on a pay-as-you-go (PAYG) basis dominate in most countries. These schemes pay pensions out of current contributions or taxes. The problem with PAYG systems is that they are in danger of becoming massively underfunded when the number of people drawing pensions begins to markedly increase relative to the number in the active labor force paying into the systems. By contrast, prefunded pensions-both private and public-play a subordinate role in most countries. These schemes make pension payments from a fund that is an accumulation of financial assets built up over a period of years from its members' contributions.

So what are Europe's options? Three stand out:

* Closing PAYG financing gaps on a year-by-year basis through "parametric" reforms that boost pension revenue (increasing pension contribution rates or the number of contributors) or cutting pension spending (reducing benefits or the number of pensioners), or both.

* Shifting to public prefunding of pensions, which would imply running surpluses in the public pension system, at least over the next two decades or so.

* Shifting to...