The Truth About Pension Reform

• Author: Nicholas Barr
• Position: Economics Department at the London School of Economics

Aging populations in industrial and transition countries have provoked heated debate about pension reform—in particular, about the desirability of abandoning pay-as-you-go schemes in favor of private, funded pensions. What kind of pension plan would best meet the needs of future retirees?

There are two ways we can provide for a secure old age. We can save part of our wages each week and draw on the accumulated funds after we retire to buy goods produced by younger people. This is the principle underlying funded pension plans. Or we can obtain a promise—from our children or our government—that, after we retire, we will be given goods produced by others. This is broadly the way pay-as-you-go (PAYG) systems, with pensions paid out of tax revenues, are organized. Both types of pension plan thus exchange current production for claims on future production, but there is considerable controversy about which is the better choice. This article investigates arguments suggesting that funded plans are superior. Although it finds that those arguments can be overstated, it does not mean to discredit funded plans themselves, merely some of the claims that are made about them.

Funding versus PAYG

The working-age population in most industrial countries will soon have to support increasing numbers of pensioners, arousing fears that PAYG systems will become unsustainable. Many—including the new U.S. administration—are arguing that future retirees would be better off investing at least part of their savings in private, funded pension plans. But funded plans face many of the same problems as PAYG systems; some of their claimed advantages are more myth than fact. And PAYG state social insurance systems are more flexible than most people realize; many of the problems they now face can be solved, as Sweden demonstrates (see box).

How does Sweden's PAYG system work?

Sweden introduced a "notional defined-contribution" scheme in 1998. The state pension is financed by a social insurance contribution of 18.5 percent of earnings, of which 16 percent goes into the public scheme. Although this year's contributions pay this year's pensions, the social insurance authorities open a notional account that keeps track of each person's contributions. The account attracts a notional interest rate reflecting average income growth. Aperson's pension is based on his or her notional lump sum at retirement (in other words, social insurance mimics annuities) and on projections about life expectancy and future output growth. There is a safety-net pension for people with low lifetime earnings, and periods spent caring for children carry pension rights. The remaining 2.5 percent of a person's contribution goes into a funded scheme—either a private account or a government-managed savings fund. The individual can choose to retire earlier or later, with the pension being actuarially adjusted accordingly.

Thus, Sweden has a defined-contribution scheme with a safety net. It is a publicly organized, PAYG analogue of Chile's privately managed, competitive, individually funded arrangements. Either method gives people choices, for example about their preferred trade-offs between the duration of retirement and living standards in retirement, while presenting them with the actuarial costs of those choices.

Myth 1: Funding resolves adverse demographics. Population aging reduces the workforce and, as a result, a country's output. The effect on PAYG schemes is that the contribution base shrinks. The effect on funded schemes is more subtle but equally inescapable. When a large generation of workers retires, it liquidates its financial assets to pay for its pensions. If those assets are equities, sales of financial assets by the large pensioner generation will exceed purchases of assets by the smaller younger generation, leading to falling equity prices and, hence, to lower pensions. Alternatively, if those assets are bank accounts, high spending by the large pensioner generation will generate inflationary pressures and—again—reduce the value of pensions.

Myth 2: The only way to prefund is through pension...