(Reprinted from HKCER Letters, Vol.28, September 1994)


Averting the income Crisis for the Old


Editor's Note: While old age and retirement protection remains a hotly debated issue in Hong Kong, arguments of various views have made relatively few references to foreign experiences. The World Bank has recently published a comprehensive and global study of the problem of old age financial security and related government policies. The following article summarizes the main points of this study and is drawn from World Bank Policy Research Bulletin (August-October 1994). It should provide insights on our own problem from a more international perspective.

Systems providing financial security for the old are under increasing strain throughout the world. Rising life expectancy and declining fertility mean that the proportion of old people in the general population is growing rapidly. Extended families and other traditional ways of supporting the old are weakening. Meanwhile, formal systems, such as government-backed pensions, have proved both unsustainable and very difficult to reform. In some developing countries, these systems are nearing collapse;, in others, governments are on verge of adopting the same programs that are spinning out of control in middle- and high-income countries. The result is a looming old age crisis that threatens not only the old but also their children and grandchildren, who must shoulder, directly or indirectly, much of the increasingly heavy burden of providing for the aged.

For these reasons, many economists and policymakers are seeking information and advice about old age security arrangements. But there are still too few who are aware of the impact these arrangements have on such diverse concerns as poverty, employment, inflation, and growth. Averting the Old Age Crisis Policies to Protect the Old and Promote Growth, A World Bank Policy Research Report, is the first comprehensive, global examination of this complex and pressing set of issues. The culmination of a two-year research project, it synthesizes what is known, analyzes policy alternatives, and provides a framework for identifying the policy mix most appropriate to a given country's needs.

The study identifies three functions of old age financial security systems - redistribution, saving and insurance. It evaluates the policy options for fulfilling those according to two criteria: their impact on the aged and their impact on the economy as a whole. It finds that most existing systems provide inadequate protection for the old - for example, benefits often are not sustainable - and redistribution is frequently perverse, for example, from poor, young families to comfortable retirees. Moreover, as the systems mature, they may actually hinder growth - through high wage taxes, which cause evasion and push labor into the less efficient informal sector; through reduced or misallocated savings; and through rising fiscal deficits that squeeze out public spending on growth-promoting goods, such as infrastructure, education, and health services.

The study suggests that financial security for the old - and economic growth - would be better served if governments develop three instruments, or pillars, of old age security: a publicly managed pillar with mandatory participation and the primary goal of reducing poverty among the old; a privately managed, mandatory saving system; and voluntary savings. The first covers redistribution, the second and third cover savings, and all three coinsure against the many risks of old age. By separating the redistributive function from the saving function, the amount of spending in the public pillar - and the tax rate needed to support it - can be kept relatively small, thus avoiding many of the growth-inhibiting problems mentioned above. Spreading the insurance function across all three pillars offers greater income security to the old than reliance on any single system.

The relative importance of each pillar, and the timing of transitions to a sustainable old age security framework, will vary among countries. The report analyzes these differences and the appropriate reform strategies in detail. The bottom line is that all countries should begin planning for their aging populations now.

The scope of the problem

Today, as the world's population ages, old age security systems are in trouble worldwide. Consider these facts:

Why should governments get involved?

When traditional informal arrangements for subsistence break down in other spheres, they are replaced by formal market arrangements. Why doesn't that happen for old age subsistence? Why do governments everywhere in the industrial world and increasingly in developing countries intervene so extensively in this area?

Depending purely on voluntary actions by individuals to provide for their own old age security leaves several problems.

So government interventions are usually justified on grounds that private capital and insurance markets are inadequate and redistribution to the poor is needed. All too often, however, these interventions have introduced inefficiencies of their own and have redistributed to the rich.

What have governments done?

About 40 percent of the world's workers - and more than 30 percent of its old - are covered by formal arrangements for old age, buttressed by government policy. Public pension spending as a proportion of GDP has increased closely with per capita income and even more closely with the share of the population that is old. If past trends continue, public spending on old age security will escalate sharply in all regions over the next 50 years. The most rapid escalation will occur in countries that may not expect it, because their populations are young today.

Government intervention can take and has taken many other forms besides taxes and spending. The government may regulate private pension funds, mandate saving, guarantee benefits, offer tax incentives, create a legal system for reliable financial institutions, dampen inflation to encourage voluntary saving, and so forth. So the important policy questions are not: Should spending on the old increase? And should the public sector be involved? They are: How should the public sector be involved? Are public taxes and transfers the best alternative, or are other types of public interventions and old age arrangements better?

Formal arrangements also differ in ways that go beyond the type and degree of government involvement. Pension funds may have either redistribution or saving and insurance as important objectives. They may specify either their benefits or their contributions in advance - defined benefits versus defined contributions. And they may be financed on a pay-as-you-go basis - current pensions are financed by taxes on current workers - or on a largely funded basis - current pensions are financed by prior savings, and liabilities don't exceed accumulated reserves.

Key policy issues

For these reasons, it does not make sense to focus on simple public- private distinctions. Instead, it is necessary to open the lens to five sets of questions that distinguish among alternative old age policies and determine their effects.

Alternative financing and managerial arrangements

Three institutional arrangements sum up the most important sets of answers to these questions. They are public pay-as-you-go programs, employer-sponsored plans, and personal saving and annuity plans.

Public pay-as-you-go plans. This is by far the most common formal system, mandatory for covered workers in all countries. Coverage is almost universal in high-income countries and widespread in middle-income countries. As its name suggests, it places the greatest responsibility on government, which mandates, finances, manages, and insures public pensions;, it offers defined benefits that are not actuarially tied to contributions and usually finances them out of a payroll tax (sometimes supplemented from general government revenues) on a pay-as-you-go basis. And it redistributes real income, both across and within generations.

Occupational plans. These are privately managed pensions offered by employers to attract and retain workers. Often facilitated by tax concessions and (increasingly) regulated by governments, these plans tended to be defined benefit and partially funded in the past. But the number of defined contribution plans (in which contributions are specified and benefits depend on contributions plus investment returns) and the degree of funding have been increasing in recent years, and these have quite different effects. More than 40 percent of workers are covered by occupational schemes in Germany, Japan, the Netherlands, Switzerland, the United Kingdom, and the United States - but far fewer in developing countries.

Personal saving and annuity plans. These are fully funded, defined contribution plans. Workers save when young to support themselves when they are old. Since benefits are not defined in advance, workers and retirees bear the investment risk on their savings. Voluntary personal saving is found in every country, often encouraged by tax incentives, but some countries have recently made it mandatory. A key distinction is between mandatory saving plans managed by the government (as in Malaysia, Singapore, and several African countries) and those managed by multiple private companies on a competitive basis (as in Chile and soon in Argentina, Colombia, and Peru).

Government policies - that mandate, encourage, or regulate - largely determine the relative roles of these three arrangements.

Criteria for policy choice

How are we to evaluate alternative policies? The effects of government policies depend on individual responses, such as evasion, compliance, and the possibility of offsetting actions that reduce other saving, transfers, and work. As a result of these private responses, each arrangement has broad implications for the operation of labor and capital markets, for the government's fiscal balance, and for the income distribution in society.

The report argues that old age security programs should be both an instrument of growth and a social safety net. They should help the old by:

And they should help the broader economy by:

Few programs fulfill these criteria. As the examples above show, they do not operate the way they are supposed to or the way many people believe they do - a conflict between myth and reality (box 2).

Toward a multipillar system

One of the prime policy issues in the design of old age security programs is the relative importance of the saving, redistribution, and insurance functions - and the role of government in each:

A central recommendation of the report is that countries should separate the saving function from the redistributive function and place them under different financing and managerial arrangements in two different mandatory pillars - one publicly managed and tax-financed, the other privately managed and fully funded - supplemented by a voluntary pillar for those who want more (figure 2).

The public pillar would have the limited object of alleviating old age poverty and coinsuring against a multitude of risks. Backed by the government's power of taxation, this pillar has the unique ability to pay benefits to people growing old shortly after the plan is introduced, to redistribute income toward the poor, and to coinsure against long spells of low investment returns, recession, inflations, and private market failures.

The public pillar could take three alternative forms. It could be part of a means-tested program for the poor of all ages, with eligibility criteria taking into account the diminished ability of the old to work and benefit levels taking into account age-linked needs. Alternatively, it could offer a minimum pension guarantee to a mandatory saving pillar. As still another alternative, it could provide a universal or employment-related flat benefit that coinsures a broader group.

But the public pillar should be modest in size, to allow ample room for other pillars, and pay-as-you-go, to avoid the problems frequently associated with public management of national provident funds. Having an unambiguous and limited objective for the public pillar should reduce the required tax rate substantially - and therefore evasion and misallocated labor - as well as pressures for overspending and perverse intra- and intergenerational transfers.

A second mandatory pillar - one that is fully funded and privately managed - would link benefits actuarially to costs and carry out the income-smoothing or saving function for all income groups within the population. This link should avoid some of the economic and political distortions to which the public pillar is prone. Full funding should boost capital accumulation and financial market development. The economic growth this induces should make it easier to finance the public pillar. But a successful second pillar should reduce the demands on the first pillar.

The second mandatory pillar could take two alternative forms: personal saving accounts or occupational plans. In either case, mandatory programs require careful regulation.

Voluntary occupational or personal saving plans would be the third pillar, providing additional protection for people who want more income and insurance in their old age.

Although the redistribution and saving functions would be separated, the insurance function would be provided jointly by all three pillars, since broad diversification is the best way to insure against a very uncertain world.

The benefits of a multipillar system.

A mandatory multipillar arrangement for old age security helps countries to:

The broader economy should be better off in the long run as a result. So should both the old and the young.

How to get there

How should countries start the process of establishing a multipillar system? And how can those that already have large public pillars make the transition? Although the ultimate goals are similar for all, the paths and time frame depend on country circumstances.

Young, low-income economies. Consider first a country with a young population, a low per capita income, and only a small public pillar, one covering primarily government sector employees. Many countries in Africa and south Asia are at this stage. The weakening of informal systems of old age support and the absence of reliable capital and insurance market instruments are prompting political pressures for an expanded public pillar. These countries typically do not have the financial markets or regulatory capability necessary to establish a decentralized funded pillar. But they should be creating an enabling environment for voluntary and, later, mandatory saving and pension plans by:

These basic conditions, important for old age systems, are also necessary for continuing economic growth.

These countries should also be taking steps especially geared to providing old age security, using methods that avoid the problems of large pay-as-you-go plans and that will eventually fit into a multipillar system. They should:

Young but rapidly aging economies. The next set of countries, also with young populations, is aging and often growing rapidly since rapid economic growth is associated with falling fertility rates and increasing longevity. Many East Asian economies are at this stage. In addition to accelerating all the actions just mentioned, these economies should:

Older economies with large public pillars. The third set of economies comprises those that are already middle-aged, are growing older rapidly, and have substantial public pension programs that provide widespread coverage and whose costs will soar, with dependency rates, over the next three decades. This set includes OECD and Eastern European economies and several Latin American economies. Although the degree of urgency varies, all these economies face imminent problems with their old age systems. Rather than relying on an ever more costly public pillar to do it all, at high tax rates that inhibit growth and bring low rates of return to workers, the time is ripe for these economies to make the transition to a mandatory multipillar system.

  1. Downsizing the public pillar gradually while reallocating contributions and productivity increases to second mandatory pillar.
  2. Or holding the public benefit relatively constant (in cases in which it is low to begin with) but raising contribution rates and assigning them to the second pillar.
  3. Or recognizing accrued entitlements under the old system and agreeing to pay them off while starting a completely new system right away. This involves designing the new system, calculating the implicit social security debt that is owed under the old system, and figuring out how to finance it all in a way that is both politically and economically acceptable.

Several OECD countries are engaged in the gradual transition (alternative 1 or 2). Several Latin American countries have already introduced a radical transition (alternative 3). And many formerly socialist countries are trying to decide which way to go.

Summary. The right mix of pillars is thus not the same at all times and places. It depends on a country's objectives, history, and current circumstances, particularly its emphasis on redistribution versus saving, its financial markets, and its taxing and regulatory capability. The kind of reform needed and the pace at which a multipillar system should be introduced will also vary - from quick in middle- and high-income countries whose systems are in serious trouble to very slow in low-income countries, which should avoid these same mistakes. But one recommendation is clear; all countries should begin planning - and educating the public - now.


Box 1 The problem of early retirement

In traditional informal systems of old age support, all members of the household, including the old, contribute to its productive capacity in some way. Most people continue working until they become disabled or die.

The formalization of jobs made it difficult for people to continue working as they aged, and introduced the concept of "retirement". Problems occur if people retire from the labor force too early. W, while they are still able to work productively. Early retirement ages reduce the supply of experienced workers in the economy, and therefore its productive capacity. Early retirement also doubly threatens the financial viability of public pay-as-you-go pension plans - by reducing the number of workers making contributions and increasing the number of retirees drawing benefits.

Suppose that there are equal numbers of people in each age category and that workers enter the labor force at age 25, retire at 65, and die at 85. The dependency rate is then one retiree to two workers, and a contribution rate of 20 percent will cover a pension paying 40 percent of the average wage. If the retirement age is increased to 70, the required contribution rate falls to 13.3 percent. But if the retirement age is lowered to 55, the dependency rate becomes one to one, and the required contribution rate soars to 40 percent. This has been the trend in many countries.

Raising the retirement age regularly, as longevity increases, is an essential ingredient of pension system reform.


Box 2. Myths and facts about old age security

Myths abound in discussions of old age security. Consider some of the most common:

Myth 1. Old people are poor, so government programs to alleviate poverty should be directed to the old.

Fact. The old are even better off when comparisons are based on lifetime income rather than current income. Why? Because people with higher incomes are more likely to live long enough to become old, whereas people with low incomes are more likely to have many children and die young. Targeting young families with children is a better measure for alleviating poverty than targeting the old.

Myth 2. Public social security programs are progressive, redistributing income to the old who are poor.

Fact. Even if benefit formulas look progressive, four factors neutralize most of the progressive effect:; The first people to be covered by new plans are invariably middle- and upper-income groups, and they typically receive large transfers. The rich tend to have a longer life expectancy. Ceilings on taxable earnings keep the lid on tax differences between rich and poor. And when benefit formulas are earnings-related or subject to strategic manipulation, as in many countries, upper-income groups benefit even more, so the net redistributional effect can be regressive.

Myth 3. Social security programs insure pensioners against risk by defining benefits in advance.

Fact. Benefit formulas are redefined frequently, so substantial political risk remains.

Myth 4. Only governments can insure pensioners against group risks such as inflation and most do so.

Fact. Most developing countries do not index pension benefits for inflation in their publicly managed old age programs.

Myths 5. Individuals are myopic but governments take the long view.

Fact. Governments have repeatedly made decisions about old age programs based on short-run exigencies rather than long-run benefits.

Myth 6. Government action is needed to protect the interests of generations yet unborn.

Fact. Most public pay-as-you-go pension schemes provide the largest net benefits to workers who are 30 to 50 years old when the schemes were introduced. The unborn children and grandchildren of these workers are likely to receive negative transfers as the system matures and the demographic transition proceeds.


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