Ageing population & pension dilemma

The recent World Economic and Social Survey 2007 analyses the challenges and opportunities associated with ageing populations. Following are exceprts from the report focussing on the issue of
pensions.

Savings and ageing
A second theoretical notion is illustrated by the life-cycle model of savings, which posits that, during their working years, individuals produce more than they can consume, thus generating a surplus that can be used to provide for their dependent children and/or saved to secure an income after retirement. In this view, economies with high levels of child dependency are expected to have relatively low national saving rates. In contrast, economies with large shares of working-age population can potentially grow faster both because this demographic structure generates a larger aggregate life-cycle surplus and because savings rates are expected to be higher as individuals save in anticipation of their retirement. Also, if individuals perceive that their life expectancy is increasing, they may be inclined to increase savings during their working years in order to finance a longer retirement.

Again, although ageing may exert an influence, many other factors play a role in determining savings behaviour and the level of savings in the economy.

These factors include the level and distribution of income in the economy, the value of assets that people hold and their distribution, perceptions about the future, tax rates, existing pensions systems, and the provisions for care of older persons in the case of chronic illness. Moreover, the life-cycle hypothesis applies to household or personal savings which will be affected by the design of pension systems, but such effects may be small relative to the impact that pension schemes may have on the savings patterns of Governments and enterprises.
What is clear, though, is that an increasing share of household savings flows into pension funds and other financial investment plans for retirement. Institutional investors, which typically manage such savings, have already become the main players in financial markets.

These investors manage not only large amounts of household savings from developed countries, but also, increasingly, savings from developing countries where the importance of privately managed capitalized pension systems has grown (see below). Institutional investors can play an important role in deepening financial markets and providing additional liquidity for long-term investment projects. At the same time, however, institutional investors largely operate outside of financial market regulation and supervision mechanisms that apply more generally to the banking system.

If unchecked, the financial market operations of pension funds could thus be a source of financial instability. Also, as increasing financial investments are intermediated outside of the banking system, the control of monetary authorities over credit growth tends to weaken the effectiveness of monetary policies. Improved (possibly international) regulatory measures are needed to avert possible destabilizing effects on financial markets of the operations of large pension funds and to prevent the income security of older persons from being jeopardized.
Ensuring old-ageincome security

Living standards often decline for people at older ages. Reduced economic opportunities and deteriorating health status frequently increase vulnerability to poverty as people age. Such conditions vary greatly, however, across contexts and groups of older persons. Livelihood strategies tend to differ accordingly. In developed economies, pensions are the main source of livelihood and protection in old age, while in developing countries few older persons have access to pensions and must therefore rely on other sources of income. In fact, 80 per cent of the world’s population are not sufficiently protected in old age against health, disability and income risks.

This would mean that in developing countries alone about 342 million older persons currently lack adequate income security. That number would rise to 1.2 billion by 2050, if the coverage of current mechanisms designed to provide old-age income security is not expanded. The demographic transition poses an enormous challenge with respect to ensuring the availability and sustainability of pensions and other systems providing economic security for an ever-increasing number of older persons in both developed and developing countries. The Survey concludes that the right approach would render this challenge far from insurmountable.

Poverty and old age
Empirical evidence suggests that older persons living in countries with comprehensive formal pension systems and public transfer schemes are less likely to fall into poverty than younger cohorts in the same population. In countries with limited coverage of pension systems, old-age poverty tends to parallel the national average.

Of course, the probability of being poor at older ages does not depend only on the coverage of pension schemes. Generally, the degree of poverty among older persons varies with educational attainment, gender and living arrangements. Better education lowers the likelihood of falling into poverty in old age. Older women find themselves in poverty more often than do older men.

In the absence of formal pension coverage, the majority of persons in developing countries face considerable income insecurity during old age. For the unprotected—often small farmers, rural labourers and informal sector workers—the notion of retirement does not exist.

Not having held formal jobs, they do not qualify for a pension; and if they have been unable to accumulate enough assets, they must continue to rely on their own work. The situation can be rather precarious for the very old (those aged 80 years or over) who may not be as fit to work as their younger counterparts. Those, in particular, who were already poor during their prime working years are likely to remain poor in old age. Those who are above the poverty line but unable to build up precautionary savings to finance consumption in old age also face the risk of poverty as they grow old.

Often, older persons may count on the support of the family and the community to survive or to complement their income needs. In this regard, older persons who are single, widowed or childless (particularly women) face an even higher risk of destitution. Reliance on family networks may not fully protect older persons against poverty, as these networks are themselves income-constrained. The challenges of providing adequate old-age income security naturally are much larger in circumstances of widespread poverty.

Providing better incomesecurity through broad and multi-layered approaches
Privately or publicly administered pension systems are the main policy instruments used to address poverty and vulnerability in old age. Ideally, they should ensure income security during old age for all and they need to provide benefits that place recipients above the socially acceptable minimum living standards.

However, pension coverage is limited in most developing countries. In developed countries, well-regulated labour markets have made it possible for employment-based contributory pension schemes to cover almost the entire population. Those not entitled to contributory pensions are normally supported through non-contributory old-age support schemes.
Yet, the sustainability of existing pension systems is being questioned in developing and developed countries alike. Increased longevity, faulty programme design, mismanagement, insufficient economic growth and inadequate employment-generation have undermined the financial viability of these systems in some contexts.

Increasing old-age dependency rates will place further pressure on both formal and informal support systems, if economic growth (and the generation of decent jobs) cannot be accelerated and sustained.
Issues of accessibility, affordability and sustainability are at the core of old-age pension system design and reform. Ultimately, the design of old-age income security systems is country-specific and needs to reflect societal choices and preferences. A multilayered approach to developing pension systems, building on existing practice in many countries, seems desirable as regards achieving affordable, financially viable and equitable systems of old-age income security.

Ensuring universalaccess to old-agepensions
As a matter of overarching principle, all pension systems should aim at providing, minimally, some form of basic income security to all persons in old age. This objective could be achieved by creating, or expanding where it already exists, a basic pillar providing a minimum pension benefit. Such a universal social insurance mechanism could be contribution-based or non-contribution-based, depending on the context. In countries where formal employment is dominant, a single basic pillar may be sufficient to provide income security in old age, and its financing could be based on earnings-related contributions, as is the case in most developed countries.

In countries with a dominant informal sector or with both informal and formal labour-market segments, the basic social pension scheme could have two components: an essentially non-contributory scheme offering minimum benefits financed from taxation and, where feasible, with some solidarity contributions made by those who can afford to contribute; and an entirely contributory scheme.

In most contexts, basic non-contributory pension schemes seem affordable, even in low-income countries. A simple numerical exercise under reasonable assumptions suggests that abolishing extreme poverty in old age by providing a basic universal pension equivalent to $1 per day to all over age 60 would cost less than 1 per cent of gross domestic product (GDP) per annum in 66 out of 100 developing countries (see figure O.5). The costs of a basic pension scheme for such countries, despite rapidly ageing populations, are projected to be relatively modest by 2050.

However, the affordability of such pension schemes depends as much on the political priority given to ensuring a minimum income security in old age, as on the pace of economic growth. Moreover, particularly in low-income countries, there may be competing demands on scarce government resources: For example, in Cameroon, Guatemala, India, Nepal and Pakistan, the cost of a universal basic pension scheme as outlined above represents as much as 10 per cent of total tax revenue. In Bangladesh, Burundi, Côte d’Ivoire and Myanmar, it is equivalent to the public-health budget. How to finance a basic pension scheme may therefore need to be determined in close coordination with the resource allocation process (including the use of development assistance) for other social programmes.

Sustaining pensions systems
Much of the debate on pension systems concentrates on the financial sustainability of alternative schemes, in particular upon the two types of financing mechanisms. One is a “pay-as-you-go” (PAYG) scheme, where contributions paid by the current generation of workers are disbursed as benefits to retirees. The other is a fully funded scheme under which benefits are financed by the principal and return on previously invested contributions. In the pension reform debates, the sustainability of pay-as-you-go schemes has been often questioned, as higher old-age dependency rates imply that fewer workers pay in relative to the number of beneficiaries.

Reforms of contributory pension systems have taken two directions: strengthening existing systems by changing underlying parameters (parametric reforms) and radically changing system design (structural reforms).

Parametric reforms have been implemented in virtually every pay-as-you-go scheme and are much more widespread than structural reforms. Countries have introduced measures on both the revenue and the expenditure sides to ensure the affordability and sustainability of such schemes. In particular, measures are increasingly being adopted to raise the effective retirement age. In the United States, it is to increase to 67 by 2027 and in France, the number of contribution years is to increase in line with increases in life expectancy from 2009. In addition, countries are considering removing the fiscal incentives for early retirement that are embedded in their pension systems.

These measures aim at addressing the problem presented by longer years of retirement resulting from both increased longevity and a shorter working life. In most countries, delaying retirement and staying longer in the workforce can go a long way towards keeping payas-you-go systems viable.

Other countries have focused on structural reform of their pension schemes. In the 1980s and 1990s, several countries introduced structural reforms in their systems offering a basic pension and moved from pay-as-you-go scheme with defined benefits to a fully funded defined contribution system.

The United Kingdom of Great Britain and Northern Ireland, for instance, did so partially in 1980. Chile took a more radical approach by replacing its publicly administered pay-as-you-go system with defined benefits with a mandatory privately managed fully funded scheme, and several Latin American countries have followed suit. Under a fully funded scheme, the payout at old age depends on the amount of the contributions made and the returns on the investment of those contributions. Because of the capitalization of pension contributions, it was believed that the system would stimulate national savings and, through this, overall economic growth.

Although fully funded schemes have been presented as being more viable and may have led to deeper financial markets, there is no evidence that their introduction has indeed led to higher savings and growth. While fully-funded systems with individual capitalization can be financially sustainable in principle, the transformation of a pay-as-you-go system into a fully funded system has negative implications for public finances as the pension obligations contracted under the old system still have to be honoured, while pension contributions are being channeled to the new system.

Although the large share of Treasury bonds in the portfolio of pension funds largely provides the financing for these fiscal costs, the effect is not neutral in macroeconomic terms, as the rising public sector debt may affect interest rates, increasing in turn the fiscal costs of the transition as well as having implications for private investment.

Moreover, under a fully funded scheme introduced as a single-pillar pension system, economic risks are shifted entirely to the pensioners; and, inasmuch as it depends on the rates of return on pension investments, full income security during old age is not guaranteed. Equally important, these schemes are not immune to the pressures exerted by a rising share of the non-working population.

In fact, many reforms have overlooked the fact that regardless of the type of financing mechanism, all schemes face a similar sustainability problem. Any pension-related “asset” acquired by today’s working population—either a financial asset, in the case of a fully funded system, or a promise by the public sector through a pay-as-you-go scheme—constitutes a claim on future output.

Hence, under both types of scheme a redistribution of income between the retired and the active populations has to take place. With increasing old-age dependency ratios, this implies that in order to provide the same amount of old-age income security, either greater pension contributions will have to be drawn from the working population or output growth will have to increase.

Overall, however, demographic dynamics do not pose an insoluble problem for oldage pension schemes. Pension systems should be tailored to specific country contexts, but built up or reformed based on broad principles, of which financial sustainability is but one. Intergenerational solidarity and adequacy of benefits with respect to providing sufficient income security for all should be other guiding principles.

In fact, more recently, pension reform processes have been moving away from a narrow focus on fully funded schemes as the centrepiece of national income-security systems. Recent reforms recognize the need to have a multilayered approach, which has as its basis a social pension scheme to ensure universal coverage and to directly address problems of poverty in old age.