The Economic Impact of Pension Reform and its

Implementation

by

Estelle James

Populations Are Aging

• By 2030 the proportion of the world’s population that is > 60 will nearly double, from 9% to 16%

• % > 60 15% in ECA/FSA region. Wide variation--much higher in Eastern Europe, lower in Stans. But aging is increasing in all.

Percentage of the Population Over 60 Years Old, by Region, 1990 and 2030

OECD countries

Transitional Socialist Economies

China

Latin America and the Caribbean

Asia (excluding China)

North Africa and the Middle East

Subsaharan Africa

WORLD

0 10 20 30Percentage of population over 60

19902030

When Populations Age, Public Pension Spending Increases

• Many industrialized countries now spend more than 10% of their GDP on pensions

• Public spending on health and pensions now exceed 20% of GDP in some countries

• ECA/FSA region spends more than average for its demography

Relationship Between Percentage of the Population over 60 Years Old and Public Pension Spending

5 10 15 200

4

8

12

16

Pension spending as percentage of GDP

Jamaica

Israel AustraliaJapan

AustriaItaly

Sweden

U.K.

France

Luxembourg Greece

China

Uruguay

Panama

Costa Rica

U.S.

Percentage of population over 60 years old

Poland

Public Health and Pension Spending versus Population Aging

Spending as a percentage of GDP

Percentage of population over 60 years old

0 5 10 15 20 250

5

10

15

20

Spending on health and pension

Spending on health

U.K.

Poland

Sweden

Austria

Czechoslovakia

Iceland

Australia

Cyprus

Switzerland

Japan

Brazil Trinidad & Tobago

ChinaJamaica

IndonesiaS. Korea

SwazilandZambia

Canada

New Zealand

With such large sums, social security affects entire economy. It influences:

• Peoples’ incentive to work (espec. near retirement)

• Employers’ willingness to hire labor

• Labor allocation between formal-informal sectors

• Level of national saving and its allocation

• Financial market development

• Government’s fiscal position

• Therefore quantity and productivity of labor and capital and level of GNP

• Important to choose system that increases size of the pie--this is good both for old and young

• This is the rationale for multi-pillar systems that include funding and defined contribution pillars

• But--System design and implementation both matter.

Labor market: 1)impact of payroll tax on wages and employment

• If employers bear tax, this raises labor costs, lowers competitiveness, employment, output: employers less willing to hire

• If workers bear tax in form of lower take-home pay: less willing to work, exert effort (in most OECD countries workers bear tax)

• Labor may shift to informal sector--lower productivity-problem in transition economies

Impact on employment (cont’d)• Payroll tax > 20% in many countries in region,

even greater than 30% or 40% in some--in contrast to Asia where < 5%, US where = 15%

• Old age security should cost < 20% in well run system in long run

• Distortions increase exponentially with tax. Important to choose system that keeps tax low and avoids peak rates--rationale for pre-funding

Biggest impact on work--retirement age

• Workers retire early if can receive benefits for more years without actuarially fair decrease in pension (6-7% decrease per year of early retirement) (Gruber-Wise)

• Yet, many systems permit this--big problem in transition economies

• Women often allowed to retire earlier, live longer• Longevity increases require periodic hikes in

retirement age--but politically difficult to do this• So experienced labor supply declines; less

productivity and output

Retirement age (Cont’d)• Important to choose system that encourages continued

work--rationale for multi-pillar system with DC plan• In DC plan, when worker retires and converts savings

to annuity in competitive market:– Pension is automatically lower for early retirees– Annual benefit decreases as longevity increases– This encourages more years of work, helps economy and

fund

• But details matter. If DC plan is notional DC:– Government sets conversion rate to annuity – DC advantage is lost if conversion does not depend on

expected lifetime at retirement

Impact on national saving• New PAYG system decreases national saving

– due to increased consumption of first generation covered and expectation that government will pay on-going benefits

• Mandatory pre-funding can increase saving

– builds up fund of investable resources, providing not offset by decrease in voluntary savings or public dissaving (deficits)

• Many countries in this region need more capital, can use funded pension system to increase saving

But: how transition is financed affects national saving

• Suppose given contribution rate is diverted from PAYG to funded system; this is saved. But promised benefits still must be paid.– If financed through increased government borrowing:

doesn’t increase national saving, because public dissaving offsets private saving

– If financed through taxes or cuts in government spending: increases national saving, but heavy current burden

• Mix is possible and probably best

Impact on capital productivity

• Most important, pension funds shift type of saving--committed for long term--can be used for equity investment, venture capital, infrastructure, long term government debt

• Productivity of savings depends on how funds are managed and allocated--rationale for private competitive management

• Regulation needed; but--not over-regulation

Impact on financial market development

• Privately managed funds stimulate stock markets, secondary bond markets, new financial instruments, credit rating agencies, info disclosure (Chile, OECD).

• Aid in corporate governance, minority rights, accountability--if regulated to avoid conflicts of interest

• Credit for large growth effect in Chile

• But: regulations and guarantees accused of distorting financial markets

Impact on government’s fiscal position

• Pension deficits may lead to general revenue finance, less money for important public goods, inflationary deficit finance

• Deficits can be avoided by prefunding

• Transition to prefunding makes implicit debt explicit, increases explicit debt in short run

• Important to have plan to pay off transition debt in long run or advantage is lost

Impact on intra-generational income distribution

• Many people think social security should avoid old age poverty and redistribute to low earners--but most DB plans don’t do this: Studies show little or no lifetime redistribution to the poor– Rich live longer, collect benefits for more years

– Only labor income is taxed

– Ceiling on taxable income

– Pension often based on wage in last 1-5 years

– People who retire early are subsidized

• New system can avoid this but may not--important to include social safety net for the poor

Impact on inter-generational distribution

• In PAYG schemes largest redistribution is to first generations covered, future generations lose

• Reduced savings hurts future generations

• Shift to pre-funding helps future generations

• But--distributional effect depends on how transition costs are financed, since the old promises must be kept: taxes hurt present, debt finance hurts future

How have multi-pillar systems worked? Reform has helped Chilean economy

since 1981

• Employment and wages rose--5%

• National saving increased--7% annually

• Financial markets developed

• Total factor productivity increased--.4-1% per year

• Average annual rate of return over 10% real

Many gains have been made but implementation problems remain

• How can countries cover transition costs--increasing explicit debt v. taxes?

• Administrative costs--are they too high?• Demand for guarantees and regulations that may

distortion markets (herding)• How do investors choose when uninformed?• Collection and record-keeping problems• Annuities markets--how to organize?• This seminar deals with these issues, which

influence economic impact of the reform

Conclusion• Important to choose system that

– is sustainable so promises can be kept,

– distributes tax burden and benefits fairly

– maximizes size of GNP pie, by beneficial labor and financial market effect

• Pre-funding, defined contribution, good fund management and regulations, social safety net and transition finance plan help to satisfy these criteria. But details matter as well as basic design.