Sunday, March 22, 2009


The issue of pension reform is definitely the most challenging macroeconomic issue in the time to come. Faced with unfavorable demographic situation, economic policymakers in Western countries will need to reconsider the structure of the pension system to ensure the long-term sustainability of pension systems and overall macroeconomic stability as well. Negative demographic trends, namely a decreasing labor supply relative to increasing retirement rates as post-WW2 baby-boom generations retire and the burden of the welfare state is beared by the existing labor supply thru higher tax burden unless the reforms are launched.

Jose Pinera predicted (link) that Europe's aging population and the unsustainability of pension systems in the Euroarea could distort the functioning of optimum currency area and, consequently, launch a series of instability issue in the euroarea due to the inability of fiscal policies to cope with the exponentially growing net financial liabilities to the retirement system. Ageing population is, of course, more pronounce in the euroarea and Japan compared to the United States or Canada. In G7, assuming ceteris paribus, dependency ratio is expected to move from 40 percent to 70 percent by 2050.

The evidence from the OECD predicts that by 2050, Spain and Italy will face the highest dependency ratios. In Sweden, where private retirement accounts have been introduced (link) as a long-range supplementary to PAYG system back in 2000 (link), the trend of the ratio of population aged 65 and over is expected to reverse between 2030 and 2040. The United States is the only advanced country where the share of population aged 65 and over is not expected exceed 40 percent of the overall population (link).

Recently, Martin Neil Baily and Jacob Funk Kirkegaard of the Peterson Institute wrote a book entitled US Pension Reform: Lessons from Other Countries (link). The authors examined the prospects for the reform of the pension system in the United States considering the evidence from abroad. They showed that southern (Spain, Italy, Greece, Portugal) and continental (France, Germany, Belgium, Austria, Hungary, Slovenia) European countries are in the dead-end scenario of weak total assets of the pension system, unsound government finances. Although Austria, Spain and Belgium had a surplus structural fiscal balance in 2006, these countries are still unfamous for high corporate and personal income tax burden which has, by all empirical proportions, a negative overall effect on labor supply as working time is substituted for leisure activities, while as those of you who studied introductory micro and macro, productivity is the key to higher standards of living.

There is a three-step approach that European welfare states must face sooner or later if these countries want to avoid a continuous macroeconomic crisis whose effect is similar to oil supply shocks in 1970s. First, pension systems should be privatized by the introduction of private retirement accounts and PAYG net financial obligations should diminish gradually either in the framework of fiscal policy rule or in terms of partial lump-sum in the intragenerational transfer. Second, the transition to private retirement accounts must ensure the combination of risk-management approach to portfolio investment and returns managed by private pension funds. Sound and smart regulation should not be avoided such as the avoidance of investment into toxic assets backed by subprime mortgages where a decreasing interest rate has virtually inflated assets prices and propelled a the burst of the bubble that spurred the financial crisis in 2008/2009.

However, lessons from financial crisis and financial innovation will probably peer the question whether pension funds shall benefit from investing in asset-backed securities. Traditionally, pension funds diverse the portfolio structure by hedging or diversification into a stable and predictable rates of return with low beta coefficient on most of securities as pension fund managers aim to reduce the variability of return rates as risk fluctuates except for in optional accounts. And third, European countries should immediately deregulate its rigid and inflexible labor markets and also strongly decrease marginal and average tax rate on personal and corporate income and should nevertheless immediately raise the retirement age in the effort to stimulate labor supply and avoid early retirement. The combination of high tax burden, early retirement age and inflexible labor markets is a vicious circle where stagnation, ageing time bomb and macroeconomic crisis are the main consequence of delaying pension reforms into the future while such reforms never really happen.


denis bider said...

It seems to me that what needs to happen for the pension system to work out is not necessarily privatization, but measures to decrease the dependency ratio. Privatization in itself is not going to decrease the dependency ratio, unless it does so through a normal market mechanism of yielding low returns due to overcrowding (too many would-be pensioners), and thus forcing people who can keep working to keep working. If this happens, there is going to be a strong negative backlash against privatization, since people will blame their need to continue working on privatization instead of blaming it on demographics, which is the real cause.

The major goal we would want to achieve with privatization, I think, is to make the pension system independent of the government budget, to make it self-financing. If the pension system is in a state where it cannot finance itself, then letting it depend on tax revenue is postponing the inevitable, making the Ponzi scheme larger, causing a greater mess when it eventually breaks. And it is unfair.

What we don't necessarily want to do, I think, is force the pension system to invest its assets on the market. A private pension system with volunteer members could very well work in much the same way that it works today. People could have individual accounts, but these accounts would not necessarily imply linkage to actual existing assets, or an obligation of the system to pay out what is in the account. Instead, account balances would provide a relative measure of how much one person can be extracting from the pension system relative to others.

When it comes down to it, it doesn't matter how you structure the pension system; in all cases you have younger people working for retired ones. I don't think that you necessarily need to bring actual asset ownership into the equation. On the contrary, exposure to market fluctuations may make the pension system less robust than it might be.

It seems reasonable to me if a pension system is designed so that it takes dues from those who want to receive a pension in the future, and turns around and pays the money out directly to retirees. If the pension system is to operate perpetually, I don't see how it is economically any more efficient if, in addition to the inflows and outflows, it also has to manage a bunch of assets that may, at times and unpredictably, strongly depreciate.

Perhaps a system that operates on a direct transfer basis has to be a single, government-run one, because it has to have a credible property of perpetuity in order to work, whereas a private system cannot have a credible property of perpetuity. Even so, the pension system's finances can be divorced from the state - this can possibly be ensured by constitution - and fairness can be achieved with individual "accounts".

Finally, people are ringing the bell about the soundness of our existing pension systems in the face of demographics, but I don't really see this as a huge issue. The dependency ratio can be shifted dramatically by simply slowly increasing the retirement age by a few years. This is the default adjustment that is going to happen, and things will continue to work just fine after it does.

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