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.