Systems of retirement-income provision are facing a crisis in many OECD countries as a consequence of the ageing of the population combined with generous social security promises. The vast increases in contributions required in the future to make such systems sustainable demonstrate the scale of imbalances. This has led to frequent calls for funding (accumulation of financial assets in advance of retirement) to replace pay-as-you-go (where workers’ contributions finance current pensions directly). From an economic point of view, funding has a number of advantages over pay-as-you-go.
At a macro level, funding can be seen as a form of burden transfer in the light of ageing, and more generally as a buffer against the need to raise contribution rates at a potentially undesirable time in the future. Second, funding allows for diversification via international investment, thus reducing vulnerability of the retired to the overall performance of the economy, which could deteriorate as ageing proceeds. Third, even abstracting from effects of ageing, funding may offer a higher rate of return than pay-as-you-go if as is likely the return on capital exceeds the growth rate of aggregate wages.
At a micro level, there is typically a tighter link of benefits to contributions than for pay-as-you-go, so contributions are more likely to be seen as saving than taxation. Hence, funding is likely to reduce distortions to labour and financial markets and may reduce the overall economic impact of ageing, by raising labour force participation, and also by potentially raising aggregate saving, thus increasing the stock of capital and output from which future pensions are to be paid. Even if saving remains stable, it may shift towards longer term instruments such as equities, which may favour productive investment, enhance the development of capital markets and hence promote efficient resource allocation. Funding may also increase overall economic efficiency and flexibility by providing workers with a stake in the profitability of firms.
Despite these arguments, a wholesale switch to funding may not be desirable or even feasible, particularly because funding is unable to redistribute to elderly persons facing poverty in the way societies typically prefer; and more generally funded pensions are often ill-suited to low income workers or those with broken career patterns. Also, it may be optimal to provide both forms of retirement income as a means of diversification, because pay-as-you-go and funding are subject to different risks, respectively, the political risk that obligations will be reneged upon by governments and market risks of low returns on investments) which are to some degree independent of one another. It cannot be ruled out that returns on investment may fall at a global level as funding becomes more widespread.
Furthermore, switching to funding does not relieve pressure on public finances in the short run, as existing pension promises need to be met. Hence there is a need for a rather contractionary fiscal stance, and the likelihood of political resistance to generations in the transition being thereby forced to pay twice” for pensions, once for the previous generation via pay-as-you-go, and once for its own via funding. These points raise an important public policy issue of how a transition to be financed and the burden distributed between generations.
The polar opposite to raising contributions is to recognise the implicit government obligations arising from pay-as-you-go, and convert them immediately to marketable debt, so the transition is financed largely by future generations. However, given the scope of net accrued obligations under pay-as-you-go - typically well over 100% of GDP in OECD countries - this would seem not to be feasible without severe effects on financial markets and on confidence in the economy. Accordingly, OECD governments have preferred in current circumstances to focus largely on scaling back their benefit promises to current and future generations, implicitly “defaulting” on part of their pension obligations. Such a process of reform may facilitate a partial switch to funding.
Turning to relative advantages of types of funding, one may distinguish public funding (“trust funds”) from private funding. Labour mobility problems typical of voluntary private schemes can be avoided by a compulsory funded public scheme. Difficulties are that if there is a degree of redistribution, contributions to a trust fund may be seen as taxes, thus engendering market distortions. Moreover, a trust fund may induce higher government consumption or even fiscal deficits, thus actually reducing national saving. Investment in government bonds, typical of such funds, contributes little to retirement income security. Even if used to fund capital investment, finance may be diverted to unprofitaable projects for political reasons. Lack of international investment typically leads to over- dependence on the performance of the domestic economy.
Private funding avoids some of these difficulties. Benefits to saving arising from a switch from social security are more likely, as workers should perceive contributions as saving invested at market rates of return. Fund managers may focus on maximisation of return for a given risk, which will ensure efficient allocation of funds. By being more able to invest internationally, they may avoid being constrained by limited investment opportunities in the home economy and reduce risk. Defined contribution plans are more capable of meeting individual preferences, while defined-benefit plans may provide intergenerational risk-sharing similar to pay-as-you-go. It should, however, be noted that private pensions have some disadvantages, notably cost of
regulation, administrative costs, vulnerability to market risks (notably for defined-contribution funds), inability to redistribute and, for defined-benefit funds, obstacles to labour mobility. Final-salary defined-benefit funds may increase incentives of employers to lay off older workers, as the rate of their pension accruals increases as retirement age approaches.
On balance, we would favour a partial shift to funding via reduction of social security promises and encouragement of voluntary private pensions, while ensuring regulatory provisions are set to overcome some of the difficulties noted above.
E Philip Davis is with the European Monetary Institute in Frankfurt. The views of the author are set out in more detail in his book ‘Pension Funds, Retirement Income Security and Capital Markets’ published by Oxford University Press in 1995. See also ‘Can pension systems cope?’, published by the Royal Institute of International Affairs in 1997”