We've all heard about the problems that pay-as-you-go pension (PAYG) systems have delivering on their promises. These are the most common public pension systems around the world and many are going bust — largely because as populations age, there are fewer workers making contributions to pay for the pensions of an increasing number of retirees. Well, now we know how to fix them...
The recipes are in a two volume anthology (Vol. 1 & Vol. 2) edited by Robert Holzmann, Edward Palmer, and myself, that came out a couple of months ago. You don't have to read the various chapters, some dealing with quite esoteric topics, but the overview and country cases are worth looking at. After all, reforming pension systems to make them solvent has been grabbing headlines in our post 2008-09 financial crisis debate.
In a nutshell, PAYG pension systems can work just fine — even when populations are aging — if you do the accounting right and societies invest in good jobs.
How well designed PAYG schemes work
Like any financial institution, PAYG pension funds are solvent when their liabilities are lower than or equal to their assets. The liabilities are easy to define: they're equal to the value of the benefits that active members have acquired to date through their contributions plus the present value of the pensions owed to current retirees. The assets used to be a mystery. Most PAYG systems have some "reserves" invested in financial assets (such as government bonds, equities, and real estate) but these are usually only a fraction of the liabilities. So the question was: What is the asset that makes up for the difference?
We now know that the asset — which we call the PAYG asset — depends on the value of current and future jobs covered by the social security. There are various ways to do the calculation (see chapters 18, 19, and 20). But the basic point is that the value of the PAYG asset increases when (i) each job is worth more, (ii) a larger share of working-age people are in covered jobs, and (iii) people spend a larger share of their life in jobs.
So there are two secrets to success. First, make sure that liabilities don't grow faster than the PAYG asset. For this, offer or pay benefits that reflect the contributions made by individuals during their active lives plus the gains from the growth in the PAYG asset. Second, try to get the PAYG asset growing as fast as possible. This means adopting policies to increase participation rates (including at older ages), create more jobs with social security coverage, and boost the productivity of all jobs.
What happens in practice
Easier said than done? Maybe, but these aren't just theories. In the mid-1990s, countries such as Italy, Latvia, Poland, and Sweden began setting up this type of PAYG pension system — called Non-Financial Defined Contribution (NDC) systems because benefits depend on contributions and liabilities aren't fully backed by financial assets. NDCs, or at least elements of them, have started being used around the world. Egypt, before the revolution, passed a law to introduce an NDC, and China is seriously thinking about NDCs to reform its fragmented pension system.
The verdict as these systems enter their teens is that their design can still be improved — and much more should be done to get the PAYG asset growing faster — but the reforms constitute major improvements over the old PAYG systems.
Clearly, the political economy of these reforms isn't easy. In the end, NDCs make PAYG sustainable, because they realign benefits with the value of contributions and gains in the PAYG asset. Any additional benefits — for instance, to guarantee a minimum pension for all — require explicit subsidies that need to be financed through general taxation.
At the same time, one would hope that because NDCs introduce transparency and fiscal discipline, the tradeoffs between subsidizing pensions or other social programs — such as those that support early childhood development or education and health for children — will become clearer. This, in turn, will make it easier to reach a consensus on reforms.
This post was first published on the Jobs Knowledge Platform.
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