Population ageing and pay-as-you-go pensions

Larry Willmore*, United Nations, New York

Documents reviewed

• Joint report by the Commission and the Council on adequate and sustainable pensions. (Brussels:
Council of the European Union, 2003, 6527/2/03 REV 2)
• The 2003 aging vulnerability index: An assessment of the capacity of twelve developed countries
to meet the aging challenge. By R. Jackson and N. Howe (Washington, D.C.: Center for Strategic
and International Studies and Watson Wyatt Worldwide, 2003)
• Germany and the challenge of global aging. By R. Jackson (Washington, D.C.: Center for
Strategic and International Studies and Nationwide Global, 2003)
• Achieving financial sustainability for the social security systems. Report by the commission. Rürup
Commission (Berlin: Federal Ministry of Health and Social Security, 2003). English summary of
Rürup-Kommission, Die Nachhaltigkeit in der Finanzierung der Sozialen Sicherungssysteme.
• Assessing the political sustainability of parametric social security reforms: The case of Italy. By
M. D’Amato and V. Galasso (London: Centre for Economic Policy Research, Discussion Paper
No. 3439, 2002)
• Population ageing and public finance targets. By H. Oksanen (Brussels: European Commission,
Directorate-General for Economic and Financial Affairs, Economic Papers No. 196, 2003)
• Ageing and pensions in the euro area: Survey and projection results. By P.C. Rother, M. Catenaro
and G. Schwab (Brussels: ENEPRI Conference on Ageing and Welfare Systems, January 2003)

Europeans are living longer and having fewer children. The population aged 65 years and older is expected
to increase by 40 million over the next 50 years while the working-age population (those aged 15 to 64
years) falls by 100 million, sending the support ratio –the number of persons of working age per elderly
person– from its current level of 4:1 to 2:1 by the year 2050 1 (see Table 1 at the end of this essay). With
fewer workers available to support each pensioner, a crisis is looming for pay-as-you-go (PAYG) public
pensions. The crisis is one of distribution, however, not of output. No one is predicting a fall in gross
domestic product (GDP), much less in GDP per capita. The European Commission expects productivity
gains and increased female participation to more than offset the effects of a reduced working-age
population, allowing GDP to increase by 1.4% per annum even in slow-growing Italy and Germany (see
the first column of Table 1).

Private and Public Pensions sold to younger workers. If the supply of

financial assets on the market is high, due to
All pension systems –PAYG or pre-funded, large numbers of retirees who want to sell,
public or private, compulsory or voluntary– and the demand for them is low, their price
transfer output of today’s workers to today’s can fall, lowering the market value of the
retirees (Barr, 2000). Indeed, that is their pension fund. Unless financial risk is borne
purpose. Contributors to a public PAYG by contributors (defined contribution), a
system receive promises from government crisis can erupt, despite pre-funding, when
that future earmarked taxes (compulsory revenue from sales of bonds and equity is
contributions) will provide them with goods less than required to meet pension promises.
and services in their old age. When there is
not enough tax revenue to meet pension Governments become involved in the old
promises, a distributional crisis can result. age pension business for two distinct
Contributors to a pre-funded pension system reasons. First, they would like to eliminate
also obtain a claim on future output, but in a poverty among the elderly by assuring all
different way: they accumulate financial residents a minimum income once they
assets (bonds and equity), which are later attain a specified age, regardless of their

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 Population ageing and PAYG pensions

work history. Some argue that the The Analytics of Pay-as-You-Go

responsibility of government stops here. Dr. Pensions
Michael Cullen, New Zealand’s Deputy
Prime Minister and Minister of Finance, In a balanced PAYG system, expenditure in
articulated such a view when he said “the each period equals revenue such that
ability to retire in a degree of personal
comfort, without worry and with dignity, is pR = swL (1)
the least that citizens can expect in a
modern, developed economy.... [I]t is also where p = the average pension and R = the
most they can expect. They cannot expect number of pensioners. Expenditure on
the state to maintain in retirement the pensions, pR, is financed by a proportional
incomes people became accustomed to contribution s (percentage rate 100s) on
during their working lives” (Speech of 13 covered wages. Typically there is a wage
June 2003, quoted in O’Connell, 2004). ceiling above which no contribution is
New Zealand’s public pension is wage- collected, and a maximum pension is
indexed, non-contributory, financed from associated with it. If L workers participate in
general revenue, and given to everyone aged the scheme, and their average covered wage
65 and older who satisfies a modest is w, then swL is the revenue collected.
residency requirement. It is not
employment-tested, means-tested or Equation (1) can be re-written to show that
retirement-tested, but it is taxable as income, the rate of contribution (s) must equal p/w,
so a larger portion is ‘clawed back’ from the replacement ratio, divided by L/R, the
those who continue to work or have other support ratio:
income. (See St. John and Willmore, 2001
and O’Connell, 2004.) In the European s = (p/w)/(L/R) (2)
Union, all governments offer means-tested
assistance and minimum pensions to lift With a constant replacement ratio and a
elderly citizens out of poverty, but only constant support ratio, the proportional
Ireland limits its contributory pension to a contribution is also constant. Pensioners
modest benefit based solely on years of share increases in worker productivity, for
contributions, not income. wages typically track productivity and the
replacement ratio refers to current wages,
The second reason governments become not past wages. In other words, pensions are
involved in the pension business is to insure indexed to wages. If the support ratio is 4
that citizens, in retirement, are able to workers per retiree, and an average pension
maintain the standard of living to which they is equal to 60% of the average wage, then
have been accustomed during their working workers must contribute 15% of their wages
lives. In pursuit of this goal, 14 members of (60/4) to the PAYG scheme.2 Often the
the European Union (Ireland being the contribution rate (s) is known as a payroll
exception) require all workers to contribute tax. In a contributory, earnings-related
to earnings-related pension schemes. PAYG pension scheme, it is better to think
Sometimes this is in addition to a of it as a contribution rather than as a tax,
contributory or non-contributory basic for reasons that will soon become clear.
pension. For the most part, these income-
related schemes are public and operate on a When L/R changes, the PAYG system
pay-as-you-go (PAYG) basis. Each of the breaks down; expenditure is no longer equal
seven studies reviewed here analyses, or to revenue. Suppose that population ageing
claims to analyse, this type of system, so it causes the support ratio to fall by half. To
is helpful to set out the basics using simple balance revenue with expenditure, either
algebra. contributions (s) must double to 30% or the

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 Population ageing and PAYG pensions

replacement ratio (p/w) must be cut by half, as taxes; if so, they are taxes unlike any
to 30%. Either change —or some other, for they are returned with interest in
combination— will restore financial old age. Contributions resemble the
solvency to the system. But what is the purchase of bonds, for the promised
ethically preferred course of action? pensions are implicit debt of government,
just as bonds are explicit debt. There are two
In the case of a flat, basic pension, financed important differences, however, between
from general revenue, the answer is clear: implicit pension debt and explicit public
maintain the gross value of the pension as a debt. First, pension contributions are
percentage of the average gross wage. mandated whereas purchase of government
Provided pensions are universal and taxable bonds is voluntary. Second, pension rights
as income, as in New Zealand, the cannot be transferred or sold, whereas bonds
demographic shock affects pensioners as are freely traded.
well as workers, the latter more than the
former to the extent that the tax system is Early participants in a PAYG pension
progressive and workers have higher system receive a gift, for they obtain full
incomes than pensioners. If basic pensions pensions even though they contribute only
are means-tested and not taxable as income, briefly at the end of their working careers.
they will have to be indexed to average Later participants receive windfall gains as
wages net of taxes rather than the gross well with each increase in the contribution
wages, so that recipients of basic pensions rate. In a mature system, with a constant
retain the same standard of living relative to contribution rate, the Samuelson-Aaron rule
that of an average worker. (Samuelson, 1958; Aaron, 1966) states that
the real return on contributions for the
In the case of an earnings- (contribution-) average participant in a balanced PAYG
related pension, if we view contributions as scheme will equal the sum of the rate of
saving rather than taxes the answer is growth of the labour force plus the rate of
equally clear, but precisely opposite: restore growth of real wages (productivity). This
financial solvency by cutting benefits rather rule assumes a constant contribution rate (s),
than mandating higher contributions from but does not require a constant support ratio
current workers. Contributions to PAYG (L/R) provided the replacement rate (p/w) is
pension schemes are sometimes referred to allowed to vary.

To illustrate the Samuelson-Aaron logic, consider a simple model in which citizens spend one
period of time working and a second period retired. (We ignore time spent in childhood.) For
realism, think of each period as being 30 years in length. Let the number of workers at time t be
Lt and their average wage be wt. The number of workers grows according to Lt+1 = (1+n)Lt and
the average wage grows according to wt+1 = (1+g)wt . The total pension benefit that this
generation will receive when it retires, Pt+1, is equal to the total contribution to be paid by the next
generation: Pt+1 = St+1 = swt+1Lt+1. The ratio of pensions received by retirees to the contributions
these retirees paid while working is Pt+1/St = St+1/St = swt+1Lt+1/swtLt = (1+g)(1+n), which implies
a return of approximately n+g. The Samuelson-Aaron rule assumes that the contribution rate, s, is
constant. If the rate doubles, say from 10% to 20% of covered wages, then Pt+1/St = 2(1+g)(1+n)
and current retirees (who contributed at the lower rate) receive as pension twice the amount they
contributed plus an additional return of approximately 2(n+g). A return in excess of 100% seems
large, but recall that each period is about 30 years long, and a 100% return over 30 years is
equivalent to an annual return of only 2.3%.

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 Population ageing and PAYG pensions

The share of wages in GDP changes only 2000 and 2050” (p. 6). The report looks with
slowly, so the rate of growth of GDP –not favour on containment of this spending,
GDP per capita, but GDP– is a useful proxy noting that the relatively small increases
for the return on contributions in a mature projected for Italy and Sweden “can largely
PAYG pension scheme. So long as GDP is be attributed to the switch to new
rising, contributors to a PAYG system can contribution-defined pension schemes with
receive positive return with no increase in close actuarial links between contributions
contribution rates, regardless of what and entitlements and a benefit formula
happens to the ratio of workers to retirees. which takes account of life expectancy at the
GDP projections of the European age of retirement” (p. 62).
Commission for the next 50 years suggest
that real returns would range from 1.4% in The Report frames the problem as fiscal, as
Germany and Italy to 4% in Luxembourg. a matter of taxes and transfers, thus misses
(See Table 1 once again.) This is the an opportunity to explain that notional
outcome if the contribution rate is held defined-contribution systems run on a
constant and all adjustment is done by PAYG basis, yet are able to mimic pre-
lowering the replacement ratio (p/w), in part funded systems with individual, notional
by increasing the age at which full pension accounts and a notional rate of interest. It
benefits become payable, and making full praises Sweden and Italy for having
actuarial adjustment for earlier pensions. “changed their public pension systems to
Individual participants have the option of notional defined-contribution systems, with
higher income in retirement by postponing the aim of stabilising contribution rates
retirement, saving privately, or contributing across generations and incorporating better
to a private pension plan. incentives to work, thus contributing also to
meet the objective of higher employment
Whether this outcome is perceived as fair rates” (p. 7). This is praise of tax-smoothing
depends on whether mandated contributions rather than intergenerational equity. Support
are regarded as taxes or as forced saving. for constant contribution rates across
Framing is important. Each of the studies generations would be strengthened if it were
reviewed here advocates a freeze on payroll pointed out also that in the wake of a
taxation (contributions). Nonetheless, each demographic shock this produces a much
frames the issue as one of taxes and transfers more equal return on contributions
rather than return on retirement saving. It is compared to stabilization of the replacement
for this reason the arguments are less than ratio.
compelling, even though the policy advice is
sound. Because the Report focuses on taxes and
transfers rather than return on contributions,
Europe’s Pension Crisis it counts as “pension expenditure” most
replacement incomes provided by
The Joint report by the Commission and government to persons aged 55 years and
the Council on adequate and sustainable over. This amounts to “the sum of seven
pensions draws on earlier work of the different categories of benefits: disability
Economic Policy Committee (2001). It is the pension, early-retirement benefit due to
longest (175 pages), the most complete, and reduced capacity to work, old-age pension,
by far the most balanced of the seven studies anticipated old-age pension, partial pension,
under review. Especially useful are the survivors’ pension and early retirement
concise country summaries in the annex (pp. benefit for labour market reasons” (p. 108).
106-175). The Report expresses concern that Many of these benefits are non-contributory
“public spending on pensions is likely to rise and, indeed, are given to individuals
by between 3 and 5 percentage points of younger than minimum retirement age, so it
GDP in most EU Member States between is difficult to see how they might be related

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 Population ageing and PAYG pensions

to reform of the PAYG pension system. The arrangements (percentage of elderly who
generosity of what, in effect, are early live with their adult children), on grounds
retirement benefits disguised as that close ties between the elderly and their
unemployment or disability pensions are the children make it easier to reduce public
reason that workers in many countries are spending on the elderly. Curiously, neither
able to exit the labour force at a young age. old age dependency ratios nor PAYG
contributory pensions are components of
The 2003 aging vulnerability index this index. Contributory pensions are
presents an alternative, more alarmist view included in total public expenditure on the
of the future. Jackson and Howe employ elderly, but this expenditure is swamped by
projections for the years 2000 to 2040 to other types of government expenditure. Also
construct an ‘Ageing Vulnerability Index’ missing are numbers for projected GDP and
for 12 countries, eight of which are members GDP per capita. Positive income growth
of the EU.3 They start from the premise that seems to underlie the projections, but it
the “rising old-age dependency ratio will would help to know its magnitude and
translate into a sharply rising cost rate for variation across time and countries.
pay-as-you-go retirement programs — and a
heavy burden on the budget, on the On the basis of this Index, the authors rank
economy, and on working-age adults” (p. the twelve countries from least to most
iii). But their projected costs include much vulnerable. Three countries score as low
more than PAYG public pensions. In fact, vulnerability, six as medium and three as
they include nearly all public expenditure on high. The only European country in the
those aged 60 years or more, including study to register ‘low vulnerability’ is the
expenditure on civil service pensions and United Kingdom, which ranks between two
health benefits. With such a broad Anglo-Saxon countries, Australia and the
definition, they are able to calculate that the United States. Four European countries
cost of “pay-as-you-go retirement programs” (Sweden, Germany, Netherlands and
in the eight European countries they study Belgium) register medium vulnerability
will increase on average from 14% of GDP while three (France, Italy, and Spain)
in the year 2000 to 26% in the year 2040. register high vulnerability.
The Joint report by the Commission and
the Council, even though it uses a broad The 2003 aging vulnerability index
definition of pension expenditure, projects a attempts to measure sustainability of current
much smaller rise in expenditure, from 10% policies, but it is very difficult to project
to 13% of GDP, for these same eight expenditure other than pension promises
countries over the same period of time. into the future. This is especially true for
expenditure on health benefits, which are a
Jackson and Howe calculate the Ageing large and growing portion of expenditure on
Vulnerability Index from country scores on the elderly in the forecast period, reaching a
eleven indicators. Six of the eleven third or more of total expenditure in most
indicators consist of public expenditure on countries by 2040 (Aging Vulnerability
the elderly in various guises (percentage of Index, 2003, Table 2, p. 34.). It is difficult to
GDP in 2040, growth to 2040, percentage of know with any confidence how much
income of the young in 2040, percentage of government might spend on health care forty
income of the elderly in 2040, percentage of years in the future, much less how it might
total government expenditure in 2040, and allocate this expenditure between the elderly
percentage of elderly that would be pushed and the non-elderly population.
into poverty by a ten percent cut in this Technological change, such as the
expenditure). Two indicators relate to fiscal possibility of transplanting organs of
policy and two to the relative affluence of genetically modified pigs into humans, may
the elderly. A final indicator refers to living make increased expenditure on elderly

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 Population ageing and PAYG pensions

patients feasible, but this does not mean that earnings have the option of opting out and
all desired surgery will be financed by purchasing private insurance instead. It is
government. What evidence there is to date fair to conclude, then, that the 41% figure is
suggests that population ageing in itself unnecessarily alarmist.
currently has little effect on health care
expenditure because expenditures tend to be On a positive note, Germany and the
concentrated at the end of life, regardless of challenge of global aging does a superb job
the age of death of an individual (Economic describing how government incentives are
Policy Committee, 2001, pp. 38-39). Indeed, responsible for the fall in average age of
for reasons that are not entirely clear retirement from 65 to 60 years in the past
(perhaps because of age discrimination), three decades. “Germany, like many
hospitalisation costs tend to peak at 80 years European countries, has tried to create jobs
of age, such that expenditure per capita on for younger workers by bribing older
the oldest old is less than expenditure on the workers to retire. The experiment has been a
younger old (Seshamani and Gray, 2004). failure. Germany now has one of Europe’s
earliest retirement ages and one of its lowest
Jackson and Howe (p. 2) claim that the rates of job growth” (p. 22).
Ageing Vulnerability Index “clearly shows
that global aging is pushing much of the Jackson’s recommendations are somewhat
developed world toward fiscal and economic vague, expressed as “larger reductions in
meltdown. There is still time to avert crisis. pay-as-you-go benefits and providing for a
But time is running short, and the problem is more certain and secure funded alternatives”
worse than is generally supposed.” This may (p. 26), but he clearly favours replacing at
be true, but their Index is unlikely to least part of PAYG pensions with private
convince careful readers. pensions. Financial rates of return may not
be attractive in an ageing, slow-growing
Germany and the challenge of global Germany of the future, but “workers can
aging provides a detailed look at Germany, continue to earn higher returns by investing
making use of projections that underlie The in faster growing economies around the
2003 Aging Vulnerability Index. The world” (p. 25). There are various obstacles
author, R. Jackson, views contributions to to this investment strategy, “including the
PAYG pensions as taxes rather than saving, lack of transparency and security in the
asserting (p. 8) that “payroll taxes, the main capital markets of many developing
means of financing pensions and health-care countries. Much progress will have to be
benefits, already total 41 percent of workers’ made before retirees in Berlin will be able to
wages in Germany”. Somewhat later (pp. entrust their golden years to investments in
10-11) we learn that this is not entirely true. Beijing” (p. 25). Indeed.
“The payroll tax—19.1 percent in 2002, split
evenly between employers and employees— The “Commission for Sustainability in
covers just under three-quarters of total costs Financing the German Social Insurance
[of public pensions]. …. If benefits were Systems”, known popularly as the Rürup
financed entirely by payroll taxes, the Commission after its chairman Bert Rürup,
contribution rate would have to rise to 27 was set up by the German government in
percent.” This is still far from 41%. To get November of 2002 and published its report,
that figure, it is necessary to add in a 14% Achieving financial sustainability for the
contribution that funds, for all ages, “the social security systems, in August of 2003.
entire range of medical expenses, from In the commission’s view, payroll taxes
dentistry to prescription drugs”. Moreover, must be kept below 22% “to ensure that the
retirees who want health care benefits have rising costs of social security in an ageing
to contribute, albeit at a lower, 7% rate, society are spread more evenly across all
while the self-employed and those with high generations” (p. 3). This requires a decrease

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in the generosity of pensions, beyond that strictly work-related, with little

implemented in major reforms of 1992 and redistribution within cohorts. The Rürup
2001, to be accomplished primarily by Commission rejects calls for more intra-
increasing the normal retirement age and by cohort redistribution, such as a larger
modifying the pension benefit indexation minimum pension or reduction of benefits
formula.4 for higher-income earners and, with its
proposed sustainability factor, would bring
The commission recommends a gradual the German system close to the notional
increase in the statutory retirement age from defined benefit systems of Sweden and Italy.
65 to 67 years, to be introduced in monthly Yet the commission makes no mention of
steps over 24 years, beginning in 2011. Life moving to a defined contribution system,
expectancy at age 65 is projected to increase preferring to frame its proposals within the
by three years (to 18.4 years for men and existing defined benefit paradigm, thus
22.6 years for women), so this measure focusing on taxes and transfers rather than
would offset only two-thirds of the increased the rate of return on contributions. For this
pension costs anticipated from longer life reviewer, with no knowledge of German
expectancy. The commission also proposes politics, this seems unfortunate, as it might
that the minimum retirement age be have been possible to address the fact that
increased from 62 to 64 years, in tandem payroll taxes finance only three-quarters of
with the statutory retirement age. Workers the cost of pensions, providing pensioners
will still have every incentive to take early with an excessively high return on
retirement, for the commission was not able contributions.
to propose an increase in the actuarial
adjustment for early pensions, currently set The commission also rejects calls to bring
at a low 0.3% per month (3.6% per year). civil servants into the contributory scheme,
With an actuarially fair adjustment, the age for two reasons: “firstly, the right of civil
at which participants choose to retire would servants to a non-contributory pension is
have no effect on costs to the system, but enshrined in the German Constitution and,
neutrality requires a rate roughly twice as secondly, civil servants’ pensions are
high as that currently in effect. already financed within the pay-as-you-go
system (i.e. out of general taxation)” (p. 10).
The second major reform proposed by the Actually, civil service pensions, because
commission is the introduction of a they are not based on contributions, are best
“sustainability factor” that links pension described as deferred wages. Civil servants
benefits to the system dependency ratio. The accept a lower current wage in exchange for
sustainability factor is automatic: “it raises the promise of a pension in their old age. If
pensions whenever the employment level this pension were contributory, they would
rises and lowers them whenever the number insist on a higher wage and government
of benefit recipients is growing faster than would have to either increase taxes or
the number of contribution payers” (p. 8). borrow (issue debt) to pay it. The real cost
The sustainability factor is based not just on of civil servants is thus much higher than
demography—changes in life expectancy, recorded under the current system of cash
birth rates and immigration—but also on accounting. A good reform would be to
labour market developments. The move to a system of accrual accounting,
commission wisely allows for the possibility setting up at least a notional fund to pay
that increased labour force participation these deferred wages, but the commission
might offset the inevitable increased did not touch this subject. The commission
numbers of elderly and reduction in the was right, however, to treat civil service
working-age population. pensions separately, something authors of
The 2003 Aging Vulnerability Index failed to
In the German pension system, benefits are do.

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 Population ageing and PAYG pensions

In Italy, the Dini reforms of 1995 seek to years, with a life expectancy of 83 years. If
reverse the upward trend in pension the retirement age is 65 years, the median
spending by moving to a notional defined- voter would pay contributions for only 8
contribution system and by reducing the years, and receive benefits for 18 years. “In
incentives for early retirement. The this case, our simulations suggest that the
reformed system appears to be economically social security tax rate would reach 46.8%”
sustainable, but D’Amato and Galasso, in (p. 13). And, if the retirement age is 57,
Assessing the political sustainability of would the model not predict a payroll tax
parametric social security reforms, insist rate of 100%? After all, a majority of voters
that it is not politically sustainable because would be retired, and could vote to transfer
“despite the defined-contribution formula – all income to themselves!
the generosity of the system may still be
easily changed by modifying the conversion This “intergenerational voting game” raises
coefficients. These coefficients transform – interesting issues but is not a good predictor
at retirement – the capitalized contribution of the outcome of a notional defined-
into a pension annuity. The Dini reform – contribution system, for two reasons. First,
and thus its supporting majority – has set if the pessimistic forecast of D’Amato and
these coefficients according to actuarial Galasso were feasible, it would be in
principles as a function of the expected everyone’s interest to assure political
residual life at retirement. Current sustainability of the system by making a rule
regulations allow these conversion that changes in the conversion coefficients
coefficients to be reexamined every 10 years are to apply only to new pensions, not to
to take into account changes in longevity existing pensions, so that retirees would
gains. These regulations – we argue – can have no interest in increasing the generosity
not however prevent future majority from of the system. Second, voting behaviour is
modifying these coefficients towards more seldom so selfish and calculating. After all,
generous pensions, as the population ages. young workers who pay payroll taxes are the
Under budget balancing, this increase in the children and grandchildren of pensioners.
generosity of the system amounts to
choosing a higher tax rate” (pp. 28-29). If H. Oksanen proposes in Population ageing
young workers rebel against tax increases and public finance targets that PAYG
imposed by an elderly majority, the system pension benefits be financed with “a
may well break down. gradually increasing tax rate so that
intergenerational fairness is fulfilled, at least
D’Amato and Galasso assume, in effect, that approximately” (p. 4). Since “the increase in
PAYG pension systems remain tax and public expenditure is mostly caused by
transfer mechanisms, despite attempts to declined fertility and increasing longevity
frame them in terms of notional rates of and … successive age cohorts differ from
return. In their model, the size of the system each other in these respects, it can be argued
depends on majority voting, hence on that these factors should be taken into
preferences of the median voter. Retirement account in setting the tax rate for each
age is exogenous. In 1992 the age of the generation” (p. 11). The revenue from
median voter in Italy was 44 years, the higher payroll taxes would be saved to fund
median retirement age was 57 and life future pension expenditure or, what amounts
expectancy was 78 years. A 44 year-old to the same thing, used to pay public debt.
voter would have expected to contribute to
the system for 13 years and receive pension It is difficult to see how low fertility might
benefits for 21 years, and would set the result in increased public expenditure; the
optimal tax rate accordingly, from a purely opposite is more likely. Perhaps what
private, selfish point of view. In 2050, the Oksanen has in mind is that there will be
median age of voters is expected to be 57 fewer workers to support the next generation

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 Population ageing and PAYG pensions

of retirees. Pre-funding is certainly an option software of the World Bank, and present
in this case, as Oksanen suggests, but so is a aggregate results for the four countries
reduction in benefits, with an unchanged combined. “Hypothetical contribution
contribution rate. Increased longevity does rates”, defined as total pension payments
impact directly on pension expenditure, but divided by wages of contributors, were used
the solution does not necessarily lie in pre- for the base year. This adjustment is
funding this expense. An intergenerationally important for Germany, where a significant
fair alternative is to increase the age at portion of contributory pension benefits are
which full benefits are paid, decreasing financed from general taxation. The system
benefits, in an actuarially fair way, for early is thus balanced in the base year, by
retirement. This has the added advantage of assumption.
encouraging greater participation by the
elderly in the labour force. Rother, Catenaro and Schwab’s baseline
simulations reveal that, with unchanged
Analysts of mature PAYG pension systems contribution rates and increasing
sometimes note the low rate of return they expenditure, the PAYG systems incur large
offer on contributions—expected to average deficits, amounting to 5 or 6 percent of GDP
around 1.5% a year in real, inflation- by the year 2050. They examine two
adjusted terms over the next 50 years in the alternative reforms, one partial and one
EU—and ask “Why not let participants comprehensive, each designed to reduce the
divert a portion of their contributions to present value of these deficits to zero over
private accounts, so they can earn a higher the projection horizon. The “partial reform”
return?” The short answer is that it is simply consists of a combination of changes in
not possible, for all revenue is used for three parameters: i) gradual increase in
payment of current benefits, which is the retirement age, reaching one year in 2010;
very essence of a pay-as-you-go system. If ii) “a rise in the contribution rates by 10%,
participants reduce their contributions, e.g., from 30% to 33%”; and iii) “a
government, to honour its pension promises, reduction in average replacement rates
will have to make up the shortfall by levying sufficient to balance the system” (p. 19).
taxes or borrowing. This situation exists The “comprehensive reform” is radical and
because an early generation received abrupt: “Contribution rates to the pay-as-
pension benefits despite contributing little or you-go system are reduced immediately and
nothing to the system. The difference permanently by 6 percentage points. That
between the market rate of interest and the amount is invested in a funded pillar which
rate of return on contributions to a PAYG carries a net return of 4% after taxes and
system represents a tax, the cost of servicing administrative costs. Replacement rates for
this implicit pension debt. new old age pensioners are reduced to
achieve balance of the system, namely a
Sophisticated analysts recognize the zero present value of deficits. Existing
existence of implicit pension debt, but argue pensioners remain unaffected …, i.e. their
that it might be desirable to burden the pension levels and indexation mechanisms
current generation in order to pay off, at remain as in the partial reform case” (p. 21)
least partially, this inherited debt. Rother,
Catenaro and Schwab present such an The authors prefer the comprehensive to the
argument in their paper Ageing and partial reform, but they are honest in
pensions in the euro area. Using reporting the cost of the transition.
demographic and economic assumptions Participants in the comprehensive reform
similar to those of Economic Policy retiring before 2040 will receive pensions
Committee (2001), they calibrate a model that are as much as 23% lower than they
for four euro area countries (Germany, would be with the partial reform. Even after
France, Italy and Spain) using PROST 2040, pensions are only slightly larger than

AGEING HORIZONS - OXFORD INSTITUTE OF AGEING, Issue 1, 2004 9

 Population ageing and PAYG pensions

in the case of partial reform. Large benefits old age. With these policy changes,
from partial funding do not show up until Europeans can relax and enjoy their longer,
the next 50 year period, 2050-2100. healthier lives and increasing per capita
Nonetheless, as the authors conclude, the incomes.
decision as to who will bear this cost “is a
political question. In addition to leaving it
on new pensioners as in the reform scenario, References
it could be imposed on current pensioners
through lower indexation, on future Aaron, H. (1966) The social insurance paradox.
generations through raising public debt, or Canadian Journal of Economics and
on any combination of these groups” (p. 24). Political Science 32 (3), August, pp.
Of course, imposing the cost on future 371-374.
generations by raising public debt is Barr, N. (2000) Reforming pensions: Myths,
equivalent to eschewing partial funding in truths, and policy choices. IMF
Working Paper WP/00/139, August.
the first instance, except that the implicit
Economic Policy Committee (2001) Budgetary
debt becomes explicit. challenges posed by ageing
populations. Brussels: European
In conclusion, it is the opinion of this Commission, ERC/ECFIN/655/01.
reviewer that these studies are much too O’Connell, A. (2004) Citizens’s pension:
gloomy because they focus on PAYG Lessons from New Zealand. London:
pension systems as systems of taxes and Pensions Policy Institute, March. Posted
transfers rather than as systems of forced at
saving for old age. If contributors to http://www.pensionspolicyinstitute.org.
pensions are treated as purchasers of uk/.
Samuelson, P. (1958) An exact consumption-
government debt, most fiscal problems and
loan model of interest with or without
problems of intergenerational equity the social contrivance of money.
disappear. If workers want to retire with Journal of Political Economy, 66 (6),
more income than is provided by the December, pp. 467-482.
Samuelson-Aaron return on their PAYG Seshamani, M. and Gray, A. (2004) A
contributions, they have a number of longitudinal study of the effects of age
options. They can save voluntarily, they can and time to death on hospital costs.
lobby for government to mandate Journal of Health Economics, 23, pp.
contributions to pre-funded pensions 217-235.
(additional to current obligations), or they St. John, S. and Willmore, L. (2001) Two Legs
are Better than Three: New Zealand as a
can retire at an older age. It is important for
Model for Old Age Pensions, World
government to provide proper incentives, to Development, 29(8), August, pp. 1291-
avoid facilitating early retirement via 1305.
disability pensions or penalizing those who
choose to postpone retirement and save for

Correspondence
Larry Willmore, United Nations, New York:
[email protected]

AGEING HORIZONS - OXFORD INSTITUTE OF AGEING, Issue 1, 2004 10

 Population ageing and PAYG pensions

Table 1. European GDP and population, projections, 2000-2050 (% per annum and ratios).

Real Population Old-Age Support Ratio

GDP Total 15-64 65+ 2000 2050

B-Belgium 1.7 -0.02 -0.25 0.93 3.8 2.2

DK-Denmark 1.5 0.04 -0.11 0.81 4.5 2.8
D-Germany 1.4 -0.17 -0.47 0.93 4.2 2.0
EL-Greece 2.0 -0.06 -0.40 1.09 3.8 1.9
E-Spain 1.8 -0.23 -0.67 1.13 4.0 1.7
F-France 1.7 0.10 -0.14 1.14 4.2 2.2
IRL-Ireland 2.6 0.47 0.23 2.04 5.9 2.5
I-Italy 1.4 -0.36 -0.79 0.90 3.7 1.6
L-Luxembourg 4.0 … … … 4.8 2.6
NL-Netherlands 1.8 0.21 -0.04 1.35 5.0 2.4
A-Austria 1.6 -0.13 -0.49 1.15 4.3 1.9
P-Portugal 1.9 0.17 -0.15 1.33 4.3 2.2
FIN-Finland 1.6 -0.08 -0.38 0.98 4.5 2.3
S-Sweden 1.8 0.07 -0.07 0.86 3.7 2.4
UK 1.7 0.08 -0.11 1.01 4.2 2.4

EU-15 1.6 -0.07 -0.36 1.04 4.2 2.0

Source: Economic Policy Committee (2001), table 3.4, p. 21 and Annex 7, pp. 109-110.

Note: Old age support ratio is number of persons aged 15 to 64 for each person aged 65+.

*
The views and opinions expressed are personal and should not be attributed to the United Nations. Susan
St. John, Doug Walker and Chris Willmore provided helpful comments on an early draft, but are not
responsible for shortcomings that remain
1
All statistics refer to the European Union of 15 members, thus exclude the ten states that joined the EU in
May of 2004.
2
Pensioners collect 60% of the gross wage; this amounts to 70.6% (60/.85) of the wage net of pension
contributions.
3
The eight European countries included in the study are the United Kingdom, Sweden, Germany, the
Netherlands, Belgium, France Italy and Spain. The other four countries are Australia, United States,
Canada and Japan.
4
The commission also discussed reform of health care and long term care insurance, but its key proposals
refer to the pension system.

AGEING HORIZONS - OXFORD INSTITUTE OF AGEING, Issue 1, 2004 11