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Pension Reform in Developing Nations

Philip Longman

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Even among the advanced welfare states of Europe, efforts to contain pension costs are now common. The United Kingdom, Sweden, Germany and Italy have all enacted partial privatizations of their pension systems in recent years. France has made changes to its public sector pension provision while Greece recently approved pension reforms in order to comply with European Union regulations that limit government borrowing in spite of widespread protest strikes. Spain has been debating reforms to its pension system for years while Hungary and Poland have both adopted hybrid systems, in which traditional plans are being phased out and replaced by mandatory savings requirements.

In part because of their need to attract and retain foreign investment, and the need to be seen to be following World Bank and IMF reform programs, some developing countries have been forced to make deep cuts in their public pension and Social Security systems that would be politically unthinkable in richer countries.

Under pressure from the World Bank and other foreign investors, such developing countries as Argentina, Columbia, Uruguay, Mexico, El Salvador, and Croatia have all engaged in pension reform efforts over the last ten years. Pension reform is often economically and politically painful. In China, there have been frequent street protests, and even riots, by pensioners who lost their benefits when state-sponsored industries failed. In both France and Italy, proposed pension reforms caused governments to fall during the 1990s. The political and financial instability that gripped Argentina at the turn of the century was partly attributable to its costly efforts to reform its pension system. Nonetheless, most countries around the world will likely experience mounting pressure to reform or at least contain the cost of their pension systems for two fundamental reasons: 1.) Aging populations and 2.) the pressures of globalization.

Aging Populations

The increase in the average age of the world’s citizens is a phenomenon most pronounced in the industrial countries of Europe and Asia. But it is also rapidly gathering momentum in many parts of the Third World, as birthrates fall and life expectancy increases. In the Western Hemisphere, Barbados, Cuba, Trinidad, Martinique and Guadeloupe are among the Caribbean locales with birthrates lower than that of the United States. Tunisia, Lebanon, and Sri Lanka have likewise joined the ranks of nations in which the number of births is no longer sufficient to keep the average age of citizens from increasing, or even to prevent an absolute decline in the number of working-age individuals over time. Other developing countries with birthrates currently below replacement levels include China, Russia, Kazakhstan, Bosnia/Herzegovina, Thailand, Singapore, Macedonia and Georgia. Even in North Africa and among the Persian Gulf states, birthrates are declining, and the relative burden of supporting the elderly is increasing, though at a much slower rate than elsewhere.

Population aging is a product of many trends most people would view as positive, including improving sanitation and health care delivery systems that have cut infant mortality and boosted life expectancy in many countries, and the expanded roles available to women, which have reduced economic incentives to raise large families. And in many developing countries, this demographic transition is occurring at a much more rapid pace than it did in the industrial nations. In France, for example, it took 140 years for the proportion of the population age 65 or older to double from 9 percent to 18 percent. In China, the same feat will take just 34 years; in Venezuela, 22. Moreover, according to United Nation’s projections, developing regions will experience far larger growth in the absolute size of their elderly populations over the next half century than will developed regions. In lesser-developed countries, the population 60 and over is expected to quadruple from 374 million in 2000 to 1.6 billion in 2050. The developed world at least got rich before it got old; the Third World is growing old before it gets rich.

Unfortunately by reducing the number of workers available to support each retiree, population aging also puts great strains on Social Security systems. In 1955, for example, Chile’s Social Security system had 12 active contributors per retiree, but by 1979 there were only 2.5 contributors paying into the system for every retiree collecting a pension. As in many developing countries, the trend was exacerbated a growing underground economy that further reduced payroll tax receipts. By 1980, the system was running a deficit equal to 2.7 percent of gross domestic product, and the cost of honoring all its future pension promises exceeded the country’s total annual output. Because of these pressures, Chile became in 1981 the first country to privatize its Social Security system.

Pressures of Globalization

Globalization, or the increasing integration of the world economy, also continues to put pressure on both developed and developing nations to contain their pension costs. This was seen in Eastern Europe in the early years of the decade, where countries hoping to join the European Union had to contain their pension spending before they were even considered for admission. More generally, countries with inefficient industries that are suddenly exposed global competition often find they can no longer afford to pay for generous pensions. This has occurred most dramatically in China and the former Soviet Union. There, poverty among the elderly exploded during the 1990’s following the failure or privatization of many state-sponsored industries to compete in a market-based economy after the collapse of Communism. When state-run companies had to compete in the global marketplace, many went under and were unable to pay pensions.

Globalization has also been accompanied by large flows of immigrants moving from poor to rich countries—a trend that often exacerbates the challenge of population aging in the developing world.. This is particularly a problem among Caribbean countries, which have both low birthrates and high rates of emigration, leaving fewer and fewer young people available to support the aged left behind.

Policy Prescriptions

Even the most committed advocates of Social Security, such as the International Labour Organization, now concede that population aging and globalization pose huge challenges to any system of collective provision for old age. But how individual nations should go about meeting that challenge is a subject of increasingly hot debate.

In 1994, the World Bank published an influential report, entitled Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth, which highlighted the bank’s deepening concern that the high and growing cost of pensions in many developing countries is a major drain on economic efficiency. In the bank’s analysis, the best way for countries to manage their pension cost is to create a three-tiered system.

  • The first tier, funded by payroll taxes or general government revenues, focuses on providing minimum benefits to the most needy.
  • The second tier is a so-called “pre-funded,” system, in which workers must make contributions towards his or her future pension; under these so-called “defined contribution” plans, future retirement benefits depend on how well, or poorly, an individual manages his or her own retirement account.
  • The final tier relies on voluntary savings, which allow individuals to choose how to allocate their income over their lifetime.

In broad outline, this is the blueprint adopted by pension reformers around the world, although many variations in detail are possible. World Bank staffers have been engaged in pension system reform work along these lines in 30 countries. The record of pension reforms around the world shows, however, they often impose huge hardships and economic dislocation—at least in the short term.

Key Concepts

The record of pension reforms around the world shows, however, that they often impose huge hardships and economic dislocations—at least in the short term. Argentina, for example, attempted to follow the World Bank’s prescriptions for pension reforms by enacting a system of individual retirement accounts. But the cost of this transition reached three percent of Gross Domestic Product by 2000—a cost the country could not bear given its other financial difficulties as the crisis took hold. The subsequent economic recovery has meant that the reforms have brought some relief to state coffers, but the evidence at the moment is that the problems of low compliance and coverage have not been resolved. Elsewhere, charges of corruption, and high administrative costs, have tarnished pension reform efforts. In many of the poorer provinces of China, for example, money intended to help younger workers pre-fund their retirements was instead diverted to paying for current retirees. Journalists covering pension reform efforts need a clear understanding of the key concepts involved, and also a shrewd eye for how theory may not be working out in practice.

“Pay-as-you-go” financing. The rhetoric used to describe traditional Social Security systems often gives the impression that they operate like insurance schemes: workers make “contributions” and beneficiaries collect “earned benefits” that are paid out of “trust funds”. But in reality these systems function as devises for transferring income from one generation to another. The money today’s retirees pay into these systems during their working years is used to pay for people who have already retired. Sometimes it is also used to pay for government operations.

Advantages and Disadvantages:

The system works well so long a country’s population and economy continue to grow robustly, but breaks down when population aging and a slower economic growth set in. Increases in productivity, or the rise in wages after accounting for inflation, can help sustain pay-as-you-go systems, as can cuts in future benefits, but so long as there are consistently fewer workers available to support each retiree, such systems will be under strain. Does your country have a pay-as-you-go system? If so, is the population growing? What about your country’s productivity? If both of these rates are stagnant or negative, try to find out if any economists or institutions have calculated how long it will be before the pension system runs out of money.

Trust-fund financing: Some governments, such as the United States, use so-called trust funds to keep track of the long-term financial position of their Social Security systems. It is important to realize that, with important exceptions such as Denmark and Norway, these funds usually consist simply of paper claims on the income of the next generation of taxpayers. The so-called “assets” that these trust funds contain are bonds that the government has issued to itself. In essence, the bonds are IOUs that the government has written promising to pay money in the future with taxes it hasn’t yet collected. In an economic sense, these bonds convey no real wealth that can be used to defray the future cost of these programs. Though they may play a role in reducing a country’s need to borrow from financial markets (or raise taxes) in the short term, they are best understood as an accounting device that measures the sums future taxpayers will have to contribute over time to finance the pension promises made to future retirees.

In many countries, this implicit pension debt, or unfunded liability, is far larger than the official national debt, and effectively just as difficult to repudiate. As it comes time to make good on pensions promised to future retirees, these unfunded liabilities the government will have to meet them through some combination of raising taxes, cutting benefits, or borrowing from financial markets.

“Trust fund” financing forces governments to calculate in long-term deficits in their Social Security system, even if they do nothing to fund those deficits. The arrangement may also help build political support for Social Security systems by creating an impression that funds are being set aside in reserve to pay for future benefits. Yet talk of “surpluses” building up in trust funds can be highly misleading to the public, and also provide governments with an excuse for spending more money than they actually have. Ask, what are the unfunded liabilities in your country’s pension system? Has your government issued debt to try to account for those liabilities? Does your government’s budget include this information? You should try to include this information when calculating the government’s performance in reducing national debt or balancing the budget.

Pre-funding. Pre-funding is where each worker must make contributions towards his or her future pension; under these so-called “defined contribution” plans, either individual retirement accounts are created, or the government directs the investments and uses the returns to pay promised Social Security benefits to workers in the future. Advantages and disadvantages: In an aging society, making the transition from “pay-as-you-go” financing of Social Security, to one in which each generation pre-funds the costs of its own retirement, will theoretically save money in the long run and defuse the ticking time bomb of implicit pension debt. That is because, each generation gets the benefit of compound interest on its investments during its working years. Yet in any effort to move from a pay-as-you go to a pre-funded system, there is a key challenge to be surmounted, namely the cost of financing the transition. If benefits are to be preserved for the current generation of retirees, current workers will have to bear that cost PLUS pay for the pre-funding of their own retirement. As the World Bank acknowledges in one of its publications: “Moving from a pay-as-you-go to funding means that current workers pay twice: for both their own (funded) pensions and current retirees’ (pay-as-you-go) pensions.” This transition cost, known as the “double burden” problem, bedevils all proposals to move toward pre-funding of pension costs. Is your country planning on making this change? Can it afford to make this investment without causing undue economic hardship in the short-term?

Key Things to Watch For:

  • Hidden costs. Though a country’s current “pay-as-you go” pension scheme may be unsustainable, political leaders are often reluctant to communicate the true costs of reform. A frequent ploy is to suggest that government finance the cost of the transition by issuing new debt. Yet if the pension debt built into the old system is simply replaced by new bonds sold to the public, how will future generations of taxpayers benefit? In effect, the debt is still there. Be wary of claims that pension reform can be achieved without any group—current taxpayers and retirees, or future taxpayers and retirees—sharing in some measure of sacrifice. Some countries have sought to avoid raising taxes or cutting benefits by borrowing against future tax receipts. However this does little or nothing to reduce a pension system’s long-term deficits. In the simplest economic terms, investment equals deferred consumption—by someone.
  • Ask what the overall change is in the nation’s savings rate, and in the national debt level as a result of a change in the pension scheme. What are savings rates and debt levels doing in the short and long-term? What does the government project for these levels? How much debt do independent economists think your country’s economy can stand to take on?
  • What is the cost involved in switching to a pre-funded system? During the transition, workers may, for example, earn 10 percent annually on their retirement accounts, but the same generation will be responsible for paying all or much of the cost of honoring benefits promised to current retirees. An honest reckoning of the rate of return available to participants in the new, pre-funded system must take this liability into account.
  • Rates of Return. Pension reformers also sometimes make dubious claims about the rate of return individuals or governments are likely to make through investment of pension funds in private securities, such as the stock market. Historically, the long-term return on stocks in developed countries has averaged 7-8 percent after inflation. In contrast, unless a country has a growing population, the returns that a “pay-as-you-go” system can offer each generation of participants (without any future increase in taxes) will be limited to the country’s underlying rate of productivity growth, or the amount wages increase after inflation, which rarely averages more 2-3 percent annually. But claims that participants will get “a better deal” from a pre-funded pension plan that invests in stocks than from a pay-as-you-go system can be misleading because:
  • Money invested is private securities is inherently at risk; markets are volatile and past performance is no guarantee of future reward, as the current global financial and economic crisis amply demonstrates. Though pay-as-you-go systems are also vulnerable to economic depressions, losses are not born exclusively by individuals who made failed investments, as they are under defined-contribution plans, but are instead spread out across the entire pensions system.
  • In small countries with under-developed capital markets, requiring citizens to invest their whole retirement nest egg in the domestic economy can be imprudent. The entire Russian stock market is worth less than a moderate-sized U.S. company, for example. A country may have a deep need for increased savings and investment, but individual savers need to hedge their risks by investing in a wide portfolio of holdings, which may not be possible so long as they are required to invest only in domestic companies. Unfortunately, this is precisely what the World Bank and many governments prescribe. Notes economist Laurence Kotlikoff: “In effect, the Bank is telling citizens of developing countries to do something it would never suggest to its own employees - namely, to invest their retirement assets in a single, small country that may default on its bonds and whose corporations do not meet western standards of accounting or corporate governance.” Does your country allow workers to invest pensions outside their own country? If not, what is the worth of your country’s stock market? What is its historical rate of return and how safe are investments there?
  • There is also good reason to believe that the return on capital will decline in the coming decades even in advanced countries. In the long run, interest rates paid to savers, as well as the value of stocks and bonds, are to a large extent a function of supply and demand. To the extent that both people and governments save more to pre-fund the cost of retirements, the world’s supply of financial capital should (all else being equal) increase. This rise in supply implies a decrease in price, and thus reduced premiums, or rates of return, paid to savers. At the same time, the slowing growth of the labor force should—again, all else being equal—lead to higher wages, leaving fewer resources available to compensate investors.
  • The cost of administering defined-contribution plans has to be taken into account. These costs are often substantial, particularly during the early years of a transition to a pre-funded system. Has your government said how much it is paying for the administration of the pension system? Is it being done by a department of the government, or was the contract given to a private company?
  • Alternative Reforms: Consider whether pension reform can be achieved by measures short of full privatization, especially if your country is likely to struggle with the costs of making a wholesale change in the pension system. Ask if you government has considered other options such as:
  • Including a large underground or informal work force that escapes, or is excluded from, participation in the national pension scheme, as a potential new source of funding. The United States, for example, has helped preserve its Social Security system to date by expanding its coverage to occupations previously excluded, such as doctors, clergy, domestics, farm workers, and public employees, as well as by embracing a dramatic increase in the number of women working outside the home and therefore paying taxes into the system.
  • In countries where the labor force is shrinking, has the government done anything to encourage young workers to stay at home, rather than emigrate? What government policies, corruption etc. are driving young workers away?
  • In some instances, the long-term solvency of pay-as-you-go systems may also be achieved through increases in productivity. Is the government giving priority to policies promoting productivity, including effective spending on education and other measures to improve the quality of the workforce?

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