"A Model for Pension Reform in 21st Century Europe"
Date:20-3-2003
by Gosta Esping-Andersen
Professor, Universitat Pompeu Fabra
Today, pension spending accounts for roughly a tenth of GDP in most EU countries. Assuming no change in entitlement rules or benefits, population aging alone will raise this level by 30-50 percent over the next 3-4 decades. Concomitantly, we shall witness a sharp fall in the ratio of contributors to recipients. The real challenge we face is how to ensure that we can meet this additional financial obligation.
The ongoing debate is overly dominated by actuarial concerns. This is like putting the cart before the horse. Actuarial issues only become relevant once we have decided how to allocate the additional spending burdens. The first question to be settled is distributional, about equity. The debate is also way too myopic, one-dimensionally focused only on public expenditures. This leads to poor analysis. The additional burden is equally real to citizens whether it appears in public or private financial accounts. Unless we are prepared to accept an erosion of retiree well-being, total pension outlays - be they privately or publicly financed - will inexorably rise.
We can assume that most policy makers insist on maintaining pension benefit standards at levels similar to today's. Indeed, this is more or less enshrined in the EU's 10 principles for pension reform. There are solid reasons for why we need to maintain adequate guarantees. The heightened concern with social exclusion and less stable careers mirrors a reality in which a sizable share of today's young citizens may fare poorly in terms of amassing private wealth and/or pension credits. The move towards life-time contributions for pension calculations, already under way, will punish workers who suffer poor careers. Hence, basic income guarantees may remain important as a way to respond to the new risk structure.
Principles of Allocation
We need a decision rule for how to fairly allocate the additional costs of population aging. To repeat, the added costs will not disappear if we privatize. Schematically, we can imagine two extreme scenarios. In the first, we continue unabated with the conventional PAY-GO defined benefit model. In this case, all the costs of population ageing will fall on the working population. Besides appearing quite inequitable, this scenario may create severely negative prospects for job growth since it inevitably raises contribution and tax rates on employment. For example, German contribution rates were projected to rise from 22 to 38 percent of wages. The second extreme scenario is one with a fully funded, defined-contribution pension regime. This scenario is equally problematic in terms of fairness because it implies double-financing among current contributors. In a fully funded system, the entire additional expenditure burden will end up falling on the shoulders of the retirees themselves.
The core issue of pension reform is to find an equitable formula that, at once, minimizes contribution rate growth and allocates the additional costs fairly between retirees and workers. A choice in favour of inter-generational equity must, however, also consider intra-generational fairness. As we suggested in our report for the Belgian Presidency of the EU (Myles, 2002), the Musgrave rule of fixed relative position is as good a method as any to arrive at a fair and stable allocation of the additional expenditure burden between the generations. The idea is to fix, once and for all, a relative per capita GDP ratio between the 'old' and the 'young' Any necessary additional spending would, according to the principle, be allocated to either in accordance with the pre-defined proportionality. Once the ratio is fixed, the tax rate is adjusted periodically to reflect both population and productivity changes. The main problem here, of course, is how to initially fix the ratio -- a task that undoubtedly is easier to undertake in polities capable of forging broad social pacts. A second obstacle is that it would be difficult to apply to private and occupational pension plans that are not under government control. Thus, in a dual pension system, the equitable financing that may be obtained in the public pension regime may be undone by behaviour in the private pension market.
The intra-generational equity problem is a question of welfare distributions within any given cohort of retirees. The necessary starting point has to do with heterogeneous life courses and 'generational luck' (Wolfson et.al., 1998; Thompson, 1998; Myles, 2002). The point can be illustrated by comparing two historical cohorts. If we look back at the 1950s and 1960s, we find high poverty rates among the elderly across all OECD countries. They were poor because public retirement plans were ungenerous, but also because they were 'unlucky' generations. When we examine pensioners today, we will find very little poverty in virtually any country - whether or not public schemes are generous. The reason has to do with generational luck as much as with pension policy. The pensioner cohorts of the 1950s were poor mainly because they had poor lives: Born at the close of the 19th Century, their youth was marred by World War I; their careers straddled the difficult 20s, the depression of the 1930s, and World War II. In brief, they were unable to accumulate much during their life time and this was especially the case for the weakest. Moving forward, today's retirees are broadly well-off (typically their disposable income hovers around 80 percent of the national mean) in large part because they had good lives: beginning their careers during the booming post-war decades, generally enjoying job security and rising real wages, they have accumulated substantial savings and resources. Even low-skilled males did quite well in the post-war era.
The quest for intra-generational equity must start with knowledge of the kind of life course that contemporary youth is likely to face. Happily, we can rely on more than fortune tellers and crystal balls. Starting poorly (especially in terms of human capital) in the 'new economy' is likely to have lasting adverse consequences. Citizens with less than the equivalent of secondary education will face strong probabilities of labour market precariousness and low pay. They will, in say 2050, look more like the retiree generation in 1950 than those now in retirement. It is also well-documented that not only is average longetivity increasing (we now live 10 years more than did our grandfathers) but that longetivity is positively correlated with socio-economic status: the resourceful live longer and will, therefore, end up consuming more pension benefits. Simply combining these two factors leads one to conclude that intra-generational equity must, at a minimum, require some basic, universal, and progressively financed, pension guarantee. As we proposed to the Belgian Presidency, the single most obvious policy is a first-tier, flat-rate, and general revenue financed 'peoples' pension' of the sort traditionally provided in Scandinavia. If the guarantee were pegged to just above the poverty line, the additional cost to the exchequer would be surprisingly modest (about 0.07-0.08 percent of GDP in countries like France and Germany).
Ensuring Long-term Sustainability
Equity principles will guide us as to who will pay and benefit, but do not address the underlying financial pressures. These can, of course, be eased. If we a priori exclude a serious roll-back of benefit levels, the parameters that we can manipulate are few: those that affect the size of the contribution base (the actives) and the recipient base (retirees). Rebalancing the two is urgent for future financial sustainability, as well as for top-priority EU goals, such as maximizing employment. Rebalancing the two is also integral to the goals of equity.
The ultimate cause of population aging is low fertility. Yet, a return to replacement fertility now is unlikely to resolve the sustainability problem over the next decades in any event. Immigration is often cited as an alternative solution. Unfortunately, the most comprehensive simulation models show that realistic levels of immigration can help, but will not make a decisive difference. Only very unrealistic immigration scenarios, such as one exclusively based on skilled, prime age males (and without family reunification), will make a huge difference in terms of financial equilibrium. This leaves us with the two most realistic and effective policy options: raising overall employment levels among women and raising retirement age. In some EU countries female employment rates are below 40 percent. These, like Spain and Italy, are also countries that face extraordinarily problematic long-term scenarios. Raising employment to Nordic rates (that are almost double) will augment the future employment and contribution base by almost 25 percent in the most extreme cases - in other words, this is potentially a far more effective policy than the immigration option. The main challenge with the 'women's-employment' strategy is that it will likely further aggravate the fertility crisis unless accompanied by adequate day-care provision.
The last - and by far most effective - solution is to raise the age of retirement. Some estimates suggest that postponing average retirement age by ten months is financially equivalent to a ten percent cut in pension benefits (OECD, 2001:69). Available prognoses and simulations give divergent results. Several indicate that a return to age 65 as the norm would come close to 'balancing the books'. Delaying retirement is a very effective tool because it cuts both ways: reducing pension years while raising contribution years simultaneously. Delaying retirement is a policy in harmony with the Musgrave model of inter-generational equity and is, furthermore, even desirable considering ongoing trends in education and health standards among older workers. For one, the huge educational gap that exists now between old and younger workers will disappear within the next ten years or so (when the baby-boom generations arrive at retirement age). Additionally, the health conditions of older workers are improving rapidly. Average expected 'disability-free' years for a 60 year old male are now more than ten. One widely assumed obstacle to delayed retirement, namely citizens' preference for early exit, may not be as problematic as we think. Still, two principal problems do remain. Firstly, while older workers' productivity declines, seniority-based wage setting implies constantly rising earnings, and this affects employers' incentives to keep older workers. Secondly, given that life expectancy is correlated with socio-economic status, delaying retirement will be unfair to the lower income workers (for whom a curtailment of 'leisure years' will appear relatively more drastic).
As Wolfson et al (1998) argue, the welfare inequalities within one generation swamp all differences between generations. The equity and the cost problems associated with any pension reform would be far more manageable if inequalities in earnings, careers, and life-long resource accumulation were minimal. Such inequalities spring from conditions in childhood and youth, including the impact of social origins. When we discuss pension reform we must think in terms of long-term horizons; in terms of half a Century at the least. It is therefore that I insist that good pension policy must take a life course perspective and broaden its scope to inequalities in childhood and working life. In brief, the best way to think about pension reform is not to begin with the aged, but with the welfare of children. Good pensions begin at birth.
References
Myles, J. (2002) 'A new social contract for the elderly?', in G. Esping-Andersen (ed.) Why We Need a New Welfare State, Oxford: Oxford University Press, Pp. 130-172.
OECD, (2001) Ageing and Income, Paris: OECD
Thompson, L. (1998) Older and Wiser: The Economics of Public Pensions, Washington DC: Urban Institute
Wolfson, M., Rowe, G., Lin, X. And Gribble, S. (1998) 'Historical generational accounting with heterogeneous populations', in M. Corak (ed.) Government Finances and Generational Equity, Ottowa; Statistics Canada, Pp. 107-126