Pitfalls of Funded Pensions


A trend can be observed that countries switch from pay-as-you-go (PAYG) to funded or semi-funded systems. “Brussels” supports this switch, because it supposedly is “actuarially fair”. The interest in pension systems has risen because of the aging problem. Many welfare states instituted fairly generous pension systems in post-WWII decades. They started paying out pensions to those who suffered the war and could no longer work. But since those governments had not collected contributions, these pensions had to be paid out of taxes. Implicitly, the workers who paid those taxes were promised that whenever they were to retire, that the workers of that time – future generations – would pay their pensions. This is basically what is called a PAYG pension system. Pension payments increased steadily over time, thus becoming more generous, which was not really a problem during the 20th century because of increasing populations and economic growth.

Currently, the ageing problem presents itself more and more, with baby-boomers actually nearing their retirement age. Families have fewer children, life expectancy increases and economic growth falters, with projections indicating that such developments are not likely to change anytime soon. This creates tension in PAYG pension systems, because the fiscal pressure on current workers becomes intolerably high. Typically, retirees are older than 65 years, and workers are aged between 15 and 64 years old. The old-age dependency ratio equals the number of people older than 65 (let’s call them “oldies”) divided by the number of people between 15 and 64 years old (“workers”). For Europe, Eurostat data shows that this ratio was about 0.150 in 1960, and is expected to increase to more than 1/2 in the coming decades. This means that in 1960 there were, on average, more than 6 “workers” for every “oldy”. In the future, less than two “workers” are expected to have to bear the burden of producing for one “oldy” if nothing were to change.

Nicholas Barr shows comprehensively that economically there are four, and only four, ways in which this problem can be “solved”: (1) Pension payments are decreased; (2) Pension contributions are increased; (3) The retirement age is increased; (4) Output is increased. Historically, options (2) and (4) were utilised to cope with the increasing old-age dependency ratio, and if anything, pension payments were increased.

Let’s review governments’ options considering recent demographic and economic trends. Nowadays, increasing pension contributions is, because of the severe fiscal pressure, hardly an option anymore, if governments do not wish to scare away their workers, or interesting companies, to other countries. Increasing output can happen in two ways: increasing productivity or increasing the number of workers. The latter, increasing the number of workers (i.e. immigration) is a politically sensitive topic. Increasing productivity is also quite difficult – it is what the current crisis is all about. During post-WWII decades high growth rates were recorded, which have been attributed to, depending on whoever you believe, catch-up growth, mechanisation, the inclusion of women in the workforce, workers tranferring from the agricultural to the industrial workforce, increased trade and subsequent specialisation, or some combination of these and other factors.

But such factors of economic growth seem largely exhausted. The retirement age has been raised, but only very moderately, and even these moderate increases were already met by massive demonstrations. Reducing pension payments is a very, very tricky thing to do for elected officials. Retirees, or almost retirees, are strongly motivated. They have paid for other people’s pensions all their life, and feel that they are entitled to a significant pension. Next to that, they are a highly organised group, which means that they are easily mobilised. Governments are thus reluctant to cut back on pension payments, also because the group of retirees makes up an increasingly large share of the electorate (because of the same demographic trends that underlie the ageing issue).

The 4 options thus do not seem to provide a politically feasible solution. It is my suspicion that governments have tried to find a way around it. They have tried to switch to funded pensions. Funded pensions are characterised by that you pay pension contributions into a pension fund, which invests it on your behalf, and from which your pension payments are paid when you retire. If there is a clear link between the contributions and the accrued pension rights, then such a scheme is called a defined contribution plan. Whether a defined benefit or contribution scheme, if it is fully funded, the payments to current retirees depend on whatever they paid into the pension funds themselves in earlier years.

Some argue that this may be a (partial) solution to the ageing problem, for instance, if the capital that pension funds accumulate can be used to make profitable investments, which fuel economic growth. But this may not happen, or even backfire, if there is no general lack of capital. Many may believe, intuitively, that funded systems might solve the ageing issue; if everyone pays for his own pension, and gets back on average whatever he or she contributed, then no matter how many people retire at the same time (i.e. how severe the ageing problem actually is), there must be enough capital because they also all contributed.

Alas. Firstly, there is the problem that some people have two pay twice. If you switch from a PAYG to a funded system, then current workers have to pay once for their own pension rights, and once to pay for the current retirees, who have not built up an account of “personal pension capital”.

Even if this were, somehow, taken care off, Barr convincingly argues that switching from PAYG to funded systems cannot be the universally perfect solution to ageing, since it is a claim on future production what it is all about – not some nominally determined amount of money. Assume that, indeed, there is a significant ageing development, and that all workers pay into their own pension account, to build up a pension. When these workers retire, the ratio of retirees to workers increases (we assumed an ageing development). These new retirees all have money to spend, but the workforce that should provide whatever they want to buy has become (relatively) scarce: their prices go up (unless their productivity increases with their relative scarcity – but it hasn’t in recent years). Thus, retirees might still have a nominal amount of money, but its real value disappears. Alternatively, you might consider that the contributions of these retirees have been built up in pension funds, which have invested it to earn a return. If a significant portion of the population retires, and wants to cash in their pension rights, an “oversupply” of stocks is the result, with the consequence that stock prices will decrease – only the very first of the big group of retirees might be lucky enough to sell the stocks at a right price. Again, the real worth of the pension payments decreases. There are some objections to this line of reasoning (it for instance, in this simple framework, assumes a closed economy), but one way or another: funded pensions are not a solution to ageing.

But this is all quite well-known. When Nicholas Barr explained it to my class last year, I could not help but think: “Why could I not have thought about this myself?” Still, I think that governments may find funded pensions attractive. In the “old”, PAYG situation, the government, somewhere and at some point, has to take “the blame” for making the system sustainable again (any of the 4 mentioned options, which if productivity growth is difficult, are all very, very politically hazardous and salient). Funded systems won’t help this. But, what is different is that in the case of funded systems, it is not the government who seems at fault. Then, as explained above, stock prices might just decrease, or the prices of labour may go up; but it is more difficult to blame the government for this, when pension payments have to be cut.

I would like to highlight three additional things, which in my view are infrequently (or not) discussed, but which are, as I see it, major risks of funded system.

(1)   Governments are already, more and more, being held accountable for whatever happens in the economy – It’s the economy, stupid! Of course, politicians have themselves to blame for this. When not in power, oppositional forces claim to be able to have a better economic plan than the one the government executes. When in power, and when the economy is in a good state, there is not a single politician who would not take credit for it. With funded systems, this will only be amplified. The focus of the electorate will be more and more on how good the government is able to “steer the economy”. I happen to have the belief that the economy is not some macroeconomic entity that lends itself to be steered easily, if at all.

(2)   Pension funds can become massive, and thus very attractive, pools of money. In the Netherlands, the total worth of pension funds is way higher than the level of GDP. You must have a massive faith in governments, all across the globe, to believe that they will keep their hands off this money when they are in dire straits. Examples can be found in Argentina (or Hungary, Ireland, France, Portugal, …), where the government seized private pension funds to pay off its debt. But it can also happen more innocently. At my internship at the Dutch Ministry of Finance, I am investigating venture capital policies, and how to jumpstart them. I have met quite some government officials who, totally unaware of the precedent they might create, suggest that we could force pension funds to invest more in domestic VC projects. Once on it, that may be a very slippery slope.

(3)   And lastly perhaps the least discussed issue. Consider the graph below (data source: OECD Databases). It shows the worth of pension funds’ assets as a percentage of GDP, with the Netherlands traditionally having the highest percentage.

Pension Fund Assets as a Share of GDP (2011)

Assume that, indeed, funded pension systems become fashionable and that governments manage to keep their hands off it. Percentages might skyrocket; there is hardly a limit. They might go as high as 200%, or 300%. But let’s assume that they would somehow reach an average of 100%, which is not unthinkable at all. That would mean, for Europe, translated to contemporary figures, that the total worth of pension funds would be as high as the sum of GDP levels. That would be about €12.629 trillion. And these funds are all looking for a decent return, in a world where exactly these returns are already under pressure. Europe will not have enough opportunities to earn a decent return, so, where to go next? It might be difficult for all these euros to be invested in developing economies. And what if those economies start ageing? I don’t find it hard to see how this might lead to a major breakdown, at least for some funds.

As has already been argued by many, although largely for different reasons, the best pension system is likely one that combines features of a PAYG and a funded system. I just wanted to emphasise that relying (entirely) on stock markets might not be such a good idea for pension systems, in times when riskless assets do no longer exist (well, technically they never did). Retirees and almost-retirees became hostile when they perceived that they might have to work a few months, or a year, longer. Imagine what would happen if they would learn that half of their pension rights have evaporated overnight.

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One comment on “Pitfalls of Funded Pensions

  1. […] I argued before, pension systems are already put under increasing pressure because of the increasing ratio of […]

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