Information about Asia and the Pacific Asia y el Pacífico
Equitable and Sustainable Pensions

Chapter 3. The Role of the Public and Private Sectors in Ensuring Adequate Pensions: Theoretical Considerations

Benedict Clements, Frank Eich, and Sanjeev Gupta
Published Date:
March 2014
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Nicholas BarrThis chapter draws on writing with Peter Diamond, including Barr and Diamond (2008, 2009, 2010a, 2010b).

The Backdrop

After brief discussion of background issues in the opening part of the chapter, the second section sets out the central lessons from economic theory and some of their main implications for policy. The third section discusses the role of government and is followed by a section that provides examples of good pension design. The fifth section sets out the widening range of options available to countries as their fiscal and institutional capacity increases, and the final section offers some brief conclusions.

Objectives of Pension Systems

Pension systems have multiple objectives. For the individual or family, the major ones follow:

  • Consumption smoothing, that is, redistribution from one’s younger self to one’s older self. Pensions should allow a person to transfer some portion of consumption from his or her productive middle years to his or her retirement years.
  • Insurance. In a world of certainty, individuals save during working life to finance retirement. However, people do not know how long they are going to live. Thus, a pension based on individual savings imposes the risk that the person will outlive those savings. The purpose of annuities is to allow people to insure against that risk. Pensions can also insure against disability and can protect spouses and young children should a worker die before retirement.

Public policy has additional objectives:

  • Poverty relief is necessary if a person’s earnings record does not provide an adequate pension.
  • Redistribution can be achieved by paying pensions to low earners that are a higher percentage of their previous earnings, thus subsidizing the consumption smoothing of lower earners. Because lifetime earnings are uncertain, such a system provides some insurance against low earnings. Redistribution toward families can also occur, for example, by paying a higher pension to a married couple than to a single person.

Principles of Analysis

Of the principles of analysis discussed in Barr and Diamond (2008, Chapter 10), three stand out: the need for a holistic approach, the need to frame analysis in what economists call a second-best context, and the need to consider the redistributive effects of pensions. The first two are discussed here, the third in the section on the role of government.

Analysis requires a holistic approach

Pensions have effects on the labor market, economic growth, the distribution of risk, and the distribution of income, including by generation and gender. Analysis needs to consider the pension system as a whole, including its multiple objectives and all of the constituent parts of the system. It is a mistake, for example, to be overly concerned about an actuarial earnings-related pension, given the need for a poverty-relief element elsewhere in the system. What is relevant for analysis is the combined effect of the system as a whole.

Analysis should be framed in a second-best context

What economists call first-best analysis is the world of rational economic men and women. The assumptions of that model include perfect information, rational behavior, complete markets (e.g., the ability to buy an indexed annuity that pays out at some future date), and no distortional taxation. As emerges repeatedly in the next section, the market for pensions is characterized by multiple and serious failures of these assumptions, including the following:

  • Imperfect information, addressed by the economics of information (for which the 2001 Nobel Prize was awarded);
  • Nonrational behavior, addressed by behavioral economics (for which the 2002 Nobel Prize was awarded);
  • Incomplete markets and incomplete contracts (for which Peter Diamond’s work was cited in the 2010 Nobel Prize); and
  • Distortional taxation, which is inherent in any system that includes poverty relief, and hence has to redistribute from richer to poorer people; this topic is addressed by the literature on optimal taxation (for which the 1996 Nobel Prize was awarded).

These failures are relevant not only to the analysis of pensions but to many other markets (Barr, 2012).

First-best analysis is useful as an analytical benchmark, but is a bad basis for policy design.

Economic Theory and Implications for Policy

These analytical principles give rise to a series of lessons for policy design. This section discusses the most important of these lessons, together with their implications for policy: imperfect information and nonrational behavior are pervasive; output is central; different pension systems distribute risks differently; and transition costs matter. A final lesson is that despite the availability of sound principles for pension design, no single best pension system for all countries is attainable.

Imperfect Information and Nonrational Behavior Are Pervasive

Imperfect information. Individuals are imperfectly informed in several ways. First, they frequently have only a limited understanding of the risks and uncertainties they face, for example, about future benefits from different types of pension or about their longevity.

Second, individuals are generally badly informed about complex pension products. Many do not understand basic concepts in finance: Orszag and Stiglitz (2001) quote the chairman of the U.S. Securities and Exchange Commission as stating that more than 50 percent of Americans did not know the difference between a stock and a bond. The problem also has distributional implications because the worst-informed people are disproportionately among the least well off; that is, information poverty and financial poverty are highly correlated.

A further issue is that information is frequently asymmetric, leading to potential problems of inappropriate products being sold to ill-informed consumers. It is clear that one of the roots of the global financial crisis was that the sellers of financial products often had a better idea of their riskiness than did the buyers.

Nonrational behavior arises with pensions in two strategic ways: people may do a bad job of working out their optimal consumption-smoothing and insurance strategy (bounded rationality), or they may know the right strategy but fail to carry it out (bounded will power).

Bounded rationality. Sometimes a menu of choices is too complex for a person to make good decisions, even when provided with the necessary information. Such problems are more likely if the time horizon is long, the outcome involves complex probabilities, or the details are inherently complex, all of which characterize most pension products.

Bounded rationality leads to poor choices in a variety of ways:

  • Presentation. Choices are influenced by the way in which they are presented. The order in which alternatives are set out can make a difference, and choices can be influenced by the number of alternatives a person is given.
  • Familiarity. A worker may invest heavily in the stock of his or her employer. If the firm goes bankrupt, the worker loses both wage income and a significant portion of pension savings. Such behavior shows a failure to understand the benefits of diversifying risk.
  • Immobility. Complexity and conflicting information can lead to passive behavior, where people freeze like a deer caught in the headlights. More alternatives can result in lower participation. In Sweden, a small fraction of a worker’s contribution goes into an individual funded account; the great majority of new workers, able to choose from more than 700 pension funds, make no choice at all.

Bounded willpower. Many people know they should save more but do not do so. Evidence suggests that in some circumstances people have a higher discount rate in the short term (i.e., a tendency to instant gratification) and a lower one in the medium term. The problem is that when the future arrives, it becomes the present; hence, short-term gratification continues. The resulting problems include the following:

  • Myopia. Some workers pay little attention to the future. They may not make careful choices and may be influenced by current inducements, for example, entry into a prize drawing for a foreign holiday, when choosing a pension provider. And many people retire as soon as they are allowed, even if that leaves them (or, later, their surviving spouse) in poverty.
  • Procrastination. People agree that they should save more for retirement but delay saving, do not save, or do not save enough, just as people delay losing weight or giving up smoking.
  • Inertia. Whether someone is automatically enrolled in a savings plan or has to take explicit action to join should not matter. In practice, automatic enrollment leads to considerably higher participation.

Implication for policy: Uncritical adherence to choice and competition is illadvised. First-best theory suggests that a system in which workers choose from competing pension providers will (1) maximize each worker’s welfare by allowing him or her to choose a portfolio that best reflects the worker’s time preference and risk aversion; and (2) exert downward pressure on administrative costs.

What is observed is very different as the result of procrastination, inertia, and immobility. The analysis above helps to explain these outcomes:

  • The costs of choice. As discussed below, charges for individual accounts tend to be high and largely a fixed cost per account (managing a small account is not much cheaper than managing a large one), and thus bear most heavily on small accounts and in smaller countries that cannot exploit economies of scale.
  • The benefits of choice. It might be worthwhile to incur these administrative costs if the ability to make choices were beneficial to workers. For example, the ability to choose one’s preferred food or music or smart phone increases a person’s welfare. As discussed, however, problems of imperfect information, bounded rationality, and bounded will power are serious for complex, long-term contracts such as those for pensions, and all the more so in poorer countries where citizens have little financial market experience. In the case of complex products, the benefits of choice are small and may be negative, both because the person may make a bad choice and because of the transactions costs (time, effort) in making a choice.
  • Poor choices by workers should not be surprising. The principles of finance, including the advantages of diversification and the trade-off between risk and return, are not intuitive. In addition, the noise in returns makes it difficult to tell whether good outcomes are the result of a manager’s skill or of random luck.

There are good reasons for arguing that consumers will not choose well even if they have the necessary information and skills. The gain from choosing more effectively (in the form of higher returns and lower charges) in any particular month is small, whereas the transaction costs—the time required to make an educated choice—are significant. Thus, workers, particularly low earners, for whom the gain in any month is smallest, have little incentive to keep up with the changing details of alternative investments and alternative charges.1

In sum, there are good reasons to be skeptical about the gains from individual choice in mandatory accounts. The considerable difficulty that occurs in making investment choices, even in countries with generations of individual experience in investing, should be a major concern in countries with limited histories of individual investment. The major criticism is, therefore, not of pension providers but of the model selected.

Output Is Central

The role of output. There are two (and only two) ways of seeking security in old age. One is to store current production for future use. With the exception of housing, this approach is inadequate for most consumption needs: it is expensive; it does not address uncertainty (e.g., about how the saver’s tastes might change); and it does not work for services that derive from human capital, notably medical services (for fuller discussion, see Barr, 2012).

The second approach is for individuals to exchange production when younger for a claim on future production. There are two broad ways to do so: a worker could save part of his or her wages so as to accumulate assets that would be exchanged for goods produced by younger people after his or her retirement; or the worker could obtain a promise—from children, employer, or government—that he or she would be given goods produced by younger workers after his or her retirement. The two main ways of organizing pensions broadly parallel these two types of claim. Funded systems are based on accumulations of financial assets, pay-as-you-go (PAYG) systems on promises.

A fundamental purpose of pensions is to allow people to continue to consume after they have stopped working. Pensioners are not interested in money per se, but in consumption. Thus, future output is central. PAYG and funding are simply financial mechanisms for organizing claims on that future output. In macroeconomic terms, the differences between the two approaches should not be exaggerated.

The salience of output remains true in an open economy. In principle, pensioners are not constrained to consumption of domestically produced goods, but can consume goods produced elsewhere so long as they can organize a claim on those goods. If British workers use some of their savings to buy Australian firms, they can in retirement exchange their share of the firm’s output for Australian goods, which they then import to the United Kingdom. This approach is useful but not foolproof. It does not work if Australian workers all retire; thus the age structure of the population in the destination of foreign investment matters. In addition, if large numbers of British pensioners exchange Australian dollars for other currencies, the Australian exchange rate might fall, reducing the real value of the pension. Thus, the ideal country in which to invest has a young population and products one wants to buy and political and financial stability and is large enough to absorb the savings of other countries with aging populations. Countries with aging populations include almost all of the Organization for Economic Cooperation and Development (OECD), and many others, including China.

Overlooking the importance of output leads to faulty, or at least oversimplified, analysis. Two important examples are discussed below.

Implication for policy: Funding is not an automatic solution to demographic change. Though the point was shown to be flawed many years ago,2 it is widely believed that funding necessarily assists pension finance in the face of demographic change.

Suppose that a large workforce in period 1 is followed by a smaller one in period 2. In a pure PAYG system, all else constant, contribution revenues decline, creating upward pressure on the contribution rate, downward pressure on the level of pensions, or both.

It is argued that funding can ease the problem: each member of the large workforce in period 1 builds up pension savings; the pension of a representative worker exactly equals those savings; if there is a large number of such workers, it is argued that this is not a problem because the average worker accumulates enough to pay for his or her own pension. That argument is correct as far as finance goes but may not provide workers with the consumption they expect. Unless a decline in the number of workers has no effect on output, output will fall, and hence consumption or investment, or both, will fall. Lower rates of return or higher prices deny pensioners the consumption they expected; or mandatory increases in pension savings by workers reduce their consumption by more than they would choose; or the increase in the combined consumption of workers and pensioners is at the expense of investment, and hence puts future growth at risk. As noted, PAYG and funding are both mechanisms for organizing claims on future output; because demographic change generally affects that output, it causes problems for pension systems however their finance is organized (for fuller discussion, see Barr, 2012).

Even more clearly, suppose that the birth rate is stable but the life expectancy of pensioners increases. With pure PAYG the resulting increase in the number of pensioners requires a higher contribution rate or lower monthly benefits. With funding and no change in interest rates, the sustainable level of monthly benefits is lower if retirement is longer.

What matters is not financial accumulation but output. If output increases, it becomes easier to meet the claims of both workers and pensioners. The solution to population aging lies not in funding but in output growth that meets consumption demand.

Implication for policy: Funding does not necessarily contribute to output growth. There are two potential links between funding and growth, each of which needs exploration. First, funding may increase national saving or may improve the effectiveness with which capital markets allocate savings to their most productive investment use (or it may do both).

Whether funding increases saving depends on the reaction of private savers and government:

  • Workersresponses. If workers are required to contribute an additional amount per month to a pension fund, they may partly or wholly offset those savings by reducing their voluntary savings.
  • Government responses. If additional mandatory savings go into pension funds, government may borrow more, for example, to pay for PAYG pensions previously financed by workers’ contributions that now go into funded accounts.

Thus, the positive effects of the introduction of mandatory pension saving may be partly or wholly offset by private or public responses.

Second, does funding improve the effectiveness of financial markets? In two cases the answer is no. In advanced countries with highly developed financial markets, mandatory pension saving is unlikely to lead to significant improvement. At the other extreme, in countries with very limited capacity, the existing financial infrastructure is weak, making mandatory membership in pension plans highly risky. Between the two extremes is a range of country capacity in which there is a possibility of improving capital markets, but also a risk that returns might be low or that government might have to bail out the pension system if private institutions fail. Inadequate markets can yield low returns and are likely to have high administrative costs. But net gains are also possible given that capital markets that work better increase economic efficiency and hence economic growth.

An alternative approach is to encourage voluntary pensions as a stimulus to market development, particularly in a large economy.

Does higher saving increase output? The simplest argument is that a move to funding (1) increases savings, which (2) increases investment, which (3) increases output:

  • As just discussed, a move to funding does not necessarily increase national saving.
  • The link between higher saving and increased investment is not automatic. Instead, saving could drive up the prices of assets in limited supply, for example, urban land.
  • An increase in investment may not greatly increase output. Inefficient capital markets can lead to a low marginal product of investment, as in the communist countries, where rates of investment were very high, but growth rates low, and in some countries eventually negative.

Thus, funding may increase output, but not always.

Different Pension Systems Allocate Risks Differently

Pensions help to transfer consumption from the present to the future during a person’s lifetime. But the future is uncertain, including as a result of the risks outlined in Box 3.1. Different pension systems allocate these risks differently. It is useful to recognize the varying underlying philosophies in different systems. Different pension arrangements are discussed in ascending order of risk distribution.

Box 3.1Multiple Risks

The future is inherently uncertain, and includes systemic risks, market risks, and risks connected with individual behavior.

Systemic risks emanate from macroeconomic turbulence, demographic risk (e.g., longer life expectancy and lower fertility rates), and political risk.

Market risks arise in various ways. Workers face earnings risk connected with labor market and health risks. They also face investment risk; for example, accumulations held in the stock market are vulnerable to market fluctuations. A third risk arises in annuities markets because a person’s annuity at a given age will be affected by the life expectancy of his or her birth cohort and by the discount rate used by the annuity provider.

A further set of risks relate to individual behavior. Individuals may make bad choices, for example, investing too heavily in equities too close to retirement. Fund managers may be incompetent or fraudulent. In addition, as the financial crisis demonstrated, managers may have different incentives from plan participants (see, for example, Woolley 2010).

Funded defined-contribution plans. In this arrangement, individual workers set aside a portion of their earnings to accumulate financial assets. These assets finance retirement either through an annuity or a series of withdrawals. In a pure plan, the risk of fluctuations in the return on assets during working life falls on the individual. If the worker buys an annuity at retirement, he or she faces the risk in pricing the annuities, reflecting both mortality projections and projected future returns. Once the annuity is purchased, risk is generally borne by the annuity provider. If the retiree does not buy an annuity, he or she faces mortality and return risks. In sum, the risks of different outcomes up to retirement fall on the individual because benefits adjust to what is in a worker’s individual account at the time of retirement. Annuitization shifts risks after retirement to insurers, but still puts the risk of the pricing of annuities at the start of retirement on the retiree.

Funded mandatory defined-benefit plans. In this arrangement, individual workers receive benefits based on their earnings history and length of service. Thus, both the return on assets and cohort mortality risks can be addressed by adjusting contributions. Because there is a single fund for all benefits, and changes in contribution rates are normally uniform across workers, such plans have a collective dimension. A plan need not be fully funded at all times—fluctuations in the degree of funding are a device for shifting risks across cohorts. In a pure defined-benefit plan the risk of varying returns falls on the plan sponsor. If the sponsor is a firm or industry, the risk of financing higher contributions can be spread across current and future workers via changes in wages, across shareholders through changes in profit distributions, and across customers through changes in the prices the firm charges for its products. Thus, the risk is allocated more broadly than in a defined-contribution plan. If the sponsor is the government, the risks are shifted to current and future taxpayers.

In a pure defined-contribution plan, therefore, benefits adjust to available resources; in a pure defined-benefit plan, resources are adjusted to meet the benefits that have been promised. In practice, firms and governments typically make adjustments to both resources and benefits. A second element is the collective aspect of having a single fund rather than individual accounts. Thus, a typical defined-benefit plan distributes risk more widely than does a typical defined-contribution plan. In addition, a central fund has lower administrative costs and sidesteps poor decision making by workers, although it is at risk of poor investment decisions by the fund managers. However, a central fund does not provide workers who have different levels of risk aversion with the opportunity to have different degrees of asset returns.

It is important that corporate pensions remain close to fully funded because corporations can fail, leaving the workers with less than had been promised, or leaving it to government to insure the workers. In contrast, in countries with well-managed economies, governments can have defined-benefit systems that are less than fully funded.

PAYG defined-benefit systems financed by social security contributions. In such plans, the risk to the income of the plan comes from fluctuations in the earnings of covered workers. In a pure arrangement (i.e., one financed entirely by contributions, hence not able to run a deficit), risks are allocated among current workers through changes in contributions.

If the plan can run surpluses (partial funding) or deficits (borrowing against future contributions or using previous surpluses), the risks can be shared with future workers or eased by the presence of accumulated past contributions. Any accumulation involves risk in rates of return. The risk of the evolution of mortality rates remains—if people live longer, the cost of paying a given level of benefits will increase.

Systems financed from general tax revenues. In a system financed from general revenues or through a mix of social insurance contributions and general revenues, the risks are allocated across all taxpayers and hence, through government borrowing, across generations. Thus—crucially—a system with a PAYG element allows intergenerational risk sharing.

In practice, plans are not pure, and countries frequently adjust both contributions and benefits, thereby distributing risks between workers and pensioners.

Implication for policy: How risks are distributed becomes an essential question.

When designing a new system or considering reform of an existing one, a central issue for policymakers to consider is where risks fall and how they should be allocated. As with income redistribution, different answers are possible, but ignoring the question is a major error.

Transition Costs Matter

A move toward funding requires that a larger fraction of workers’ contributions go into their funded pensions, leaving less to finance PAYG pensions, which then must be financed from some other source such as government borrowing. Thus, a move toward funding raises public spending during a transition period until a new steady state is reached. However, that period is long. Chile moved to mandatory individual funded accounts in 1981, but in 2008 public pension spending was still 5.2 percent of GDP (OECD, 2011).

Implication for policy: Pay proper attention to the scale of transition costs. It can be argued that the move toward funded pensions in central and eastern Europe in the late 1990s was based on optimistic fiscal projections, which, at least in part, explains why pension reform in some countries is being slowed (e.g., Poland) or abandoned (e.g., Hungary; see Simonovits, 2011).

Implication for policy: Do not exaggerate the scale of implicit pension debt. A related mistake is to exaggerate the fiscal costs of PAYG pensions. The concept of implicit pension debt is often used, but can be abused. Considering only the total of future liabilities (i.e., future pension payments) is misleading. This approach ignores (1) explicit assets (i.e., any accumulated funds); (2) the implicit asset of the government’s ability to levy taxes; and (3) the considerable improvement in people’s well-being from increased old-age security. Just as public debt never needs to be fully paid off so long as the debt-to-GDP ratio does not get too large, so publicly provided pensions need not be fully funded, as long as the unfunded obligations are not too large relative to the contributions base. The mistake, in short, is to argue that implicit pension debt should be minimized rather than optimized.

Sound Principles of Design but No Single Best System for All Countries

As discussed, pensions have multiple objectives, including consumption smoothing, insurance, poverty relief, and redistribution.

The pursuit of those objectives must surmount a series of constraints:

  • Fiscal capacity. Greater fiscal capacity makes it easier to find additional resources for a pension system.
  • Institutional capacity. Stronger institutional capacity makes feasible a wider range of options for pension design.
  • The empirical value of behavioral parameters. For example, the responsiveness of labor supply to the design of the pension system, and the effect of pensions on private saving, must be accounted for.
  • The shape of the pretransfer income distribution. A heavier lower tail increases the need for poverty relief.

There is no single best system because (1) policymakers will attach different relative weights to the objectives, including the importance of poverty relief and how risks should be allocated within and across generations; and (2) the pattern of economic, institutional, and political constraints will differ by across country. If the objectives differ and the constraints differ, the optimum will generally differ.

What Role for Government?

Just as there is no single best pension system, there is no single package of tasks for government. What government does will depend on, among other things, the design of the pension system, which, itself, will depend in part on government capacity. Nevertheless, some government tasks are clear. This section discusses some of the different ways in which pensions redistribute income, a task in which government is inescapably involved given that different pension designs have different distributional effects, the different blends of private and public arrangements that are possible, and lessons from international experience.

Pensions and Redistribution

Pensions redistribute resources in many ways, including across generations, by gender, and between people at different income levels.

Any pension system will affect the intergenerational distribution of income. Suppose policymakers are establishing a brand new pension system. If they introduce a PAYG system, the contributions of today’s workers pay for the pensions of today’s retirees; thus, the first generation of retirees receives a pension. If, instead, policymakers introduce fully funded pensions, the contributions of today’s workers go into their own pension savings accounts; thus, the first generation receives little or no pension. The same argument applies in a country that already has a PAYG system: a move toward funding through higher contributions or toward lower benefits redistributes from current generations to future ones. Thus, any choice about how a pension system is financed is inescapably also a choice about the intergenerational distribution of income.

The fact that any policy choice between PAYG and funding necessarily affects redistribution across generations cannot be ignored. The gain to pensioners in later generations should not be presented as a Pareto improvement3 because it does come at the expense of the first generation.

Thus, a country considering a move toward mandatory funding has to consider whether the move would have desirable intergenerational redistributive effects. A decision to introduce funding will benefit a future generation of workers who, other things equal, can pay lower contributions. The question is whether there is a good reason to impose a larger contribution (because of the move to funding) on today’s workers so that, other things equal, future workers can pay a lower contribution. If, as frequently occurs in countries in Asia, today’s workers are relatively poor and subject to economic uncertainty, but growth rates are high, then workers in future generations are likely to be much better off. Imposing higher contribution rates on today’s workers so that future workers can have lower contribution rates or higher pensions may not be the right objective.

Any choice of pension system redistributes resources by gender. A requirement to price annuities on the basis of joint-life tables (i.e., to charge unisex premiums) redistributes, on average, from men to women because women tend to live longer than men.

Such redistribution, however, is only a small part of the story. Consider the following questions. How is consumption shared within the family? How should it be shared? How should the earnings of husband and wife be taxed? To what extent should taxes, current benefits (e.g., subsidized child care, or child benefits), and future benefits (such as pensions) encourage mothers with young children to accept paid work or discourage them from doing so? Should taxes and benefits be designed to encourage marriage? How should survivor pensions be organized? How should pensions be arranged for couples who divorce?

The main reason for posing these questions is to make it clear that none has an unambiguously correct answer. For example, should policy favor paid work or care activities? The matter is further complicated because it is often not clear whether a particular outcome, for example, a woman forgoing paid work to look after young children, is the result of choice or constraint. The conclusion is that, in this aspect of pensions as in others, there is not—and cannot be—a single optimal policy.

Different designs have different redistributive effects by income level. One archetypal design (broadly that in New Zealand) has a flat-rate noncontributory pension plus individual saving accounts. In such a system, the degree of redistribution will be greater, all else equal, (1) the more progressive the tax system that finances the flat rate pension, and (2) the larger the flat-rate pension relative to the earnings-related pension. A different archetypal design has an earnings-related formula with a redistributive tilt. In the United States, for example, workers with higher earnings during their careers receive less pension per dollar of contribution from Social Security than do workers with lower earnings.

Conclusions are twofold. First, any pension system has redistributive consequences. Second, no single pension system is fairer than any other. For all the reasons discussed above, there is no single, unambiguously correct answer.

What Is Meant by “Private”?

“Public” and “private” pensions are discussed as though the choice is binary. A pure public pension could, for example, be a mandatory national PAYG system. A pure private pension would be voluntary membership in a fully funded individual account that is privately managed and with no tax advantages. In reality, between the two poles is a range of intermediate cases, so that in practice, pension systems vary widely with respect to the roles of government and the private sector.

Dimensions of the issue

  • Is the system compulsory? A pure private pension plan will be voluntary, for example, 401(k) pension plans in the United States. If the system is compulsory, is it mandated by government (as, for example, in Chile), or by the industry or firm (as in many occupational plans)? Second, what is the size of the compulsory contribution? A system that has only a small compulsory contribution comes close to being voluntary.
  • What is the extent of regulation—light or extensive?
  • Who manages pension assets?
  • Is financing public or private? A pure private plan will have no tax advantages.
  • Who bears the risk? As discussed, different pension arrangements allocate risks differently. With voluntary saving in a fully funded individual account, all the risk falls on the individual saver. In other private arrangements (e.g., an occupational defined-benefit scheme), risks can be allocated more widely.

Problems with undue reliance on private solutions

Undue reliance on voluntary participation typically results in people not saving enough (see the earlier discussion of bounded will power). Appropriate roles for government range from “nudging” (for example, automatic enrollment) to mandated participation. If the problem of bounded will power is ignored, the resulting problem is elderly poverty.

Undue reliance on individual choice of pension provider is also suboptimal. Because of bounded rationality, people may choose badly or not choose at all. The government’s role, in ascending order of the degree of intervention, could include the following:

  • Nudging through automatic enrollment (see the later discussion of the U.S. Thrift Savings Plan and of KiwiSaver in New Zealand);
  • Mandatory membership in privately organized individual accounts, for example, as in Australia; and
  • Mandatory membership in a public system of insurance and consumption smoothing as, for example, in Canada and Sweden.

If the problem of bounded rationality is ignored, adverse outcomes include selling of inappropriate financial products to ill-informed consumers, excessive charges, and elderly poverty.

Problems with undue reliance on government solutions

Government failure can arise in various ways. Governments may make profligate promises, or ones that seem reasonable when made but turn out in hindsight to have been based on overoptimistic assumptions. Or government may appropriate resources in funded accounts as, for example, in Argentina and Hungary (on the latter, see Simonovits, 2011). Or pensions may be poorly administered such that contributions are not collected effectively or benefits not paid accurately or promptly. Ignoring the possibility of government failure can lead to worse old-age security through lower pensions, greater worker and pensioner uncertainty about the security of future or current pensions, or both.

A second potential problem arises if governments make poor decisions about the way in which funded schemes under their control should invest funds. Government proclamation of the assets that pension funds must invest in is prone, at best, to attempting to honor multiple objectives; for example, government is legitimately concerned not only with old-age security but also with other objectives such as keeping employment rates high, pursuing economic growth, and so forth. At worst, asset choices by government are subject to political interference for nontransparent reasons. If these problems are ignored, investment outcomes will be poor, resulting in lower pensions. Not many countries do a good job; two that do are Canada and Norway (Canada Pension Plan, 2011; Norges Bank Investment Management, 2011).

The choice of pension design will depend on a country’s objectives and constraints

A system with a significant private element, for example, individual accounts, could make sense in a country that

  • Gives poverty relief a relatively lower weight;
  • Gives individual freedom a relatively high weight;
  • Is not excessively risk averse;
  • Can regulate financial markets effectively;
  • Trusts financial markets; and
  • Is suspicious of government failure.

A more public system could make sense in a country that

  • Gives social solidarity a greater weight;
  • Gives risk allocation a greater weight;
  • Does not have major concerns about government failure; but
  • Does have concerns about the conduct of financial markets.

International Experience

Lessons Learned

Implementation matters. Good policy design is important. But the best design will fail to achieve its objectives without sufficient financial, political, and administrative capacity. Policy design that exceeds a country’s implementation capacity is bad policy design. Implementation, the importance of which is often not understood, requires skills that are just as demanding as policy design and needs to be considered from the start, not as an afterthought. Government has a central role in implementation of both public and private pension arrangements.

Financial capacity. Consumption by pensioners comes at the expense of consumption by workers, spending on investment, and other uses of resources. From a macroeconomic perspective, therefore, pensions are, in part, a device for allocating output between workers and pensioners. Clearly, the amount that is spent on pensions must be compatible with a country’s financial capacity.

Technical capacity for PAYG systems. Mandatory public pensions require significant public sector capacity. A public pension requires that government be able to

  • Collect contributions effectively;
  • Track individuals across changes of name, jobs, employment status, and location;
  • Keep workers informed through regular statements;
  • Calculate benefits accurately, including actuarial calculations to adjust benefit levels for the age at which they start for an individual;
  • Pay benefits accurately and promptly;
  • Project future contributions and benefits to adapt the system slowly to evolving economic outcomes; and
  • Coordinate between central and subnational governments, if both are to have a role.

Simply listing these requirements emphasizes their enormity.

Technical capacity for funded individual accounts. Private pensions require that governments have the capacity to maintain macroeconomic stability, to regulate financial markets, and to protect consumers in areas too complex for them to protect themselves. Regulation is subject to at least three strategic problems: that the regulatory regime collapses or is ineffective, that the state assumes de facto regulatory control, or that the management and regulation of pension funds crowds out other demands for scarce skills.

Private pensions also require private sector capacity (Barr and Diamond, 2008, Appendix 9.1), including the ability to collect contributions, keep records, inform workers, select portfolios, invest funds, and determine and pay benefits.

Implication for policy. Do not underestimate the importance of implementation, nor delay consideration of how a pension will work in practice. A common mistake is overoptimism about institutional capacity. A particularly egregious error is to argue that because benefits will not need to be paid until later, there is no urgency to work out the arrangements for doing so. 4

Both mandatory and voluntary pension systems critically depend on effective government. As discussed, government has a central role in running a mandatory system. However, voluntary pensions do not relieve government of responsibility. Private pensions, whether mandatory or voluntary, depend on government to set rules and to enforce them. Government must be able to enforce compliance with contribution conditions, to protect asset accumulations, to maintain macroeconomic stability, and to ensure effective regulation and supervision of financial markets, including insurance and annuities markets. Such regulation is vital to protect individuals in areas too complex for them to protect themselves. It requires tightly drawn-up procedures and a cadre of people with the capacity and will to enforce those procedures. More generally, private markets function best when government, in its legislative role, has put in place clear rules and where enforcement is even handed, not corrupt, prompt, and predictable.

Similar requirements hold for mandatory pensions that rely on private providers. Chile offers an illustration. Its system is sometimes described as relying on unfettered markets rather than government, but this is a misreading. The description overlooks the fact that, at the time the reforms were introduced, a substantial government surplus helped to finance the transition. The individual accounts are handled by private firms that specialize in such work, and those firms are tightly regulated by an agency set up specifically for this purpose. Regulations, which have evolved, restrict portfolios, the structure of charges to workers, and the process of competition between firms.

Administrative costs matter. As discussed, funded individual accounts that allow workers to choose among pension providers generally have high administrative costs. Moreover, such costs are largely a fixed cost per account, and thus bear most heavily on small accounts and in smaller countries with limited options for economies of scale, and even more so in countries where most people have low earnings. The cumulative effect of administrative charges is considerable. For example, an annual charge of 1 percent of a worker’s account would reduce the accumulation at the end of a 40-year career by roughly 20 percent (Barr and Diamond, 2008). Sweden has a central clearing house to reduce costs and rules limiting charges by funds, but still has charges that reduce balances at the end of a career by 14 percent (Swedish Pensions Agency, 2011).

Centralized investment by a government agency can minimize transaction costs either for individual accounts, as in Singapore, or with a diversified portfolio for a defined-benefit system, as in Canada. The international history of the quality of investment is very mixed. Some countries have done poorly with centralized investment. With recent focus on incentives and the transparency of the investment process, some countries have garnered returns comparable to those of private investors. Good quality investment is more likely with full and transparent accounting, including a clear and explicit remit; independent, nonpolitical management; and detailed, audited accounts that are published regularly. However, putting in place a system that can ensure good quality investment is difficult, particularly if experience with pension investment is limited.

Examples of Pension Design

What do these various lessons imply for pension design? This section discusses four useful policy directions: noncontributory basic pensions; later and more flexible retirement; simple, low-cost savings plans; and notional defined-contribution (NDC) pensions.

Noncontributory basic pensions

The idea. A noncontributory basic pension, also called a citizen’s pension or a social pension, is financed from taxation and paid at a flat rate on the basis of age and residence rather than on individual contributions.

The contributory principle assumes that workers have long histories of stable employment. At least three reasons indicate why history has not borne this out. First is the changing nature of work: people are less likely to be in full-time employment for the whole of their careers; they have spells of full-time employment, of self-employment, and of part-time work, along with spells outside the labor force. Thus, the contribution record of a representative worker is less complete today than in earlier decades. Second, family structures have become more fluid, with a weaker association between marriage and children, and divorce more common. Third, women’s labor force participation has increased.

The changing nature of work means that, on average, workers will have less-complete contribution records, so that the contributory principle no longer provides poverty relief as effectively as it once did. The second and third reasons suggest that basing a woman’s entitlement on her husband’s contributions (regardless of whether it was ever desirable) is no longer feasible.

Noncontributory pensions strengthen poverty relief: they can cover everybody and can pay a pension high enough to keep people out of poverty. They also have advantages for gender balance because it is women who tend to have the most fragmented contribution records. In addition, the benefit is fairly well targeted, because age is a useful indicator of poverty, and noncontributory pensions can be made internationally portable on a pro rata basis.

Various instruments can be used to ensure that noncontributory benefits are affordable, in particular, the size of the monthly pension and the age at which the pension is first paid. The pension can also be subjected to an affluence test, such that retirees with the highest incomes do not receive the benefit. 5

International examples. The United Kingdom illustrates the issues with coverage in a contributory system. Until 2010, workers needed more than 40 years of contributions to receive a full basic state pension. In 2005, only 80 percent of men and 35 percent of women had full contribution records. The problem was not that the authorities could not collect contributions but that the contributory principle for poverty relief no longer fit current labor markets and family structures. For those reasons, the British government relaxed the contributory requirements.

Several OECD countries have noncontributory pensions, including Australia, Canada, Chile, the Netherlands, and New Zealand; Canada and the Netherlands have among the lowest rates of elderly poverty in the world. Chile introduced a noncontributory pension in 2008 with the explicit purpose of addressing elderly poverty (Box 3.2). Duflo (2003) shows that if the grandmother lives with adult children and grandchildren, the noncontributory pension in South Africa benefits the wider family, including health gains for the grandchildren. 6

Noncontributory pensions can be workable in countries with large rural populations and in developing economies (Barr, 2012). More specifically, Barr and Diamond (2010b), written at the request of the government of China, make recommendations about pension reform. Sections 7 and 8 of that report suggest that China should introduce a noncontributory pension (called a citizens’ pension) for all older people. The suggestion was for a national system that would cover urban workers, rural workers, and migrant workers. The pension would be based on age and residence and subject to a pensions test, that is, the noncontributory pension would be progressively withdrawn in proportion to any pension a person has from the mandatory contributory pension system. Thus, the system would screen out pensioners who previously had high formal sector earnings.

Box 3.2Pension Reform in Chile

Chile introduced a system of mandatory, funded, privately managed, competitively offered individual accounts in 1981. These individual accounts were set up to provide consumption smoothing and are supported by various institutions to assist poverty relief. Until 2008, someone with at least 20 years of contributions received a guaranteed minimum pension; in addition, a means-tested pension paid a benefit of about half the level of the minimum guarantee.

The post-1981 system in Chile was rooted in competitive supply, the argument being that competition would increase choice and coverage, and drive down administrative costs. Because of the information and decision-making problems discussed earlier, these predictions were not borne out.

In the face of continuing elderly poverty, a Presidential Advisory Council was appointed. The central recommendation of its report (Chile Presidential Advisory Council, 2006) was to replace the minimum guarantee and the means-tested pension with a noncontributory pension financed by taxation, payable to the poorest two-thirds of the population. The noncontributory pension was phased in beginning in 2008.

The primary lessons are threefold (for a fuller assessment, see Barr and Diamond, 2008):

  • Mandatory funded individual accounts are not easy to implement and depend on complementary reforms.
  • Private supply in a competitive marketplace is not sufficient to keep down transaction costs or charges.
  • Unless accompanied by a robust system of poverty relief, individual accounts are not a full pension system, just part of a pension system.

Later, but more flexible, retirement

The idea. People are living longer healthy lives, which is very good news. But a given pension beginning at a given age is increasingly expensive with greater life expectancy. The problem is not that people are living too long but that they are retiring too soon. The obvious solution is that the pensionable age should rise in a rational way as life expectancy increases. The argument for later retirement is stronger because many people enjoy their work and may not want to retire.

Alongside later retirement is a separate argument for more flexible retirement. When retirement was invented, a typical 65-year-old worker was weak and infirm, and interfered with the productivity of younger workers. The purpose of pensions was to weed dead wood out of the labor force, so it made sense to make retirement mandatory and complete. Since then, however, countries have gotten richer and can afford to give people a period of leisure at the end of their working lives. That, however, means that the purpose of retirement has changed. Policy should take account of the fact that people vary widely in their preferences and personal circumstances. Many people do not want to retire fully as soon as they are allowed—because of the extra earnings, because of possible extra pension benefits, or because they continue to enjoy working.

The most efficient and equitable approach is to increase the average retirement age to accommodate resource pressures, but to recognize differences across individuals by offering choice during a person’s time path from full-time work to full retirement. Making retirement more flexible would be good policy even if there were no problem in paying for pensions.

International examples. OECD countries are increasingly taking action on retirement age. The United States is raising its retirement age from 65 to 67. The U.K. Pensions Commission (2004a, 2004b, 2005) handled the politics of change with great skill; thus, the state pension age will rise from 65 to 66 in 2020, with further increases thereafter. The Netherlands is also in the process of increasing retirement age, and many other countries are discussing the issue.

Simple, cheaply administered saving plans

The idea. Earlier discussion suggests a number of lessons rooted in second-best analysis:

  • Make pensions mandatory or use automatic enrollment. Bounded rationality and bounded will power explain why financial education and voluntary participation will generally be insufficient. Automatic enrollment turns inertia to the individual’s advantage—once automatically enrolled, most people will stay in the plan.
  • Keep choices simple by offering a small number of clearly differentiated funds. In sharp contrast with theory, this type of constrained choice is a deliberate and welfare-enhancing design feature, respecting the constraint of bounded rationality.
  • Include a default option for people who make no choice. That option should include life-cycle profiling, whereby young people’s savings are mainly in the stock market, with assets moving into government bonds as a person moves toward retirement age.
  • Keep administrative costs low. To do so, account administration, that is, the back office tasks such as record keeping, should be decoupled from fund management, the investment decisions. Record keeping should be centralized to exploit administrative economies of scale. Investment decisions can be handled in two strategic ways: they can be outsourced to the private sector in tranches offered on a competitive basis (e.g., the U.S. Thrift Savings Plan, discussed below), or they can be run by government (for example, the Norwegian government’s petroleum fund; Norges Bank Investment Management, 2011). Either approach, however, makes significant demands on the quality of public and private institutions.

For voluntary pensions, an additional option is to allow people to commit now to action in the future, thus making use of procrastination (i.e., bounded will power) to assist policy. People are happy to promise to save more in the future, as in the “Save More Tomorrow” plan of Thaler and Benartzi (2004).

International examples. The Thrift Savings Plan, organized by the U.S. government for federal civil servants (, is an example of this approach. Workers are automatically enrolled and choose from six funds, for example, an equities fund, a government bonds fund, and so on. There is also a life-cycle option. A government agency keeps centralized records to keep costs low. Fund management is on a wholesale basis. Investment in private sector assets is handled by private financial firms that bid for the opportunity and that have to manage an identical portfolio for their private clients, providing some insulation against political interference. As a result, administrative costs are astonishingly low: as little as 6 basis points annually, or $0.60 per $1,000 of account balance.

In 2012, the United Kingdom introduced a similar system, the National Employment Savings Trust (NEST), established under the U.K. Pensions Act 2008, to provide a low-costs savings vehicle, particularly for low-to-moderate earners (

KiwiSaver individual accounts in New Zealand, introduced in 2007, are another variant, and the first example of automatic enrollment on a national scale, reinforced by a government match for contributions up to a ceiling, plus a onetime payment when the account is first opened. The combined effect of these factors was considerable. In 2007, 13 percent of workers belonged to an occupational plan and 5.5 percent to a personal plan. KiwiSaver achieved coverage of 44 percent within its first year, about three-quarters through occupational provision, the rest through personal plans (Rashbrooke, 2009).

The lessons from information economics and behavioral economics also apply to the decumulation phase, suggesting mandatory annuitization of at least part of a worker’s accumulation.

Partially funded notional defined-contribution plans

Simple, cheaply administered arrangements such as the Thrift Savings Plan are one way to organize consumption smoothing. As noted in the discussion on risk allocation, however, any such fully funded plan can allocate risks only among current participants, that is, among workers and pensioners currently in the system. In contrast, a partially funded system can allocate risk more widely than across individual accounts. This section discusses a partially funded notional defined-contribution (NDC) pension system as an example of the approach.

The idea. Pure NDC pensions are similar to pure defined-contribution plans in that contributions are notionally accumulated to determine a balance that is converted into an annuity at retirement, but different, in that that they are not fully funded.

NDC arrangements work as follows:

  • Each worker pays a contribution equal to a fraction of his or her earnings, which is credited to a notional individual account, that is, the state “pretends” that there is an accumulation.
  • The cumulative contents of the account are credited with a notional interest rate, typically the rate of growth of average wages, or of the total wage bill.
  • Workers’ contributions are partly used to pay the benefits of current pensioners on a PAYG basis and may also be partly used to accumulate a buffer fund.
  • When a person retires, the value of his or her notional accumulation is converted into an annuity on an actuarial basis—the present value of the flow of pension benefits (given the worker’s age and the life expectancy of his or her birth cohort) is equal to the value of the person’s notional accumulation, using the notional interest rate as the discount rate.
  • However, the account balance is for record keeping only; the system does not own matching assets invested in the financial market.

Thus, NDC plans mimic funded defined-contribution plans by paying an income stream the present value of which during the person’s expected remaining lifetime equals his or her accumulation at retirement, but with an interest rate set by legislated rules rather than market returns. As with defined-contribution pensions, NDCs have multiple ways of incorporating a redistributive element, including a minimum pension guarantee or by subsidizing the contributions of people who are out of the labor force because they are bringing up young children or are unemployed.

NDC plans have a range of potential advantages. They are simple from the viewpoint of the worker. They are centrally administered, and thus have lower administrative costs than systems that offer workers choice. They do not require the institutional capacity to manage funded plans. They avoid much of the risk of funded individual accounts because, to a significant extent, they are not subject to the volatility of capital markets. A partially funded NDC system with a sufficiently large buffer fund can allocate risk more widely than can fully funded arrangements, with advantages in both risk allocation and robustness in the face of economic turbulence. Finally, partially funded NDC plans can change over time into simple individual accounts, such as Thrift Savings Plan–type arrangements.

International examples. Countries with NDC pensions or similar arrangements include Latvia, Poland, and Sweden. Sundén (2009) explains how the partially funded NDC system in Sweden adjusts to changing demographic and economic conditions.7 Of particular interest, Sundén describes the phased adjustment of benefits in Sweden following the 2008 economic crisis, illustrating the ability of such arrangements to allocate risk.

Barr and Diamond (2010b, section 10) criticize the system of mandatory funded individual accounts in China with regard to both policy design and implementation, and suggest that the system should move toward a partially funded NDC arrangement:

  • China introduced individual accounts as part of the pension reforms in 1997, with an expectation of full funding. However funding has not occurred in line with the standard model. There are no institutions for workers to select individual portfolios nor to make direct investments in different assets. The need to pay current benefits has not left enough resources to purchase assets as originally designed, seriously undermining the credibility of the new system. Since full-scale funding with individual portfolios is not a viable option in the near term, what is needed is to reform the accounts into a credible, transparent system with the flexibility to evolve in whichever direction makes sense in the future…. We recommend that China set up the existing individual accounts as notional defined contribution accounts (along the lines of Sweden’s Inkomstpension); this approach allows for eventual evolution into a mix of funded and notional accounts…, or eventually possibly only a funded account. As in Sweden, there should be a fund backing the accounts in general, but not attributed to specific individual accounts. The immediate task is to make the current accounts function better given the current level of funding. (Barr and Diamond, 2010b, p. 45).

The following specific recommendations were made:

  • By the end of the next five-year period, China should aim to have a system of individual accounts similar to the Inkomstpension in Sweden, known internationally as NDC. Implementing individual accounts through partially centrally funded NDC arrangements has significant advantages in China’s current circumstances.
    • It offers consumption smoothing to today’s workers in a similar way to funded DC plans, and thus maintains individual accounts as a central part of the pension system.
    • Because no additional fund is built up the arrangement does not require today’s (poorer) workers to make larger contributions so that future (richer) generations of workers can make smaller contributions, thus avoiding unsatisfactory intergenerational redistribution.
    • It does not require the considerable private-sector financial and administrative capacity of funded plans with individual choice, since the plan is run by the public authorities.
    • It is less risky for workers, since the rate of return avoids the short-run volatility of assets in the capital market. This is particularly important at a time when banking and financial market institutions are still developing and given current global economic uncertainty.
    • The arrangement is a basis for a future move to full funding, or both funded and notional defined contribution accounts should a future government decide that that suits China’s then economic and social circumstances. (Barr and Diamond, 2010b)

Pension Design and Economic Development

The previous section discussed options with desirable characteristics. This section, following Barr and Diamond (2009), discusses what is feasible, in particular, the widening array of options as fiscal and institutional capacity constraints subside.

Discussion is couched in the conventional terms of first-tier pensions (aimed mainly at poverty relief), second-tier pensions (mandatory, intended mainly to provide consumption smoothing), and third-tier pensions (voluntary, to accommodate differences in individual preferences).

The discussion is limited in two important ways: First, it considers three stylized types of country: a low-income developing country, a middle-income developing country, and an advanced country; not all countries fall neatly into one of these categories. Second, the examples are only illustrations, and not intended to be a template.

The examples are based on two assumptions: that the level of benefits, the age at which a pension is first paid, and similar parameters, are consistent with fiscal sustainability; and that alongside pensions, some means-tested support for the elderly is provided.

Illustrative Pension Systems for a Low-Income Country

First tier. Choices are highly constrained:

  • A very poor country may be unable to finance or administer a national system of poverty relief; in particular, such a country will generally not have the capacity to administer an income test, relying instead on family, charitable organizations, and local discretion to establish which individuals or households should receive welfare transfers.
  • As capacity develops, it becomes possible to use general tax revenues for limited poverty relief through transfers to subnational governments or through a national system that targets by age.

Second tier. A low-income country will generally not have the capacity to manage a mandatory earnings-related system, which should thus be regarded as an aspiration for the future.

Third tier. Any voluntary saving plans should not be tax favored because fiscal resources are highly constrained, and tax advantages are typically regressive. It is, however, important to provide a simple, reliable opportunity for voluntary savings.

Illustrative Pension Systems for a Middle-Income Country

First tier. Countries in this category have a choice of

  • A noncontributory, tax-financed pension (as, for example, in Chile); or
  • A simple contributory PAYG pension, for example, a flat-rate pension based on years of contributions.

Second tier. The choice is between

  • A publicly organized, earnings-related, defined-benefit pension, or possibly an NDC pension; and
  • A defined-contribution pension as part of a provident fund (as in Malaysia and Singapore), or with sharply limited individual choice.

Policymakers should consider the extent to which any tax favoring is regressive.

Third tier. Voluntary, defined-contribution pensions are possible at the level of the firm or individual. Regulation is important, and any tax favoring should avoid undue regressivity.

Options for Pension Systems in an Advanced Economy

First tier. Countries should consider either

  • A noncontributory, tax-financed pension; or
  • A contributory pension aimed at poverty relief (as in many countries, including the United Kingdom and the United States), with an array of different designs.

Second tier. The menu includes (separately or in combination)

  • A publicly organized, defined-benefit pension (as in Canada);
  • An NDC system (as in Sweden);
  • An administratively inexpensive saving plan with access to annuities (such as the Thrift Savings Plan in the United States or NEST pensions in the United Kingdom), or simple saving plans such as KiwiSaver in New Zealand;
  • Mandatory, funded, defined-benefit pensions sponsored by industry (the de facto system in the Netherlands); or
  • Funded, defined-contribution pensions (as in Chile and a small part of the system in Sweden).

Third tier. Voluntary, defined-contribution pensions can be organized at the level of the firm, the industry, or the individual; regulation (particularly of defined-benefit plans) is important and difficult, and any tax favoring should avoid excessive regressivity.

Clearly, choices expand as fiscal and administrative capacity grows. An advanced economy has a wide array of choices and, given the earlier conclusion that there is no single best system, it is not surprising that richer countries have undertaken a range of very different systems. However, the fact that a country is capable of implementing a complicated system does not mean that such a system is a good idea or necessarily superior to a less administratively demanding one. New Zealand has a simple pension system through choice, not constraint.


A wide range of systems. Countries have implemented very different pension systems, in part reflecting different relative weights for various objectives:

  • Mainly poverty relief. An example is the system in New Zealand, which comprised a noncontributory pension plus (until 2007, when KiwiSaver was introduced) voluntary consumption smoothing.
  • Largely consumption smoothing. An example is Singapore’s state-administered Central Provident Fund, which is mainly a savings plan.
  • Both objectives. Canada has a combination of Old Age Security and Guaranteed Income Supplement aimed mainly at providing poverty relief, plus the earnings-related Canada Pension Plan aimed mainly at providing consumption smoothing. The Netherlands has a noncontributory PAYG universal pension in addition to funded occupational pensions.
  • Chile has strengthened poverty relief by introducing a noncontributory pension alongside its existing system of individual funded accounts.
  • The extent of mandatory funding varies widely: Chile relies substantially on funding, whereas countries such as France, Germany, and Italy are largely PAYG.

But only four potential solutions to problems of pension finance. If a country has problems financing its pension system, there are only four potential solutions. A country can undertake one or a combination of the following:

  • Reduce the level of pension benefits. This policy reduces pension spending by lowering the living standards of pensioners, and hence raises the risk of elderly poverty.
  • Raise the age at which pension is first paid, with no compensating increase in the level of the pension. This policy reduces pension spending not by lowering living standards in retirement but by reducing the duration of retirement.
  • Increase the contribution rate. This policy reduces the living standards of workers. In many countries, because the retirement age has increased little, contributions are already high, limiting the scope for significant further increases.
  • Adopt policies to increase national output. This policy increases the contribution base and hence makes it easier to finance a given level of pensions.

Mistakes to avoid. A country should not

  • Reform piecemeal and in haste, but strategically and with a long time horizon;
  • Set up a system beyond its capacity to implement;
  • Introduce a mandatory, earnings-related pension system until it has robust capacity to keep records accurately for 40 or more years;
  • Introduce individual funded accounts (whether mandatory or as an option in a mandatory system) until it can regulate investment, accumulation, and annuitization;
  • Underestimate how administrative costs cumulate over a long life; and
  • Underestimate transition costs, hence should not move toward funding if doing so risks breaching fiscal constraints.

What really matters. In many ways, two factors matter above all:

  • Good government is important regardless of the type of pension system a country chooses to adopt. Effective government will be able to implement PAYG pensions responsibly. It will also generally be able to maintain the macroeconomic stability and regulatory standards on which funded pensions depend.
  • Economic growth is also important for any pension arrangement. Output growth makes it easier to finance PAYG pensions by broadening the contributions base, and easier for funded pensions to deliver planned living standards in retirement by ensuring that output is sufficient for pensioners to buy without causing price inflation or asset market deflation.

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This is true even for the simplest financial arrangements. Banks may offer higher interest rates on new accounts while leaving the terms of existing accounts unchanged, relying on the inertia of existing savers. In some countries regulation restricts the freedom of banks to offer different interest rates in this way.


This author’s first paper on the topic was published in 1979; for a more recent restatement, see Barr (2002).


A situation is described as Pareto efficient if resources are allocated in such a way that no reallocation can make any individual better off without making at least one other individual worse off. A policy that makes someone better off and nobody worse off is referred to as Pareto improving.


Even though great attention was paid to administrative requirements when planning the pension reforms in Poland that were implemented in the late 1990s, the reforms faced considerable administrative problems in the early days (Chłoń-Domińczak, 2004, especially pp. 165–71).


For example, in 2010 95 percent of Canadian pensioners received the full Old Age Security pension, which is noncontributory; only the top 2 percent of income recipients received no Old Age Security pension at all.


More generally, Fishback and others (2007) show the improved health outcomes that followed surprisingly rapidly after the introduction of a federal safety net in the United States as part of the New Deal.


For a more detailed discussion, see Barr and Diamond (2011).

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