24793 'EVELo*M :NT : ; IEF Number 43 The World Bank November 1994 working age population retires and Red istri buti on across age is replaced by much smaller cohorts of younger workers. Kenya starts cohorts i n pay-as-you-go out young, with a rapidly growing population, and remains young un- For younger cohorts, the costs of a pay-as-you-go til after 2030, when today's children pension scheme rise and benefits fall as populations age will be bearing children and when its demographic transition is pro- jected to begin. s income rises, families typical Eastern European country, For each country, the projections A tend to have fewer children has a population that is already old show the contribution rate required _ and people tend to live and shrinking, though the decline to finance a 40% average benefit rate longer. Together, these forces have will be more gradual than in Japan. (that is, the average benefit divided raised the old age dependency ratio The number of people in Argentina, by the average wage) and the life- in many countries.* This demo- as in many other Latin American time transfer that this type of pension graphic transition is already well countries, is expected to increase for system implies for a program begin- under way in OECD countries, and the next century, though at a declin- ning in 1995 (see the figure). Every- dependency ratios are expected to ing rate. Argentina's old age depen- one is assumed to start work at age climb in much of Latin America, dency rate will thus increase less 20 and to retire at age 60: Everyone Central Asia, Eastern Europe, and dramatically than Hungary's or over 60 receives the same pension- China over the next two decades. Japan's. China now has a younger including, at the beginning, those By the year 2050, only Africa will population than the others, but the who never contributed. The real av- still be "young." old age dependency ratio will in- erage wage in the economy is as- As the resources of fewer workers crease precipitously when the large sumed to rise 1% each year, and are stretched to support a larger old population, pay-as-you-go schemes will inevitably yield rapidly dimin- Required contribution rates will rise dramatically ishing payoffs to future genera- Contnbution rate required to maintain pension system tions, unless productivity rises fast solvency for a 40 percent average benefit rate enough to offset the effects of demography. Projected demo- 3n graphic profiles for Argentina, China, Hungary, Japan, and Kenya 25 Hungary illustrate the increasing costs and .------ Ci decreasing returns to younger co- 20 Anina horts under pay-as-you-go pension 20 Argentina plans, with populations aging be- tween now and 2075. 15 Japan's population is younger than those in most OECD countries today, but it will age rapidly. Al- though its population is still grow- ing slightly, growth will turn 5 negative after 2005. Hungary, a 0 'For moredetails,seeWorldBank,AvertngtheOldAgeCnszs 1995 2005 2015 2025 2035 2045 2055 2065 2075 (New York: Oxford University Press, 1994). Source: World Bank. Averting the Old Age Cnsis (New York: Oxford University Press, 1994). wages also grow 1% for every year Early generations gain-later ones lose of experience. Pensions are indexed Year Argentina China Hungary Japan Kenya to the economywide average wage. In all five countries, the depen- Old age dependency ratio dency ratio rises throughout the life span of the individuals born in 1995 0.27 0.16 0.37 0.36 0.12 1995, when the plan is imple- 2050 0.43 0.53 0.61 0.79 0.21 mented. This effect is greatest in 2075 0.48 0.60 0.61 0.68 0.44 China, where the old age depen- dency rate nearly quadruples. In all Lifetime benefits minus contributions as percentage of lifetime income five countries, the result is a sharp rise in contribution rates of later 1995 13.5 13.5 13.5 13.5 13.5 generations, if the benefit rate is 2015 8.3 9.7 5.6 4.5 11.5 held constant at 40%. To maintain a 2025 5.5 7.0 0.4 -2.0 10.6 constant 40% benefit rate over this 2035 2.6 3.1 -5.0 -9.0 9.5 period, the contribution rate would 2045 1.7 0.3 -6.9 -12.6 9.1 have to double in most countries 2055 0.1 -2.9 -8.7 -15.1 8.0 and more than triple in China. If 2065 -1.5 -5.7 -9.6 -16.2 6.2 evasion, administrative expenses, unemployment, disability, survi- Source: World Bank, Averting the Old Age Crisus (New York: Oxford University Press, 1994). vors' benefits, and early retirement are also taken into account, the re- many young workers to support Since their systems began many quired contribution rate would ex- them. But in Hungary and Japan the years ago, they are already well ceed 35% when today's children net gain turns negative for cohorts along in this process of high tax have retired. This high contribution who retire in 2035 and 2025, respec- rates and low returns. rate, in addition to the income tax tively (see the table). In China, chil- While variables such as retirement rate, increases the probability that dren who are born in 1995, the year age, contribution rate, and expected people will evade and retire early, the program is put in place, and re- longevity can change, the underly- making the situation worse. tire in 2055 lose lifetime income. If ing pattern remains. When less The first few generations-the the discount rate is higher than predictable perturbations-natural grandparents and parents in 1995- 2%-which seems plausible-the disasters, famines, epidemics, immi- experience large and positive gains negative transfer would be greater gration, and wars-are superim- (net present value of pension ben- and would start sooner. These co- posed on this pattern, some cohorts efits received by each generation horts will never recoup in pensions fare better and others fare worse minus the net present value of its the present value of the taxes they than the projections here show. But contribution stream divided by the paid to support the pensions of the trend toward higher old age de- net present value of its lifetime their parents and grandparents. Evi- pendency rates is inevitable, as are earnings, assuming a 2% discount dence from OECD countries, where higher required contribution rates rate). This happens because older populations are already aging, is or lower pension rates and the re- cohorts contributed for only part of consistent with this pattern of rising distribution from younger to older their working lives but receive full tax rates, lower benefit rates, and cohorts for the next 50 years or pensions, and because they have intergenerational redistributions. more, under pay-as-you-go. Development Briefs are issued by the World Bank to inform the media, busmess, academic, and government policy communities about development policy analyses and results from the Bank's research activities They are drawn from theworkof individual Bank researchers and do notnecessarily represent the viewsof the World Bankand its membercountnes-and should not thereforebeattributed to the World Bank or its affiliates. Briefs are Issued penodicaUly by the Research AdvisoryStaff, Development Economucs Vice Presidency, The World Bank, 1818 H Street, NW. 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