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Averting the
Old Age Crisis
A World Bank Policy Research Report






Averting the
Old Age Crisis
Policies to Protect the
Old and Promote Growth
Published for the World Bank
OXFORD UNIVERSIT Y PRESS



O/6ord ULniversity Press
OXFORD  NEW YORK  TORONTO
DELHI BOMBAY  CALCUITA  NtADRAS  KARACFHI
KUA1,A LUMPUR  SINGAPORE  HONG KONG  TOKYO
NAIROBI DAR ES SALAANI CAPE FONKN
MELBOURNE  AUCKLANI)
i7nd associated companies in
BERILIN IBADAN
©D 1994 Thec International Bank for ReconstrnCtiZon
ainld Development I TE iV'OR'LD BARAN
1818 H Street, A W
W4'sbhingtocs, D.C 20433, US.A.
Published by Ovtbrd UTnivers-ity /Press, Inc.
200 A'Iadison Avenue, ANewt York, N Y 10016
Oxvfrld is a registered trademalk of' Oxford Liniversity Press.
.A/1 rights reserved. A' part of this publicationi may} be reproduced, stored in a retrieval s,yw''eln,
or transmitted, in any. fcrm or bis any means, electronic. ineciAnical. photocopying, record-
iug. or otherwise, without the prior persimlision ofOCxfJrd University Press.
Alanutiazcttured in the United Stores ofAmericai
First printinig Scptember 1994
Covyer photogaraphs: At the bottom, ior lke1J3 in a television faictory in Hanoi. liet  am, by} Les
Stone/Sygm,7. Used by permission. Portraits of aged individuals are World Banik photographs
bhI Curt GlCarenark.
Librarl ofCej ngress (ttaloginy-in-Iulication Data
A i!rting the okl dage crisis: policics to protectr the old and pro mote grolvth.
p. cm. -  (A lVorld Bank policy research rporJt)
Includes bibliographictal re/frences.
0'1v U-19-S520990-6
1. Old ag pensions.        2. Retirement income.           3. Aged-Economnic
conditions.          4. COldagec assistance.        5. Economic security.
1. Se ries.
HD.I0S .3.A 94 1994
33 1.5 ' 2-dc20                                                               94-1661
'.l 1020-0851
Text pprinted on paper that couforms to the Amnerican Nitional Standardfrr Permanence
of                               -ipc'r br Printce Iibrar Aia-ral. s Z39.48-1984



Contents
Foreword   xiii
The Report Team xv
Acknowledgments xvii
Definitions   xix
Overview    1
Old Age Security Problems around the World   3
The Governmenit and Old Age Security   5
Toward a Multipillar System   10
How to Get There  19
ConIclusion   2
Notes  23
1  Growing Older   25
The Gravinig of the World's Population   27
Infornal Sysrems of Old Age Support and Their Breakdown   32
aWhy Should Governmenits Get Involved? The Failures of the
Marketplace  36
How Have Governmenits Responded?  38
Plan of This Report  47
Note  48
2   Informal Arrangements   49
The Diversity of Informal Systems  50
What Makes Informal Support Systems Run?   55
Signs of Breakdown   60
Interactions between Public and Private Transfers: Crowding Out
and Crowding In  66
Policies to Keep Family Support Systems Afloat  67
3   Policy Choices for Formal Systems   73
Voluntarv or Mandatory Mechanisms? How Much Mandatorv
Coverage?  74



AVERTING THE OLD AGE CRISIS
Saving or Redistribution-and the Link between Benefits and
Contributions  76
Bearing the Risks: Defined Benefits or Defined Contributions?  83
Financirig the Plans: Funded or Pay-as-You-Go?  87
Should Pensioni Reserves Be Publicly or Privarely Managed?  93
Which Pillars, Which Design Features?  96
4   Public Pension Plans   101
The Evolution of Publicly Financed Old Age Pensions  102
How Public Pension Plans Work  109
Hoxv Public Pension Plans Affect the Economv   120
W1ho Benefits and Who Loses?  130
The Finanicial Unsustainiability of the Public Pillar  138
Conclusioll  156
5  Occupational Pension Plans   165
Brief History  166
How Occupational Plans Work  167
Economic Impact  172
Who Benefits and Who Loses?  184
Regulatory Issues  187
Coniclusioll  198
6   Personal Savings Plans-Becoming Mandatory?   201
Brief History  203
How Mandatory Retiremenit Saving Schemes Work  204
Impact on the Broader Economy  208
Do Mandatory Saving Schemes Redistribute lncome and
Alleviate Poverty?  216 
Regulatory Issues in Decentralized Schemes  218
Conicltsioni  229
7   Putting the Pillars Together   233
The Reasons for a Multipillar System   234
Choosinig the Public Pillar-to Alleviate Poverty  239
Choosing the Mandatory Funded IPillar-for Efficiency and
Growvth  244
The Voluntary (Personal or Occupationial) Pillar  247
Putting the Pillars Together  248
Conclusion   254
vi



CONTENTS
8   Transitions   255
Laying the Groundwork: Countries with Young Populations  255
Young but Rapidly Aging Economies  258
Gradual Transitions in Middle Age  261
Middle-Aged Countries in Trouble-Considering Radical
Reform   263
The Politics of Transition   270
Countries in Transition   273
Concluding Thoughts  291
Note  292
Issue Briefs   293
1   How MucIh Should a Pension Pay Out? The Target Wage
Replacement Rate  293
2    Pay-as-You-Go or Fully Funded-Which Costs Less?  297
3   Pay-as-You-Go under the Demographic Transition   303
4    Impact of Pension Financinig on Saving  307
5   Comparing, Administrative Expenses of Alternative Pension
Schemes  311
6   The Life Cycle of Pay-as-You-Go Public Pension Schemes  315
7   Evasion   319
8    Public Penisions and Retirement  321
9    Redistribution between Generations  325
10   Annuity Market Problems and How to Resolve Them   329
11   Simulations of Alternative Multipillar Systems  333
12   Simulation of an Eastern European Transition   339
Appendix: Statistical Tables   343
Bibliography   375
For Further Reading   399
Data Notes   401
Boxes
I    Myths and Facts about Old Age Security  11
1.1   The Plight of Older Women  29
1.2   Will the Falling Child Dependency Rate Offset the Rising Old
Age Dependenicy Rate?  35
1.3   Health Care and Old Age Security  46
vii



TGNG  THE OLD AGE CRk        S
2.1   Caring for Parents in T hailand   51
2.2  In Inidia, the Informal System Treats Widows Poorly  53
2.3  Is Old Age Security a Motive for Large Families?  58
2.4   Do Public Transfers Crowd Out Pr ivate Ones?  67
2.5   Governimlenit Programiis That Complement Informal Care
of the Old 70
4.1   How Defined Are Defined Benefits?   1 12
4.2   Pros and Cons of Flat versus Means-Tested Benefits  117
4.3   Pros and Cons of Earnings-Related Benefits  119
4.4  Is Earls Rertirement a Good Way to Reduce Unemployment
and Facilitate Privarization?I 125
4.5   How Do Penisioni Reserves Fare in the Ptiblic Pillar?  127
4.6   Redistributioni withiin the Same Generation   133
4.7   Pension Problems in Eastern Europe   142
4.8   Earnings-Related Benefits: How Not to Do It  150
4.9   A Better Way: Flat and Means-Tested Benefit Formulas in
OEC D CouLntries   1 52
4.10  Inflationi and Indexation under Public Pension Schemes   155
4.1 1  Should Public Peptsions Be Indexed to Prices or Wages?   157
4.12  Tough Decisions in OF(:D Countries   159
4.13  Key Features of a Reforned Public Pillar  161
5.1   Recent Developments in Occupational Pension Schemes in
OEtCD Countries   168
5.2   Occupationial Pension Schemes in Developing Countries   171
5.3   Are Pension Fulids Good Monitors of Corporate
Management?  179
5.4   Are Underfunded Occupational Plans Viable?   189
5.5   Liberating Pension Funds: An Idea Whose Time Has Come?   192
5.6   Private Pensioni Regulation in Indonesia  196
7.1   How Do Men and Womeni Fare under Alternative Old Age
Schemes.  252
8.1   Taking Stock   256
8.2   Design Choices for the Public Pillar  258
8.3   Pillars and Pitfalls  259
8.4   Design and Regulatory Issues for the Mandatory Saving Pillar  260
8.5   How Did Chile Pay Off Its Social Security Debt?  267
8.6   Using Privatized Public Assets to Pay Off the Social Security
Debt in the T'ransitionial Economies  270
8.7  \What Reforms Have Eastern European Economies Introduced
So Far?  29'0
Text figures
I     Percentage of Increase in World Population over 60 Years Old,
by 2030   2
vi ii



CONTENTS
2     Projected Public Pensioni Spendinig by Regioni, 1990-2050   7
3     The Pillars of Old Age Income Security  15
1.1   Percentage of the Population over 60 Years Old. by Region, 1990
and 2030  26
1.2   Ratio of Olcd Women to Old Men in Developing and Industrial
Countries, 1990  28
1.3   Relationship between Aging and IncoIm1e Per Capita. Selected
Countries, 1990  31
1.4   Relationship betwveen the Old Age Dependency Ratio and Income
Per Capita. Selected Countries, 1990   32
1.5   Percentage of People over 60 Years (-)ld, by Region, 1990 and
2030   33
1.6   Number of Years Required to Double the Share of the Population
over 60 from 9 to 18 Percent, Selected Countries  34
1.7   Relation between Publicly Mandated Pensioni Plan Coverage and
Iincome Per Capita  40
1.8   Relation between the Percentage of the Population over 60 Years
Old and Public Pension Spending  41
1.9   Relation between Income Per Capita and Public Pension
Spending  42
1.10  Public Health and Pensioni Spending Compared witlh Population
Aging  44
3.1   Relative Povertv Rates for Children and for Persons over 60 Years
Old, Selected Countries in Latin America, 1 980s  78
3.2   Relative Poverty Rates by Age GroLIp for OECO) CouL1nries.
MNid- 1 980s  79
3.3   Percentage of All Persons over 65 and Females Living Alone with
Incomes below Subsistence, Selected OECD CouLntries.
Early ]980s  81
3.4   Effects of Different Rates of Inflation on1 Unindexed Pensions  85
3.5   Contribution Rates Required to Finance a 40 Percent Flat
Pension for a CouLntry with a Young but Rapidly Aging
Population   90
3.6   The Growth of the Implicit Public Pensioni Debt. 1995-2075   91
3.7   Average Annual Investmenr Returns for Selected Pension Funds,
1980s 95
4.1   Public IPensioni Spending during the Demographic Transition:
United Kingdom Historical Pattern versus Current Global
Pattern  107
4.2   Pension System Stirplus or Deficit as Share of System Revenues
(1986) and Old Age Dependency Ratio (I1990)  111
4.3   Payroll Tax for Pensions versus Old Age Dependency Ratio,
Selected Countries. 1990   120
4.4   Percentage of Labor Force in the Informal Sector. Selected Latin
American Countries, Late 1980s  123
i2.



gAVRRTING THE OLD AGE CRISIS
4.5   Expected Durationi of Retirement for Men. Selected Countiries,
Late 1980s  124
4.6   Average Annual Real Investment Returns for Selected Publicly
Managed, Partially Funded Pension Schemes in the I 980s  1 28
4.7   Access to Social Security in Latin America, by Income Quintile,
Late 1980s  132
4.8   Rates of Return to Generations Retiring Twenity-five to Forry-five
Years after the Start of a Public Pension Scheme   136
4.9   Explicit Debt versus Implicit Public Pension Debt in Seven OECD
CouLntries, 1990   139
4.10  Maturation of the Mexican Pension Schemes, 1960-92   144
4.11  System Dependency Ratio versus Old Age Dependency Ratio,
Selected Countries  146
4.12  Real Pension Levels in Venezuela, 1974-92   154
5.1   Share of Occupational Pension Fund Assets in Domestic Equities
and Foreign Securities, Selected OECD Coun1tries, 1970
and 1990   175
6.1   Relationship of Annual Administrative Expenditures to Total Assets,
Chile, 1982-92   225
7.1   The Multipillar System in OECD Countries, Mid-1980s: Percentage
of Nonwvage Income from Public Pensions, Occupational
Pensions, and Personal Savings  250
Text tables
1.1   Relative Per Capita Social Spending. by Age Group, 1980  34
2.1   Percenitage of Respondents for Whom Help in Old Age Is a
"VAerv Important' Motive for Wanting Another Child  57
2.2   Percentage of Parents Who Expect Financial Help from Sons (S)
and Daughters (D)  62
2.3   Sources of Income in Old Age, Selected Countries, 1980s  63
2.4   Living Arrangements of Older Persons, 1 980s  64
2.5   Expected Help from Children by Economy and Sex of
Respondents. 1975-76   65
3.1   Alternative Financing and Managerial Arrangements for Old Age
Security  97
4.1   Public Pension Spending and Coverage   103
4.2   Ratio of Average Pension to Average Wage in Selected OECD
Countries, 1939 and 1980   104
4.3   Contribution Rates Required for Different Benefit and Dependency
Rates under Pay-as-You-Go   110
4.4   Spending on Universal Flat and Means-Tested Old Age Benefits,
Selected Countries, 1986-92   115
5.1   Occupational Pension Coverage for Selected Countries, 1980s  170
5.2   Pension Fund Assets as Percentage of GDP, 1970-91   174
x



CONTENTS
5.3   Simulated Real Rate of RetLIln to 1'rivate Occupationial Pension
Funds in Eight Industtrial Coun1tries, 1970-90   176
5.4   Tax Expenditures in Selected Countries   183
5.5   Distributioll of Occupational Pensionis amongf Households with
Heads Age 65 or Over, by Income Quintile. Selected OE)
Countries   1 85
6.1   Contributioni Rate Needed to Pay Pension Equal to 40 Perceint
of Final Salary under Mandatory Saving Schemile  205
6.2   Payroll Tax Rates for Mandatory Saving Schienies, 1]991   206
6.3   Assets of Selected National Provident Funds  210
6.4   Operating Costs and Investiment Retirnls  224
7.1   Recomimiended Multipillar Combiniations  248
8.1   Pension Reforms in Latin America   277
Appendix tables
A.1   Demographic Inidicators. 1990   343
A.2   Percentage of Population over Sixt; Years Old, 1990-21 50   349
A.3   Average Annual Compound Real Growth Rare of W(ages,
Selected Periods  354
A.4   Public Pensioni Scheme Coverage. Selected Countries  356
A.5   Public Pension Spending Indicators  358
A.6   Publicly Managed Pensioni Scheme Financing, Selected
Countries, 1986   361
A.7   Main Publicly Mandated Pension Scheme Design Features,
1991   364
A.8   Percentage of Recenit Average Earnin1gs IPaid as a Pension after
Thirty Years of Covered Employment. Selected Countries,
1991  369
A.9   Comparison of Administrative Costs of Publiclv Mandated
Pension Schemes  370
A. 10  Expected Dtiratioin of Reriremenit at Official Retirement Age. by
Incomile Level, Selected Countries  371
A.1 I Public Pension Schemiles in Tranisitional Economies, Post-1990   373
A. 12  Portfolio Distributioni of Pension Fulids in Eight oEcWC
Countries  374
xl






Foreword
SYSTEMS PROVIDING FINANCLAL SECURITY FOR TIHE OLD ARE
under increasing strain throughout the world. Rapid demographic
transitions caused by rising life expectancy and declining fertility
mean that the proportion of old people in the general population is
growing rapidly. Extended families and other traditional ways of
supporting the old are weakening. Meanwhile, formal systems, such as
government-backed pensions, have proved both unsustainable and very
difficult to reform. In some developing countries, these systems are
nearing collapse. In others, governments preparing to establish formal
systems risk repeating expensive mistakes. The result is a looming old
age crisis that threatens not only the old but also their children and
grandchildren, who must shoulder, directly or indirectly, much of the
increasingly heavy burden of providing for the aged.
For these reasons, many economists and policymakers are seeking in-
formation and advice about old age security arrangements. But there are
still too few who are aware of the impact these arrangements have on
such diverse concernis as poverty, employment, inflation, and growth.
Averting the OldAge Crisis: Policies to Protect the Okl and Promote Growth
is the first comprehensive, global examination of this complex and
pressing set of issues. The culmination of a tvo-year research project. it
synthesizes what is known, analyzes the policy alternatives, and provides
a framework for identifying the policy mix most appropriate to a given
country's needs.
The study identifies three functions of old age financial security
systetns-redistribution, saving, and insurance. It evaluates the policy
options for meeting these according to tvo criteria: their impact on the
a,ed and their impact on the economy as a whiole. It finds that most
existing systems provide inadequate protection for the old (because
benefits are rarely indexed) and that redistribution is frequently
perverse-for example, from poor young families to comfortable retirees.
Moreover, as the systems mature, they may actually hinder growth-
througlh high wage taxes, which cause evasion and push labor into the
less efficient informal sector; through rising fiscal deficits, which fuel
inflation; by squeezing ouL growth-promoting public spending, such as
xiii



AVERTING THE Ol.D AGE CRISIW
education or health services for the young; or through a combination of
all three.
The study suggests that finanacial security for the old anid economic
growth would be better served if governments develop three systems, or
pillars," of old age securiry: a publicly maniaged system with mandatory
participation anid the limited goal of reducing poverry among the old; a
privately managed. mandatory savings svstem; and voluntary savings. The
first covers redistribution, the second and third cover savings, and all three
coinsure against the many risks of old age. By separating the redistributive
functioni from the savings fLnction, the public pillar-and the size of the
payroll tax needed to support it-can be kept relatively small, thus avoid-
ing many of the growth-inlibiting problems associated with a dominant
public pillar. Spreading the insuranice functioni across all three pillars offers
greater income securiry to the old than reliance on any single system.
Thle relative importance of each pillar, and the riinng of tranisitionls
to a sustainiable old age security framework, will vary among countries.
The report analyzes these differences and the appropriate reform strate-
gies in detail. The bottom line is that all countries should begin plan-
nilng for their aging populatiols now.
This volume is the third in a series of Policy Research Reports pre-
pared by the W/orld Bank Development Economics Vice Presidency.
Like the first two reports. The East Asian Miracle and Adjustnment izn
Africa, it brings to a broad audience the results of World Bank research
onl key development policy issties. Whlile accessible to nonispecialists,
these reports are also meanit to contribute to the debare among aca-
demics and policymakers about the appropriate public policy objectives
and instrLImenits for developing economies. As research documents, they
may also provoke debate about the analytic methods used and the con-
clusions drawn.
Averting the OltAge Crisis is a product of the staff of the World Bank,
and the judgments made hereini do not necessarily reflect the view of its
Board of Directors or the governmenits they represent.
Michael Brunlo
Vice President Development Economics
and Chief Economist
The World Bank
xiv



The Report Team
HIS POLICY RESEARCH REPORT WAS PREP'ARED BY A TEAM LED
bv Estelle James anid comprising Ashl Demirguc-Kunt, Louise
T     Fox, Donald Keesing, Robert Palacios, Klaus Schmidt-Hebbel,
Anita Schwarz, Salvador Valdes-Prieto, Dimitri Vittas, and Christine
\Xillich. Jeffrey Nugent had primaly responsibility for the chapter on
informal systems of old age income support. Meta de Coquereaumont
and Bruce Ross-Larson were the principal editors. The study was initi-
ated by Lawrence H. Summers and Nancy Birdsall and was carried out
tinder the general direcrion of Michael Bruno and Lyn Squire.
The editorial-production team was led by Anthony Pordes. The ream
was assisted by Paola Brezny, Heather Cochran, D)aniele Evans, Audrey
Heihignman, Jennifer Keller, Montserrat Pal]ares-Miralles, Sushma Rajan,
and Elfreda Vincent. Polly Means assisted with graphics. Alfred Imhoff
and Lawrence MacDonald provided additional support.
xv






Acknowledgments
M         ANY INDIVIDUALS INSIDE AND OUTSIDE THE WORLD BANK
provided valuable contributions and comments. Particular
thanks are due to: Emily Andrews, Anthoiiy B. Atkinson,
Nicholas Barr, Zvi Bodie, Gerard Caprio, David Cole, Peter Diamond,
Elizabeth Duskin, Conli Gillion, Dalmer D. 1-loskins, Michael Hurd.
Richard Ippolito. Emmanuel Jimenez, Larrv Kotlikoff, Ching Boon
Lee, Sean McAlinden, William McGreevey, Olivia Mitchell, Robert J.
Myers, Tom Powers, Monica Queisser, James Schulz. Jee Peng Tan,
John Turner, and Zafiris Tzannatos. The report drew on background
papers prepared by: Patricio Arrau, MLikul G. Asher. Barry P.
Bosworth, Gary T. Burtless, Maria G. Cattell, Eric P. Davis, Jane Falk-
inghamii, Robert Holzmann, Paul Johnson, Deborah Mitchell, and
Olivia S. Mitchell.
xvii






Definitions
Economy Groups
F     OR OPERATIONAL AND ANALYTICAL PURPOSES. THE WORLD
Bank's main criterion for classifying economies is gross national
product per capita. Economies are classified as low-income,
middle-income, or high-income. The income-based economy group-
ings used in this report are defined in 1990 U.S. dollars (not adjusted
for purclhasing power parity) as follows:
* Low-income economies are those with a gross nationial product per
capita of less than $600.
* Middle-incomne economiies are those with a gross nationial product
per capita between $600 and $8,000.
* High-iCncome economies are those with a gross national product per
capita of more than $8,000.
Low-income and middle-income economies are sometimes referred
to as developing economies. The use of the term is convenient; it is not
intended to imply that all economies in the group are experiencing sim-
ilar development or that other economies have reached a preferred or
similar stage of development. Classification bv income does not neces-
sarily reflect development status.
Geographical Groups
T       HE GEOGRAPHIC GROUPING USED IN THIS REPORTARE NOT
intended to be comprehensive lists of all countries in a particular
region. Furthermore, complete data may not be consistently avail-
able for all countries in each group. Where coverage differs significantly
from the standard definitionis that follow, those differences are indicated.
* Sub-Saharan Africa comprises Angola, Benin, Botswana, Burkina
Faso, BuruLIdi, Cameroon, Cape Verde, the Central African Re-
xix



I   G THE OLD AGE CRISIS
public, Chad, Comoros, Congo. C6te d'lvoire, Dijbouti, Equato-
rial Guinea, Ethiopia, Gabon, The Gambia, Ghana, Guinea,
Guinea-Bissau, Kenya, Lesotho. Liberia, Madagascar, Malawi,
Mali, Maiauritanlia, Mauritius, Mozambique, Namibia, Niger,
Nigeria, Rwanida, Sao Tome and Principe, Senegal, Seychelles,
Sierra Leone, Somalia, Southi Africa, Sudani, Swaziland, Tanzania,
Togo, Uganda, Zaire, Zambia, and Zimbabwe.
* Asia comprises Afghanistan, Bangladesh, Bhutan, Brunei, Cambo-
dia, China, Fiji, Hong Kong, India, Indonesia, Kiribati, the Dem-
ocratic People's Republic of Korea, the Republic of Korea, the Lao
People's Republic, Macao, Malaysia, Maldives, the Federated States
of lMicronesia, Mongolia, Myanmar, Nepal, Pakistani, Papua Newv
Guinea, the Philippines, Singapore, the Solomon Islands, Sri
Lanka, Taiwan (China), Thailand, Vanuatu, and Viet Nam.
* The ilMfiddle East and North Af-ica comprises Algeria, Bahrain,
Cyprus, Egypt, the Islamic Republic of Iran, Iraq, Israel, Jordan,
Kuwait, Lebanoni, Libya, Malta, Morocco, Oman, Qatar, Saudi
Arabia, the Syrian Arab Republic, Tunisia, Turkey, the United
Arab Emirates, and the Republic of Yemeni.
* Eastern Europe and the forier Soviet Ulnionz comprise Albania, Ar-
menia, Azerbaijani, Belarus, Bulgaria, Croatia, the Czech Repub-
lic, Estonia, Georgia, Hungarv, Kazakhstan, the Kvrgyz Republic,
Larvia, Lithuania, lMoldova, Poland, Romania, Russia, Slovenia,
Taijikstani, Turkmeinistan, Ukraine, Uzbekistan, and the Federal
Republic of Yugoslavia.
* Latini AmzeriCa and the GCzribbean comprise Antigua and 13arbuda,
Argentina, the Bahamas, Barbados, Belize, Bolivia, Brazil, Chile,
Colombia, Costa Rica, Cuba. Dominica, the Domiicani Repub-
lic, Ecuador, El Salvador, Grenada, Guadeloupe. Guatemala,
Guyana, Haiti, Honduras, Jamaica, Martinique, Mexico,
Nicaragua, Panamila, Paraguay, Peru, St. Kitts and Nevis, Sr. Lucia,
Surinamne, Trinidad and Tobago, Uruguay, and Venezuela.
Acronyms and Abbreviations
AlI)    Administradora de Fondos de Pensionies (Pensioni Fulnd Ad-
ministrator). A private pension fuind manager in Chile.
GDP   Gross domestic product
xx



GNI'   Gross national product
IL)B    Initer-Americain Developmenit Bank
ILo     International LabouL- Organisation
INfF    Iniernatioiial Monetary Fulld
ISSA    Interniationial Social Securitv Association
OECD   Organization for Econon-ic Cooperation and Development
(Australia, Austria, Belgiulll, Canada, Denmllark, Finland.
France, Germany, Greece, Iceland, Ireland, Italy, Japan, Lux-
embourg, the Netherlands, New Zealand, Norway, Portugal,
Spain, Swedeni, Switzerlanid, Turkey, the United Kingdom, and
the United States).
Glossary
Actuarial fizirn ess: a method of setting insurance premiums according to
the true risks involved.
Adverse selection: a problem stemming from an insurer's inability to dis-
tinguislh betveen high- and low-risk individuals. The price for insur-
ance then reflects the average risk level, whiclh leads low-risk
individuals to opt out and drives the price of insurance still higher
until insurance markets break down.
Average eJjffective retirement age: the actual average retirement age, taking
into accounlt early retirement and special regimes.
Benefit rate: the ratio of the average pensioni to the average economy'-
wide wage or covered wage.
Contracting out: the right of employer-s or employees to use private pension
fund managers instead of participating in the publicly managed scheme.
Defined benefit: a gLarantee by the insurer or pension agencv that a ben-
efit based on a prescribed formula will be paid.
Defined contribution: a pensioni plan in which the periodic contribution
is prescribed and the benefit depends on the contribution pIlIs the in-
vestment return.
Demograph'ic transition: the historical process of chanlginig demnograpllic
structure that takes place as fertilitv and mortality rates decline, re-
suLtillg in an increasing ratio of older to younger persons.
XXI



FRV1~TING THE OLD AGE CRISIS
Fullfunditneg: the accumulation of pension reserves that total 100 per-
cent of the present value of all pension liabilities owed to current
mem bers.
Implicit public pensioon debt (net): the value of outstanding pension
claims on the public sector minus accumulated pension reserves.
Intergenerational distribution: income transfers between different age
cohorts of persons.
Intragenerational distribution: income transfers within a certain age co-
hort of persons.
Legal retirei7zemzt age. the normal retirement age writteni into pension
statutes.
Mleans-tested benefit: a benefit that is paid only if the recipient's income
falls below a certain level.
Minimum pension guarantee: a guarantee provided by the government
to bring pensions to some minimum level, possibly by "topping up"
the capital accumulationi needed to ftind the pensions.
Moral hazard: a situation in which insured people do not protect them-
selves from risk as much as they would have if they were not insured.
Old age dependenzy natio. the ratio of older persons to working age in-
dividuals. The old age dependency ratio used in the text refers to the
number of persons over 60 divided by the number of persons aged
20 to 59.
Pay-as-you-go: in its strictest sense, a method of financing whereby cur-
rent outlays on pension benefits are paid out of current revenues
from an earmarked tax, often a payroll tax.
Pension coverage rate: in this report, the number of workers actively con-
tributing to a publicly mandated contributory or retirement scheme,
divided by the estimated labor force.
Pension spending: in this report, pension spending is defined as old age,
retirement, survivors, death, and invalidity-disability payments
based on past contribution records plus noncontributory, flat uni-
versal, or means-tested programs specifically targeting the old.
Portability: the ability to transfer accrued pension rights between plans.
Xii



DE FIN IT IONS.
Providentfund: a fully funded, defined contribution scheme in which
funds are managed by the public sector.
Replacement rate: the value of a pension as a proportion of a worker's
wage during some base period, such as the last year or two before re-
tireinent or the entire lifetime average wage. It also denotes the aver-
age pension of a group of pensioners as a proportion of the average
wage of the group.
System dependency ratio: the ratio of persons receiving pensions from a
certain pension scheme divided by the number of workers contribut-
ing to the same scheme in the same period.
System maturation: the process in which young people who are eligible
for pensions, in a new system, gradually grow old and retire, thereby
raising the system dependency ratio to the demographic dependency
ratio. In a fully mature system all old people in the covered group are
eligible for fLill pensions.
Universal flat benefit: refers to pensions paid solely on the basis of age
and citizenship, without regard to prior work or contribution
records.
Vestingperiod: the minimum amount of time required to qualify for full
ownership of pension benefits.
xxii.






Overview
S WE GROW OLD WE WORK. PRODUCE, AND EARN
A          less, and therefore need a secure source of income to
see us through life. Societies and governments have
developed mechanismiis to provide income security
for their older citizens as part of the social safety net
for reducing poverty. But these arrangements are a
concern for all of us-rich as well as poor, young as well as old-because
the arrangements adopted can either help or hinder economic growth.
Today, as the wvorld's population ages, old age security systems are in
trouble worldwide. Informal commun1ity- and family-based arrange-
ments are weakening. And formal programs are beset by escalating costs
that require high tax rates and deter private sector growth-while failing
to protect the old. At the same time, many developing countries are on
the verge of adopting the same programs that have spun out of control
in middle- and high-income countries.
Consider these facts:l
* In 1990 almost half a billion people, slightly more thani 9 percent
of the world's population, were over 60 years old. By 2030, the
nullmber will triple to 1.4 billion. Most of this growtlh will take
place in developing countries, over half of it in Asia and more than
a quarter in China alone (figure 1).
* Because of the broad diffusion of medical knowledge and declining
fertility, developing cotintries are aging much faster than the indus-
trial countries did. In Bel,gium, it took more than 100 years for the
share of the population over 60 to double from 9 to 18 percent. In
China the same transitioni will take only 34 years and in Venezuela
22 vears. As a result, developing couLntries will have "old" demo-



:WVERTING THE OLD AGE  CRISIS
Figure 1 Percentage of Increase          graphic profiles at much lower levels of per capita income than the
in World Population over 60              industrial nations.
Years Old, by 2030                     * The demand for health services increases as countries grow older,
Transitional socialist                    since health problems and costly medical technologies are con-
economies and
developing countries,                     centrated among the old. Because health and pension spendin,
28%       _
rise together, pressure on a country's resources and government
China.        budgets increases exponentially as populations age.
29%        * Publicly managed funds set aside for the old are often dissipated
by poor management. In Zambia, the public provident fund, in-
vested exclusively in public securities, lost 23 percent per year, on
average, between 1981 and 1988. More than half the contribu-
OECD                                    tions in 1988 were used for administrative expenses.
countries,              Asia
14%               (less China),      * High payroll taxes distort labor markets and reduce growth. In
Hungary, where more than one-quarter of the population are
Soince: Adapted from the World Bank     pensioners, the average effective retirement age hias fallen to 54
popLilatioiri data base.                 and the payroll tax needed to pay the pensions is 33 percent, cut-
ting the demand for labor, the supply of experienced labor, and
The number of old people will triple      national output.
by 2030, and most of the growth will
be in developing countries.            * Government pensions are rarely fully idexed to iflation, so
workers are poorly protected in their old age. In Venezuela, real
pension benefits fell 60 percent during the 1980s largely because
of inflation without indexation.
* High government spending on old age security crowds out other
important public goods and services. In 1989 Austria's pension
fund cost 15 percent of GDP (gross domestic product), and old
age benefits absorbed 40 percent of public spending. Without re-
form these already high percentages will increase further as the
population ages.
* In the Netherlands, Sweden, and the United States, workers retir-
ing in the first thirty years of the public pension scheme received
large positive lifetime transfers, whereas many workers retiring in
the future will get less than they would from other investments
and will suffer negative lifetime transfers.
* Despite seemingly progressive benefit formulas in the public pen-
sion plans of the Netherlands, Sweden, the United Kingdom, and
the United States, studies have not found much redistribution
from lifetime rich to lifetime poor in these countries. This is
partly because the rich live longer than the poor and therefore
collect benefits for more years.
2.



oVERVlgI
Everybody, old and young, depenids on the current output of the
economy to meet current consumption) needs, so everybody is better
off when the economy is growinig-and in trouble when it's not. In the
prime earning years, most people obtain claims on that output by
working and earning wages. In old age, when earnings are low, people
obtain claims on output through individual action, such as saving dur-
ing their earlier years, or through informal group action, such as family
transfers, or through formal collective action, such as public social se-
curity programs.
The choice among alternative arrangements for old age security af-
fects the welfare of the old, because it determines the share of the na-
tional pie they can claim. More fundamentally, it affects the welfare of
everyone, old and young, by influencing the size of that pie. So this re-
port holds alternative policy options up to a dual test. What is good for
the old population? And what is good for the economy as a whole? It
analyzes the successes and failures of alternative policies. It evaluates
policy options for countries introducing new formal systems of old age
securiry. And it proposes ways to reform existing programs. The idea is
to assist in the selection and design of policies that facilitate growth and
enable the old to secure an equitable share of that growth.
Old Age Security Problems around the World
I NCOME INSECURITY IN OLD AGE IS A WORLDWIDE PROBLEM,
but its manifestations differ in different parts of the world. In
Africa and parts of Asia, the old make up a small part of the pop-
ulation-and have long been cared for by extended family arrange-
menits, mutual aid societies, and other informal mechanisms. Formal
arrangements that involve the market or the governmient are rudimen-
tary. But as urbanization, mobility, wars, and famine weakeni extended
family and communal ties, informal systems feel the strain. That strain
is felt most wlhere the proportion of the population that is old is grow-
ing rapidly, a consequence of medical improvements and declining
fertility. To meet these rapidly changing needs, several Asian and
African countries are considering fundamental changes in the way
they provide old age security. The challenge is to move toward formal
systems of income maintenanice without accelerating the decline in



:THE OLD AGE CRISIS
informal systems and without shifting more responsibility to govern-
ment than it can handle.
In Latin 4America, Eastern EuL-ope, and the former Soviet Union,
which can no longer afford the formal programs of old age security thev
introduced long ago, the need to reevaluate policy is even more press-
ing. Liberal early retirement provisions and generous benefits have re-
quired high contribution rates, leading to widespreadl evasion. The
large informal sector in many Latin American countries, for example,
reflects in part the efforts of workers and employers to escape wage
taxes. The resulting labor market distortions there and in other regions
reduce productivity, pushing contributioni rates and evasion still higher,
even as limiced lonig-term  saving and capital accumulation further
dampen economic growth. Little surprise, then, that these countries
have not been able to pay their promised benefits. Most have cut the
cost of benefits by allowing inflation to erode their real value. When
Chile faced these problems fifteen years ago, it revamped the structure
of its system. Other Latin American countries are n1OW undertaking
similar structural changes, and some Eastern Europeani countries are
contemplatinig them. The challenige is to devise a new system and a
transition path that is acceptable to the old, who have been led to ex-
pect more, while also being sustainable and growth-enhancing for the
young.
Coun1tries that belong to the Organizationl for Economic Coopera-
tion and Development (OECD) face similar problems, as their popula-
tions age and their productivity stagnates. Public old age security pro-
grams covering almost the entire population have paid out large
pensions over the past three decades of prosperity, as poverty declined
faster among the old than among the youLng. But over the next two
decades, payroll taxes are expected to rise by several percentage points
and benefits to fall. That will intensify the intergenerational conflict
betveen old retirees (some of them rich) who are getting public pen-
sions and youLng workers (some of them poor) who are paying high
taxes to finanice these benefits and may never recoup their contribu-
tions. Such social security arranigements mav, in addirion, have dis-
couraged wvork, saving, and productive capital formationi-thus
contributinlg to economic stagnationl.
Many OFC(D counltries appear ro be movinlg toward a system that
combines publicly managed pension plans designed to meet basic
needs with privately managed occupational pension plans or personal
4



saving accounts to satisfy the higher demands of middle- and upper-
income groLips. The challenge is to introduce reforms that are good for
the country as a whole in the long rull, even if this involves taking ex-
pected benefits away from some groups in the short run.
The Government and Old Age Security
M    O ORE THAN HALF THE WORLD'S OLD PEOPLE ARE ESTIMA-
ted to relv exc lusively on informal and traditional arrange-
ments for income security.2 They receive food, shelter, and
care from close relatives or extended family and often provide services
or resources to the household in return. Economic development weak-
ens these informal arrangements. Families become smaller and more
dispersed. Opporttunities for market employmenlt open up for the
young. The value of time contributed by old people diminishes. And
people live longer, so the proportion of old people in the population in-
creases. Family-provided assistance continues to play an important role
in all societies. But in industrial societies, people are likely to withdraw
from productive work, to live alone, and to depend on nonfamily'
sources of income in their old age.
Why Should Governments Get Involved?
When traditional, informal arrangements for subsistence break
downi in other spheres, they are replaced by formal market arrange-
ments. Why doesn't that happen for old age sibsisrence? Why do gov-
ernments everywhere in the industrial world and increasingly in devel-
oping countries intervene so extensively in this area?
Depending purely on voluntary actions by individuals to provide for
their owin old age security leaves several problems:
* Shortsightedness-some people may not be farsighted enough to
save for their old age and may later become charges on the rest of
society.
* Inadequate savings insrrLtments-capital markets are tinde-
veloped and macroeconomic conditions are unstable in many
cotintries.
5



qR,TING THE OLD AGE CRISIS
* Insurance market failures-adverse selection, moral hazard, and
correlations among individuals make insurance against many
risks (such as the risks of longevity, disability, investment, infla-
tion, and depression) unavailable.
* Information gaps-people may be unable to assess the long-term
solvency of private savings and insurance companies or the pro-
ductivity of alternative investment programs, and cannot reverse
their choices when large mistakes are discovered late in life.
* Long-term poverty-some people do not earn enough during
their working lives to save for their old age, so redistribution is
needed to keep them out of poverty.
So government interventions are usually justified on grounds that
private capital and insurance markets are inadequate and redistribution
to the poor is needed. All too often, however, these interventions have
introdticed inefficiencies of their own and have redistributed to the
rich.
What Have Governments Done?
About 40 percent of the world's workers-and more than 30 per-
cenlt of its old-are covered by formal arrangements for old age, but-
tressed by government policy. Public spending as a proportion of (DP
has increased closely with per capita income and even more closely
with the share of the population that is old. If past trends continue,
public spending on old age securityv will escalate sharply in all regions
over the next fifty years (Figure 2). The most rapid escalation will
occur in countries that may not expect it, because their populations
are young today.
Government intervention can take and has taken many other forms
besides taxes and transfers. The government may regulate private pen-
sion funds, mandate saving, guarantee benefits, offer tax incentives,
create a legal system for reliable financial institutions, dampen infla-
tion to encourage voluntary saving, and so forth. So the important
policv questions are not: Should spending on the old increase? And
should the public sector be involved? Thev are: How should the pub-
lic sector be involved? Are public taxes and transfers the best alterna-
tive or are otlher types of public interventions and old age arrange-
ments better?
6



OVER V It
Figure 2 Projected Public Pension Spending by Region, 1990-2050
Pension spending as a percentage of GDP
20
Projections above the line are based on demographic
aging levels not yet experlenced; in 1990 the oldest
economy demographically was Sweden, with 23
percent of population over 60.                                                                OECD countries
15
T                         /    ,    ,    ,~~~~~~~~~~~~~~~~~~~~~ ~~Transiti     onal oils  orre
~~~~~~ /L~~~~~~~~~~~~atirn Anmer,ca
10                                                                                                                and the
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ASi/Ma (less China)
5
~~~~~~~~~~~~~~~~~~~~~North Africa and the
.   .                                                       S       u      b~~~~~~~~~~~~~~~~~~~~~~~~~~~~~j Saharan Africa
0   .                                                                                                            JE
1990                    2000                    2010                     2020                    2030                     2050
Note: I his projectioni ASSLIFeIeS that the CtLIrrenir relationiship berween deimogr-aphbv and speniding coniti nues. It applies coefficients of a Ii near ver-
sion ot the regression showni in tigure 1.8 to World Batik demographic projccIioIs aOf the population ovcr f0ll by region.
Source: Palacios (1994a).
Formal arrangements also differ in ways that go beyond the type and                    If trends continue, public spending
degree of government involvement. Pension funds mav have either re-                        on pensions will soar over the next
distribution or saving and insurance as important objectives. They may                     fifty years in all regions.
specify either their benefits or their contributionis in advance-defined
benefits versus defined contributions. And they may be financed on a
pay-as-you-go basis-current pensions are financed by taxes on current
workers-or on a largely funded basis-current pensions are financed
by prior savings, and liabilities don't exceed accumulated reserves.
7



AVERTING THE OLD AGE CR,ISI
Key Policy Issues
For these reasons, this report does not focus on simple public-private
distinctions. Instead, it opens the lens to five sets of questions that
distinguish among alternative old age policies and determine their
effects:
* Should the system be voluntary or compulsory? And at what levels?
* VWhat should be the relative emphasis on saving versus redistribu-
tion? And should these fLnctions be combined or provided
through separate financinig and managerial arrangements?
* Who should bear the risk of unexpected outcomes-pensioniers or
others in society?
* Shotild the system be fully funded or pay-as-you-go?
* Should it be managed centrally-or decentrally and competitively?
Alternative Financing and Managerial Arrangements
Many combinations of answers to these questions are possible but in
practice three different financing and managerial arrangements for old
age security are most common. They are public pay-as-you-go programs,
employer-sponsored plans, and personal saving and annuity plans.
Public pay-as-you-go plans. This is bv far the most common formal sys-
tem, manidatory for covered workers in all counitries. Coverage is
almost universal in high-income counltries and widespread in middle-
income countries. As its name suggests, it places the greatest responsi-
bility on governmentt, which mandates, finanices, manaages. and insures
pLublic pensions. It offers defined benefits that are not actuarially tied
to contributionis and usually finances them out of a payroll tatx (some-
times supplemented from general government revenues) on a pay-as-
you-go basis. And it redistributes real income, both across and within
generationis.
Occupational plans. These are privately managed pensions offered by
employers to attract and retain workers. Often facilitated by tax con-
cessions and (increasinigly) regltiated by governments, these plans
tended to be defined benefit and partially funded in the past. But the
ntlmber of defined contributioll plans (in whiclh contributions are
specified and benefits depend on contributions plus investmiient
returnis) and the degree of fundinig have been increasing in recent years,
8



and these have quite different effects. More than 40 percenit of workers
are covered by occupational schemes in Germany, Japan, the Nether-
lands, Switzerlanid, the United Kingdom. and the United States-but
far fewer in developing countries (see table 5.1).
Personal saving and annuity plans. These are fully funlded defined con-
tibution plans. Workers save wheni youLng to support themselves when
they are old. Since benefits are not defined in advance, workers and
retirees bear the investment risk on their savings. Voluntary personal
saving is founld in every couLntry, often encoLuraged by ta.x incenitives,
but some countries have recently made it mandatory. A key distinction
is between mandatory saving plans managed by the government (as in
Malaysia, Singapore, and several African couLntries) and those managed
by multiple private companies on a competitive basis (as in Chile and
soon in Argentina, Colombia, and Peru).
These financinig and managerial arrangements are explored in detail
in chapters 4 through 6.
Criteria for Policy Choice
The prevalence of these alternative arrangemiients depends. in large
part, on government policies that mandate, encourage, or regulate. The
effectiveness of these arranigements depends, in large part, on individual
responses, such as evasion, compliance, and the possibility of offsetting
actions that reduce other saving, transfers, and work. As a result of these
private respoonses, each arrangement has broad implications for the op-
er-arioni of labor and capital markets, for the government's fiscal balance,
and for the income distribution in society.
How are we to evaluate alternative policies? This report argues that
old age security' programs should be both an instrmellt of growth and
a social safety' net. They should help the old by:
* Facilitating people's efforts to shift some of their incomiie from
their active workinig years to old age, by saving or other means.
* Redistributinlg additional incomiie to the old who are lifetime poor,
btIr avoiding perverse inrragenerarionial redistributions and unini-
tended intergenerational redistribLutiolls.
* Providing insuranice against the many risks to which the old are es-
pecially vulnerable.
And they should help the broader economy by:
9



iA ERTING THE OLD AGE CRISIS
* Minimizing hidden costs that impede growth-such as reduced
labor employment, reduced saving, excessive fiscal burdens, mis-
allocated capital, heavy administrative expenses, and evasion.
* Being sustainable, based on long-term planning that takes account
of expected changes in economic and demographic conditions,
some of which maya be induced by the old age system itself.
* Being transparenit, to enable workers, citizens, and policymakers
to make informed choices, and insulated from political manipula-
tions that lead to poor economic outcomes.
Few programs fulfill these criteria. They do not operate the way they
are supposed to or the way many people believe they do-a conflict be-
tween myth and reality (box 1).
Toward a Multipillar System
O     NE OF THF PRIME POLICY ISSUES IN THE DESIGN OF OLD AGE
security programs is the relative importance of the saving, re-
distribution, and insuranice functions-and the role of govern-
ment in each:
*Saving involves income smoothing over a personIs lifetime: people
postpone some consumptioni when they are young anid their earn-
ings are high so that they can consumlie more in their old age than
their reduced earnings would permit.
• Redistribution involves shifting lifetime income from one person to
another, perhaps because if low-incone workers saved enougIl to live
on in old age, they would plinge below the poverty line when young.
* Insurance involves protection against the probability that reces-
sion or bad investments will wipe out savings, that inflation will
erode their real value, that people will outlive their own savings, or
that public programs will fail.
A central recommendation of this report is that a country's old age se-
curity program should provide for all three functions, but with very
different government roles for each. A corollary is that countries should
rely on multiple finanicing and maniagerial arrangements; that is, they
should share responsibility among multiple pillars of old age support.
IO



OVERVIEW
Box 1 Myths and Facts about Old Age Securit
MYTHS ABOUND IN DISCUSSIONS OF OLD AGE SE-             Myth 4: Only governments can insure pensioners
curity. Consider some of the most common:           against group risks, such as inflation, and most do so.
Myth 1: Old people are poor, so government pro-     Fact: Most developing countries do not index
grams to alleviate poverty should be directed to the    pension benefits for inflation in their publicly man-
old.                                                aged old age programs. And most OECD countries
Fact: In most countries poverty rates are higher    have skipped some cost-of-living adjustments during
among the young than among the old, and families   the past decade. Failing to index for inflation is the
with small children are the poorest of all. The old are    most common method governments use to reduce
even better off when comparisons are based on life-   real benefit levels and escape from unsustainable ben-
time income rather than current income. Why? Be-    efit promises. In countries prone to inflation, the best
cause people with higher incomes are more likely to   insurance would be international diversification of
live long enough to become old, whereas people with    pension fund investments-which is more likely
low incomes are more likely to have many children    when investment decisions are made by private man-
and die young. Targeting young families with chil-   agers rather than government (see box 4. 10).
dren is a better measure for alleviating poverty than  Myth 5: Individuals are myopic but governments
targeting the old (see chapter 3).                  take the long view.
Myth 2: Public social security programs are progres-  Fact: Governments have repeatedly made deci-
sive, redistributing income to the old who are poor.  sions about old age programs based on short-run ex-
Fact: Even if benefit formulas look progressive, four   igencies rather than long-run benefits. One example
factors neutralize most of the progressive effect. The    is the use of early retirement programs as a temporary
first people to be covered when new plans are started    solution to unemployment that in the long run costs
are invariably middle- and upper-income groups, and    the economy in lost labor and the public treasury in
they typically receive large transfers. The longer life ex-   large pensions payments. Another is pay-as-you-go
pectancy of the rich severely reduces or eliminates the    financing instead of full funding, allowing generous
apparent progressivity of social security programs when    pensions initially but discouraging saving and
redistribution is calculated on a lifetime rather than an    growth and lowering pensions in the long run (see
annual basis. Ceilings on taxable earnings keep the lid    box 4.4 and issue briefs 4 and 8).
on tax differences between rich and poor. And when     Myth 6: Government action is needed to protect
benefit formulas are earnings-related or subject to   the interests of generations yet unborn.
strategic manipulation. as in many countries, upper-   Fact: Most public pay-as-you-go pension schemes
income groups benefit even more, so the net redistrib-    provide the largest net benefits to workers who are 30
utional effect can be regressive (see box 4.6).     to 50 years old when the schemes are introduced.
Myth 3: Social security programs insure pension-    The unborn children and grandchildren of these
ers against risk by defining benefits in advance.   workers are likely to receive negative transfers as the
Fact: Benefit formulas are redefined frequently, so    system matures and the demographic transition pro-
substantial political risk remains (see box 4.1).   ceeds (see issue briefs 3 and 9).
II



INiiG    T HE O LD A (sE C RI, SXs
One Dominant Public Pillar Is Not Enough for Redistribution, Saving,
and Insurance
Most countries-including almost all developing countries and
some industrial countries-combine all three functions in a dominiant
public pillar, a publicly managed scheme that pays an earnings-related
defined benefit and is financed out of payroll taxes on a pay-as-you-go
basis. People with high incomes contribute more and get more, but
some of their contributionis are supposedly transferred to people with
lower incomiles. This combination of functionis has been defended on
grouLids that it keeps administrative costs low through economies of
scale and scope and that it builds political support for the plan. The
savings componienit encourages high-wage earners to participate,
whereas the redistributive componient lets them express their solidariry
withi those less well-off In industrial countries, these plans have been
credited with reducing old age povertv during the post-W"orld War 11
period.
BLut the evidence suggests that public schemes that combine these
fuiictionis are problematic-for both efficiency and distributional
reasons.
When populations are youlIg aind systems are immature, it is tempt-
ing for politicians to promise generous benefits to workers whien they re-
tire. But these same benefits require high contribution rates once the
population ages and schemes mature. Indeed, any system that is sup-
posed to redistribute to low-income workers while also providing ade-
quate wage replacement to high-incomne workers will be costly at that
point. But the defined benefit formulas do not make benefits actuarially
contiigenit on these contributionis. The high contributioni rate is there-
fore likely to be seen as a tax by maniy workers, not as a price for services
received. High tcax rates lead to evasion-thereby defeating the purpose
of che manidatory scheme. They also lead to strategic manipulationi that
enables workers to escape much of the tax but still qualify for benefits-
thereby causing financial difficulties for the system. And they reallocate
labor co the infoirnial sector-causing difficulties for the broader econ-
omy. Employers whio cannot pass payroll taxes on to workers cut back
on employment, reducing nationial output. Older workers who are eli-
gible for large pensions retire early, reducing the supply of experienced
labor. Such unhappy outconmes, of course, vary from coun1try to countr,
and are especially prevalent in developing economilies, which have lim-
12



ited tax enforcement capability, imperfect labor markets, and large in-
formal sectors.
The pay-as-you-go method of finanice in a single public pillar further
separates benefits from contributions for the cohort as a whole. It in-
evitably produces low costs and large positive transfers to the first cov-
ered generations. It also inevitably produces negative transfers for later
cohorts becatise of system maturation and population aging, increasilln,
the labor market distortions and incentives to evade. In some cases,
countries may wish to make this transfer across generations. More often,
the transfer is unintentional. Ironically, the largest transfers go to high-
income groups in earlier cohorts, wvhereas middle- and sometimes even
lower-income groups in later cohorts get negative transfers. The larger
and more earnings-related the benefits in the public pillar, the greater
are these perverse transfers.
A dominant pay-as-you-go pLiblic pillar also misses an opportunity
for capital market development. When the first old generations get
pensions that exceed their savings, national consumption may rise and
savings may decline. The next few cohorts pay their social security tax
instead of saving for their own old age (since they now expect to get a
pension from the government), so this loss in savings may never be
made tIp. In contrast, the alternative, a mandatory fuinded plan, could
increase capital accumulation-an important advantage in capital-
scarce countries. A mandatory saving plan that increases long-termll sav-
ing beyond the voluntary point and requires it to flow through finani-
cial institutions stimulates a demanid for (and eventually supply of)
long-term  financial instrumllenits-a boon to development. These
missed opportullities in a pay-as-you-go public pillar become lost
income for future generationis-and anotlher sotirce of intergenlera-
tional transfer.
Additionally, large pay-as-yotI-go public pillars often induce expendi-
tures that exceed expectationis-because of populationi aging. system
maturation, poor design features suclh as early retirement and high ben-
efit rates, and opportunities for political maniipulation that lead to these
poor design features. The costs of the system-whether covered by
higher contribLutioni rates or subsidies fi-om the general treasury-make
it difficult for the government to finance importanit public goods-
anotlher growth-inhibiting consequenice.
But ultimately the costs (higher taxes and their distortionary effects)
have become too large to bear in many couLntries. When the public pil-
'3



,KVtRTING  THE OLD AGE ( RISIS
lar fails to deliver on its promises, old people who depended on it exclu-
sively have nowhere else to turn. Thus a dominant public pillar in a sin-
gle pillar system increases risk for the old. The most common failure oc-
curs whenl inflation develops because demands on the national pie
exceed its size and pensions, whiclh are not fully indexed, lose much of
their value.
For all these reasons, public systems that have tried to do it all have
too often produced costly labor and capital market distortions and per-
verse redistributions to high-income groups while failing to provide se-
curity for the old-outcomes that are neither efficient nor equitable nor
sustainable.
Problems with Other Single Pillar Systems
Other single pillar systems. too, are problematic. In many countries,
especially in Africa, publicly managed funded plans (provident fLnds)
have a record of misuse. Usually they are required to invest solely in
public securities, yielding low or even negative returns for the pension
funds. Their availability at low interest rates may lead governments to
borrow and spend more than they would have otherwise, in unproduc-
tive ways. They are, essentially, a hidden tax on labor, subject to misuse
precisely because it is hidden. By giving governments control over a
major share of the financial assets in a couLn1rr, they deprive the private
sector of access to these funds and thereby inhibit growth. They con-
tain no provisions for redistributing to low-inicome workers and, in
fact, often include nontranlsparent redistributions to high-income
workers-until finally the fund is depleted and can't pay much to any-
one.
Privately managed occupational or personal saving plans would also
fail as single pillar systems. (No countryv has ever tried to use them as
such.) Occupational plans have better capital market effects than pub-
licly managed plans but may impede the smooth functioning of labor
markets. They redistribute in accordance with employer rather than so-
cial objectives. They usually do not protect those with limited labor
market experience or high mobility. And they are sutbject to employer
or insurance company default, in the frequent case in which they are
not filly funded. Privately managed personal saving accounts are ben-
eficial for capital market development, have the least distortionary ef-
fects on labor markets, and are relatively immune to political manipu-
14



OVERVIt,i'*
lation by governments or strategic manipulation by workers. They do
not, however, address the problems of information gaps or of povertv
among those with low lifetime incomes whose earning capability is filr-
ther diminished by old age. Nor do they insure against the risks of low
investment returns (because of poor individuLal choices or economy-
wide recession) or high longevity, in the absence of annuities markets.
Tying the Objectives to the Pillars
To avoid these problems, this report recommends separating the sav-
ing function from  the redistributive fLnction and placing them  under
different financing and managerial arrangements in two different man-
datory pillars-one publicly managed and tax-finaniced, the other pri-
vately managed and fully funded-supplemented by a voluntarv pillar
for those who wanit more (figure 3 and chapter 7):
Reliance on individual pillars will var)
with a country's circumstances over
time, but every country should have a
multipillar system.
Figure 3 The Pillars of Old Age Income Security
~..*                 , .  . .   ..                    ..      ___ _ _ _ _ _ _ _
Redistri butive     - ' r             Savings          J >- .H;Y          Savings
Objectives            plus                                plus                                plus
coinsurance         ,,:;S          coinsurance                         coinsurance
Means-tested,                         Personal                            Personal
Form        minimum pension                      savings plan or                     savings plan or
guarantee, or       :               occupational       *-               occupational
flat                               plan                                plan
_____________                                          -q-.                           .. 
Financing         Tax-financed                         Regulated                          Fully funded   i
fully funded
Mandatory                          Mandatory                            Voluntary
publicly managed                   privately managed                         pillar
pillar                              pillar
15



11.40- THE OLD AGE CRISIS
* The public pillar would have the limited object of alleviating old
age poverty and coinsuring against a multitude of risks. Backed by
the government's power of taxation, this pillar has the unique abil-
ity to pay benefits to people growing old shortly after the plan is
introduced, to redistribute income toward the poor, and to coin-
sure against long spells of low investmenlt returns, recession, infla-
tion, and private market failures. The public pillar could take
three alternative forms. It could be part of a means-tested program
for the poor of all ages. with eligibility criteria taking into account
the diminished ability of the old to work and benefit levels taking
into account age-linked needs. Alternatively, it could offer a mini-
mum pension guarantee to a mandatory saving pillar. As still an-
other alternative, it could provide a universal or employment-
related flat benefit that coinsures a broader group. But it should be
modest in size, co allow ample room for other pillars, and pay-as-
you-go, to avoid the problems frequently associated with public
managemnent of national provident funds. Having an unambigu-
ous and limited objective for the public pillar should reduce the
required tax rate substantially-and therefore evasion and misallo-
cated labor-as well as pressures tor overspending and perverse
intra- and intergenerational transfers.
* A second mandatory' pillar-one that is fully funded and privately
managed-would link benefits actuarially to costs and carry out the
income-smoothing or saving functioni for all income groups within
the populationi. This link should avoid some of the economic and
political distortions to wuhich the public pillar is pronie. Full funding
should boost capital accumulationi and finanicial market develop-
ment. The economic growtli this induces should make it easier to fi-
nanice the public pillar. But a successful second pillar should reduce
the demanids on the first pillar. The second mandatory pillar could
take two alterniative fortms: personial savinlg accounlts or occuparionial
plans. In either case, mandatory programs require careful regulatioll.
* Volunltary occupationial or personal saving plans would be the
third pillai; providing additionial protection for people who wvanit
more incomle and insuranice in their old age.
* Although the redistribution and saving funllctiOnIS Would be sepa-
rated, the insurance funiction wouL]d be provided jointly by all
three pillars. since broad diversification is the best way' to insure
against a very uncertainv world.
I6



OVERVIEW
Crucial Choices within the Mandatory Pillars
Within each mandatory pillar are numerous policy options-some
of which are much better than others. For the public pillar, one impor-
tant choice is between earnings-related benefits, on one hand, and
those that are flat or means-tested on the other. Although earnings-
related benefits may have political appeal, the need to pay higher bene-
fits to high-income workers while also trving to alleviate poverty
among low-income workers creates numerous problems, including
high taxes and excessively large transfers to the first generation of bene-
ficiaries, many of whom are well-to-do. For these and other reasons,
earnings-related benefits are a poor choice for the public pillar.
The next choice, between flat and means-tested benefits, is less clear-
cut and will depend on such variables as institutional and taxing capac-
ity (flat benefits are costlier but easier to administer) and income distri-
bution (means-tested benefits redistribute to the poor more efficiently,
provided that the administrative requirements can be met at low cost).
A variant of the means-tested scheme, a minimum pension guarantee,
may be the best option for the public pillar in countries that already
have a mandatory saving scheme to which the guarantee can be added.
For the mandatory funded pillar, governments must choose between
public management and private management. Most publicly managed
funded schemes, also known as provident funds, have had poor results.
Publicly managed funds are usually required to invest in governiment se-
curities or the securities of quasi-governmentt entities such as state enter-
prises or public housing authorities-frequently at below-market inter-
est rates. These funds thus earn less rhani they would on the open market
and must charge higher contribution rates or pay lower benefits thani
would otherwise be the case. In contrast, private, competitively man-
aged schemes-in which workers or employers choose their fund
managers-are rarely required to accept below-market returns and are
less likely to be used as disguised forms of government reveniue. They
have incentives to invest in stocks and bonds that offer the best risk-
yield combinations, and can tap the benefits of international diversifica-
tion and management expertise. The resulting superiority of privately
managed funds over publicly managed funds is strikingly apparent from
a comparison of rates of return of selected funds in the 1980s.
Higher returns to contributors aside, mandatory, privately managed
funded schemes offer economy-wide advantages. They can be part of a
I,'



_ RTING  THE OLD AGE CRISIS
national policy to develop new financial institutionls and deepen capi-
tal markets by mobilizing long-term saving and allocating it to the
most productive uses, including uses in the private sector. For these rea-
sons, the report strongly recommends that the fuLnded pillar be pri-
vately managed.
For privately managed funded schemes, still another choice must be
made between personal saving plans and occupational pensioni plans set
up and ruLn by employers. Occupational plans have the seeminlg advan-
tage that they can start up on a voluntary basis before the market and the
governmenit are ready for a manidatory plan. They can be implemented
throug,h payroll deductiolns with low record-keeping and marketing
costs. And they use the financial expertise of employers and prearranged
groups of workers to overcome insuranice market problems. However,
these advantages often prove illusory. Without mandatory participation
and adequate regulation, occupational plans tend to be spotty in cover-
age, to be offered mainly to middle- and upper-income workers, to in-
volve large regressive tax expenditures, to be uLnderfunded and therefore
default-prone, and to restrict vesting and portability of benefits, imped-
ing labor mobility and economic restructuring. In contrast, coverage
unider personal saving plans can be broad, and benefits are fully
portable. Because of these distributional and labor market effects, per-
sonal saving plans are probably preferable to occupationlal plans for the
funded pillar, except for countries that already have substantial coverage
under well-functioning employer-sponsored schemes. A privately man-
aged mandatory personal saving scheme was pioneered in Chile and is
now being incorporated into new systems in Argentina, Colombia, and
Peru.
Despite the advantages of privately managed, mandatory personal
savings schemes, governments should not rush to establish one. Rather,
they need to assess carefully market and regulatory capacities before de-
ciding to go ahead. A banking system, rudimentary stock and bond
markets, and the capacity to develop these further in response to de-
mand from pension funds are essential preconditions. In addition, be-
cause workers may lack the education and experience necessary to
choose effective investments, careful governmenit regulation is needed
to keep the investment companies financially sound and workers' ex-
posure to investment risk within reasonable bounds. Where market
and regulatory capacities are lacking, governments should proceed
slowly and cautiously.
I8



OV E RVI E.V
How to Get There
H         OW SHOULD COUNTRIES START THIS PROCESS? AND HOW
can those that already have large public pillars make the tran-
sition? Although the ultimate goals are similar for all, the paths
and time frame depend on counitry circumtistances (chapter 8).
Young Low-income Economies
Consider First a COulntry' with a young population, a low per capita in-
come, and only a small public pillar or publicly managed provident
fund, primarily one covering government sector employees. Many
couLitries in Africa and South Asia are at this stage. The weakeninlg of
informal systems of old age support and the absence of reliable capital
and insuranice market instrumelits are prompting political pressures for
an expanded public pillar. These countries typically do not have the fi-
nancial markets or regulatory capability necessary to establish a decen-
tralized funded pillar. But they should be creating an enablling environ-
ment for voluntary and, later, mandatory saving and pensioni plans by:
IKeeping inflation downi
• Avoiding interest rate and exchange controls
* Establishing reliable savings institutiolIs that are accessible to peo-
ple in rural as \vell as urban areas
* Developing a regtilatorv framework that gives people confidence
in banks, insurance companies, and other finanicial institutions
* Institutinig an effective tax policv and tax administrationi system
* Building the humIn capital essential for the effective maniagement
of financial and regulatorv systems.
These basic conditiois, importanic for old age systems, are also necessaly
for continuing econonic growth.
These countries should also be taking steps especially geared to pro-
viding old age security, using methiods that avoid the problems of large
pay-as-you-go plans and that will evenmtially fit into a multipillar system.
T hey should:
* Keep the existing contribtitory public pillar small, flat, and limited
to urban areas and large enterprises in which transaction costs are
I)



W    'IN GTHE OLD AGE (CR IIS
relatively small, fraud is easiest to detect, and the informal system
breaks downi first.
* Provide social assistance (in cash or in kind) to the poorest groups
in society, including the old poor wxho are not covered by contrib-
utory plans, taking into account their vulnerability stemming
from their diminished ability to work.
* Carry out simulations of the long-run impact of alternative public
plans (coverage, benefit level, retirement age) on taxes and the dis-
tribution of transfers across and within generations. This requires
making assumptions about wage growtlh, interest rates, labor force
participation, unemployment, and evasion-and recognizing that
the choice of system will affect these parameters (box 8.2).
* Phase out (or convert to voluntary status) centrally managed prov-
ident funds, which are often misused.
* Set up the legal and institutional framework for personal saving
and occupational pension plans, requiring full funding. portabil-
ity of benefits, and disclosure of information for the latter.
* Give equivalent tax treatment to occupational and personal retire-
ment plans that meet prudent standards.
* Avoid crowding out informal support systems and offer incentives
to families to continue taking care of their older relatives.
* Avoid the pitfalls-overgenerous pensions, early retirement.
benefit-contribution structures that encourage evasion or discour-
age saving, perverse redistributions to high-income groups in pub-
lic plans; and unregulated, unfuinded, nonportable occupational
plans-that are so tempting, especially in young countries witl
immature schemes and limited regulatory capability.
Young but Rapidly Aging Economies
The next set of countries, also with young populations. is aging and
often growing rapidly-since rapid economic growth is associated with
falling fertility rates and rising longevity. Many East Asian economies
are at this stage. In addition to accelerating all the actions just men-
tioned, these economies should:
* Begin designing and introducing a mandatory decentralized fLnded
pillar. Preconditions for this pillar are government regulatory capa-
bility, a banking svstem, a secondary governmenit bond market, and
20



OVER
an emerging stock market-or the abiliyv to develop these institu-
tions quickly in response to demand from new pension funds.
* Start by setting up a strong regulatory framework, determining the
required contribution rate, and deciding whether saving or CCU-
pational plans should be used for the mandatorv funded plan. Es-
tablishing this structure and phasing in the second pillar could
take several years. Governmllents should not rush ahead too fast.
beyond their institutional capabilities. But if they do not move
ahead fast enough strong political pressures will otherwise de-
velop, from middle- and high-income workers, for a dominant
earnings-related public pillar-and all its associated problems.
* Gradually expand coverage for the public pillar, keeping it modest
and redistributitve while satisfying workers' saving or income-
smoothing needs through the privately managed funded pillar.
Otherwise these economies will face the much more difficult task
of restructuring later.
* Initially use a payroll tax for the public pillar, to avoid inefficien-
cies from excise taxes and transfers from uncovered to covered
groups, but shift to a broader tax base as coverage becomes uni-
versal, the government's ability to collect general income and con-
sumption taxes increases, and the redistributive fLnction can be
emphasized.
Older Economies with Large Public Pillars
The third set of economies comprises those that are already middle-
aged, are growing older rapidly, and have substantial public pension
programs that provide widespread coverage and whose costs will soar,
with dependency rates, over the next three decades. This set includes
OECD and Eastern Europeani economies and several Latin American
economies. Although the degree of urgency varies, all these economies
face imminienit problems withi their old age systems. Rather than rely-
ing on an ever more costly public pillar to do it all, at high tax rates
that inhibit growtlh and bring low rates of rettirn to workers, the time
is ripe for these economies to make the transition to a mandatory
multipillar system.
* The first step is to reform the public pillar by raising the retire-
menit age, eliminating rewards for early retirement and penalties
21



>AVERTING THE OLD AGE CRI.SI
for late retirement, downsizing benefit levels (in rhe frequent cases
in which they are overgenerous to begin with), and making the
benefit structure flatter (to emphasize the poverty reduction func-
tion), the tax rate lower, and the tax base broader.
* The second step is ro launch the second pillar by setting up the ap-
propriate contributioni and regulatory structures. The transition
can be accomplished by:
(1) Downsizing the public pillar gradually while reallocating con-
tributions to a second mandatory pillar or
(2) Holding the public benefit relatively constant (in cases in
whilch it is low to begin with) btit raising contribution rates
and assigning them to the second pillar or
(3) Recogniizing accrued entitlemilents under the old system and
agreeing to pay them off while starting a completely new svs-
tem right away. This involves designing the new system. cal-
culatiig the implicit social security debt that is owed ulider
the old system, and figuring out how to finance it all in a way
that is both politically and economilcally acceptable.
Several oECD coulitries are engaged in the gradual transition (alterna-
tive 1 or 2). Several Latin American coulitries have already introduced a
radical transitioni (alternative 3). And many former socialist countries are
trying to decide which way to go.
Conclusion
A;i  MANDATORY MULTIPILLAR ARRANGEIMENT FOR OLD AGE
security helps couLitries to:
* Make clear decisions about whichi groups shouild gain and which
should lose through transfers in the public mandatorv pillar, both
within and across generations. This should reduce perverse or
capricious redistribLution-and poverty.
* Achieve a close relationship between incremenital contributiolis
and beniefits in the private manidatory pillar. This shoLild reduce
effective tLx rates. evasion, and labor market distortions.
z2



O VERVIW
* Increase long-term saving, capital market deepening, and growth
through the use of full funding and decentralized control in the
second pillar.
* Diversif risk to the fullest because of the mix of public and pri-
vate maniagemenit, political and market determination of benefits,
the use of wage growtlh and capital income as the basis for finanice,
and the ability to invest in a wide variety of securities-public and
private, equity and debt, domestic and foreign.
* Insulate the system from political pressures for design features that
are inefficient as well as inequitable.
The broader economy should be better off in the long run as a result.
So should both the old and the young.
The right mix of pillars is not the same at all times and places. It de-
pends on a country's objectives, history, and current circumstances, par-
ticularly its emphasis on redistribution versus saving, its financial mar-
kets, and its taxing and regulatory capability. The kind of reform needed
and the pace at which a multipillar system should be introduced will
also varv-fronm quick in middle- and high-income countries whose sys-
tems are in serious trotible to very slow in low-income countries, which
should avoid these same mistakes. But one simple recommendation is
clear: all counltries should begin planning nIow.
Notes
1. These tacts are from World Bank populationi pro-    Hurd and Shoven (1985); Boskin and others (1987); ad-
jections; B. Mitchell (1982); Zambiani National Provi-   dirional data from unpublished World Bank documents.
dent Fund (1988-89); Rofman (1994); Marquez (1992);
ILO (forthcoming,): Nelissen (1987); Srahilberg (1989);  2. Global coverage estimates used in this report come
Creedy, Disney. and Whitehouise (1992); Aaron (1977);   from Palacios (1994a).
23






R I
Growing Older
M                  OST PEOPLE EARN LESS AS THEY REACH OLD
age, because they work less or less produc-
tively (or not at all). So, many governments
have programs to provide income security to
their older citizens-arrangements that are
part of the social safety net for reducing
poverty. But the programs directly concern the young as well as the old
because, depending on their design, they can either help or hinder
economic growtlh. This concern will sharpen as the number of old
people triples over the next 40 years to nearly 1.4 billion-increasing
their share in the total population from 9 percent in 1990 to 16 per-
cent 2030 (figure 1.1).
Everybody, old and young, depends on the current output of the
economy to meet current consumption needs. Most people in their
prime earning years get claims on that output by working productively
and earning wages. But few old people can fully support themselves
through current earnings. They obtain claims on output in other
ways-through such informal group action as family transfers, through
such formal market systems as saving and investing, and through such
collective action as public social security programs.
The choice among these alternatives and the specific form they take
affect the welfare of the old by determining their share of the national
pie. These choices also affect the welfare of che youLng by determininig
the size of the pie. Alternative policy options should thus be held to a
dual standard: what is good for the old population, and what is good for
the wlhole economy? The policies adopted by many countries fail this
rest. They are beset with problems that spill over from the old age sys-
tem to the rest of the economy.
25



.:~THE OLD AGE CRISIS
Figure 1.1 Percentage of the Population over 60 Years Old, by Region, 1990 and 2030
OECD countries
Transitional socialist countries
China
Latin America and the Caribbean
1990
Asia (excluding Chinan                                                              Between 60 and 75
Over 75
Africa and the Middle East                                                           2030
* Between 60 and 75
Over 75
Worid
0           5           10           15          20           25          30           35
Percentage of population over 60
Note: Japan is included with the OECD coLintries, nor with Asia.
Source: Adapted from the World Bank population data base.
Although the old make up a larger          Consider these examples from  low-, middle-, and high-income
share of OECD populations, develop-             .
ing countries are graying faster.      countries.
*  The payroll tax rate for pensions in most countries in Eastern Eu-
rope is 30 percent or more-and this is sometimes supplemented
further by general revenue finance, discouraging employment and
deterring investment in important public goods.
*  In Hungary only 2 percent of those over 60 are officially in the
labor force-the rest are retired and receiving a pension or work-
ing in the informal sector to avoid payroll taxes.
*  In Argentina, before the 1994 reform, every worker had to sup-
port tvo-thirds of a pensioner, because early retirement increased
the number of beneficiaries and evasion decreased the number of
contributors.
26



G ROW;  l 
* In Egypt, Peru, Turkey, Venezuela, and Zambia, the rate of return
on publicly managed pension funds ranged between -12 percent
and -37 percent in the 1980s.
* In Brazil, during the 1980s, evasion reduced contribution rev-
enues by more than one-third in a typical year. Inflation, with only
partial indexation, reduced the government's fiscal burden but
made things worse for pensioners.
* By 1990 the average OECD country spent 24 percent of its annual
public budget and over 8 percent of its GDP on old age, disability,
and survivors' benefits. The average person spent more on social
security taxes than on income or value-added taxes. These num-
bers are expected to increase over the next decade as populations
age.
* Studies of old age programs in the Netherlands, Sweden, the
United Kingdom, and the United States have found large income
transfers to the early generations covered under these plans, at the
expense of their grandchildren. but little (if any) redistribution
from lifetime rich to lifetime poor.
Because of these problems, calls for policy change are being raised
everywhere. Many OECD countries are decreasing their reliance on pub-
licly managed plans and increasing their reliance on privately managed
voluntary or occupational plans. Latin American countries are intro-
ducing drastic structural changes that include mandatory saving plans.
Eastern European countries are considering major reforms of their col-
lapsing systems. And African and Asian countries, with younger popu-
lations and small formal programs, must decide which way to go in the
years ahead.
The Graying of the World's Population
T       HE PROPORTION OF OLD PEOPLE IS NOT THE SAME IN EVERY
population-nor is the rate at which populations are aging.
Moreover, chronological age may differ from functional age-
some people can work productively until age 70 or 80, whereas others
become unproductive much earlier. A 45-year-old woman might be
considered old in Zambia, where life expectancy (at age 15) is 59, but
27



NG  THE OLD AGF CRISIS
still voung in Japan, wlhere life expectancy (at age 15) is 83 (World Bank
population data). Some generalizations about the distribution of the
chronologically "old" (over 60) around the world:
* Althoughl the proporrions of people who are old is highest in OECD
and transitional socialist countries, most of the growth in the
world's old population-from half a billion people in 1990 to al-
most 1.5 billion people in 2050-wvill be in developing countries,
particularly in Asia (figure 1. 1).
* About one old person in four is "very old" (over age 75)-and of
these almost two-thirds are women. The economic position of the
very old is very different from that of the younger old, and the po-
sition of old women is very different from that of old men (figures
1.1, 1.2. andbox 1.1).
* The proportion of the poputlation that is old rises with per capita
income. In low-income countries, less than 7 percent of the pop-
ulation is over 60. This proportion rises to 12 to 16 percent in
middle-income countries and to 17 percent or more in most high-
income countries. The ratio of old people to working age people
(the old age dependency ratio) also rises with per capita income-
Figure 1.2 Ratio of Old Women to Old Men in Developing and
Industrial Countries, 1990
Ratio of women to men within age group
3.0
E Women 60+ to Men 60+
2.5
Women 75+ to Men 75+
2.00
2.0
1.48
1.5
1.25
1.07
1.0
There are more old women than old     0'5
men in the world-and the difference
rises among people over 75.            0
Developing countries             Industrial countries
Soane: Adapred Iront the World Banlk popuIlationi da[a base.
28



GROWING C:)
Box 1.1 The Plight of Older Women
BECAUSE OF DEMOGRAPHIC, CULTURAL, AND IN-   widows, compared with onlv 10 to 20 percent of
come differences between the genders, old age means   men. Whether through widowhood, divorce, or be-
something quite different-and more troubling-   cause they never married, elderly women living
for women than for men. In most countries, women   alone outnumber elderly men living alone by a large
live longer than men. Life expectancy at age 15 is   margin. In Australia, one in four elderly women live
eight years longer for women than for men in the   alone, but fewer than one in ten elderly men do. In
United States, seven years in Canada, and six years   Switzetland, four times as many elderly women live
in Belgium, Germany, and Sweden. At age 65,   alone (40 percent) as elderly men (10 percent), and
women can still expect to live some four years longer   in Germany, six times as many (37 percent of
than men in these countries. Women in developing   women, 6 percent of men).
countries also have longer life expectancies, though  Because of responsibilities for child rearing and
generally less than in industrial countries. For exam-   caring for elderly family members, women's labor
ple, at age 15 the advantage is five years in Mauritius   force participation is generally shorter and more ir-
and four years in Venezuela-at age 65 it is three   regular than that of men. Women are more likely to
years in Mauritius and two in Venezuela.       engage in part-time work and to retire early. For the
Most women marry men older than themselves   same type of work, women's wages are usually less
and are less likely than men to remarry after divorce   than those of men-70 percent of men's in the
or the death of a spouse. Since women also live   United Kingdom, 64 percent in Egypt, and 50 per-
longer than men, a much higher proportion of   cent in the Republic of Korea. Women are also more
women end up living alone. Widows outnumber   likely than men to work in the informal sector, where
widowers in almost every country. In Africa and    wages are lower and access to pensions difficult.
Asia, more than half of women over the age of 65 are         (Box continues on the following page.)
a relationship that stems directly from the lower fertility rate in
richer countries and the ability to lengthen life span through med-
ical intervention (figures 1.3 and 1.4).
* Most old people live in poor countries (which are also the most
populous), a pattern that will intensify toward 2030. By then,
more than three-quarters of the world's old people will be in areas
not now industrial-more than half in Asia and more than a quar-
ter in China alone (figure 1.5). (See appendix tables A.l and A.2
for additional demographic data.)
With rising incomes and medical advanices, families have fewer chil-
dren and people live longer. Together, these forces have raised old age
dependency in many countries. This "graying of the population" means
that a smaller working age population has to support more and more old
people. The graying is already well under way in OECD countries, and
dependency ratios are expected to rise steeply in much of Latin America,
29



JHE OLD AGE CRISIS
// M?
;'N ', g   :E ~~~~~~~~g ggUK, 
-  .  B i 2 B fl i i i *F*/~
.~ 
9-z4 
41~~~~~~~~~~
Eastern Europe, Central Asia, and China over the next two decades. By
2050, only Africa will still be "young. "
As a result of the broad diffusion of medical knowledge and lifestvle
values, developing countries will age much faster than industrial coun-
tries did. It took 140 years for the proportion of old people to double
from 9 to 18 percent in France, 86 vears in Sweden, and 45 years in the
United Kingdom. It will take only 34 years in China and 22 years in
Venezuela (figure 1.6).
Developing countries will have old demographic profiles at much
lower levels of per capita income-and the numbers will be enormous.
China and other developling countries will be much poorer than Sweden
and other industrial nations were when their populations aged. Their
large old population will need sLtpport, but their economic, political,
and institutional capabilities may limit their ability to satisfy this need.
The problem will worsen if their cultural definition of old age is not re-
30



G ROWI_,
Figure 1.3 Relationship between Aging and Income Per Capita, Selected Countries, 1990
Percentage of population over 60
25
0 Sweden/
20                                   S  Bulgaria                *N*rway /                               Switzerland
*   d              *~~~~~ Spain    j
15           *       *                          /       ;             Australia     Canada
15
* Fed Rep. of
*Yugoslavia    /
:Lo       Jamaica   *
Crina~~~~~~~~~~~~~~~~ **e*Singapore
10 ~ ~ ~ ~ ~ ~ ~~    p
/    0   (            of Korea
5 0  S¢¢5   @                 * Venezuela
0
0                    5,000                  10,000                 15,000                 20,000               25,000
Income per capita (POP)
Note: Because of space limitations, nor all data points are identified. R2 = 0.64. POP60 = 4.92 + 0.00087 > YCAP90, where POP60 is the per-
centage of population over 60 and YCAP90 is the income per capita adjusted for purchasinig power parirv in U.S. dollars for 1990.
Source: World Bank population data base; World Bank (1992d). table 30.
vised to accommodate their people's increased longevity and if their                 The old make up more of the popula-
labor productivity does not increase rapidly. The old age policies these             tion as income rises...
countries adopt now will determine whether they will have the ability to
support their old populations as the demographic transition takes place.
Some argue that the drop in the child dependency rate caused by the
fertility decline will free resources to meet the needs of the growing older
population. But careful analysis shows that it won't. Reallocating re-
sources from children to old people is not easy. The extra private subsis-
tence cost of each old person is greater than that of each child. In OECD
countries public spending per old person on social services and transfers
is two to three times as great as public spending per child, so the resources
released are less than those demanded, on average (table 1.1). And as
families and societies have fewer children, they are likely to invest more
3'



,.$i:THE OLD AGE CRISIS
Figure 1.4 Relationship between the Old Age Dependency Ratio and Income Per Capita, Selected Countries, 1990
Ratio of people over 60 to people between 20 and 59
0.5
K Sweden
0.4
a a Bulgaria                     *
0.3~~~~~~~~~~~~~*pi                                                  a                      Switzer and
0.3                                  
Fed. Rep. of                 aAuistralia                     Canada
* Yugoslavia
0.2         Jamaica
Chinaa
a < * ~~~~~Rep. of Korea                       *           Singapore
0       .    1 * is * s *Venezuela
0.10 
0
0                  5.000                  10,000                 15,000                 20.000                 25,000
Income per capita
A'ore: Becatise of space limitations, nor all data points are idenitified. R2 = 0.59. DEP = 0.1229') + 0.0000136 X YCAP90. where DEP is the
oid age dependency ratio.
£S71urcc: World Bank (1992d). table 30. World Bank poptilarion dala base.
... and the ratio of old people to the   in each child, so even fewer resources become available at the margin.
working age population rises with        Both  the young and  the old will need costly services and financial
income as well.
support. Meeting these needs requires careful planning, starting now
(box 1.2).
Informal Systems of Old Age
Support and Their Breakdown
IN AFRICA AND PARTS OF ASIA. OLD PEOPLE LIVE WITH THEIR
children in extended families. All members of the household, even
the old, contribute to its productive capacity in some way-working
32



GROWING OLDER.
Figure 1.5 Percentage of People over 60 Years Old, by Region,
1990 and 2030
Latin America
and the                        Latin America
Caribbean,                         and the
China,      6%         AsiaCaribbean.                          Asia
21%                   (lessn5'         hia                     hiC6 na),
2%            China,
26%
Middle                     Transitional                             Transitional
East,                      socialist                          %?, socialist
8%                        countries,    Africa and                 countries
13%      the Middle   M                  8%
OECD                         East,           OECD                  Most old people live in poor
countries.                     11%           countries,
30%                                          20%                  countries-in thirt-five years four of
five old people will live in countries
1990                                     2030                    that are poor today.
,iVore' Japan is inchided witlh the c)E(-D countries. nior wih Asia.
Solnce: Adapted from the World Bank populationi data base.
in the fields, caring for children and grandchildren, giving advice from
experienice. The family group covers the consumption needs of all mem-
bers. As the productive capabilities of the old decline, they are supported
by the work of their children, just as they once supported their children
and parents. Social sanctions in close-knit communities-bolstered by
parental ownership of family assets such as land and homes-reinforce
these arrangements. Mutual aid societies sometimes extend this infor-
mal insurance-redistriburional system beyond the family to the broader
ethnic or cultural group.
Even when this system  works well, some people fall through the
cracks-those who never had children, those whose children have died
or moved away, and those whose children do not earn enough to sup-
port less productive household members. These cracks widen as urban-
ization and mobility increase, nuclear families replace extended families,
medical progress extends life expectancy for the old, and the formaliza-
tion of jobs makes it difficult for people to continue workinig as they age
and their productivity declines.
In some African countries, informal systems have been subject to ad-
ditional pressures from famines, wars, and AIDS-which have reduced the
size of the working age population. Informal systems in East Asia are
under stress because the population is aging at an unprecedentedly high
3'



I:THE OLD AGE CRISIS
Figure 1.6 Number of Years Required to Double the Share of the Population over 60 from 9 to 18 Percent,
Selected Countries
France                                                                                              i1976
Belgium                                                                             (1964)
Italy                                                                  (1982)
Denmark                                                                  (1970)
Netherlands                                                             1i991!
Sweden                                                            1962)
Hungary                                        11979
Bulgaria                                (1986)
United Kingdom                              i1965)
China                        (2026)
Egypt                     (2049)
Jamaica                    (2028)
Venezuela        _        2035
Singapore               (2013)
0           20           40           60           80           100          120          140          160
Number of years
Note: Year in which population doubling was or will be reached is shown in parentheses.
Source: Mitchell (1990); World Bank population projections.
France needed 140 years to double        rate. As a result of all these factors, China, Indonesia, Sri Lanka, and sev-
the proportion of its old people from    eral African countries are considering fundamental changes in the way
9 to 18 percent-China will do it ifl     they provide old age security. The challenge is to move toward formal sys-
34 years; Venezuela in 22. 
renms of income maintenance without speeding the breakup of informal
systems, without shifting too much responsibility to government, and
without repeating the mistakes of other countries.
Table 1.1 Relative Per Capita Social Spending, by Age Group, 1980
Agegroup
County                      0-14             15-64          65 and over
Canada                       100              72.0              265
France                       100              51.4              263
Germany, Fed. Rep. of        100              59.5              316
Italy                        100             110.0              380
Japan                        100              44.0              235
Sweden                       100              43.0              234
United Kingdom               100              53.3              213
United States                100              66.9              381
Note: This table refers to public social spending as calculated in OECD (1988).
Spending on the youngest age group has index value that equals 100.
Source: OECD (1988b). Cited in Palmer, Smeeding, and Torrey (1988).
34



GROWING. /
Box 12 Will the Falibn            epe   Rate Offsetthe
Rising OMd Ae Dde   Rte?
THE INCREASING PROPORTION OF OLD PEOPLE IN            spend on the old. Instead, they concentrate
the population is caused in part by the decreasing    their spending on the remaining young.
proportion of children, during the demographic
transition. Does this enable the diversion of re-  The reduction in fertility rate or family size that
sources from the children to the old, solving the old   is part of the demographic transition has other ef-
age security problem? Although the long answer to   fects that may ease the old age problem.
this question is complex, the short answer is no.  First, many more women enter the market labor
force, increasing taxable family income and social
• The marginal subsistence cost is probably less   security revenues. But the other side of the coin is
for each child than for each old person (be-   that these women are less available to care for their
cause children live with their parents in nu-   older parents at home, so larger monetary outlays for
clear families, while many old people live    nursing and custodial care are needed. These effects
apart), so the subsistence cost saved by one    partly cancel each other out in their impact on the
fewer child would not cover the subsistence   financial viability of old age support systems.
cost of another old person,                   Second and more important, the greater money
* It is not a simple matter to reallocate child so-   spent per child may result in productivity gains that
cial service resources to the old. Children need    can improve the standard of living of everyone. In
primary schools, whereas old people tieed    East Asia, where fertility has fallen rapidly, productiv-
pensions, hospitals, and custodial care. Dur-   ity and wage growth have exploded. This improve-
ing the transition the child support system    ment may stem partly from the larger investments in
may have excess capacity while the old age   the health and education of the young people who are
support system has insufficient capacity. In    now entering the labor force and partly from the in-
Thailand, where the fertility rate has declined    creased physical capital per worker as population
rapidly over the past decade, average class size   growth slows. If so, the total wage bill-and contri-
and student-faculty ratios have fallen far   butions to pension systems-may go up rather than
below the cost-effective point, yet these re-   down as the demographic transition proceeds.
sources have not been reallocated, in part be-  But the relationship between population growth
cause the political system  lacks feedback    and productivity has not been clearly established
mechanisms to make this happen.            and probably differs across countries. Moreover,
* Families-and societies-with few children    many industrial countries set part of their benefits as
have made a quantity-quality trade-off and are    a proportion of the economy-wide average wage and
likely to invest more heavily in the health and   index pensions to wages, so pension expenditures go
education of each child, both priwately and pub-   up commensurately with productivity. In that case,
licly. For example, they send their children on    productivity gains increase the absolute amount of
to secondary schools and universities, which are   the pension but do not eliminate financial pressures
much more expensive than printy schools As   on pension systems as populations age.
the proportion ofchildren in the population de-  Sowuce: Sanderson and Tan (1994); Birdsall and
clines, most countries do not "save" large    Sabot (1994); Kelly (1973 and 1988); Kling and
amounts of resources that they could then    Pritchett (1994).
35



gTTNG  THE OLD AGE CRSI'S
Why Should Governments Get Involved?
The Failures of the Marketplace
W    H     HEN TRADITIONAL FAMNILY-BASED ARRANGEMENTS FOR
production and subsistence break downl, formal market-
based arrangements often replace them. Why do pure mar-
ket solutions to the problems of old age often fail? Why don't people
simply save or purchase annuities when they are young, so that they can
maintain a decent standard of living when they are old and less produc-
tive? Why do governmlents intervene in this area throughout the indus-
trial world and increasingly in developing countries?
Market solutions-such as individuals saving and investing for their
old age-help to fill rhe gaps left by the breakdown of rhe family system,
but they fail to do the job completely. In the simplest case, people may
not save enough wheni they are young becatise theyv are shortsighted.
They may not expect to live long or they' may place a much higher value
on consuming today than on saving for tomorrow. It is difficult for 30-
year-olds to anticipate their needs when they reach 80. Income security
in old age requires very long-term planning, and manv people lack the
i.nformation for this type of planning (including information about fu-
ture health, cost of living, lifetime earning capacity,v and the safety and
productivity of alternative forms of investment and insurance).
Probably every society has some myopic members. But it is hard to
prove whether or not people are generally' myopic-the evidence points
in both directions. Some societies have very high voluntary saving rates,
while other societies have low saving rates. Consumer borrowing at high
interest rates-10 to 20 percent in industrial countries, 20 to 30 percent
or more in developing countries-is consistent with the notion that
many people value present consumption much more than future
consumption.
Shortsighted behavior becomes a social problem for two reasonis.
First, as people age they may change their preferences and wish that they
had saved more-but then it is too late. Second. if people don't save
enough for their old age, the rest of society may feel obliged to support
them. (This obligation may even deter people from saving when they'
are young, a problem known as free ridin-g and moral hazard.) InstIffi-
cient saving may' also starve the economy. So, government policies that
encourage or require people to save can make everyone better off.
36



GROWING OLDfl
Even if people try to save whieni they are young, they may findfiw re-
liable savings inistruments, particularly in developing countries. Or work-
ers may not invest wisely, later finding themselves with much lower re-
turns than expected. Or investment returns may be low for the entire
economy during long spells. During the Great Depression of the 1930s,
many U.S. and European workers saw their life savings go down the
drain. And in developing countries experiencing a sudden devaluation
or inflation, the savings of maniy workers have evaporated in real terms,
discouraging further saving.
Another set of problems stems from the absence of insuiraince mnarkets.
Since people are always uncertain about how long they will live, they
may wish to purchase insurance that will pay them an income-a pen-
sion or an annuity-over their lifetime. But insurance companies are
not well developed in many countries because of informational defi-
ciencies and weak capital markets. When people have more information
about their life expectancy than the insurance company does, a problem
known as adverse selection occurs. Good and bad risks are pooled, and
premiums are charged according to the average risk of the group. The
gTood risks (those who expect to die young) find these terms unaccept-
able. So the insurance company, left with only the bad risks (those who
expect to live long), raises its premiums, leading more good risks to opt
out. In the end, prohibitive prices put annuities beyond the reach of
most people.
Even when annuities are available at a fair price, consumers must com-
mit large sums of money irreversibly before age 65 in return for the
promise of a lifetime pension paid out over tventy to thirty years. Many
people, for good reason, would doubt the credibilitly of such long-term
promises by private insurance companies. Private insurance companies
also have a difficult rime insuring against risks such as unexpectedly high
inflation, which hits everyone simultaneously. For all these reasons, pri-
vate annuity markets are undeveloped in most countries, and annuities
that fully insure against inflation and recession are generally not available.
In Western countries, employer-sponsored group annuities devel-
oped as one response to the deficiencies of individual annuities. In the
late-ninleteenth and early twentieth centuries, large companies intro-
duced pensionis as a way of rewardinig and retaining the loyalty of their
long-term employees. Later, unions and tax advantages fostered the
growth of these and other fringe benefits. But few employers, especially
small emplovers, have this long time horizon and easy access to insur-
37



tT0H0E OLD AGE CRISIS
ance or capital markets. And employers who started plans often failed to
fund them adequately, limited the number of workers who qualified,
disqualified workers who left before retirement, did not index for infla-
tion, or were unable to follow through on their promises because of
competitive pressures or bankruptcy.
Thus when systems of communal living in extended families break
down and before remedial government policies are firmly established,
old people may have a hard time maintaining their customary standard
of living because of saving or insurance problems. Furthermore, pockets
of severe poverty have developed among those whose lifetime incomes
were too low to cover minimally adequate consumption levels during
their retirement as well as their working years (the long-term poverty
problem).
It is clear, then, that governments should get involved when informal
old age security arrangements no longer work. And the need for govern-
ment involvement becomes more urgent as a country's population ages.
How Have Governments Responded?
G    OVERNMENTS GET INVOLVED IN OLD AGE SECURITY FOR
many reasons, and their policies take many forms. Govern-
ments can simply require or encourage families to look after the
old, as in China. Malaysia gives a rebate to adult children whose parents
live with them and an additional tax deduction for parental medical ex-
penses. Governments can set up savings instruments, such as the postal
savings program in Japan. They can also provide information to people
about how much they will need to save to attain different living stan-
dards when they are old and about the likely effects of alternative in-
vestment programs. And governments can give employers tax incentives
to provide pensions for their workers-or even require them to do so, as
in Australia, France, and Switzerland. In addition, investment and in-
surance companies providing annuities can be required to meet speci-
fied fiduciary standards, as in the United Kingdom and the United
States. Going a step further, governments can also offer means-tested as-
sistance to the old, a practice in many industrial and some developing
countries. Such assistance can take the form of cash or of goods and ser-
vices, such as health care and housing.
38



G ROWiNW I
Moving another step, governments can establish mandatory pension
plans into which all the young must pay to provide support for old age,
as in every industrial society. Such plans can cover the entire population,
the entire labor force, or selected groups that are easier to reach. The
plans can be redistributive toward the lifetime poor-or they can be
based on savings and insurance principles that closely link contributions
to expected benefits. They can be financed out of current contributions
on a pay-as-you-go basis or out of funds accumulated from past contri-
butions. If funded, they can be managed publicly or privately. The mul-
titude of long-term risks can be borne largely by the old or shared more
generally among all groups in society.
The term "government policies" thus encompasses a multitude of
arrangements for financing, managing, regulating, rationing, and deliv-
ering income security in old age. The following chapters evaluate how
these alternative policies have worked, drawing a sharp distinction be-
tween policies that are appropriate to solve the three main problems of
long-term poverty, inadequate saving, and insurance market failure.
The Growth of Formal Mandatory Plans
Formal old age programs and public spending on old age support
both increase with economic development. At the same time, the varia-
tion among countries at similar stages of development shows that poli-
cies are to some extent discretionary and that which policies govern-
ments choose does make a difference (figures 1.7, 1.8, and 1.9).
Per capita income and coverage by formal mandatory plans. An estimated
40 percent of the world's labor force participates in formal programs of
old age income support, most of them publicly mandated and publicly
managed. Per capita income is the best predictor of a country's cover-
age: the relationship is close and explains 94 percent of the variance in
coverage rates (figure 1.7). Richer countries have higher coverage by
formal plans, in part because informal systems no longer function ade-
quately and in part because richer countries are better able to enforce
compliance. In high-income OECD countries, nearly all workers and
their survivors are covered. In developing countries, much smaller pro-
portions of workers are covered, usually in privileged occupations such
as the civil service or the military. Agricultural workers, domestic ser-
vants, temporary labor, and self-employed people-the bulk of the
labor force in developing countries-are generally not covered.
39



,ERTING THE OLD AGE CRISIS
Figure 1.7 Relation between Publicly Mandated Pension Plan Coverage and Income Per Capita
Percentage of labor force actively contributing to public penslon plan
100
.1~9 *Japan                  United States
Spain/
80
* Ctilie  *     /                          Singapore
60~~~~~
60 0/
Trinidad and Tobago
Tunisia* o 
Jamica        /
40
0      0 Venezuela
. 7 *~~ Colormbia
20
0I
0                   5,000                 10,000                 15,000                20,000                25,000
Income per capita
None: Becaulse of space limitationis, not all data poimts are identified. R2 = 0.94. COVPATE =-1.5  +  0.010664 X YCAP9O - 0.00000028 X
YCAPOO2, where COVRATE is the number of contributors as a proportion of labor force. Sample covers fiftv-five cotintries betWeen 1985 and
1992.
Source: Palacios (1994a).
Richer countries have broader cover-    Extending coverage to the rural population is often impeded by illiter-
age by publicly mandated pension        acy, administrative difficulties, and high transaction costs.
plans.                                     Approximately half of the labor force is covered by formal plans in
middle-income countries such as Argentina, Brazil, Cosca Rica,
Malaysia, and Tunisia. Coverage falls to less than 20 percent in lower-
income countries such as Indonesia, Morocco, the Philippines, and Sri
Lanka-and to less than 10 percent in most of Sub-Saharan Africa. Five
of the world's poorest countries-Bangladesh, Malawi, Mozambique,
Sierra Leone, and Somalia-have schemes for public employees only, and
even these are not always implemented. Coverage usually expands from
public sector wvorkers; to employees of public enterprises, public utilities.
and large private enterprises; to other employees in the formal sector in
40



GROWING OLO,
Figure 1.8 Relation between the Percentage of the Population over 60 Years Old and Public Pension Spending
Public pension spending as a percentage of GDP
16
*Austria
14                                                                                               0 Italy
12                                                           ~~~~~~~~~~~~~~~~~~~~~~Luxem-bourg   &Greece /
12                                                                                Frarce *                    Sweder
10                                                                                  * 0
*                      0 United Kingdom
6
*Panama                                               0 Japan
4                     Costa R ca               Isra
:0                _ hn                  Australia
2
0            5                        10                        15                       20                        25
Percentage of population over 60 years old
Vote: Becatise of space limitarions, niot all dara points are identified. R2 - 0.88. PS/GDP = 0.6517 + 0.191088 x POP60 + 0.01759 X
POP(60o, where PS/G DP is the public penisioni speridi ig shlare of GDP. Samiipie is n inew-tvo cotin tries for various vears between 1985 and 1992.
Source Palacios (1994a).
Most countries with older popula-
tions spend more on public pensions.
urban areas; and much later to agriculture, small business, and the self-
employed.
Per capita income, old age dependency, and public spending on pensions. Pub-
lic spending on old age programs as a proportion of GDP is tied closelv
to per capita income but even more closely to the proportion of the pop-
ulation that is old (figures 1.8 and  1.9). In fact, spending increases
slightly faster than the proportion of the population over 60. Austria has
the highest ratio of public pension spending to GDP (15 percent), fol-
lowed by the other OECD and Eastern European countries, which spend
between 6 and 12 percent. Middle-income, middle-aged Latin Ameri-
can countries spend from  3 to 8 percent of GDP, while most young, low-
income developing countries spend less than 2 percenr of their GDP on
4'



,Y j,0:T;HE  OLD  AGE CRISIS
Figure 1.9 Relation between Income Per Capita and Public Pension Spending
Public pension spending as a percentage of GDP
16
Austria
0
14                                                                 Italy 0
12                                   *Greece                        France 0    Sweden
10~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~l4
*B3elgium 
10                                                   *                                                 witzerlard
* ruguay
8
Poland             t*
6                          t            *      :      /                                               * United States
Panama * 
4                             *                             Israel                     Canada 0
Chin*                *                                         AtLstralia
2                        *Singapore*2
*   00        0 2 @Venezuela
0                                    * *Rep. of Korea
0                    5,000                  10,000                 15,000                 20,000                25,000
Income per capita
Naon: Becatise o[space limitationis. riot all data points are idenrtified. R2 - 0.55. PS/GDP - 0.66708 + 0.0(05101 X YCAP90. Phe sample
comprises ninery-rwo countries for various years hewvcen 1986 anld 1992.
Smiice: Palacios 11 994a); World Batik (I 9)2d).
Richer countries usually spend more      formal pensions, mainly on schemes for public employees and other
on public pension plans-but some         special groups.
poor countries also spend more.              CoLintries can use information on the relation between age prohiles
and pension spending as a diagnostic tool-to see whether the policies
they have adopted have put them  above or below average for countries
with equivalenit per capita incomes and similar demographic structures.
For example, as national income dropped in the Eastern  European)
economiiies during the 1990s, they had the per capita incomes and tax-
collecting capabilities of middle-income countries but the old age de-
mographv  and  spending  (as a proportion  of GDP) of high-income
countries-most likely, an unsustainable combinationi (box figure 4.7).
Per capita income and occupational or personal savings plans. Reliance on1
formal personal savings and occupational plans also increases with a
42



GROW IN          U_
country's per capita income, but data on total spending is not available
for most countries. Coverage by formal voluntary plans is never more
than half that of mandator-y plans. (In a few countries where employers
are required to provide pensions, the occupational plans are thus
mandatorv and coverage rates are high [table 5.1].) Often tax incentives
are involved. The people covered by occupationial and personal plans are
usually higher-income groups and are almost always covered by publicly
managed plans as well; so, voluntary occupational and personal savings
plans augment rather than substitute for publicly managed plans.
Old age dependency and public spending on health. The demand for other
social services, particularly health services, also increases as countries
grow richer and their populations grow older. Richer countries have
more expensive health facilities that keep people alive longer, increasing
the demanids on their pensioni systems. Conversely, an aging population
places increasing strains on the health care systemii of a country, since
health problems and costly medical technologies are concentrated
among the old. In Australia, public health spending per person over age
65 is six times that per person under age 15: in Hungary this ratio ex-
ceeds ten (Palmer, Smeeding. and Torrev 1988; Vukovich 1991). The
proportion of the popLulation that is old explains 92 percent of the vari-
ance in public health pILIs pensioni spending in a large sample of indus-
trial and developing counltries (figure 1.10). The correlation betveen
health and pension spending means that pressure on a countrv's re-
sources and on government budgets increases exponentiaily as popula-
tions age, unlderscorinig the need for long-term planning (box 1.3).
The Failure of Government Programs
The old age security programs adopted by many governments in the
past helped people who grew old over the past three decades. This first
generation of beneficiaries received generous slices of the national pie.
But chese programs are now in trouble, and they may also be causing
trouble for the broader economy-keeping the pie smaller for evervone.
The big problem:
* Political pressures lead ro tax-finianiced benefit formulas that are
not sustainable.
* High payroll taxes that are not closely tied to benefits discourage
employment.
43



ING THE OLD AGE CRISIS
Figure 1.10 Public Health and Pension Spending Compared with Population Aging
Public spending as a percentage of GDP
25
*Austria
20                                                        ~~~~~~~~~~~~~~~~~Former                 *Sweden
Czechoslovakia
Poland 0
15*    
New Zeln                   * United Kingdom
10                                                                             a
Spending on health and peions      SAustralia   Japan
Trinidad                                                    Spending on health
*Brazil Tobago                     y
5
Swaziland *  a                 *aa-
Zambia *0
0           *g                                 Ind20esi
0                       5                        10                       is                       20                      25
Percentage of population over 60 years old
NVo'e: Because of space limitations, not all data points are identified. Data poinits show health pluis pensioni spendinig data only. For health spend-
insg, R2 -0.76. H/GDP = 0.069915 + 0.298553 X POP60: for health anid penisioni spenlding. R2 = 0.92. H + P/GDP = 0.25449 + 0.369237
X ]'OP60 + 0.0227'44 x  POP602, where H is pLtblic health spending and P is pLiblic penision spending. Sanmple covers sixty-six coLintries for
varions years between 1983 anid 1992.
Sour:c. Murray, Goviisdafai, Ghellara; (1993); Palacios (9949aJ.
Spending on health and pensions                 *  Early  retirement provisions  reduce  the  supply  of experienced
increases exponentially as the popu-               workers.
lation ages.                                    =  Financing methods misallocate capital and may reduce national
saving.
*  Workers often  evade contributions but manage  to  qualify  for
benefits.
*  The failure to index benefits means that pensioners in many coun-
tries have not been protected from inflation.
*  The growing deficits of old age programs are passed on to the gen-
eral treasury, requiring higher taxes, higher public borrowing, or
less public spending for other important purposes.
44



G ROWIN G: :
* Publicly managed pension reserves are invested unproductively,
earning iow, even negative, rates of return.
* Large income transfers go to upper-income old people, while
many of the lower-income old are not helped.
* Occupational pension plans have not been adequately regulated.
* Today's children and voung workers may pay the price of higher
taxes, lower pensions, and therefore lower living standards, as old
age dependency rates rise and growth declines.
Policy Constraints and Incentives in Developing Countries
These market and planning problems are particularly great in devel-
oping and transitional countries. Capital and insurance markets are mrore
limited in poorer than in richer countries. This is both a major reason
for government intervention and an important constraint on the kinds
of policies that can be implemented. One reason the industrial coun-
tries chose the policies they did and are now reevaluating was the lim-
ited development of financial markets at the time their old age security
systems were introduced. But because of their lower levels of income,
education, and infrastructure, developing countries also have less gov-
ernmental capacity to collect taxes, implement complex programis, and reg-
ulate to correct these market failures than industrial countries. Closely re-
lated, the greater ease of evasion and the larger size of the informal mnarket
in developing countries limit the degree of reliance on mandatory pro-
grams, the success of these programs, and the amount of redistribution
that can be accomplished through taxation.
Market failures are thus greater in developing countries than in in-
dustrial societies. But the government also has less ability to remedy
these failures. This explains why extendedfamily arrangements continue
to play a much greater role in developing countries, why governments
should take special care not to drive out informal systems rapidly as they
explore formal systems, and why they need to choose these formal sys-
tems with great care.
Developing countries have younger populations than industrial coun-
tries, and the poorest countries are the youngest. This makes old age se-
curitv look like a distant problem that can be ignored. It also tempts
politicians to promise large pensions today to influential older workers.
Both temptations need to be resisted. Within the next thirty to fifty
years-that is, within the lifetimes of todav's workers-almost every
45



CTHE OLD AGE CRISIS
Box1`, Heqi:   Cae  n  04A ge$uft
HEALTh C~ME AND ?hN$ION £%TEMS ARE    tow   whns3iiedhat  aeisai4er~
providsd a&c,_6~ts pni   o�sbot fo  hdic'h ,                  f  o   fi~t  ee
uM   andfor  t e  counry.   C nvers f ai og $ s fqsderknb    o  e Pe, $ ~ h  &     . M
td~~~~fi    th  ''t;   'otlC.                s4i oss.Bynise.rr dM  l*lan
11i ia   t$ .  t         cmst    in o%  -                                     A'' "
i_ceae te  bikofth_4          on#  -tAhes  costs.
An irivd4'  eat cr csr  is  it   1W       O  Ae   tt
cause plyi1'cal nd mentl healthdeterioates as ea-,  / 
piegrw  lde Te indofmeica crereuird oroW   e~trrmt~   oijd
aMpoi otnivlvsmr epnierehooy        btesata  alereznpeti4~neoss3
hospirlizason5 ad hnl&eun nrsirt  care'than  etplcapfro~h~ ol  4  frc~&frath, tey at
doesmedcalcat fo yonge peple So co~oties Wrey n retivt~ tsw   %Jh#s#  o  h
The ergerag of he ppuaio  o A' 0                                   Vpan  xml  fhwsedoyn lE ad9  h
mor ofthearitic  acosscoutris i th helth aItcw&enitn__  cor4fde l_
shar of nxz handoesincoe pe ca is (seSgx  WIz41bi4isasbjetendrbgzosc
110 oe he r)adn~hi bewee  pouaionoe         p, e@    or"4esg  n'ornws i  ec'
age 60adtehat  haeoIT)                            irdrailyluerero                h   uirt
'Pr siiaresn , th  avi#s  adcs or   4lame m6                 r fsl4b  o  a    om'qua
helt svks av a iprtntimac o  de n   'sediabliy  ,sas siid~   a~y"Hc~
cla  ned     4po10Teariro icm   t                 rga,aP4 ,eodsz   m4ot
qretos maiuin    pernricn iig rnad'# b  rMlges  cest  haulyhn   o 
t _heeor th   _ deiedszey  znio prsra rss  hic    'i  agd4'&6.I Czol            2   ecnto  l
coutr  i  th 2volwilhvgrydPoiistasemamesnw
~~gp  44 ~ ~ ~ ~ ~~Dveopig  outres av oe bg dvntge:soeoe  id t efre
fourithcomn g  eorpi  rniina   ela  h   te  eiu   rb
nW,rc::.4,em   ht lerssem  renwfaig.W   no    or  o  ta  w   i
149 M    arlie,  adnwotnS:aeaalbe
46    tMcA,4



pensioners receive disability pensions and more than    As the pension scheme *raxurod W.n it's  Wasde
a third of social insu-rance spending is for disabiity   capitalized, it could no, o r
payments (Caja Costarricense de Seguro Social   transfers. to' the hae,l  s`ecior, Now _Veri?e"
1992). China introiuced early retirement through    whose:population i,sprpc,  to,ve' r,: ly In the
disability programs as a way of shedding excess work-   next 25 years, must.c   wi,t  n    r4rising
ers in public enterprises. Ia one enterprise in Wuhan,   demnand for resources tir both hetlth and pension
4,312 of 5,612 retirees were put on total disability re-   proans"
tirement (World Bank 1990). This may reduce en-
terprise costs in the short run, but it increases the    L4g*T,    plannag   Tr w
country's pension costs for many years to come.
'When countries   , you,. they ca*i 'ance
CrossSubuW"es from Pensions to                   h alth4 pension, and 'tdisbiiy '"n   th rela-
tively Jow.payroll taxes. Bt'thec rex e-
Sometimes govermments tr to hide some of the   tialy as populations ag: Ft d-d  f, ,,, h
health costs of an aging population through financial   services and old age  shod        l  d
transfers from pension programs to health care pro-   planned f-r as a Pfiae  :sec-f he
grams. MostLatin American countries have a special   demographic tmrsition. To  .cc   rs'
system of health care for workers covered by socWial
insurance programs. The large surpluses of immature  U Pension and hcalth f cin shoid be sega-
pension programs are often used to pay for the health  rate and. transparent t  avoi d? pleting,pen-
care of covered workers. This hidden cross-subsidy is  - si'on rese,rves andiding the Ltr,e,_s of each
poor policy because it impedes good planning for      ,service.
health services and for pensions.                   *. Eligibility for disability ',4elems should be
As populations age, these reserves are depleted     carey' defined to avoid cheating nd should
and the health system must find its funds elsewhere.   not be used as:asubti    1    . titement
So too must the pension system, whose reserves have    or unemploymect.'' 
been depleted by this cross-subsidization. In    .    The compleheltionship bet ttal
Venezuela, between 10 and 30 percent of pension        bhealth spe ndiosi  s,ing d
reserves were "invested" in the hospitals of the social  be.' taken. into acnt in,' panig youse-
security Mstem during the 1980s (Marquez 1992).        holds and govterment.-
Plan of This Report
A        FTER DESCRIBING THE INFORNAL SYSTEMS THAT SUPPORT
more than half the world's old people (chapter 2), this report
analyzes the key policy choices that must be made as countries
shift their emphasis to formal systems (chapter 3). It analyzes three com-
mon financing and managerial arrangements for old age support-
publicly managed tax-financed plans. occupational pension plans, and
47



.,,ING THE OLD AGE CRISIS
personal savings plans (chapters 4-6). The final chapters (7-8) outline
how these arrangements can be combined in a multipillar system con-
n
sisting of:
* A mandatory tax-financed public pillar that has primary responsi-
bility for redistribution,
* A mandatory funded private pillar (of personal saving or occupa-
tional pensioni plans) that has primary responsibility for saving,
and
* A voluntary pillar that provides supplementary protection.
All three pillars coinsure against life's risks and uncertainties-as the
best Waay to achieve the dual standard set forth at the beginning: doing
what is best for the old population and what is best for the economy as
a whole.
Note
1. Sources for rhese examples are IDB (1993); Palacios    nev, and Whitehouse (1992); Aaron (1977); Hurd and
(1994a); Banco de Prevision Social (1991); World Bank    Shoven (1985); unpublished OECD social data base
(1994a); Nelissen (1987); Stahlberg (1989); Creedy, Dis-   (1993); Boskin and others (1987).
48



R  2
Informal Arrangements
HE INFORNAL SYSTEM FOR INCOME SECURITY-
with no governmental and little inarket involvement-
is still the mainstav in most developing countries. The
extended family takes care of insurance, redistribu-
tion, and even saving-investing in children and in
land or housing for the *vhole family. Although vol-
untary, this system has been buttressed by strong social sanctions, and an
estimated 60 percent of the world's labor force and 70 percent of the old
rely on it exclusively.
The remnants of informal systems remain important in industrial
countries, as children care for their parents and income transfers flow
between generations in both directions. But with economic develop-
ment, these informal arrangements have given way to formal market
arrangements and mandatory government programs, which dominate
in industrial cotintries.
Informal support systems worked because the extended familv can
pool the work opportunities, income, and risk of all its members-and
solve manv of the informational problems that plague more formal sys-
tems. BLut modernizationi-urbanization, migration. secular education,
nuclear families, and the breakdown of traditional social norms-lowers
the prestige of the old, reduces their control over resources, and dimin-
ishes the effectiveness of the extenided family in pooling incoimie and
risk. Because mandatorv formal programs can hasten this process, gov-
ernments should carefully assess when, where, and in what form to in-
troduce formal programs of old age support. They should use measures
to maintain rather than crowd out informal systems that may still be
functioning reasonably well.
49



,ERTTNG(. THE OLD AGE CRISP,
The Diversity of Informal Systems
NFORMAL SYSTIENMS SHOW TREMEN DOUiS DIVERSITY. THE BASIC
system is one of childreni taking care of their old parents, whille other
support systems involve local commilunities, informal clubs, kinship
networks, patrons, and religious and other nongovernmental organiza-
tions. These institutions generally supplement the support from families
in industrial as well as developing coulitrics. Although chronological age
is used to defiine "old age" in this report, in most societies with large in-
formal systems, "old" is not synonymous with chronological age. In-
stead, old age is defined primarily as the inability to earn, work, and care
for oneself. Family members and other providers of informal support are
likely to have mucih better measuLres of functional inadequacies and
needs than chronological age can provide. Indeed, this is one of the big
advantages of informal systems.
Informal Systems in Asia
Asia has the most old people-230 million people over the age of 60
in 1990. It also has the highest old age depenidenicy ratio in the develop-
ing world and is expected to experience the most dramatic increases over
the next thirty years (World Bank population projections). And al-
thougih it has some of the strongest informal support systems, rapid
growth is puttinIg them under stress.
One source of the strength of informal systems of old age security is
the deeply embedded sense of filial loyalty in most Asian cultures.
Nowhiere is this bond stronger than in China, where for at least 3,000
years filial loyalty has been a cultural cornerstone, continuously encour-
aged except during the chaotic Cultural Revolution, wheni families were
broken up, children were turnied against parents, and some members
were exiled from urban to rural areas. Chinese parents have reinforced
filial loyalty through control of property, marriage age, and choice of
marriage partner for their children. The 1954 Constitution continued
this tradition by asserting that "parents have the duty to rear and educate
their minor children, and the children who have come of age have the
duty to support and assist their parents" (Fang, Chuanbin, and Yuhua
1992). Modern China also has unusually strong control of out-
migration from rural areas, whiich helps to protect the informal system
from the corrosive effects of massive rural-urbanl migration.
50



INFORMAL ARRANGEM            N
Several recent changes nevertheless signal a weakeni ig of China's in-
formal systems. In many' urban areas, employment-based pensions,
commun`ity-based health care, and old age clubs are emerging. Small
apartments-and clhaniges in the occupational strLmcture away froi ac-
tivities in w*hich experienice-based knowledge is important-have un-
derminied extended houselhold living, arran(gemnents and the respect of
children for their parents. Even in rural areas, the informal support sys-
temn is feeling stress from such forces as out-nigration, educationi, longer
life expectancy, and the official one-child policv-stress that can be ex-
pected to increase, as the old double from 9 percent of the populatioll to
18 percent in 2025 (figure 1.6).
Some of the greatest stresses on family support systems are in other
East Asian economies with high growth and urbanizationi rates-such as
Hong Kong, Malaysia, the Reptiblic of Korea, Singapore, Taiwan
(China), and Thailand. But those systemiis are demonistrating resilience,
which seems to come fromii flexibiliry and adaptability (box 2. 1). Higher
incomies allow for increased monoetary transfers betweeni households, so
that financial aid is substituting for joint living arrangemenits. Higher
incomiies also allow more personal saving by the old, relieving pressure
8o, .1 C*'*. g V,r,re , i  Tailand"
TiiN.W~TI~1TS M~Pfl3 ¢.ONQ)2CGkO',TH.              * The mnoral obligation of children to support
:tt4een4*~tis,a *iiid dwixg fiertiht`y, ma nottheig thir parents .regardless of gender, birth order,
a1Eh t   3 ,    tra-m infbrznal sy'texn of         marital status, or distance from the parental
ol?l ~  ~a# rrF   Yet a fakge pctcenage of' married   residence
*fiE+i>¢>*ii',$ugi asa rnajor tea;                 U  .The tradition of parents living with a single
st^rt%.   }  citdn ':is thepattern of older par- :''  child, which means that little adjustment was
entsiM4 itid~ th~fr ~dijlt chiki'srein se    to be hok  -  needed when the number of children declined
5n~ ~ipAJ*bf   y*iXil eopk till- eixpect to  Vith     I - ncreased education and earnings, which help
ans .'(hdi' ~4  7,p4r          gtts (K~d4d ohers -  --the smaller number of Thai children to sup-
*gl Itfl   '.'. ";,.5. '' ,   " .,, ' -' ' ..  pOot their parents
',tiy .f ,    eW    n  and anayk ' .  ' "-'hA high rate of remarriage, which increases the
ted 4q bes~t4W1 a~tid h  c~llaboxarors cend1.u    :  opporrunities for filial support for those with-
F        f+tia1'kri lueecs myri.4-i-''ue--e-.  out natural children
A  Higher rates of saving than in the past (made
-P    frseatie4 sodal *+ots t:hat- still prevail in  possible by reductions in fertility), which corn-
the' -P-n~e of large .t:  for social security  . ....... -plement rather than substitute for help from
children (Mason and others 1993).
5'



IL:TING THE OLD AGE CRISIS
on children. Another adjustment is the support that daughters provide,
offsetting some of the effect of having fewer sons. And the strategic use
of inheritance for encouraging support from children seems to be on the
rise. In Japan, the proportion of women of childbearing age who ex-
pected to leave property to the child who takes care of them rose from
18 percent in 1963 to 32 percent in 1977 (Martin 1990).
In the Hindu, Muslim, and other cultures of the subcontinent, chil-
dren's responsibility to support their elderly parents also has a long
history-still intact. Well over 75 percent of the old live with their chil-
dren in all these countries-almost 95 percent in Nepal. Even in urban
Bombay, more than 80 percent of the old live with their children (Mar-
tin 1990; Pathak 1978). As in China, much of the strength of the sys-
tem rests on parental control over property, inheritance, marriage age,
and choice of partner-the last is particularly important because of the
vital role of daughters-in-law in providing dowries and care to support
parents-in-law.
This does not mean that the old are well taken care of in South Asia.
More than in East Asia, responsibility for supporting parents continues
to rest primarily with sons and their wives, so parents without male chil-
dren are considerably more vulnerable. Daughters-in-law are frequently
subject to abuse by dissatisfied parents-in-law. And when they become
mothers, they are much more vulnerable to income insecurity than are
fathers because of their younger age at marriage, longer life expectancy,
growing probability of divorce, and lower rates of remarriage, labor force
participation, inheritance, and ability to borrow. The problem is great-
est for widows, with or without children (box 2.2).
All these problems are increasing. In rural areas, filial loyalty has been
weakened by out-migration and poor communication systems. In urban
areas, the shrinkage of extended families to their nuclear core and the
changing occupational structure are pushing the old out of the labor
force and reducing their access to family support. So, although the
extended family system is by far the most important old age support sys-
tem in India and other countries of South Asia, the beginnings of its dis-
solution is evident even there.
Informal Systems in Africa
Africa's support systems are based on a broader definition of family
than Asia's. Households are often extended in many dimensions (for ex-
52



INFORMAL ARRANGEMENTS0
Box 2.2  In India, the Infornal Systen Treats Widows Poorly
THROUGHOUT SOUTH ASIA, MOST OLD WOMEN              Despite laws to the contrary, a widow with living
are widows, and widows ate among the poorest of the   sons is rarely able to inherit anything-purportedly to
poor. Informal systems of providing for the old af-   keep her from abandoning her children to marry
ford fittle protection for these women. Indeed, tradi-   again. Yet without inheritance or other property she
tion and custom frequently work against them. In   lacks the collateral to obtain loans, self-employment is
India, for example, households headed by widows are   largely infeasible, and the possibility of extreme
by far the poorestgroup, with an average expenditure   poverty looms large. Support from sons is the primary
per person 70 percent below the national average    means of support for 90 percent of the women in
(Dreze 1990). Dreze identifies five important con-   Dreze's sample. Widows without sons have a higher
straints on Indian widows:                      rate of remarriage-although it is still remarkably
low-than those with sons. Many women complained
• Their inability to return to the parental home    bitterly about the abrupt change in their treatment by
* Restrictions on remarriage                  family members after their husbands' death.
* The division of labor by gender, which limits a  A comparison of three villages from different parts
wornan's opportunities for self-employment   of India reveals that widows in villages of West Bengal
and confines her almost entirely to agricultural   are better off. Reformers in Bengal have promoted
wage labor                                 widow remnarriage and women's rights. But even in
* Restrictions on inheritance, which is patrilineal   Bengal widows are one of the groups for whom the in-
* Lack of access to credit.                   formal system of old age security is not working well.
ample, adult brothers and sisters may live together, as well as parents and
children). Likewise, old age support from siblings is far more common
than in Asia. The definition of children is also much more inclusive-
adoption, fosterage, and borrowing offspring of other family members
are common. In some cases, grandparents raise and are eventually cared
for by their children's children. Where polygamy is practiced, several
wives and children typically live in a common compound-a very ex-
tended household.
Nonfamily institutions-such as kin, community, and tribal support
networks-are also more important in Africa. In urban settings, com-
munity organizations sometimes spring up around the village or region
of origin-often stressing self-help and income-generating activities and
providing assistance with burials. But because the ties are weaker than
those in families, these community support systems are not very effec-
tive insurance. Children are still the main source of support for old age,
and being childless is a serious problem for the old.
53



ffigTING  THE OLD  AGE CRIISIS
The old make up only 5 percent of the population in Africa, so in-
formal support systems have not vet felt the stress experienced by those
in Asia and Latin America. Africa's much poorer economic performance
has made it more difficLulc for the younger generation to support the old,
but it has also bluntIed urbanizationi, social change, and modertiization.
In most Africani countries more than 75 percent of the populationi live
in rural areas. The old continue to play visible roles in village govern-
ment, tribal relations, and dispute resolution. Moreover, much of the
rural-urbani migration in Africa has been circular or temporary, helpinig
to keep intact the informal arrangemelits for old age support.
Not surprisingly, most surveys show Africa's inforimial sLipport sys-
tems to be vorking relatively well. A high proportioni of old people, in-
cluding those in cities. live in extended houselholds, and older people
frequelntly receive goods and money tfrom  their children. In Nigeria,
more than 97 percent of the urbani old and 93 percent of the rLral old
reported receiving some finanicial or material support from family or kin
(Ekperiyorig, Ovenieye, and Pie1 1986). The provision  of lump sum pav-
menits to retirinig civil servants has allowed maniy of themic to buy land or
busilnesses and to resettle in their villages among their families of origin,
bringing them  back into the inforimial system. Even witilout pensions,
the old commonily retulir to their birthplaces on retiremenit. And being
accepted generally depenids on their havinig been loyal to their pareints-
by sendinig remittances or returnling to visit from time to time. But some
of the fabric of old age support is wearing thin.
Informal Systems in Latin America
Despite substantial diversity across Latin America, several broad dif-
ferences from the inforimial systems in Asia and Africa stand out. First,
increases inl life expectancy, urbanizationi, and industrializationi and
other demographilc changcs occurred earlier in Latin America than else-
where, althoughi not at the same ullifornily high rates as in Eastern Asia.
The southierin part of Latin America is already aging, while Central
America is still quite young. A second difference is the sharply dualistic
character of society in several coulitries that have a relatively large low-
income indigenlous populationi, a much smaller well-off European pop-
ulationi, and rural-urban migrationi that is usually permanient.
Third and closely related are the large urban-rural and rich-poor dif-
ferenices in househlold structure, fertility, occupation-and thus in the
54



INFORMAL ARRANGEMEN.
importance of informal support svstems. In Sao Paulo, Brazil, the rich
elderly have good access to public and private pensions, individual sav-
ings, housilng and health care entitlements, and life and disability insur-
ance. So, they do not need monetary support from their children. But
the urban poor are almost totally dependent on support from children,
having few alternative sources of support, and maniy still live in extended
falillies (Ramos in Kendig and others 1992). The situationi is similar for
the rural poor, except that indigenIous commullities stress communal
systems of support more heavily thani populations of European origin.
A fourth difference is that formal support systems are generally much
more developed in Latin America than in other developing countries-
pcrhaps helping drive out informal systems. Some of these formal sys-
tems that have been in effect for main' years are now near collapse as a
result of demographiic pressures and design weaknesses. But the infor-
mal system is seldom there to fall back on.
What Makes Informal Support Systems Run?
P   WEOILL IN  RA,D I TIONAL SOCIETIES lUSF INFORMAL RISK P()OOL-
ing within extended multigenerational families or village groups
to insure against the risk of old age dependenicy and other vicissi-
aides of life. The family's size and heterogeneitv enable the realization of
economies of scale and risk pooling vwithin a diverse group while avoid-
ing the informational costs and asymmnetries of formal systems.
Two kinds of old age risks are particularly importanit-the risk of be-
coming uniproductive through ill health or disability, and the risk of liv-
ing long and needing income for consumption. VoluIntary market-based
insurance arrangemenits againist these risks often break down because
people whio think they have a low risk will opt out of the system, while
high risks opt in (adverse selection), making the price that insurance
companies must charge prohibitive for the average person. Market-
based arrangements also break dowin because people whio are insured
may fail to protect themselves against disability or may pretend to be
disabled when they are not (moral hazard). Families are different: thcre
is little choice to opt in or out, and the molLitorilng and knowledge of
relatives can distinguishi a feigned illiess fromil a reail one. Members who
do not cooperate can be punishied by the head of the household.
55



tgRTPNG THE OLD AGE CRISIS
By pooling risks, the family can adjuLst to unforeseen outcomes in a
fairly flexible way, in contrast to a formal contract that cannot spell out
every contingencv, and may therefore end up with unexpected outcomes
and unintended sharing of risks. One problem with informal risk pooling
is that if the entire family lives in the same village and engages in the same
occupation, their risks would be correlated and the gains from risk pool-
ing small. Extended families sometimes solve this problem bv spreading
risk beyond the village. A satellite family unit might be set up in an urban
area, where the wage rate is high enough to raise the joint familv's expected
income and the activities are sufficiently different to reduce the joint risks.
Or the family might marny off a child into another family from a distant
village, after researching the resources and reliabiliy of the other family.
The informal system also holds down the cost of old age support. Be-
cause of a household's many needs and variety of tasks, it is easy to find
useful activities for old members to perform: they can cook, take care of
small children, and clean or paint the home, freeing younger members
to do the jobs that demand more energy and speed. And because care of
the old is within the household, the caretakers can carny out other activ-
ities, reducing the opportunity cost of the care.
The Old Age Security Motive for Children
Ir has long been alleged that one reason people in developing coun-
tries have so many children is for old age security (Leibenstein 1957,
1975). Without reliable saving instrunments or public pensioni programs,
children are the best bet. People voluntarily save and invest in their chil-
dren, expecting to reap the return later. And because infant and child
mortality rates are high in these areas, having a large number of children
helps ensure that at least some children-of the "right" gender-will
survive to provide support in old age. A stark example is the persistence
of families with more than one child in rural Chinia-despite the official
one-child policy-and the steps taken to make sure that at least one
child is male (the male-female ratio at birth is 1.2 to 1).
Other analysts (such as Lindert 1980, 1983) have strongly challenged
this motive, citing the costs of children, the low returns on children after
the first three or four, the long time betveen fertility decisions and old
age, the possibility that childreni may die and that even surviving chil-
dren will not support their parents, and the unimportance of old age in
societies with high mortality rates.
56



INFORMAL ARRANGtME
What does the empirical evidence say? One source of evidence is
what people have said about their motives for having children-in sur-
veys conducted in several countries (table 2. 1). In almost everv develop-
ing country surveyed, more than 40 percent of respondents indicate that
having help in old age is a "very important" motive for "wanting another
child" (Arnold and others 1975; Kagitcibasi 1982). The percentages are
generally higher for women than for men, for the urban lower class than
for the urban middle class, and for people in rural areas. Similar data are
available for many other countries. But evidence based on behavior is
limited and inconclusive (box 2.3). There is probably a weak old age se-
curity motive for having some children, but it is not clear that it is a mo-
tive for having mzany children.
How the Old Exact Compliance
What prevents the family head or coalitions of family members in
intergenerational households from deciding to shirk responsibility for
providing assistanice to older members? Why do people "voluntarily"
provide assistance? One protection, certainly, is the empathy and altru-
ism of the household members who derive happiness from the welfare of
the older members. Another is concern for the family's reputation, par-
ticularlv in communities or kin networks in which social norms make
Table 2.1 Percentage of Respondents for Whom Help in Old Age Is a "Very Important"
Motive for Wanting Another Child
Urban        Urban
middle       lower
Area                     Males       Females        Total        class        class        Rural
Indonesia Uava)           73            82          78            -             _            _
Japan                     -             -            12            2            7            21
Korea. Rep. of            12           18           16             3           26           43
Philippines                            78           78            49           53           80
Singapore                 43            48          46            -            -            -
Taiwan (China)            53            48          50             9           21           35
Thailand                  67            71          69            12           55            58
Turkey                    37            48          43                         -            -
United States (Hawaii)     7             9           S
- Not available.
Source:Arnold anid others (1975), cable4.16; Kagircibasi (1982), table 1.
57



$ -NG THE OLD AGE CRISIS
BoxZ23 hs Od Age ecattya MotiveforLar ft*Akt
WHEN AKEDHYT    HE  H                                              thai    nia   ag, 
pie often say the want someone to provide fir  e  e       tApfain  he fertility r
iontheir oldage. There is little evidence onacule-   Nugent anti  yied tM id
havior, however, to :verlif  or efutne Suc  1a ims.   workez- iwu r: in i 5tsje pruducto :w xi wo
Though the Iod  yge  seity motive is likely to be'  q e -u -old age eg
considerably str  in developing co utries than                      a0 o     %rw i  ik wks
industrial countries, most attempts tostesttfior. the im  h did nt qu   -      a
portanceof the tmotive have used cosecton  dta  vie:s aneive t    l    l              a
from industrial countries (Friedlander and Saiver   port But  the   sesthd two  ixnportant shott-
1967; Holm 1975; Kelly, Cutright, andHlitltle 1976;   com inis: a sml  tnuber 4f  hr (     and :
Entwisle and Windgarden 1984). tud  artioiants   thirtsix) andtheuse ofe       r ther ta
are usually men living in urban areas, ealthogh,    household obseratnons:.
again, the old age security motive is likely to be  Using data fromi the Malayiani  a UIy   Sur-::
stronger in rural areas thain in urban ones and am'ong    vy Kenney (1988) foun thatk: esiueto ie
women1than among meneven oe of the few stud-    greatesta rsk preferred to hae moreh enand to
ies'in a developing country, for a village in Idia in-   ec   te  l hess than otherAwd,'i. Jensen
cluded only men: Vlassoff and Vlassof 1980). That   (1989) used a two.-sraproceddre on t  saxne data
few studies haveAshown the old age secunty motive to:   and found tr old age sup' ort id notiveh a ismnill
be important, then, really tells litrl about its nrflu-   influefice on alyi"tilit (e decis ion to he the:
ence in rural areas of developing countries.    first childr i); but not on later trtility.  :
For rural areas in BBangladesh and India, Cain   Thewkl in th           ut seto be t
(1981, 1983) hypothesized that the risks are greater  -assertion thar lae  nunberofchidren are needed
and the alternatives to children fewer ani weaker in,  to provide old age p a  fromthe    sia
much information about a family public. The system is also protected
against breakdown by the social norms of filial loyalty inculcated
through repeated religious and family teachings. Similarly, the adults
who provide such aid to their parents know that they will one day de-
pend on their children.
Perhaps the most important means by which the old protect them-
selves is bv retaining control of the household's resources almost until
death. Savings in traditional societies-in housing, land, cattle, gold,
and jewelry-are a means of inducing support from children. The abil-
ity to threaten disinheritance is a strong motivator, and having several
children compete for inheritance helps to strengthen the credibility of
the threat. An aging head of household is often assisted in holding onto
headship and control of household resources by superior knowledge of
the activity in which he (and sometimes she) has specialized. Indeed, in
58



INFORMAL ARRANGE?
, tf~is  teir ldC ag ie,   the odutirn of forn al d yster s of
some,'a countrie                                                    should t educe ferbality rates and
the9                                       'tt~t    p11~tiul .  owth               old age depen-
~7 ~ 4   w              ~ratee this jrocess ixiay p1a~isunexpected finan-
Shor m inA stof                                  O                      s         To the
such informal systems from mesttne allsehe oldpublic pay-as-yotu-go
met inw>~ childen-o  the retur  to cehseeof ihv ireowt  desrutwn
I  '-3,4          ~~      ~~~5  6   7       5        9      10+
liyi~sg a~aX?- (~a~x~  0,54    0.60    0.71  04  0,7  0.73    0.82     0.80    0.78
O~~~6  ~L7l    0.73   067k    :0,79    0.80    0.83  0,84    0.85
7   154  X~~    2,Ci7~~   244.    25           3.11    .38      426
The n~Sctspa  ~   ~ThIv 4;w  edau awio                    rs aged 50 and overain peninsular Malaysia known
sonie couentries and time periods, the balance of power may have favored
the old too much relative to the young.
Shortcomings of Informal Systems
Even when the safeguards work well, othier shortcomlings ofteni keep
such informal sstems fromi  meeting all the old age security needs. The
resouirces tranisferred to an old parent may not be enouIgh. The invest-
mients in childreni-or the returni to chese investfments-mav be low.
The household head may be inieffective and unproductive. The younig
whio move to cities may be less responsive to the social sanctions of the
village. Older people in cities may' prefer to I've alone rather than in ex-
tended famiilyv households. Iniformal systems have little ability to redis-
btribte incomie from rich families to poor families, anid eveni some
59



f TIN G  THE OLD AGE CRISfS
wealthy family members may be reluctant to share with their less
wealthy relatives. As the capabilities of governments and financial mar-
kets develop, formal systems can address these deficiencies.
Signs of Breakdown
C       HANGES IN THE ECONOMIC, POLITICAL, SOCIAL, LEGAL, AND
demographic environments-having already broken down the
family systems of old age support in industrial countries-are
nlow weakening those systems in developing countries.
Changes in the Broader Environment
Economic environment. With development, the structure of production
changes. Rural activities-such as agriculture, fishing, forestr,v and
animal husbandry-became less important, and urban-based industry
and services, more. As the importance of agriculture diminishes, so do
the opportunities for older people to participate in the labor force. And
with the growing capital intenisitv of agriculture, older people are less
able to provide their children with employmiient opportunities, so the
clildreni are more likely to move away.
Political environment. Many newly independent developing couLntries
installed activist, interventionist governments that encouraged indus-
rrialization througLh policies of import substitution behind high, pro-
tectionist walls, systematically disadvantaging the stronghold of infor-
mal support systems. They also invested heavily in education. The
wider availability of schools and the growing need for nevw skills in the
labor market encouraged school attendanice, but at the expense of fam-
ily time available for the care of dependent parents. And the fact that
childreni are better educated than their parents or grandparents under-
mined the respect of the young for the old.
Social and cultural environment. Greater mobiliry and less communica-
tion between rural-based parents and urban-based children reduce
altruislll, parental control, and social pressure for parental support.
Urbanizationi also unidermiiines the norm that children should live with
and care for their older parents. In urban areas housing space is more
cramped, so if parents move in with their children they may be
6o



INFO RMAL ARRANGEMET4
blamed for overcrowdinig the home. Another important cultural
change is the gradual erosiOI of parents' property rights in their chil-
dren. In almost all couLntries, children have increasingly assumed the
right to choose their own marriage partners. age at marriage, and
place of residence.
Legal environment. When bequests are taxed or laws require that prop-
erty be divided equallv among all family members, or rights to rent out
or dispose of property are attenuated, parents lose the most important
means they have of rewarding children who have treated them well.
\X'hile such legal restrictions are often justified on grounds of equit,v
they have potentially serious consequellces for the ability of older peo-
ple to induce support from theil children and other relatives.
Demographics. Fertility rates have begull to fall, but life expectancy
has continued to increase. Young adults are caught in a squeeze: there
are fewer of them to take care of their increasingly long-lived parents.
Longevity tends to increase more rapidly for women thani for men, cre-
ating a growinig disparity in widowlhood among older men and
women. Women live longer as widows and are more dependent on
their childreni for support.
Evidence of Breakdown in Informal Systems
All these changes undoubtedly affect intform-fal syscems of old age sup-
port. But almost no studies are nationially representative, comparable
over time, and sufficiently quantitative to test hypotlheses about wlhether
and how much traditional voluntary systems have broken down. The
limited evidence shows considerable variation across countries in the
importance of children for providing old age support.
The Value of Childreni project addressed a common questionnaire to
more than 20,000 married adults in nine countries in the mid-1970s. To
the questioni "Would you expect your son(s)/daughter(s) to support you
finanicially when you grow old?" the percentage of respondents answering
yes varies from a low of about 11 percent (for daughters) in the United
States to a high of 91 percent (for soIns) in Turkey (table 2.2). Generally,
more mothers thanl fathers answered yes-and more for sons thani for
daughters. Becatise the yes rates are muchi higher for low-ilncomiie countries
thani for the United States, with Singapore somewhere in berween, find-
ings like these are frequentlv used to argue that informal SuippOrt systems
fade away as counltries develop.
6i



0THE OLD AGE CRISIS
Table 2.2 Percentage of Parents Who Expect Financial Help from Sons (S) and Daughters (DI
Indonesia    Rep. of                          Taiwan                            United
(Java)     Korea    Philippines  Singapore   (China)    Thailand    Turkey     States
S    D    S    D    S    D    S    D    S    D    S    D    S    D    S    D
Mothers   85   83   85   46   86   85   39   31   85   39   89   87   91   78   12   11
Fathers    79   77   78   42   82   80   31   25   76   29   78   75   84   64   12   11
Source: adapted from Kagitcibasi (1982), rable 1, p. 34.
Similar patterns are apparent within countries: support from children
is generally higher for rural areas than for urban areas and for smaller and
poorer communities than for richer ones. Scattered data are available-
though not in strictly comparable form-on sources of financial sup-
port in old age in a larger number of countries (table 2.3). In low-
income regions (except urban China), the most important sources of
support in old age are "own work" and "family." Formal support systems
(pensions or welfare) play a negligible role. In middle-inconme regions,
"work" and "family" are still important but "pensions/welfare' is even
more common. In high-income regions, "pensions/welfare" is an almost
universal source of support. Again, the data seem to imply a shift from
informal to formal sources of support as a couLntry s economy grows.
In high-income countries (except Japan) fewer than 20 percent of
older parents live with their children (table 2.4). The proportion rises to
approximately 50 percent in middle-income countries of Latin America
and to more than 75 percent in the generallv lower-inicome countries of
Africa and Asia. Financial support and joint living arrangemiients are, of
course, not the only ways children help their parents in old age. Helping
witlh housework and in emergencies is common in most countries, and
the high numiiber of positive responses in the United States suggest that
nonfinancial assistance remains strong even as income levels increase
(table 2.5).
Even in Japan, the only high-income country with the majority of
old people still living with their children, support from children seems
to be on the decline. Between 1974 and 1983. the share of middle-aged
children (35 to 49 years old) providing economic support to their aging
parents declined from 45 to 40 percent. The percentage of people 65
years of age and older living with their children dropped from 77 per-
cent in 1970 to 65 percent in 1985 (Martin 1990).
6z



INFORMAL ARRANC G&
Table 2.3 Sources of Income in Old Age, Selected Countries, 1980s
Percentage ofpersons over 65 receiving income from
Pensionl
Work        Family       welfare      Savings
High-incomne countries
Australia                      9           -             93
Canada                        19          -             97
France                         4          -             96           -
Germany                        2          -             98
Netherlands                    5          -            100           -
Sweden                         0           -            100          -
UJnited Kingdom               13          -            100
United States                20           -             94
Average                        9           -             97
Percenzage ofpersons over 60 receiving income from
Pension!
Work        Family       welfare      Satvings
Alidalle-income countries
Argentina                     26            8            74           6
Bulgaria                     28             5           99           -
Chile                         20            9           73           -
Costa Rica                   21            23           46           -
Hungary                      47           40            99           -
Budapesu                  34           21           100          -
Villages                  58           54            99          -
Korea, Rep. of               24           64              6           8
Singapore                     18           85            16          37
Trinidad and Tobago           15           26           77
Average                       25           32            61          17
L ow-income countries
China                        45            34            13          -
Urban                     15            17           64
Rural                     51           38             5
Indonesia                    46            63            10           4
Kenya                        -             88           -            -
Malaysia                     34            83            14          11
Nigeria                      -             95
Philippines                  63           45             13           2
Average                       47           58            13           6
- Not available.
Vore: Averages are unweighted.
Source: Uniited Nations (1992a); Japanese Organization for Interinational Cooperation
in Family Planning (1989); Ju and Jones (1989); Pan-American Health Organiization
(1989b, c, d and 1990a. b); D. Mitchell (1993); Hoddinott (1992); Vukovich (1991);
Petrov and MEnev (1989).
6-



T,1NG THE OLD AGE CRISIS
Table 2.4 Living Arrangements of Older Persons, 1980s
Percentage ofpersons over 65 living
With children
orfamily          Alone            Otheea
High-incoine countries
Australia                       7               30               62
Canada (Quebec)                16               21               63
Japan                          69                8               23
Netherlands                    12               33               56
New Zealand                    -                39
Sweden                         -                40
United Suates                  13               30               57
Average                        23               29               52
Percentage ofpersons over 60 living
With children
or family         Alone            Other7
Middle-incomne countries
Argentina                      25               11               64
Chile                          59               10               31
Costa Rica                     56                7               37
Panama                         76               10               14
Trinidad and Tobago            41               13               46
Uruguav                        53               16               31
Average                        52               11               37
Low-income countries
China                          83                3               14
Urban                      74                 5              22
Rural                      89                 1               10
C6te d'lvoire                  96                2                2
Guyana                         61                2               38
Honduras                       90                5                5
Indonesia                      76                8               17
Malaysia                       82                6               12
Philippines                    92                3                5
Thailand                       92                5                4
Average                        84                4               12
- Not available.
ANote: Averages are unweighted.
a. Iuicludes persons living with spouse.
Source: Japanese Organization for Interiational Cooperation in Family Planninlg
(1989); Pan-American [iealth Organization (1989b, c, d: 1990a. b); JLI and [ones
(1989); Keller (1994); Kenidig, Hashinoto. and Coppard (1992).
64



INFORMAL ARRANGEMEN'
Table 2.5 Expected Help from Children by Economy and Sex of Respondents, 1975-76
Rep. of                      Taiwan                         United
Indicator                  Indonesia   Korea  Philippines Singapore  (China)  Thailand   Turkey    States4
Mothers
Percentage expecting help from sons
Help around the house         81        82        83        39        68        73        65        85
Part of salary                60        71        67        38        76        71        77        29
Contribution in emergencies   83        87        88        58        92        92        95        74
Percentage expecting help from daughters
Help around the house         92        84        94        55        82        96        94        92
Part of salary                56        59        68        32        72        58        60        29
Concribution in emergencies   81        75         88       49        88        89        85        73
Fathers
Percentage expecting help from sons
Help around the house         89        82        86        33        67        73        80        87
Parc of salary                52        63        61        29        52        53        67         19
Contribution in emergencies   81        81        85        49        86        87        88        66
Percentage expecting helpfirom daughters
Help around the house         93        80        92        48        79        92        91        90
Part of salarv                50        42        61        24        57        49        27         18
Contribution in emergencies   80        66        84        43        80        84        62        65
a. Hawaii onlvy.
Source: Derived from Bulatao (1979), table 4.
Expectations and attitudes are changing, too. In Korea in 1988, 68
percent of people 60 or older said they would rely exclusively on sons,
20 percent on1 sons and daughters, and 8 percent solely on self-support
(National Bureau of Statistics in Martin 1990). Of those 20 to 29 years
old, 33 percent said theyv would rely exclusively on sons and 44 percent
on both sons and daughters, with 17 percent expecting to be self-
supporting. In Taiwan (China), the share of married women aged 20 to
39 living or eating with their husbands' parents declined from  81 per-
cent in 1973 to 69 percent in 1985 (Martin 1990). In Kenya, 91 per-
cent of the rural old felt that their children did not do as much for them
as they had done for their parents (Kinsella 1988).
So once close-knit communities no longer exist to exert social sanc-
tions and older family members no longer control resources or crucial
life choices of their children, purely voluntary family-based systems of
risk pooling and income sharing may not work xvell.
65



.~T0H;E O LD AGFE C RM11S
Interactions between Public and Private
Transfers: Crowding Out and Crowding In
I RONICALLY, THE GROWTH OF GOVERNMENT PROGRAMIS
to help old people may further undermine the remnants of the fam-
ily support system. The effects of public support on private transfers
depend on the motives for private transfers between family members:
are they motivated by altruism or are they part of an exchange? Altruis-
tic transfers are made by well-miieaning donors because another family
member is in need. Exchange transfers are made by donors who expect
to get something in return, such as a bequest. If the state steps in and
provides a transfer to a family member, the altruistic donor no longer
sees the need to provide the transfer. So the public transfer crowds out
the private transfer. But if the donor is motivated by an exchange, the
public transfer does not necessarily undermine the private donor's desire
to provide the transfer, since the donor expects a quid pro quo. So, the
public transfer need not crowd out the private transfer or need not
crowd it out completely.
Because of the complementarity of different types of support, prop-
erly designed formal support could increase informal support. For ex-
ample, a son or daughter providing care and money to an elderly parent
might be willing to supply more if the parent had access to medical
treatment in a government clinic, which could increase the parent's ex-
pected life span and therefore the value of the private transfer. Such
crowding in of informal support might also occtir if the receipt of a pub-
lic transfer increases the respect for or bargaining power of an older per-
son. Community organizations that support older people often design
their programs to minimize the crowding out of family support and,
sometimes, even encourage additional family support.
Quantitative evidence on crowding in and crowding otit is scarce be-
catise data sets providing the relevant evidence are available for only a
few countries. Peru is one. Like several other Latin American countries,
Peru has a fairly well-developed formal social security system, yet private
transfers (mainly fiom adult children to their parents) still constitUte a
significant share of the income of social security recipients. For every
dollar of social security taxes and benefits, private transfers fall 17 cents.
Social security makes elderly pensioners better off, but not as much bet-
ter off as its expenditures would suggest because it partially crowds out
private transfers (box 2.4).
66



I N FORMAL ARRANGEMEJ
Policies to Keep Family Support Systems Afloat
IT IS INEVITABLE THAT FORkVAL SYSTEMS SHOULD EVENTUALLY
replace informal systems as the dominant form of old age support.
But it is usefiul to extend the lives of intformal systems, particularly in
low- and middle-income countries whose formal systenms have limited
capabilities to do the full job.
Avoid Biases against Traditional Agriculture
The most obvious way to extend the lives of family systems of old age
support is to avoid policy biases against traditional agriculture, in which
BwcZ4 Ot Pic Tanshfer Crwd Oqt Puvat Ones?
O1.X) AGE> J ?£;ENSJ0, 1E MSNY  IT   PU          used their estimates to simulate how much more pri-
.prras ould prP   offretig privat raponses   vate transfers would, have been without social security.
ta need to e *eni-t  account  en measuring    The answer? Twenty percent higher. (The simula-
.-dist iti eff      ?    e     childrn}miht -ons accounted for both the reduced incomes of par-
-ic l:es suppot r   r      parets ihe public   enis anid the increased incomes of taxpaying children
se     ,   o re,            ubisigpnic tpesion -en    that would have arisen had social security been cur.)
fits,y a' do  l      na       n a dors wor       This imples that the Peruvian social security system is
of extra benefits to the elderl ,Thiscrwdigoutcan    less effecive at delivering benefits than a simple as-
be especiayiportant.' 't 4evelo g countries,.. signment of benefits would suggest. For evety dollar
Swher  the icidleJice: 6t privte tnsferr  giving -is   of increased benefits, private transfers are reduced by
hiher. t*lan in cdievope countries. Recent sttdies in   17 cents, leaving 83 cents for the elderly beneficiaries.
Peru (Cox d."  Jimein  1t92a) a4d the Ippines      A siilar computation was done for the Philip-
4Cox and Js?inenez.   hcornii g) )llustrate.    pimes,, where the proportion of the population cov-
-n -     )85  vpeentofPe:secooilyacive   ered by the social security system is lower than in
pop      s w1 s cedyte con,          py-you-    Peru arnd the incidence of private transfers is higher.
go soi stierity s. A nationaly representat    Te crowding out effect is larger-a dollar increase
hti~~ d a         als- in4diated that the public w   - - in public pensions would be associated with a decline
ne. Xoexted with a substantial privatae network A  :uin privte transfers of 37 cents, leaving 63 cents for
third of iii+ban househokl+ received private tra s   tih eld .
in*: t three: mos prior rthe survey. For niet re- - -iThese simulations imply that social security does
ipi, ?prvate transfers;constitued a -ffth of total    indeed prompt reductions in private transfers. Al-
:househld       .......... ..t.; .  .:       . -  - .- hough the magnitude of the reduction is significant,
;i'~e amated'  e4etcnninanrs of priaite   it is. mu   less than that predicted by models of
tifn~myoung to9 old'in Peru,. ratig into-ia°-   purely altuiistic transfers among households. Pub-
c~wxr      e e.:. crs that social security couldl.hve --icly inanced pensions still boost the incomes of tar-
iind'Wn E ~tra- *ts fnnn 4~1ldr  to parents. ~ey then   gteed be4eficiaries-but not dollar for dollar.
6;-



VERTING THE OLD AGE CRISIS
family pooling of work, risk, and resources works best. Typical among
these policy biases are the protective tariffs and subsidized credit and
electricity that favor the modern sector. By artificially supporting sectors
that compete with agriculture for scarce resources, these policies draw
resources away from rural areas and make them less able to hold onto
their work force. Avoiding these policy biases is good for many other
reasons and also preserves informal networks of information and social
sanctions that are based on the frequent contact, close proximity, and
long-term residential stability that underpin the family support system.
Improve Communication between Rural and Urban Areas
Rural-urban migration can have a doubly deleterious effect on old
age support systems. The older generation of rural residents, who have
invested in the education and rearing of their children, see the risks of
these investments rise as their children migrate. The children, for their
part, are removed from the rural information and support network.
Some children earn more and send remittances home to their parents,
but some do not, so uncertainty increases. The weaker the communica-
tion links between urban and rural areas, the more harmful the effects of
migration-both in allowing children to escape their obligations of sup-
port to their parents and in cutting children off from future support net-
works in their communities of origin. Policies that improve communi-
cation between urban and rural areas have the side effect of improving
the functioning of informal old age support systems.
Consider Special Programs for Widows
W4omen are especially vulnerable in their old age. Most women even-
tually become widows because of their younger age at marriage, longer
life expectancy, and lower rate of remarriage than men. Women also
have lower labor force participation rates and wages than men, and in-
heritance and property laws often discriminate against them. These fac-
tors make womeni dependent on their children, and womenl without
children are especially disadvantaged. The most direct way to alleviate
these problems is through legislation to remove discrimination against
women in the labor market and in property and inheritance laws. But
change this fLndamental cannot be achieved overnight, since pervasive
social norms stIpporting discrimination have to be chaniged as well.
68



INFORMAL ARRANGEMENTS'.
Encouraging widows to remarry and not penalizing older men and
women who live together outside marriage (as many formal old age se-
curity systems do) are other options. China apparently has had favorable
experience with these policies. But they are less likely to work in other
countries where the sexual imbalance is less severe and where remarriage
or living together out of marriage violates strong cultural norms. Wid-
ows are thus one of the first groups of old people who should be targeted
for formal social assistance, in the interest of alleviating povertv among
those whom the traditional system fails.
Try to Have Formal Systems Complement Informal Systems
A general principle in establishing government programs is to pro-
vide goods and services that complement rather than substitute for those
provided by families and other voluntary sources of support. Singapore
gives preferred housing assignments and Sweden provides a housing al-
lowance to families willing to take care of an older relative. Respite care
is provided in Canada, France, and the United Kingdom. Community
clinics, outpatient health facilities, and day care and social facilities for
older people are available in Angola, Hong Kong, and Thailand. In
Malaysia, a small stipend goes to adult children who live with their par-
ents. Israel and Singapore grant tax deductions to people who provide
support for their parents or for other old people in their communities.
These policies make it more feasible for families to care for the old
withini their households, by easing what could othervise be an intolera-
ble burden (see box 2.5).
Limiting the level and type of public support may also be important.
A lump sum payment on retirement may permit the old to buy their
way back into the informal system in their village of origin. Targeting
social assistance programs to people without adequate income or with-
out family members capable of supporting them is another way to re-
duce the crowdinig otit of private transfers. An innovative program in the
Indian state of Kerala uses this principle in a means-tested pension
scheme for agricultural workers. A pension of 45 rupees ($1.50) a
month is paid to agricultural workers whose annual income (inclIding
income of spouse and unmarried children) does not exceed 1,500 rupees
($50.00) annually. Although this purportedly is a subsistence income,
the recipient cannot get by without additional assistance from relatives.
The pension has been credited with enablinig relatives to take care of the
69



TING THE OLD AGE CRISIS
Box 25 Govemenimt Progam That                             I              _ of 
MANY GOVERNMENT POlCWES.e O  IN C    i   h it e p d. is
and developing countries, complement and tiere-   and dh ne Ki- do 0.
fore encourage family cre of old peple. These1i
include housing assistance, respite ca; com lrw- t;    -   ;  ,--
niry health and day care centers, and  ainancia4l: :g-:e. l::Mays    dli                     : hs
assistance.                                       u         alce g   rl r l   to 1 -  -
with aged' or :4sa     mebes n $ingapore+ -
OECD Coutries                                   lies willing to le etdo   odr reatives at .
Housing asstance. Lack of adequate space in' the-  gie prti in hi osig   im           ilies in
home to comfortably accommodat an older re l ativs                     ati    ve it
can be a major barier to farmily care of the old. In,  g  i gie prioity, i si  cr    n   ald n
Victoria, Australia, prefabricated t4nits called:    appl fort:flaiance to a           a
"granny flats" are available as a form of public hous;.-    S orve k'V.  a   e an counsln set-
ing to help solve this problem. This hmodel has now'v   vices aret provdd hout ast Asia   out-     I
been adopted by New Zealand-and by Ontario,   eastAsia. n   ail  riYtsaceterspro-
Canada, as well. Japan provides low-interest last to   vide' health caire, day c, faily asststa, and
families to remodel their homes to acconm6daie an    counseling  i-long Kong ad Sin-gaore provide
older relative and offers public housing with an extra   homrehelp iad nusing ;Cae at home,6 Iaswelas: day
room to low-income persons with older reltives,   centers. In Aiga;  e ngrgnatis schs
Sweden provides a generous housing allowance to   churches, duanlcloeiesareuses s
enable family m.embers to adapt their homes. In   for day car d other su     tive servses. In At-
Norway, special loans are granted for the, purchase    genta  usv, lth,and
of multigenerarional houses.                     recreatialsevies to theold.:
Supportive services for caregzvers. One of the set-    Finc ansitnr ce. Ina a at children
vices most frequently requested by car-givers. is   whi- live      paeTs, hve rc d a: tax re-
respite care to enable them to perform importanter-   bate, and : aadditonaJl t   iavai tol t
rands, have a night away from home, or take a vaca-   help th*emcv  mecdA epe a   supporting
tion. In France, Germny, Japan, a nd the United   equpmen r disab i-paren   T   R
Kingdom, rooms are available in some nursing   FKorea the Phil        at
homes or geriatric hospitals for short-term stays, to   are also considering sucsAn",rtS.
give caregivers at home a respite. In-home respite  Sne of tee sercare poddirlb
care, in which a family caregiver is relieved ar af few :L L agen sa Me are di edb    ior-
hours at a time, is available ;  i n many  anian -t orza            sithe  oe et.
provinces and in some states in the UnitredStates.: j:&T pubc            gre        le    at
Day care for the mentally aned isapy ;xnila  sies; .              : hei,r eW  t: cw  i rath;
important in Australia, C anada,France, a   - a  tarowdot e
the United Kingdom. "Night-sitting" services,: in.  SoUre: Most:a  take f:                  m
which a social service person helps ani ctare fo    i     t       8
an ill older relative by taking care of the old persor    Copa id (1992 .-
70



INFORMAL ARRAN:
elderly by subsidizing the cost of home care-and thereby encouraging,
or crowding in, traditional informal support (Nair and Tracy 1989).
Go Slow with Formal Systems
In rural areas in low-inicome countries, informal systems may work
better than formal ones. Given limited taxing and administrative capa-
bilities, governments in Africa and Asia should be cautious about ambi-
tious formal programs, which might fail, after crowding out family
arrangements that function reasonably well. Family investments in edu-
cation or small businesses may provide better old age security than
would required contributions to public pension programs.
Public programs in the rural areas of poor countries should concen-
trate on social assistance for the neediest of all ages, while every effort is
made to develop the capacities that will enable more complex formal
systems to work well. Mandatory contributory programs should be in-
troduced first in the formal labor markets of urban areas, where the
informal system is most likely to have broken down.
71






C R 3
Policy Choices for
Formal Systems
N INDUSTRIAL COUNlRIES AND MOST LOW- AND MIDDLE-
income countries, governments have developed formal
arrangements for old age support. An estimated 30 percent of
the world's old people are covered by these formal arrange-
ments, and 40 percent of the world's workers are contributing
with the expectation of being covered wlhen they grow old.
The key policv questions that must be answered in setting tip the for-
mal arrangements are:
I Should the primarv reliance be on voluntary or mandatorv
mechanisms? When should mandatorv coverage be phased in.
and at what level of pensions and contributions?
I What should be the balance betweeni the ob jectives of poverty al-
leviation and redistribution versus saving and income smooth-
ing? And what role should the governmenit play in satisfying
each objective?
- Who should bear the many risks that beset people in old age,
what kinds of insuranice should be provided, and how?
* Should the system be financed on a funided or a pay-as-you-go
basis?
* Should it be managed publicly or privately?
The answers to these key policy questionis determine how a coun-
trv's old age security system affects the economy and how its benefits
and costs are divided between old and younlg, rich and poor. This
chapter introduces these issues, and chapters 4 through 6 discuss the
answers that are provided by public, occupational, and personal saving
plans.
73



THE OLD AG E C RI S I S
Voluntary or Mandatory Mechanisms?
How Much Mandatory Coverage?
I NFORMAL SYSTEMS OF OLD AGE SECURITY RELY ON VOLUNTARY
actions, buttressed by strong social sanctions. When a govern-
ment decides that such systems do not suffice, it must also de-
cide whether to reinforce voluntary actions or install a mandatory
plan.
Voluntary actions-such as personal saving plans and employer-
sponsored occupational pension plans-can be encouraged by
macroeconomic stability, reliable saving instruments, and favorable
tax treatment to long-term saving and annuities. This approach to
old age security has the lowest evasion and disincentive costs. It also
provides the greatest accommodation of diverse tastes. And it places
the lightest administrative burden on government. These are big
advantages everywhere, especially in developing countries. But
there also are disadvantages. This simple approach may not reach
some people. It does not fill the gaps in the insurance market. It will
not eliminate the vestiges of lifetime poverty among the old. And it
involves hidden-probably regressive-tax costs. Low-income
workers may not respond to tax incentives, while many high-
income workers who receive the tax advantages might have saved
anyway.
If the goals are to cover everyone, to prevent people from be-
coming a charge on the public treasury, and to redistribute income
to the old who are long-term poor, a mandatory scheme with broad
coverage is required, one that does not permit people to opt out.
Compulsory schemes have the further advantage that they can save
the treasury money, since they do not require tax incentives, al-
though incentives are often included to facilitate enforcement and
political acceptability. All industrial countries have mandatory
schemes as the core of their old age security systems-usually fi-
nanced by worker or employer contributions and buttressed by tax
provisions that encourage voluntary saving through personal or oc-
cupational plans.
Mandatory schemes require extensive government management
or regulation, which may strain the capabilities of many developing
countries. They also incur administrative costs that tend to be par-
ticularly high in relation to per capita income and total contribu-
74



POLIC-Y CHOICES FOR FORMAL S
tions in low-income countries. For these reasons, they should be
phased in and expanded cautiously, after careful analysis of the
long-term impact on costs, benefits, and their distribution within
and across generations. Policymakers must decide which groups to
cover first-and at what level of pensions and contributions.
In practice, coverage has been extended first to workers in the
public sector and in large private sector firms, where enforcement is
easier and transaction costs are low relative to wages and pensions.
Almost every country has a mandatory plan that covers these
groups. Employees of small firms, the self-employed, and agricul-
tiral workers-the bulk of workers in developing countries-are
added later, as government tax and administrative capabilities grow
and income levels rise.
This phasing in of mandatory coverage poses three potential
dangers. Costs are high because the plans do not benefit from
economies of scale. Low-income workers not covered may be taxed
to subsidize the retirement plans of higher-income workers who
are covered. And some informal sector or rural workers may find
themselves in poverty when they grow old. Countries can guard
against these dangers by starting with administratively simple sys-
tems, avoiding subsidies from outsiders to insiders by minimizing
general revenue financing at the beginning, and supplementing
contributory retirement plans with social assistance for the poor of
all ages.
How generous should the mandatory contribution and benefit
rates be for covered workers? Some households might wish to re-
place 75 percent or more of their gross average lifetime wage on rc-
tirement. Others might prefer a lower wage replacement rate so that
they can consume more when young. Forcing the second group to
contribute enough for a high replacement rate would make them
worse off rather than better off. Divergent tastes can be accommo-
dated and evasion minimized, while avoiding poverty, by setting a
target replacement rate (through mandatory public and private
plans) of, say, 60 percent of the gross average lifetime wage for the
average worker, with a floor at the poverty line for low-income
workers. Survivors' benefits should be required to protect depen-
dents who do not have income of their own. These mandatory pen-
sions could be supplemented by voluntary saving by households
that have higher wage replacement targets (see issue brief 1).
75



YEiRTING  THE OLD AGE CRIS
Saving or Redistribution-and the Link
between Benefits and Contributions
JN AN OLD AGE SEC[!RITY SYSTEM THAT EMPHASIZES SAVING OR
income smoothing, people shift their income over their lifetimes,
spending less now to spend more later. The lifetime expected value
of benefits and contributions are equal for each individual. In a system
that emphasizes redistribution, one group receives greater expected life-
time benefits than its lifetime contributions, and another group receives
less. Income is shifted across groups.
A system that emphasizes saving has several advantages. By making
benefits directly contingenit on contributions according to market prin-
ciples, it discourages evasion, labor disincentive effects, and political
pressure for design features that lead to inefficient, inequitable out-
comes. But it has one major disadvantage: It fails to alleviate poverty
among old people who did not have sufFicient resources to save or reli-
able financial institutions in which to place their savings.
In choosing its old age security system, each country must decide on
the relative emphasis on saving versus redistribution. The link between
the contribuLtions workers make and rhe benefits they receive will vary
accordingly. The assumptioni throughout this report is that poverty
elimination is an important goal, although the degree to which it can be
aclhieved will depend on costs and couLntry circumstances. Policymakers
must also decide whethier the saving and redistributive objectives will be
satisfied througLh one ullified program-or through separate financing
and managerial arrangements.
Should Income Be Transferred to the Old?
Three a-gumnents are often pUt forth for emphasizing the redisrribu-
tive objectives of old age security programs:
*Thle old tend to be poor in currenit income, so it makes sense to
use old age as a criterion for targeting income transfers.
* Younger generations will benefit from econiomic growth, so they
should make incomiie tranisfers to older generations wlhose lifetime
income is less.
* Poor people who are old should receive more generous income
transfers thani other groups who are poor.
76



P't l ICY CHOICES FOR FORMAL SYSTEMSti
Are these arguments valid? Are old age programs an effective way to
reduce poverty? And should that be their primary objective? To evaluate
these arguments one must distinguish between poverty measures based
on current income and those based on lifetime income (the present
value of total or average annual income generated over an individuals
lifetime). Also to be considered are the relative claims to redistribution
of the old versus other groups, suchi as young families with children.
Are the old poor in terms of current income? If old people are dispropor-
tionately poor in the absence of extended families or government pro-
grams, redistributioll from younger to older cohorts will help equalize
current incomes. But empirical data suggest that, in currenit income.
the old are not disproportionately poor in many countries. Data for
developing countries such as India and Nigeria in the 1970s and Cote
d'lvoire and Thailand in the 1980s show that households with old
people do not have lower average incomes than young households,
particularly wheni urban-rural differences are taken into account
(Deaton and Paxson 1991; Gaiha and Kazmi 1982; Hill 1972). Ex-
tended family arrangements in these countries are an important
explanatory factor. But they are not the full explanation, since findings
are similar in middle- and high-income countries where the nuclear
family is more important. While the incidence of povertv can be quite
sensitive to the choice of poverty line, to the relative costs of living
imputed to large and small families, and to the time period under con-
sideration (Forster 1993), it appears that:
* In countries such as Brazil and Chile, poverty rates among chil-
dren are higher than among old people (figure 3.1).
* In Hungary, Poland, and Russia, families with young children are
more likely than old pensioners to be poor (van de WValle, Raval-
lion, and Gautam 1994; Fox 1994; Vorld Bank data).
* In Poland the poverty rate among old people is half the national
average, whereas the poverty rate amonig children is almost 50 per-
cent higher than the national average (World Bank data).
* In most OECD countries, current income is lower and poverty is
higher among working age adults and childreni than amolng the
old (figure 3.2).
How can this be? There are several explanations. Young workers are
at the bottom of their age-earninlgs profiles, wlhereas older workers are at
the top; those who continue to work may receive high wages. Old peo-
77



'JNG THE OLD AGE CRISIS
Figure 3.1 Relative Poverty Rates for Children and for Persons over 60
Years Old, Selected Countries in Latin America, 1980s
Percentage of demographic group in relative poverty
35
Childer
30
Old
25          people
20
15
10
More children than old people live in     5
poverty in some Latin American
countries.                                0
Brazil         Chile        Honduras       Panama         Uruguay
Note: Relative poverty is defined as 50 percent of mediani incomiie per capita, witlh childreni
weighted: those tinder 5 are 25 percenit of an adult: those between 5 anid 14 are 45 percenit ofan
adttlr. Children are defined as persons under 15 years, old as over 60 years.
Source. Calculations by \X'orld Bank, using Household Survey Data: Keller 11994).
ple have also had an opportunity to save and accumulate assets-
including, in some cases, homes that reduce their need for monetary
outlays. Those who have retired also have considerable leisure time as a
reserve, which they can use to make their money go farther. So, their
consumption capacity exceeds their current earnings. In contrast, chil-
dren are born disproportionately to low-income families, further de-
pressing the per capita income of these families. Targeting transfers or
services to families with children may be a more effective way of allevi-
ating poverty than targeting to the old.
Do the old have lower lifetime incomes than the young? If an economy is
growing rapidly, the average member of a young cohort will have a
higher lifetime income than the average member of an older cohort.
Then, equity considerations could motivate redistributions from work-
ing age cohorts, who will benefit from growth, to the old, even Chough
the old have a higher current income thani the young (the young will
earn more later on).
78



POLICY CHOICES FOR FORMAL
Figure 3.2 Relative Poverty Rates by Age Group for OECD Countries, Mid-1980s
Australia (1985)                                                                               Children (18-)
4   All adults (18+)
Canada (1987)        -          .                   : _                                      Old (65+)
France (1984)
Germany (1984)
Netherlandsa (1987)
Sweden (1987)
United Kingdom (1986)
United States (1986)
0                    5                     10                   15                    20
Percentage of group in poverty
Note: The poverty usle is definied as 40 percent of adjusted farnily inconse after tax anid transfers, adjusting for family size, usinig the U.S. povertv
line equis'alence scale.
a. For the Netherlands, the poverty rate Lor persons over 65 is zero.
Source: Luxembourg Income Study, as presented in Smeeding (1992).
Two countering forces weaken this argument. First, economies do                  In some OECD countries, old people
not always grow rapidly. Over the past two decades, real per capita in-            have lower poverty rates than chil-
come has declined in many African countries, and real wage growth has              dren or other adults.
slowed down in OECD countries (appendix table A.3). In Latin America,
real wages have been subject to wide swings. When economies are slug-
gish, average lifetime earnings are not much higher for younger than for
older cohorts. Second, people who survive to old age are not a random
sample of their cohorts. They generally come from higher socioeco-
nomic groups, whose expected longevity is high. People who are poor
for most of their lives are much less likely to survive to old age.
* In the United States, the mortality rate of working age persons in
the lowest income group is five times that of workers in the high-
;9



AVERTING THE OLD AGE CRISIS
est income group, and the differential has increased over the past
three decades (Pappas and others 1993).
* In Argentina, high-income public workers are estimated to live ten
years longer than low-income industrial workers (Rofinan 1994).
* In the United Kingdom workers in high-paid occupations have
substantially lower mortality rates than workers in low-paid OCCU-
parions (Creedy, Disney, and Whitehouse 1992).
Given this difference, a large proportion of people who are young
will have shorter lifetimes and lower lifetime annual incomes than peo-
ple who are old.
Should poor old people be treated differently from others who are poor? To
the degree that old age poverty has been caused by inadequate saving,
it can be prevented by forcing people to save when they are young.
Thus a remedy is available for old age poverty that is less appropriate
for other groups and does not involve transfers-but it requires
advance planning. Redistributive old age policies should be carefully
structured to encourage saving and not to crowd it out. For example,
providing a minimuLm1 pension guarantee as part of a retirement saving
program may encourage saving, while stand-alone income and asset-
tested programs may have the opposite effect.
Even if saving and work are encouraged, some low-wage workers will
simply not earn enough income to keep out of poverty for their entire
lifetimes. If forced to save for old age, they may be plunged into poverty
when young-these are the long-term poor. Rather than expecting them
to sae, which would push them below the poverty line throughout their
lifetimes, it may be more efficient to concentrate redistributions to this
group in their older years. When people are young the presumption is
that they are able to work, but whien they are old the presumption is that
they cannotv work, or at least not productively, especially in urban indus-
trial economies. Thus the labor disincentive effect of transfers is smaller
for the old than for the vounig. as a group-providing the retiremenit age
is set high enough. In addition, it may be more politically acceptable to
transfer to the long-term poor after they have "paid their dues" by work-
ing, when they are no longer able to work because of old age. Therefore,
both economic and political forces suggest that the long-term poor may
receive larger transfers wheni old than when young.
There are also identifiable subgroups of old people whose currenit in-
come is particularly low. In many' counlries, these subgroups include
8o



I'01 l(   ( lC Ol( LS FOR  FORMAL SYSTEMS
womiien livinig alone and the very old-nearly the same groups, since
women live longer than men. In OF(.CD countries, very old people living
alone are more likely than other groups to be in the bottom  decile of the
income distribution, and most of them  are women  (figure 3.3). In
urbani areas in China 41 percent of old women but only 4 percent of old
meln live below  an extreme poverty line (Cangping  1991). In India,
households headed by widows are by far the poorest group, with an av-
erage expenditure per person 70 percent below  the national average
(Dreze 1990). Many of these people have not participated steadily in the
labor market, had few resources of their owvn to save when yotng, and
are not likely to be reached by pension plans tied to employment. WThile
giving them joint ownership of their spouses' pension rights is a part of
the answer, this is not always feasible. These pockets of old age poverty
might be targeted for redistribution.
Figure 3.3 Percentage of All Persons over 65 and Females Living Alone
with Incomes below Subsistence, Selected OECD Countries, Early 1980s
Percentage in poverty
so
* All old
Female, living alone
60
40
20
Old women living alone are more like
0                                                                                    ly to be poor than are other groups.
Australia   Canada    Germany    Sweden   Switzerland   United    United
Kingdom    States
totr: Povertv thresholds are those nritploved by the U.S. Btire,at of (he Celnsu.ss, taking illo
accOLnt uhlle TILImber ald .tges of personis withiti the hou1seOLold and adjuIstILg for ecoionomies of
Scale ill colis oillipti(il.
Soaurce: .Adapted frorit Palmer, Smccding. old Torrev 11 9S8) table 5.8. p. 1 -5. D)ata soLtrce K
LUxesbotim.g I ucomiev Strvey for variouLs Nears berveet 1')7')r ]ani 1 982
81



%jTING THE OLD AGE CRISIS
For all these reasons, it may be efficient to use different types of pro-
grams and eligibility criteria, reliance on saving as a preventative as well
as redistribution as a cure, and more generous transfers to reduce long-
term poverty among the old than among the youLng.
What Should Be Done?
Taxing and transferring iicome should be done wirh great care be-
cause of the distortions and evasion they engender and because poorly
targeted transfers can be perverse. In considerinig whether to emphasize
the saving or redistributive aspect of old age security programs. coun-
tries should evaluate the relative positions of the old and other groups in
their incomiie distribution. In many countries, this evaluation will lead to
the conclusion that the old are not disproportionately poor in cLirrent
income or lifetime income. In these countries, targeting transfers to
young families with children (through public spending on primary edu-
cation and health care, among other ways) is likely to have a more equal-
izing effect on income and on stopping the intergenerational transmis-
sion of povertv. Poverty among the old could be substantially alleviated
by encouraging or requirinig people to save when they are young.
At the same time, there are some pockets of extreme poverty among
the old. In industrial countries, old women living alone who had little
labor market experience earlier in life are one such group. Another con-
sists of people who were low-wage wvorkers when young, had no surplus
funds to save, and despite the odds survived to old age. More generally,
the labor disincentive effect is a lesser concern when people are old. The
old are less adaptable, more vulnerable to economic shocks, and unable
to reverse mistakes they made earlier in life, and their lifetime incomes
are low relative to those of younger cohorts in periods of rapid economic
growth. For all these reasons, this report makes the value judgment that
redistribution and saving both have an important role to play in old age
security programs, although their relative importance will vary across
countries. Furthermore, both the criteria for and amount of redistribu-
tion may be different for the old and for the young. The potential and
actual roles of public, occupational, and personal saving plans in achiev-
ing these saving and redistribution objectives are discussed in chapters 4
through 6. Whether these dtial functions should be provided through
one mechanism or through separate managerial and financing arrange-
ments is a central issue in the design of pension systems.
82



POLICY CHOICES FOR FORMAL SYST
Bearing the Risks: Defined Benefits
or Defined Contributions?
P        LANNING FOR OLD AGE INVOLVES ENORMOUS UNCERTAIN-
ties. People can become disabled, die young, require expensive
medical care, or live long and healthy lives. Firms can go bankrupt,
and new industries emerge. The economy can stagnate or flourish. There
can be major demographic changes, revolutionis, wars, droughts. floods,
famines, inflation, depressions-and governments good and bad. These
vicissitudes affect the amount of goods and services available in the econ-
omy for consumption and the claims of different people on1 these goods.
They thus affect the viability of young people's plans for their old age.
Who should bear these long-term risks, and how should they be
shared between the old and the rest of society? In informal systems, the
old share in the fortunes of the extended family with whom they live. In
formal systems, old people bear different kinds of risks, depeniding on
how old age security is provided. Among the many risks are the risks of
investment, disability, longevity, political disruption, company insol-
vency, and inflation. Broadly speaking, the risk faced by old people ver-
sus young depends on whether the plan is set tlp as a defined benefit or
defined contribution plan and whether it is publicly or privately man-
aged. Public, occupational, and personal saving plans each pose different
sets of risks and offer different kinds of insurance (chapters 4-6).
Defined Contribution Plans-and Investment Risk
When people save for their own old age, as in personal saving plans,
contributionis are specified and ultimately determine fLture benefits.
But there is considerable uncertainty about futtire rates of return, the
duration of working and retirement periods, and therefore about future
annual benefits. So, workers bear considerable investment, disability,
and longevity risk. This kind of arrangement is known as a defined con-
tribution plan, because the annual contribution is defined in advance
but the benefit-wlich depends on hoxv wvell the investments are man-
aged and how long workers contribute and collect-is not. To a large
extent, investment returns depend on the economic health of the
country-and that of other countries in the case of foreign investments.
For privately managed funds, the inability of workers to evaluate the
competence of investment companies and the possibility of outright
83



VEARTING THE OLD AGE C R ISIS
fraud further increase investment risk. For publicly managed funds, the
government may intervenie to limit investment options and returns, so
political risk is intertwined with investment risk.
Defined Benefit Plans-and Political and Insolvency Risk
In defined benefit plans, the pension formula is defined in advance.
Often benefits depend on years of employment and salary over some
period, such as the final three years or the lifetime average. The rest of
society bears the risk that the economy will not do as well as expected
or that people will live longer than expected. The sheltering of old peo-
ple from these risks-on grounds that they are less able to adjust and
recoup than the young-is considered one of the big advantages of de-
fined benefit plans.
In reality, workers continue to bear important risks in defined bene-
fit plans. For one thing, their pensions depend directly on their wages,
especially their wages in the last few years of employment. If wages fail
to rise as rapidly as expected, the pension amount will be commensu-
rately less. In occupational defined benefit plans, workers bear the risk
that they will lose their pensions because of employer insolvency or
worker mobility. In public defined benefit plans, workers bear the risk
that the taxing ability of the government will decline or the political
regime may change, with the new government repudiating the arrange-
ments made by a previous government.
Disability and Longevity Risks
Disability risk arises because some people are unable to work pro-
ductively and contribute as long as expected. Longevity risk comes of
living longer than expected and outlasting savings. These risks can be
handled by covering them in defined benefit plans or by purchasing dis-
ability insurance and annuities from insurance companies in defined
contribution plans (in effect this converts part of the defined contribu-
tion into a defined benefit).
One problem with disability insurance is that workers may claim to
be unable to work eveni wheni they can work, raising costs for everyone;
this is known as the moral hazard problem. Another problem is that be-
cause of the informational failures described in chapter 1, disability in-
surance and annuities may not be available at an actuarially fair price;
84



POLICY ( Ho)ICES FOR FORMAL SYSTE9MS$
this is the adverse selectionz problem. In addition, if the insurance is pro-
vided privately, workers face the risk of insurance companiy insolvency.
And if it is provided publicly, they face political risks, given the long pe-
riods involved.
Inflation Risk
Inflation poses a particularly important risk. Inflation averaged 7.7
percent a year from 1965 to 1980 and 4.5 percent from 1980 to 1990
in high-income countries. In middle-income couLntries it averaged 21.1
percent and 85.6 percent over the same periods, and in low-income
countries, 17.3 percent and 15.1 percent. Annual inflation exceeded
200 percent in Argentina. Bolivia, Brazil, and Peru durinig the 1980s
and recently exploded in the former Soviet Union (World Bank 1 992d).
NX/ages usually rise with prices, albeit not always as fast. But pensions are
often fixed in nominal terms, so their real value declines precipitously
during inflationary periods, leaving the old in poverty. With annual in-
flation at 10 percent, the real value of a pension that is fixed in nominal
terms is cut in half in seven years. And with inflation at 100 percent, it
takes just one year (figure 3.4).
Figure 3.4 Effects of Different Rates of Inflation on Unindexed Pensions
Index of real pension value
100
80
60
10 percent inflation
40
25 percent inflation
20
'-,100 percent inflation                                      The real value of unindexed pensions
slides down a slippery inflationary
0                      -                                                   slope.
1  2  3  4  5  6  7  8  9  10 11 12 13 14 15 16 17 18 19
Time period (years)
85



STING THE OLD AGE CRISIS
Policymakers need to decide whether indexation of pension benefits
should be required in mandatory plans, and if so, whether the indexa-
tion should be fLll or partial-and be to wages or to prices. Under price
indexation, pensions move with the price level: their absolute real value
remains unchanged. and the risk that aggregate demand exceeds the
country's output is borne by other groups in society. Under wage
indexation, pensions rise and fall together witlh wages. The relative
position of old people is protected, but their absolute standard of living
is not.
In general, indexation by either method requires a higher contribu-
tion rate or lower initial benefit rate than a nonilndexed plan, since in-
dexed pensions are likely to rise nominally over the retirement period.
Workers and citizens unaccuLstomed to high rates of inflation may be
reluctant to pay this price. but they may be disappointed later on if in-
flation accelerates and the real value of benefits declines. Indexed pen-
sions can be and have been provided by private annuity companies or
by public defined benefit plans.
How Should People Share the Risks?
In view of the uncertainties and long periods involved, it is dif-
ficult to predict which risk-bearing arrangement is best for the old-
or for the rest of society. Clearly, older age groups cannot be insulated
from all these economic and political risks. Nor is this the most
desirable outcome. But a variety of techniques can and should be
used to reduce the social costs of risk. Risk can be reduced through
pooling or neutralized through diversification or shifted to those
more willing and able to bear it. As countries make their choices
about the best risk-sharing arrangement, the following principles
might be observed:
* Certain risks that are uncorrelated across individuals, such as
longevity risk, are minimized by pooling across the largest num-
ber of people-including everyone in a single insurance pool or
reinsuring across several smaller pools-since the average out-
come for the group is much more certain than the experience of
anv particular individual.
* Other risks, such as disability risk, are subject to moral hazard
problems, which should be constrained to keep costs down.
86



PO LICY CHOICES FOR FORMAL SYST
* Some degree and type of indexation, shifting part of the inflation
risk to younger workers, is needed to prevent the very old from liv-
ing in poveruv during inflationary periods.
* Investment, insolvency, and political risks are real and potentially
large, but they cannot be reduced through risk pooling because
they are correlated across individuals and subject to moral hazard
problems. Diversification is the solution here. Diversification
across several managerial and finanicing mechanismiis protects pen-
sioners against exposure to extreme failure of any one arrange-
ment, reducing overall risk for the old.
Financing the Plans: Funded or Pay-as-You-Go?
O     LD AGE SECURI-T7Y I'LANS CAN BE FULLY (OR PARTIALLY)
funded-or financed on a pay-as-you-go basis. Under pay-as-
you-go financing, workers today pay pensions to retirees today,
expecting that their pensions will be paid by future workers. A plan's
current revenues cover its current obligation, and there is no stock of
savings to pay future pensions. A low ratio of retirees to workers (the sys-
tem old age dependency ratio) and a high rate of productivity and real
wages permit high benefits or low contributions.
In a fully funded scheme, a stock of capital accumulates to pay future
obligations so that aggregate contributions plus investment returns are
sufficient at any time to cover the present value of the entire stream of
future obligations. The current generation of workers supports itself
through wages and saves part of its output for support after retirement.
A low ratio of retirement years to working years (the passivity ratio) and
a high rate of interest enable high benefits or low contributions.
Defined contribution plans are by definition h-illy funded, since peo-
ple are entitled only to the proceeds of their individual accounts. It is
also possible for defined benefit plans to be ftully funded. But the con-
cept of full funding is ambiguous in defined benefit schemes (whether
public or private) because of uncertainties about the future rate of
return, worker longevity, and age-earnings profiles. If the actual rate of
return turns out to be lower than expected or if people live longer than
expected or retire earlier, a defined benefit plan that appeared to be fully
funded might not be. Most privately managed defined benefit plans in
87



;AVERTING THE O L[) AGE CR1 SI S
industrial couLntries have substantial funding. Most publicly maniaged
defined benefit plans are pay-as-you-go or ornlv lightly funded.
Which Financing Method Requires Lower Contribution Rates?
In the early years of an old age support program-when the systemii
dependency rate is verv low because there are few eligible beneficiaries-
pay-as-you-go will always appear cheaper than a fully fuLnded plan. But
as the system matures, more retirees are eligible for benefits-so this
temporary advantage disappears. Pay-as-you-go will continue to have a
cost advantage or higher rate of return in the long run if the earnings
growth rate plus the labor force growth rate exceed the interest rate
(Samuelson 1958; Aaron 1966). In this case (providing the pension sys-
tem does not affect the growth rate), pay-as-you-go could make all gen-
erations better off: each generation could get back a higher present value
of pensions than it paid in as contributions.
But if the rate of earnings growth plus labor force growth falls below
the rate of interest, the long-run cost advantage and the higher rate of re-
turn go to fully funded programs. This can easily happen in plans tied
to particular firms or industries. It also happens for a country as a whole
if its population and earninigs cease to grow rapidly. Data from several
countries show that wlhen the time period for investment is long, the
rate of interest on a combination of debt and equity has generally ex-
ceeded the rate of earnings growtlh by approximately 2 to 3 percent.
This means that because of the productivity of capital. the same benefits
can be paid to each generation with a lower contribution rate under full
fundinig, unless the population is growing by 2 to 3 percent. If popula-
tion growth is less than -2 percent and pay-as-you-go funding is used (or
if pav-as-vou-go funding has a negative impact on growth-see below),
each generation gets back in benefits a lower present value than it paid
in as contributions (issue brief 2).
Intergenerational Transfers and the Demographic Transition
To many, a high rate of populationi growth seemed inevitable three or
four decades ago, in whiclh case pay-as-you-go seemed a good way to fi-
nanice old age programs. But today, birthrates are falling or projected to
fall everywhere, while the longevity of the old is increasing rapidly. Dur-
ing the demographic transitioni that industrial countries are going
88



POLICY CHOICES FOR FORMAL S
through now and developing countries will go through in the next half
century. population growth falls toward zero. Unless there are large off-
setting productivity gains, tax rates must rise or benefit levels must fall
under pay-as-you-go plans. With the growth rate of average earnings
below the interest rate, as in most countries, workers will get back in
pensionis a lower present value than they put in as contributions. So,
early cohorts of pensioners who retired wlile the covered population
was growing rapidly will have gained lifetime income. But later genera-
tions will lose, as a result of the initial choice of pay-as-you-go.
Suppose that China decides to use pay-as-you-go financing to pay a
flat benefit equal to 40 percent of average wages to all people over the
age of 60. starting in 1995. The contribution rate needed to pay those
pensions would be less than 7 percent in 1995 but would rise to 18 per-
cent in 2035 and 23 percent in 2065. When allowanice is made for Lin-
employment, evasion, strategic manipulationi of benefits, survivors' ben-
efits, ceilings on taxable earnings, and administrative costs, the required
tax rate could easily exceed 35 percenit-on top of income taxes charged
for other purposes. Cohorts retiring in the early years of the plan would
get back much more than they paid in, but later retirees would get back
much less. In effect, today's children and their children would be inak-
ing large transfers of their lifetime income to today's middle-aged and
old people (figure 3.5 and issue brief 3).
What would happen tinder a filly funded plan? Such plans require a
start-up time of twenty years or more to build retirement savings. So,
earlier cohorts of retirees would not get large pensions because they
would not get large positive transfers from younger generations. But
later cohorts woLld fare better, as theyl have not lost lifetime income. Ei-
ther their benefit rate would be much higher or their contribution rate
would be much lower. (Although saving by large cohorts of young peo-
ple and dissaving by large cohorts of old people during the demographic
transition could cause swings in the interest rate that also have distribu-
tional conseqLiences, these effects would be substantially mitigated by
international diversification, since different countries are aging at differ-
ent rates [Reisen 1994].)
Policymakers need to know that wheni a population and earninigs are
not growing rapidly, the financing method chosen affects the distribution
of lifetime incomiie betveen present and future generations. If they want
to favor the present generation of workers, pay-as-you-go has an advan-
tage. If they want to be distributionallv neutral, fuiil fuLnding is preferred.
89



ATING THE OLD AGE CRISIS
Figure 3.5 Contribution Rates Required to Finance a 40 Percent Flat
Pension for a Country with a Young but Rapidly Aging Population
Contribution rate and transfer rate
30
25
20                                                                     C      t
15
10
5
0
In the early years of a pay-as-you-go
plan, retirees get back much more              -5
than they paid in, but later retirees
will get back much less.                      -10
1995      2005      2015       2025      2035       2045      2055      2065       2075
TVoie: ID)eniographic projectioins for C hina are tised. This bCitLre is based on the following
aNSUrnptions: I he average beniefit rare is 40 percenL oft ohe cconoomy-widc wage. The requlired
contribution rate is expressed as a perentttage of wages (a payroll [ax). The transler lrare is a per-
centage of cle lifeti ote wage for a cohort retirinig in a giveni year. The solid linie assuniots inostait
IIauration, thia is, all old people are imrilediarels' eligible fror ftlLI benefits The dotted line
;tssute.s graduit tm aitiratrion trhar is, there is to Credit for service prior to 1995. zaitd rhc pension
equLalls I percent of thc economvy-wide wage for each year of work after  995. For otlrer stuntip-
tio is see iss5Li brief table 3.
Souror: SchwLarz (Ii 94j)
The Implicit Public Pension Debt
Because  of irs emphasis on  current cash  payouts, pay-as-you-go
finance hides the true long-run cost of pension promises. The current
situation is onlv the tip of the iceberg. When workers pay their social
security taxes, they expect to get a specified benefit in return. The pres-
ent value of this fIuture stream  of expected benefits is known as the "im-
plicit public pensioni debt." This liability  for the government, corre-
sponding to the "entitlemenit" people believe they have acquired, is the
iceberg underneath the tip. Although this implicit debt varies by coun-
try and depends on the coverage of the pension svstem, the age distri-
9o



POLICY CHOICES FOR FORMAL SYST
bution of workers, the level of benefits, and the discount rate used in
the calculation, in many countries it is two or three times the value of
the conventional explicit debt (figures 3.5 and 3.6). In simulations
using China's demography and two alternative discount rates, the pen-
sion debt starts low as the hypothetical system described below is in-
troduced but rises to 100 to 200 percent of GDP (figure 3.6).
But an implicit debt is a hidden liability, of which many citizens and
policymakers are unaware. In the early years of a pay-as-you-go pension
plan, costs may look very low because required contribution rates are
low, but the implicit pension debt is building up surreptitiously and will
have to be paid off through higher taxes, as the system matures and pop-
Ulation ages. Policymakers should take this into account from  the start,
through simulations of the debt and tax rates required in the long run,
before choosing the system and the target benefit rate.
Figure 3.6 Growth of the Implicit Public Pension Debt, 1995-2075
Public pension debt as a percentage of GDP
250
200
150
100               '.                         5 percent discount rate
/
/    -
50 /o , 
,    ,                                                             The benefits people expect to receive
,' -                                                                 from public pension programs
becomes a large hidden debt for the
,,
0                                                                               government.
1995           2015            2035            2055            2075
VoSc Projecrionus are based oni the demograiptiics of Chin.:. See the .IssLIIpion1s ill issuLI brief
Cable 3. The solid lilne Iss:mTIes iffsrant ma toi rs-trhat is, fLil service credit ro workers and retirees
in 9') 5. The (lotted 1i1n .lSLI MCs gradLial ma1.1lnration (See figLire 3.5 for a,sLimptioris).
9I



4i     G   THE  OLD AGE CRISIS
In contrast, in fully fuLnded schemes, contribution rates are higher
from the start, accumulating assets sufficient to pay the pension debt.
The simulated pensioni debt line in figure 3.6 is also a mcasure of the as-
sets that would build up over time to pay an equivalent benefit stream
in a fully funded scheme. Governm1ents will not be hit by exploding lia-
bilities later on. This is a much more transparenit situation for citizens
and policymakers.
How Financing Affects Saving and Growth
Increasing productivity is che only way a smaller working age popu-
lation can support a larger retired population without a fall in the over-
all standard of living, regardless of which funding system is used. A cru-
cial question: Are productivity and GDP growth likely to be higher under
one system than the other?
Since pay-as-you-go funding breaks the marker link between benefits
and contributions, it may lead to evasion and labor supply distortions,
especially in developing countries with large informal sectors and weak
tax enforcement capabilities. In addition, many economists argue that
pay-as-yoLL-go schemes reduce saving, capital accumulation, and there-
fore growth. The reasoning is that the firsc few cohorts reap a windfall
gain in the form of pensions that enable them to consume more w ithout
having saved more. Unless the government compenisates by increasing
public saving, total national saving will decline, withi harmful conse-
quences for productivity and growth. This negative effect on growth is
another potential source of intergenerational transfer.
Numerous empirical studies have tried to determine whether this sav-
ings effect held for social security systems in the United States and else-
where during the 1950s and 1960s. Some studies claim to have proved
negative savings effects, whereas others claim to have proved their ab-
sence. The results are inconclusive, in part because it is so difficult to de-
termine what people would have saved otherwise. (See issue brief 4 for a
fuller discussion of the impact of pay-as-you-go plans on saving.)
Nevertheless, even if a mandatory pay-as-you-go plan does not re-
duce saving relative to a voluntary scheme, it seems likely that a fully
flunded mandatory plan will increase saving relative to pav-as-you-go.
Although never tested empiricallv (because of the paucity of empirical
cases), this effect seems inevitable-providing people are required to
contribute more than they would otherwise have saved, consumers do
92



P'oLICX CHOJCES FOR FORMAL
not evade these constraints by borrowing or dissaving other assets, and
government does not react to the greater availability of household sav-
ings by runninig a larger deficit. The first and second requirements re-
mi-nd us that small funded plans (say, less than 5 percent of wages) will
be ineffective as a means of capital accumulation because they will sim-
ply crowd out voluntary saving or induce consumers to borrow offset-
ting amounts. The third requiremlent warns that if government con-
sumes the extra pensioni savings, national saving will be unlchanged even
if household consumptioll falls. Full ftundinig has the added advantage
that its accumulated savings are committed for the long term, may flow
through financial institutions, are largely invested in financial assets, and
cani therefore be an instrulmienit of capital market developmenlt (for em-
pirical evidence see chapters 5 and 6).
The bottom line is that a funded pension plan, if appropriately man-
aged, has a strong saving and capital market advantage over pay-as-you-
go. A credible funded plan may be an important part of a national sav-
ings policy that includes fiscal discipline by the government and
inducements against consumer borrowing or dissaving other accumu-
lated assets. Under these conditions, a pension svstem with a large
finded component may be part of a country's strategy for increasing
capital accumulation and growth. Although increased saving may not be
desirable evervwhere and at all times, many analysts would argue that it
would be growth-enhancing for mosc couLntries and for the world as a
whole today. For these reasons, many capital-scarce countries are be-
coming increasingly interested in funded old age security arrangemiients.
Should Pension Reserves Be
Publicly or Privately Managed?
L      ARGELY FUNDED PLANS HAVE THE POTENTIAL TO CHANNEL
savings into capital market institutions for long, well-defined
periods-facilitating financial intermediationl and long-termll in-
vestment. The process also concentrates substantial capital market
power in a small number of large pension funds. Examples are the pen-
sion funds in Chile, the national provident funds in Malaysia and Sin-
gapore. and the social security reserves in Japan, Sweden. and the United
States. The investmiient policies of the fund managers strongly influence
93



LWQ THE OLD AGE CRISIS
the allocation and productivity of capital, with important effects on the
economy. Since centralized public managers chosen by political leaders
and decentralized private managers chosen by individual savers in a
competitive environmiiienit face different incenitives and, more important,
very different constraints, the investmenlt outcomes may be very differ-
ent under these two arrangements. The choice between public and pri-
vate management of pension funds is thus crucial.
Public Management
Publicly managed funds are usually required to invest in government
securities or the securities of quasi-government entities such as state en-
terprises or public housing authorities-often at below-market interest
rates that become negative in real terms during intflationary periods.
This imposes a hidden tax on contributing workers. The fund earns less
than it could have on the open market and must charge higher contri-
bution rates or pay lower benefits than it would have otherwise (figure
3.7 and chapter 4).
The impact of publicly managed pension funds on capital accumula-
tion and its allocation depends on how the government responds to the
availability of these cheap resources. Suppose that access to these funds
does not change the spending and tax policy of the government: it sim-
ply sells its bonds to the pension fund instead of to other buyers (albeit at
lower rates of interest). In this case, an increase in household saving chani-
neled througll funded pension plans increases private sector investmiienlt,
because other bond buyers IIow shift their resources to the private sector.
But in some cases, as governmenit gets privileged access to large pen-
sion reserves, it may be induced to spend and borrow more. Borrowilng
from the pension fund is less transparent than that from the open capi-
tal market. Ir is often not reported as part of the public debt, and the in-
terest cost is generally lower. This mav tempt governmenits to increase
deficit spending and therefore deter private investments that might oth-
erwise have been made. The danger is that this choice among uses can
be made without an explicit productivitv comparisoni, without a marker
test based on interest rate and risk, and without citizens and policyvmak-
ers being fully aware of the expenditures and trade-offs (see chapters 4
and 6 for fuller discussion).
If the publicly managed funds are partially invested in the private sec-
tor another problem arises: fund managers may be motivated by politi-
94



Pt(L IC Y ( HOICES FOR FORIMAL SYSTi '
Figure 3.7 Average Annual Investment Retums for Selected Pension Funds, 1980s
Peru           -37.4                                                                          (1981-88)
Turkey                                     -23.8                                                (1984-88)
Zambia                                      -23.4                                                (1980-88)
Venezuela                                                     -15.3                                 (1980-89)
Egypt                                                            -11.7                         (1981-89)
Ecuador                                                               -10.0                       (1980-86)
Kenya                                                                            -3.8           (1980-90)
India                                                                          (1980-90)    0.3
Singapore                                                                           (1980-90)           3.0
Malaysia                                                                           (1980-90)              4.6
U.S. OASlP                   Publicly managed                                        (1980-90)              4.8
Netherlands (occupational)                   Privately managed                                       (1980-90)                  6.7
U.S. (occupational)                                                                          (1980-90)                     8.0
U.K. (occupational)                                                                          (1980-90)                      8.8
Chile (AFPs)                                                                          (1981-90)                       9.2
-40               -30                -20                -10                 0                 10
Percentage of rate of return after inflation
,Vote: SitoTpIc annual averages are comiiputed for coLititries with at least live sears of data. Inidia, Keniya. NIalavsia. Singapore. and Zambia are provi-
dent funds. Rates reported are retLirns credited to worker accounts. Ecuiador, Eypt, Perm, Tuirke, the United States, and V enezuela are publicly
mranaged reserves of partially fLinded pensioni plans. Rates reported are not adjusted for administrative costs. For privatelI maniagcd occLpational
plans itt t[h Netherlaids, the Uniti(d Kingdonm. anid the Unrited States, estimated aNerage net returns have been reported by subtracting onie per-
centage poitit fromii simulared average gross retUrrns. Acital average niet returns, after expenses. are rcpor[ed for the Chilean A! PS; aserage gross
rcruirns were 12.3 percent. For the occLipational plans and AF.Ss aLtual rerLirns anid expenses varied by fuind.
a. Old-Age and Sturv'ivor's Insurance.
_Source: Nlesa-Lago ( 1991 a): Davis 11993): MarqcIc7 (1992 ; Asher ( 1992a): Actifia and Iglcsias ( 1992) India Emrployvcs IProvident Flttid
1 991): U.S. Social Securitv Admnittistrationi (varioLs yearr)I Pdtlaci(ts (1994b..
cal rather than economic objectives. In general. central planninig has not                         Privately managed pension funds
been the most efficient way to allocate a country's capital stock. Pension                         beat publicly managed funds hands
funds hold a large part of the financial assets in a country, especially if                        down.
the funds are mandatory. The net impacc on growth may be negative
rather than positive, if public fuid managers allocate this large share of
national saving to low-productivity uses.
Private Management
Privately managed schemes-in which workers or employers choose
their fund managers-are usually not required to accept below-market
returns and are less likelv to encourage deficit spending by government.
9'



W4NG THE OLD AGE CRISIS
In general, private managers have invested much more heavily in pri-
vate securities and have earned much higher rates of return than their
public counterparts (figure 3.7 and chapters 5 and 6). They have in-
centives to allocate capital to stocks and bonds that offer the best risk-
yield combinations, whether these securities are public or private. They
can benefit from international diversification of investments and inter-
national managerial expertise. Governmenits can and do borrow from
these funds but very transparently, as part of the nationial debt, and by
paying the market interest rate.
Of course, these arrangements too are not trouble-free. Some counI-
tries simply do not have well enough developed financial markets to
allow such sclhemes co fiunction. Demand from pension funds will even-
tually stimulate the supply of financial instruments, but this process may
take a long time. Another problem is that workers and employers might
not have enough information to choose capable investment managers,
misallocating capital and leaving some old people with inadequate pen-
sions. To avoid this problem, privately managed pension funds must be
regulated by government-but many governments do not have this ca-
pability. A third problem is that privately maniaged funds may have
higher marketing costs and may not benefit from economies of scale as
much as publicly managed funds; but by contrast public funds may have
less incentive for cost efficiency than private ones (issue brief 5). Chapters
5 and 6 discuss in detail how cotintries can solve these problems and con-
tinue to get the benefits of private management of mandatory pension
funds.
Which Pillars, Which Design Features?
T     (HIS STUJDY ANALYZES THREE FINANCING AND MANAGERIAL
arrangements for old age security that give different answers to
the five key policy questions (table 3.1).
*P PIblicplans are by far the largest and most pervasive in the formal
system. They are used in all OECD and Eastern European countries
and in most Latin American countries. They are mandatory and
redistributive, offer defined benefits that are largely financed on a
pay-as-you-go basis, and are publicly managed.
96



PoL[('i CH(-OICES FOR FORMAL SYS.TEM,
Table 3.1 Alternative Financing and Managerial Arrangements for Old Age Security
Formal                            Iniformal
Public        Occupationial       Personal
Claracteristic                         plans            plans             savings       Ex-tendedfamzily
Volintary or                        Mandatory         Voluntarv or     V oluntary or        Social
mandatory                                             mandatory'        mandarory          sanctions
Redistribution                          Yes               Yes             Minor             Family
Benefits                                No              Mixed              Yes              Within
closely linked                                                                              famiLy
to contributions
Defined benefits                      Defined           Mixed            D)efined            n.a.
or defined                            benefits                         contributions
contributions
Type of risk                          Political      Job mobilitv,      Investment        Joint family
company                               risk
insolvency
Pay-as-you-go or                   Pay-as-youi-go       Mixed          Fully funded         Mixed
fully funded
Public or                             Public            Private           Public            Private
private management                                                       or private
Examples                           Eastern Euirope     Australia        Mandatory:       Most of Africa
Latin America        Brazil            Chile            and Asia
OECD countries       France           Malaysia
Netherlands       Singapore
Soutil Africa
Switzerland       Voluntary:
United Kingdom
United States
na. Not applicable.
*  Occupational plans are also fouLnd in many couLLtries and cover
about 40 percent of the labor force in OECD countries (table 5.1).
They are sponsored by employers, are usually voluntary-but in
some countries have become mandatory-have some redistribu-
tive effects based on the employer's objectives, can be a defined
benefit or defined contribution, and are largely funded in indus-
trialized countries but unfunided or only partially fuLnded in devel-
oping  countries. Private sector plans are privately  mana,ed,
whereas schemes for government workers, which are quite com-
mon, are publicly managed.
97



4VIRTING THE OLD AGE CRISIS
* Personalsavingplans are usually voluntary but have become coin-
pulsory in several countries. They are defined contribution, gener-
ally not redistributive, and fullyv fuLnded. When mandatory, they
can be publicly maniaged (Malaysia, Singapore) or privately man-
aged and regulated by the governmenit (Chile).
The choice among these arrangements for old age support-public,
occupational, and personal savings-has major implications for the effi-
ciency of labor and capital markets, the fiscal balance of government,
and the distribution of income in society. In making this choice, gov-
ernments should aim to maximize the national income and to distribute
it equitably among old and young, rich and poor. Old age security pro-
grams should thus be an instrument of growth and a social safety net.
The1 shouild help the old by:
* Facilitating people's efforts to shift some of their income from
their active working years to old age (the saving or income-
smoothilng function).
* Redistributing income to the old who are lifetime poor but avoid-
ing perverse intragenerational and unintended intergenerational
redistribu tions.
* Providing insurance against the many risks to which the old are es-
pecially vulnerable, including longevity, disability, and inflation
risks.
They shoulJ help the econom-y a-s a whole by:
* Minimizing hidden costs that impede growth, such as reduced
employment, reduced saving, heavy fiscal burdens. misallocated
capital and labor, heavy administrative expenses, and evasion.
* Being sustainable, in the sense that expected revenues cover ex-
pected payouts in the long run after taking account of expected
changes in economic and demographic conditions, some of which
may be induced by the old age svstem chosen.
* Being simple and transparenit, to enable workers, citizens, and pol-
icymakers to make informed choices, and insulated from political
manipulation that leads to poor economic outcomes.
In the following chapters, each arrangement is evaluated according to
these criteria-showing its strengths, its weaknesses, and the comple-
98



I'OL Ot \ CHOICEs FOR FORMAL SYSTs
mentarities among them. The conclusionI: a multipillai- system, inclutd-
ing tw,,o mandatory pillars-a publicly maniaged pillar concenitratiln, on
redistribution and a privately managed (personal saving or occupa-
tional) pillar concenitratling on saving-supplemented by a third. volun-
tary pillar, may be the best way to achieve the nmany objectives of an old
age securiry system.
9''






( i      4R  
Public Pension Plans
P            UBLIC PENSION PLANS -ANDATORY, PUBLICLY 1AN-
aged, defined benefit, largely pay-as-vou-go, and backed
by the power of taxation-have the unique capability to
redistribute income to the lifetime poor and to poorer
generations as a group. This is their big advantage over
other financing arrangements for old age security, and
their success in achieving this povertv alleviation objective may be taken
as the litmus test of a well-functioning public plan.
Public pension plans have indeed improved the well-being of the first
old generationis covered in manv countries. But their redistributive po-
tential has sometimes been used to benefit rich rather than poor indi-
viduals or to help one generationi at the expense of another even when
not justified on equity grounds. And the social costs-evasion, forgone
and misallocated labor, capital, and public resources-have been large.
In both developing and industrial countries, public old age schemes
are beset with contradictions and myths. This chapter sorts out myths
from realities, analyzes the sources of problems, and proposes solutions.
The public pillar is supposed to:
* Redistribute to the poor. But mnany ich people get back in pensions
more than they -ontributed, while nany poor people do niot collect any
benefits.
* Augment the income of the old who can no longer wvork produc-
tively. But many recipiients are mniddle-aged and still canpable of working.
* Protect the old from risk by defining the benefits in advance. But
thljee benzefits are i-definedfirequeiitly, so considerable r'isk remails.
* Protect the old against inflation. But nzany governments hav'e failed
to index,fid ly, using inflation to reduzce their real costs.
101



tR.T:IN G  THE OLD AGE CR1 I.IS
* Be a remedy for myopia among workers. Blut the progra?6 imple-
mentation often demonstrates the mnyopia ofpoliticians, in some cases
causning the old age system to collapse.
The problems facing public pension plans stem partly from poor de-
sign features such as early retirement and overgenerous wage replace-
nient rates that favor high-income groups-features that seemingiv can
be fixed withLout jettisoning the basic structure. But more basic prob-
lems stem  from  the separation of benefits from contributiolIs that
induces evasion, labor and capital market distortions, wasteful use of
pension reserves-and political pressures for poor design features. The
dilemma facing policymakers is how to achieve the redistributive objec-
tives that only the public pillar can fulfill-while avoiding perverse
transfers and inefficienicies that impede growth.
The Evolution of Publicly Financed
Old Age Pensions
P      L[BLICLY MANAGED PENSION SCHEi ME`S WITH DEFINEE) BENE-
fits and pay-as-youL-go finalce. usually based on a payroll tax,
have become the most common oway for governments to provide
incomile support for the old. Coverage currently ranges from virtually
universal in industrial couLntries to about 50 percent in middle-income
CouLitries and 10 to 20 percent in lower-income countries. For many
counitries, old age security programs are the largest single item in the
consolidated government budget, exceeding 20 percent of the total
(table 4.1 and appendix tables A.4 and A.5).
Industrial Countries
Until the advent of industrialization and urbanizationi, families
were the main meanIs of sipport for the old in most Europeall COuLn-
tries. But these methods were rendered obsolete by the mass migra-
tions to urban ceniters bv the end of the ninieteenith centLiry and much
earlier in the United Kingdom. Economic change. ulicertainity, and
the absence of reliable finanicial instrumlienits made it difficult for peo-
ple to plan and save for their old age. A groxving nuniber of old poor
102



PUBLIC  PENSION  PLANS--.
Table 4.1 Public Pension Spending and Coverage
(national averiages by iiitoine group)
Pension      Pension spending
spending as     as percenitage     Coverage of
percentage      ofgovernment    public pension
Income level      of GDP          expenditures       scheme
Low               0.7 (32)          3.9 (18)         10.2 (19)
Lower-middle      2.9 (29)         10.1 (16)         27.9 (16)
Upper-middle      6.7 (20)         23.8 (13)         50.7  (7)
High              8.2 (23)         23.1 (20)         95.8 (12)
PVote: Nuimihber in parentheses indicates noimber of cotiuntries for which data are
available.
.Source: World Ban.k staff.
filled poorhouses ill equipped to deal with their special problems
(Weaver 1982).
The industrial working class began to demand new wa's to deal with
old age incomiie security.  One responise was the friendly society. a mutual
relief fund to which workers contributed a nomiinial sum and which was
used to provide assistance in the event of injury, death, or declining in-
comiie because of old age. But these funds were often mismanaged. their
coverage was limited, many people did not join, the amounts involved
were small, and their membership was too restricted for adequate risk
pooling. In 1889 German chanicellor Otto von Bismarck seized a polit-
ical opportllity to mollify industrial workers and lure them awav from
the socialists by creating the first national contributory old age insur-
ance scheme, giving workers a stake in the central government (Kohler
and Zacher 1982).
At the turn of the century European countries were debating whether
to provide broadly based contributory old age social insuranice as in
Germanv-or narrower means-tested noncontributory schemes for the
old to complemenit the poor laws that applied to everyonie (Petersen
1986). Arguments for the contributory schemiies were the universality of
the old age problem. their self-financing aspect, and the disincentives to
work and saving posed by means-tested programs. Arguments for the
noncontributory schemes were their lower cost (since not all the old
needed public interventioni) and their greater efficacy at alleviating
poverty. These arguments-pro and con-are still heard todav. In 1891
Denmark put in place a means-tested program, and means-tested old
age schemles were subsequenitly adopted in Australia, France, Iceland.
103



VERTING  THE OLD  AGE CPRISIS
Ireland, New Zealand, and the United Kingdonm. But social insurance
schemes were becoming increasingly common. By the start of World
War 11, national contributory schemes, partially funded and partially
pay-as-you-go, had been created in Austria, Belgiumll, Bulgaria, Czecho-
slovakia, France, Greece, Hungary, Italy, Luxemibotirg, the Netherlands,
Poland, Portugal, Romania, Spain, Sweden, the United Kingdom. and
the United States (Weaver 1982).
Whatever the type of scheme, all publicly managed pensions before
World Wir 11 were modest, providing no more than 15 to 20 percent of
the average wage, with most workers expected to live only a few vears
after retirement (cable 4.2). Thlese modest benefits-combined with the
predominlance of means-tested old age pensions in the British Com-
moniwealtlh and the Nordic countries-reflected the original goals of
public schemiies: to provide a bare subsistence and to reduce poverty.
In 1942 the Beveridge Report in England called for a new and larger
public sector role in old age security. Confident in the government's
ability to compensate for private market failures, Beveridge saw pub-
licly financed pensions as a way for the emerging social welfare state to
Table 4.2 Ratio of Average Pension to Average Wage in Selected OECD
Countries, 1939 and 1980
1939                      1980
Country                   (actual)                (synthetic)a
(1)                       (2)
Australia                   19
Belgium                     14
Canada                      17                        34
Denmark                     22                        29
Germany                     19                        49
Italy                       15                        69
Netherlands                 13                        44
Norwav                       8
Swedeil                     10                        68
Switzerland                 -                         37
United Kingdom              13                        31
United States               21                        44
Average                    15.4                       45.0
- Nor available.
a. Synchetic replacemenrit rates are simulared percenrages oftirial salary for single work-
ers with average wages in manufacturing for 1 980.
Souirce: (1): replacemiienit rates for 1939 trori SSIB dara Files, Esping-Andersoni (1990).
(2): Aldrich (1982).
I04



PUBLIC PENSION PLAX00
guarantee a minimum  income to all older citizens. Although the
amount of the penslionI Beveridge had in mind is still a matter of dis-
pute, it was clearly meant to provide a more generous pension to a
greater percentage of the old than had the earlier means-rested schemes
(Atkinson 1991a).
How could these ambitious goals be financed? With funded pension
schemes discredited by the financial disarrav of the interwar and
wartime periods, public pension plans increasingly became contribu-
tory, payroll-tax-financed, and pay-as-you-go. Conditions for the suc-
cess of such a scheme could not have been better. The two crucial vari-
ables for a pay-as-you-go pension system-population growth and real
wage growth-were at historically high rates (Maddison 1987). A
iVews'week editorial by Paul Samuelson in 1967 (February 13) captures
the enthusiasm:
The beaury of social insurance is that it is actuarially unsound.
Everyone who reaclhes retirement age is given benefit privileges
that far exceed anything he has paid in.... How is this possible? It
stems from the fact that the national product is growing at com-
pound interest and can be expected to do so for as far ahead as the
eve cannot see. Always there are more youths than old folks in a
growinig population. More important, with real incomes growing
at some three percent a year, the taxable base upon which benefits
rest in any period are muclh greater than the taxes paid historically
by the generation now retired.... A growing nation is the greatest
Ponzi game ever contrived.
The result was the creation of new social insurance schemes or tiers
in Switzerland (1949), the Netherlanids (1957). Sweden (1960). Nor-
way (1966), and Canada (1966), and the dramatic expansioni of
schemes in the rest of Europe, Japan, and the United States. All public
pension systems were expanded and made more generous, usually by
adding a large earnings-related tier to the existing, smaller means-tested
or flat tier (table 4.2). Australia and New Zealand were the only indus-
trial countries that refused to make pensions dependent on prior earn-
ings and contributions. These new, expensive, pay-as-you-go plans pro-
duced massive lifetime transfers to the generations retiring in the 1960s
and 1 970s-substantially reducing old age poverty.
But it is not clear that much thought was given to their long-run
consequences. Today, just as OECD plans are beginning to mature, the
I05



THE OLD AGE CRISIS
conditions conducive to a successful pay-as-you-go scheme are fast dis-
appearing. Population growth is coming to a halt. Mortality rates are de-
creasing among the old, raising their share in the population. Wage
growth is slowing dramatically, and public pension plans are in trouble
in industrialized countries.
Developing and Transitional Countries
The enthusiasm for public pension schemes soon spread to develop-
ing countries. Even before World War II, countries suchi as Argentina,
Brazil, Chile, and Uruguay had contributory schemes with substantial
coverage, schemes that initially were supposed to be funded. When low
investment returns and rising benefits hit the funded schemes, these
countries switched to pay-as-you-go financing, allowing them to pay
more generous pensions to greater numbers of old people. After World
War 11, a few former British colonies-India, Singapore, and later parts
of Africa-opted for funded provident schemes. But most developing
coLuntries, some of them newly independent and newly establishing
their social policies, established contributory pay-as-you-go plans. In the
republics of the Soviet Union and Eastern Europe, old age pensions
were included as part of the cradle-to-the-grave securitv that commu-
nism was supposed to provide all workers.
Developing countries created public pension plans at a much earlier
stage of economic and demographic development than industrialized
countries. These countries were poorer when they started these plans,
their populations were younger, and they had less ability to tax and ad-
minister complex public programs. More than 8 percent of the German
and U.S. populations were over 60 years old when their first national
pension schemes were instituted. In contrast, dozens of developing
countries established such programs when only 4 percent of their popu-
lation was over 60, and most of the old lived in rural areas.
Developing countries also promised higher income replacement rates
than industrial countries had when they started. As a result, many de-
veloping countries today spend more on pensions than industrial coun-
tries did at a similar stage of development. A cross-section of ninety-two
countries today shows much higher pension spending as a percentage of
GDP than occurred hiscorically in the United Kingdom, for comparable
demographic conditions (figure 4. 1). Yet, with a few exceptions (Mauri-
tius and Trinidad and Tobago), little of this money is going to poverty
io6



P UBLIC PENSI0
Figure 4.1 Pension Spending during the Demographic Transition: United Kingdom Historical Pattern versus
Current Global Pattern
Public spending as a percentage of GDP
16
* Austria
14                                                                                                   Oltaly
Luxembourg   reece
12                                                                                          .0                  *See
France                 Sweden
10                                                                                     * *
*Uruguay   /       4United Klingdom
Cross-section of 92 cotintries circa 1990   **
6
Panama *                      Arge                   Japan /
4               ~~~~Costa Rica *                             
Egypt ic S                                Austraia          United Kingdom, 1910-90
2                                                         tes
*              Ja/a maica Denmark,   a
0~~~~~~~~~~~~~~4 
0                      5                      10                      15                      20                     25
Percentage of population over 60
Note: Because of space limirationis, liot all data poinits are identified. For rhe United Kiilngdiom, data show fitted linc for fifteen observacions
between 191(0 and 1990. For cross-section ot ninerv-iwo contL1ries circa 1990, see tiguire 1.S. See texs for further explanlarion.
Sourte. Palacios 1 9))4a): Johnison (1985); United Kingdon (I8991; U.S. Sociial SeuLrity Admiinistrarion.
alleviation and noncontributory social assistance. One result is the jux-             Developing countries spend more on
taposition of a formal public pension svstem for a privileged minoritv of             pensions than did industrial coun-
w k wh io l s f m t t p u i        tries at the same stage of the demo-
workers with an informal system  for most of the popLIlation. A second                graphic transition.
result, most obvious in Latin America and Eastern Europe, is that many
developing and transitional countries can no longer afford their pension
arrangements.
Why a Dominant Public Pillar? The Politics of Social Security
Public management and financing are clearly needed to address the
redistributive side of old age security programs. But the saving and insur-
ance side could  be addressed, in large part, through private plans-
mandated and regulated by governmenit. Some believe that this would be
107



.4RVjIRTJNG  THE OLD AGE CRISIS
a more efficient system. Others believe that if government is going to re-
distribute and to mandate and regulate saving and insurance, it would be
more cost-effective for governiment to provide the entire package in the
first place. A major question analyzed by this report is whether combining
these functions in one dominant public pillar is an efficient way to go.
Besides this normative question is the positive question of why dom-
inant public plans have evolved in most countries. Why have these com-
bined programs won widespread public support, and why did citizens
and policymakers choose to finance them out of payroll taxes on a pay-
as-vou-go basis? One explanation is that workers who pay the taxes to
support the program view it as an implicit, ongoing intergenerational
contract. Current wvorkers pay for the pensionis of current retirees and
expect to receive pensions that others will pay for in the future-very
much like an extension of the informal system. But there is much to
throw doubt on this explanation. These implicit contracts are nor en-
forceable. They have frequently been changed. Evasion and strategic
manipulation are common problems. And predictable lifetime redistri-
butions among generations are involved, so not all cohorts gain.
Another explanation is that workers may not pay much attention to
old age securitv programs when they are youn1g, but once they reach mid-
dle age they have accumulated substantial entitlements in existing pay-as-
Voi-go programs. At that point, they are better off if the program continues-
even if they wvould have been still better off w'ith a fully funded defined
contribution plan from the start. This does not explain why a country
chooses pay-as-you-go in the first place. But it does explain why, once in
motion, these plans are very difficult to change. They' have a built-in conl-
stituency, which is at its most politically influential stage of life.
Still another political explanation is that middle- and high-income
workers realize that a basic income floor is necessary to prevent old age
povertv, but they want to achieve this with a minimum amount of re-
distribution. The financing method used by public plans typically con-
tains many provisions that limit redistribution. For example, contribu-
tory programs help onily people who have worked most of their lives.
The payroll taxes generally used are based on earnings from labor, nor
income from capital. There is a ceiling on taxable earnings. Pensions are
usually higher for people with higher wages. Rich people live longer
than poor people and so receive more annual payments. T he design of
the public pillar thus limits redistribution to the poor, making it more
acceptable politically to the rich.
108



PUBLIC PENSION PLA
Perhaps the most plausible political explanation for the popularity of
public pension plans comes from the demographic transition and the
life cycle of a typical program (see chapter 3 and issue brief 6). Pay-as-
you-go schemes have generally been instituted during periods of rapid
populationi growthi, initially paving large benefits to old people who
have contributed relatively little. In coulltries with young populations
( maniy workers), an immature old age security system (few retirees), and
expanding coverage, current and promised benefits can be generous
while costing little in current taxes. Under these circumstances, practi-
cally everyone-young anid old, rich and poor-benefits in the early
years. The appearance of a high rate of return is intensified by the fact
that employers usually pay part of the tax, and workers may not realize
that much of the cost has been shifted to them in the form of lower
wages.
Problems develop later, as systems mature, birthrates taper off, and
life expectancy increases-reducing the returns and transfers for future
generations. These effects are worse if growth in labor productivity has
been dampened, perhaps as a consequence of the old age system itself
Those who support the pay-as-you-go public plan at the beginning may
fail to realize that their grandchildren will pay a high price. Many' years
later, however, they may regret the fact that they have gone:
down the primrose path of unfunded employee pensions and in-
adequately funded social security programs.... When population
growth slows down, so that we no longer have the comfortable
Ponzi rate of growth or we even begin to register a decline in total
numbers, then the thorns along the primrose path reveal them-
selves with a vengeance (Samuelson in Wise, 1985, p. 442).
How Public Pension Plans Work
A      LTHOUGH MOST PUBLIC PENSION PLANS ARE LARGELY PAY-
as-you-go, are financed by a payroll tax, and pay a defined bene-
fit, there are many variations on this theme. Some countries build
up large reserves. Some use general revenue finance. The defined benefit
may change often. And it may be flat, means-tested, or earnings-related.
(Publicly managed plans that are fully funded and based on defined con-
tributions, known as provident funds, are discussed in chapter 6.)
IOg



GTHE OLD  AGF CRISIS
Pay-as-You-Go versus Partial Funding
Under a pure contributory pay-as-you-go plan, the benefits received
by current retirees determinie the taxes paid by current workers. If the
system is financed by a payroll tax (as it usually is), the contribution or
payroll tax rate Cdepends on the benefit rate B (average benefit/average
wage) times the dependency ratio D (beneficiaries/covered workers), or
C= BD. For example, if there is one retiree for every four workers and if
beneficiaries have been promised an average pension equal to 40 percent
of the average wage. a 10 percent contribution rate will cover system
costs (table 4.3).
If the dependency ratio rises to one retiree for every two wvorkers, ei-
ther the contributioni rate must be raised to 20 percent or the benefit
rate must be slashed to 20 percent of the average wage. Important fac-
tors left otit of this eqtiation-such as administrative costs, unemploy-
ment, early retirement, survivors' benefits, ceilings on taxable earnings.
and evasion-could raise the required contribuitioni rate to 30 percent or
more. This is the situation maniy countries are in today-or will be
tomorrow.
Pure pay-as-you-go plans are rare in the real world. Most public plans
accumulate a current cash surplus in their early years, but as the systems
mature and populationis age their reserves disappear and the plans shift
into current deficit. The initial cash surplus is an illusion, since it is only
a partial offset to the implicit pension debt that is building up, and the
later deficit meanis that some of this debt is being covered by broader tax
(or bond) revenues. This is the life cycle of a pay-as-you-go system (issue
brief 6 and figure 4.2). Today, partially funded (or scaled premiIm) sys-
tems are common in countries with youLIg populationis, SuCII as Egypt,
Table 4.3 Contribution Rates Required for Different Benefit and
Dependency Rates under Pay-as-You-Go
Benefit                          Dependency rate
rate (penrenzt)    1/2     1/3       1/4       1l5        1/10
100             50         33         25        20         10
80             40         27         20        16          8
60             30         20         15         12         6
40             20         13         10         8          4
20             10          7          5         4          2
Source: World Banik staff.
IIO



PUBLIC PENSI_V
Figure 4.2 Pension System Surplus or Deficit as Share of System
Revenues (1986) and Old Age Dependency Ratio (1990)
Surplus (or deficit) as share of total revenues
100                           gRep. of Korea
80  \Bhan4    :0
\ Is
60
Mi        ~~~~Jamiaica
40
20                                                        *United States
0
-20                  ~~~~~~Morocco                                Belusnagiu
-20
40                                                                  6                Early pension system surpluses are
G   aly      an illusion-they soon become a
-60                                                                                  deficit nightmare.
0                10                 20                30                40
Ratio of people over 60 to people between 20 and 59 (in percentage)
Ante. Because of space htinatiatons, not all dara poi1its arc idetifriied. R2 = 0.68. S1UR/REV -
89.0086 - 327.688 X OAD)EP, where SUR!REV is the ratio of svsreni surplus or deficit to
roiral svsemin rcs enues and OAD[EP is the old age dependenicy ratio.
Sorce: Calcutlated fronit data froilm ILr (1 992a). World Batik popLularion6 dara base.
Guyana, Honduras, Jordan, Mexico, the Philippines, the Republic of
Korea, and Tunisia. A few industrial countries, such as Canada, Japan,
Sweden. and the United States, also have partly capitalized systems, ac-
cumulating substantial reserves in preparation for the pension liabilities
they will soon have to pay off. But most industrial countries and older
Latin American and Eastern European countries rely primarily on pay-
as-you-go finance, supplemented by growincg payments from  the na-
tional treasury.
Defined Benefits and Risk
Public pension plans use a defined benefit formula that promises a
specified pensioni to retirees. Most also include disabilitv and survivors'
benefits. The most important characteristic of defined benefit formulas
is that they supposedly reduce the risk of income uncertainty in old age;
III



#vR-TING THE OLD AGE CRISIS
risk is transferred to younger workers, who are considered to be more re-
silient in the face of unexpected change. This freedom from risk is some-
what illusory, however, since most governmenits chanige their benefit
promises many times over a typical worker's lifetime (box 4.1).
The second important characteristic of these formulas is that they
break the link between benefits and contributions. Annauities sold bv
private insuranice companies make defined benefits contingent on con-
tributions according to actuarial, market-based principles, but defined
benefit formulas used by public pension plans virtually never do so. To
maintaini such a connection the ptiblic plan would essentially have to
Box 4.1  How Defined AreDefined Benefits?
ADVOCATES OF PUBLIC DEFINED BENEFIT                 Changng the rules of the game. Even if workers
schemes argue that governnents should shield pen-   have enough information to calculate their pen-
sioners from the vagaries of capital markers and other   sions, the attempt would be meaningless, since ben-
risks. Contribution rates are adjusted to cover the de-   efit formulas change so frequently. Not one public
fined benefit, which transfers risks to younger workers,   defined benefit scheme has held to the same benefit
who are considered to be more resilient in the face of   formula over lifetimes of a cohort of members.
unexpected change. Just how defined are the benefits   When public schemes were running surpluses and
in pay-as-you-go public pension schemes? In most   the fiscal environment was favorable, governments
countries benefit levels fluctuate less from year to year   frequently raised benefits. The average replacement
than stock market prices do, but over the longer run    rate doubled in Japan between 1969 and 1980
defined benefits change frequently, so substantial risk   (OECD 1988b). In the United States the ratio of
remains.                                         average pension to average wage rose from 0.14 to
Calculatng the defild benft When the defined    0.37 between 1950 and 1980 (U.S. Social Security
benefir is flat, workers know just what pensions they    Administration, various years). France raised its
will receive. But when benefits are earnings-related,   replacement rate 50 percent and lowered the retire-
the value of the benefit depends on the wage base    ment age to 60 in the 1970s. But when public
used to calculate the pension, marital status, and    pension schemes run into deficits, whether because
other aspects of the worker's personal and employ-   of maturation of the scheme, aging of the popula-
ment history. Often benefit formulas are so complex   tion, or general fiscal pressures, governments cut
that few people can calculate their expected pension.   benefits.
Some of the complexity may serve a useful purpose
by building flexibility into the system so that pen-  * Germany, Sweden, and the United States have
sions can adjust to different circunstances. Higher   scheduled increases in the retirement age;
benefits for workers with dependents are an example   France and the United Kingdom are consider-
of an efficient contingent benefit. But some contin-  ing doing so.
gencies may increase risk or be prone to strategic ma-  * France recently increased the number of years
niputation. Tying pension benefits to wages during    used to calculate the wag base and the number
the last few years of employment is an exam           of ye  required to qualify for a full pension
112~ ~~~~~~~~~~Pi.asI1



P U BLIC P'ENSIONEPJ
"sell" a small annuity to the worker each year in exchange for the con-
tributions made that year. The price of the annuity Would depend on
the worker's age (young workers would get better terms) and life ex-
pectancy (which raises problems concerning pooling of risk categories,
discussed in issue brief 10), as well as the expected future interest rate in
the economy and the retirement age at which the payments could begin.
Each year the worker would purchase a somewhat different annuiLt, as
the size of the annual contribution and the variables determining the an-
nuity price change. When the worker retired, all these small annuities
would be added together to determine the total pension.
* The United States effectively reduced the de-  Undefling defied benefNb In, several countries
fined benefit for higher-income retirees by    people have brought suit to determine whether
making 50 percent of the pension taxable in   defined benefit promises.are enforceable by law. The
1984 and raising the taxable share to 85 percent   United States Supreme Court ruled in 1960 that so-
in 1994. The average wage replacement rate   cial security beneficiaries do noc have a legally
also declined over this period.             enforceable contract and that the government can
* Japan's defined benefits were made less gener-   cut off benefits at' any time (Ferrara 1985). The
ous in 1986.                                Brazilian Supreme Court ruled to the contrary in
• In 1992 Iceland shifted from a universal flat   1992, finding that the government must honor
benefit to a means-tested benefit, and thou-   promises made to pensioners. A year later the Brazil-
sands of pensioners had their benefits reduced   ian governmnent still had not paid these benefits,
or eliminated.                              which would have required raising benefit levels by
* Turkey is considering a higher retirement age,   147 percent- at a .cost of,LUS$10. billion (Lloyd-
lower replacement rates, and more radical re-   Sherlock 1992). In 1994, after long-standing litiga-
forms to deal with a nearly insolvent pension   tion, the constitutional court in Italy ruled that the
system.                                     government had to make good the difference be-
• Beneftts have been severely eroded by inflation    tween the full benefits owed and the reduced bene-
and in a few cases by outright cuts in the for-   fits it had paid, dating bac as far as 1983, which
merly socialist economies, as decining.per   would cost the government more than US$3.8 bil-
capita incomes, aging populations, and early re-   lion in arrears plus more than US$380. million an-
tirement left them no alternative.       L nually (Financial Timen .June 1994). It is not' clear
when or how the Italian, givernmnent will raise the
While many of these changes constitute desirable    money, possibly some of it will corme irm reducing
reforms, workers who planned for their retiremeent   future pension promises. Thus expetience has
under the old rules of the game have not been pro-   taught members of most public sej es aroun:d the
tected from risk. By far the Most coCMMon tool for   world, especially in developirn countries, that their
downgrading defined benefits is inflation without in-   defined benefits are, to a large extent, undefined.
dexation (box 4.8).
113



T1HE OLD AGE CRISIS
While it would be possible for public pension plans to operate in this
manner, none of themii do so, possibly because it would entail detailed
records and interest rate projections, but more likely because it would
require that all redistributions become explicit. Instead, public pension
plans rely on defined benefit formulas that fail to make benefits actuar-
ially dependent on contributions and imply substantial redistributions
that are implicit and nontransparent.
Flat, Means-Tested, or Earnings-Related Benefits
The defined benefit formula takes different forms in different countries:
* Universal flat, with the same benefits for everyone above a certain
age, regardless of income and work history
* Employment-related flat, with the same benefits for everyone per
year of covered emplovment
* Means-tested, with higher benefits for those witlh lower income or
smaller assets
* Minimum  pension guarantee or top-up to a manidatory saving
scheme
* Earnings-related, with higher benefits for those who have earnied
and contributed more.
Flat and means-tested benefits are more commoni in industrial than
in developing countries, possibly because they work best wlhere coverage
is widespread and tax collection eftective (table 4.4). A flat benefit is the
mainstay of the public pension plans in Canada, Iceland, Mauritius, the
Netherlands, New Zealand, and South Africa. In Japan, the flat benefit
is both contributory and universal: workers and the self-employed pay
flat contributions for themselves and their dependent spouses. and all
contributors receive a flat benefit at age 65. Jamaica, Switzerland, and
the United Kingdom use an employment-related flat formula as an im-
portant part of their plans. Broadly based means-tested benefits pre-
dominate in Australia, Hong Kong, and Trinidad and Tobago. Canada,
Denmark, Norway, and Sweden offer a generous combination of flat,
means-tested, and earnings-related benefits. In countries that have a
mandatory saving plan, as in Chile, the public plan can take the form of
a top-up or minimum  pension-designed to get the individual to a
specified level if the savings are not enough to do the job. This is a spe-
cial variation of a means-tested scheme. In most OECD countries with
114



PUBLIlC PENSION Pt,
Table 4.4 Spending on Universal Flat and Means-Tested Old Age Benefits, Selected Countries, 1986-92
Speniding on      iVuinber    UJniiversal                    Spendinig oni       Number        UJiniversal
uniiversal flat   receiving    flat andl                     universal flat      receivinig    flat anndl
or means-         flat or     or means-                      or means-          flat or      or means-
tested pensions  mzeans-tested    tested                     tested pensions    means-tested    tested
as percenitage    penzsion as    benefit as                  as percentage      pension as    benefit ais
of total      percentage   percentage                        of'total        percentage   percenitage
spending onl     of nunber       of non-                     spending onl       of nunber       of non-
old age        ofpersons   agricultural                      o1l age          of personis   agricultural
pensions         over 65        wage                         pensions           over 65        wage
More cuan USr .,.$1 1,200p purtcl asin,g pow?er per capita   [en than                rper,pita
New Zealaiid'    100             100            39           Mauritius           94             100)           I
Hong Konig        1(0             73            21           Trinidad and
Australia'        10()            8(            28              Tobagol          57              56            --
Netherlands       100            10()           38           Costa Rica"         16              20            11
Iceland            73             93            3l1         Jamaica               8              16            -
Denmark            72             89            29           Portugal             8              16            1 5
Canada             64             9)7           27           Larvia               5               6            ---
NorwVay            57             X8            3(1          Urugua               S              16            17
Swederl            39            1 00           28           Venezuela            S              15             7
Irelanid           33             39            17           Brazil               4             2              -
Finland            32            100            22           Greece               1               2
United Kiinomi      7             20            13           E\'pt                0               7            -
France              6             17            19           Romania              0              1 1
Luxembourg          4                           -            Argerntina5         -                              6
Germanv             4             -             -            China               -                4
Itald               4              9            25
Belgium             3              5            33
Spain               2              3            16
Utnited Stares      1              7            13
- Nor available.
a. Not inclUding spcndinig oni goverinment employees scheme.
b. 1983 for column 2.
Source. EUrosrat (1992); Nordic CoU nriie" Statistical Secretariat (1993h1 US. Social Securitn Admlinistration (varioIs yearn): Bairco de
Previsioni Social de Uruguay (1991) D. Mirichell (1993): Plani-Aimiericani Health Organizacio  (1')989b and 199)b): Hol7111m1a 1992):
.\Iauririus (1987)): Jamaica (1993); P.Llacios (1994h).
flat or means-tested benefits, the basic pensioni is tvpically about 20 to
30 percent of the average nonagricultural wage. The share is mtich
lower, more variable, and difficult to define in developilng coLintries.
Most cotnitries featuire eariiiigs-i-elated pensions. sLipplenenited by
smaller means-tested components. In theory,v contributionis anid bene-
fits, both tied to prior earnings, are rhereby tied to each other, reducilig
the incentive to evade. In practice. however, this connection  is verv
"15



ZTING  THE OLD AGE CRISIS
loose. The higher contribution rates required by earnings-related
schemes may, in fact, raise the incentives to evade.
Two types of earninigs-related formulas are used. In the more com-
moo type, tised in practically all developing countries, eligible retirees
receive a benefit equal to their wage base times an accrual rate for every
year of covered service. The pensionable wage base is usually the last one
to three years of earnings, which strongly favors high-wxage earners
wlhose income rises steeply witlh age.
In some OECI) countries, such as the United States and Switzerland,
the pensioni is based on average anlLial lifetime earnings over a thirty- to
thirty-five-year period, with early year earnings revalued upward accord-
ing to inflation or average wage growth in the economy. In these coun-
tries, a higher proportion of average earnings is paid to lower-income
workers. This progressive formula is difficult ro apply in developing
countries, where workers move in and out of covered status and under-
reporting of incomes is relatively easy.
The choice among flat, means-tested, and earnings-related benefit
formulas goes to the heart of system  design. Flat and means-tested
schemes have a limited poverty alleviation goal and more readily permit
a separation between the redistributive and saving functions through a
multipillar system. Earnings-related schemes, to a large extent, combine
these funictions and facilitate the growth of a dominant public pillar
(boxes 4.2 and 4.3). (See appendix table A.7 for more detailed data on
benefits and other characteristics of public pension plans.)
Payroll Taxes or General Revenue Finance
Public pensioni benefits-especially earnings-related benefits-are
mainly financed through an earmarked payroll tax, usually with a ceil-
ing on taxable earnings. The tax, generally shared between workers and
employers, ranges from 3 percent in a few African and South Asian
countries witlh very young populations to more than 25 percent in older
countries with mature schemes, such as Brazil, Bulgaria, Htingary, Italy,
Poland, Russia, and Uruguay (figure 4.3). The ceiling on taxable earn-
ings varies widely, but often it is two or three times the average wage.
The lower the ceiling the narrower and less progressive is the tax struc-
tire and the higher the tax rate required to cover expenditures.
Universal flat and means-tested benefits are often intentionially
financed out of general revenues, in keeping with their redistributive in-
II6



PUBILIC PENSION PLA1 "
Box 4.2 Pros and Cons of Flat versus Means-Tested Benefits
MEANS-TESTE  PLANS HAVE TWO KEY ADVAN-                save when young or work when old and near
tages. They:                                          the income threshold (the poverty trap).
-  May become politically unpopular in times of
* Incur .1OweF COStS or-allow larger benefit pay-
.  Incur lowet costs or allow larger benefit P~Y   budgetary stringency, since middle-income
rments for the same. expenditure, thereby hav-
ing a stronger poverty alleviation impact. (Aus-  groups do not benefit.
tralia's means-tested pension reaches 70
"' t t g * . ' ' r t Ir ~In contrast, flt benefi
percent.of the population but costs only half as
much, as a proportion of GDP, as New           * Involve minimal record-keeping and transac-
Zealand's universal flat benefit.)               tion costs, important considerations when ad-
* Keep the rich from collecting larger lifetime    ministrative skills and work records are scarce.
transfers than the poor. This is especially im-  a Avoid the high marginal tax rate, disincentives
portant in countries where coverage is usually   to work and save, and stigma and take-up prob-
limited to higher-income groups and where        lems that come with means-tested programs.
life expectancy is much greater for the rich   * And they provide a basic income floor (say, 20
than for the poor.                               percent of the average wage) to all old people,
thereby coinsuring and possibly winning wider
Means-tested plans also have three key disadvan-   p        s
tages. They:                                          poltical support.
The big disadvantage of flat benefits is their higher
* Incur administrative costs plus stigma and    cost, requiring higher tax rates, much of wvhich goes to
take-up problems. (in the United Kingdom 21    upper-income groups. Some of these costs can be
percent of people eligible for the income-tested    "clawed back" by subjecting benefits to income
supplement don't apply for it.)             taxes-which, in a progressive tax svstem, would re-
• Set up perverse incentives for people not to               (Box continues on thefollowingpage.)
tent. But even in earnings-related schelmces that are supposed to be conI-
tributory, the payroll tax frequently fails to cover burgeoning benefits,
and the unplanned deficits are met by transfers from the general treasury
(figure 4.2). Australia. Hong Kong, New Zealand, and South Africa fi-
nance flat and means-tested benefits out of general revenues. Chile pays
for the minimum pension guarantee through the public treasury.
Canada and Denmark finance flat and means-tested beniefits out of gen-
eral revenues and the earnings-related component out of payroll contri-
butions. In France, Greece. and Italy. despite high payroll taxes, contri-
butions are lower than promised benefits, and large deficits are covered
by general tax revenues. (See appendix table A.6 for more comprehen-
sive data on sources of revenue.)
117



ktI4NG  THE OLD AGE (CRl1.s
Box 4.2(oniud
suit in lower net beneft f    r Howvr              . 
would not work effectively in' v    Pg  Ouess    women :or                 k     ibo         0
that have little capacity,tocoec nmeate,1wjoydorlg  4** h*  (k 
disadvantages prbab    twgh ti                         ma          4
countries with very low incotes, wher th       
tioncosts ofpaying smallp snsiots;to  luat                                                          p
would be relatively high, an  incountrs w   dis"   theiigadv ra:  
parate income distributions, where a sm'a I -at benefi  A     -i0;m ; psi ' n
|   wouldhave lirte value to the rich and tting pub'          i
tic transfers to the poor is particularlyt-00 impay,   ai  sen   '- ;                .       i-
A variant, the emp/oymen-rdaedflatbengfl,-pro-   : -1a-e e     ..   r-     p d ha   ;e   i -:
vides a specified flat benefit (Say, 0.75 percent of the
average wage) for every.ya of employment. it has   liri when TheVeiecudrcd.         h   irt
many of the same advantages as the fiat beinefr but   f  n
to different degrees and may be the preferred,4prdoo  04s te cheatway to  lis te ol 
in situations in which administnitive a4nfc  r-pver.:4
fsources do not permit universal coverage. ( Compared  o Elimnae ' :.t ad s                  
with universal flat benefits, employmentt-rel,ated 11  tak-sip .proems :        , ;*e)tisaiedI
benefits.     :                                        b     i,n recotds xt0:nr.n& by 4te :.:0i tory
0  00tVEV  fif   ;; 00-0t0i ;X0  saintgschm e. -   - 
a Cost less or enable higher pensions fir long-I   3 M    i   negativesc0ctsoek        av i    I
term employees.                                 S Provid l0
* Require more record-keeping (ottyears of coy,     above the m    urn    i   revel U-  a a:at
ered employment).                                 b f would.
Which tax is a better source of finance-the payroll tax or general
revenue taxes? In industrial countries, general income or consumption
taxes are more efficient because they have a broader base. They are also
more progressive since all forms of income are taxed (labor's share of in-
come is about 60 to 70 percent).
In developing countries, the situation is more complex. On the one
hand, payroll taxes have an even narrower base (typically only 30 to 40
percent of national income) and thus require a much higher rate than
income taxes, making them more distorrionarv And wage rigidities may
force employers to bear more of the payroll tax, reducing employment
and otitput (see next section). But on the other hand, developing coun-
tries may niot have the capability, to collect incomiie taxes. And the other
general taxes (excise or import taxes) that they can collect are also dis-
tortionary (World Bank 1991b). In addition, general taxes in develop-
u8



PUBLIC PENSIOf
ax4.3 Ptoa.,d  ons oft 4atd feBef Rs
--R    BINQS*ATEt) BENItS  ARE t    SOMETAES .              -Such schemes are complicated and lead to
sp.Ore  on the eround that rhe - '                       stra-tc maniptdation and political pressures
-  : e -     : : -:       . - - -            -      - for untrealistic pension promises and early re-
tirement -opportunities that mainly benefit
- y co*biritng the s'in& insurance, and redis-
-ribins   a single public planpr.vileo   groups
U, -mp ro'~'e pns. -adu         ad r                U.... a Even when earnings-related benefit formulas
:~ ~ ~ ~ ~ ~~~ad reduce.e p,tso- aeuc ae euc -.
the middle dar~~ ~        appear to be progressive, careful empirical stud-
,:  :tisvkZ  :         when they,e  ,classes, hy fouxng  ies show they are not (box 4.6). Often the rich
: ,   ena t,X',oEitti-mao¢ vhen.e  are,e young
.. ,: .,.pd%.:tli¢m,a,hiem ttY CsiOWX)when   t-hget. larger transfers than the poor. OECD coun-
"' d ' ..-,'    t hem" .  . iger pe's'onwhen'-  tries with large flat or means-tested comnpo-
NiOffer a closer -,- k between contributions'a    -   nents to their public pension plans (Canada,
bet than  t  or means-tested              d -       the Netherlands, Sweden) have lower old age
' '' : th   t g   si, ''  : - ' -   ' :   - - -     poverty rates, relative to poverty rates in other
- - r   bo   pu 'p -:                                  population grups, than countries with pre-
for all,  cluding the por, in the long     -.- doiminately earnings-related plans (Germany,
benetfit$ ror asl, tecIudmg the poor, gn tne long  -the United States [see figure 3.2]).
, ,, r,urn, ,,, ; , ,, , ,,,,   ,  ,U ,             Since access to earnings-related benefits is based
. he- ,o,ppoin!g. argument is 'that'combining these   on employment history, these plans are of Jim-
fun,ris''i-'one eanmings-related pulc -plan in-          ited hep to women and others who have had
cr'eass labo tdistortions and evasion while reducing     little or low-paid labor market experience. In
redistribution to low-income groups     '                OECD countries with earnings-related benefits,
old women living alone have a much higher
:  Paying higher benefits to high-income workers      poverty rate than other groups.
while also trying to alleviate poverty among      a High contribution rates and generous benefit
- lower-income workers requires a high conrribu-    promises reduce the supply offunds and the de-
..on ,rat,e th:a.t.is closely linked to benefits If  mand for supplementary plans, diminishing
:-the--con+gi,ribu is perceived as a tax, it may en-  the opportunities for building a strong funded
courage; wokers to evade and withdraw from,         pillar. Lack of diversification increases risk for
the finr, ldaor forc. and may lead employers        the old. Many countries have eventually de-
-  to ut backon employment.-                        faulted on.their pension promises, failing in
,     The high public spending implied by en          particular to protect pensions against inflation.
-riated[chemes adds tO the government's fiscal      By the tixne people realize they cannot count on
;b,urd  andm,ay pvt spending on other itn-          these promises, it is too late to arrange for alter-
portant publc Roods.'                               native sources of old age support.
ing countries are often regressive, drawing heavily from  low-income
rural areas, whereas formal old age security programs usually limit cov-
erage to relatively high-income urban workers. Using general tax rev-
enues to finance pensions under these circumstances could perversely
redistribute benefits from the rural poor to the urban rich.
II9



MTING THE OLD AGE CRISIS
Figure 4.3 Payroll Tax for Pensions versus Old Age Dependency Ratio,
Selected Countries, 1990
Payroll tax, percentage
40
35
PoadRussia  Ljkraine
30                   Brazil *                         Hungary
*   Bulgaria
25                                  *~~~~Egp g  Argentina  g Italy
25                    EPrguay *@                           U ruguay
Paraguay * ~~~~~~~Sweden
20              Ecuador                                              nitec @
15                                                                  ingdom
Bahrain             _                                 B
10
Payroll tax rates rise steeply as pop-
ulations age and pension systems          5
mature-but some countries are way                 Afghanistan   * A        Jamaica
above average.                            0
0       5      10       15      20      25      30      35      40       45
Ratio of people over 60 to people between 20 and 59, percentage
Now: Because of space limitritiolIs, noro all data points are idenrifled. R' - 0.46. PTAX
1.7035 + 57.34 x OA)DEP. where PTAX is [ihc payroll tLx for peoisioris.
Soure': CalCLilated froits data from U.S. Social Sectirirv Admitsnistrationts 1 93)\ World Baiik
popLlatiots dart base.
So, the choice between tax methods is not clear-cut on efficiency or
equity grounlds in developing countries. Most important. these consid-
erations limit the amount of taxation that is efficient and make it all the
more important to use the scarce tax revenues wisely.
How Public Pension Plans Affect the Economy
A         S COUNTRIES AGE, PUBLIC PENSION PLANS HA'VE CONSUMED
_,A, a large share of their GDP and a much larger share of total tax
revenues. These plans thus have major effects on labor and its
productivit,v, on capital accumulation and its allocation, on the ability of
government to finance public goods and services-and therefore on the
growth of the economy.
120



P UBLI C PENSION- PL
Impact on Labor Markets
A public scheme that is finaniced through a payroll tax provides in-
centives for employers to reduce their hiring of labor, for workers to es-
cape to the informal sector, and for covered workers to retire early.
Therefore, it may lower the employment of trained workers and the pro-
ductivity of labor-and these effects may be greater in developing than
in industrial economies.
Employer and worker response to the payroll tax. If benefits were truly
contingent on contributions and valued as much, the payroll tax
would be viewed as a price, not a tax, and would have few distor-
tionary effects on the labor market. This was part of the reason for
most countries to opt for contributory social insurance schemes. But
the defined benefit formula and pay-as-you-go method of finance
break this link between benefits and contributions-benefits to some
are not as great as their contributions, whereas others can get the ben-
efits even if they do not contribute. So, workers who bear the tax may
trv to evade it by reducing their labor supply or escaping to the infor-
mal sector, whereas employers who bear it may reduce the quantiry of
labor they demand.
Who bears the tax earmarked for old age security? In most countries.
the payroll tax is nominally shared by workers and employers. But the
ultimate impact of the tax depends on the relative elasticities of demand
and supply. In industrial countries, the supply of labor is relatively in-
elastic witlh respect to wages: most workers, especially prime age males.
continue working when a tax lowers their disposable wage. In that case,
workers pav not only their share btit their employers' share as well, in
lower wages, since wages fall enough to keep everyone employed. Al-
though wages fall, output does not fall and the tax is not inefficient.
In the few situations in which wages cannot fall any further because
a legal or social minimum has been reached, employers pay the tax and
may cut back on employment and output as a result. This is inefficient.
This line of thought suggests that the rise in payroll tax rates in OECD
countries over the past two decades may be one possible explanation for
the rise in unemployment and the more general slowdowni in the growth
of real wages. This process redistributes income away from workers but
in an opaque way (less employment, slower wage growth) that may lead
workers to pressure for a larger public pension plan than they would
want if thev realized its full cost.
121



XTING  THE OLD AGE. CRISIS
Wage rigidities may be more common in developing and transi-
tional economies, making it more difficult for employers to shift the
tax to workers. One possible employer reaction is to substitute capital
for labor, employing fewer workers as they become more expensive. But
the scarcity of capital in developing counltries limits the degree (and ef-
ficiency) of this adjustment. A second reaction is for employers to try
to pass some of the tax on to consumers in higher prices. But in a com-
petitive product market, especially one facing international competi-
tion, emplovers will be unable to raise prices. A third reaction is to cut
back on production or go out of business. If the payroll taxes cannot be
passed on to consumers in higher prices or to workers in lower wages,
the result is likelv to be unemllployment, as is occurrinig in Eastern
Europe todav.
A policy conclusion: in the presence of wage rigidities, the efficiency
loss is smaller if workers pay most of the tax directly. In the absence of
wage rigidities, the ultimate economic effecr is very similar regardless of
who initially pays the tax. But the political effect mav be quite different-
if workers pay they are more likely to be aware of the cost and less likely
to support overly generous public pension programs.
Escape to the informal sector. Another difference between industrial
and developing economies stems from the lax tax enforcement in low-
income countries, where workers can readily escape to the informal sec-
tor. Evasion is particularly easy in countries where labor force coverage
is low and the informal sector is large. Employers, too, often move into
the informal sector to avoid taxes. Even large companies can contract
out some of their work to microenterprises that operate informally.
Indeed, the informal sector is made tIp largely of workers and employers
escaping payroll taxes and other regulations. A recent study in Caracas,
Venezuela, found that payroll taxes accounted for one-third of the costs
of becoming formal (Cartaya 1992). Roughly' half the workers in
Bolivia, Costa Rica, Guatemala, Honduras, and Paraguay are in the
informal labor market (figure 4.4 and issue brief 7 on evasion).
The growth of the informal sector defeats the main purpose of the
public pension scheme-to see that workers contribute in their youth
to financial security for their old age. It also hurts the government's fis-
cal capacity, labor productivity, and national otitput. Workers and em-
ployers in the informal sector generally try to avoid taxes of all sorts,
reducinig government revenue. And workers in the informal sector may
have lower productivity because they have less access to capital, on-the-
122



PUBLIC PENSIO
Figure 4.4 Percentage of Labor Force in the Informal Sector, Selected Latin American Countries, Late 1980s
Bolivia
Brazil
Costa Rica
Guatemala
Honduras
Panama
Paraguay
Uruguay
Venezuela
10              20              30              40              50              60              70
Percent
So/,rce. Psacharopotilos and others (1993).
job training, and broad product markets. If marginal output per    A large informal sector makes tax
worker in the informal labor force is 20 percent lower than in the for-    evasion easier-and defeats the pur-
mal sector and if the payroll tax causes 20 percent of workers to oper-    pose of a public pension scheme.
ate informally, labor's contribution to annual GDP would be cut by 4
percent. The efficiency loss in the labor market from high payroll tax
rates may thus be more substantial in developing than in industrial
countries.
Early retirement. In developing and transitional countries, the legal
retirement age is lower than in high-income countries. The effective
retirement age and the labor force participation by older men has been
declining almost everywhere (issue brief 8 and issue brief table 8).
The legal retirement age in public pension plans in developing coun-
tries is typically 60 for men and 55 for women, compared with 65 for
men and women in most high-income countries. One obvious explana-
tion is shorter life expectancyv But the higher incomes and above-average
longevity of covered workers suggest an alternative explanation: provi-
sions for early retirement are secured bv politically influential groups
who use this as a nontransparent way to gain from public pension plans.
123



KERTING THE OLD AGE CRISRiIS
Figure 4.5 Expected Duration         Consistent with the latter explanation, the average person lives longer
of Retirement for Men,               after retirement in many developing countries than in industrial coun-
Selected Countries, Late 1980s       tries. For example. the average male in Ecuador wlho retires at the stan-
Sri Lanka                        dard retirement age can expect to have eight more years of retirement
Ecuador                         than his counterpart in Germany (figure 4.5).
Zambia                           'The effective retirement age is even lower than the legal retirement
France                         age in many countries because public schemes offer multiple opportu-
Italy                        nities for early retirement-but no rewards, and often penalties, for late
Colombia
retirement. In some transitional socialist economies, the actual average
China                         retirement age is under 55, because many young people qualitfy for dis-
Peru                         ability or other special benefits. China and Romania have tried to encour-
United States                       age enterprise restructuring by encouraging early retirement (box 4.4).
Hungary                           Thle low and declining retirement age shows up in the low and de-
Germany                        dclining labor force participation rate among 55- to 64-year-olds. These
United Kingdom _..
rates have been declining almost everywhere over the past three decades,
10 12 14 16 18 20 22    but faster in richer thani in poorer countries. Many forces are at work,
Years
but public and private pension plans bear part of the responsibility for
A'ore This refers to life expectancy at rhe    this decline. Plublic pension plans in most industrial countries have an
legal retiremient age...                                          . ..,.
lgsal: Uneited Nations tl992b); U.S.  earnings test that stronglv indLuces older people to stop working-
Social Secoiritv Admniistration 11993).  otherwise they would lose their pensions. The slower decline in poorer
countries may be due to the light coverage rate of public plans, the ab-
sence of an earnings test in some cases, and the large informal sector that
Males retiring at the normal retire-  allows people to continue working unofficially after retirement (appen-
ment age often live longer in devel-  dix table A. 10).
oping countries than in industrial      The decline in the supply of experieced workers has reduced the
countries.
labor force by about I to 2 percent in developing countries and by 3 to
6 percent in industrial countries. This becomes inefficient if the cost of
lost output exceeds the value of the increased leisure that retired workers
get in return. In Slovenia, the steeply rising age-earnings profile ob-
served after the market transition signals the higlh return to experienced
labor and the high social cost of early retirement (Orazem and
Vodopivec 1994). Raising the normal retirement age and equalizing it
for men and womeni, makinig early retirement available only with actu-
arially reduced pensions, and rewarding those wvho work beyond the
normlal retirement age by increasing the expected lifetime pension are
important steps to take to reduce the negative effect on employment. If
this lost outptit could be recaptured. it wouild cover a large portion of
total pension spending in many coun1tries (see issue brief 8 for a fuller
discussion of earlv retiremenit).
124



PItBLIC PENSION  PLAr4e
Impact on Saving and Capital Markets
Some economists believe that pay-as-you-go systems have reduced
national saving. Others argue that they have had no such effect. Briefly,
a pay-as-you-go system can hurt savings because of the unanticipated
increased consumption of the first generation of eligible retirees and
the anticipated income transfer in the form of high pensions to the first
Box 4.4 Is Eal1y Retirement a Good Way to Reduce Unemployment
and Facilitate Pnvatization?
SOME GOVERNMENTS VIEW EARLY RETIREMENT    is stuck with a large liability as a result of privatiza-
as a painless remedy for unemployment, arguing that   tion combined with early retirement. And provisions
the vacancy left by the retiree can be filled by a   for early retirement may be difficult to change when
younger worker who would otherwise be unable to   the apparent short-term need is gone.
find work. In Spain early retirement is allowed only  There is little evidence that early retirement re-
if the retiring worker is replaced by a young person    duces unemployment. Many of the vacancies created
just entering the labor force. Socialist economies in   by early retirement are never filled, perhaps because
Eastern Europe and the former Soviet Union have    of permanent reductions in labor demand in certain
long disguised the true rate of unemployment and   industries. Younger workers are imperfect substitutes
underemployment by encouraging people to retire   for older, more experienced workers; they have dif-
early, a practice that has intensified in recent years   ferent skills, which, in some cases, are complemen-
with enterprise reform and privatization. Romania   tary rather than substitutes. The productivity of
eased eligibility requirements for retirement in 1990   some young workers may be less than the going
as part of its restructuring program, increasing the    wage. Some of the younger replacement workers pos-
number of pensioners by 40 percent between 1989   sess special skills that would have made them em-
and 1992. China has done the same. Some countries   ployable in any event, while workers without these
are considering "buying out" workers who oppose   skills remain unemployed. When Bulgaria and Ro-
privatization, and paying them pensions out of the    mania tried to increase the employment of younger
public coffers, in order to reduce the liabilities of   workers in public enterprises by lowering the retire-
state enterprises and make them more attractive to    ment age, enterprises did not take on new inexperi-
potenrial investors.                            enced workers but instead reduced employment.
Early retirement, though appealing in the short   And to encourage workers to retire early, the govern-
run, is a costly and shortsighted way to reduce un-   ment must increase current and future levels of pen-
employment and facilitate enterprise reform. It re-   sion spending, leading to higher payroll taxes, which,
duces the country's labor force (especially its experi-  in turn, may lead to higher unemployment.
enced labor force), shrinks potential output, reduces  Rather than being painless, early retirement is a
political pressures to cut unemployment, and results   costly solution to the unemployment problem and
in regressive redistriburions. Pension benefits are   an expensive way to restructure enterprises. Unem-
often much higher than unemployment benefits, and    ployment should be attacked in other ways, while
these costs continue for many years. The government   pension plans should be aimed at the truly old.
125



_.ING  THE OLD AGE CRISIS
generation of working age members. However, empirical studies of this
issue in industrial countries have come to very different conclusions,
depending on the data, the period, and the model. A major problem is
the difficulty in estimating the counterfactual-what saving would
have been in the absence of social security. Although very few empiri-
cal studies have been done in developing countries, it appears likely
that the negative effect of pay-as-you-go plans on saving has probably
been small, for at least four reasons: coverage is not widespread, the
absence of reliable savings instruments means that savings and assets
are small to begin with, private intrafamily transfers may offset the
public transfers, and the new pension system may lack credibility, so
young people go on saving for their own old age. (Issue brief 4 discusses
the impact on saving of pay-as-you-go and fully funded plans in greater
detail.)
But even if existing pay-as-you-go systems have had little negative
impact on saving relative to the no-pension state, they are an opportu-
nity lost to increase long-term saving through large mandatory fiunded
plans. This could be significant, in view of the capital scarcity in many
industrial and developing countries today.
From this vantage point, partlv funded public plans may have more
positive effects on long-term saving and capital accumulation than pure
pay-as-you-go plans. Bitt this effect depends crucially on how the funds
are managed and how they affect government spending. If they are
used to increase current government spending and deficits, national
saving does not rise even if private saving does. If they are allocated
exclusively to public investments, some of the potential private capital
market development is lost. And if these investments have low pro-
ductivity, some of the growth-enhancing effects are lost. Although not
conclusive, observations from many countries are consistent with these
scenarios.
Pension fiunds in young countries with immature systems, as in
Africa. Central America, and South Asia, often accumulate reserves,
which almost always are required to be invested in government securi-
ties or the securities of state enterprises. Usually the nominal rate of in-
terest on these securities is less than the inflation rate, and devaluation
lowers the returns furcher. International diversification is rarely al-
lowed. The ultimate uses of these fLinds are not knowni, since data are
unavailable and money is fungible in the governm1ent budget. But the
large negative returns to many' public pension funds in the 1980s sug-
126



PUIBLIC PENSION P
gest that capital was being misallocated in capital-scarce countries. De-
veloping countries need to be particularly careful about this issue be-
cause their unstable political environments, lack of private financial
markets, and large number of loss-making state enterprises make mis-
use of publicly managed old age securitv reserves more tempting (box
4.5 and figure 4.6).
Box 4.5 How Do Pension Reserves Fare in the Public Pillar?
LOW NOMINAL INTEREST RATES, HIGH INFIATION,   as new contract workers were required to contribute
weak accountability, and prohibitions on interna-   to finds managed by enterprises or state agencies.
tional diversification have resulted in negative inter-   These funds are often kept in bank accounts earning
est rates being earned on the reserves of most public   negative real interest.
pillars. The funds are used exclusively to purchase  In many Latin American countries the decapitaliza-
government or public enterprise bonds or to finance   tion of pension reserves is even more pronounced
housing loans at low rates of return. This is a non-   (Mesa-Lago 1991a). In Ecuador mortgage and per-
transparent tax on workers whose contributions will  sonal loans to members of the elite accounted for 19
not be there to pay pensions when they retire.  percent of the loan portfolio of the Social Security In-
Real returns averaged -23.8 percent in Turkey be-   stitute. Low-income workers and peasants had little
tween 1984 and 1988 (IssA 1990c) and -12 percent   access to these funds. In 1988, these loans yielded re-
in Egypt over the last decade (World Bank data). The   turns of -42 percent-this at a time when borrowers
National Investment Bank of Egypt credits the pen-   were able to deposit the money in commercial banks
sion fund with negative real interest rates, in effect   and receive positive real interest rates. Real estate and
transferring the funds to the government's coffers.   mortgage loans also helped shrink the institute's assets
More moderate rates of inflation in Tunisia held re-   from 2.8 to 1.4 percent of GDP between 1986 and
turns to about -3 percent in recent years, but equip-    1989.
ment bonds and social housing loans to the govern-  Pension reserves were channeled to housing subsi-
ment threaten the medium-term financial outlook of   dies in Mexico and Venezuela during the 1980s, with
social insurance funds (Vittas 1993a). Probably the   similarly dire financial consequences. Venezuela'used
worst case is Peru, whose public pension reserves had    pension funds to cover the deficits of failing public
negative annual returns of -37 percent during the    enterprises-in 1989 stock in these enterprises ac-
1980s (figure 4.6).                             counted for more than half the portfolio of the Social
Russia has recently used pension reserves to keep    Security Institute (Marquez 1992). That year alone,
public enterprises afloat and to buy government   real pension reserves shrank more than 70 percent.
bonds, which in 1992 had real monthly interest rates   The pension fund averaged a -13 percent return on
of -20 percent. Hungary used the first surpluses of its   investment during the 1980s. Several Latin Ameri-
reformed pension scheme to make housing loans on    can countries are responding to this pension fund cri-
concessional terms. Pensions funds began to accu-   sis by planning a complete restructuring of their old
mulate in China after the reforms of the mid-1980s,   age security systems.
I27



ETr1ING THE OLD AGE CRISIs
Figure 4.6 Average Annual Real Investment Returns for Selected Publicly
Managed, Partially Funded Pension Schemes in the 1980s
Costa Rica                                -10.5           (1980-87)
Ecuador                                    -10          (1980-86)
Egypt                                -11.7            (1981-89)
Jamaica                                        -4.8     (1980-87)
Peru       -37.4                                      (1981-88)
Trinidad and Tobago                                      -5.2     (1983-87)
Turkey                    -23.8                        (1984-88)
United States                                      (1980-90)      4.8
Most publicly managed pension
funds lose money.                              Venezuela                             -15.3               (1980-89)
-50      -40       -30      -20       -10        0         10
Percentage of rate of return after inflation
Nore: Cotintries were selected on the basis of data availabilitv for at least five vears. Simple
averages of inflation-adjusted annUal returns are shown.
Source: Mesa-Lago (1991a); ISSA i 1990c); Marquez 11992); Palacios (I994h).
Impact on the Provision of Public Goods
In countries with young populations and immature systems public
pension funds run surpluses that can finance the provision of public
goods. The problem is that since the tax is not transparent, the wrong
public goods with low social value may be chosen. In countries with
older populations and mature systems, public pension funds may reduce
the provision of important public goods, because they run deficits cov-
ered by the general treasury.
In most OECD countries, older Latin American countries, and transi-
tional socialist economies, pension payments are the largest item in the
consolidated government budget. Most of these plans began as self-
supporting contributory schemes that ran a current surplus, but the sur-
plus was soon dissipated. As the social security debt built up behind the
scenes and eventually came due, large current deficits became common.
In 1990 Uruguay spent one-third of the consolidated government bud-
get oii old age security, including 10 percent of general revenues that
covered 27 percent of all pension payments (Szalchman and Uthoff
1992). Italy spends 37 percent of its total government budget on pen-
128



PIUBILIC PENSION  PLANS
sions (OECD data). And in Turkey, current pension deficits are almost 2
percenit of(DP (World Bank 1993).
These high expenditures on public pensions have contributed to fis-
cal crises in manv councries. With tax revenues limiced by economic and
political considerations, countries with large pension obligations find it
difficult to finance growth-enhancinig public goods, such as education,
infrastructure, and health services.
It might appear that counitries should use partial fundinig of the pub-
lic pillar in the early years to build up reserves for paying off the pension
debt in later years. But the danger is that these reserves might make
thinigs worse, because they might tempt governments to spend more-
and to spend it on consumption rarher than investment, while dissipat-
ing the reserves through negative real interest rates. The funds would
not be there wlheni needed and would have induced wasteful public
spending in the interiim.
With public pension reserves required to be invested in government
bonds at low interest rates, some analvsts argue that this encourages the
governmenit's proclivity toward deficit finance, absorbing saving that
would otherwise be available for productive private investment. Others
argue that these reserves simply buy government bonds that private
savers would otherwise have bought. In that case, a low interest rate im-
plies a hidden tax on workers but does not discourage private invest-
ment. The issue hinlgies on whether pension saving reduces private
household saving and whether the government's monopsonistic access
to pension reserves encoLirages it to spend more on current consump-
tion. It is difficult to resolve this issue, since empirical studies lack an tin-
ambiguous counterfactual.
One study explored experiences with pension fund surpluses in
Canada, Japan, Sweden, and the United States. Pension reserves did not
seem to increase government spending in Japan but did seemll to facili-
tate public spending at the provincial level in Canada, where pension
funds were obliged to buy government bonds (Munnell and Ernsberger
1989). If there are social securitv reserves it might be best to keep them
separate from  the rest of the budget, have them  managed by an au-
tonomous institution, and invest them in private as well as public secu-
rities. But this could result in lack of accountability, political manipula-
tion, or backdoor nationializationi of the private sector, particularly if the
reserves are large. In any event, the fact that this is rarely done suggests
it is nor a politically plausible option.
I12c



RERTING  THE OLD AGE CRISIS
The United States has a unified government trust fund budget, anid
usually the net deficit is reported. The trust finds of the social security
system and the government employees' pension system are the largest
purchasers of governmllent bonds, holding one-quarter of the explicit
debt, wvhich is netted out of the total reported debt. The trust funds are
paid the market interest rate and in this sense fare better than public
pension reserves elsewhere. But the market rate for governmlent bonds
might have been higher if all bonds had to be sold on the open market
and the trust funds earned less than privately managed occupational
pension plans over the same period (figure 3.7). The U.S. nationial debt
has grown concurrently wvith the trust fuids since 1983. and some be-
lieve that the large ctrst funds enabled the government to increase the
deficit, perhaps in turn depressing private investment (Marlow and
Crain 1990). In about twenty years, the U.S. government will have to
begin redeeming its unreported debt to the trust funds-to pay benefits
to the baby boom generation. It wvill then have to raise other taxes or cut
other important public spending far beyond current levels (Weaver
1993).
Who Benefits and Who Loses?
P oAY-AS-YOU-GO SCHEMES ALWAYS INVOLVE REDISTRIBUTIONS
across generations. Defined benefit schemes always involve redis-
tributions within generations as well, since benefits are not
linked to contributions in an actuarially fair way. The ability to redis-
tribute to low-income individuals and generations is the big advantage
of public pension plans. But if the defined benefit formula is not care-
fully devised or if the total wage bill in the economy does not growv fast
enough, the result mav be perverse redistributions from poor to rich.
What does the evidence say about the actual lifetime redistributions
brought about by public, defined benefit, pay-as-vou-go schemes? The
first step in this calculation is to measure the present value of contribu-
tions paid and the expected present value of benefits received over the
course of a worker's lifetime (anld even beyond, since benefits usually in-
clude payments to survivors). The difference between these tvo is the ex-
pected net transfer or lifetime redistribution to the worker. This is positive
if expected lifetime benefits exceed contributions, and negative otherwise.
130



PUBLIC PENSION PLANS.
Sometimes the rate of return that would equate benefits to contribu-
tions is calculated. If the redistribution is positive, the rate of return
exceeds the market interest rate, implying that the worker got a better
return through the pension system than would have been possible in an
alternative investment. Usually. the net transfer or rate of returni is cal-
culated across groups of people-poor and rich, males and females,
married and single, early and later cohorts of retirees. Because of the
heavy data requirements, few studies have measured lifetime redistribu-
tional effects. These studies indicate that the first generations of pen-
sioners are indeed helped, but at the expense of later generations. and
there is little redistribution from rich to poor within any generatioll.
Intragenerational Redistribution
Intragenerational redistribution refers to transfers of expected lifetime
incomes of individLIals born at about the same time, especially redistrib-
ution amonig income classes. In the Netherlands, Sweden, the United
Kingdom, and the United States, the main countries where studies have
been done, it has been found that there is little redistribution from rich
to poor despite progressive benefit formulas, minimum  and maximum
pensions, and similar devices ostensibly designed for this purpose. Such
devices have failed because upper-incomiie people enter the labor force
later in life and live longer after retirement, so they contribute less and re-
ceive more than lower-inicomiie people over a lifetime. They have failed,
too, because of policy choices such as low ceilings on taxable earnings and
the common use of earnings-related benefit formulas, in which pensions
rise with earnings. These studies have also found "capricious" redistribu-
tions within generations, that is, redistributions that most citizens may
not be aware of and may not approve. For example, public plans often re-
distribute from dual-wage-earnier families to single-wage-earner families
and from women workinig in the market to those who stay at home.
Studies of lifetime income redistributions are generally not available
for developing countries, but indirect evidence shows that intragenera-
tional redistribution0 is even less progressive there. Usually, high-incomne
formal sector workers in urban areas are the main group to be covered.
but the schemes may be finaniced, in part, by lower-incomiie taxpayers
(figure 4.7). In addition, privileged groups are often eligible for better
benefit formulas and earlier retirement, income-related differences in
longevity and age-earninlgs profiles are strong, and the pensioni depends
13]



.,THE OLD  AG E C R I IS
Figure 4.7 Access to Social Security in Latin America,
by Income Quintile, Late 1980s
Poorest quintile
Second quintile
Boli      v ih        ird  quintile
Fourth quintile
Richest quintile
Brazil
Costa Rica
Social security programs are sup-             Peru
posed to help the poor, but they usu-
ally help the rich more.
0           20            40           60           80           100
Percentage of quintile with access
oVote. Qtiitnriles ordered by per capita incomie; "access" refers to members of hotiseholds with
at Icast onie active participant it a social sectirin' prograim.
Source: Psacharopoutlos anid others (1993).
mainly on final vear salary. In their present form, public pension plans
in both industrial and developing countries do not seem to be effective
at redistributing to the old in lower-income groups (box 4.6).
Intergenerational Redistribution
The second type of transfer-intergenerational-occurs in all un-
funded schemes. It is measured by comparing the difference between
lifetime benefits and costs for successive generations of retirees in a
countrv. All empirical evidence to date shows such transfers to be much
larger than intragenerational transfers, especially during the first few
decades of unfunded schemes. In all cases, earlier generations have done
better than later generations, regardless of income. That is, covered
workers aged 30 to 50 at the inception of the scheme always gain,
whereas their children and grandchildren lose. In the United States, real
rates of return were more than 1 5 percent for workers retiring in the
1 950s and 1 960s and about 8 percent for workers retiring in the 1 970s,
signiS'inog large positive transfers to these workers from the social secu-
132



PUBLIC PENS1 0
Box 4.6  Redistnbution within the Same Generation
PAY-AS-YOU-GO PUBLIC PENSION SCHEMES HAVE    who thus e   pg those years
the capacity to redistribute lifetime income from the    without coniin- io            beneft for-
rich to the poor. From that objective comes the ra-    mulas that give m nore it -in the years
tionale for public management and pooled finance   just bef r¢tr                     low-ncome
with complex benefit formulas instead of separate ac-   workers, as Lca*e+ '  '       d   igher-
counts with actuarially based risk categories. To    ince k      hs.     n     rseitha e   Such
achieve redistributive objectives, the United States   forrmulas are ee'dti       pigcouitries.
and the Philippines provide higher wage replacement  'Financing   n.sdce another regres-
rates for individuals with lower lifetime wages. The    sive ellmtrnt to mos i    pl   In OECD
Netherlands uses a flat benefit and Switzerland a    countries,$whecereio4;ivesl,systems
combination of employment-related flat and pro-    are financ4dv,ia pa  ts ii.s       .... of general in-
gressive earnings-related benefits (box 4.9). Many    come taxes, adtaxab ln    yeu sualycapped-
developing countries use explicit minimum or maxi-   in developigunti       et    e is sparse, the
mum pension levels for the same purpose. None of   regressive. effec comes from u&  geneia revenues
these mechanisms seems to work as expected.       to subsidize pension-plans fo the- better-off.
Why the poor don't benefit mere than the dch. Em-    Guatemala pays a third :fth:coss of its public pen-
pirical evidence indicates that once certain income-   sion plan our,of geretatiovdenes e~Mected from the
specific characteristics of workers are taken into ac-   entire popuati  ent h st pension program
count, public schemes redistribute little lifetime    covers less.than a thiid of- tr population. Tax de-
income to the poor. For one thing, the well-off live    ductihility of ccont ibutiosi ;a corMon feature of
longer than the poor and so collect pensions over a    public pension plasg, in* favlo higher-income
longer period (chapter 3). Many poor people con-   workers ever liw-intomeworers.
tribute but die before they become old enough to col-  Ain                       al thse fosces of
lect benefits. People who live longer than average re-   regressive distributioni, -i'ls not siirpr4iig that stud-
quire larger lifetime incomes to maintain their   ies for the Nethierlan$s, SWedea' the United King-
standard of living, and pensions are designed to insure   dom, and thc Unit tats    te  if any redis
against this eventuality. Nevertheless, the longevity   tributrionrm& the    richothelifetimepoor.
differences between rich and poor are predictable, not   The public pension,  in te Netherlands was
random, so the differences in benefits received because   found to have redistite '1:inco-e: primarily from
of these longevity differences are expected and consti-   unmarried to iiar   -iiv ls regardless of in-
tute redistribution rather than insurance. Does society   come (Nelissen  19888A st He Swedish ystem
wish to transfer income to the rich because they live    detected no intra ioeziiuon and sug-
longer? We do not know whether well-informed citi-   gested that he see m    r    essive if mortal-
zens and policymakers would consider this equitable-   ity differences were rk'  i unt kStahlberg
yet that is exactly what many societies do.       1990),. in    atd if        -i    lity rates
Besides drawing a pension over fewer retirement   and earnings p110 tUgdom offset
years, lower-income workers usually enter the labor   progressive le t feis res (iey, and
market earlier because they leave school earlier. Yet   Whirehense -19)   Italy igtranera ional tedis-
they often fail to accrue much extra pension credit   tribution has  i      :       a well. One
during these extra contributing years. Germany and    study  .d   a.rn  of  a       om the poor
Hungary grant pension credit to university students,                                       p
'33



i,AVERTING THE OLD AGE CRISIS
Box 4.6  (continued)
South to the richer North, the result of steeper age-   also shown a variety of other nontransparent redistri-
earnings profiles, longer lifetimes, and a higher old    butions that may not have been intended or widely
age dependency ratio in the North (Schioppa 1990).   desired: from  single workers to married couples,
Several studies have looked at the intragenera-   from  dual to single wage-earner families, from
tional effects of the U.S. social security system and    women in the work force to other women (Feldstein
found little support for the contention that the life-   and Samwick 1992; Boskin and others 1987).
time poor have received significantly higher rates of  Develping counbies. Indirect evidence for develop-
return than others. Four studies found little or no    ing countries suggests that intragenerational redistri-
difference in the rate of return to lower- and higher-   bution in public pension schemes is strongly regressive.
(lifetime) income workers retiring in the same year,   Typically, only formal sector workers in urban areas are
particularly after adjusting for mortality rate differ-   covered by the plans; the very poor are usually excluded
ences and other income-based factors (Aaron 1977;   (figure 4.7). Income-related differences in mortality
Hurd and Shoven 1985; Burkhauser and Warlick    rates, age of entry, and age-earnings profiles are even
1981; Steurle and Bakija 1994). Three other studies    more pronounced than in OECD countries. Many de-
fbund small progressive effects (Meyer and Wolff   veloping countries have multiple plans that provide
1987; Rofman 1993b; Leimer and Petri 1981).   more generous terms to privileged groups of workers
Some of these studies do not take into account bene-    with more political dout. In Brazil higher-income
fits received by surviving children; this would proba-   workers have an easier time documenting their covered
bly increase the degree of progressivity. But they also    employment, so they are eligible for generous length-
do not take into account the fact that poor workers   of-service-related benefits. Civil servants in Egypt and
probably have a higher discount rate than rich ones,   Mexico receive better inflation protection than private
which makes the system less progressive. Studies have    sector workers, and in Colombia they contribute at a
ritv system (Moffimt 1984; Hurd and Shoven 1985). But the return is ex-
pected to fall to about 2 percent for workers retiring after 2000, less than
they could have gotten in other investments (figure 4.8).
The redistribution from younger to older generations may be equi-
table if the youinger generations have much higher incomes than older
ones. But if national income is not rising rapidly, young workers with av-
crage or below-average wages maya find themselves subsidizing the pen-
sions of retirees who are better off. In the United States, the largest trans-
fers during  the 1960s and  1970s went to the old, wlho were
wealthv-because of their greater earnings, pensions, and longevity-
(Hurd and Shoveni 1985; Steurle and Bakija 1994). Middle- and even
some low-income workers today and tomorrow will pay the price and get
less than they put in. In developing countries, where upper-income
groups are the first to be covered, this regressive intergenerational effect is
likely to be accentuated.
134



PUBLIC PENSION PLA%
lower rate than private sector workers, yet get the same    Box Table 4.6 Dsribtinal Effects
wage replacement rate. In Brazil, Hungary, Turkey,   of Colowbian Public Pension Scheme
and many other countries, white collar workers are
more likely than blue collar workers to retire at age 40                                     Transfers
or 50, increasing their rate of return rclative to those           Present  Present  Present    of
who continue working. In Colombia, though all cur-                 vabueof  alxepof vale of benefits
'                       ~~~~~~~~~benefits taxes paid transfer (percent)
rent retirees receive net transfers that constitute approx-
imately the same proportion of benefits for all income    Minimum-wage
groups, the absolute value of the transfer is eight times  worker   12.8      3.1      9.8     76.5
Worker making
as large for a high-income worker as it is for a mirni-  five times
mum wage worker (box table 4.6).                       the minimum
Misuse of pension fund reserves contributes fur-    wage         51.8     15.4    36.9    71.3
ther to regressive intragenerational transfers. In    Worker making
Ecuador and the Philippines pension fund reserves      ten times
are lent to high-income workers at negative real in-   the minimum
terest rates of as much as 40 percent a year. In       wage         102.0    30.7    72.8    71.4
Trinidad and Tobago well-off workers borrowed         Note: Married male worker contributes for thirt years and
pension reserves for mortgages at below-market rates.   retires at age 60 without children.
Not a single study for any country has presented   SorUrce: Fernandez Riva (1992).
strong evidence that the public pension scheme has
substantially redistributed income from the lifetime    are taken into account. In fact, in some countries the
rich to the lifetime poor once mortality differences    redistribution goes from the poor to the rich.
Before adopting or expanding old age security systems, countries
should carefully calculate the likely intergenerational transfers over long
periods, by establishing a system  of intergenerational accouLLts that
tracks benefits received and costs paid by each generation (Auerbach,
Gokhale, and Kotlikoff 1994). Policymakers will then be better able to
evaluate whether the expected transfers are desirable-and if not, how
the system should be chaniged to make it more equitable (see issue brief
9 for further evidence on intergenerational redistributions).
Poverty Reduction
Even if public pensioni plans have not redistributed significantly
across income classes, they have probably alleviated poverty among the
old. The large intergenerational transfers found in all pay-as-you-go
schemes would be expected to have this effect temporarily. But that
135



AVERTING THE OLD AGE CRISIS
Figure 4.8 Rates of Return to Generations Retiring Twenty-five
to Forty-five Years after the Start of a Public Pension Scheme
I1 _  _ 25 years
30 years
Sweden                             3  er
SW~~~~~~~4 year
45 years
nt available
Switzerland
not ava iable
United States
As public pension programs mature,
returns to new retirees shrink.
0          2         4          6          8          10        12
Rates of return
,one: Starting dates ofeartings-related public pension scliemnes are: Sweden 1960. SwVitzer-
lanid 194'), Unlited States 1 935. Swedish rates are for men onvly; Swiss rates are for single, high-
itcome males. and data are not available for- LAverity-five and forrt-vear cohorts.
Sotace: Stahlbcrg (1989); HaLlSer and others (1983I); Moffirt ( 1984).
transfer is now  coming to an end and becoming negative in many
countlries, so it will no longer alleviate poverty  Dependenits' and sur-
vivors' benefits should help reduce poverry among older women-but
their poverty rates remaini higher than those of men in OECD countries
with large public pillars, just as in informal systems. Public plans could
also alleviate old age poverty more permanently by shifting people's
consumption from  youliger to older years (the saving fuiiction) or by
developing  risk-pooling opportunities (the insuranice fuLiction) that
wvould not otherwise have been available. These saving and insurance
effects would reduce the incidenice of poverty amonig the old, even if
the lifetime incomes of different income classes were unclhaniged. A
mandatory saving pillar would reduce old age poverty for exactly the
same reasons.
Thlere is even less empirical evidence about the effects of public
schemes on old age poverty than there is about its lifetime redistributive
effects. Fragmentary evidence indicates that the old are not particularly
poor in developing counttries, including those with and without large
public pensioni plans (chapter 3). Evidence from  or(L) couLntries sug-
gests that poverty among the old was disproportionately high during the
136



P'UBLIC PENSION PLA1
Great Depression and shortly after World \Var II but has fallen substan-
rially over the past four decades. In York, England, the old made up more
than two-thirds of the poor in 1950 (Crowuvtree and Lavers 1951), but in
the 1980s they made up less than one-qUarter natioinwide (Luxembourg
Income Study). In the United States, the absolute poverty rate among the
old fell from 35 percent in 1959 to 12 percent in 1991 (U.S. Bureau of
the Census, various years). Today. in Australia, Canada, France, the
Netherlands, Sweden, and the United Kingdom the relative poverty rate
is lower among the old than amonig the workinig age population (figure
3.2). Most of these countries have large flat or means-tested components
in their programs.
Clearly the vast expansion in old age security programs during this
period deserves some of the credit for the drop, but it is difficult to know
how much-because other factors wvere at play. The prolonged prosper-
itv of the 1950s and 1960s in OECD countries enabled people to save for
their old age. The rapid rise in real estate prices benefited workers who
owned their own homes. There was some improvement in the general
status of women. Moreover, social security transferred income to all
older cohorts over this period, but this effect was only temporary. Coun-
tries will have to target their benefits and costs much more carefully in
the future to achieve the same poverty alleviation effects.
If povert, reduction and income redistribution toward the lifetime
poor are the objectives, countries should be wvary of earnings-related
pay-as-you-go pension systems that produce large intergenierational
transfers from later to earlier cohorts but few equalizing intragenera-
tional transfers. They should also be wary of nontransparent systems
that make it difficult to figure out who is gaininag and losing. To reduce
the likelihood of inequitable transfers, public pension systems should:
* Avoid paying benefits that exceed contributionis to middle- and
upper-income classes at the start of the scheme.
* Use a progressive benefit formula such as a flat or means-tested
formula or minimum pension guarantee.
* If an earnings-related formula is used it should be compressed,
with the maximum and minimum not far apart.
* Be sure to tax either benefits or contributions and imputed returns.
* Impose a floor but no ceiling on taxable earnings.
* Finance benefits through general revenues once coverage is
widespread.
137



tXkNG THE OLD AG E C( R I S I S
* Use other financing arrangements-such as mandatory saving
plans-to provide higher pensions to higher-income groups.
The Financial Unsustainability of the Public Pillar
P        UBLIC PENSION SCHEME.S ARE UNDER INC(REASING FINANCIAL
pressure. The problem is three layers deep. First, some are on the
verge of insolvency, particularly in Latin America and Eastern
Europe. Second, pension deficits are straininig already strained public
treasuries, which can no longer bail themIl our. And third, behind the
govermilents fiscal crisis lies the deeper crisis of labor and capital mar-
kets that are malfunctioning, preventinig the growth that is ultimately
the only way out of these difficulties. This multilayered problem
threatens the financial sustainability of pension plans, which may not
be able to keep their promises to workers.
The situation is worst in Latin America and Eastern Europe. Ar-
gentina tried to deal with the fiscal crisis and inflation of the late 1970s
by raising contribution rates and indexinig pensions. The increased
contribution rates led to greater evasion, the indexation raised costs,
and when the unemployment rate also rose in the mid- 1 980s, the result
was an even larger deficir. To avoid insolvency Argentina arbitrarily re-
duced pension beniefits below legally determined targets and increased
transfers from general revenues. The arbitrary reduction in benefits was
successfully challenged in court, leaving the government with unpaid
pensioni liabilities and a crippled pension system. After a prolonged po-
litical debate, Argentina has scaled back its public pensionl and is now
radically restructuring its old age security system by shifting to a multi-
pillar system.
Of Hungary's 10.3 million people, 2.9 million were receiving a peni-
sion in 1993 (including 100,000 orphans). The result was one of the
highest system dependenicy rates in the world, with an estimated 0.75
beneficiary to every contributor. To cover the systrem's huge outlays, 10
percent of CDP in 1993, the payroll tax for pensions has risen to more
than 30 percent, increasling evasion and making it difficult for Hun-
garian firms to compete in international markets. By 1993 the accu-
mulated arrears plus interest penalties owed by Hunigarian firms had
reached 3 percent of G'DP and was expected to grow. Hungary is now
138



PUBLIC PENSION'1
trying to decide which way to go-how to restore its pension system in
a way that helps rather than hurts the economiiy (World Bank data).
Things seemingly are better in OECD countries, but they, too, face
looming problems. which can be summed up by examining the size of
their implicit social security debt. Countries with public pension plans
owe an implicit debt to retirees and workers who have accumulated large
social security entitlements. The present value of this implicit debt de-
pends on the number of covered workers and retirees, their age distri-
bution and expected life spans, the size of the average benefit, the retire-
ment age, and the discount rate used to calculate present value. In OECD
countries, the social security debt varies from  90 percent to more than
200 percent of GDP (van der Noord and Herd 1993). Although not well
knowni because it is implicit, the implicit social security debt for all
countries is muchi larger than the explicit debt (figure 4.9). Adding both
componenits would in most cases triple the total national debt.
Current payroll tax rates are not nearly large enough to pay off this
debt. The gap betveen expected revenues and expenditures over the
next 150 years (much of it in the next 50 years) exceeds 200 percent of
Figure 4.9 Explicit Debt versus Implicit Public Pension Debt
in Seven OECD Countries, 1990
CanadaExp~~~~~~licit debt
Canada - W S^.f -::.; Implicit social securty debt
France                                 / ,
Germany
ItaI
Japan
United Kingdom                           -                                      Hidden public pension debt-which
....  Explicit governnient debt held  needs to be paid off to reform pen-
United States                 by public retirenlent trLISt funds               sion schemes-often dwarfs the
____________________________________________________ explicit national debt.
0        50        100       150       200        250       300
Percentage of GDP
:Voe. 1 he assunted disCUtiLur rate is 4 percenti.
Seturc. Vait der Noord anid Herd (1')');l.
'39



,,E:E.RT(NG THE OLD AGE CRISIS
GODP in most couL1tries. A much larger tax will have to be imposed to pay
off these obligations-unless the promises themselves are not kept. Fig-
ure 4.9 also indicates the debt that countries will have to make explicit
if they decide to move away from a pay-as-you-go system. The prospect
of making such a large implicit debt explicit and transparenit is likely to
deter efforts to reorganize the pension system.
In developing countries the implicit debt is smaller because of their
lower coverage and younger popLIlations. But estimates for Argentina,
Chinla. Colombia, and Turkey indicate that the public pension debt al-
ready exceeds one-third of GDP because of generous benefit promises-
and it is increasineg rapidly (IDB 1993; Lora and others 1992; World
Bank 1993).
How did these couL1tries get into so much trouble, and what can they
do to get out of it? The public pension plans of many middle- and high-
Income coLintries are in crisis today because:
* Populations are aging.
* Pensioni systems have matured.
* Coverage can no longer be readily expanded.
* Early retirement and easy access to disability benefits have raised
the svstem dependency rate.
* Increasing nulmbers of workers and employers are evading the
high contributioni rate.
* Wage replacement rates are too high.
* Ceilings on taxable earnings are too low.
* Penision reserves are earning low, even negative, returns.
* Productivity is not increasin1g fast enough.
Box 4.7 describes these problems in the Eastern European and tran-
sitional countries.
Pensionl system reform is always painful and sometimes politically
impossible. The strong message for countries whose svstems are still
young is to avoid these costly and irreversible mistakes.
The Temptation of Young Populations and Immature Systems
Pay-as-you-go schemes are deceptive. When populations are young,
systems are immature, and coverage can easily be expanded to younger
groups, it is tempting for countries to offer generous benefits, since the
140



PUBLIC PENSION PLAR;
costs are low. But these low costs will not continue indefinitely. The
pension debt is building up. As populations age, systems mature, and
coverage can no longer be expanded, these same benefit levels may be-
come unaffordable.
Aging population. The aging of the population is due to falling
birthrates and to falling mortality rates. Although in the past the
biggest drops were in child mortality, many demographers believe that
in the future the most rapid drops will be among the old, putting
great strain on old age support systems. A two-year-per-decade
improvement in life expectancy among retirees-less than today's
trend in many countries-could double both the dependency and
required contribution rates over the lifetimes of today's young work-
ers. This process is already well under way in Eastern European, ILatin
American, and OECD countries (see issue brief 3).
System matuuity. Although it is possible for a new system to mature
instantly by giving all old people full pension rights, most countries
have chosen not to give benefits to people who retired before or shortly
after the scheme was introduced. Many countries in Africa and Central
America with young pension schemes have a system dependency rate
much lower than the demographic dependency rate for this reason.
But the system dependency rate rises rapidly as the system matures.
Ineligible retirees die and are replaced by new retirees who qualify for
pensions. Even though Mexico is still a young country that is aging
slowly, its system dependency rate tripled over the past thirty years, ris-
ing much faster than the population rate (figure 4. 10).
Expanding coverage rates. Worker coverage in public pensioni plans
usually starts from a narrow base. As the system matures and costs rise,
governments frequently finance the generous benefit promises made
earlier by expanding coverage to new occupations with young workers.
Since the old people in these occupations are not eligible for benefits
but the young workers are contributing, system dependency ratios fall
and the system remains immature. Many Latin American countries
increased their coverage substantially in the 1960s and 1970s. Al-
though the increases in coverage are presented as egalitarian measures
to help the newly covered low-income workers, it is often the high-
income workers who benefit. Ecuador had 29 percent coverage in
1982, but only 15 percent of those covered were rural peasants. By
1991 coverage had increased to 43 percent, with almost half rural peas-
ants. Most peasants are not yet eligible for pensions. but their contri-
141



fr 4G THE OLD AGE CRISIS
Box 4.7  Pension Prols IR Esr  Euro:e
THE WORLD    UTT OUTO BE DIF   ET                tax cllta ti  capaiyare much     e  Iw did
from the one that the old had exeted a?nd grown ac-   this come about and what are the icosequpps? ;
customed to in the transitionfal'scialist economies.  NW :ta:tw  i;    nt*:.Mot atu-
For citizens who followed the rules, the old command    ropein economiesh-a   s tautor  eplac
economy had promised cradle-to-rve incomes-   ratesat aouti 8Q perceft of wages. Altoug  iu    : 0
rity. support for filies with children, a job with a    t:on ha erded these vues theavera  pionis
modest and: relatiey  u ndifferentiated wage, and    still a very hih c tof he a     
compensation for these relatively low wages thxough a .peret in Hugary, 70 percent in Poland, an  85
generous pension after retirent. Butvnow    pen-   Percent in $qvenia.
sioners have come to collect, the coffers are lae  Hia d pmdes,pv r.o and early reVrswuL :Be-
Oldta seuity systems are part  the problem,   cause of declinng bth    e di        rts  are
not the solution. Th etransitional counrties hae oinly    higher in transitionaleconomiesthnicome lels0
a single Ipillar, a publidcy  ianagd, Wpay-s-you-go would predict Adtesystemd       ncyaeis:
scheme financed by payroll taxes. Occupan  p    highe stll be   ofe e           ent, unep
sion; plans and vluntr aving did; not em rg      ment, devasion (many w orke  adipyrs:
under central planning, as they hadi in OECD con^-   simply do no pay) Th        ¢reirmt
tries. Private financ  intermedation and competi-   age is 57 is r men and 53 fin women,;using,: the
tive financial markers never d6veloped and personal   *atofneficarito contritrs upto06 i6no-
saving was small. Though a dominant p ubli& plan -   ania, 0.7 in ngary, and 0.87 itlai 
with high tax rates could fu  ion in an auithoritarin    evy   rkhas to su t almost a fll pen
command economy, it is dysfuctional :in a, rarkt'   H00   '*Iape EI bx Pyll taxesrqiredosup-
economy that ded  on inntives, co               port:the   eefits are  oa -ia bt
decentralized capital mobn, and  c eiitin    percnt fir pensions pliu 20 percet   foth  soci a
in world markers on the baasis of costs andprice.  inisurance., Firs are squeezed fm bith, .sidesa-
Eastern European economies spend Tmuchimore    ministerew pWagesreventthem frm f
on old age benefits than teirincome orP#Yr doa   te po taxto worker,' swhile:opar   slead  to 
would predict. And this sre has   n rsing rap idl    low aad  ilingre wares. This sitiation drivs eva-
(box figure 4.7 and appendixableA.11).XAs r0P hais sion to the growing infmal e    ss np
fallen, the share of  Pcaptued by the:od, :throug  ficti  ew   oriers an  emplo       between
public spending, has increas.;In my cutntesj!  : worke nd retiree:s, discoraes priae Wettqpe-
pensions are the largest sine item ithe govern-'   es::  :    hip s itimpsibleLforfirstocmtn
ment budget, acounting for more thn15P pret  itnioam              s    dprives: theo       nt
of spending  or some 10 to 14 percent of GEP il Bin - i f rn   t invest  in  cnee    pl  o
garia, Hungary, Pwoland and`Slovenia. is isas large   that mi     g        g    to  a b     r x
a share of GlP as in: the OECD :wefare states4;wer ase woud refleas    these pressu, but the
the:proportion o4f old peope pe          and      stutio
142



PUBLIC PFNS100e
Box 1hipPR I       U7:s0lp  of tV  Percote of fte Popudbaion over 60 Years Old and Pension
$po ~T_uu Vea  i,nme, Pre    d Pt-i990.
PenjeoTg  as a.s entw- toGDP
14,    - -             - i   I               ',   ''     
tro t + o '* r ~~~~~~~~~~~~....... .   -. ......
12-
-  fi :^ 1 z  :Wz. @e *K                     YuJgoslavia _ .................... ..................... .
-o -   -    . -   . t       Azer         :             Romania  1   f    Latvia
:  ~~~. - ,..    - 0           Kazatstat                      L u/Ltranis  m
4   -              -- -----nenia
2  .  *   - --    -  -r -- / -  ~~~~~~~~~   -                   i  | *~~ P +t1990 
.     :: . .         ,/        Regression rine on sample of 92 couritries: R2 = 0.88.
±0                   15                   20                   25
PWrfltag of popfWzon ovew 0D,
-     See P oascio 1994b i,t deqts.
.. I    9 :i*_,R .Real.benefits and expenditures    young cannot afford. Too much money goes to
are being red,ced -    ,oi ctly because of high inflation    transfrs to early retirees who could stil work, while
without idxtin. d    i   is not viable untess    the truly old receive pensions thaE are barely ade-
these countruiitnes    netke expts  elicitly. While teal    quate. High tax rates and excess government spend-
pensiois ae ,no6t .fihig 6stet than real wages, young    ing on pensions encourage evasion, distort employ-
workers at lt.st can hope  Por,a better future. For    ment, deter private enterprise, and crowd out public
,,klr r:etirees t$e future is "now-                     investments in productive infrastructure that could
hi at4uP Te  transitonal enornies offer old age    boost economic growth, Overhaul of the system  is
: benefits    the ol,&d"fin'd unsa6 actory: and the    clearly needed.
143



EkTRING THE OLD AGE CRISIS
Figure 4.10 Maturation of the Mexican Pension Schemes, 1960-92
Ratio
0.16
0.14
Old age dependency ratio
0.12
0.10 
0.08
System dependency ratio
0.06
Mexico has a young population but a
maturing pension system, so the sys-  0.04
tem dependency ratio is rising fast
while the old age dependency ratio is
still falling.
0.02
1960    1964    1968    1972    1976    1980    1984    1988    1992
Source: Instituto Mexicanio de Segtrliidad Social (1993); B. Mitchdll (1983): World Bank staff
calcuLlations.
butiolns (albeit small) are helping to finance the retirement of urban
workers.
During the past two decades, the finances of public pensioni plans in
OECD countries have been helped by the increased number of women
who contribute. Concomitant with the declining fertility rate, manv
women have made the transition from  home work, not subject to the
old age security tax, to market work, increasing contributions to the sys-
tem. Although this increased the number of contributing workers bv 10
percent or more, it did not increase the number of beneficiaries by
nearly as much, since manyv womeni would have been eligible for pen-
sions as dependents of their spouses. The incremental returni that house-
144



PUBLIC PENS1019 P
holds receive from these social security contributions is thus low, even
negative, decreasing their lifetime disposable incomes. But the contri-
butions have enabled the old age security' systems of several OECD coun-
tries to stay afloat without raising taxes more transparently.
Coverage cannot expand indefinitely. Nor can it always bring in new
young workers. As the rate of coverage expansion slows and newly cov-
ered workers age. the system dependency rate rises. Contribution rates
must then rise or benefits must be cut-or the difference will have to be
made up by the treasurv. When the pension plan runs into financial
trouble, the latest groups to get coverage, who tend to be from lower-
income groups than the initial entrants, are likely to get a lower rate of
return than they expected.
Policy Choices That Raise System Dependency Rates above
Demographic Rates
The aging of the population and the maturing of systems are part of
the reason for old age programs to be in trouble. But they are not the
whole story. In Argentina, Brazil, Hungary, and Turkey, among others,
system dependency rates are much higher than demographic depen-
dency rates because of policy choices in their public pension schemes
(figure 4.11). The main culprits are early retirement, lenient disability
benefits, unemploymenit, and evasion stemming from high contribution
rates that are not closely tied to benefits. Not surprisingly, the same de-
sign features that cause problems for the economy as a whole also cause
problems for the financial sustainability of the public pension system.
Early retirement. Early retirement-in addition to its drag on growth-
doubly threatens the financial viability of public pension plans by
reducing the number of workers making contributions and increasing
the number of retirees drawing beneits. Suppose that there are equal
numbers of people in each age category and that workers enter the labor
force at age 25, retire at 65, and die at 85. The dependency rate is then
one retiree to two workers, and a contributioni rate of 20 percent will
cover a pension paving 40 percent of the average wage. If the retirement
age is increased to 70, the required contribution rate falls to 1 3.3 per-
cent. But if the retirement age is lowered to 55, the dependenicy rate
becomes one to one, and the required contribution rate soars to 40 per-
cent. This has been the trend in many countries. For example, in France
pension spendinig as a proportion of GDP more than doubled over the
145



,:THE OLD  AGE CRKISIS
Figure 4.11 System Dependency Ratio versus Old Age Dependency Ratio,
Selected Countries
System dependency ratio (circa 1990)
0.9
Italy-
0.8
Bulgaria 6
0.7
*Argentina
S
0.6
Hungary
0.5        ~~~Turkeyo
0y               * S                   Systein dependency rate =
0        /        demographic depencency rate
0.4                                         /
Brazil                        * Sweden
S                   0 * Norwav
0.3
United States
0.2
Policy choices can boost system                                              *Barbados
dependency rates high above demo-            0.         n
graphic dependency rates, spelling
trouble for public pension schemes.           0
0                 0.2                 0.4                 0.6                 0.8
Old age dependency ratio (1990)
.AVrte. Becausc of spaCe I llinC.1ioIS, riot all dar.i poirirs arc iderirified. Fle old age depernderice
iatio is the nunmber of persons aged 60fi or ver divided by the itLrnber of personis aged 290 to 59.
.ys rnin dependenicy races are tor years ranginig ffrorir 1)98  tot 1992 and refe rto rhe number of
pensiotiters divided by the iliniber of activ. conitribLutors.
Sonce: Palacios (1994b).
past two decades, and one-third of the increase was due to earlier retire-
ment spurred by the lowering of the retirement age from 65 to 60 in
the early 1980s (Guillermard  1991). Although Brazil has demograplhic
characteristics similar to Mexico's, its system dependencv rate is three
times as high, in large part because workers can retire earlier. In Turkey.
some workers retire in their forties, and more thani half retire before 55.
The system  dependency ratio for the main public pensioni scheme is
three times as high as the demographic dependency rate.
146



PUBI IC PENSICON PS
Raising the retirement age-regularly, as longevity increases-is prob-
ably the single most important reform to improve the financial prospects
of the ptiblic pension plan. It will also raise the supply of experienced
labor in the economy. Because of the early retirement age in many pub-
lic pension plans, these plans now pay out generotis benefits to middle-
aged workers and may not have the resources to continue paying as pen-
sioners grow older or to pay young workers when they retire. When Chile
faced this problem fifteen years ago. it drastically raised the retirement
age in its public pillar shortly before introducing a multipillar system. Ar-
gentinla also raised its retirement age as it introduced major reforms in
1994. Benefits should be reduced on an actuarially fair basis for people
who retire early, while people who continue to work after normal retire-
ment age should get actuarially fair increases in benefits.
Disability benefits. In many) countries easy eligibiliry conditions for
disability benefits have been a major route to early retirement. In the
Netherlands, 20 percent of all retirees are on disability, and in Hun-
gary, 27 percent. This raises the dependency rate and, because disabili-
ty benefits are relatively generous, the required contribution rate even
higher. As the normal retirement age is raised, more people can be
expected to apply for disability benefits and more will qualifv-thereby
offsetting some of the gains of the higher retirement age. Disability
benefits should be retained for those who are truly disabled but not be
used to disguise unemployment or early retirement by those who are
able to work. Therefore careftil application of the disability criteria is
needed. To prevent abuse by healthy workers, some countries put truly
disabled people on the boards that review applications for disability
benefits.
Unemployment and withdrawal from the labor market. Unemployed work-
ers do not contribute to the pension system although they eventually
become eligible for benefits. Dependent spouses, who do not work in
the labor market, may also become beneficiaries. Although coverage
for the unemployed and for dependents and survivors is important, it
raises the dependency rate and cost of the system, particularly in coun-
tries where unemployment is high and labor force participation is low.
This points up the strong interaction between the health of the overall
economy and the health of the pension system.
Strategic manipulation and evasion. If escape to the informal sector is
easy and the eligibility period is short, workers may respond to a high
tax rate by opting out as contributors as soon as they become eligible
147



AWVERTING THE OLD AGE CRISIS
for benefits. As required payroll tax rates rose in Uruguay. the propor-
tion of contributing workers fell from 81 percent in 1975 to 67 per-
cent in 1989, largely because of evasion (Szalchman and Uthoff 1992).
Workers in Brazil are eligible for a pension equal to 75 percent of their
wage base after only five years of contributionis, making evasion highly
profitable thereafter. During the 1980s, the rates of evasion and
delayed contributions were 60 percent in Brazil, 44 percent in Bar-
bados and Jamaica, and 33 percent in Peru (Schulz 1992). Arrears were
29 percent of total social insurance revenues in Estonia in 1992
(Cavalcanti 1993) and more than 20 percent in Hungary (World Bank
data). In many cases the noncontributing workers had already become
eligible for pension benefits. (See issue brief 7 for a fuller discussion of
evasion.)
Informal systems of old age security, in which contributions and ben-
efits are shared within the family, avoid evasion and strategic manipula-
tion by close observation of family members and strong social pressures
to cooperate (chapter 2). But in formal systems these social sanctions
and mutual monitoring are lacking, so people may exploit the system.
Evasion and strategic manipulation increase the dependency rate and
preclude the option of raising revenues by boosting the contribution
rate, thereby undercutting financial viabilitv. The pension system
should close off these opportunities and get the incentives right. Taxes
for the public pension plan should be kept as low as possible, while part
of the responsibility for old age support is shifted to a second mandatory
scheme, runl as a defined contribution plan-which workers have less
reason to evade because benefits depend directly on contributions and
the costs of evasion are borne by the individual directly involved rather
than the rest of society.
Other Design Flaws
Flawed benefit formulas, high administrative costs, and low ceilings
on taxable earnings add further to the finanlcial difficulties faced by
manv public pensioni planis and their negative effects on1 the economy.
Unsustainable benefit rates and inefficient benefit formulas. Manv countries
have set statutory wage replacement rates unirealistically high. And
because the benefit formulas usually are earnings-related, the highest
payoffs go to upper-incomne workers. In Costa Rica, the average old age
pension was 68 percent of the average economy-wide gross wage in
148



P'UBLIC PENSION PLANS,
1992 (Caja Costarricense de Seguro Social 1992). In Hungary, Poland,
and Slovenia, the average pension in the early 1990s was, respectively,
67 percent, 70 percent. and 85 percent of the average net wage. When
other European countries were at a similar stage of development before
World War 11, they paid a replacement rate 15 to 20 percent of average
gross wages. Even now, most pay only 35 to 50 percent of gross wages,
or 40 to 50 percent of net wages (table 4.2), although Austria, Italy,
and Sweden pay much more. High replacement rates imply corre-
spondingly high contribution rates, which, in developing and transi-
tional countries, lead to evasion, which requires still higher tax rates-a
vicious cycle that may eventually lead to a breakdown of the entire sys-
tem. Lower and flatter benefit rates in the public pension plan are
more consistent with system sustainability and with its poverty allevia-
tion and basic income goals. This also allows room for the develop-
ment of complementary pillars that raise overall replacement rates in a
less distortionary way (boxes 4.8 and 4.9).
High administrative costs. In many developing countries, a big part of
total expenditures goes for administrative costs-10 to 15 percent in
Brazil and Turkey, compared with I to 2 percent in most OECD coun-
tries. Administrative costs per worker (or pensionier) tend to fall as per
capita income rises, because of improved education, infrastructure, and
commiiiiunicationi systems. They also fall as the number of plan members
rises, because of economies of scale (issue brief 5). So, to some extent,
it is inevitable that immature schemes in poor countries will have high
expense ratios. They lack the humllani and physical infrastructure. They
have limited coverage. And they must incur the fixed costs of building a
new system. But inefficient practices add to this burden. Good records
are absent in many countries. WV'hen Peru recently reformed its pension
system and tried to pay off its old social security debt, it had almost no
records of prior employment or contributiolns on which to base these
payoffs. In Brazil, the only records are kept on social security cards in
the possession of workers-and easily subject to loss or fraud. The
absence of such records makes it possible for people to collect benefits
without having made commelnsurate contributions. One advantage of
a flat benefit system is that it puts the least burden on record-keeping
capacity and reduces the opportunities for corruption and fraud.
Countries should be wary of establishing complex pension systems
before they have the critical size and administrative skills to runl these
plans effectively and with low transactioln costs.
'49



+ N:     THE OLD AGE CRISIS
Box 4.8  EaningsRelated: B Mf. How Notito Do t-
MANY COUNTRIES HAVE GOTrEN INTO SERIOUS    eairnings is, a sinple: way to corre,cti lr rapitising
financial difficulty by making thewrong choices about   intlation and absenwe owok recr& bui s t
earnings-related benefit formulas, These wrong    Mh Costs, strategic manipu tion (W
choices lead to unsusrainably generous benefts thatgo    tie for    thc last treeI  'tQ    IC pi   t
disproportionately to high-wage w    The  also   instance), and :i dp     nte   h      e
encourage evasion, stratgic manipulation, and ely   goitg to higher-itcome,wo  er,    ith s Ste a
retiremenr, and governments oWfte escape fo  trnings l-. fi1 .
obligations by not indexing benefits forifation.    Fai-ing a  f  t       l g h   c   ra(the Pr" 
portion of the w ag bse towhhaorker
The: Pmblems in: Br   ::: a : z: : : il   f::::: 0 0 :: 0 ;: 00   acquires pension i   rightsoor, each ya of c  verd
emloynent4 is 15 percent a yafr:ar  tefist Ie
lligh ueeN   at. Stamttory replacement rates   years (75 petcent total)d   pee '          np 
are 75 to 100 percent of the calculated wage base.i  to :10: pecent fof: hewe base. f    first fiveii
Such rates are common ia Latin A:erica but much -    -years extracntniutionsL sadd only a- sial anoit:
higher than rates used in most OECD countries,   to benfits, and after tyers te  ddnthig. 
Sho ai Sb  . period   rfue wast bas andW i.-,   Ths sts the stage;a fir"strt
quasb ercords. Because of high inflation    instane, staying in cov           p     nt js long
and no public tracking of work r ds, mst deve   :: enough to qualif for geir; p:os and then
oping countries count only the last three to fve    evadn f u th .ayro taes . L
years in calculating the pensionbable wage base-    El r       tteis  Athouigh 65, is  'thl 0
Brazil counts the last three years; China and Sua  r        a w-Forkers can reire      on h
count only the last month, Tying pensions to recenit   of yarof servie or dis   Many * arl _ er re s
Low ceilings on taxable earnings and unprofitable reserves. Almost all pub-
lic pension plans include a ceiling on taxable earnings. In some cases.
the ceiling is not much higher than the average covered wage, so a
large proportion of the total wage bill is not subject to the payroll tax.
This mitigates the possible negative effect of the tax on the supplv and
evasion of high-wage workers, but it also reduces the redistributive
impact of the plan and the revenues of the system. In many cases the
ceiling on taxable earnings should be raised-and eventually the bur-
den should be shifted to a broader tax base.
The revenue base of the public plan is also depressed by the low earn-
ings on pensioni reserves. A higher competitive interest rate would im-
prove the financial balance of the system. But this does not seem to be
politically feasible. An alternative is to spend down public reserves by fi-
nancinig pension benefits and making a downsized public plan truly
150



PLUBLIC PENSIO<
are  idd       works W ho th_ the infoma sec- s            s          '",
.tot wile colectingtheit igenerous pemxions from:      .-.- -                              -
the rxna sfe ctr.                                    Brazil, like many other developing countri6 has
-ats. 'Te crreDnt .contribution - allowed inlAtion without indexarion to do the job
rate is abok 30 prcent,  nj tis: in  enough to     cutung 'ea benes that it could not do m     ex-
cover- h pi isedel't. In 'I992* the govern-   plicitly beaiise ofpolitical obstacles. This isinef-
nisent-swas rt d by:the courts to come.up with   cient because it creates uncettainty for woikers.-
add iional.f      *    .       .     .            and inequitahle becuse its effcts are capricious and.
Jucomplets h4atios. Until 191, o.nly iro of the    unpredickable.:-
- tbx;i casu-to .cdre thte   wage base were reva-    A better way would be to lower promised re-
upward for todexidtion, sothis  low eredbenefits   placeme,ntrrates, reduce eary retirement, shift to a
by 25 to                i pecnt Tih m u    pension  was sp   :con-stant or rising accral rare structure, use a longer
posed to be :indexd dfbr ftioni to help low-income    averaging period for the wage base, and index the re-
worlkers, but the gsoverntent often delayed-or- sulting:pension fully to wages, prices, or a com-
tefused t Maetnflaon adjusienrs. Pensions   ination of the two. Tese reforms could cut costs in
above the 'mnimum were: Only party indeXd, so    half aftr they are fully phased in. A more radical
their real 4ue feli to the minrimum. Ilelt and    approach would introduce a reform riilar to that re-
rep4cene  rates plunmeed: iniflaftionary perods.    cendy adopted by several Latin American countries-
6;i The  short averaging period, the falling    dosnsize the public pillar, flaten its benefitsr and
accrual rates, and the high cmntribution rate encour-   supplement itwith a defined contribution plan in a
age  vi-which average well over 25. -percent   privately  anaged pilla.
- for &he past dcade. - 
pav-as-you-go while creating a second mandatory pillar that is fully
funded and privately managed.
Inflation, Indexation, and Productivity Growth
Protecting pensionis against erosion by inflation is one of the major
arguments for having a strong public pillar in an old age security pro-
gram. Wheni the cost of living rises, old people on fixed pensionis are es-
pecially vulnerable. Private insurance plans sometinmes offer indexed
annuities-backed by indexed bonds, equities, and other assets whose
value is expected to rise with inflation. But such plans may be unable to
honor their promises in times of hyperinflation. In theory, the govern-
ment can guarantee the real value of pensionis by using taxation to shift
the cost of inflation to younger generations, wlhich are better able to
'5'



- TINsfG T HE O LD A GF C 'R ISI S
Box 4.9 A Better Way: Flat and Means-Tested Benefit Formulas in OECD Countries
00SWl17EWAN TI-)EMSWISS PAY-AS-YOU-GO PUBLIC:L      The employment-related flat pension provides
pension schem.e has a two  part benefit structure.:   basic income insurance to most old people. Since it
The first partisan employment-related flat benefit  is proportional to total years of employment, it
based on years of covered employment and the se&-   avoids the problems of workers who never qualify
ond part is based on each worker'S average lifetiMe    because the eligibility period is too long and workers
cearnings. For a full career worker, Lthe twoparts    who escape contributions by entering the informal
together pay a pension varying from 20 percent to   labor market but are still entitled to large pensions.
40 percenr of the average economy-wide wage-a    Making average lifetime earnings the pensionable
relatively: compressed benefit schcdule. :'The    wage base in the earnings-related part discourages
r-equired contribution rate is only 8.4 percent (split   workers from understating eamings when they are
evenly berween worker and employer), supplement-   young or evading when they are old-and mini-
ed by a government transfer of 20 percent of total   mizes perverse redistribution to higher-income
system expenditures.                             workers whose wages rise steeply at the end of their
TIhe system has several safeguards to minimize    careers. Pensions are indexed to the arithmetic aver-
labor market, distortions,:strategic manipulation,   age of price inflation and wage growth. This protects
and perverse redistributions. The relatively low con-   pensioners against inflation-but only partially,
tribution rate dampens the effect on labor supply or   which helps put a brake on an inflationary spiral that
demand. The absence of a ceiling on earnings sub-   is accompanied by real wage declines-and lets pen-
ject to the payroll tax and the use of general revenue    sioners share in.the country's economic growth.
finance help keep the tax base broad, the required   : he Netherlands. A more redistributional benefit
rate low, and the redistributive impact positive.   formula in the Netherlands pays a universal flat
There are few opportunities to retire early (below    benefit of about 38 percent of the average gross
age 65 for men, 62 for women).                   manufacturing wage to a single person and 54 per-
adapt and recoup. In practice, many public old age security schemes do
not include indexation for inflation-or they index inadequately, so the
real value of pensionis paid after a few years of retirement is quite differ-
ent from the initial value. Inflation without indexation is the way that
most couLntries have scaled back unrealistic benefit promises.
Inflation needs to be taken into account both when setting the initial
benefit and when adjusting benefits after retirement. In earnings-related
schemes, the initial benefit level is calculated as a percentage of wages
during some averaging period. Many OECD countries use a long averag-
irg period of twenty to forty years and revalue earnings upward for wage
inflation during the period. Instead of revaluinIg for inflation, develop-
ing countries shorten the averaging period. But this method does not
adequately resolve the inflationi problem. For example, during the 1 980s
Mexico used as the base wage a simple average of nominial wages over
152



PBLIC PENST,O
cent to a couple, inded for inflation and supple-   They also leave an,4e room  i,r,e      of
menitd by special means-testedbenefits. The srs," supplemtal privatey manged *dedesion
tern is financed by a payroll tax on earnings, wit a    plas .
ceiling on taxable earnings 1.7 times,ithe average    ,None of theses nipro       ,fe Th
wage-a financing method that is less progressive   -erous    4it srce  in te Ne4er1as 4Iosr
an&dprobably also less,efficient,than that in    co- m.plytelyin     oldabutitiss
Switzelandr. Tlhe low tax ceiling and higher benfit   vesy costly'and coulIhe contriing-t-early ire-
rate lead to a hither required contribution rate of  , ment of old woki6 and unemp      t among
15.2 percent, This is augmented by payments from  young 'workers. The 'Australian  yte ':is 4rch
the general treasury (about 15 percent of system    cheaperi but rmanyold people are clust   ust
expenditures) ro.cover the contributions of very   above thed*hold,fir support, wheassome-.iid
low-income workers. The Ihigh tax cost of this pro-    dle-classraeirees may give aataytheir in.coie andas
gram could have distoronary effects,              sets to qualify for benefs. As in all paywasyo-go
AusbaP,fi  The Australian system, more redistrib-   plans, intergeneratibnal transfers he been l, es-
utive and less costly than the Swiss or Iutch sys-   p'ecially in -the Neterlands. Costs will escalate
rtems, pays a mneans- and asset-tested pension to   sharply'as the population 'ages'and, prelirminary ef-
those whos,e other incomw is not sufficient, to bring    forts -io dal wit this t problem hae provoked in1.
their standard of living to the specified levil. Abut   tens political contrsy. To relive. the prsure
70 percent of the population gets at least part ofthe    on the public Pillar, Australia and Switzoerlan  re-
public pension, financed out of general revenues  cendy niide oceupaional apension plans adaoy,
In Sum. These benefit structures, unlike .the one   aad in the. Netherlands they are virtually mnatory
in Brazil (box 4.8), minimize perverse redistribu-   as a resu of colectie bargainiig,(seechapterr5).
tion and opportunities for strategic manipulation.
che preceding five years. A high rate of inflation over this period reduced
the real base for new beneficiaries to a small fraction of what its revalued
amount would have been.
Most countries witlh high rates of inflation periodically adjust the
level of payments to current retirees. In OLCD countries, this process
tends to be largely automatic, although sometimes cost-of-living adjtust-
ments have been skipped. In developing counltries, the adjustments typ-
ically are not automatic, and they are ustIally delayed and perhaps only
parrial, reducing pensioners' real incomes. The public pension plans of
the transitional socialist economies have no atitomatic indCexing provi-
sion because prices were stable under central planning. Now that short-
ages are showing up in price increases rather than queues, penisioners liv-
ing on fixed incomes are at a disadvantage. In Mexico. only minimtIM
pensions are indexed-so, all pensionis quickly gravitate to the mini-
153



WI THE OLD AGE CRISIS
mum. In Venezuela, the average real pension fell 80 percent between
1974 and 1992 because of inflation without indexation (figure 4.12 and
box 4. 10). Ninety-nine percent of pensioners received the minimum in
1993 (Instituto Venezolano de Seguro Social 1993).
When political obstacles prevent policymakers from reaching an ex-
plicit decision to cut spending, inflation cuts real benefits implicitly, as
in Eastern Europe and the countries of the former Soviet Union. If these
countries reduce inflation, they will have to find some more explicit way
to deal with the high benefits and escalating costs of the public pension
plan-politically difficult but fairer and more efficient. Workers who
expect the real value of their pensions to be maintained do not make off-
setting plans to save when they are young and are not able to compen-
sate wheni they are old. Workers wlho are more realistic discount the
Figure 4.12 Real Pension Levels in Venezuela, 1974-92
Index of real value of pension, 1974 = 100
120
100
SO
60
40
20
Inflation destroyed the value of unin-
dexed pensions in Venezuela.
O
1974   1976   1978   1980   1982   1984   1986   1988   1990   1992
.So,urce': M4arquez (1992).
154



PUBLIC PENSIO          10
promised benefits and try to avoid making contributions when they are
younig. Inflation affects different cohorts in capricious ways. In the in-
terest of minimizing evasion and maximiiizing equity. the government
should make modest, credible pension promises to begin with and
should index pensions to adjust automatically to inflation. In an earnings-
related benefit formula, the earnings used to compute the wage base
should be fully revalued for inflation.
Pensions can be indexed to wages or prices or to some combination
of both (as in Switzerlanid). Wage indexation maintains the relative po-
sition of pensioners. It allows themii to share in the fruits of productivity
growth, but it also subjects them to the risk of falling real pensions. If
payroll taxes are expected to increase, countries mav wish to use net
wages rather than gross for the index, to hold the relative after-tax posi-
tion of workers and pensioners constant. This is done in Germany and
Japan (box 4.1 1). Price indexation holds the real value of benefits con-
Box 4..10 IfatOand lftion  nder Public Pensin Schemes
ALTHOU<GH AUToMATW-ri( l mAToN; QF- PUS-   Mexico, for example, the scheme covering private
lic pension, benefits is now cotrn in most indu  sector workers averages the last five years of wages to
trial countries, cthemajority of de ping ountries   determine the pensionable base, while the civil ser-
adjust pentsion levels for in-flRain 'only' irulary,  v: rice sche' e looks only at the last year's wages, yield-
on an ad hoc basis. Many Latint American countries   ing a .rituch higher base in inflationary periods. Pub-
and transitional socialist .economis Idex. only Ithe   licly managed pension reserves in Tunisia, Turkey,
mtinimnumi pension..  igh ates of inflation have   and rany other countries are invested in public
driven average real pensionswn.toward the minii-   bonds' denoriinated in nominal terms. The bonds
mum, with,as many as 40 t'o 70 percent of pension-   earn negative returns, and the funds become decapi-
ers in thtese: ',regiorns now .rec:eiving only the mini-  talized,during inflationary periods.
mum pension. Industrial :untrries also,,did not    The average real pension fell 80 percent in
index pensiors before World War:'r For example,. Venezuela between 1974 and 1992, 30 percent in
real pension levels felldrastucally in Germany duirig . Argentina between 1985 and 1992, and 40 percent
the hypetrinflation of the 1920s.               in Hungary during the 1980s (figure 4.12). These
Inflation, aflJicts pubic pnsn benefts and rc- ' and. other public pension schemes failed to protect
serves in other ways as.well. Iii earnings-related de-   the ol firom Iiflation. Because uncontrolled infla-
fined benefit sche mes, high Inflation rates re-duce the   tion te',nds to be a country-specific risk (and is often
real value f tihe pensioinable base salary, if past wages   accompanied by devaluation), a private scheme with
are not revalued upward in, his calculaion. Many    some international diversification of pension fund
countries have multiplte scheme, with those in  ip:vestment (and so.e investment in stocks and real
higher-incoinie oupans   t eeng better   estate) would.provide better protection to the old.
inflation protection_than thegeneral labor force. In          (Box continues on thefollowingpage.)
'55



40 G THE OLD AGE CRISIS
ive when written into law, indexation is not a   What's to be done:
solid Mguaranret. When inflation is particularly high,
hth  overnment rnay decide to ignore indexation    0    Index pensions automatically to price inflation
previsions, introducing the issue of political risk.  or to a combination of wage growth and infla-
Brazil delayed implementing indextion provisions     tion, taking care to set a real value of pensions
fduring periods when the price level soared by 1 per-  that can be maintained under difficult fiscal
cent a dai. The United States suspended inflation    conditions.
hiexatiin for one year in 1984. The 'index skip"   U Pursue complementary policies to protect say-
lasted thfee years in Belgium in i983-85 and two     ings from inflation, say by issuing inflation-
years in New Zealand in I992-93. Suspensions like    indexed bonds and encouraging the develop-
these may be= warranted when they are part of a      ment of financial markets.
tpackae of reforms designed to reduce everyone's   * Avoid the temptation to require pension funds
claims on the national budget, but they are not a   to invest in government bonds, often at nega-
good substiture fbr real reform.                     tive real interest rates, and thus to decapitalize
When governments reduce real benefits to solve a   the funds.
fiscal crisis, they default on their implicit promise of  a Encourage internaEional diversification of pen-
income security for pensioners-and in a way that is  sion fund investments.
most harmful to the old. Older retirees end up being   If earnings-related pensions are used, base
treated differently from  newer retirees, current    them on lifetime average earnings, revalued for
workers lose faith in the system, evasion increases,  price inflation or wage growth, before applying
and the financial problems of public pension pro-    the benefit formula.
grams intensify.
stain, protected from price increases or wage declines, but their relative
value will fall when real wages rise. If a country expects real wages to rise
over long periods, indexinig to prices or partially to wages and partially
to prices vill hold costs per pensioner down and help cover the rising
costs of the demographic transition. It will also help countries garner the
resources for the shift to a multipillar system.
Conclusion
A        S  A RESULT OF P'OLICY CHOICES BY GOVERNMENTS AND RE-
sponises by individuals attempting to get the most while pay-
ing the least, the actUal contributioni rate required for systemll
solvency is often much greater than the rate determined by demogra-
156



PlUBLIC PENS       10N<
Box 4.11  ShouW  Public Pensions Be Indexed to Plces or Wages?
MOST OECID COUNTRIES AND SOME DEVELOP-   silient to external shocks that alter real wages. Austria
ing countries adjust pensions for inflation, but they    and Mexico are among the countries using wage in-
differ as to whether they tie these adjustments to   dexation. Germany and Japan index to,disposable
price or wage changes. Under price indexation pen-   wages; when payroll taxes increase to cover the risiag
sions move with the price level; their absolute real   costs of social insurance, old people share the burden
value remains unchanged. Price indexation means   with workers by getting lower pensions. Othercoun-
that the risk of changes in the standard of living that   tries may also move in this direction in the future.
sometimes accompanies inflation is borne by the    If productivity is unchanged, indexation to the
young, whose contribution rate would have to in-   wage level is equivalent to price indexation. But if
crease if the economy slowed. The insulation of the    productivity changes-whether because of random
old may make it more difficult for governments to   shocks, cydical decline, or growth-wage and price
cut back on the high aggregate demand that caused   indexation will yield different real pensions, contri-
inflation in the first place. Price indexation also   bution rates, and degrees of old age security. Which
means that the old do not share in any productivity    method people prefer depends on whether they care
growth that occurs after they retire. The argument   more about their relative or their absolute position
fGr price indexation is that old people are less able to   and whether they are willing to pay a higher payroll
adapt to falling real incomes than young people and   tax now for the possibility of a higher consumption
are less concerned about rising real incomes, since   level after retirement.
their consumption habits are already established.  When productivity is rising, wage indexation
Canada, the United Kingdom, and the United States   holds the required contribution rate constant if all
index pensions to prices.                       else remains unchanged, while price indexation al-
Under wage indexation pensions move with   lows the contribution rate to fall. Policymakers may
wages. Old people share in higher real income when    wish to use the fruits of productivity growth for other
wages rise and in shrinking real income when wages   purposes-for example, to offset the rising depen-
fall. The argument for wage indexation is that young    dency rates that are expected during the demo-
families should not be expected to bear the full brunt   graphic transition or to provide the resources for a
of drops in real per capita income and that old peo-   shift to a multipillar system. Using price rather than
ple should share in the fruits of any economic    wage indexation would help to dampen the contri-
growth. Wage indeaation also helps keep pensions    bution rate increase needed to meet these other chal-
equal for all beneficiaries in systems that pay a flat,  lenges. If people care about both their relative and
means-tested, or minimum pension, where pensions   absolute positions, while governments want to cap-
for new beneficiaries are likely to rise with average   ture some savings from productivity growth, the best
wages. Moreover, since most public pension pro-   position may be a fifty-fifty combination of wage
grams are financed through a payroll tax, wage in-   (possibly the after-tax wage) and price indexation, as
dexation makes the system as a whole relatively re-   in Switzerland.
phv alone. But the high tax rates lead to still higher evasion. Ultimately.
the system has become unsustainable in many countries. More basi-
cally, the system has become unsustaiinable because it has impeded eco-
nomic growth.
157



RP-1T  THE OLD AGE CRISIS
In Latin America and the transitional economies of Eastern Europe,
high payroll taxes have increased business costs, pushed labor into the
informal sector, led to widespread evasion, and diverted spending away
from important public goods. A number of Latin American countries
are now making radical changes in their bankrupt pension systems as
part of an overall reform of their crippled economies. In the transitional
countries, too, the pension systems and the broader economies have
broken down, but policymakers in these nationis have not yet decided
how to repair either. In virtually all of the developing countries, even
though retirees frequently start out with generous pensions. these belle-
fits have not been well protected from the ravages of inflation and other
economic shocks. In addition, pension reserves have been depleted by
inflation combined with government borrowing at low nominal rates.
The old remain insecure.
OECD countries are seemingly in less trouble because of better func-
tioning labor markets, greater ability to collect taxes, and lower inflation
rates. But public pay-as-you-go schemes may have dampened long-term
saving and capital accumulation relative to what would have occurred
under fully funded schemes. And earl) retirement ages combined witl
earnings tests for pensions have helped diminish the labor force partici-
pation rates of older workers. As the baby boom generation retires,
OECD COuLntries will face tough choices betwveen raising tax rates, cutting
benefit rates, or diverting spending from  other important public
goods-choices that will be all the more difficult if old age policies have
impeded growth (box 4. 12).
Have the insurance and redistributional gains been worth the price?
Despite their poverty alleviation goals, the intragenerational redistribu-
tions by public pension plans have not been very progressive, are often
capricious, and are sometimes perverse, favoring upper-income groups.
The biggest redistributive effect has been intergenerational, toward the
first few cohorts of retirees and away fromii later cohorts. In industrial
countries, this positive transfer probably deserves much of the credit for
reducing poverry among the old and providing longevity insurance in
the last three decades. But these transfers are about to end-and turn
negative.
fEor developing countries tomorrow, just as for OECD  countries today,
the demographic transition and system maturation will create severe fi-
nancial and intergenerational strains for public pay-as-you-go plans. To
improve their financial sustainability, efficiency, and equity, these plans
158



PUBLIC PENSN IO
tw,exv eitpccsed iizttwtpe*wio  &a,.,tib4o*it . .d  WIin'he.Unted Starej pensions of.high-income
payouts. The pre,snt v4nt.ofbcndim4~bsHw              rctireWs have hecome taxable, inlatJion iadexa-
be paidbet3i                       ,',we  aon25ee.4pk  issipdnone year, payroll taxes
val0f      tfi+td   t+fi.c ,:e4aad .s.he  for raising the
(bo tbl  YI ehwn4  Tkflc    dejat i$.-"                 4i#ne Kingom    ublc pensionenride-
plie    Ss      f   d.d4Sc qng                    '                    i: 1988 frotn25 percentof
many d     coun$s bu 4rieorct Iec :f   :;e bes twet yers ot earnin}gs to 20 percent
real $,psio  cts, a  S%her                   ,' ": '       i   o   die entire wori  life.
- the ,rotag pension&f l&                     ' -       a  'rese the   niber o corribtinion
:-.AhPav t up  OW&hqukiXsrsa.vy.se  in cakularing pensions and intr-
eroded b,nes and aised     nll         :.             di, wd a new'income tax,'earmarked fio the
. . .  ' .'. <:    ; ~   '                         (fl.x can#n:r:;a..:  :e:fl/lowing pa.
0)  ktdtringrama                   ~~~      ~      ~~(4)  (5)
$'~~'4t ~C9O~~     .&equired        Requ~ioredlei
Co'un,"iy' ';2                  -'                  -                       "qsug  'en  age'
-5& '''.  'S                                     ZO lE  ' iS uS.'    ''16'
Frac  ...I ' =5'    tO                                                 6
Gemay        ,       ,; 1,.,6R,   *;i,0 ',/f    s 2(4  34 ;" i" .    ,  0 i    -- ,1
~~~~~~~~~~~~~,                                                              8a...  ,;i..->.X.  ..........  .1
: taly0    i
b. bl,Hlnvt *r A > i>$ ~~~~~4"                                  29:F-P°tl !° GDP,
Jaa  i                            6Sw.8                 44'          tt 30     i9z 
1Jni~djQgctx.   f18i46 -3.'a5                                                       1
UairedSran    p434~~~M         4A                          , 5
159



T,.HE OLD AGE CRISIN
W De1~i~un r*4~ved rpal pension levels through    4). "he l1st option shows how Manyerswld
- '~ *~al '.: 'k~ps~ i4P,0;is n,' 9 . U0d,: eary, 1980-s 'haveto ;be aded tOhe :present retirent age to
-  ., r~at1y h. }g. +i gradu4ly re4ng  ts :re- f4eliminate the pension revenue shorfiAll (colum  5).
* * emeXr rat# fos'rnulag linkog to  posttax    If no chianes are Mad icentpsio  pro-
rai:e~ .han pkerazwage * ~ ig;:  ;  ;;f-: :::0f;  granms, cotibutionscwouldhavebtoubeograduaually
* V rttiounced a planned *lihe-ye  increase in    coeasedb5 to     t 6 perceit of GDP ii in ost countcs
- ...rein~nr~.:          --.an. :- ;;. t00;:.-d y almiost 12 Percent in t  (         .Ti
,.  J..~ n red;ed ;l i c she--; benefit accl s.  ;iIMPl n agradual payroll cas increase o(fabout 15 to
2.) prcentage..points, ,.eend,  on the .oun,,  I.
* itese-ad hoc *dt,srmexus are far from sufficient.    paitial funding fis used.taxes would have to rise 3
A    A tct     ptI gap for   to 4 pecent ofGD?, requiring an iimediate Payroll
~eft  u4 xs ad e3Va atn rade    tax &icease &of hbout 9, to 12 percentag  in  in
that~ would bIF treired r+ coveprje0Mcted defi:CIt    most countries. At least part of the utenwould
ov             if current benefit poliies werun-  $probably      on pensioners, in a: contitiuaition f th
changed (column 2). This io  arie *sce§nano was process of benefit erosion that began in the 1980s.
cotnpased wish three hypothetical refc ns-ch to    Achie-ing pensionw fiind balance through wage rel- 0
..ert imsi dia#-ro balance pension- finunces par- f uarion for pensions would require cuttingdthe ad'u
tigl  ning. asti* wagein4eiatn    beftor  icu fr ecnm-iewg  rwh by at least half.
'mulas,                           aioUa 4                 the etir nt gwoldr         postpong
pe;rcent discoutarii e    rhe period19901   re-   re tirenti for eigttotevd* yers, a politicallyrim-
ducing it gradually t re   o 3 perLcnt   aia-   Possible option in the shott rn but muh more
'uroc real wage growth 'f 1'' ,enr .Int  ite d    ikey in trhe long rin. In fact, later retirement0 is both
ttd W:t2peitt           her ol cnc ountrpobable and efficient.
e parti     din' opn entlsaone-time    hike       These options do nor eust the possibilities6  but
in   cu           i"      iirare tmass a, tetnporary   they illustrate some of hchoices D   cnti
surpus so be4 use  to pay   rtising pesion  nefits   will have to  a.T    decisions lie ahead. Will
(column ;. Public $w¢nptioiar i sehexn  in apa andathe    pensio  benefit levels fil, and how will that affect
*thed Stat    rI filning but,nor   the old, jwhose incomes are already Ilo   Will rising
-r~u~h ~ ~ov~ -he e $ shorall The second:optiorn, re-,  payrol 1and othereseapdbwerswse
4~w   dxodioouldworhY-curtipback    wages ae gro INgsly or not atiall? Will Other
osi she upward -e~ahtion.- ef the pensionabl wagie government prams be cut in order to cover pen-
base; pensior ne.t wou-d ;e smller because they   sion ec? W illgovernmentpensiopnpromiseslos
wotild gs, longer reflect the IIry gain that   credibility? n:shoti,Jt wilpublic penss sur-
has r.kW laeovrth   o&  lifeime (clun   'iv in thYei fu       presnt  :form? 'f 0     ff:f fff0:f fff0f:
should be reformed in a nuLmlber of wvays, depending on their starting
point (box 4.13):
* Raising the retirement age, reducinig opportunities and incentives
for early retirement.
I6o



PUBLIC PENS10iA,
Box 4.13 Key Features of a Reformed Public Pilar
THE PUBIC PIUAR OF AN OLD AGE SECURITY                   accnal strucure that rewards workers for stay-
program should offer benefits that are fairly distrib-   ingin the system. Short-term workers should
uted, adequate as a safeguard against poverty, yet af-   get a 'reduced pension hu,t should not be ex-
.firdable and therefore sustainable in the long run.      duded en'tirely.
The following elements of a public pension plan are       The retirement age sould rise rguarly with life
essential on their merits and as a prelude to a more      rpetaccy fbr the country as a whole. Early re-
basic reform-a trnsition to a multipillar system         tirernent schemes have been a major source of
that also incorporates a decentralized funded retire-   financial problems in pubhc- pension schemes
Ment plan     '                                          and ,a negative force in the economy. Early re-
tirees should have their.benefits reduced and
-.  A fiat or a means-tested pension or a minimum     late retirees should have their benefits increased
pension guar4%ntee to a mandatry saving plan is     in an actuarially fair way,
the simplesr, least costly way ofproviding a min-     Measures to redsice the costs of the old age,secu-
'mum, level of security, to all. For high-income    rity system can be complemented by measures
countries flat benefits could be univeral and fi-   to increase revenues, such as increasing or elim-
nanced from  general revenues. For lower-           inating.the ceiling on taxable earnings, shifting
income countries benefits could be tied to years    to a broader income or consumprion tax base,
of service in covered, employment and financed      and investing the reserves of partially funded
through payroll taxes. Countries with significant   schemes o marximze returns.
flat or means-tested components to their public.  A Pension reserves should be kept separatefrom gen-
pension plans spend less than other countries on    eralgovernmentfinds, and investments should be
old ag security, and this spending is better tar-   diversified  Forced investment in govemment
geted toward the poverty alleviation goal.          securities, which often results in negative re-
is Benefits should be set at a realistic level that in-  turns, should be ivoided. Better still, because
sures people against poverty and should be in-      such changes may not be politically feasible and
dexed (to prices or to a combination of prices      pension reseves will continue to be diverted to
and after-tax wages) to retain their value    -     low-yielding government projects, the public
through time.                                       pension plan Lshould be run on a strictly tax-
a Whle an earnings-related scheme is not recom-       financed Asis. Pension reserves should be accu-
men4ed, if one is used, the wage nsplacement        mulated in a privately managed pillar that is
rane shUld be baed on ifesme earnings, with an      more sheltered fron political influence.
* Lowering statutorv replacement rates in cases where they are now
coo generous.
* Making the benefit formula relatively flat, means-tested, or a min-
imum penslonl guarantee.
* Tying the earnings-related component (if there is one) to long-
term wages.
* Reducing contribution rates but raising ceilings on1 taxable earnings.
16i



RtATING  THE OLD AGE CRISIS
* Eliminating pension reserves that invariably earn below-market
interest rates.
* Indexing for inflation or wage growth.
Nevertheless, because commitments to retirees and workers nearing
retirement dominate the total costs of the system, the short-run impact
of many reforms is limited. These commitments were easy to make but
are difficult to reverse-a reminder that initial costs in pay-as-you-go
schemes are misleading and old age security requires very long-term
planning. To avoid future shocks, countries currently formulating or ex-
panding their old age systems need to calculate the long-term financial
viability and intergenerational implications of their plans, taking pro-
jected demographic changes into account (see chapter 3 and issue brief
3). In the past, few countries have done so.
Are these problems endemic weaknesses or incidental design mis-
takes? Their universality suggests the former. The problems are greatest
in countries where the public pension plan is supposed to do the whole
job of providing old age security, with little if any help from other plans.
In this situation, the public plan is inherently in conflict because it is
asked to meet multiple but incompatible goals.
If the system is actuarially fair it provides a form of insurance and sav-
ing for workers but does not meet the redistributive objective. If it meets
its redistributive goals, it fails to link benefits closely to contributiolls,
encourages distortionary evasion, and is not a good instrument for sav-
ing and insuranice. The combination of multiple conflicting goals leads
to an expensive, complex, and nontransparent system that is open to po-
litical manipulation and ultimately unlsustainable.
The complexity of a dominant public pillar enables influential
groups to exert political pressures for design features that are neither
equitable nor efficient-from which they benefit while passing the hid-
den costs on to others in their own or future generations. Such a strat-
egy is especially tempting when populations are young, systems are im-
mature, and politicians are concerned about today more than
tomorrow. This political perspective helps explain why the design flaws
described in this chapter-early retirement, high contribution rates
that are evaded, low ceilings on taxable earnings, overgenerous pen-
sions for the first generation of retirees, and greater benefits for the rich
than for the poor-are so widespread in both industrial and developing
countries.
i62



PUBLIC PENSION PLt:
A multipillar old age security system reduces these adverse political
pressures. The saving functioni and part of the insuranice fuictioni can be
turned over to a mandatory, fuLided, privately managed competitive
schemile in which beniefits are directly tied to contributiolIs, so reducilig
the incentives for evasion and the opportinities for manilpulation. T his
scheme is likely to have a more positive effect on national saving, labor
productivity, and growthi. Planninig for tomorrow is built-in. The extent
and direction of redistributioni and the degree of coinsurance needed
from the government will then become muchi clearer and more explicit,
and these functionis canl be carried out through a redesigined and more
carefully targeted public pension plan.
I63






CtER 5
Occupational
Pension Plans
I   N MOST COUNTRIES THE FIRST PENSION SCHEMES WERE
both occupational and public-set up by the government to
cover its military and civilian employees. In some low-income
countries these are still the only groups covered. But in middle-
and high-income countries, eveni as public sector employees
kept their superior benefits, the concept of pensions tied to
emiiployment was gradually extended in two directions: publicly run
plans were established to cover all formal sector workers and supple-
mentary occupational plans were established by many private employ-
ers. Today'. occupational plans cover about one-third of all workers in
OECD) countries but far fewer in developing and transitional countries.
Unlike public pension plans (chapter 4) or personal saving plans
(chapter 6), occupational schemes are sponsored by employers, usually
voluntarily or as a result of collective bargaining. Their big advantages
are that they can be launched with little direct government involve-
menlt and relatively low administrative costs-and their contributiolns
are Lnlikelv to be viewed as taxes that people try to evade. But their
coverage is uneveni, their benefits are not always trustworthy, they dif-
fer significantly from one employer to anotlher, and they often are not
transferable. This last feature distinguishes them from the other kinds
of old age plans and raises efficiency and equity questions.
Both occupational and personal saving schemes enable workers who
earn more during their active years to accumulate larger pension rights
for their retirement years. Countries must decide which is a better com-
plemenit to a redistributive public plan that provides a floor to retire-
ment income.
I65



iiwE g-G  T HE O LD AGC;E. C' I lI
Brief History
O        NE OF THE FIRS T OCCUPATIONAL PENSION PLANS WAS SET
up in the United States in 1776 (the year of independenice),
providing half-pay for life for soldiers disabled during the
Revolutioniarv Wvar with England. Old age benefits for those in military
service were added in 1780. By the early ninereeith century, civilian
public sector workers in the United States, rhe United Kingdom, and
other counitries were receiving pensions from their employers, the gov-
erminenit. Within the private sector, employers paid lump sums to retir-
ing employees on a discretionary basis-to reward them for their long
and faithful service-long before formal pension plans were estab-
lished. This practice is still found amoing family-owned firms in devel-
oping coulitries (Williamson in Turner and Beller 1992; Schieber
1989; Hannah 1986).
Formal pensioni schemes became popular in many industrial
couLtries in the second half of the nineteenith and the begrinning of
the twenitieth centuries as a tool of personnel adminlistrationl for
large corporationis-to encourage retentioni of workers with valuable
job skills and to ease older workers, whose productivityl had de-
clined, into retirement. The offer of deferred payment also deterred
fraud and embezzlemenit amonig money-handling clerks in banks,
railways, and gas companiies and induced loyalty among persoiiel
with access ro confidential informationi about newv competitive tech-
nologies. In these situations, pension plans may have raised produc-
tivity, wilich in turn supported a higher level of compensation. Some
workers may have preferred pensions to wages because group plans
overcame adverse selection problems that limited their access to an-
nuities markets.
Employers treated pensionis as discretionary benefits, not as em-
plovee rights. Most plans were defined benefit, largely untfunded,
skewed toward senior workers and managers, and lost by workers who
left the company before retirement. Thus, besides the efficiency reasons
for offerinig pensions instead of simply offering wages, employers also
offered pensionis because they did not have to pay until much later and
perhaps not even then. Before World \War 11, these plans had few fi-
nanicial problemics because of their limited coverage, modest benefits,
small numliber of pensioners, and fast-growing industrv.
i66



OCCUPATIONAL PENSION PL,
Increases in income tax rates and changes in tax rules in the decades
following World War II encouraged the expansion of pension plans and
the creation of separate trust funds. Most countries made contributions
to occupational pension funds tax deductible and deferred taxes on
their investment income. Thanks to these tax advantages not available
to personal pension plans, workers and employers alike considered oc-
cupational plans a desirable substitute for higher wages, so their cover-
age and assets grew in most OECD countries. Further growth occurred
more recently as occupational plans became mandatory in Australia
and Switzerland and quasi-mandatory as a result of collective bargain-
ing in Denmark and the Netherlands. Japan and the United Kingdom
allow employers to opt out of the earnings-related part of their public
plans and into occupational plans (box 5. 1).
Currently, about one in every four old persons and more than one-
third of the working age population in OECD countries are covered by
an occupational pension (table 5.1). As such pension plans grew in im-
portance, problems and pressures to regulate them also grew. Although
social security pensions are larger than occupational pensions for low-
income workers, occupational pensions are more importanit than social
security for high-income workers in industrial couintries. They also are
heavily regulated.
In developing and transitional economies, this move toward occu-
pational plans is at an early stage. In most cases, employer-sponsored
pensioni plans cover pLiblic sector workers, and the coverage of private
sector workers has been growinig in such countries as Brazil, India, In-
donesia, Mexico, South Africa, and Zimbabwe. These countries and
others must decide whether to adopt policies that encourage, constrain,
or regulate the spread of occupational pension plans-as a mechanism
for achieving the saving or consumption-smoothing function of old age
security systems (box 5.2).
How Occupational Plans Work
W HE HETHER SPONSORED BY SINGLE OR MULTIPLE EMPLOY-
ers, occupational pension plans can be defiied benefit or
VrI  defined contribution or partially or fully fLnded, and their
economic impact varies accordingly.
167



T   N: G~ T HE o LD A GE c RI SI[s
0oi SE Recent 0evelopmts in OccpatonalPension Schemes
IN O      COuN  lTRIS OHERE IAS EEN A SLOW    limited portability beyond the minimum amo unt
trend to,    ig  Occupational plans   -dat       may restri mobiity, and low:rturns are eare on
to reducethe burden on the iublic VpWiar, while reg- these pension finds. Moe recently, Australia intro-
uAg         to i,pose minimum st        of vs    duced mardatory provision of funded occupational
irig, p- ltyand  ndin, l in teaig t 0h rol   tpenrsion (nnuation guaranteechar  (see
o-:    ocdaa plans aree pionsathpat allow em-    chaprer 8). In Denmark and the Netherla    ma0ny
-  -   ; . .   ;f  t ,r  .- ps   t                                     herl. Es
p::    ers toopte-   out Of, p c P,lans, i   theymneet cer  occupational plans are estblshed on industry-wide
tam  minimum con4irions.t :00   :.0-;           lines and coverage is extensive, with participation
In Switzerland, a -constitutional amendment,   often compulsory as a result of collective agreements.
paised ln 1972 nieendin 1985, iposed pThese, too, are funded and they vest quicdy. 
on all emplolyeirs the obigaio  to,provide pension  In the Unitd Kingdom, where the state offers an
benefits:to their employees. The law requires seprate   earnings-related benefit and an employment-relat
fudindigind im pses  0inum  conditions akin to   flat benefit, employers are allowed to co6ntract our of
defined contribution schemes ( ajt; ugh defined   the former:but not: the latter. Anemployer who con-
benefii schemes ofering greter benefits can also be   -tracts out must provide either a defined benefit
established). The pension  law expanded coverage    scheme with a pension at least as generous as the
among rnmployees of sm all' firms, but in many to-   earnings-related public pension would have been or a
spects, itV simply: reatirmed   ng pracie: among    defined contribution scheme with a minimumr con-
large employers. Minimum contibutions are vested   tdbution rate at least as great as the contribution that
immediately, while employers' contributons beyond    would otherwise have been paid. Contacted-out
the minimuum vest grdal.Two ptobleins remain:   benefits are indexed (partly by the company and:
Single Employer or Multiemployer
Occupational pension schemes can be industry-wide or company-
based. Industry-wide schemes, which are common in continental
Europe, facilitate transferability of benefits. Company-based schemes
predominate in Anglo-American countries, supplemented by multi-
employer plans in sectors with high labor mobility, such as construction.
Occupational plans in developing countries tend to be single-employer,
covering workers in civil service, public utilities, financial institutions,
large corporations, and local subsidiaries of multinationals. For both
types. administrative and marketing costs tend to be low, since they can
easily be added to existing payroll systems.
168



OCCLUP'ATIONAL PENS               JO
vart1~i b| _heo        t)3 d are0 insured by the    t ihe  p.tcin as _they grow  dler and find the ac-
Aht~sr  U~        k ',forc i,s ow, ,,,,V,    .,',,cru il rar ,e iula more attractve. To prevent this,
- e',red- 'by be4, i0 cornr+,cte  to opat al '--.-     United Ksgdo;x  hlias giv.en larer rebates to,
sc.hernes, As       . :tes~  a   ntis,  psl" -. ,w,or,kerswer 3.0 wh&s   out i thei sta sysrem anl
-   f t  ant      wf .                             h  raiitcntribti atefthose Who stay in
.:me 'a  .I er4.-xeof~  in~ the Unl4 ~ixd -xz   :(Dsneyand hir ehose l 992).
, th  i4#d,res' (tae 52'. Ut :"""' O" :pt   out o:f thg, ernings-reated pa   of the
more- r,    prsonsa,   wo+ers X opt oi,t. ,of  p*& 'he, is -also per]mitted in Japan, but the
bo" h i:+  ,e ,inblii ai  4 l    'ad   ,conditiOMs  re, more sringenit.Ony large employers
plans and into theii o~i pptrnaI               ;,'aln plns:'a~ el,digible. .They must provide a pension that is
d aut  ';ofrEi    l,s  o,remge,iius than the stare penston, th"y get a
th' s . Iwo i s ,   t'offtii                      sl    d on in reqi  o ial secity   tri-
schemes itt the ~~ttture.' butions and th fiinds nmust be tuxncd over-to a trust
, : ,e,se  . p   llotts dirn *te  d i,+e po 'a':s or aninsurance ornpany approved by the gov
te;aof',;elaed                        r,s,ic-    eme.   bontaeted-ou, benefits ate insured (and
6workr, ` h  itrk4,  y    '.I  I,iag..an'ipa  '   a '   inde) by the gove,rnment, a service that is
out.. Arce  s     in      t        gom  O               for  y premiwns levied on the Lemployer
. that the    b4ftecr*   4thoigh sniaL . .eIii~   (Turner 1993ia) As a resut, the ocupational, plar
got eve.. ...    e             X w     itter . n    in Jiarge, but not as large as that in the United
- parriciAar,~ young workers .;a  tended to contrat   nKingo.
out; ithe.pubi yte . wil be tn finaca trouble if.   :- ....................
Defined Benefit or Defined Contribution
Occupational defined benefit plans provide an annuitv based on a
specified formula, as in public pensioni plans. The benefit usually de-
peends on years of service and the worker's salary over the last few years
of employmenlt. Sometimes workers are required to contribute a per-
centage of their salaries to the pensioni plan, with the employer mak-
itlg Up the difference. Employers usually retain the right to fire work-
ers, terminate plans, and convert accrued benefits to a defined
contribution plan. Most important, benefits are vested (or owned) and
portable (to another plan) after a qualifying period of employmenlt; if
workers quit or are dismissed before vesting, they lose the rights to
I69



4GC THE OLD AGE CRISIS
Table 5.1 Occupational Pension Coverage for Selected Countries, 1980s
Plercentage of  Ocupational            Occupational
labor force         pension              pension
covered by        recipcients as         assets as
occupational      percentage of       percentage of
Country                 pension         persons over 65    GNP (1990-91)
Austria               less than 1 0
Australiaa                   60                13                 39
Belgiumn                      5               -                   -
Brazil                        3               -                    4
Canada                       45               42                  35
Costa Rica                    4                 2
Denmarkt'                    -                  3                 60
France'                      80               -                     3
Germany                      65                18                   4
Greece                       40                -
Hong Kong                    35               -                   -
Ireland                      50
Italv                         5               -
Japan                        38                10                   8
Nerherlandsb                 82                72                 76
New Zealand                  27-               -                  -
Norvay                       25                -
Sourh Africa                 70               -                   57
Spain                         3                -
Switzerlanda                 92                28                 70
Trinidad and Tobago          -                  8
Unired Kingdom           50-60                 33                 73
United States                55                25                 66
- Nut availiable.
Aote: Private sector labor force coverage is less thani 3 percent for most other countiiries.
a. Coverage by occupational pension1 is compulsory. In Franice moss occuipational pen-
sionis are pay-as-you-go.
b. Coverage quiasi-comIpulsory, arranged by collective bargainiing.
Source: Data for varying years in 1 980s.
Colunimn I: OFD countiIries from orcEC) (1992). except Japan and Switzerland, which
come from Turner and Dailey (1991); Brazil from initernial World Bank files; Hong
Konig government (1992); South Africa (1992).
Column 2: Auistralia. Canada, Nerherlands, anid United Stares (I 985) from Luxem-
bourg Incomile Study; for Germany anid Denmark (1988) fromii Eurostat (1992); France
(I 988) anid Switzerlanld (1987) fronit T urimer anld Dailey (i199 1); Japani fronit Yuittiba
(1990); United Kinigdom (1986) fronit Daykin (1990). Data fur Trinidad and Tobago
(1983) From Pan-Anmerican Health Organizationi (1989d1.
Column 3: from Davis (1993). Brazil from internial World Bank tiles. Mouton Report,
South Africa (1992). Sce rable 5.2 for riores.
170



OCCTPATIONAL PENSION,
Box 5.2 Occupational Pension Schemes in Developing Countiies
IN DEVELOPING COUNTRIES, AS IN INDUSTRIAL    sion plans may not be able to keep their benefit
countries earlier, occupational pension plans are few    promises.
in number and mainly cover employees of govern-     The limited coverage of occupational pension
ments, public enterprises, financial institutions, and    schemes and the absence of regulations have enabled
local subsidiaries of multinationals. Publidy man-   companies to impose stringent vesting and portability
aged plans for public sector employees are the most   restrictions. Vesting of ten to fifteen years is common
common, and they tend to be more generous than   for pension schemes that offer only minimal benefits-
other public plans.                              and as many as twenty-five to thirty years when bene-
Company-based schemes are found in some    fits are more generous. Moreover, the benefits have
countries formerly under British rule, such as   limited portability, posing possible equity and effi-
Cyprus, India, South Africa, and Zimbabwe, and in   ciency problems if the plans should grow. Workers
countries in which multinational corporations have a    with many years of service may be reluctant to move to
strong presence, such as Brazil, Indonesia, and Mex-   jobs in which their wages and productivity may be
ico. Such plans are rarer in countries with extensive    higher if this means they will lose their accumulated
social security systems, such as Tunisia and Turkey,   pension rights. Some who move may be uninformed
or with well-developed national provident funds,   and may lose their pensions unexpectedly. Normal re-
such as Malaysia and Singapore. Company-based   tirement age varies considerably and is as low as 50 to
pension schemes are often established to meet a    55 years in many countries. Workers who join a com-
country's obligatory seniority and severance payment   pany at age 20 or 25 and remain until age 50 or 55 fare
rules. In Mexico, companies use pension schemes to    well under these plans. Others get little or nothing.
avoid layoffs: employees are induced to retire volun-  South Africa, which has long had well-developed
tarily by the promise of a pension equivalent to-but   and well-regulated private pension funds, in lieu of a
receiving more generous tax treatment than-the    large public pension plan, is an exception to this pat-
severance pay to which they are entitled.        tern. So is Indonesia, whose national provident fund
Since regulations do not require full finding,   has operated with very low contribution and benefit
pension schemes are frequently unfunded or only   rates, allowing company pension schemes to fill the
nominally funded through book reserves. In many    gap. Indonesia recently passed legislation to regulate
countries most interest and capital gains are tax-free,   occupational pension funds, which is likely to lead
so concentrating investment income in pension    the way for regulatory reform in other developing
funds offers little tax advantage. But unfunded pen-   countries (box 5.6).
their pension benefits. Even those who are vested normally lose some
of their benefits.
The employer thus bears the investmienit risk, bur workers bear the
risk of employer insolvency and job mobilitv. Workers also bear the risks
that their waages will fail to rise late in their workinig years, which will re-
duce their pension as well, and that inflation will erode their benefits
after retirement, since benefits are rarely indexed.
Defined benefit plans can be funded or operate on a pay-as-you-go
basis. Pay-as-you-go plans are self-administered, whereas fillv funded
17'



N:G THE OLD AGE C R I SI S
plans, especially those of small employers. are often administered by life
insurance companies. Plans covering civil servants and military personnel
are usually pay-as-you-go. Unregulated plans in developing countries are
largely unfunded. The mandatory private occupational scheme in France
is also pay-as-you-go. Many German companies use a "book reserve" svs-
tem in which pension obligations appear as liabilities on the books of the
companies, deductible for tax purposes, but are used internally rather
than being placed in a separate trust. This facilitates corporate financing
out of retained earnings but is otherwise very similar to pay-as-you-go.
With the foregoing major exceptions, most defined benefit schemes in
the private sector in industrial countries are substantially funded. Tax pro-
visions often encourage funding. and regulations sometimes demand it. In
a competitive world economy, with an aging labor force, the risk of em-
ployer default is substantial in pay-as-you-go schemes (see below). Fund-
ing reduces this risk but also raises the cost of pensioni plans to employers.
In defined contribution plans, the worker or the employer or both
contribute, with retiring workers getting a lump sum or annuity that de-
pends on the contributions plus the investment income. Thus, defined
contribution plans are fully funded by definition-and easily integrated
with a national mandatory saving plan. Often, they are administered bv
life insurance companies or other financial institutions. Workers some-
times have some choice about how their contributionis are invested, but
usually the choice is limited to selecting among bond, equity, and
money market finds specified by the employer. There are relatively few
vesting and portability restrictions, especially if the plans are financed
primarily by worker contributions. In other words, employer solvency
and mobility risk are less than in defined benefit plans, and workers also
beniefit from diversification-the pension is not tied to their wages or
place of employment-but they bear the remaining investment risk. If
the accumulated capital is insufficienit to pay them their expected pen-
sion, the employer has no responsibility to bail them out.
Economic Impact
UN NLIKE PUBLIC PENSION PLANS, OCCUPATIONAL PLANS,
when funded, have important positive implications for the
operations of capital markets. Their impact on labor mar-
172



OCCUPATIONAL PENS SOI
kets, income distribution, and public finance is more ambiguous and
problematic.
Impact on Capital Markets
Long-term saving and capital accumulation. Current regulations in most
OECD countries require that occupational pension plans be fully fLind-
ed. Such plans should raise long-term saving unless households cut
back on their personal saving or borrow to offset the increased pension
saving.
Evidence from the United States indicates that each dollar of occupa-
tional pension savings reduces individual savings by 60 cents, so total
private savings increase by 40 cents (Munnell and Yohn 1992; Pesando
1991). In Switzerland, a crowd-out effect of about 20 percent was
found, so the net positive effect is 80 percent of occupational pension
savings (OECI) 1988c). In Australia, government projections assumed
that half the contributions to the new mandatory occupational schellme
would be offset by declines in voluntary saving, so net national saving
would increase by 16 percent (Bateman and Piggott 1992b, 1993).
These estimates are all consistent with the argument that funded
schemes increase saving moderately relative to the no-pension state and
more substantially relative to pay-as-you-go plans. Furthermore, the in-
creased saving is committed for the long term, which should enhance
the financial backing for long-term investments (chapter 3 and issue
brief 4).
Besides increasing total long-term saving, occupational plans concen-
trate these savings in a small number of institutional investors. In Den-
mark, the Netherlands, Switzerland, the United Kingdom, and the
United States, the assets of private pension funds, including pension
funds run by banks and life insurance companies, are equal to more
than half of GNP and are rapidly increasing (table 5.2). In the United
Kingdom and the United States, this growth is due to the spectacular re-
cent rise in stock market prices. In Denmlark, the Netherlands, and
Switzerland, it is due to a substalltial expansion in coverage as plans be-
came mandatory or quasi-mandatory. In developing and transitional
countries, the capital accumulationi by occupationial plans is much less.
both because their coverage is muchI lower and because they tend to be
largely unfunded, as in the early years of plans in OECD countries. As oc-
cupational plans spread to these countries, they might become a mech-
'73



+i;N G T HE O LD A GE C R I slS
Table 5.2 Pension Fund Assets as Percentage of GDP, 1970-91
(inchldinzg esti'mated pension fiind assets mnaged btr insurance firms
1970      1975       1980       1985       1991
Australia            -         -          -          -          39
Canada              14.2       14.2       18.7       25.3       35
Denmark             18.8       18.8      26.3       45.0        60
Germaniy             2.6        2.6        2.6        4.0        4
Japan                0.0        1.6        3.2        6.4        8
Netherlands         29.0       36.0       46.0       68.0       76
Switzerland         38.0       41.0       51.0       59.0       70
United Kingdom      20.7       18.3      28.1       57.3        73
Unired Stares       29.3       34.6      40.7        50.6       66
-Not available.
Note: For 1970-85. the share of total pension fundcis managed by life insurance firmis is
assumed to be the same as it was in 1991. Book reserves are important in Germany and
Japan, representing 3 and 7 percent of GDP. respectively, in 1991. These are nor in-
cluded here. Bank-runi pension funds are a large share of the total in Denmark; the share
is assuined to be the same for 1970-8S as it was in 1991.
Source: Davis (1993, 1994); Branikato (1994).
anism  for capital accumulation and capital market deepening-if they
require funding.
Capital allocation. Occtupational pension funds in OECD countries have
become a major source of long-term capital in their own economies and
beyond. Unlike public pension reserves, these funds have been invested
relatively free of political ties. As a result, most investments have been in
private sector assets, including equities, and they have earned much
higher returns than publicly managed pension funds and reserves (Davis
1993; figures 3.7, 4.5, and 5.1: appendix table A.12).
The United Kingdom  led the way: pension funds hold almost two-
thirds of their reserves in stocks and own about half of all domestic cor-
porate equity, as well as considerable foreign equity. The move to equi-
ties was spurred by high rates of inflation and a booming stock market
at varying times over the last three decades, plus the absence of regula-
tions restricting investment choice. Although the equity share is much
smaller in continental European countries, private sector securities and
loans (some of them to the sponsoring employers) still make up the
largest part of European pension fund assets. The United States stands
somewhere in between, with about half of all pension funds in the stock
market (see figure 5.1 and appendix table A.12). Pension funds own a
174



OCCUPATIONAL PENSIO
Figure 5.1 Share of Occupational Pension Fund Assets in Domestic
Equities and Foreign Securities, Selected OECD Countries, 1970 and 1990
Canada                 |                    Domestic equities (1970)
Domestic equities (1990)
a Foreign securities (1970)
Denmark                                      Foreign securities (1990)
Germany
Japan
Netherlands
Switzerland
United Kingdom'                                                            Unfettered by political investment
criteria, occupational pension funds
have become a source of long-term
United States                                                            capital for the private sector, at
home and abroad.
0       10      20      30      40       50      60      70
Percentage share of assets
Somrce: Davis (1993).
quarter of all equities and more than half of all corporate bonds in the
U.S. economy. To the degree that occupational pension funds have in-
creased long-term saving or directed savings toward productive invest-
ments, they have enhanced growth in their countries and in the broader
world economy.
Simulated real annual returns to occupational schemes averaged 3 to
5 percent in a sample of OECD countries betveen 1970 and 1990 and
exceeded 7 percent durinig the 1980s (table 5.3). The highest returns
over the period were in the United Kingdom in the 1980s because of its
strong stock market and large proportion of equity investments. Occu-
parional plans in the United States did very well in the 1980s btit not as
well as other institutional investors, such as equity mutual funds
(Lakonishok, Shleifer, and Vishny 1992)-a result that has been vari-
ously attributed to high risk aversion, lack of competition, agency' prob-
lems, and public management of civil service plans. The lowest returns
were in Switzerland, where interest rates and equity proportions are low.
175



,NG THlE OLD AGE CRISIS
Table 5.3 Simulated Real Rate of Return to Private Occupational Pension
Funds in Eight Industrial Countries, 1970-90
1970-      1975-      1980-      1985-      1970-
75         80         85         90         90
Canadaa              -1.8       -1.1         5.2        7.7       2.2
Denmark'             -2.0        0.8        16.9        -         4.1
Germany               3.3        3.2         7.6        6.2       5.1
Japana               -1.0        -1.6       10.9       13.6       4.4
Netherlands          -1.5         1.9       10.4        6.2       4.2
Switzerland          -1.4        3.7         2.7       -0.2       1.2
United Kingdom       -0.5        5.0        12.4        8.0       6.1
United States        -1.6       -2.0         7.7        9.6       3.3
Average              -0.8         1.2        9.2        7.3       3.8
- Not available.
Aote: Figures are compounded annual averages rounided to first decimal. Average is
uinweighred simple average. These rates of return are based on por[folio allocations
among asset types and anniual data on yields and prices by asset type, since direct data on
rates of returns are not available. These rates of return are very sensitive to the base year
chosen. For example, the rate of return in the Uniited States is 3.3 percent for the period
1970-90 but is only 1.8 percent for 1966-90 and would be much higher for 1961-90
or 1981-90. Administrative costs are not subtracted from returns.
a. Data through 1987 (Denmark), 1988 Uapan), 1989 (Canada).
Ssource: Davis (1993).
In defined benefit plans, sponsoring emplovers choose the investment
manager and bear the investment risk, since they will have to cover any
shortfall. Thev therefore take both y ield and risk into account in their de-
cisions. Occupational defined contribtition plans-in which employers
choose (or limit the worker's choice of) the investment manager but work-
ers bear the investment risk-pose a potential agency problem  that may
distort capital allocation decisions. Employers might make risk-yield trade-
offs different from those preferred by workers. Or they might hand invest-
ment management over to financial institutions that will cover the firm's
administrative costs rather than maximize net returns to the pension fund.
(This contrasts with personal saving plans, discussed in the next chapter. in
which workers who bear the investment risk get to choose the investment
manager.) Although disparities might be expected in the investment per-
formance of defined benefit and defined contributioll plans, data from the
United States show little difference (Turner and Beller 1989).
Overall, occupational plans, whether defined benefit or defined con-
tribution, have more  investmenti freedom   than  publicly  managed
schemes and greater incentives to maximize yield for a given level of risk.
176



OCCU'PATIONAL PENSION PLAC
As a mechanism for allocating long-term saving productively, with rates
of return as an indicator, decentralized occupational plans appear to be
far superior to centralized funds.
Institutional investors and financial innovations. In the United States, pen-
sion funds and life insurance companies became the main forces behind
financial innovations after the Employee Retirement Income Security
Act (ERISA) of 1974, which imposed minimum  funding requiremenits
and sharply increased the demand for hedging instrumenits. New instru-
ments have been tailored to the needs of pension funds (such as zero-
coupon bonds, collateralized mortgage obligatiolls, mortgage-backed
securities, indexed futures and options, and guaranteed incomiie con-
tracts). These financial instruments have transformed illiquid loans into
highly liquid and tradable securities and enabled new forms of risk shar-
ing, facilitating both business investment and housillg finance. U.K. pen-
sion funds make active use of financial instrumenits in their international
investment strategies, increasing liquiditv and lowering transaction costs.
So, one reason for encouraging private funded pension plans in middle-
income developing and transitional countries is they might become an
instrument of financial innovationi and capital market deepening.
Concentrating savings in large pension funds, rather than leaving
them in the hands of individual investors, can also have undesirable ef-
fects on finanicial markets. Institutionalizing savings and formalizing
procedures may make it harder for small firms and new ventures to get
financing. This mav be particularlv relevanit in developing counltries
where small firms predominate and informal intformation networks
often work better than formal ones. Pension funds have difficultv re-
searching firms without track records. They minimize costs by dealing
with larger companies, preferablv those traded on exchanges. They lack
expertise in supplying venture capital. And thev face prudenitial limits
on the proportion of a companv's equity that they ma' hold. Pension
funds have also been accused of contributing to stock market volatility
by their herd behavior and overly rapid responise to price changes.
Pension funds and corporate governance. When pension funds have a big
stake in corporate equities, they are in a better position than individuals to
overcome "free rider" problems. demand improved accounting and audit-
ing procedures, zad get informiiation. They are also better able to tIse that
information to assess company managers and press for changes if manage-
ment is not performing effectively-therebv lesseninlg problems stemming
fromii diversified ownership and separation of ownership from control.
'7,



G-TTHE OLD AGE CRISIS
When, however, pension funds have only a small stake in a company,
it is easier for them to vote with their feet (by selling company shares)
thani with their voices-a strategy they have used for many years. Pension
fund managers have been criticized for focusing too much on the short
term and failing to monitor managerial performance, especially long-
term performance. This has left company' managers unconistrained, ex-
cept by the threat of merger and takeover, a socially costly route. Onlyv re-
cently, as owniership stakes have increased, have occupational plans begun
to monitor the governance of the corporations in which they invest-
developing long-term relationships and bringing about changes in the
structure of corporate boards and managerial compensation (box 5.3).
Although problems arising from separation of ownership fiom con-
trol and corporate governance are not yet on the agenda in low-incomiie
countries, they are coming to the fore in some middle-income and tran-
sitional economies. Can pension funds solve this problem for them? In
many of these countries, large occupational pension plans are found
mainly in the pLiblic sector and state enterprises, so control over corpo-
rate management by plan sponsors would be tantamoullt to government
control-precisely what they are trying to move away from.
Private sector schemiies are emerging slowly, few of these schemes
(aside from those in multinationals) are large enough to serve as moni-
tors, and the sponsoring employers would probably be reluctant to
interfere in the affairs of other companies that might reciprocate. In ad-
dition, most occupationlal plans in these countries are largely unfunded,
so they' do not even have substantial assets. Until funding is required by
regulations, and the regulations are enforced, occupational pension
schemes will not play a constructive role in corporate governance-or,
for that matter, in capital market deepening.
Impact on Labor Markets
Occupational plans, especially defined benefit plans that limit vesting
and portability and encourage retirement at an early age, have poten-
tially important effects on labor force participation, training, and
mobility-and therefore on the efficiency of labor markets.
Vesting and portability. Where job-specific skills are importanlt, com-
pensation schemes that attract stable workers and discourage labor mo-
bility allow employers to recoup hiring and trainingr costs and raise labor
productivity, serving a useful economic role. WXage schedules that rise
178



OCCuPATIONAL  PENSION  PLANS::
Box 5.3  Are Pension Funds Good Monitors of Corporate Management?
ONE OF THE MOST IMPORTANT FUNCTIONS OF              Recently, however, pension fund representatives
financial institutions is to monitor the corporate sec-   on the boards of some leading U.S. and U.K. corpo-
tor in which their funds are invested. In Germany and    rations have begun to press for significant changes in
Japan, commercial banks play this role. They main-   corporate governance: electing outside directors,
tain long-term  relationships with their customers,   eliminating directors who are company suppliers
monitor corporate performance, and intervene when    and therefore might have conflicts of interest with
necessary to replace managers and restructure opera-   shareholders, opening up the proxy process to allow
tions. Some analysts argue that banks are too conser-   greater communication among shareholders, using
vative as monitors, since their primary concern is loan    confidential voting at board meetings, expanding
repayment rather than profit maximization.       the roles of committees that are independent of the
The United Kingdom and the United States have    directors, disdosing the amount of and rationale for
a different monitoring system, with such specialized    managerial compensation, and opposing costly mea-
institutions as credit rating agencies, stockbrokers,   sures designed to protect existing managers in the
and-indirecdy-securities markets. When in-   event of a takeover. In the United States, the Cali-
vestors lose confidence in a corporation's managers,   fornia Public Employees Retirement System and the
they sell its stock, driving down the price of the    New York State Common Retirement Fund have
stock relative to the value of the corporation's assets   led the way. As institutional investors grow in size
and making it an attractive target for a buyout or a    and find it increasingly difficult to sell their large
takeover. Some analysts maintain that this is a cosdy    holdings without disrupting the market, they will
monitoring mechanism and argue for a more con-   exert greater pressure on corporate boards.
structive and direct system of evaluation and con-  In developing and transitional economies, if occu-
trol: sticking with corporate managers whose    pational pension plans grew and were funded they
prospects for long-term performance are good and    would own a large share of the country's financial as-
replacing others. Pension funds that own large   sets and could play an even larger role in corporate
blocks of stock obviously are in a better position    governance. In fact, the concentration of ownership
than individual investors to exercise this supervisory   could become a problem. Ten years ago Sweden con-
oversight, but in the past they have failed to do so.    sidered allowing the funded part of its pension plan
Part of the problem is the fragmentation of the   to invest in private corporations, but the idea was
pension fund industry and the diversification of its   dropped for fear that the unions that controlled the
holdings. There are a million pension funds in the   fund would end up controlling Swedish industrv.
United States, each with many small holdings. Diver-   The bigger problems in developing countries are that
sified institutional investors have litde incentive to    most plans are underfunded or only partially funded
monitor and strengthen the long-term performance of   and equity investments are often restricted; so, they
individual companies. It is easier to sell the shares of   do not even have a foot in the door.
failing companies and walk away from the problem.
with tenure and long-term labor contracts could serve this purpose. But
collective bargaining agreements or other legal or cultural factors some-
times prevent the use of such contracts. Pensions with limited vesting
are then a less transparent way (and, because of tax advantages, a pri-
179



. TING THE OLD AGE CRISIS
vately cheaper way) of encouraging investment in job-specific skills that
boost productivity.
Occupational pension plans in OECD countries historically had re-
strictive vesting periods (after which pension benefits are owned by the
worker), some as long as twenty to twenty-five years, and no provisions
for portability. Workers who switched jobs before vesting lost all their
accumulated pension rights. Actuarial calculations in early occupa-
tional pension schemes built in the expectation that few workers would
ever qualify for pensions. Employers even had a perverse incentive to
fire workers just before their pensions vested. Many schemes in devel-
oping countries today impose similarly long vesting requirements.
Although long vesting requirements may encourage the employer to
provide on-the-job training, which is valuable, they have three major
disadvantages.
* First, workers may not understand the details of the pension pro-
gram, particularly the vesting and portability restrictions, so they
may impute a value to the pension that is higher than its trLe ex-
pected value and therefore may choose a job in which their com-
pensation package and productivit' are not maximized.
* Second, nonportable pensions may impede labor reallocation even
when reallocation would be efficient, as wlhen economic condi-
tions change unexpectedly. In both cases, labor ends up allocated
to low-productivity uses as a result of the vesting restrictions.
* Third, some workers who lose their jobs late in life, shortly before
vesting, may suffer from poverty and become a burden on social
assistance programs.
As a result of these criticisms, most industrial countries have passed
regulations that limit vesting periods and require preservation and
portability of pension rights (see below). But even if these regulations
are effective, labor mobility in midcareer may still be discouraged be-
cause of benefit formulas that give a higher present value of pension
compensation to older workers as they age and approach retirement-a
process known as "backloading." Defined contributioni schemes have
the big advantage that they are inherently portable and therefore should
not discourage mobility.
The empirical evidence is ambiguous about the degree to which oc-
cupationial defined benefit plans have actually impeded mobility. In the
United States, where turnover is lower in firms that offer pension plans
I80



OCCUIPATIONAL PENSIONPO
than in those that don't, studies have shown an association between
reduced mobility and restrictive vesting or backloading. Part of this
association, however, may be due to the higher overall compensation
packages of these firms, their abiliny to attract stable workers, and their
reluctance to fire long-term workers-not to reduced mobility among
workers anxious to retain their pension rights. It is difficult to disentan-
gle the magnitude of these effects (Schiller and WVeiss 1979; Kotlikoff
and Wise 1987a; Gustman and Steinmeir 1990; Wolf and Levy 1984).
In developing and transitional economies, where legislation does not
require vesting, where labor markets are very imperfect to begin with,
where uncertainty about the ftiture is great, and where major restructur-
ing is currently going on, the negative effects on mobility and efficiency
may be much greater if occupational plans grow. These countries need
to strike the right balance between encouraging employers to invest in
the workers they have versus avoiding misinformed workers and ineffi-
cient barriers to reallocating workers in a rapidly changing economic
environment.
Retirement age. In OECD countries, the labor force participation rate of
older workers has fallen in recent decades, and private pension plans
have contributed to this change. In most occupationial plans, the value
of the pension wealth ceases to increase after the worker reaches a speci-
fied age such as 60 or 65, encouraging workers to retire. Sometimes spe-
cial early retirement schemes have encouraged retirement before age 60
(issue brief 8). These incentives for retirement are often rationalized as
attempts to deal with the declining productivity of older emplovees, es-
pecially those whose wages rise witlh tenure. Although employers would
prefer to hold on to workers who remain productive and to let the oth-
ers go, they may be prevented from making that distinction by unions,
laws, or cultural factors. If so, companies may use pension plans to en-
courage older workers to leave because, as a group, their wages exceed
their productivity.
Early retirement schemes are also used as a substitute for layoffs when
a firm is reducing its labor force. This policy cuts current prodLIction
costs but raises long-run pension costs. When workers retire early, the
firm's total labor cost (of retirees plus workers) may increase-but in a
hidden way. The cost is passed on to the pension scheme. Funded plans
based on expectations of later retirement become acmtarially unsounid.
Eventually, the pension plan may not be able to pay the promised bene-
fits. The governmllenlt may be left with the debt, if public subsidies or
I8I



VERTING  THE OLD AGE CRISIS
guarantees are involved. And the country's labor force, a major produc-
tive resource, declines. If younger workers are laid off instead, this would
be painful in the short run-but in the longer run they are more likely
to find new jobs and continue adding to national output. Early retire-
ment plans need to be introduced with extreme caution and with coIml-
menisurate additional funding of pension plans by employers to ensure
that they take into account the full social cost. (See box 4.4 for a discus-
sion of early retirement under public pension schemes.)
Fiscal Effects
Occupational pension plans can reduce government spending and tax
rates if they dampen political pressures for large earnings-related public
plans. This may be their most important fiscal effect, albeit one that is
difficult to quantitf. The other side of the coin is that they usually involve
large current tax expenditures. And when government guarantees are in-
volved, occupational plans may have large future explicit costs for the
government as well (guarantees arc discussed in the next section).
Most countries allow workers and employers to deduct pension fund
contributions from their taxable income and exempt investment income
from tax, but treat pension benefits like any other taxable income. Tax de-
ferral is especially valuable to high-income workers in countries with pro-
gressive income tax systems. SLich workers may be in a much lower tax
bracket when they retire and pay taxes on their pensions. Australia, Ire-
land, Japan, and the United Kingdom go beyond tax deferral and allow
tax-free payments at retiremenlt, subject to specified limits. The resulting
tax expenditure has been estimated at 20 to 40 percent of explicit public
pension expenditures in some OECD couLntries. It is I percent of GDIP for
the United States, 3 percent for the United Kingdom (which has broader
coverage and more progressive tax rates), and 2.5 percent in South Africa
(table 5.4). These figures may be overestimates, because they do not take
into accoullt the fact that returns to saving are often taxed more lightly
than other sources of income, nor do they fully recognize that, in imma-
ture systems, taxes will be recaptLred later when the worker retires and re-
ceives the pension benefits. But to compensate for these deferred revenues,
in the interim, higher taxes must be imposed elsewhere, government
spending must be cut, or government borrowing mtist be increased.
To containi the negative budgetary impact, some governments have
set limits on the deductibility of contributions to pension plans. Den-
182



OCCUPATIONAL PENSIO
Table 5.4 Tax Expenditures in Selected Countries
Percentage of
poiblic pensiotn  Percentage
Country              Year         expenditures      of GDP
Australia            1984             25              1.0
Ireland              1985             22              1.3
United Sta[es        1989             20              1.1
United Kingdom       1989             40             3.3
South Africa         1992             -               2.5
-Nor available.
Source: oECL (I1992): for SOLIth Africa, ftom Virtas (1 994b).
mlark imposes a special 44 percent tax on pension asset returnis wlheni real
returns exceed 3.5 percent a year, an obvious disincentive to risk taking.
This may help explain the low returnis over the past two decades. In the
Netherlands, a special tax applies to surpluses that exceed indexed pen-
sion obligations by more than 15 percent. Some analysts have proposed
using tax credits rather than deductions to reduce the fiscal impact and
the advantage given to high-incomne workers. Going a step fLrther, in
1988, New Zealand made all contributions and investments taxable,
but left most pensions untaxed, treating pensioni savings roughly the
same as other savings. Removing the tax exemptions sharply reduced the
popularitv of occupational pensioni plans (Davis 1993).
Preferential tax treatment for occupational pension plans maya be jus-
tified by the importance of encouraging people to save for their old age
ratlher than rely on public transfers or private charity-and because it
encourages the growth of group annuities that help solve the adverse se-
lection problem. Tax deferral is also a way of recognizilng that part of the
nominal return on long-term saving is simply an offset to inflation. But
the evidence is inconclusive on whether tax preferences stimulate people
to save more-and if so, wlhether these benefits exceed the costs.
Tax deferral is a less important benefit in developing countries that
do not tax other forms of investment income, such as interest on bank
deposits, governmenit bonds, and capital gains. In addition, income tax
enforcement is very weak in many developing countries-being allowed
to dedtIct pension contributions is worth little to workers who do not
intenid to pay their income tax in any case. The absence of large tax ad-
vantages may be a major reason why occupational plans have not gotten
off the ground in these countries.
183



£ffg TING THE OLD AGE CRISIS
As the tax enforcement capability of developing countries improves
and as the transitionial economies develop new tax systems, policymak-
ers need to think about the role of occupational pension plans and how
to use tax policies to provide appropriate incentives. It is unclear why oc-
cupational pensions should receive better tax treatment than personal
long-term saving or pension plans. To encourage capital accumulation,
some economists have argued that consumptioni rather than income
should be taxed, so all saving Would be tax deferred. Others have pro-
posed that real rather than nominal investment returns should be taxed.
Extending equivalent tax advantages to all long-term saving schemes,
whether personal or employer-sponsored, would probably retard che fu-
ture growtlv of occupationial pension schemes.
Who Benefits and Who Loses?
L r   IKE PUBI IC SCHEMES, OCCUPATIONAL DEFINED BENEFIT PEN-
sion plans also have redistributionial effects. But in occupational
plans. the direction of the redistributioll is determined bv the
employer operating within the labor market rather than by policymak-
ers operating within the political process. As a result, the direction of re-
distribution may be quite different.
Who Benefits?
Coverage in occupational defined benefit plans is usually limited and
tilted heavily toward high-income workers and workers in large union-
ized firms. Sometimies, companies cover only senior employees or pro-
vide different benefits for different groups of workers. Women and oth-
ers who have had unleveni employment histories are more likely to be left
Witlhout pension coverage. Among covered workers, early leavers lose
and long stayers gain-and some of these workers may not have cor-
rectly calculated the odds early on. Workers with high salaries in their
last few years of employment gain relative to workers whose salaries have
not increased rapidly, becatise occupationial pensions are often based on
final salaries rather than average career earnings. Managers may have the
power to award themselves large salary increases in their last year of em-
ploymenit increasing their pensios substantially.
i84



OCCUPATIONAL PENSION. Pt
Differential benefits also occur in defined contributioll plans. For
example, employer contributions inay be lost by early leavers. Some
workers may fare badly becatise their employers do not choose capable
investment managers. And (as in public and mandatory saving plans)
low-income workers lose out because of their shorter life expectancy if
they are thrown into the same annuity pool as high-income workers. In
general, however, defined contribution plans provide more equal treat-
ment to all covered workers than do defined benefit plans.
As a result of these factors, occupational pensions are often more
skewed toward high-income groups than are public pensions or wages
(table 5.5). Some governments have tried to curtail such practices
through tax and pension regulations but have not eliminated them en-
tirely. And except in countries wlhere they have become mandatory, oc-
cupational pensions are not particularly effective at alleviating poverty
or resolving capital market failLure-since their beneficiaries are more
likely to have saved voluntarily and have access to alternative saving in-
struments for their old age. But occupational plans probably help rem-
edv insurance market failures. -To that extent, they may prevent sharp
Table 5.5 Distribution of Occupational Pensions among Households with
Heads Age 65 or Over, by Income Quintile, Selected OECD Countries
United
Australia,   Canada, Netherlands, Kingdomn,
1985       1987      1987        1986     Average
Percentage of households witli occupationalpension income
All income levels 12.4    41.9       72.1       49.9       44.1
Poorest quintile  4.0     20.1       54.8       35.3       28.6
Quintile 11     8.7       42.4       52.0       40.0       35.8
Quintile III    8.6       60.1       91.0       65.6       56.3
Quintile IV    25.8       54.1       90.4       65.6       59.0
Richest quintile  25.2    38.2       73.0       45.9       45.6
Percentage of gross incomefrom cccupational pensions
All income levels  5.4    11.7       23.6       14.5       13.8
Poorest quintile   0.8     3.9        2.6        6.3        3.4
Quintile 11     3.2        9.1       12.3        7.7        6.8
Quintile III    2.1       13.0       20.2       13.7       12.3
Quinrile IV    11.5       16.3       39.8       24.0       22.9
Richestquintile   9.1     16.2       42.9       24.0       23.1
Source: Luxembourg Income Survey; calculations nmade by Deborah Mitchell (1993).
I85



vtkTING THE OLD AGE CRISIS
deteriorations in the standard of living of the very old, who otherwise
may not have been able to purchase annuities at a fair price.
Do Occupational Plans Redistribute?
Economic theory would argue that pensions are deferred compensa-
tion, that total compensation packages reflect differences in productiv-
ity. and that pay scales are adjusted to compensate for the value of pen-
sion benefits (the theory of "compensating wage differentials"). So,
Occupationial pensions would affect the mix of wage and nonwage com-
ponents in the total compensation package. But they would not affect
the individual's total income or the distribution of income overall.
Several observations suggest, however, that wages don't fall to offset
occupational pensions, so pensions do affect the income distribution.
* Emplovers who pay high wages are also more likely to provide pen-
sions than those who don't (Gustmani and Steinmeir 1990). If
workers at these firms receive both higher wages and higher pen-
sions than equivalent workers at other firms, pensions have helped
skewv the total incomiie distributioll. (But if workers at these firms
have superior productivity and if, without pensions, their employ-
ers would have paid still higher wages to attract them, the theory of
compenisating wage differentials would still hold and access to pen-
sions would not have changed the overall income distribution.)
* A stronger argument about the distributional effects of pensions
stems from social or legal obstacles to raising wages. Public em-
ployees may receive a disproportionate share of their compensa-
tion in the form of pensions because higher wages would be more
visible and less politically acceptable. Similarly, top managers in
private companies may be rewarded with large pensions because
higher wages Would be more transparenit and less acceptable to
stockholders. In these cases wages would not rise commensurately
if pensionis were Linavailable.
* In most countries contributions to and investment income of pen-
sion funds are tax deductible, so their recipients impose a cost (a
heavier tax burden or fewer services) on wage earners, who are taxed.
In all these cases, access to generous occupational pensions increases the
real income of the favored recipients and influences the overall distribution
of income and wvelfare-in an inefficient and probably a nonequalizing way.
i86



O(CCUPATIONAL PENSION PLAN'S
Regulatory Issues
A        LTHOUGH OCCUPATIONAL PENSION PLANS WERE INITIALLY
unregulated, substanitial regulations have developed in every
country wlhere they are important. A basic reason for regulat-
ing complex pension schemes is that workers may not fully understand
the schemes and may as a result make decisions that are best neither for
themselves nor for the broader economy. For example, in occupationial
plans workers may not correctly evaluate the probability of being fired
or of quittinig before retirement. Or they may not realize that pension
promises are underfunided and therefore not trustworthy. Since em-
ployers control the degree of underfunding and the firing of workers,
they have more informationi about these probabilities and an incentive
to understate them to prospective emplovees. Along similar lines work-
ers may not know if their defined contributioni plan engages in risky in-
vestments. To prevent informiiationial deficiencies of this sort from in-
ducing workers to enter into agreements that benefit neither them nor
the economy, governments need to establish regulations requiring full
disclosure and restricting the actions of pension plans.
Also, once governmlenits encourage the use of occupational plans
through special tax concessions or guarantees, they bear some responsi-
bility for ensuring that these concessions are not abused. A first wave of
governient policies favorable to occupational pension schemes expands
their use. But it may also have some unlliltenided effects that necessitate
a second wave of more restrictive policies. For example, granting tax ad-
vantages to pensioni fuLnds could make them a haveni for tlpper-incomiie
groups. Or government guaranitees could prompt excessively risky in-
vestmenits by some pension plans. since if the investments fail the bur-
den will eventually be passed on to the government. Regulation thus
prevents companies from taking advantage of tax concessionis and guar-
antees in inefficient or inequitable ways. A basic problem is that devel-
oping and transitional economies may lack the institutional capaciry to
regulate effectively.
Ensuring Financial Soundness in Occupational Defined Benefit Plans
In a funded defined benefit plan, the employer's required contribti-
rion depends on the investment performance of the pensioni fund. The
emiiployer chooses the investment policy and bears both the investment
187



,1hING    THE Ol.D AGE CRISIS
risk and the longevity risk, providing insurance to the worker. In an tin-
funded or partially funded plan, the employer must pay the pension out
of cuLrenlt revenues. The worker bears the risk that the employer will be
unable to do so, a very real risk given the long-term nature of pension
obligations.
When occupational schemes were started, the number of beneficia-
ries was very low relative to the number of active workers, so it was easy
to run them on a pay-as-you-go or partly funded basis. Rapid growth of
the labor force and output for muchI of the last century in industrial
countries helped keep the dependency rate low-in defined benefit oc-
cupational schemes as in public schemes. This meant that a small wage
reduction for workers could finance a large pension for retirees. Or pen-
sion costs could be passed on to constimers in slightly higher prices in
industries in wihch competition was limited.
But the conditions required to make unfunded occupational plans vi-
able no longer exist. Many firms in industrial countries have large num-
bers of retirees, their labor forces are no longer growing. and they face
intense competition, often from younger firms in other countries. In a
competitive economic environmenit, firms have serious problems cover-
ing unfunided pension obligations. Companies with many retirees that
try to pass their higher pension. costs along to workers through lower
wages will be unable to attract employees if the labor market is compet-
itive. Anid those that try to pass these costs along tlhroughi higher prices
will be unable to attract customers if the product market is competitive.
These problems also occur in some developing countries with aging
populations. As one example, the heavy reliance on unfunded plans run
by enterprises in China, in the past, is pUttillg companies with older
workers at a competitive disadvantage now (Friedman 1994).
Although public plans can operate on a pay-as-you-go basis because
they are backed by the power of taxation (so long as the taxes are not so
high as to stimulate evasion), companies with private defined benefit
plans ordinarily cannot force workers and consumers to deal with them.
Newer firms with a younger work force will have lower costs that give
them a competitive advantage if pension schemes are unfunded. Fhis
also means that pensioners with unfunded plans constantly face the risk
of emplover default. Although cases of outright default have so far been
few, many occupational plans (like some public plans) have escaped fi-
nancial difficulties by failing to index pension benefits, downgrading real
benefits without an explicit default, as inflation takes place (box 5.4).
i88



()(( LUPATIONAL PENSION.FPLA
Box 5A4 Are Underfunded Occupational Plans Viable?
THE AUTOMOBILE INDUSTRY IN THE UNITED              The outcome in the U.S. automobile industry has
States shows the problems caused by underfunded    been to protect the real value of pensions for new re-
plas and the difficulties in calculating whether a    tirees and, to a much smaller extent, for old retirees,
plan is fully funded. The industry has declined over   while passing costs back to new workers in lower
the past two decades, in part because of increased   starting wages and the use of temporary rather than
international competition, and its work force has   permanent jobs. The higher pension levels exacerbate
grown older. The number of retirees is now as large   the underfunding problem, but the lower wages help
as the number of workers and will grow larger still   companies cover these obligations. This tactic can
in the years ahead. Pension obligations are largely   work only in a depressed area with few alternative
but not fulty funded; some were incurred in the    employment opportunities, or where industry-wide
1960s before fuiding became mandatory and some   or occupation-wide collective bargaining makes it
were incurred unexpectedly in the 1 990s when early   difficult for workers to escape to higher-wage firms.
retiremenr plans were introduced to avoid layoffs.   In the long run, in a competitive product and labor
Health insurance coverage for early retirees has   market, it would be difficult for unfunded defined
been another unexpected escalating cost of the    benefit plans to raise the money to cover their pen-
retirement program  for automobile companies.   sion promises. Under current conditions, the auto-
Even plans -that appeared well funded in 1990 now    mobile industry might have been able to sell more
appear less well funded as rising medical costs and    cars, hence to increase employment, if it had lower
falling interest rates have further increased the gap    pension costs and therefore lower prices. Thus young
between revenues and expenditures. This illustrates   workers have lost both wages and jobs.
the difficulty in establishing whether or not a    As another example of the dangers of underfund-
defined benefit plan is fully funded, since future   ing: When states and municipalities in the United
costs and returns may turn out to be different from    States ran into fiscal difficulties in the late 1980s and
those that were assumed in the actuarial calcula-   early 1990s, some of them revised their assumptions
tions. And eventually the government may be pres-   about rates of return on their pension funds. Push-
sured to pick up the tab for part of the higher health   ing these assumed rates up a notch or two allowed
insurance coSts,                                state and local governments to conclude that fund-
Recent iabor negotiations have tried to determine   ing was more than adequate and therefore they
the share of labor expenditures that should go to   could cut their contribution rates. In fact, interest
young workers in the form of wages, to new retirees   rates fell sharply shortly after these optimistic fore-
in the form of pensions, and to old pensioners in the   casts were made, and many plans are now under-
form of cost-of-living adjustments. The choice was   funded. Estimates indicate that almost one in three
dictated by three considerations: labor leaders want   public plans has less than 75 percent of the assets
to satisfy the majority of union members (many of   needed to meet its liabilities (0. Mitchell in Wall
whom are old and about to retire), employers want   S$reetJvurna4 April 5, 1994). Although this tactic
to induce early retirement as a substitute for layoffs   saved states and localities considerable money yes-
(which are esricted by the union), and alternative   terday, the bill will come due tomorrow, to be paid
employiment opportunities in the surrounding areas   through lower wages to civil servants, reduced bene-
are relativelyLlow paid.                        fits to pensioners, or higher taxes to citizens.
189



AVERTING THE OLD AGE CRISIS
Fears that companies would default on1 their pension promises, and
some actual defaults, have led governments in several industrial countries
to require funding that covers the estimated liabilities of defined benefit
pensioni schemes. Canada, the Netherlands, the United Kingdom, and
the United States require substantial advance funding. In France, where
funding is not required, mandatory nationwide contributions to occupa-
tional plans enable pension costs to be passed back to current workers-
so long as workers do not protest the slow growth of net wages.
Requirements of full funding do not completely solve the default
problem. Full funding requires a complex calculation that involves ac-
tuarial assumptions. The future rate of return on assets determines the
growth rate of the fund, whereas projected salary growtlh, inflation,
turnover rates, and years of retirement determine future obligations.
None of these variables is known with certainty. The values that em-
ployers and their actuaries use in these calculations strongly influence
the contribution rate deemed necessary for an actuarially sound fund.
Many occupational plans in the United States raised their estimates
of expected returns in the early 1 990s, just before interest rates fell and
just as many companies instituted early retirement plans. Some of these
pension plans are now underfunded. This behavior may lead to a new
round of regulations, covering the actuarial assumptions themselves. In
the Netherlands, where funding is comptIlsory, the government speci-
fies the expected wage and the maximum real interest rate of 4 percent
to be used in these calculations. But so far, political forces have pre-
vented other countries from implementing such actuarial standardiza-
tion (box 5.4).
In developing countries, occupational plans are not subject to mini-
mum findinig levels, and most plans are unfunded or the funds are held
in the form of book reserves (Mexico and the Republic of Korea). In some
countries-including Brazil, Cyprus, India, Panama, the Philippines, and
South Africa-occupational plans are funded through separate trusts, but
the trusts can be controlled by the employer and may not have enough as-
sets to cover promised benefits. In the transitional socialist economies,
companies may make promises about the future that they will simply be
unable to keep, given the rapidly changing economic environment.
From the start, developing and transicional economies need to estab-
lish regulations requiring a sound long-term  financial basis, for it is
much cheaper and easier to prevent abuses than to correct them. Fund-
ing requirements may reduce the temptation for employers to make ir-
I90



OCCUPATIONAL PENSION PLANk
responsible promises and increase the trustworthiness of the promises
that are made. And for the funding requiremiienits to have meaning, gov-
ernments should specify their key actuarial assuLMptionIs. such as ex-
pected rates of return and wage growth.
Regulating Investments
A closely related question is whether the investment portfolio should
be regulated to prevent excessively risky investments and problems of
moral hazard. Sponsoring employers have considerable motivation to
choose capable investment managers, given their obligation to cover any
deficiencies in defined benefit plans. From society's viewpoint, overly
strict regulations defeat the capital market advantages of decentralized
pension funds. But if investments fail, pensioners may be in trouble-
and if there are government guarantees, the burden ultimately falls on
the public treasury. The line between under- and overregulating the in-
vestment portfolios of occupational pension plans is thus narrow.
In many countries, the line has been drawn to give considerable lee-
way to occupational funds. In the United States, they are subject to the
"prudent person" rule, which requires sensible portfolio diversification
but places no limits on portfolio allocations other than a 10 percent
limit on investments in securities of the sponsoring employer. In the
United Kingdom, pension funds are subject to trust law and the pru-
dent person rule, with a 5 percent limit on investments in the sponsor-
ing company. Similar rules apply to occupational pension plans in the
Netherlands. Pension funds have taken advantage of this regulatory free-
dom to place a larger share of their portfolios in equity investments,
yielding a higher rate of return than more restricted financial institu-
tions can achieve. In developing countries, the limits on equity invest-
ments are generally stricter.
Most countries, especially developing countries, restrict the foreign
investments of their pension funds. Foreign investment entails an ex-
change rate risk as well as ordinary stock and bond market risks. It may
thus seem to increase risk. But it actually decreases risk because markets
are not perfectly correlated across countries. Comparisons of returns to
actual portfolios, hypothetical domestic portfolios diversified between
equities and bonds, and foreign portfolios in OECD countries for
1970-90 show that a higher share in equities raises both rates of return
and risk, whereas international diversification generally reduces risk,
I9I



TING THE OLD AGE CRISIS
sometimes at the expense of yield (Davis 1993 and box 5.5). Opening
the door to international investments of pension funds would seem to
be warranted, to diversify and thereby diminish risk.
Governments often prod private pension funds into investing in
such "socially desirable" assets as government bonds, housing. and in-
frastructure. Usually, but not always, occupational schemes have had
the political clout to resist these pressures. In developing countries,
minimum  investments in government bonds are often required-a
form of central control over investments, which generally decreases
yield and (because they limit diversification) increases risk. For exam-
Box 5.5 UberatigPension Fundst An Idea Whose ime HasCwme?
PENSION FFUNDS ARE OFTEN LEGALLY CON-    domestic markts can be eroded gradually, through
strained from investing in foreign assets. The reasons    modestly negative teal rates of return, or more sud-
are varied: general capital account restrictions, a be-   denly, through forced shouldering of losses elsewhere
lief that savings "belong" to the home economy and:  in the economy, as, for example, when governments
should be invesred there, or featrthat incomplete in-   pass large banking system or state enterprise losses on
formatnon will result in :poor investments and pen-   to the pension fund, leaving it insolvent.
sion fund losses.                                    Funded pension schemes are often viewed as a
But there are also srong advantes from interna-    means of increasing national saving and long-term
tional diversification of pension funds, particularly for   domestic capital formation. And outflows of pension
countries with ssmall or concentrated domestic   funds are considered a loss to society. Governments
economies. Lower risk and sometimes higher returns:  can minimize this loss by improving the conditions
are possible over the long term through international   for domestic financial markets and easing capital
investment, which reduces the exposure of investors to   conrrols more generally. Easy capital outflow helps
countuy-speciflc riks6 sudc as inflation and gives them    stimulate capital inflows, because a prime concern of
an opportunity to move :their capital to, countries that   international investors is to be able to get out of a
offer the hig   return The switch to frer capital   market quickly when the need arises. Bilateral or
flowscould be gradual to allow pension nmanagers time    multilateral asset pools in which pension funds from
to learn about foreig investmnts and to mininiize   two or more countries share investments, risks, and
disruptive effcts on he country's capitl account.  returns in their respective countries might develop as
Any restriction on capital is like a tax. The rich    a financial innovation that would permnit diversifica-
can often -avoid the tax by evading capital controls,   tion of country risk without a net loss of long-term
while middle-.and low-income residents with a sub-    capital to either country.
stantial share o4 their savings: tied up in fuinded pen-  Allowing pension funds to diversif jcontributes to
sion plans beat the full brunt of finarcial repression.   th e credibility of domestic stabilization policies and
Only if par of their funds are invested overseas are   is an easily controllable way to begin a wider process
they proteed ftfrom an increase in financial repres-   of opening up the domestic economy to become part
sion at home. Pension reserves that are confined to    of the global economy. :
192



OCCUPATIONAL PENSION  PLANS-.
ple, "prescribed investments" in South Africa earned a negative real re-
turn of 3.6 percent in the 1970s and negative 0.9 percent in the 1980s,
while the real return to equities was strongly positive-13.2 percent
and 5.6 percent, respectively (Vitrtas 1994b). Special investment re-
quirements for pension funds for state and local workers in the United
States also decreased yield (Mitchell and Hsin 1994a, b). The lower re-
turn constitutes an implicit nontransparent tax on the funds. A better
policy would tighten funding requirements but loosen investment re-
strictions, subjecting all investments to the market test of a competitive
rate of return. The costs of social investments would then become more
transparent, so citizens could decide if they want to meet these costs-
and if so, who should pay.
Protecting Benefits in Defined Benefit Plans
The uneven coverage offered by occupational plans, combined with
the lack of worker information about how they functioni, has also led
OECD governments to regulate some aspects of the benefit formula.
Typically, all emplovees at a firm are required to receive equal access to
pension coverage, and several European countries require that benefits
be indexed. In some countries (Australia, Denmark, France, the
Netherlands, Switzerland) almost all firms must offer pensions as a re-
sult of legislation or collective bargaining.
Particularly important concerns are that vesting and portability provi-
sions in defined benefit plans are often misunderstood by workers and
exploited by employers-and they may inefficiently limit workers' mo-
bility. To overcome these problems, most OECD governments limit the
qualifying period for vesting and make it harder for employers to fire
workers just before they acquire vested rights to their accrued benefits.
The most common vesting period is two to five years, although the range
is large. In Switzerlanid, compulsory benefits vest immediately, but addi-
tional voluntary benefits require five to thirty years of service. Vested
rights are indexed in the Netherlands, Switzerland, and the United King-
dom  but not in Canada, Japan, and the United States. A departing
worker whose rights are preserved in nominal rather than real terms is pe-
nalized, and mobility may continue to be discouraged, particularly in in-
flationarv environments. Developing countries generallv do not regulate
vesting, or other aspects of benefits, except in such cases as the Philip-
pines, South Africa, and Indonesia under the new pension law.
'93



&RTING  THE OLD AGE CRISIS
Closely related, portability rights have also been strengthened. In
some countries (Denmark and the United Kingdom), companies are
required to calculate the present value of the vested benefits of depart-
ing employees and to transfer that SumLl to the pensioni fund of the new
employer or to a personal pension plan. In the Netherlands, transfers
are effected through industry-wide clearinghouses, and in Japan,
through a nationwide clearinghouse. In Switzerland, the mandatory
part of the pension is portable, but the voluntary part may not be, so
mobility continues to be hampered (Hepp 1990).
Even when portability is required, the employer usually has consid-
erable discretion over the actuarial assumptionis and accrual rates that
tend to favor workers wvho stay. For example, the assumption of a high
interest rate reduces the present value of future benefits and therefore
the amount that must be transferred. Basing the transfer on ctirrent
rather than expected future salary or assuming a low rate of wage
growth has the same effect. If the transfer is small, the new employer
may grant only partial credit, compared with the benefit that would
have been received had the worker stayed put. In other words, the same
factors that make it difficult to define full funding make it difficult to
implement full portability, even in a well-regulated defined benefit sys-
tem. Portability is facilitated by using a defined contribution scheme,
which may be part of the reason why this type of plan prevails in the
mandatory programs of Australia and Switzerland. In developing coun-
tries, even partial portability protection is rare.
Information Disclosure and Monitoring
Full disclosure to workers-as an alternative to regulation-is fa-
vored by free market advocates. Employers could set whatever terms
they desire, but workers would have to be given full information about
the benefits and risks. Those opposed to this approach argue that work-
ers may not be able to evaluate the information properly. Doing that re-
quires estimating the probabilities that they will be fired or will want to
leave the firm before retirement, the likelihood of different age-
earnings profiles, and the prospect that the firm will still be solvent and
able to pay the defined benefits fifty years down the road.
Trade-offs are possible between disclosure and regulation. Standard-
izing some provisions through regulation simplifies information disclo-
sure, while full disclosure can reduce the need for regulation. In prac-
194



OCCUPATIONAL PENSION  PLA
tice, though, requirements for information disclosure have gone hand
in hand with investment regtilations rather than substituted for them.
In the United States, pension funds must provide participants with an
annual report outlining the plan, their rights to receive pensions, and
the status of individual pension benefits. In the Uniced Kingdom,
trustees must provide a statement of individtial benefits and audited
annual reports covering the numnber of beneficiaries, level of contribu-
tions, distribution of assets, performance ratings, and remuneration of
ftunid managers. Neither regulation nor information disclosure is well
advanced in developing and transitional countries.
A promising model for enforcinig regulations and information disclo-
sures is in place in the Netherlands. A single statLtory authoriry, the In-
surance Supervisory Board, oversees occupational pension plans, in con-
trast to the fragmented monitoring system in many other OECD countries.
Pension funds must provide tle board with detailed information on ben-
efit payments and investments. The board ensures that pension fund
commitments are adequately covered by assets and that plan rules and
conditions are satisfactory. This model of monitoring-one supervisor,
specific rules on funding, standardized actuarial assumptions, portability
provisions, annual verification, and periodic on-site inspections-has
considerable merit for developing and transitionial economies, wlhere reg-
ulations, disclosure requirements, and enforcement are at an early stage.
Such a board could also issue annual statements to workers on their ben-
efits and contributions. Indonesia recently passed a detailed occupational
pension law covering these regulatory and disclosure issues that may be-
come the standard for developing countries (box 5.6).
Guaranteeing Occupational Pensions
Even with requirements of funding, prudent management, and
information disclosure, risk remains that the sponsoring employer will
declare bankruptcy and the pension fund will be unable to meet its
obligations. Should the government insure against this? Several coun-
tries, including Finland, Japan, Sweden, and the United States, have
public pension guarantee agencies for this ptirpose.
The U.S. Pension Benefit Guaranty Corporation (PBGC) was set up in
1974 to guarantee pension benefits up to a specified ceiling. All private de-
fined benefit plans must participate and full funding is required to limit
the government's losses. Until recently, the PBGC was a seriously flawed
195



M'TIM  G  THE OLD AGE CR IS[
Box 5.6  Priate Pension Regultion in l_koesia
INDONESIA PASSED AN INCOME TAX L4W IN 1983           join a defined contribution plan run by a bank
that exempted pension contributions of employers      or an insurance company.
and employees, and -new pension programs began to  * Permissible investments are specified, with
spring up. No pension legislation governed the pro-   strict diversification standards. Transactions
grams, whose policies were set entirely by employers,  between the pension fund and the employer
and there was no dear separation of pension fund as-  are restricted.
sets from the firm's asses., Most funds were invested  * Both contributions and pension fund invest-
in bank deposits, real estate,- or subsidiaries of the  ment income are tax-free, but pensions are
sponsoring enterprise, or put to other uses at the dis-  taxed as normal income.
cretion of the sponsoring employer.                * Regular reporting to participants is required,
The Indonesian government intended to enact a      and independently audited financial state-
private pension law soon after passage of the new in-  ments and actuarial opinions must be submit-
come tax law, but it took nine years to do so. Legisla-  ted to the Ministry of Finance.
tion defining a comprehensive public social security  * Procedures are established for winding up a
program was passed at the same time. Among major      pension fund and for liquidating hopelessly in-
provisions of the pension legislation:                solvent funds. The government assumes no re-
sponsibility for the obligations of such funds.
* Firms are free to establish pension plans or
not; employees may opt out of plans that re-  Because of concerns about the annuities market,
quire them to contribute.                  the government plans to impose strict financial and
* An occupational pension program must be op-   investment standards and rigorous solvency margin
crated as a legal entity separate from the em-   requirements on the annuities part of insurance
ployer's business, with the pension fund's as-   company business. It is also hoped that competition
sets held by an approved custodian.        among life insurance firms will be intense and that
* At least 80 percent of total benefits must be   the government-owned life insurer will set a stan-
paid in the form of annuities (with death ben-   dard of fair pricing and prudent investment. To add
efits for a surviving spouse or minor children).   financial market expertise, joint ventures with for-
• Employers may provide different benefits for   eign companies will be allowed. A separate Pension
different classes of employees; but all employ-   Fund Directorate has been established in the Min-
ces over the age of I 8 must be covered if other   istry of Finance, and its enlarged staff has received
employees of their class are covered.      special training for conducting compliance exemp-
* Pension programs must be fully funded.      tions. The new law brings Indonesia up to OECD
* Benefits are vested and portable after one year   norms and will probably set the standard for devel-
of service.                                oping countries. But it is not clear whether Indone-
* The self-employed and employees whose em-   sia has the institutional capacity to supervise and
ployers do not offer pension programs may   enforce these regulations.
institution-with little control over actual funding levels, the actuarial
assumptions behind them, or the investment policies followed by the
funds. Recent measures have strengthened the PBGC, but major short-
196



(i)CCUPATIONAL PENSION PAL
comings remain, including the accumulation of past deficits totaling
billions of dollars in the pension schemes of several large corporations.
These shortcomings should serve as a warning to developing and tran-
sitional economies to prevent such deficits from the start. It is very dif-
ficult to reverse them later on.
The United Kingdom has no pension guarantee plan, although a vol-
untary compensation scheme was set up to cover beneficiaries of the
Maxwell companies following the recent massive losses from fraud. A
compulsory guarantee scheme is being considered-but not very enthusi-
astically, in part because of the fear that it will have the perverse effect of
encouraging risk taking.
Developing countries should trv to avoid public guarantees of occupa-
tional pension plans, although reinsuranice through private pooling
arrangements might be encouraged (Smalhout 1994). Public guarantees
may lead to large fumtre fiscal outlays and may also create moral hazard
problems-that is, workers and their employers may take larger risks than
before, knowing that their pensions will be protected. But avoiding guar-
antees may be difficult, especially since many occupational pension plans
are offered by public enterprises. And political pressures often make guar-
antees implicit even if they are not explicit. The best course is to establish
strong fiduciary rules and monitoring mechanisms for occupationial plans
from  the start-to minimize the probability that financiallv unsound
schemes will get off the groLind.
Employer Response to Regulations
Requiremenits for equal access, ftull funding, vesting, portability, and
the paymenit of premiums for public guaranitees make defined benefit
pensioni plans more costly and less attractive for sponsoring employers.
Regulated companiies can no longer tise penisionis to attract and reward
long-service or other selected workers as before. They cannot count on
worker mobiliry to reduce their pension costs. Nor can they tise unlifunded
plans as, in effect, a low-interest loan to the company. The administrative
costs of complying with regulations of defined benefit plans are high, es-
pecially for small businesses that must spread the set-up costs over a small
number of workers. This is particularly important in developing coun-
tries, where small businesses predominate.
Employers are likely to react in several ways: They may engage in less
on-the-job training because they are less able co identify stable workers
197



-VE.RTING THE OLD AGE CRISIS
or induce workers to stay. They may use wage differences rather than
pensions to make desired distinctions in compensation, leading to
greater wage inequality. And they may avoid contributing to pension
schemes by hiring more short-term or contract workers, so fewver work-
ers get pension coverage. Such employer behavior has been observed in
the labor market in the past decade, although to different extents in dif-
ferent countries.
Employers are also likely to shift their emphasis to defined contri-
bution rather than defined benefit plans. In the United States, the uise
of defined contribution plans has increased dramatically over the past
decade. In Australia and Switzerlanid, where occupationial plans have re-
cently become mandatory, most private employers have defined contri-
btition schemes.
This may be efficient, since defined contribution plans are by defin-
ition fuilly ftinded and portable, so workers face less employer default
risk and mobility risk even without government regulation. Portability
is particularly valuable in developing and transitional countries, which
will be changing rapidly in the coming years. Although workers bear
more investment risk in defined contribution plans, they probably
come out ahead because the separation of investment risk from em-
ployment risk implies risk diversification. The possibility of investing
penlsion funds in stocks, real estate, or foreign assets further diversifies
and provides partial inflation insuranice. But the fact that employers
choose or limit the worker's choice of investment manager poses agency
problems that could lower returns for workers. T his disadvantage can
be overcome by requiring an expanded set of choices or permitting dis-
satisfied workers to opt out of occipational schemes and into personal
pension schemes with equivalent tax advantages.
Conclusion
T       HE BIG ADVANTAGES OF OCCUPATIONAL l'ENSION SCHEMES
are that they are adaptable to diverse tastes and can be established
with little government involvemenit or incentive to evade-useful
features in developing countries with limited governmental capabilities.
Their adminiistrative costs tend to be low. W'hen funded and privately
managed, they have increased long-term saving. stimulated the modern-
198



OCCUPATIONAL PENSION -P
ization of capital markets, and encouraged financial innovation. In recent
vears, several industrial countries have tried to ease the financial burden on
public pension plans by encouraging the growth of occupational schemes,
making them mandatory (Australia and Switzerland) or quasi-mandatory
through collective bargaining (Denmark and the Netherlands), or permit-
ting employers to opt out of the public plan if they provide an equivalent
private plan Uapan and the United Kingdom).
Occupational plans suffer from several shortcomings, however, stem-
ming from  their uneven coverage, underfunding, and complexity.
When these plans are not mandatory, low-income workers often are not
covered; and workers with high final salaries fare the best. Workers who
thought they wvere covered have been left without adequate benefits
wlhen their plans turned out to be underfunded. Vesting and portability
restrictions, often poorly understood by workers, have penalized earls
leavers, discouraged labor mobility, interfered with efficient labor reallo-
cation, and created distributional inequities. In OECD countries, the
plans have grown at considerable fiscal expense because of generous tax
preferences. And failing plans have placed an unexpected burden on the
treasury, as the insurer of last resort.
These flaws have led increasingly to regulations over occupational
pension schemes, especially defined benefit schemes, as they have grown
in size and importance in industrial cotintries. Government involve-
menit has thus turned out to be essential and inevitable after all. Regula-
tions prohibit companies from offering different pension plans to dif-
ferent groups of workers and from  imposing onerous vesting and
portability conditionis. Adequate funding, indexation of benefits, and
information disclosure have been required, and public insuranice
schemes have been instituted in many countries. These regulations have
mitigated the problems but not eliminated them completely. Nor is it
probable that they could, given the complex actuarial calculations and
inherenit uncertainty involved.
Regulations have also changed the nature of occupational plans in
OECD countries, making them more costly, more uniform, less adaptable
as a personnel tool, and so less valuable to employers-who are therefore
less inclined to offer defined benefit plans voluntarily. The costs and dis-
incentives are particularly great for small business. As a result, defined
contribution schemes. automatically funded and more easily vested and
transferred, have been growing in importance. Occupational defined
contribution plans are very similar to the personal saving plans discussed
199



AVERTING THE OLD AGE CRISIS
in the next chapter, except that they do not provide complete coverage
(unless thev are mandatory) and they allow employers to choose the in-
vestment manager, although workers bear the investment risk.
In developing and transitional countries, occupational pension
schemes are still small. They are likely to spread, however, especially to
large domestic corporations and local subsidiaries of mtiltiniational cor-
porations. Although occupational schemes should be permitted, it is not
clear that they should be encouraged by special tax privileges unavailable
to other long-term saving arrangements. If tax incentives are involved,
for efficiency they should be given equally and with similar qualifying
conditions to personal and occupational plans, so that job choice is not
distorted by access to tax advantages. Most important, co prevent the
growth of ill-designed plans that ultimately fail, occupational schemes
should develop in accord with a regulatory structure in place from the
very beginning. These regulationis should include requirements of fund-
ing (according to specified actuarial standards), vesting, portability, and
information disclosure. They might include private reinsurance but
should not include public guarantees. Even if the regulations are not
fully enforced at the start, they become a standard and a warning of
what is likely to be enforced in the future. Such regulations will proba-
bly slow the growth of occupational schemes, especially defined benefit
schemes. But they will make those that survive more dependable and ef-
ficient. Drawing up this scructure is a step that developing and transi-
tional economies should take right now.
200



R 6
Personal Savings Plans-
Becoming Mandatory?
STRAIGHTFORWARDC WAY TO REPLACE EARNINGS
in old age is to save when young-something people
have done voluntarily in all countries and all time
periods, although to varying degrees and with differ-
ent instruments. In developing countries, this saving
was often part of the informal support system and
took the form of investments in land and children. In industrial coun-
tries, financial assets and government policies are more likely to be
involved.
Governments have encouraged personal long-term saving by creating
a stable economic and political environment, by establishing a legal
framework for banks and other finanicial institutions, and by offering
tax incentives to savers. Governments in several East Asian countries, in-
cluding Japan, Korea, Malaysia, and Singapore, have established postal
saving systems that offer greater security and accessibility, higher inter-
est (often tax-free), and lower transaction costs than would othenvise be
available, especially in rural areas. oECD countries such as Canada,
Switzerland, the United Kingdom. and the United States have granted
tax advantages to retirement saving and annuity accounts set up in
banks, life insurance companies, and mutual funds. Despite favorable
tax treatment, these and other voluntary long-term saving accounts tend
to be small compared with other sources of income in old age, it is not
clear whether tax incentives have increased aggregate saving, and most of
the tax benefits have gone to high-income households, many of which
would have saved in any event.
In recent years several cotintries have made retirement saving manda-
tory. The motivation for mandatory saving schemes is to solve the prob-
1em of shortsighted individuals who do not save when they are young
201



V2jT I NG THE OLD AGE CRISIS
and become a charge on1 the rest of society when they are old. Also, these
schemes may include provisions for increasing the reliability of savings
institutions-their absence in many countries constitutes another rea-
son why people do not save. Their basic mode of operations is as fol-
lows: contributions are deposited in personal accounts, and benefits
available in old age depend on these contributions plus the investment
income they earn. These schemes are thus fully funded defined contri-
bution plans not sponsored or differentiated by employer. In making
them mandatory, countries must confront a host of policy questions.
While recognizing the continuing importance of voluntary saving, this
chapter is mainly about these mandatory personal saving plans and the
policy issues that they raise.
Ftill funding implies capital accumulation, and a key question is how
these funds are managed and invested. Quite commonly, the govern-
ment determines the use of the mandatory saving accounts and sets the
rate of return. This type of plan, usually called a "provident fund," can
involve capital and labor market distortions and capricious redistribu-
tions similar to those in public defined benefit plans. As an alternative,
mandatory saving schemes may be privately and competitively man-
aged, in which case they are likely to have fewer distortions, fewer in-
centives for evasion, and less political manipulation.
Like funded occupational plans, mandatory saving schemes can fos-
ter long-term saving and capital market development. But unlike de-
fined benefit occupational schemes, they are fully funded by nature
rather than by regulation. Their coverage can be broad. They do not
imply portability problems or inhibit labor mobility. They permit work-
ers to diversify risk. And unlike defined contribution occupational
schemes, they allow workers, who bear the investment risk, to choose
the investment manager.
Mandatory saving nevertheless creates a new set of problems. Most
notably, privately managed schemes fail to insure workers against poor
investment performance of the funds, a problem especially great where
many workers have had little financial experience or information. In ad-
dition, they do not assist workers with low lifetime incomes or provide
adequate pensions in the start-up years of the plan. For these reasons, a
decentralized mandatory saving scheme requires a regulatory structure
that protects workers against ill-informed investment choices. And it
must be supplemented by a redistributive public plan that alleviates
poverty. Three central dilemmas are posed:
202



PERSONAL SAVINGSAP
* If mandatory schemes are needed because of shortsighted workers,
how can these same workers be counted on to make wise invest-
ment decisions?
* If governments have mismanaged their centrally administered
pension plans. how can they be counted on to regulate private
funds effectively?
* If government regulates and guarantees the schemes, won't it even-
tually end up controlling these funds?
Brief History
D        URING THE PAST FOUR DECADES, SEVERAL COlUNTRIES HAVE
begun experimenting with mandatory personal saving plans.
These plans were not only an alternative to voluntary saving.
They were, more important, an alternative to earnings-related public
pay-as-you-go systems of old age security that would have been de-
manded if some other mandatory scheme had not been adopted.
The first nationally mandated provident fund was established in
Malaysia in 1951, and the largest such fund is Singapore's Central Prov-
ident Fund, created in 1955. India and Indonesia established provident
funds in the early 1950s, but with limited coverage. Several African
countries followed in the 1960s, and several Caribbean and Pacific is-
land countries did in the 1970s and 1980s. Contributionis, which are
compulsory, are paid into individual worker accoLints in a national prov-
ident fund managed by a public agency. Today, some tventv countries,
mostly former British colonies in Africa, Asia, and the Pacific islands,
have such schemes. These countries had no public pay-as-you-go pillar
when they established their national funded plan.
These provident funds have earned positive investment returns in
such East Asian and Pacific cotintries as Fiji, Malaysia, and Singapore,
where economic policies have emphasized financial stability and fiscal
responsibility. But economic instability, inflation, and devaluation in
most African and some Caribbean countries have produced large nega-
tive rates of return and widespread dissatisfaction with the performance
of the funds. So, several of these countries-including Dominica,
Grenada, St. Lucia, and St. Vincenit and the Grenadines in the 1970s
and 1980s and Ghana in 1991-have replaced their national provident
203



W   ING  THE OLD ACE CRISIS
funds with defined benefit pay-as-you-go pension schemes. Several
other African countries are considering following Ghana's example.
Until 1994, Chile was the only country that had fully replaced an ex-
isting public pay-as-you-go pension scheme with a mandatory saving
scheme. Chile was also the only country whose mandatory saving pro-
gram is privately and competitively managed. Operating since 1981, the
Chilean scheme is known as the AFP system, after the private companies,
called Administradoras de Fondos de Pensiones, authorized to run it.
The public pension system was replaced because of widespread evasion,
unsustainably high contribution rates, and an inequitable benefit struc-
ture. For similar reasons, other Latin American countries, including Ar-
gentina, Colombia, and Peru are now replacing or supplementing their
public pension schemes with mandatory competitive saving schemes.
It is curious-although not surprising in view of their age structures
and historical experiences-that this transition away from a dominant
public pillar toward greater reliance on mandatory saving schemes is oc-
curring in older Latin American countries at the same time that younger
African countries are contemplating a transition in the opposite direc-
tion. Because Chile's is the only fully implemented decentralized scheme
at this point, the discussion here draws heavily on1 its experience.
How Mandatory Retirement Saving Schemes Work
I N MANDATORY SAV'ING SCHEMES, THE BENEFITS WORKERS
ultimately receive depend on their contributions, investment earn-
ings, and expected longevity. The performance of these schemes de-
pends largely on whether the funds are publicly or privately managed.
The Contribution and Target Replacement Rates
In a mandatory saving scheme, the worker's pension is financed by
the savings accouLtC that accumulates before retirement, and its size de-
pends on the contribution rate, the growth rare of earnings, the interest
rate, and the number of working and retiremenit years. The required
contribution rate rises the higher the target wage replacement rate, the
longer the retirement period relative to the working period (the passiv-
icy ratio), and the smaller the rate of return relative to the growth rate of
204



PERSONAL SAVINGS. PL
i-eal earnings (table 6.1). The required contribution rate is also higher in
plans that make poor investments, incur high administrative costs,
index pensions to prices or wages, or permit accumulated balances to be
used for such other purposes as housing. education, or health care.
When rates of return are high because of a scarcitv of capital, a manda-
tory saving scheme enables a high wage replacement rate while making
resources available for investment and growth.
Differences in the basic parameters of the plan may explain why the
contribution rate is only 13 percent of wages in Chile but 20 percent in
Sri Lanka, 22 percent in Malaysia, and 35 percent in Singapore. During
the 1980s in Singapore, about two-thirds of fund withdrawals were used
for housing purchases, some of which may eventually have found their
way back into retirement income. In Chile, about one-quarter of total
contributions are used for term life and disability insurance and fund ex-
penses, with all the rest used for retirement savings. Given this and the
higher interest rate relative to wage growth in Chile, it is likely that the
same replacement rate of final gross earnings-about 40 percent,
Table 6.1 Contribution Rate Needed to Pay Pension Equal to 40 Percent
of Final Salary under Mandatory Saving Scheme
Nonindexed pension       Pension indexed to prices
Passivity rate      I  / 2        1 / 3         1 / 2         1  / 3
Real wage
growth             0       2      0     2       0      2      0      2
Real interest rare
0             13    18       9     14     20     29    13    20
2              7    11       5      8     11      16     7    12
5              3      5      2      3      5       7     3      5
Real pension
rate at deathd    15    15    19    19    40       40    40    40
Relative pension
rateatdeathb    15    10      19     14     40     27    40    30
Note: Plan expenises and disability and survivors' benefits are not included. These
would raise the required contribution rate 3 to5 percentage points in a well-run plan. A
5 percent inflation rate is assumed. The one-half passivity rate stems from an assumption
of forty working years and twenty years of retirement. The one-tlird passivity rare
implies forty-five working years and fifteen years of retirement.
a. Real pension in year of death as proportion of final year's salary.
b. Pension relative to average wage in the economy in year of death.
Source: Schwarz (1992a); Vittas (1992).
205



FR.T:ING THE OLD AGE CRISIS
Table 6.2 Payroll Tax Rates for Mandatory Saving Schemes, 1991
Combined
as a
percentage
of wage plus
Percentage of wages                e'mployer
Country             Employees      Employer       Combined          tax
Africa
The Gambia                5             10              15         13.6
Ghanaa                    5           12.5            17.5         15.6
Kenya                     5              5             10           9.5
Nigeria                   6              6             12          11.3
Swaziland                 5              5             10           9.5
Tanzania                 10             10             20          18.2
Uganda                    5             10             15          13.6
Zambia                    5              5             10           9.5
A.ia
Fiji                      7              7             14          13.1
India                    10             10             20          18.2
Indonesia                 1              2               3          2.9
Kiribati                  5              5              10          9.5
Malaysia                  9             11             20b         18.0
Nepal                    10             10             20          18.2
Singapore                25C            10             35          31.8
Solomon Islands           5            7.5            12.5         11.6
Sri Lanka                 8             12             20          17.9
Western Samoa             5              5              10          9.5
Latin America (1994) d
Argentina                11              0             11          11.0
Chile                    13              0             13          13.0
Colombia                2.9            8.6            11.5e        10.6
Peru                   13.3              0           13.3          13.3
Note: African and Asian schemes are publicly managed provident funds; Latin
American schemes are privately managed.
a. The provident fiind is being converted to a social insurance scheme.
b. This was raised to 22 percent in 1993.
c. The contribution varies from 7 to 30 percent of gross wages for workers.
d. ForArgentina and Colombia a new plan started in 1994, for Peru in 1993.
e. This will rise gradually to 14.5 percent in 1996.
Source: U.S. Social Security Administration (1993); Colombia (1993); World Bank
data.
indexed-will be produced in both countries (tables 6.1 and 6.2). If
workers want to have a higher replacement rate, say, 60 to 65 percent of
final gross earnings, they will have to save more voluntarily.
206



PERSONAL SAVINGS:PLK
The contribution rate could vary with income and age. For example,
the rate could be lower for young and old workers-but high in the
middle years, which are generally the high point of life cycle earnings. In
Singapore, the rate is lower for older workers-40 percent for those
under the age of 55, 25 percent for those 55 to 59, 15 percent for those
60 to 64, and 10 percent for those 65 and older-and workers with low
annual earnings also pay less. This schedule helps smooth consumption
over the worker's lifetime, a major purpose of the scheme.
Investment, Longevity, and Inflation Risk
In mandatory saving schemes, workers assume the investment,
longevity, and inflation risks of their retirement funds. Retirement in-
come will be lower if investment performance is poor. And if people live
longer than expected, they may outlast their retirement savings. Some
schemes require workers to purchase annuities when they retire-to in-
sure against unexpected longevity. Investment risk is particularly high
wheni accumulated assets are used to purchase the lifetime annuity, and
the market interest rate on the date the annuity is purchased is critical.
It is important that schemes include some method of spreading this risk
across time (see below and issue brief 10).
For inflation risk, an important question is whether pensioners
should be required to purchase indexed annuities-and if so, whether
these should be indexed to wages or prices. In a mandatory saving
scheme, individual workers pay the cost of their own indexation in the
form of lower initial benefits or higher contribution rates (table 6. 1 ), in
contrast to pay-as-you-go schemes, in which workers bear this risk to
protect retirees. In reality, however, retirees are never completely pro-
tected in either type of scheme (see chapter 4). Mandatory saving plans
can reduce inflation risk by investing in equities and real property
(whose nominal values generally rise with inflation), foreign assets
(avoiding country-specific shocks), and indexed instruments (passing
on the risk to those who are most willing to bear it).
Centralized or Decentralized Management
Risks, costs, and rates of return are strongly influenced by whether
the fund is centralized or decentralized. Centralized provident funds are
run by an agent of the national government. In their ideal state, they in-
207



T1NG THE OLD AGE CRISIS
vest productively and benefit from economies of scale that minimize op-
erating costs. Malaysia and Singapore are examples of national provi-
dent fuinds with low costs and stable, though modest, returns. However,
more typically, managers of centralized provident funds, which are com-
pulsory monopolies, may have little incentive to operate efficiently or
earn reasonable returns-and may be subject to political pressures to in-
vest unproductivelv.
Decentralized competitive plans, by contrast, face market pressures
to operate efficiently and maximize returns and are at least partially in-
sulated from political pressures to misallocate capital. Workers choose
the fund in which to place their savings, presumably based on its record
of returns and risk. But these plans require a complex regulatory struc-
ture to ensure the financial soundness and integrity of fund managers
and to prevent workers from making big mistakes. Regulating decen-
tralized mandatory saving schemes requires considerable human capital
and institutional capacity, including the ability to enact clear rules and
penalize malfeasance in predictable ways. Some elements of modern fi-
nancial markets are also needed, though these are likely to develop in re-
sponse to the scheme. For countries that satisfy these criteria, privately
managed mandatory saving plans deserve careful consideration.
Impact on the Broader Economy
L   IKE FUNDED OCCUPATIONAL PLANS, MbANDATORY PERSONAL
plans can have positive effects on capital accumulation and capi-
tal market development-but they attain these effects with fewer
labor market distortions.
Implications for Capital Markets
The mandatory saving pillar can be important for increasing long-
term saving, accelerating capital market development, boosting invest-
ment in productive capital, and monitoring corporate performance. For
countries where the currenit rates of long-term saving and capital accu-
mulation are below optimal levels, such changes have the potential to
enhance economic growth. But the allocation and productiviry of this
capital depend on whether the funds are publicly or privately managed.
208



PERSONAL SAVIN GS    "
Impact on long-term saving. When a mandatory saving rate is set, to
some extent it simply replaces voluntary saving. A low mandatory sav-
ing rate, say 5 percent or less, is likely to be largely counteracted by cuts
in voluntary saving, having a negligible effect on net capital formation.
At higher rates, this crowd-out effect mav be only partial because people
are shortsighted and would not have saved as much voluntarily for old
age. Some of their personal saving may be for bequests or precautions,
not easily satisfied by mandatory retirement saving schemes. Limits on
consumer borrowinig may prevent people from dissaving against future
pension benefits. And people might have little faith in the new system,
treating their contributions as a tax and continuing to save privately for
their old age.
Overall, then, it seems likely that a mandatory saving scheme will in-
crease household saving relative to the situation without a scheme (and
even more so relative to a pay-as-you-go system). The higher the re-
quired contribution rate and the lower the opportunities for offsetting
actions such as consumer borrowing, the greater this effect will be. Per-
haps more importanit is the shift it brings about in the composition of
savings in favor of long-term financial assets controlled by large financial
institutions, instead of real estate, precious metals, and land (see chapter
3 and issue brief 4).
Empirical evidence on the savings effect of mandatory saving
schemes is ambiguous. During the 1970s and 1980s, Singapore had the
highest private saving rate in East Asia, with Malaysia close behind. In
Chile, private saving went up sharply in the decade after the mandatory
saving scheme was introduced. But many other factors were at work in
all three cases, so it is difficult to pin down how much of the high sav-
ing, if any, was due to the mandatory saving scheme. More striking was
the large increase in financial assets controlled by the scheme. In Singa-
pore, the resources of the Central Provident Fund rose from 28 percent
of GDP in 1976 to 76 percent in 1991 (despite large withdrawals for
housing). In Malaysia, the balances of the Employees Provident Fund
increased from 18 percent of GDP in 1980 to 41 percent in 1991 (table
6.3). In Chile, resources of the 4FP system totaled 35 percent of GDP by
1991, after ten years of operation.
Mandatory saving plans are thus able to generate-in a short time-
substantial long-term savings invested in financial assets. Consider the
case in which labor income represents 50 percent of national income. A
compulsory scheme covering 50 percent of the labor force and imposing
20c



*4g~T1NG THE OLD AGE CRISIS
Table 6.3 Assets of Selected National Provident Funds
(as a percentage of GDP)
County                 1983              Most recenttyear available
Singapore              53.8              75.6             (1991)
Malaysia               24.4              40.8              (1991)
Solomon Islands        15.4               -                 -
Zambia                  9.1               5.8             (1989)
Sri Lanka               8.1              15.2             (1990)
Swaziland               6.0               5.4             (1987)
Nepal                   3.8               -                 -
India                   1.9               4.5             (1990)
Indonesia'              1.0               1.4             (1990)
Ghanab                  -                 0.6             (1986)
Fiji                    -                43.9             (1987)
Nigeria                 -                 0.7             (1988)
Barbados                -                16.0             (1986)
Kenya                   -                11.5             (1989)
-Not available.
Note: Refers to main provident fund in each country.
a. Refers to both public employees' and national provident funds.
b. Provident funds are being replaced by social insurance svstems.
Source: IMF, InternationalFinancial Statistics (various issues); International Social
Security Association (1986); Dixon (1989); Astek (1992); Asher (1992a, 1992b); India
Employees' Provident Fund (1990); Zambian National Provident Fund (1989); Kenyan
National Provident Fund (1990). See Palacios (1994c) for further description of the
dara.
a 10 percent contribution rate would annually accumulate funds equal
to 2.5 percent of national income. If the rate of return on fund balances
equals the rate of growth of GNP (and because pension payouts would be
minimal in the early years of operation), such a scheme would accumu-
late resources equal to 12.5 percent of GNP over five years and 25 percent
over ten years. Afrer the first ten years, the growing volume of benefit
payments would slow the pace of accumulation-though a higher in-
terest rate, broader coverage, and rising share of labor income would ac-
celerate the rate of accumulation.
In the very long run-in a closed economy, and even in an open
economy if mandatory funded plans become common-the marginal
productivity of capital and the real rate of return may fall as long-term
savings accumulate. At some point, the productivity of capital may fall
so far that further high saving is no longer warranted. Since the problem
in many countries now appears to be a shortage rather than an over-
210



PERSONAL SAVINGS PLANS
abundance of capital, this effect is far off in the future. And it can be
forestalled further by international diversification, investment in human
capital complementary to physical capital, shifts of labor from the in-
formal to the formal sector, and capital-intensive technological change.
But it is well to bear in mind that a mandatory saving rate, if too high,
will diminish social welfare-and that the "right" rate may decline as the
stock of long-term capital grows.
Impact on capital allocation. Establishing a mandatory saving scheme
presents an opportunity to stimulate capital markets and expand the
supply of productive capital. Nevertheless, the allocation and produc-
tivity of this capital depends on whether the funds are publicly or
privately managed. Most centrally managed funds have been invested
in the bonds of government or in failing public enterprises at low
nominal interest rates that become negative during inflationary peri-
ods. If government has exclusive access to the funds, spends them
wastefully, and pays workers an arbitrary interest rate, the potential ad-
vantages of mandatory saving schemes are lost. In fact, such schemes
become very much like pay-as-you-go schemes in their capital and
labor market effects.
Because of the fungibility of money once it becomes part of the gov-
ernment budget, the real productivity of these provident funds is not
known. The funds may increase government consumption or invest-
ment beyond what they would have been otherwise-or they may sub-
stitute for explicit taxes while holding government spending un-
changed. Each has a different impact on national output and its
composition and distribution. It is known, however, that the real re-
turns credited to worker accounts have ranged from around zero
(India) to highly negative (Zambia and other African countries) (fig-
ures 3.3 and 4.5). So, for the worker, these systems have failed. And for
the broader economy, their allocations have not been subject to any
competitive market test or even public scrutiny.
Even in Singapore, more than 90 percent of fund assets have been
invested in nontradable government securities with an average rate of
return of 3 percent in the 1980s (Asher 1992b), similar to that on
twelve-month time deposits and less than what long-term contractual
savings could have earned in the market. Using revenues borrowed
from the provident fund among others, the Singapore government has
invested in foreign assets. The authorities claim that returns have been
high, but the claims cannot be corroborated, since audited published
211



r*-I_T1NG  THE OLD AGE CRISIS
data are not available. At any rate, the returns go to rhe government,
not to the provident funds. The relatively low interest rate paid to the
fund could thus be viewed as a hidden tax on workers to finance gen-
eral government expenditures and reserves.
Most countries with national provident funds allow employees to use
part of their balances for housing and other specified purposes, and
Singapore now allows limited investments in approved securities. Mem-
bers are obliged to redeposit the funds with the provident fuind if they
sell the houses or other investments (Asher 1992a). This use of funds
has a positive effect on home ownership and the housing market but re-
duces the impact of national provident funds as a source of productive
capital investment and retirement income. It is not clear that mandatory
saving for housing is justified on efficiency grounds.
By contrast, in a decentrally managed competitive system such as that
in Chile, workers pick their management company from a small num-
ber of authorized AFPs and can transfer their accounlts from one com-
pany' to another. This gives decisioninaking authority to workers, wlho
are cle,rlv interested in maximizing returns and minimizing risk, and
avoids the problem of earning below-market returns and encouraging
excess government spending. But workers may not have the information
needed to make wise choices. Their investments may be too risky in
some cases and too conservative in others, so they may eventually be-
come charges on the rest of society. To counter this problem, the
Chilean government has imposed strict regulations to protect the safety
and profitability of investments (see below).
Given the decentralized managemenit and the block on personal with-
drawals, the Chilean pension system has become a dominant player in
the capital market-a force facilitating privatization and growth. Initially
the AFps invested predominantly in government bonds, but gradually
they shifted to corporate securities-especially equities, as the Chilean
stock market boomed and investment rules were liberalized (Vittas and
Iglesias 1992). Now the government must compete for access to funds
and pay the competitive market price. The AFP system also invested heav-
ily in the privatization of public utilities in the mid-I980s, accounting
for 10 to 35 percent of the equity capital of the privatized utilities-and
even more of the domestically held equity capital. By 1991, 38 percent of
AFP funds were in state securities, 24 percent in corporate equities, and
about 13 percent each in corporate bonds, mortgage bonds, and bank de-
posits. AFPs hold more than one-third of all public sector bonds, two-
2.12



PERSONAL SAVINGS PLA"
thirds of all private sector bonds, and 10 percent of all corporate equities
in the country (Superintendencia de AFPs, Banco Central de Chile).
Perhaps more important, the pension system has stimulated the de-
velopment of other institutions and practices that have deepened
Chilean financial markets over the past decade. These include modern
bank supervision, new securities and corporation laws, increased dis-
closure requirements for public companies, risk classification agencies
for bonds, a long-term corporate bond market and a second stock mar-
ket, new types of mortgage bonds, and improved regulation of insur-
ance companies.
The rate of return to workers in the Chilean system has been much
higher than in countries with centrally managed mandatory saving pil-
lars. During the first ten years, the gross annual real return averaged 13
percent, and the average net yield to workers, after fees, was about 9.2
percent, albeit with large variations among different funds and individ-
uals (Acufia and Iglesias 1992). Such high gross returns cannot be ex-
pected in the long runi, but the high start-up costs of the first two years
also will not continue; they have already been reduced from 14.7 per-
cent of assets in 1982 to 1.6 percent in 1992. Overall, this experience
is consistent with the observation that decentralized funded plans have
earned far higher rettirns than centralized plans-perhaps reflecting
their competitive nature and the market tests for their allocations.
Pension fund concentration and corporate governance. Mandatory pension
funds, if invested in the private sector, could eventually come to domi-
nate the owniership of financial assets that represent claims on the econ-
omy's real assets-land, housing stock, commercial property, and indus-
trial equipment. This ownierslip structure has implications for corporate
governance, since pensioni funds would become major stockholders and
could exercise voting rights and power over corporate management. Al-
though also true for voluntary occupational pension plans (chapter 5),
the magnittides involved can become much greater with a manidatory
plan.
The concentration of ownership means that mandatory pension
funds could not simply buy and sell shares without disrupting the mar-
ket. It also makes it worrhwhile for them to incur the costs of gathering
and processing information. And it allows them to monitor the man-
agement performance of corporations. The other side of the coin is that
it may give a small numiiber of pensioni funds an influential voice in in-
terlocking directorates-an anticomiipetitive force in strategic corporate
213



AVERTING THE OLD AGE CRISIS
decisions. Centralized provident funds are even more concentrated. If
these funds were to invest in corporate equities, public officials could
gain control of corporate affairs, a back door to nationalization.
In Chile, the three largest companies account for more than 60 per-
cent of total funds and a big chunk of total corporate equity. So far, the
AFPs have not attempted to monitor or control corporations, and pub-
licly managed provident funds have not invested in private corporations.
But funded plans in other countries are doing so. In the United States,
funded occupational plans have begun to monitor the governance of the
corporations in which they have an ownership stake. Because this chan-
nel allows pension funds to have a far-reaching influence on the econ-
omy, it becomes particularly importanit for them to be concentrated-
but not too concentrated-and to have incentives that encourage the
right performance from corporations (chapter 5 and box 5.3).
Implications for Labor Markets
Mandatory saving plans, unlike public or occupational plans (partic-
ularly defined benefit plans), have relatively little impact on the labor
market. Since workers eventually recoup their contributions, with inter-
est, they are less likely to see saving as taxes, which they try to evade. And
since they "own" their accounts, they can carry them along from one job
to another with no penalty for mobility. In this sense, the important
story is that there is relatively little labor market story, compared with
the other types of plans.
Even so, some distortions remain. First, when contribution rates are
much higher than households' desired saving rates (presumably the rea-
son for a mandatory scheme), incentives are created to evade by shifting
to the informal market, tinderstating covered wages, and substituting in-
kind benefits for wages. When interest rates are below-market, as is
often the case for provident funds, this effect is exacerbated. If workers
cannot evade they may be induced, by their higher accumulated savings
and compulsory savings rate, to retire early. Thus, mandatory saving
plans may reduce the supply of labor, especially experienced labor, in the
formal sector. In addition, wage rigidities may prevent employers from
shifting their share of the payroll tax to workers-and may decrease em-
ployment instead. Singapore seems to have experienced this effect in
1984, when it raised the contribution rate to 50 percent of wages, shared
equally by employers and employees. T he employers' rate was cut in half
214



PERSONAL SAVINGS P1.
the following year because of the belief that this had affected employ-
ment adversely. Both of these factors imply a tax element that distorts
the labor market and limits the efficient contribution rate.
Fiscal Implications
A mandatory saving plan also has fewer fiscal implications than a
pay-as-you-go public plan since workers receive only the value of their
contributions plus investment earnings. Political pressure to increase
public spending on pension benefits is absent. In fact, governments have
borrowed from provident funds at below-market interest rates, cutting
future pension benefits and current public borrowing costs. But these
low rates could increase public deficits if they induce the government to
spend more on other goods and services. The danger is that the spend-
ing, financed by a hidden tax on workers, may not be productive. (This
is similar to the problem posed by large reserves in a partly funded pub-
lic plan.) Decentralized schemes that charge market rates avoid this
problem. But if the government guarantees their benefits, this consti-
tutes another state obligation that could become surprisingly large if
strategic manipulation and moral hazard are not controlled.
Another important fiscal effect stems from the tax treatment of pen-
sion savings. Tax incentives are not essential for mandatory schemes, but
they improve compliance and are therefore common. The tax loss may
force the government to reduce spending or to raise other taxes, which
could have a high efficienicy cost (Valdes-Prieto and Cifuentes 1993).
Contributions to most mandatory saving schemes are deductible for
income tax, as is the current investment income from the funds. Work-
ers in Chile are allowed to contribute additional amounts on a voluntary
tax-exempt basis. In most schemes, withdrawals are subject to tax, like
any other income. The benefits of tax deferral are greater for higher-
income workers, because their initial tax savings are higher and they are
likely to be in a lower tax bracket after retirement. To avoid this perverse
redistribution, limits may be placed on the tax-advantaged benefits or a
tax credit may be offered rather than making contributions tax-
deductible, as has been proposed for occupational plans (chapter 5).
Malaysia and Singapore exempt both the contributions and the
withdrawals-as well as the interest earned in between-from taxation.
The total tax benefits of Singapore's national provident fund (and the
government tax revenue forgone) are estimated at slightly more than I
215



THE OLD AGE CRISIS
percent of GDP for 1987. roughly the tax expenditures for the U.S. oc-
cupational pension system (Turner and Beller 1989). The Singapore
fund thus provides a valuable tax shelter for contributors, especially
high-income workers who would be subject to higher marginal tax rates
on other investment income (Queisser 1991). The higher tax benefits
received by upper-income groups may be one reason they go along with
the high contribution rates and low interest rates.
Do Mandatory Saving Schemes Redistribute
Income and Alleviate Poverty?
IN PRINCIPLE, A NMANDATORY SAVING SCHEME COVERS Al-L FOR-
mal sector workers, far more than in a voluntary or quasi-voluntary
occupational plan. So, everyone should benefit from access to saving
and insurance instruments. Moreover, in principle, there is no explicit re-
distribution: benefits and contributions are directly linked. In particular,
the large intergenerational redistributions in pay-as-you-go systems are
avoided. But some nontransparent intragenerational redistributions still
occur, particularly in centrally managed funds, and these often involve
transfers from low-income households to high-income households.
Redistributions
People whose voluntary saving rate was lower than the mandatory
rate, as already noted, value their expected pensions less than their cur-
rent contributions, and in terms of their own evaluation are losers-
although others in society may feel they are misinformed, myopic, and
therefore winners from the mandatory plan. They are likely to be pre-
dominantly from lower-income households. If the government borrows
from provident funds at below-market rates, in lieu of increased taxes to
finance general public expenditures, this has a further redistributional
effect-since the incidence of the payroll tax is not the same as that of
the general revenue tax and generally is more regressive. If the borrowed
funds are used to finance public expenditures that would not otherwise
have been undertaken, income is redistributed from fund contributors
to the beneficiaries of the additional government spending. Such trans-
fers are hard to trace, because doing so requires knowing what would
2i6



PERSONAL SAVINGS PL,A:I.
have happened if the funds had not been available. That is why the
tranisfers are likely to benefit privileged groups, who are in a position to
understand and influence government transactions. This unclear redis-
tribution is far less likely in a decentralized mandatory saving scheme.
Allowing contributors to withdraw funds before retirement also
benefits middle- and upper-income grouips. Singapore's condition of
permitting early withdrawals from the national provident fund for edu-
cation, home ownership. and alternative investmenits as long as contrib-
utors maintain a minimum balance in the plan is one that few low-
income workers can meet. In some countries, plan members are
permitted to borrow against their savings at below-market rates for spec-
ified purchases-an option again used mainly by high-income groups.
A more competitive system for investing pension funds, yielding a
higher rate of return, would reduce this perverse redistribution.
Perverse redistribution may also result, in both publicly and privately
managed funds, if retiring workers are compelled to purchase annuities
that pool people with long and short life expectancies. Public policies
that prohibit distinctions among different demographic and socioeco-
nomic groups in setting the terms of annuities and life insurance con-
tracts have this effect. For example, if regulations require retiring mine
workers and white collar employees to pay the same price for annuities,
the result would be regressive. This effect could be offset by reducing an-
nuity prices for lower socioecononic groups, by topping up their ac-
counts directly. or by paying larger benefits to their survivors.
Most mandatory saving schemes avoid this problem by paying lump
sums instead of annuities on retirement. But this means they do not
provide longevity insuranice and do not protect the very old against
poverty. Chile gives workers a choice between purchasing an annluity or
taking phased withdrawals that are scheduled to last an expected lifetime
and that avoid the redistribution problem. Chile also requires all em-
ployees to purchase term life and disability insurance, in which mine
workers get a net benefit if they are in the same pool with white collar
workers.
Poverty Alleviation
Mandatory saving schemes have been criticized for their failure to
protect low-wage workers or workers withi interrupted careers, many of
whom are women who spend part of their lives doing household work.
217



E-RTING THE OLD AGE CRISIS
Another criticism is that they may prevent old age poverty among
middle- and high-income workers, but low-income workers may never
accumulate enough in their pension accounts to support themselves in
their old age. A third criticism is that early generations of retirees are not
protected by these schemes, because it takes many years for enough pen-
sion capital to build up. Along similar lines, pensions mav fall below
subsistence standards because of inflation or unexpectedly low returns.
For all these reasons, mandatory saving schemes can still leave consider-
able old age poverty.
Some of these possible sources of poverty can be handled without
public transfers. In Chile, the purchase of private disability insurance
and term life insurance is compulsory. Most provident funds do not
provide or require such insurance, leaving survivors and disabled work-
ers largely unprotected and poor. Regulations could require joint contri-
butions and joint ownership of retirement savings accounts between
spouses, protecting women whose labor force participation has been in-
terrupted. Beyond that, governments can deal with the problems of
long-term poverty alleviation and extreme investment risk by guaran-
teeing a minimum pension based on years of employment-or by redis-
tributive social assistance programs; this might be considered an accom-
panying role of the public plan. Chile provides such assistance and
guarantees, financing them from general tax revenues.
Regulatory Issues in Decentralized Schemes
D_       ECENFRALIZED COMPETITIVE SYSTEMS ARE MORE LIKELY
than centralized provident funds to maximize investment re-
turns and contribute to capital market development. But de-
centralized plans raise a host of public policy issues related to the fidu-
ciary standards of pension companies, the safety of their investments, the
size of fees and commissions, the information disclosed, and the guaran-
tees provided by government. Extensive regulation is needed because
workers often lack the expertise to invest wisely and because private pen-
sion companies might exploit their ignorance. Some private investment
managers might take too many risks to maximize yield and attract affili-
ates, whereas others might be too conservative to keep up with produc-
tivity and inflation. Given the long term of pension investments, it may
218



PERSONAL SAVINGSPL`
be too late for workers to recover financially through new saving once the
damage becomes evident. Trying to remedy this flaw through govern-
ment guarantees may create moral hazard and fiscal problems. Regula-
tions are designed to protect both individual workers and society from
perverse competition in the face of information deficiencies. This pro-
tection is particularly important in a mandatory program.
If governments cannot control centralized pensioni funds very well,
can they be counted on to regulate decentralized systems well? And at
what point does a strict regulatory structure wipe out competition and
become government control? Chile shows the kinds of regulations that
are workable and may-or may not-be advisable.
Ensuring the Solvency of Funds and the Integrity of Managers
Which funds qualify as custodians of mandatory saving accounts? To
ensure competent and responsible administration of pensions finds and
protect solvency, criteria must be established for entry conditions and
miniimum capital margins. The shortage of local expertise in many de-
veloping countries can be overcome by using foreign fund managers in
joint ventures with local firms. Developing countries reluctant to use
joint ventures may have a hard time assembling the expertise needed to
run pensioni funds well, especially in the early years.
Chile limits participation in the mandatory scheme to AFPs, the spe-
cialized pension fund management companies. The Aids are regulated
and supervised by the Superintendency of AFPs, which has authority
over charter approval. Any group of shareholders-including corpora-
tions, trade associations, labor unions, and other financial institutions
(but not banks)-can establish an AFP. Until recently, the three largest
AFPs, serving about two-thirds of the market, were joint ventures (Vittas
and Iglesias 1992).
The pension fund is an independent entity, segregated both legally
and financially from AFPs. The assets of the pension fund belong exciti-
sively to individual members, are not attachable, and are not affected by
any financial losses suffered by AFPs. AFPs are required to maintain in-
vestment reserves equal to 1 percent of the total assets of the pension
fund they manage. Reserves must be invested in the same assets as the
pension fund under the AFP's management to ensure that AFl's apply the
same incentives in investing the resources of the pension fund as they do
for their own resources.
219



t:EFRTING THE OLD AGE CRISIS
In Chile, to simplify the workers' choice ofAFP and the switch of their
accumulated balances to another AFp, regulations impose a strict limit of
one account per worker and one fund per management company-
regulations that are very restrictive and very controversial. Allowing work-
ers to have accounts with more than one company would let them hedge
their bets and reduce their dependence on the performance of a single
companv. And allowing management companies to operate a wider range
of funds would let them develop expertise in market niches and tailor
products to different tastes and age groups. For instance, equiry growth
funds might appeal to vounger workers, more conservative stock funds to
middle-aged xvorkers, and income-yielding stock-bond funds to older
workers. The one-account, one-fund rule reduces variety, choice, and
diversification-three potential advantages of a decentralized system.
The restrictions are aimed at preserving the system's simplicity and
transparency, features considered important for a compulsory scheme
involving large numbers of financially unsophisticated people. Allowing
companies to manage a wider range of investment funds and allowing
workers to use more than one fund would complicate compliance mon-
itoring. For example, it would become more difficult to prevent with-
drawals or a concentrationi of the worker's portfolio in risky assets. As
the systemn matures and workers gain financial experience, regulations
may become less restrictive. But in the meantime, the cost of simplify-
ing regulations is the loss of choice and risk diversification.
Keeping Investment Risk within Reasonable Bounds
Finanicial regulation aims to protect participants from fraudulenlt or
imprudent behavior by the managers of financial institutions-a task
that assumes particular importance in long-term mandatory schemes.
One way to provide such protection is through regular disclosure of in-
formation. AFI's in Chile are required to provide statements to contribu-
tors three times a year-disclosing the last four monthly contributions
paid by employers, the financial performance of the pension fLnd, and
the accumulated balance and rate of return on individual accounts.
Participants are further protected throughl investment rules. C'hile
started out with rigid investmenit regulations-and gradually eased
them as the experience of workers and funds increased. Initially, invest-
ments in equities and overseas securities were not allowed, but they now
are, in steadily increasing amounts. Only tipper limits are imposed on
220



PERSONAL SAVINGS PLAN.:8-
investments to control the exposure of pension funds to particular risks.
There are no floors requiring purchase of government bonds or other
"socially useful" investments. Currently, the upper limits are 50 percent
on government bonds, 30 percent on corporate equities, 10 percent on
foreign securities, and similar limits on bank deposits, mortgage loans,
and other assets (Vittas and Iglesias 1992). As discussed above, currenit
portfolio allocations imply that these ceilings are not binding for most
AFPs. Ceilings also apply to permissible investments in the securities of
individual companies. Ceilings are higher for so-called Chapter 12 com-
panies, which accept severe restrictions on their management indepen-
dence. So far, only recently privatized utilities have opted to qualify for
Chapter 12, which has allowed pension funds to play an important role
in their privatization.
The dispersion in returns across AFPs is reduced through the regula-
tion of relative maximum and minimum returns. If a fund's real invest-
ment return over a rolling twelve-month period is 50 percent higher or
2 percentage points higher (whichever yields the higher rate of return)
than the average for all pension funds, the AFP has to place the difference
in a profitability reserve, which becomes an asset of the pension fund,
not the AFP. Similarly, if the real investment return for a pension fund is
less than half the average of all pension funds or 2 percentage points
lower (whichever yields the lower rate of return), the AFP has to make up
the difference by transferring funds from the profitability reserve-and
if this is inadequate, from its owxv investment reserves. If an AFP cannot
pay the shortfall, it is declared bankrupt, its pension fund assets are
transferred to other AFPs, and the government makes up any remaining
difference. So far, no profitability reserves have been established, and
three AFPs have been dissolved or merged, with no loss to the govern-
ment or the pension funds they managed.
Maximum and minimum limits on annual relative pension fund re-
turns are designed to avoid wide dispersion across AFPs. But they also in-
duce herd behavior, since funds are penalized for being different from
the average, not for being wrong in absolute terms. In addition, using a
twelve-month average in calculating returns unduly emphasizes short-
term performance. which is undesirable for long-term contracts that
may span sixty years or more. Volatile funds that might get higher re-
turns over the long run are penalized, while less volatile funds that per-
sistently perform at the lowver end of the permitted range, producing
substantially below-average returns over the long run, are not penalized.
221



1THE OLD AGE CRISIS
An alternative approach would apply narrower limits (say, 25 percent
rather than 50 percent) on performance over three- to five-year periods.
Another alternative would specify the maximum and minimum returns
as two standard deviations away from the average in a given year or one
standard deviation over five years. The better informed workers are, the
less need there will be for such regulations, as workers will shift their sav-
ings away from consistently poor performers.
To protect against inflation, pensioni fund managers could be re-
quired to invest a portion of their portfolios in assets that provide an ef-
fective hedge against inflation. Although Chile does not require indexa-
tion by AFPs, this position is widespread in Chilean financial markets-a
response to demand in an environment in which inflation has histori-
cally been a problem. More than 95 percent of AFP investments are in
equities, real assets, or indexed bonds, including indexed bonds issued
by banks or private firms whose value is tied to the monthly cost-of-
living index. This counters the common assertion that the private sector
cannot offer fully indexed securities and cannot protect against infla-
tion. Hedging against inflation would be much more difficult, however,
in countries with less developed financial markets, poorly indexed fi-
nancial instruments, and an inflation rate that is high and volatile.
Allowing Investments in Overseas Assets
Allowing pension funds to invest freely overseas permits diversifica-
tion of counltry risk. But it also raises fears of institutionalized capital
flight, loss of control by monetary authorities, and depriving local mar-
kets of the increased availability of long-term funds (box 5.5). Perhaps
because of these fears, Chile did not allow the AFPs to invest in foreign
securities until 1991 and then only on a gradual schedule, beginning at
I percent of funds and rising to 10 percent by 1995. Authorizing in-
vestment in foreign securities represents a recognition of the maturity of
the system, the large size of the pension funds, the saturation of domes-
tic markets, and the growing need for diversification of coultlry risk. Ic
is also a response to the large capital inflow that Chile has experienced in
recent years. Conversely, liberalization of capital outflows may encour-
age inflows by convincing foreign investors that they will be able to get
their money out. It may also impose fiscal discipline, which is badly
needed in some countries.
For these reasons, Chile's approach may be too cautious. In particu-
Z22



PERSONAL SAVINGS PLAN$.
lar, saturation of the domestic market would come sooner in smaller
countries, suggesting a need to relax investment rules at a much earlier
stage and to a much larger extent. The scheme being considered in
Argentinia would permit investments of up to 10 percent in foreign se-
curities from the start. One proposal for Bolivia would feature complete
international diversification (Kotlikoff 1994).
Regulating Fees and Commissions
In principle, competition among plan administrators should make
regulation of fees and commissions unnlecessarv. In practice, agency and
information problems can lead to distortions in the structure of fees and
commissions. Because mandatory saving schemes are by definition comIl-
pulsory and economies of scale in the pension industry may result in
concentration, investment companies may end up charging more than
they would in a purely voluntary competitive system.
Chile regulates the types of fees that AFPs can levy but not the level of
fees or the structure of commissions paid to agents. Authorized fees in-
clude a fixed fee per contribution, a prorated fee on wages subject to
pension contributions, fees for opening new accounts, fees per pension
payment. and fees for volintary savings accounts. No AFP has imposed
the last two fees, and only one has levied a fee on new accounts. Fees
may not be assessed for closing an account-to prevent AFPs from dis-
couraging account transfers. Nor may fees be charged as a percentage of
assets-to avoid depleting the reserves of inactive accounts.
The flat fee per contribution is probably the most controversial. This
fee would seem to be regressive, but it may siimply reflect-or even
Lunderstate-the real costs of managing an account. The fee was high in
the early years of the program. leading to lower net rates of return to
low-income workers, but competition combined with negative public-
ity has led most AFPs to abolish or greatly diminish it. A prorated fee of
about 1.5 percent on wages subject to contributions is currelitly the
major fee, and net returns have been roughly equalized across income
groups (Acunia and Iglesias 1992).
Keeping a Lid on Operating Costs
Decentralized systems that allow workers to choose management
companies and tranisfer accounts tend to incur higher operating costs
22-



$jVR:TING THE OLD AGE CRIS1I
than efficiently run centralized plans. Decentralized systems cannot
achieve the same economies of scale. They incur high marketing and
transaction (switchinlg) costs. And thev perform such added functions as
investment research and processing (which may, however, result in higher
rates of return). At the same time, decentralized plans have more incen-
tive to operate efficiently thani centralized plans that have a monopoly in
a compulsory system. These diverse factors help explain why, in 1990,
operating costs were 1.5 percent of covered wages and 2.3 percent of total
assets in Chile, compared with 0.2 percent and 0.1 percent in Singapore
and 0.4 percent and 0.2 percent in Malaysia, while the costs of Zambia's
centralized svstem were twenty-five times higher than Singapore's and ate
up half of all contributions (table 6.4 and issue brief 5).
The higher expense ratio in Chile as compared with Singapore and
Malaysia may be an intrinsic cost of a decentralized system that has also
produced a higher rate of return. It may nevertheless be possible to take
steps to keep these costs down. Marketing costs are a particularly sore
point. Where investors are relatively uneducated and uninformed about
financial matters, they are susceptible to intensive marketing campaigns,
which increase costs. Promotional expenses are estimated to account for
as much as 30 percent of operating costs for Chile's AFlPs. IPaying sales-
people by commission leads to high turnover of accounts and corre-
spondingly high transaction costs. These costs are eventually passed on
to consumers in the form of high fees. Advertising campaigns also em-
phasize short-term performance.
Table 6.4 Operating Costs and Investment Returns
Chile,    Malaysia,  Sinjgapore,   Zambia,
Costs or retuirns     1990        1989        1990      1988-89
Operating costs as percentage of-
Annual contributions   15.40      1.99        0.53      51.70
Average total assets  2.30        0.18        0.10       6.80
Covered annual xvages   1.54      0.40       0.21        5.17
Affiliates times per
capita income      2.31        0.54        0.16        4.48
Real investment returns
on individual accounts
(during 1980s)     7.5-10.5       4.82       2.86      -55.00
Source: Zambian Narional Provident Funid (1989); Asher (1992a, 1992b). Vitras
(1992).
224



PERSONAL SAVINGS PLANS
Requiring companies to provide data on fees and commissions as
well as investment performance over longer periods (three, five, and ten
years) would provide a more accurate picture of relative returns and
might also help to keep operating costs down. Marketing costs and ac-
count turnover would decline if transfers, which workers might choose
during an open enrollment period, were limited to one per year. Mar-
keting costs might also fall if AFPs were allowed to pass along the savings
to long-term affiliates in the form of a bonus on their rate of return or
a reduction in their required fee. The entry of new AFPs in a competi-
tive market may eventually lead to lower costs and fees. Economies of
scale and learning by doing as the system grows will undoubtedly en-
hance efficiency. Indeed, costs fell dramatically through the 1980s, are
continuing to fall, and are lowest for the largest AFPs (figure 6.1 and
issue brief figure 5.2).
Figure 6.1 Relationship of Annual Administrative Expenditures
to Total Assets, Chile, 1982-92
Administrative expenditures as a percentage of total assets
16
14
12
10
8
6
4
2                                                                              Administrative costs have fallen over
time thanks to economies of scale,
01982  1983  1984  1985  1986  1987  1988  1989  1990  1991  1992             lerigbdon,adcmtto.
Souwee:AbLihadba (I 994): Acufia and Iglesias (I 992); V'aldes-Prieto (i 91) ); Prov'ida H 993).
225



t'~RTING THE OLD AGE CRISIS
Regulating Annuities
Although most provident Funds simply pay lump sums upon
retirement, there has been a move toward phased withdrawals or
annuities-to prevent overly rapid consumption of savings. In Singa-
pore, since 1987, retiring workers have been required to purchase a
minimum pension. In Chile, workers are given a choice between pur-
chasing an annuity or taking phased withdrawals over their expected
lifetimes. Annuities must be indexed to the cost of living, and insur-
ance companies meet this requirement by investing heavily in in-
dexed public and private securities. T hese requirements give rise to a
host of potential problems in the insurance market.
In Chile, annuity salespersons receive large commissions up front,
giving them an incentive to withhold information or to shade the
truth to gain a customer. Since the purchase of an annuity is an irre-
versible act, a wrong decision by an ill-informed retiree may have dis-
astrous consequences that cannot be readily corrected. Chile is consid-
ering various measures to control commissions and inform workers
about their options. One proposal would limit annuity products to
two or three standard options, such as partially indexed life annuities
for the retiree, combined with survivors' benefits for a ten- or twenty-
year period, or joint annuities that cover the entire lifetime of the re-
tiree plus a designated beneficiary. That would simplify comparison
shopping for annuities offered by different companies. Broad disclo-
sure on premiums and commissions would also be required. Other
proposals call for indepenident professional advisers to assist retirees in
evaluating annuity choices and for the establishment of an ombuds-
man to investigate complaints and arbitrate disputes. These proposals,
focusing on better information flows, should help the market work
better. But some believe that increased competition will eventually
lead insurance companies to move toward direct sales of annuities,
which would reduce the price by cutting out the commission.
Another problem concerns the worker's exposure to the risk of a
sharp decline in the market at the time of retirement. This risk could
be reduced by requiring workers to purchase small annuity contracts
periodically once they reach a predetermined age, such as 50. By re-
ducing the lumpiness of the purchase, this method would diversify
the interest rate risk. In effect, it would convert a defined contribu-
tion program into a defined benefit program, partly protecting work-
226



P'ERSONAL SAVINGS PLA.
ers from investment risk after age 50. But it would, at the same time,
raise the risk premium charged by the insurance company and in-
crease workers' exposure to the risk of insurance company insolvency,
making regulation of fiduciary standards all the more important.
The timing problem could be mitigated more effectively by devel-
oping variable annuities, whose value would rise and fall with the mar-
ket rather than being fixed at the retirement dare. This would redtice
the exposure of the worker to market conditions at retirement time
but would continue the investment risk throughout retirement. Such
variable annuities are used in South Africa and the United States. Caps
on annual movements in value of variable annuities might make this
risk more acceptable to retirees (issue brief 10 provides a more general
discussion of annuity market problems and possible solutions).
Monitoring Compliance by Investment Companies
Close monitoring of investmenit company behavior is essential to
ensure compliance. Supervision in Chile's AFP system includes daily
reports on investment transactions and monthly reports on each
company's financial position and performance. Compliance with in-
vestment limits is monitored continuously. On-site inspections are
undertaken periodically to ensure the accuracy of submitted returns.
Chile's system is supervised and controlled by the Superintendency
of AFPs, an autonomous agency linked to the Ministry of Labor and
Social Security. The superintendency, which enjoys considerable in-
dependence and authority, has the right to authorize and revoke the
license of AFPs, to isstie detailed regulations for the smooth function-
ing of the system, and to promote changes in the law. With more
than 100 lawyers, financial atiditors, examiners, and other employees,
it stipervises the investments of AFPs, the operation of profitability re-
serves, the crediting of member contributions, and the payment of
pensions.
An ever-present danger in regulatory systems is that the regulated
will "capture" the regulators and prevent them from operating effec-
tively. Although this does not seem to have happened in Chile, coun-
tries with a weaker regulatory capacity might have a more difficult
time monitoring decentralized firms. Countries should assess their
institutional and human capital capacities for regulating effectively
before undertaking a decentralized mandatory saving plan.
22;



X,rTING THE OLD AGE CRISIS
Guaranteeing Pensions and Pension Returns
Various types of government guarantees are designed to ensure at
least some pension coverage for everyone. In countries with a manda-
tory saving scheme, social assistance is often provided to people who are
not covered, and a minimum pension may be guaranteed to those who
are covered.
Singapore provides modest benefits (12 percent of the average wage)
to poor old people, widows, and orphans through a social assistance pro-
gram financed from general revenues, and it sets the rate of return to its
provident fund. But it does not provide a guaranteed minimum pen-
sion. Chile's system includes four types of state guarantees. First, the
government pays a social assistance benefit of about 12 percent of the
average wage to old people not covered by the mandatory saving plan.
Second, for workers who have contributed to the mandatory saving plan
for at least twenty years, the state guarantees a minimum pension of
about 22 to 25 percent of the average wage. Third, a minimum prof-
itabilirv rate is guaranteed for each pension fund relative to the average
for the country. Any shortfall in rate of return is covered first through
the profitability reserve, then through the investment reserves of the ,'Fp,
and finally by the state. Fourth, the government guarantees annuity pay-
ments for old age pensions and disability and survivorship benefits in
case the insurance company fails. The guarantee covers 100 percent of
the minimum pension and 75 percent of the rest of the benefit involved
up to a specified limit. These guarantees are financed out of general rev-
enues and constitute the public pay-as-you-go plan in Chile's old age se-
curity system.
What are the likely costs of such guarantees? As long as the rate of re-
tLrn remains at least 2 percentage points above the growth rate of wages,
most people who work full-time during their active years (about forty
years) will receive a pension far above the minimum without any public
transfers (table 6.1). But a problem arises if low-income workers will
contribute just long enough to qualify for the subsidized minimum pen-
sion (twenty years) and then escape to the informal sector to avoid mak-
ing further payments. As many as 30 to 40 percent of covered workers
in Chile may fall below the minimum if strategic evasion is common or
if fund performance falls drastically. But even then the government has
to make up only the shortfall between the minimum pensioni and the
benefit payable by the pension fund.
228



PERSONAL SAVINGS PLAN-$.
Simulations indicate that these guarantees will cost less than 1 per-
cent of GDP, easily absorbed in a country such as Chile that has only a
small budget deficit (Gillion and Bonilla 1992; Diamond and Valdes-
Prieto 1994; Wagner 199 1). But the cost of a minimum pension ought
to be carefully calculated in advance to ensure that the state is not tak-
ing on1 a large unfuinded liability that it will be unable to meet. If the
cost is expected to be high, the minimum guarantee should be lowered
or the required contribution rate raised, unless the government wishes
to use general revenue finance as a redistributive instrument.
A contrasting problem is that a minimum pension of 22 to 25 per-
cent of the average wage is well below the poverty line in most coun-
tries, and the social assistance of 12 percent is below subsistence. One
way to attack both the evasion and the povertv problems is to guaran-
tee a higher minimum pension to workers who have contributed for
more years. For example, the guarantee could be set equal to 12 percent
of the average economy-wide wage (the employment-related or means-
tested floor for everyone over age 65) plus 0.5 percent for every year of
contributing employment. A worker with twenty years of service would
then be guaranteed 22 percent of the average wage, and one with forty-
five years' service would be guaranteed 35 percent. Given the 10 per-
cent contribution rate and the link to years of employment, which de-
ters evasion, this scheme would not cost the government much more
than the current one in Chile-and might even cost less.
Conclusion
M          -ANDATORY IlERSONAL SAVING SCHEMES REQUIRE WORK-
ers to accumulate a pool of long-term savings for consump-
tion in old age. Since they are not tied to place of employ-
ment, they are more portable and diversifv risk more than occupational
plans. They are also likely to be more concentrated and therefore ben-
efit more from economies of scale than occupational plans. Since they
make benefits directly contingent on contributions, the) are less likely
than public plans to induce evasion and shifts of labor to the informal
sector. Political pressures for poor design features-such as early retire-
ment, nonsustainable pension levels, and hidden redistribution to in-
fluential groups-are avoided becaLise each person's contribution
229



1iI G THE OLD AGE CRISIS
determines the benefits that person ultimately gets. If evasion or early
retirement does take place, the costs are borne by the individual
worker, not by others in the plan.
Mandatory saving schemes have the potential to stimulate capital
accumulation and the development of modern financial instruments
and institutions. But if governments are given exclusive or favored ac-
cess to the funds, many of these potential advantages are lost. When
the pension funds are publicly managed, they are invariably required
to be invested in government debt as a source of general revenue in
return for low nominal rates of interest that become negative during
inflationary periods. Often the government has used the fiunds for
consumption rather than productive investments, canceling out the
positive effect of these plans on long-term saving.
In principle, centralized national provident funds could become
competitive by turning them over to one or more private managers
on the basis of competitive bidding and with the authority to invest
in private sector securities. This procedure, which has been consid-
ered in Malaysia, would enable the fund to minimize marketing costs,
reap economies of scale, and possibly earn a higher rate of return. But
the potential for corruption and cronvism in the bidding process
would outweigh this advantage in many countries. Another option
would retain centralized control but passively index the fund to the
domestic and international stock markets, a procedure that is fol-
lowed in the volunrary occupational plan for federal government em-
ployees in the United States. But many developing countries lack the
necessary securities market for indexation. In any event, most gov-
ernments have demonstrated that they do not want to relinquish
privileged access to national provident fuinds.
Empirical experience indicates that decentralized mandatory sav-
ing schemes are likely to achieve higher returns and allocate capital
more efficiently than centralized schemes. Political interference over
investments is always a possibility, but decentralization makes this
explicit and sets up a constituency against it-private pension funds
and their worker affiliates. The danger is that workers' choices of
investment might be ill informed, eventually leaving many people
without adequate pensions. Regulation must walk a fine line between
adequately protecting workers and giving funds enough latitude that
competition and investment choice are not stamped out. To mini-
mize risk:
230



PERSONAL SAVINGS P
* Only prudent companies, including joint ventures with experi-
enced foreign firms, should be allowed to manage pension finds.
* Information disclosure should be emphasized.
* Investments shoLIld be diversified and subject to ceilings, not
floors.
* There should be no requirement to invest funds in public
securities.
* The range of funds, marketing expenses, and annuity products
could be limited in the early years of the system and then gradu-
ally expanded.
* Investment in overseas securities should be encouraged in order to
reduce exposure to country-specific risk.
Decentralized mandatory saving schemes will function best in
middle- or high-income countries with a population well enoLIgh in-
formed to make intelligent investment decisions, with financial markets
that offer (or could be prompted to offer) a variety of debt and equity in-
struments, and with effective regulatory institutions or the capacity to
develop these institutions quickly. Because financial market develop-
ment and a regulatory apparatus are necessary for continued economic
growth of all countries, funded pension plans are more viable as coun-
tries develop and can also speed up the development process.
Mandatory saving plans can provide an adequate pension for middle-
and high-income workers, but they fail to protect workers with low
wages as they grow old or to insure against sharp dips in investment per-
formance. To alleviate long-term poverty and to help diversify risks,
these plans must be accompanied by a minimum pension guarantee or
other publicly financed redistributive benefits, thereby ensuring old age
security for all.
231






ER7 
Putting the
Pillars Together
OW  SHOULD A COUNTRY CHOOSE AMONG
these alternative financing and managerial arrange-
ments and develop a coherent strategy for provid-
ing old age security? Any strategy should have the
basic goals of helping the old and helping the
broader economy. That is, old age programs
should be both a social safety net and an instrument for growth. Chap-
rer 3 argued that they should help the old by:
* Facilitating people's efforts to shift some of their income from
their active working years to old age (the saving or wage replace-
ment function)
* Providing a basic income floor that protects those with low life-
time income (the redistributive or poverry alleviation function)
* Insuring against the many risks the old are especially vulnerable to,
including disability, longevitv, inflation, political, and investment
risk (the insurance function).
And they should help the economy by:
* Minimizing hidden costs that impede growtth-such as reduced
employment, reduced saving, misallocated capital and labor,
heavv fiscal burdens, high administrative expenses, and evasion
* Being sustainable-based on long-term planning that takes account
of expected changes in economic and demographic conditions
* Being transparent to enable workers, citizens, and policymakers to
make informed choices, and being insulated from political manip-
ulations that lead to poor economic outcomes.
233



1tR3'TING THE OLD AGE CRISIS
Since each of the three arrangements has different advantages, a combi-
nation, or multipillar system, is the best way to satisfy multiple goals.
Many countries with low incomes and young populations lack the
governmental or private capacity to start a multipillar system immedi-
ately or in the near future. These countries should move slowly; doing
nothing is better than doing wrong. Chapter 8 discusses the best strategy
for these countries. This chapter outlines the multipillar system that is
most appropriate for older middle- and high-income countries. Even if
the time path is slow, all countries should have a sense of where they are
headed in the long run-to prevent them from making wrong choices at
the beginling that keep them from getting to the right point later on.
The Reasons for a Multipillar System
A     CENTRA l'OLICY ISSUE IN SYSTEM D)ESIGN IS THE BALANCE
among the redistributive, saving, and insurance functions of
old age security programs and the role of governmenit in carry-
ing out these functions. This study has argued that a country's old age
security policies should encompass all three functions. But a different
governmlent role is appropriate for each.
Problems with a Dominant Public Pillar
Most countries-including almost all developing countries and some
industrial countries-combine all three functions in a dominant public
pillar-a publicly managed scheme that pays an earnings-related de-
fined benefit and is financed out of payroll taxes on a pay-as-you-go
basis. People with high incomes contribute more and get more, but
some of their contributions are supposedly transferred to people with
lower incomes. This combination of functions has been defended on the
grounds that it keeps administrative costs low through economies of
scale and scope and that it builds political support for the plan. The sav-
ings component encourages high-incomiie earners to participate, while
the redistributive component lets them express their solidarity with
those less well-off.
But, as the evidence in chapter 4 suggested, public schemes that com-
bine these functions are problematic-for both efficienicy and distribu-
234



P'UTTING  THE PILLARS TO,WT:.
tional reasons. Some of these problems-such as high tax rates and large
informal sectors-are readily observable. Others-such as reduced em-
ployment and growth-are more insidious because countries may be
unaware of them until the damage has already been done.
Any scheme that redistributes to low-income workers while also pro-
viding adequate wage replacement to high-incomiie workers will require
a high contribution rate once populations age and systems mature. But
defined benefit formulas do not make benefits actuarially contingent
on these high contributions. In particular, contributions made when
very young or after eligibility for the maximum pension has been es-
tablished will have a below-market payoff. The high contribution rate
is therefore likely to be perceived as a tax by workers, not as a price for
services received. High tax rates lead to evasion-thereby defeating the
purpose of a mandatory scheme. They also lead to strategic manipula-
tion that enables workers to escape much of the tax but still qualify for
benefits-thereby causing financial difficulties for the system. And
they reallocate labor to the informal sector-causing difficulties for the
broader economy. Employers who cannot pass payroll taxes on to
workers cut back on employmenit, reducing national output. Older
workers who are eligible for large pensions retire early, redtIcing the
supply of experienced labor.
Such outcomes, of course, vary from country to country but are
especially prevalent in developing economies, which have limited tax
eniforcement capacities, imperfect labor markets, and large informiial sec-
tors. In addition to these domestic effects, in an open global economy,
payroll tax rates and defined benefit formulas that vary across countries
can influence interniational labor and capital flows in inefficient ways.
And they often imply capricious redistributions (for example, from
workers with flat age-earnings profiles to those witlh steep profiles) that
many societies would not regard as fair if they were carefully scrutinized.
The pay-as-you-go method of finanice in the public pillar further sep-
arates benefits from contributiolns for the cohort as a whole. It inevitably
produces low costs and large positive transfers to the first covered gener-
ations. It also inevitably produces negative transfers for later cohorts be-
cause of system maturation and population aging, increasing the labor
market distortions and incentives to evade. In some cases, countries may
wish to make this transfer across generations. More often, the transfer
has not been foreseen or intentional. Ironically, the largest transfers seem
to go to high-income grotips in earlier cohorts, while middle- and some-
235



-G THE OLD AGE CRISIS
times even lower-income groups in later cohorts get negative transfers.
The larger and more earnings-related the benefits in the public pillar,
the greater are these perverse transfers.
A dominant pay-as-vou-go public pillar also misses an opportunity
for capital market development. When the first old generations get pen-
sions that exceed their savings, national consumption may rise and sav-
ings may decline. The next few cohorts pay their social security tax
instead of saving for their own old age (since they now expect to get a
pension from the government), so this loss in savings may never be
made up. In contrast, the alternative, a mandatory funded plan, could
increase capital accumulation-an important advantage in capital scarce
countries. A mandatory saving plan that increases long-term saving and
requires it to flow through financial institutions stimulates a demand for
(and eventually supply of) lonig-term financial instruments-a boon to
development. These missed opportunities in a pay-as-yoti-go public pil-
lar become lost income for future generations-and another source of
intergenerational transfer.
Additionally, large pay-as-yoti-go public pillars often induce expendi-
tures that exceed expectations-because of population aging, system
maturation, and poor design features such as early retirement aind high
benefit rates. The costs of the system-whether covered by higher con-
tribution rates or subsidies from the general treasury-make it difficult
for the government to finance important public goods-another
efficiency-inhibiting consequellce.
But ultimately the costs (higher taxes and their distortionary effects
on growth) have become too large to bear in many countries. When the
public pillar fails to deliver on its promises, old people who depended on
it exclusively have nowhere else to turn. Thus a dominant public pillar
increases risk for the old. The most common failure occurs wheni infla-
tion develops because demands on the national pie exceed its size and
pensions, wlhich are not fully indexed, lose much of their value.
For all these reasons, systems that have tried to do it all have all too
often produced costly labor and capital market distortions, perverse re-
distributions to the rich, and insecurity for the old-outcomes that are
not efficient or equitable or sustainable.
Some of the problems-such as the inevitability of intergenerational
transfers and low rates of return to later cohorts-are inherent in pay-as-
you-go systems. Some of the other problems do not seem to be inherent.
Instead, they seem to result from poor design featLres-such as overly
236



PUTTING  THE PILLARS TOG.ET
genierous benefit formulas that place too much weight on final year
salary; early retirement provisions that induce low labor force participa-
tion among experienced workers, and low ceilings on taxable earnings.
These design features can and should be fixed. But their commonal-
ity suggests that strong political factors are at work and may lead them
to endure. Given their separation of benefits from contributions, their
low initial costs that rise thereafter, and their complexity and nontrans-
parency, large earnings-related pay-as-you-go public pillars are prone to
policical pressure from influential groups. These groups want provisions
that will benefit them, they want others to finance these benefits, and
pay-as-vou-go defined benefit schemes make it easy for them to intro-
duce poor design features that accomplish this goal in the early years of
the plan. In this political sense, the design features may be inherent-
not incidental-and they come back to haunt the country in later years.
(For fuller discussion see chapter 4.)
Problems with Other Single Pillar Systems
Other single pillar systems, too, are problematic. Publicly managed
mandatory saving plans (provident funds) have a record of misuse. Usu-
ally they are required to invest solely in public securities, and their avail-
ability at low interest rates may lead governments to borrow and spend
more than they would have otherwise, in unproductive ways, yielding
low or even negative returns for the pension funds. They are, essentially,
a hidden tax on labor, subject to misuse precisely because it is hidden. By
giving governments control over a major share of the financial assets in
a country, they deprive the private sector of access to these funds and
thereby inhibit growth. They contain no provisions for redistributing to
low-income workers, and, in fact, they often include nontransparent re-
distributiolns to high-income workers-until finally the fund is depleted
and can't pay much to anyone.
Privately managed occupational or personal saving plans would also
fail as single pillar systems. (No country has ever tried to use them as
such.) Occupational plans have better capital market effects than pub-
licly managed plans but may impede the smooth functioning of labor
markets. They redistribute in accordance with employer rather than
social objectives. They do not protect those with limited labor market
experience. And they are subject to employer or insurance company de-
fault. Personal saving accounts are beneficial for both capital and labor
237



+ WG:THtE OLD AGE CRISIS
markets and are relatively immune from political manipulation by gov-
ernments or strategic manipulationi by workers, but they, too, do not ad-
dress the problem of poverty among those with low lifetime incomiies
whose earning capacitv is further diminished by old age. Nor do they in-
sure against the risk of low investment returns or high longevity, in the
absence of annuities markets. (See chapters 5 and 6 for fuller discussion.)
The Solution: A Multipillar System
To avoid these problems, which are inherent in single pillar schemes,
this srudy recommends separating the saving function from the redis-
tributive function and placing them tinder different financing and man-
agerial arrangements in two different mandatory pillars-one publicly
managed and tax-financed, the other privately managed and fully
funded-supplemented by a voluntary pillar for those who w*ant more
(figure 3).
* The public pillar would then have the limited object of reducing
old age poverty and coinsuring against a multitude of risks.
Backed by, the government's power of taxation, this pillar has the
unique capacity to pay benefits to people growinig old shortly after
the plan is introduced, to redistribute income toward the poor,
and to coinsure against long spells of low investment returns, re-
cession, and private market failures. Having an unambiguous and
limited objective for the public pillar should reduce the required
tax rate substanitially-and therefore evasion and misallocated
labor-as well as pressures for overspending and perverse intra-
and intergenerational transfers.
* The second mandatory pillar could be personal saving accounts
or, in some cases, occupational planis. The important point is that
it shouild be fully funded and privately managed, but publicly reg-
ulated, and it should link benefirs closely to costs, because it car-
ries out the income-smoothing or saving function. These charac-
teristics should enable it to avoid some of the distortions and
manipulations to which the public pillar is prone, should boost
capital accumulation and financial market development, and
should reduce political pressures to expand the public pillar. The
economic growth this induces should make it easier to finance the
public pillar.
238



PUTTING  THE PILLARS TOGETi
U Voluntary occupational or personal saving plans would be the
third pillar, providing additional protection for people who want
more.
This multipillar system should have better-targeted redistributions,
mnore productive savings, and lowver social cost. In addition, it best
achieves the third goal of old age security programs-insurance-since
it reduces the exposure of workers to political, investment, and country-
specific risks. In a single pillar system, by contrast, workers are putting
all their eggs in one basket. And they will be in serious trouble if that
basket-public or private-breaks. Because some of the risks of the next
sixty years are not even dreamed of today, broad diversification across
differing financial and managerial sources is the best way to insure in an
Lincertain world.
Choosing the Public Pillar-to Alleviate Poverty
JN A MULTIPILLAR SYSTEM. THE PUBLIC PILLAR SHOULD BE CHOSEN
to achieve the redistributive and reinsurance goal at the lowest cost.
Four options, each with different costs and benefits, meet this crite-
rion. The first tvo are universal. The second two are tied to years of em-
ployment and exclude people (such as women) with little or no labor
force participation. They would have to be supplemented by other
arrangements (social assistance, survivors' insurance, or joint contribu-
tions between spouses) to reach these groups.
The Benefit Fonnula
A means-tested plan that pays benefits to people with low income and
few assets is a relatively cheap way to alleviate poverty. If the public pil-
lar for old age security takes the form of a means test it should be har-
monized (and possibly administered jointly) with other social assistance
programs-although eligibility criteria should take into account the low
capacity of the old to work productively and benefit levels might vary by
age, according to estimated consumption needs.
But means testing incurs administrative costs plus stigma and take-
up problems. Ideally, lifetime income would be used as the means test,
239



FXG, THE OLD AGE CRISIS
but this is especially difficult to track. If current income and assets are
used, this sets up perverse incentives for people not to save when young
or work wheni old and to spend down or give away their assets to qual-
ifv for benefits. The high marginal tax rate at the threshold creates a
poverty trap. Middle-income households that are not near the threshold
receive no insurance. For these reasons means-tested plans might be-
come politically unpopular and vulnierable in times of budgetary strin-
gency. The danger of the plan falling tinder the budgetary knife can be
mitigated by using a broad definition of need rather than a narrow one.
Australia uses a broad-based means-rested public pillar with an income
and asset test for eligibility, financed from general revenues. It pays full
or partial benefits (similar to the social assistance benefits paid to
younger people who are unable to work) to about 70 percent of the old
population.
The universal flat benefit is given to everyone of pensionable age, regard-
less of income, wealth, or employment history, as in New Zealand and
the basic pensions paid by the Nordic countries. Administratively, this is
the simplest structure, with the lowest transaction costs, for the public
pillar-an important advantage in developing countries with limited in-
stitutional capacities and incomplete record-keeping systems. It avoids
the disincentive to work and save inherent in means-tested plans. Its uni-
versal coverage helps ensure that the poverty reduction objectives are met,
provides a basic income for all old people (coinsuring against low invest-
ment returns or high longevity), and might receive broad political sup-
port. It also facilitates the transition to a multipillar system. since the flat
benefit paid to everyone pays off a large part of the social security debt.
The disadvantages are the incentive to evade contributions and the
possibility that evaders will nonetheless collect benefits, which are not
contingent on contributions or number of working years. In very low-
income countries, the transaction costs of paying small pensions to
every old person might be high relative to benefits. Total program costs
are greater than for the other alternatives, because it is universal. In
countries with very unequal income distributions, much of these bene-
fits will go to the rich, who live longer but have ample support of their
own; however, targeting public transfers to the poor is particularlv im-
portant in these countries. Part of this cost might be "clawed back" by
subjecting benefits to income taxes-which in a progressive system
would charge higher tax rates for upper-income groups. Income clawed
back from the rich could finance benefits for the poor. But this would
240



PLITT[NG THE PILLARS TOQ ETa
not work effectively in developing countries that have little capacity to
collect incomiie taxes.
If used, the flat benefit might be set at arounld 20 percent of the av-
erage wage in the economy, wlheni it is combined with a manidatory sec-
ond pillar. This will only require a payroll tax of 2 percent in countries
with young populations (that is, with one old person for every ten work-
ers). But once the demographic transition has occurred, it will require a
payroll tax rate of 8 to 10 percent or an equivalenit amount from general
revenues-much more than a means-tested scheme would cost.
An employment-related flat benefit overcomes some of the disadvantages
of the universal flat. Coverage is limited to those in the formal labor
force, and employees of small firms are often excluded, reducing trans-
action costs. But keeping track of employment histories adds to transac-
tions costs; good employmenir records simply do not exist in many de-
veloping and transitional economies. If this method is used, a flat
benefit of 20 to 30 percent might be paid co everyone who has worked
and contributed a specified number of years, such as twvenry or thirty, as
in Argentina's new multipillar system. This, however, would exclude
short-service workers such as w*omen with interrupted labor force par-
ticipation and would discourage contributionis after eligibility is estab-
lished. A better method would pay a flat benefit per year of contributing
service, as in Switzerlanid and the United Kingdom. With a benefit per
year of. say, 0.75 percent of the average wage in the economy, twenty
years of work would earn a pensioni equal to 15 percent of the average
wage, and forty years, 30 percent. This benefit formtila deters evasion
more than a universal flat, bLit it is also much less effective at eliminat-
ing poverty because some groups get very little. To become more inclu-
contributions-with corresponding credits-might be accepted or
required from people wlho are not engaged in market work, such as
housewives. This system is used in Japan, but it would be difficult to im-
plement in developing countries.
Atop-up scheme or minimum pension guarantee is the cheapest way to elim-
inate old age poverty, when coupled witli another mandatory pillar to
handle the saving function. If pensioni income from the other pillar is
below some specified level-such as the poverty line, as it might be for
low-income workers or becaLise of low investmiient returns-the govern-
ment tops it up to bring retiremenit income above the poverty line. In ef-
fect, a top-up scheme is an automatic means test in whichi the only
means tested is other pensioni incomiie. The big advantage over a broader
24]



, 4gT1NG  THF OLD AGE CRISIS
means-tested scheme is that it eliminates transaction cost, stigma, and
take-up problems. because it is automatic and based on records main-
tained by the "savings" pillar. It also eliminates some of the negative ef-
fects on work and saving, since saving is mandatory and an earnings test
is not involved, and it encourages compliance with the mandatorv sav-
ing plan by providing a bonus, in the form of a guarantee, to those who
participate.
One disadvantage is that in an uncertain world it provides less insur-
ance against income fluctuation to people who are above the minimum
pension level than a flat public pillar would. Another disadvantage is that
it leaves opportunities for strategic manipulation by low-income workers
who are close to the poverty line-as soon as they qualify for the top-up,
they might try to evade further contributions to their mandatory pension
accounts. Both problems might be mitigated by letting the guaranteed
minimum pension rise with years of contributing service. For example,
the guaranteed minimum might be 1 percent for every year of service.
Twenty years of work would then guarantee a pension at least 20 percent
of the economy-wide average wage, and forty years, 40 percent. With a
suitably high mandatory savings rate (of about 15 percent), this top-up
could be financed by a payroll tax rate of 2 to 4 percent or a lower gen-
eral revenue tax rate (see issue brief 11). The minimum guarantee could
be higher than the flat or means-tested options yet cost less and have
fewer distortionary effects, since it is built on the worker's own pension
or savings in the funded mandatory pillar (see simulations below). These
characteristics make it a very attractive option.
Other Design Features
Whatever the nature of the benefit, other design features-such as
average replacement rate, retirement age, and indexation method-
should be chosen carefully. The average replacement rate financed
through the public pillar should be modest, in keeping with its poverty
alleviation goal. And the age at which the pension is paid should be
high, high enough so that it is a good proxy for the inability to work for
the majority of people. A retirement age that implies a 1:3 passivity ratio
(ratio of expected retirement to working years) makes the system much
more affordable than a 1:2 passivity ratio. This also requires periodically
raising the retirement age as life expectancy increases. People who want
to retire earlier can finance this option through the voluntary pillar.
242



PUTTING THE PILLARS TOGETHtR.
To encourage labor force participation from experienced workers-
who will become an increasingly large share of the labor force as the
population ages-an earnings test for receipt of pensions should be
avoided. Benefits should be paid once a specified age is reached-or if
payment is postponed, benefit increases should be actuarially fair. Dis-
ability and term life insurance should be included prior to retirement,
and survivors' rights after retirement, to protect workers and their de-
pendents in case of death or invalidity. Contribution credits might be
split between spouses to further protect dependents. Pensions should be
indexed to prices to maintain their real value or to a fifty-fifty combina-
tion of prices and disposable wages to give pensioners a stake in eco-
nomic growth and a share in the risk of economic decline.
Choice of Tax Base
Policymakers must also decide how to finance the public pillar.
Heavy reliance on a broad tax base, such as an income or consumption
tax instead of a payroll tax, is most efficient in the long run, since it re-
duces the tax rate needed to finance benefits. It is also most consistent
with the redistributive function of the public pillar, particularly when
coverage is broad. General revenue finance has the added advantage that
it does not pit workers against retirees. Instead, it taxes all generations
according to their income or consumption.
Many developing countries, however, lack the administrative capac-
ity to collect broadly based taxes, and those taxes that they collect (such
as excise taxes) are often distortionary and regressive. In addition, when
the public pillar gets started it usually covers only a small part of the
population-those in the urban formal sector in which middle- and
tipper-income groups predominate. It would be inequitable to make
transfers to these groups from general revenue.
For these reasons, the public pillar should initially be financed from
payroll taxes levied on covered groups. The worker (rather than the
employer) should pay much of this tax to make people politically aware
of program costs and to reduce effects on labor demand in the presence
of wage rigidities. To redistribute, the taxable wage might have a floor,
but to keep tax rates low it might have no ceiling or a very high ceiling.
Young or low-income workers might be exempt from the tax, and older
workers might be exempt once they have reached retirement age or
have contributed for a specified period, such as fortv years. These are
243



,GTINC THE OLD AGE CRISIS
the groups where the potential negative effects on labor supply and de-
mand are greatest. As coverage expands. benefits become more univer-
sal, and the government's rax collection capacirv increases, greater re-
sponsibility should be shifted to a broader, more progressive tax based
on income or consumption (see Wobrld Bank 1991b for a general dis-
cussion of tax policies).
Choosing the Mandatory Funded Pillar-
for Efficiency and Growth
U        NLIKE THE PUBLIC PILLAR-WHICH IS REDISTRIBUTIVE,
centrally controlled, and tax-financed-the second mandatory
pillar should emphasize saving. It should therefore be nonredis-
tributive and fully funded, with decentralized control over the accumu-
lated pension and saving reserves. It could be based on occupational
schemes, personal accounts, or a combination of the two. The choice
should depend on efficiency. V'hich type of pillar maximizes the return
for a given risk in the capital market without creating new distortions in
the labor market? Although private competitive management provides
incentives for good performance, extensive government regulation is also
important to compensate for market failures such as lack of information
by workers and socially inefficient restrictions imposed by employers.
Mandatory Saving Schemes
The advantages of a mandatory (defined contribution) saving
scheme-which requires people to save when they are young so that
they will have adequate income when they are old-are that coverage
can be broad and benefits are fully portable. Having a rudimentary
banking system is a precondition, but a mandatory saving scheme can
be part of a national policy to develop new financial institutions, deepen
capital markets, mobilize saving, and allocate it to the most productive
uses, including uses in the private sector. It also allows workers to in-
crease their returns and insure against political or other couLntry-specific
risks through international diversification of investmiients.
The disadvantage is that governmilents may be tempted to mianage
these schemes themselves, as in national provident funds. Such manage-
244



PUT lTING THE PILLARS TOGXt
ment often preempts the funds for public sector uses only, in very non-
transparent ways, earns low rates of return, and misallocates capital. Pri-
vate competitive management is thus needed to secure the capital mar-
ket benefits of mandatory saving schemes.
But some low-income countries lack the expertise and private finan-
cial infrastructure needed to get these schemes off the ground. And
workers may lack the edtication and experience necessary to choose ef-
fective investments and investment managers. So, extensive regulatory
capacity is needed to keep the investment companies financially sound
and the workers' exposure to investment risk within reasonable
bounds-capacity that many governments lack. (Chile currently uses a
decentralized mandatory saving scheme, and Argentina. Colombia, and
Peru are introducing this pillar in their new systems.)
Occupational Plans
Mandatorv occupational pension plans are an alterniative to manda-
torv saving plans. Occupational plans have the seeming advantage that
they can start up on a voluntarv basis before the market has the capacity
to run-or the government to regulate-a mandatory plan. They can be
implemented through payroll deductions with low record-keeping and
marketing costs. Thev use the finanicial expertise of employers and pre-
arranged groups of workers to overcome insurance market problems.
The disadvantages are that these voluntary plans are likely to be spottv
in coverage, to be offered mainly to middle- and upper-income workers,
to involve large regressive tax expenditures, to be underfunded and
tiherefore default-prone. and to restrict vesting and portabilitv of bene-
firs, impeding labor mobility and economic restructuring.
These problems can be avoided, in part. through regulation-require-
ments for broad information disclosure, full funding, backup insuranice,
nondiscriminiatory benefits, and portability. Stich regulations are impor-
tant once occupation.al plans become widespread-and essential once they
become manidatorv. But setting up these rules is not easy, and the rules are
never fully effective-in part because it is very difficult to define full fund-
ing in a defined benefit plan. It could take many years for plans that have
sprung up under looser conditions to adjust to tighter controls. In the
meantime, their pensioni promises will be problematic-so the right
ground rLIles must be established from the start. Thus, one of the seeming
advantages of occupational plans-regulatory simplicity-vanishes.
245



;:VRTING THE OLD AGE CRISIS
Voluntary plans also vanish to a large extent, since the regulations will
discourage employers from escablishing these schemes on their owin.
The regulations are also likely to lead employers to set up defined con-
tribution plans-which avoid some of the problems inherent in defined
benefit plans but create new conflict-of-interest problems as employers
choose the investment managers while workers bear the investment risk.
It does not appear to be efficient for workers to face different restrictions
on their choice of investment manager, depending on their place of
employment.
Occupational defined benefit plans may impede labor markets' effi-
ciency. Occupational defined contribution plans avoid this problem
but ma' pose agency problems. Neither allows the economies of scale
that are likely in a mandatory saving plan, in which pension funds tend
to be highly concentrated. Overall, personal saving schemes would
seem to have the edge for the privately managed mandatory pillar, ex-
cept in countries that already have substantial occupational coverage on
which to build. (Australia and Switzerland, for example, had wide-
spread coverage as a result of collective bargaining or employer discre-
tion before their plans became mandatory.) So, the mandatory occupa-
tional route does not seem like a good way to go in most developing
and transitional economies, though it may be a more desirable path for
industrial countries.
Giving Workers the Choice between Occupational and Personal
Saving Plans
A third option would give workers a choice between the first two
options-that is, between occupational and personal saving plans. 'This
clhoice would mitigate the job mobility risk in occupational defined
benefit plans and the agency problem in defined contribution plans.
Many workers would presumably choose personal saving plans, over
which they have more control. Occupational plans that survive over the
long run would do so because of genuine economies of scale and infor-
mation. From this point of view, giving workers a choice may be the best
alternative.
Choice, however, inevitably adds to the government's administrative
and regulatorv burden, since it requires monitoring multiple systems,
keeping track of shifting affiliations, and making sure that options are
fairly and accurately presented to workers. These problems are still
246



l'UTTING THE PILLARS TOGE
being worked out in the United Kingdom, where employers can con-
tract out of the public earnings-related scheme by offering an occupa-
tional plan and workers can opt out of the employer's plan and into their
own personal plan. For most developing and transitional economies,
giving workers a choice between a mandatory saving or an occupational
scheme would probably not be the best option in view of their weak in-
stitutional and regulatory capacities. BLIt it is a strong option for indus-
trial countries.
The Voluntary (Personal or Occupational) Pillar
T HE TWH     O NMANDATORY PILLARS TOGETHER MIGHT AIM TO
replace about 50 percent of gross average lifetime wage (revalued
upward for inflation) or 40 percent of gross final year wage for
workers who have contributed throughout their adult lives-with a
floor to keep low-income households above the poverty line. But some
households will want additional retirement income, and they can
achieve this through voluntary arrangements. In Switzerland, where oc-
cupational plans have been manidatory for the last decade, many em-
ployers provide benefits beyond the required floor. In most countries
people save on a voluntary basis. But the existence of a second manda-
tory pillar will reduce or crowd out some of this voluntary action, par-
ticularly for low-income workers for whom the mandatory amount is
likely to exceed what they would have saved voluntarily.
If govermilenits wish to increase capital accumulation, they can en-
courage voluntary occupational plans and long-term saving accounts in
several ways: by creating a stable noninflationary economic environ-
ment. by setting up a regulatory framework that gives people confidence
in financial institutions, by educating citizens about the high saving rate
needed to ensure a comfortable retirement, and possibly by giving tax
incentives. The first three policies are undeniably good for growth and
efficiency in any event. The fourth policy needs to be applied cautiously,
because it has a large cost in terms of forgone revenues to the govern-
ment, most of the benefits will go to high-income groups that would
have saved anyway, and the tax incentives may simply shift their saving
into tax-advantaged instruments rather than increasing the total. One
approach would index the initial investment for inflation and tax real re-
247



THE OLD AGE CRISIS
tLrnls only for long-term  savxing. Any tax incentives for voluntary
arrangemenits should be equivalent for occupational plans and personal
accounts.
Putting the Pillars Together
F        OUR ALTERNATI\VE COMBINATIONS ARE RECOMMENDED FOR
a multipillar system (table 7.1):
* A manidatory personal saving plan with a flat benefit public
scheme
* A mandator)' personal saving plan with a minimum pension guar-
antee in the public scheme
* A mandatory occupationial plan with a flat benefit public scheme
* A mandatory occupational plan with a means-tested public
scheme.
Each of these mandatory combinations would be accompanied by
public policies that facilitate voluntary saving and pension plans.
Empirical Evidence with Multiple Pillars
The first combinationi is now being implemenited in Argentina. Thle
second has been working in Chile since 1981. Variations on the third
are founid in the Netherlands (wlhere occupational plans are quasi-
manidatory through collective bargaining) and Switzerlanid (where the
Table 7.1 Recommended Multipillar Combinations
Alter-nativeforms for tle fisnded,  Alternativefonms for the tax-
privately mzanaged pillar      financed public pillar
Mandatorv savings              Flat    or    Minimum
guarantee/top-up
Mandatory occupationial        Flat    or    Means-tested
248



pllTTTING THE PILLARS TO4i
public pension includes an employment-related flat benefit). Australia
has just introduced the fourth arrangement, by adding a mandatorv oc-
cupational scheme to its existing means-tested public plan. (The mini-
mum pension guarantee probably would not coordinate well with occu-
pational plans in the second pillar because of variations among employer
plans and moral hazard problems that would discourage firms from of-
fering good benefits to low-income workers.) The United Kingdom has
a multipillar system that is probably too complicated for most develop-
ing countries: the employment-related flat benefit in the public pillar is
compulsory, but employers can contract out of the earnings-related tier
and workers can opt out of the employer's plan.
Most OECD countries do not have well-developed multipillar systems,
since, until recently, only the public pillar has been mandatory. But vol-
untary occupational and personal saving plans have developed on an un-
even basis. Although the relative sizes of the mandatory and voluntary
pillars-as measured by their relative shares of old people's income-
differ widely, public pay-as-you-go plans have the lion's share of respon-
sibility for providing old age security (figure 7. 1).
Simulations of Multiple Pillars
Empirical experience with two mandatory pillars is too limited to
allow for detailed comparisons of how they accomplish their dual goals
of poverty reduction versus saving or wage replacement above the basic
floor, and of their relative costs of doing so. But simulations show the ef-
fects of combining a fully funded defined contribution pillar (wlhether
occupational or personal) with a flat, means-tested, or minimum pen-
sion guarantee financed on a pay-as-you-go basis in the public pillar
(issue brief 11).
* The flat benefit alone, if fixed at the poverty line or above, elimi-
nates poverty-but it may require a high contribution rate to do
so. It generates large intergenerational transfers, some of them per-
verse. It yields negative rates of return to later groups of retirees,
even for low-income retirees, and thus is a poor savings vehicle for
them. And it fails to provide adequate wage replacement for
middle- and upper-income groups in all generations.
* The defined contribution plan alone is an effective saving or wage
replacement mechanism, but it leaves large pockets of people poor
249



&NG THE OLD AGE CRISIS
Figure 7.1 The Multipillar System in OECD Countries, Mid-1980s:
Percentage of Nonwage Income from Public Pensions, Occupational
Pensions, and Personal Savings
Switzerland
Canada
Netherlands
Australia
United States,
United Kingdomr
Sweden
Most OECD countries have weak
multipillar systems-the public pillar          Germany
dominates, but other pillars are                                                                                    .-
growing.                                              0           20           40          60           80          100
Percentage of nonwage income
U Mandatory public  Voluntary occupational   Voluntary personal
pensions           pensions                 savings
ANVot. OcCLlpational plans became mnandaronr in Switzerland azd AListralia in 1985 and 199 ,
respectivelv.
Source: LuxenmboLirg Incoine Study as presented in D. Mitchell (1993).
in their old age, unless the interest rate is very high. (If the contri-
bution rate is high enough to alleviate poverty among all retirees,
it creates poverty among low-income workers, who may be left
with less disposable income when young than when old.)
*  Given that future interest and wage growth are uncertain, only the
mixed systems can be counted on to achieve both the poverty re-
duction and saving or wage replacement goals. Over the long run,
the minimuLm1 guarantee. combined with a defined contribution
plan, achieves both objectives most effectively or at least cost.
* Although the simulations do not capture effects on efficiency, sav-
ing, and growth, these are likely to be more positive for defined
contribution  schemes than  for pay-as-you-gc) defined  benefit
250



PUTTING THE PILLARST
plans, for all the reasons given above. This reinforces the argument
for using a funded defined contribution scheme to accomplish the
saving goal, while a tax-financed defined benefit plan concentrates
on redistribution and poverty alleviation.
* Countries with older populations should expect to spend about
20 percent of their current wage bill on old age security arrange-
ments. The split of the 20 percent between the public and private
pillars should be about 1 0-10 if the public pillar is flat, 4-16 if a
minimum pension guarantee is used, and somewhere in between
with a means-tested public plan, depending on whether the
means test is broad-based or narrow. Given the transaction costs
and the possibility that small mandatorv saving requirements will
simply crowd out voluntary saving, the funded pillar should ab-
sorb at least 10 percent of wages when mature. But it might start
at a smaller level and gradually increase with the growing capac-
ity of the country's financial markets.
* Mixed schemes also reduce the exposure of pensioners to unex-
pected failure in the public or private sectors-for example, to fis-
cal mismanagement that forces the government to cut back on
public defined benefits, or to bad investments that lead to low ac-
cumulations in the private defined contribution plan.
The different pattern of transfers means that different income and
gender groups will have different preferences among these multipillar
combinations. In general, poverty is eliminated most completely with
the minimum pension guarantee, which might be preferred by the
poor. Middle-income workers are ambivalent. If interest rates are ex-
pected to be low, they fare best under the flat benefit combination, but
under high interest rates they might prefer a larger defined contribu-
tion allocation, as under the top-up scheme. High-income workers get
a lower expected replacement rate and rate of return under the multip-
illar system with a flat benefit. Those who are very risk-averse might
nonetheless prefer this because in exchange they get more diversifica-
tion and income protection against investment risk before they fall
below the poverty line. High-income workers who are not very risk-
averse would prefer the combination witlh the minimumii pension guar-
antee. Women fare better with a combination that includes a public
pillar in which benefits are not tied to prior years of employment or
earnings (box 7. 1).
251



4T1NG  THE OLD AGE CRISIS
Box 7.1 How Do Men and Women Fame underAlteatve Old   Schemes?'
BECAUSE OF THEIR DIFFERENT EMPLOYMENT:  Johnson (1993) allows us  toexamiuine thed           fer
histories, men and women are afeaed diffierently by:  treatiment dfmen and women under aternative pen-
each pillar and by their design features. Many    sin Olanis. Aased on their ownh letime erinoih,
women have not had a continuous employment hi    women are concentrated inthe boti Of half of the
tory and have not earned as much as men while   population wagedi:stri$ution, while rhen ate con-
working. As a result,:women benefit more firom uni-.   cenrated -in the upper half. Theore,r nwomen re: 4:
versal public schemes that offer flat or means-tested    more than twice a's liklyas men to get positve life-
benefits, while men benefit more from emnployent-7  time trnfrs from thei universMflat sistemboth bte-
or earnings-related schemes. Extending benits to   cause they earni (id so contribute) legs and because
survivors reduces po     among wornen, who tend- they ive,longer than hen Tfe  effet are shar ly
to outlive their spouses. But in most cases o*ly half    educedE  If eligibili    'bdi n d onyears and
the Enarriage pension:goes to survivors. This is gener-   amount of contributins tore imposed. Under tlhe
ally inadequate for a single person, given economnies  ied contribution plan, whikh is hot redistribu-
of scale in housing and other household expenses.  tive, mostLolderLwomen live in poverty. NotLsurpris-
Women are much less likey than men wo receive    ingly, women benefit imorethan men from a plan
occupational pensions, and they receive sialler pen-:L  that combines defined contributions WI  a rmni-
sions when they do. In defmied contribution schemes,   mum pension guarant6e-lriost 90 percet of the
men fire better than women because of their higher   toup   t goes to women, virtually eliminang oldi ge
earnings and contributions. Pooling the contributioins tp ty.
of husbands and wives and dividing tfhe proceeis b- L :::Some odf thetra: r goes to w en who have
tween them equally tends to help women. When an-'   worked but. earnd low incomes. But some of it goes
nuities are purchased, an important issue is whether   to women who hae notworked and are married to
gender-based life expectancy tables are allowed or    men Iwth high ic sit is nor clear thtsociety
whether pooled tables are required. If pooled tables are    wishes to tranfr inconei to this  Oup.  ter instru-
required, as in occupational schemes in the United    menits are avalaable toLreduce their   y   at lwer
States, women benefit because they tend to livelor    social cost. For exme the disparity between men
(But women lose if pooled tables are required for, life   and w c   sustay reduced by policies
insurance, which may also be provided by pemloyers.)    tarqeoint treatmentofmrclas rc-
ommended within the European Union. and as re-
Evidence from Microsiulations                    quiretA in rany states of iel United States. Ifempl
The microsimulation of work and retirement be-:  rnent credit- and contribibtions of both partners are
havior in the United Kingdom by Falkingham and   :split evel between them, pty is elininated for
252



PUTTING  THE PILLARS TOG ET             .
most woleti.m  And the costc ofthe ,tp-up sch1eme fals, .   A universal flat, means-tested, or minimum
because most wome,n receive adequate pensions tiat     pension scheme that gets everyone above the
are finacd by their husta,,nds' contributions (box     povery line, regardless of employment history
tabl.e7.1), In effe,t;inot con,tibu.-tions and income '   Joint treatment of the employment credits and
pooling withiin.*ehou.ehold- p rovide in al insur-     contributions of husbands and wives
ance;h, ahhou   morc limited than that provided by   * Mandatory survivor benefits that exceed 50
extene fiies. Tere is less'disparit in we and          percent of the joint marriage benefit
pension iwome among ho,seolds than among mdi-. -      Special benefits for the very old, who have run
viduals, and it is easier toalleviate povert But a for-  out of their own resources (and are more likely
.aIa SOfl ,of this informal arrffem ent is needed for  to be women).
,divorwed or widoWed womeno, wh, constitute the
largst Lgrp amopg old  e.in povert-       .          But Lthe best way to improve the income security
of old women is to raise the income of young women
Wh,I,wt Slo.M     Ibone,?  ,         -     .'    by elitrinating gender-based wage and employment
Several approachas can be ud, separately or in   ineuaiy-a sttegy that has the added benefit of
tandem, .to improve old age seity amon,g ,wome:    improving overall equity and economic growth.
oxt T,abh 7.1   u    ed. PoertRtes among Men and Women
10percent    10 percent    15 percent
-dfined      defined       dfined
Empoyment-   15 perent    contributioln  contribution   contribution
4&percent      related      defined       plus 20       plus          plus
flat         flat,      centribftion p"erentflat    means test    top-up
Own cnbiburi ns
Men                   0             3            21             5            5            0
WOW =                              35            67            52           52            0
:Join eon fri&- bu42s 
Ment           .      0             3            34             5            5            0
Women                 0             8            36            18           18            0
Not4 Poverty is deed as 40 pcrcent of average economy-wide wage for each individual.
Sor e:Adopted &ia mmicrosi muations based on demogrphic and earnings data for the United Kingdom in 1985 by Falkingham
atnd Johnon (1993).
253



_+ ~THE OLD AGE CRISIS
Conclusion
A      MIANDATORY MULTIPILLAR ARRANGEMENT FOR OLD AGE
security forces countries to:
* Make clear decisions about which groups should gain and which
should lose through transfers in the mandatory public pillar, both
within and across generations. This should reduce perverse or
capricious redistributions-as well as poverty.
* Achieve a close relationship between incremental contributions
and benefits in the mandatory private pillar. This should reduce
effective tax rates, evasion, and labor market distortions.
* Use full funding and decentralized control in the second pillar.
This should increase long-term saving, capital market deepening,
and growth.
* Diversify risk to the fullest because of the mix of public and pri-
vate management, political and market determination of benefits,
the use of wage growth and capital income as the basis for finance,
and the ability to invest in a wide variety of securities-both pub-
lic and private, equity and debt, domestic and foreign.
The broader economv, including both old and young. should be better
off as a result.
The right mix of pillars is not the same at all times and places. It
depends on a country's objectives, history, and current circumstances,
particularly its emphasis on poverty reduction versus saving, its financial
markets, and its taxing and regulatory capacity. Middle- and high-income
countries should move in this direction quickly, whereas low-income
countries should see it as a long-term goal.
254



_R 8
*   S
Transitions
HE COSTS OF A TRANSITION FROM ONE SYSTEM OF
old age security to another are large, and resistance is
likely to be strong. A country intent on reform needs a
clear vision of where it is starting from and where it
wants to be wvell into the future to guide the steps it
takes today (box 8.1). This chapter sketches out such a
path for several sets of countries: countries with young populations, low
incomes, and only rudimentary formal old age security systems; young
but rapidly aging and rapidly groving countries with immature public
pillars; and older middle- and high-income countries with large pub-
lic pillars that need to be reformed gradually or, in some cases, urgently.
Laying the Groundwork: Countries
with Young Populations
C    onsider first a country with a young population, low per capita
income, and only a small public pillar or provident fund cover-
ing primarily public sector employees. Many countries in Africa
and South Asia are at this stage. Weakening informal systems of old age
support and an absence of reliable financial instruments are prompting
calls for an expanded public pillar. These countries mav not have the fi-
nancial markets or regulatory capacity necessary to establish a decentral-
ized funded pillar. But they should be preparing the environment for
voluntary-and later mandatory-saving and pension plans by:
* Keeping inflation down.
255



THE OLD AGE CRISIS
BOX 81  :Ta:ng  tok:
ANY PLANS TO tT144tSH Oi06lO: A C60N-                A :  ibnirons hih     th  overxpected
: try'soldhaSsecxirihdag- secuity syst                     l,rcdd   a  pyou nthnea    disant fuiture? How
stocrking. tat considersL  contr iisof thot-rpo;d    mpl oyment?
extended                                                    :Il , financial    -:to s  a  c o  l   is te inwlor sector and what
pension plani and governnpogamto the w             ipce  o i) thleodasecurity system
fare ofthe old, A chclt ofueio4iFns'Llb -fr si au    ae :on its Wi e?
vey should indude the fo1lon                      U Wh 00 0; S 0 ;:;: ff 0 -000000:; - :00 -: :; f; t  at iste  titd   io rate? 'What as-
PeCLtso Lthe4" puli plar init eaion?
* How touch: poery is te:p:i5 ththe old? - -     At :e tpre aiVe,    e i nil instEutions
Where are the pke of o14 ag p:r (wid           such abnk  i           co     , and stock
ows, the vey old, u or rurL  reas) W                s  Wh   s.teps should be takn to
of povertyaongthodad what pr           ..   .    What iu         are th  fir fvoluntar sav-
r migtt bean aus?                                                    a thesebe expanded?
H :How effeive is e  fora sysMem OfOk ag         Watf are th     d    t to exanAsioen? :
support? Weredto it         A W-o  d t. x   policie on saving and consumP-
I ermi e nts progra  ca                  :-d this -rocess?  ion   erSouldUmgre taX incentives be in-
* What pentae  of    ' s spent on pensions?      mrodd toS en+uLage lonq-erm  saving?
What propoirtoof pi s            s j     " -   Whr doe  ret savig fit into this
on pensions? Howq  does t   shrev compar       picture?
with other countries at he. m t    f eco-    U  How  pln  re occupationial  pension
nomic andL demograic vlp t                     shn:   Hove wel  dothywork? What regu-
* What; proportions of workers. nd old popit   - :hions and tax privilege apply and should
are coveredby 6raal teSionplnsi  does          these  be changed?
coVerageva b  o     an nme, andgen-                                  % W   e th zeston on international capi-
der? W tare te plans r r           s               1fws     h    eh        erelaed?
in the year Cahed?:.                         U Wha is t-   ely .        yofg ovemnenr? 
* What is the dende              p       p-      W     is the lee  f f acilp   ing in the
4lat?: Howo sitcoar Vtthedemphic               po: la,ion?
dependency ratio? How wil t? npHow do women
ated y din turs    en  atu                                 pu    nd  i Sectors have the
andmderograpChi,c chgg in th fn                  t       run  in p    rograms?
* Avoiding interest rate and exchange controls.
* Establishing reliable savings institutions accessible to people in
rural as well as urban areas (the postal savings system in Japan and
other East Asian countries might be a model).
* Developing a regulatory framework that gives people confidence
in banks, insurance companies, and other financial institutions.
256



TRANSIT    I
* Instituting an effective tax policy and tax administration.
* Building the human capital that is essential for the effective man-
agement of financial and regulatory systems.
These basic conditions are important for the old age system and,
more broadly, for continued economic growth.
These countries should also be introducing measures more directly
related to old age security that will eventually fit into a multipillar sys-
tem. The noes-using methods that avoid the problems to which large
pay-as-you-go plans are prone-are as important as the yeses. This
means that countries should:
* Keep the existing contributory public pillar small, flat, and limited
to urban areas and large enterprises in which transaction costs are
relatively small, fraud is easiest to detect, and the informal system
breaks down first.
* Provide social assistance to the poorest groups in society, including
the old poor who are not covered by contributory plans, taking
into account their vulnerability stemming from their diminished
ability to work.
* Carry out simulations of the long-run impact of alternative public
plans (coverage, benefit level, retirement age) on taxes and the dis-
tribution of transfers across and within generations. This requires
making assumptions about wage growth, interest rates, labor force
participation, unemplovment, and evasion-and recognizing that
the choice of system will affect these parameters (box 8.2).
* Phase out (or convert to voluntary status) centrally managed prov-
ident funds, which are often misused.
* Set up the legal and institutional framework for personal saving
and occupational pension plans, requiring full funding, portabil-
ity of benefits, and disclosure of information for the latter.
* Give equivalenit tax treatment to occupational and personal retire-
ment plans that meet prudent standards.
* Avoid crowding out informal support systems and offer incentives
to families to continue taking care of their older relatives.
* Avoid the pitfalls-overgenerous pensions, early retirement, bene-
fit contribution structures that encourage evasion or discourage
saving, and perverse redistributions to high-income groups in ptib-
lic plans; and unregulated, unfunded, nonportable occupational
257



IMG,4NG  THE OLD AGE CRISIS
Box 8.2  Design Chie  f  the P               Pil- :                                    -
0; 0 * Cover :age and  lt   rif  bene.-r0 jtoit? Should, cosstsubsidization between
Should the plan co-e;¢oernm     emlees     :-    arriedandiglewgeearners:beinldedoor
an  urban wotl0.tonl?EXi1yesof           --a1    av. o i4ed?00;0;00t0     t;000000
00 tfi0 00Rrms? AgricxIruta   Vrer h f         Size oft suyvivos    s: What level will ipre-
: . employed?                                  ve::f::l:-;::EX: -::::- -f:    00::t :t:   poverty. among widows?
:   Average wage repianen r Wat klil  :fPovsions for disabil    fit$s How can
be' Sustainable i th                              p e dl ard be avoided?
tax rate that is lo no  t ;v;  evasion       * -  d- a-ion:     it be by wagtesor pioris?
and labor  tarket diOrEions.                 ua $0  of  finance. Shoulit be by ropayrol taxes
* Reriementae Wha shoulit be:, d shouId  -or genroo eeus
it rise, autraiclyw          io                   orbti rate:How low a rate will avoid
can it be structredto avoi   tMfu effects on  labo allocation n  em-
retirement aind p nties fo0 lt r "dre-tat?     p Ioye It
* Benefit strucure Shoudiie u-     6r-  e"ti * l-oor- o.ie eag: Should young or
: fployment-relaed  at, dsfsted  .or;-   . iin -  .low-isteone w.orkAea lower  tax rai:te 0
mum guarantee?  ow wo                          C          t abl  a       Shoul te  be a
different income and   g ¢der    ;,            hg -  .    noel  for abroad tax base?
*s Earngs-related for m ua If 'n      OWsd ho  * Tax   etv   Shuld benefits or contribu-
com presd an how long s .ould.t- amna   ': 4nsb :tax-eempt?
ingpd                                                            for ree  Shu  they
a Treatment of marrie coupis and s:ingl  . :;t-wag  e p b     o:privatomanorshould re-
ear£ners: Should conbution  by s      b -      srives be elimiated?
plans-that are so tempting, especially in younig countries with im-
mature schemes and limited regulatory capability (box 8.3).
Young but Rapidly Aging Countries
T        HE NEXT SET COMPRISES COUNTRIES, ALSO WITH YOUNG
populations, that are aging and often growing rapidlv-since
rapid economic growth is associated with falling fertility rates and
rising longevity. Many East Asian countries are at this stage. In addition to
accelerating all the actions just menitioned, these countries should:
* Begin designing and introducing a mandarory decentralized
funded pillar (box 8.4). For countries that do not already have
258



system. Beiesaoiig i!inrbih;*kj 4 *vuba oru
prograw of old age seuy    a     n s c          du fr Seve
common pi: alls;
UInpublicminr                                   to hig-
and estblishng oeygnros:et $vtn cayrei-
meat opporruniti~  hrcni li nn'lne'd. ,  ,4in *f,lg r,n. -
fit, a -k high reireet ap* "n   eu$f  ai  eate
. workrs who Art  eirl..
:pcnitions aid ieoarr n*o e'W4lc  (sec n4,
-which doom tetat  tifkla,   hsrens   egnb
estalihng a smk*lag    4tan 4uo   scraore
advanStags1 u withu  4ut hwngv41n  poiw
'biliry proison- is dilf   :t4Ot :i thias late on:.
Avsoidance sm^seg  lnro.cn   die retsietrs up front,
wvhich makes ocuatona zhensesn*w cedil, less distor-
tsonasy, and- more coprikwt  nec     rahpll@ar sys-
temn, and providinigeqriltxceunern Em nillong-term saving,
whether in personal or occupational plans.
~~~~~~~~~~V  MY
widespread occupational plans. the second pillar is likely to consist
of manidatory personial saving accounits. P'reconditions for this pil-
lar are govetinielit regulatory' capability a bankinig system, a sec-
ondary government bond marker, and an emerging stock
market-or the ability to develop these institutions quickly in re-
sponse to demanid ftomi new penisionl funds. Incomie per capita or
average wag,e pet worker is anothler importanit criterion. If wages
are low, transaction costs could wipe out much of the contribu-
tions to a decentralized pillar So the covered wage should be high
enough to get transactionl costs down to a reasonable rate, and the
mandatory second pillar should be confined ro countries ot sub-
groups that meet this criterionl
259



~~T HE O LD A GE C RIS5I1S
BO   g4  UU5lp  l1K1S    :07 111     fW 151 lIWU1  IW:f
cwx 4~~~~~~~~~~~~~~~~~~'
* coverage: Should employees of slla-    i        s C  d;i;  
self-employed workers, I) covered.?     ;vi-:*lwn                    4
E ContributioA rate Is it high ano    oPmud          With4 r.   -  t#l   $.
a minimally adequate rioeplacement rste under V_  tion otipn£:        -          /
peced wage rota*dinterest rate, c-on...tions      SU-Nivors n
• Tax incentives: Shouldi contrib, iuor;' and i-w
vestment incomne be tax-.exempt?                -  jirtt cosst                   4
* Fiduciary standards forfund oran s Should          hol  te  <                 
theybe vettcd and required to post bond?;ihrg
Investment restrictions.o Dos theougd  iV est    * Governite n 
merit managers conskoerabe iscretoxi bt em-
phasize prudent decisions and divreaificati*a In narger 4wage re
r Information disclosurec Does it enhasi   i rhe shcold                                      pillar
formed choice of inrvestment couptnies by         ined o     U                          t
WoDrkers?                              f    m izeand  a-o                 rs ra ma
* Penalties for poor perforface:  to an                             ublic pilr kp         m
have incentives for Maximizige yiwhd sstfi tokro  saving orincome
risk?czou#do
• Restrictions on fnes; Should tht markmetdoset                              p "Moe pItoiog  B  ir
prices?                                  seow n log-t oa*wo4anfrjat'
* Start by setting up a strong regulatory framiework, aid determinii-
ing the required contriebuton rate and the target wage replacemoent
rate. Establishing  this struCture and phasing in the second pillar
could take several vears. Couintries shIould niot ruish ahecad too fast,
beyonid their institutionial capabilities. BLut if thiey do niot miove
ahead fast enOuIgh stronig political pressuires will otherwise de-
velop, from milddle- and high-incomne workers, for a dominianti
earnings-related public pillar-aid all its associated problems.
* Gradually expand coverage for the public pillar, keeping it mnodest
and redistributive, while satisFyfing workers' saving or incomie-
smoothing needs through the miandatorly private pillar. Beniefhr
promises shiould be based on long-term projlections and simulationls.
Otherwise these countries wilJl face the miuchi more d)fiCelt] task of
restrucWtUring later.
* If (as in Chinia) the pubhlic pillar is already In trouible, onec of the
first steps should be to rcform it by emphasiziig poverty reduction
and coinsurance.
260



TRAA
* Initially use a payroll tax for the public pillar to avoid inefficiencies
from excise taxes and transfers from uncovered to covered groups,
but shift greater responsibility to a broader tax base as coverage be-
comes universal, the government's ability to collect general income
and consumption taxes increases, and the redistributive function
can be emphasized.
Gradual Transitions in Middle Age
C        OUNTRIES IN THIS GROUP ARE ALREADY MIDDLE-AGED AND
rapidly growing older. The costs of their widespread public pen-
sion programs will soar over the next three decades, along with
dependency ratios. Although the degree of urgency varies, all these
countries face imminent problems with their old age systems. Rather
than relying on an ever more costly public pillar to do it all and at high
tax rates that inhibit growth and bring low rates of return to workers, the
time is ripe for these countries to make the transition to a mandatory
multipillar system.
* The first step is to reform the public pillar by raising the retire-
ment age, eliminating rewards for early retirement and penalties
for late retirement, downisizing benefit levels (in the frequent cases
in which they are overgenerous to begin with), and making the
benefit structure flatter (to emphasize the poverty reduction func-
tion), the tax rate lower, and the tax base broader.
* The second step is to launch the private pillar by setting tIp the ap-
propriate contribution and regulatory structure. The transition
can be accomplished by:
1. Downsizing the public pillar gradually while reallocating con-
tributions to a second imiandatory pillar or
2. Holding the public benefit relatively constant (in cases in which
it is low to begin with) but raising contribution rates and as-
signing them to the second pillar or
3. Recognizing accrued entitlements under the old system  and
agreeing to pay them off while starting a completely new system
right away.
The first two "gradual" transitions are discussed here; the third, or
"radical," alternative is discussed in the next section. A gradual transi-
26i



-J:HE OLD AGE CRISIS
tion may be appropriate for countries whose payroll tax and benefit
levels are still "moderate" but will not remain so for long unless reforms
are undertaken. Several OECI) countries are in this category.
The simplest gradual transition transforms the public pension into a
modest, flatter benefit. The average pension might be downsized by in-
dexing benefits to prices rather than to wages, thereby holding them
constant in absolute but not relative terms. Or the average benefit could
be held constant while the benefit structure is flattened by indexing
lower-level pensions fully to wages while higher-level pensions are in-
dexed to prices and only partially. Both strategies reduce the average
wage replacement rate, requiring a lower contribution rate.
If the population remained stable and productivity grew at 2 percent
a year, it would take about thirty-six years for real wages to double. By
that time, if real benefits were held constant, the average wage replace-
ment rate would be half its original rate and half of total contributions
would be released to be reallocated to the second "saving" pillar. If the
break-even contribution rate is 10 percent at the beginning of the period,
in thirty-six years the public pillar would require just a 5 percent contri-
bution rate and the remaining 5 percent could go into workers' funded
plans. BtIt thirty-six years is a long time for a transition; and in any event
populations will age over this period, swallowing up much of the pro-
jected 5 percentage point savings in the contribution rate and leaving
young workers with meager retirement income. So cutting wage replace-
ment rates gradually will not finance the transition by itself, although the
principle of allocating productivity growth to the new pillar is useful.
Another way to reduce benefits-and to make a direct positive im-
pact on GDIP-ls to raise the retirement age. Raising the retirement age
enough each year to hold the dependency rate constant-two to three
months a year in many countries-would permit the full savings from
the lower wage replacement rate to be allocated to the second pillar.
However, even with a rapid rise in retirement age, this alternative still
leaves only a 5 percent contribution to the second pillar, not enough to
provide most older workers with an adequate pension. So this alterna-
tive, too, will not suffice.
Finally, in countries that have small public pillars and low contribti-
tion rates from the start, the funded pillar can be started up gradually by
raising taxes. The cost of the public pillar could be shifted to general tax
finance, while the payroll tax is allocated to the private pillar, where it is
directly linked to benefits and has smaller distortionarv effects.
262



In countries where occupational pension plans are already wide-
spread, the mandatory private pillar is likely to involve these plans, as
in Australia and Switzerland, or a choice between occupational pen-
sion and personal saving plans, as in the United Kingdom. Australia
has just made the occupational pillar mandatory. Mandatory contri-
butions start at 3 percent of wages and will rise to 12 percent by 2002,
absorbing most of the productivity growth over this period. Australia
has the advantage that its public pillar, a modest, broad-based income-
and asset-tested plan financed from general revenues, needs supple-
mentation and fine-runing, not a major overhaul. Thus the transition
in Australia consists of adding a second "savings" pillar to a redistribu-
tive public pillar-a move that will head off pressures that might oth-
erwise have developed for an enlarged public pillar. Most other OECD
couniitries will have to go through the more painful process of separat-
ing the saving and redistributive functions and of reshaping and
downisizing their public plans to avoid massive distortionary and eva-
sionary effects as dependency rates and system costs rise. That will
mean disappointing some groups, who will not get wlhat they had
been led to expect.
Middle-Aged Countries in Trouble-
Considering Radical Reform
F     INALLY. CONSIDER THE COUNT'RIES THAT HAVE LARGE, EXPEN-
sive public pension programs in urgelnt need of reform. The pay-
roll tax rate is 25 percent or higher in some countries, and still
they cannot meet their obligations because of poor system design and
widespread evasion. Many countries in Latin America and Eastern Eu-
rope are in this situation and some OlCD countries are approaching it.
They need to lower the tax rate, not raise it, and to put their old age sys-
tems on sound financial footing at the same time. To accomplish these
divergent goals, several countries are considering radical reform of their
systems-paying off the old social security debt to existing workers and
penisioniers and starting afresh with a new system. This involves design-
tic, the new system, calculating the benefits implicitly owed under the
old system, and figuring out how to finance it all in a way that is both
politically and economically acceptable.
263



P40~TI0NG THE OLD AGE CRISIS
Reforming the Old Public Pillar and Calculating the
Social Security Debt
A strong recommiendation of this report is that the old public plan must
be reformed simultaneously with or just before the transition. Reform of
the public plan is important because it improves economic efficiency
and equity. It also redefines the claims that workers and pensioners
have on the system and therefore reduces the taxes or government bor-
rowing needed to pay off the social security debt. Finally, since workers
are often given a choice, it increases the incentive to switch to the new
system.
To illustrate the complexities involved in reforming the public plan
and calculating the social security debt, consider the choice of benefit
rate. The statutory wage replacement rate is high in many countries
with bankrupt plans, but the plans will never be able to pay out these
high benefits. Many Latin American and Eastern European countries
have cut benefits covertly by failing to index them for inflation, a po-
litically expedient strategyv The public plan should be reformed by set-
ting a new statutory rate that is more realistic, and this modest rate
should be indexed for future inflation. Once this change has been in-
troduced, which value should be used to determine the amount society
"owes" pensioners-the old statutory value, the postinflation de facto
value, or the new statutory indexed value? What about cases in which
workers have contributed little but lay claim to large benefits? Should
they be paid an amounit based on a "reasonable" rate of return or the
immoderate rate of return allowed by a flawed system?
The choice of retirement age involves similar complexities. One rea-
son many plans are in trouble today is that they have granted early re-
tirement too liberally. Raising the retirement age will increase the pro-
ductive capacity of the nation and reduce the social security debt, but it
will face opposition from workers who feel they have been promised an
early retirement age. Chile raised the retirement age two years before the
new system was implemenlted; Argentina and Colombia did so when
they introduced their reforms. The retirement age should be raised as
rapidly as is politically feasible, and the new higher retirement age
should be used to calculate the social security debt.
More generally, should payoffs be designed to meet expectations or to
be more equitable and realistic from a long-run point of view? As in the
renegotiation of any failing debt, the answer involves complex political
264



T R.A4
considerations about what is feasible, fair, and acceptable to all parties
concerned. Several principles might guide these negotiations:
* The groundwork must be laid by an extensive public information
campaign to bring expectations into line with the reality that the
old promises are bad for the economy and impossible to keep.
Making sure that workers understand the full cost of the current
program, including employer contributions, should be part of this
campaign.
* Retirees and workers approaching retirement at the time of the
transition should receive a pension from the reformed public pil-
lar that keeps them out of poverty. They have few alternative
means of support and little time to adapt to the new ground rules.
* The valuation of accrued entitlements for younger workers might
be based on a lower, more realistic benefit rate. As a quid pro quo,
these workers get indexation of benefits, in some cases pay lower
payroll taxes than they would have otherwise, and will have ample
opportunity to increase their pensions and diversifr their risks
through a mandatory saving or occupational scheme.
* New entrants to the labor force and newly covered groups should
immediately be brought into the reformed system, instead of
adding to the debt of the old system.
* Since length of retirement has increased rapidly over the past half
century along with life expectancy-a trend likely to accelerate
during the next half century-the fairest and most tolerable way
to reduce benefits often will be to raise the retirement age.
* Once the old public plan has been reformed, a new multipillar sys-
tem should be established as an alternative. The new system would
include a still smaller public pillar supplemented by a second
manidatory pillar that is funded and decentralized. For example. if
the old statutory benefit rate was 50 to 60 percent of wages, the re-
formed public benefit might be 40 percent, and the muiltipillar
system might consist of a smaller public pillar that pays 20 percent
plus a 10 percent defined contributioll. Countries must decide
whether to give workers a choice between the old reformed public
plan and the new multipillar system. Argentina, Chile, Colombia,
and Peru have all given current workers that choice. In Chile, most
people under the age of forty chose the new system; the results are
yet to be determined in the other Latin American countries.
265



+i~LT1NG  THE OLD AGE CRISIS
Financing the Social Securit Debt
The social security debt is the value of expected benefit rights that
workers and pensioners have accrued under the old system. The debt
arises because the first generations of beneficiaries received more than
they paid and the workers who financed these payouts expect to be com-
pensated with generous defined benefits later on. Although difficult to
estimate, the total implicit debt is probably as much as 100 to 250 per-
cent of GDP for OECD and Eastern European countries, 30 to 50 percent
of GDP in middle-income countries with younger populations and lower
coverage, and less than 20 percent in the poorest countries (chapter 4). As
contributions are diverted to the new system, some other means must be
found to finance this debt.
First and most important, efficiency gains should help to pay off the
debt. Under some circumstances the shift of labor from the informal to
the formal labor market could boost productivity and growth substan-
tially (Corsetti and Schmidt-Hebbel 1994). Raising the efTective retire-
ment age would increase the labor force and GDP by 10 to 30 percent in
some cases (Cavalcanti 1993; Rashid 1993), resulting in an efficiency
gain as long as the value of the increased output is greater than the value
of leisure time lost. More output gains are achieved if the new system
increases saving, international competitiveness, and inflow of foreign
capital-although that is likely to be a very long-run effect. These effi-
ciency gains together with the reduction in evasion generate increased tax
revenues that can be used to pay off part of the debt. Since the reason for
the transition is to reap these efficiency gains, in principle it should be
possible to make everyone better off. But in practice this is difficult, es-
pecially for generations nearing retirement at the time of the transition.
Additional debt reduction comes from reform of the public pillar. If
the public pillar in the new multipillar system takes the form of a modest
flat benefit, say at a third of the previous average level, this is roughly a 33
percent payoff of the debt. If the new public pillar pays a means-tested
benefit or minimum pension guarantee, that is less easily viewed as a pay-
off of the old debt. It is, however, likely to cost less and to free up re-
sources that could be directly tapped to pay for the social security debt.
What remains of the debt can be financed by issuing government
bonds, cutting other government expenditures, selling public assets, or
raising tax rates. The methods chosen will determine savings, growth,
and the generational distribution of the benefits and costs of the transi-
266



TRANSIT10
tion (Arrau and Schmidt-Hebbel 1993; Valdes-Prieto 1994; Arrau,
Valdes-Prieto, and Schmidt-Hebbel 1993). As part of their general fiscal
planning. countries should estimate in advance the mix of tax and bond
finance or reduced government spending required at each point in time.
The experience of Chile offers several guidelines (box 8.5).
Debt finance simply exchanges the old implicit debt and interest pay-
ments for new explicit debt and interest payments. Property rights in the
debt are solidified, and market interest rates must be paid. This method
of handling the debt does not require current generations to reduce their
Box L5  Iow D  Ch  Pay Off fts Social Su    bt?
SO FAR CHIU IS THE MN  {COUNTRY THAT HAS    solved its calculation problem  by estimating the
turned its implJicith;socil .security debt into an ex-   number of months for which workers appeared to
plicit debt although other Latin American countries   have made contributions, using their taxable income
are now gotlg Throug'hthis same process. How did   over that period to establish past earnings, applying
Chie calculate and finanLce. this debt? The ,social se-   actuarial factors to approximate expected lifetimes by
cjurity-de,bt included (1) pensions for those who had    gender and age, and assuming the same wage growth
already retired when the new system was introduced,   for everyone.
(2) future pension paymeInts,for workers who had   How large was Chile's implicit pay-as-you-go
not yet retired huiut, who decided to stay with the    debt? One way to measure it is to calculate the present
old-but rently reform,edsystem, and (3) accu-   value of actual pension system deficits (postreform)
mulated enEtiitlements under the old system for   during 1981-92, add in forecasted amounts for
workers,who' decided to switch to the new system.   1993-2025, and discount appropriately. The annual
The first two groups were paid off in the form of   deficit starts at 0.6 percent of GDP in 1981, rises grad-
pensions, whic w.ere fnance by the general trea-   ually to 4.8 percent in 1991, and begins to decline
sury. Por the third group, the accumulated entitle-   thereafter, as older retirees die. The pension debt will
ments were paid :off by an immediate issue of   gradually diminish until the last covered retiree dies
'recagnition bonds". that were nontransferable,   and the last worker with a recognition bond retires,
earned 4 percent real interest, and were redeemable   around 2025. Estimates of the present value of these
forlump summ payments; into their mandatory saving   flows as of 1981, when the new system was intro-
accounts upon retiremen.,                        duced, vary from 38 to 128 percent of GDP, depend-
The recog,nition' bonds, were supposed to equal   ing on the discount rate used (the high rate of return
the expected present value of the benefits these work-   paid by the new pension funds or the lower GDP
ers had thus far eatned. Their value had been reduced    growth rate). The most relevant discount rate, the ac-
by the rfrm of theold system in the late 1970s, es-   tual and projected interest rate paid on government
peci4r by the rationalization of indexing, the elirni-   debt, which measures the actual cost to the govern-
nation., of speal regimes, and' the raising of the re-   ment, yields a present value of 80 percent of GDP
tirenhent age.- Calculating the Lsocial security   (Arrau 1992). This is smaller than the debt in Eastern
entitleinent Iis difficult.in developing countries,   European countries, which have older populations
w,here et)ployment records are incomplete. Chile              (Box continues on thefollowing page.)
267



fTNG THE OLD AGE CRISIS
Box 8.5  (continued) 
and mote extensive coverage, but larger than the debt    who switched to mhe IIIv i            /
in younger countries, such as Mexico or China,      dlebt until te  eie,sj* 
Under the old system, the implicit debt was fi-    were not transferablit t              i
nanced by contributions coming into the system.   yond that, the governmi at bS
Under the new, most contributions were going into    curred a fiscal deftdi       '       
the mandarory saving scheme, so other ways had to   the bonds *were hl14 +b 
be found to finance the debt. To prepare for the pen-    which were rapidly  l si0.;
sion transition, the Chilean government built up a    had to be invested so':wiw,              ,
budget surplus in the mid- 1970s and continued this    Swapping the old i        *   4                   |
practice for most of the 1980s, offsetting much of the    new explicit govemr                 X
pension deficir. In effect, the pension deficit was used    rates to rise. Rafes iWI r         / *
to absorb a budget surplus, preempting any move to    possibly because of r  i              /
cut taxes or increase government spending (box table   ing place. Chile shos i i
8.5) and in this sense keeping national saving above    ably competitive  in,   i <' 
what it might have been otherwise. Proceeds from    debtm           a1ketr dagrp1et  
the sale of public enterprises during the 1980s facii-    bility can finance:ltg  r *   d  
tated this process. Most other countries that do not   large interest rate   ep-                 3 / /
have budget surpluses or marketable public enter-    bonds can be paid ofi:6 
prises would have a more difficult time. Workers   run by levying taxes' ,,,
Box Table 8.5 Public Sector Dekfts and Natoa Savns under C hbbs 0,04
1979-81           1982-85        ' 
Fiscal balance and nat;inal saving (percentage ofGD?) GDP )                                 Q' i  '
Overall public sector deficit       -3.5               14.0              -0.     ...>.,
Pension debt                         0.6               3.6               *9,
Public sector deficit exduding       0
pension debt                     -4.1               10.4-5                         .,
Explicit public domestic debe        2.3              42.7              3 -   :
National saving                      11.5               3.7       ~        .
Public saving                        105-3.8                              47 '~ 
Private saving                        1.0              7.5                 ,     'w.'4 
Gross domestic investmnent          20.5               12.1              l.           ,&~''
Real intrerest rates
Bank deposits (90-365 days)          12.0              9.1 
Public debt yields                   -                   9b                ,
Pension funds                                          16.7               7
-Not available.
a. End-of-period stock of public domestic debt as a sharc of previous year's GDP.  .                   0
b. 1983-85 data.                                                               : 
Source: Central Bank of Chile (various issues); Arrau (I 992); Cuhean Nationa Institute of Sit
Ministry of Finance data.
268



T RAN S4T;"
lifetime consumption, but neither does it boost fiture saving and growth,
so fiture generations derive no benefit. Much of the demand for the new
bond issue will come from the new pension funds, which are rapidly ac-
cumulating savings that have to be invested somewhere. But a new bond
issue may be politically difficult in countries that already have a large
deficit. People would suddenly become aware of how enormous the social
security debt is. The transition would treble the size of the explicit debt in
most high-income and many older middle-income countries. Although
the change from implicit to explicit debt should have no macroeconomic
impact in a country with fully informed citizens, it might change govern-
ment budgetary behavior in the more realistic case in which the change
provides new. information to policvmakers and citizens.
Tax finance lays the burden of paying off the debt on the taxed genera-
rions (usually the working age generation). Their reduced consumption in-
creases national saving, which may increase economic growth and benefit
future generations. The key is to spread the tax btirden out in an economi-
cally and politically acceptable way. Lower-income groups should be pro-
tected from the additional cost. Taxes could be imposed after a rapid growth
spurt in the economy. While these taxes last, they are distortionarv-but
eventually they come to an end. General revenue rather than payroll taxes
should be used as a more efficient and progressive form of taxation.
Cutting other government expenditures is another course of action.
Budget cuts hurt groups that would otherwise have benefited from the
programs that are cut-current cohorts if current spending is cut and fu-
ture cohorts if government investments are cut. Since total spending is re-
duced, national saving increases.
Governments that are running a surplus can use it to finance the
transition. Because the surplus could also be used to reduce taxes or in-
crease other government spending, this alternative has economic effects
similar to those already discussed-although its political effects may be
different. Chile was running a surplus when it introduced its new sys-
tem, which facilitated the transition for Chileans, but few countries are
in that position today.
Finally, the proceeds from selling the assets of state-owned enterprises
that are being privatized can be used to pay off part of the debt, an op-
tion in Latin America and the transitional economies (box 8.6).
The discussion below assumes that a combination of debt and other
methods of finance is used. Bonds are issued to finance the transition ini-
tially and are gradually retired through reduced government spending and
269



-ERTI[NG THE OLD AGE CRISIS
Box 8.6 Using Privatized Public Assets to Pay Off the Social Security 0b1t iin the
Transitional Economies
THE PRESENT VALUE OF PENSION OBLIGATIONS    assets have been disappointing. OverstafTed, poorly
in the formerly socialist countries of Eastern Europe    managed, undercapitalized, andinde stare enter-
has been roughly estimated at about one and a half to   prises are not easy to sell under any circumstance.
three times GDP (Holzmann 1994). One tempting    The domesticprivatesectorhaslittlecawithwhich
proposal is to transfer state-owned assets, valued at   to buy these asses,aw domestic banking sector is
around 2.5 times GDP, to pension funds to pay off   in no position to provide the necessary liquidity, andl
obligations and create the basis for a new, funded sys-    most countries are not willing to 'transfer large
tem. Is that suggestion feasible?                 chunks of the stae enterprise sector to foreign hands.
How nany assets are really available?At least 20 per-   If the state were to sell the assets to domestic in-
cent of the assets are in public infrastructure, which    vestors over a reasonable period of,say, three to five
will not be privatized. Another 30 to 40 percent are in   years, the sales would amount to gew"ays tio the few
housing and agricultural land, which in most Eastern    people who have cash or access to credit-generally,
European countries are being turned over to former    people who 0prospered: under the former system.
owners or tenants. Still another 20 percent are in corn-   Most countries have Concluded that the: political
mercial real estate belongig to the municipalities--   consequences of selling the assets outweigh the po-0
and not available to the federal governent. That   tenuial revenue gains andi havechosen to distribute
leaves the state enterprise sector, with roughly 50 to 75:   them to the entire populationri in the form of vouch-
percent of GDP, clearly not big enough to pay off the    ers, or to encourage employee buyouts.:
social security debt (Holzmann 1994). Even this may  Why notput the vouch- s directly intopenfiatds0
be an overescimate ofthe value ofprivatizable assets, as   to pay offretirees? The equities arte not likely to pay
market prices have been disappointing,            high dividends or to be very liquid for the first ten
What are the assets really worth and who woutd buy   years, so state transfers would still be:ne:ee to pay
them? The prices fetched in the sale of privatizable   pensions over that period.
taxes imposed on a stream of generations that ultimately bear the cost of re-
duced consumption. The burden is spread out according to the time
schedule society prefers, but the gain is realized at a correspondingly slower
rate. Chile scheduled retirement of its social security debt over a period of
about fifty years, but money is fungible. so no one will know whether gen-
eral debt finance has been used to postpone further the day of reckoning.
The Politics of Transition
T        HE ONLY WAY TO WIN BROAD SUPPORT FOR JIENSION RE-
form is to structLire the new program so that there are more in-
fluential winners than losers. The gains need to be allocated in
270



TRANSiMT1   $
Woul4 pension funds be good enterprise monitors?   rate the investments of pension fund managers-
Eastern European countries at the forefront of the    bank regulators, bond market regulators, stock mar-
transition have felt that the only way to end the fiscal   ket regulators, real estate regulators. This first tier of
bailout of former state enterprises is to get real private   regulators is just emerging in most countries. If funds
owners to work actively with companies to restruc-   are built up slowly, regulatory capability could catch
ture or liquidate. There is little confidence that pen-    up. But if funds were suddenly infused with assets
sion funds under state sponsorship, or with a state    worth 50 percent of GDP, the regulatory challenge
guarantee, could provide the firm hand necessary to    will be irnmense.
enforce critical changes quickly and forcefully.      What about a more modest approach? Public assets
Clearly, the funds would have to be independent if   could be used to pay off a portion of the social secu-
they were to exercise proper corporate governance.   rity debt. Workers in midcareer whose retirement
The higher the share of these state enterprise equities    age has been abruptly raised might be partially com-
in the portfolio of pension funds and the more regu-    pensated by receiving vouchers for their pension ac-
lated the funds, the greater the danger that they will   counts. Active workers might be permitted to place
perpetuate the status quo rather than take the risks   their vouchers in pension funds, in lieu of mandatory
necessary to push the restructuring forward.       payroll contributions. Alternatively, the pension
Who will regulate thesefions? Although the work   funds could gradually buy up some of the vouchers,
forces in the transitional economies are highly edu-   increasing their liquidity. Pension fund managers
cated compared with those in other countries at   could thus become active investors in a few compa-
comparable income levels, financial skills-not    nies. This solution would allow pension funds to
much in demand under socialist systems-are in    play a role in the privatization process without be-
short supply. To do their job, pension fund regula-    coming the main owners of the industrial sector.
tors normally rely on another set of regulators who
ways that are fair and that make the reform politically popular. Both
young and old need to be convinced that the new system will make
them better off. If there are efficiency gains, a surplus is available to
make most people better off, but this requires careful planning.
Winners and Losers across Generations
Winners and losers across generations are determined by the way the
social security debt is measured and financed. If the calculation of the im-
plicit debt is generous, pensioners and older workers gain, because they
continue to receive benefits that the state might have defaulted onl other-
wise. If the calculation is stricter, older generations lose-or believe that
they have lost-because they receive less than they would have gotten
under the old formula. Pensioners are a very risk-averse lot. When they
27]



GTHE OLD AGE CRISIS
are also well organized, they have considerable political influence. It is es-
sential to come up with a new valuation of pensions that che old as well
as the young regard as fair. At the same time, the payoff to these groups
cannot be too generous, and the reform generally requires downsizing the
new public pillar. The old will buy this contraction only if they are con-
vinced that the existing benefit level cannot feasibly be maintained. In
Chile, top government officials conducted an intensive media campaign
to convince people of the bankruptcy of the old system.
If the transition is fully financed through higher taxes, taxpayers in
the current generation lose. They will have to pay higher taxes to cover
the debt while also saving for their own retirement. Countries that al-
ready have very high tax rates will have to rely on reduced benefits, re-
duced government spending, and partial debt finance in the short run,
with somewhat different distributional effects. The biggest winners are
likely to be the generations following the transition, who will reap the
economic gains of increased efficiency and growth. Is this transfer from
present to future generations fair and socially desirable? This, of course,
involves a value judgment about which people may disagree. But poli-
cvmakers who take the long-run perspective face a formidable political
obstacle: the current generation is alive and making itself heard at the
time pension reforms are being debated, while future generations of
pensioners are just children or not yet born.
The Chilean government convinced the current generation of workers
that reform was good for them by slashing contribution rates from 22 per-
cent to about 13 percent for those who opted for the new system. The
lower cost reflected the expected savings from reduced evasion, distor-
tions, and inequities. NW7orkers wvere required to pay the entire contribu-
tion themselves, rather than sharing it with their employers, to make them
more cost-conscious, but those who switched received a one-time wage in-
crease that put them ahead in terms of take-home pay. T'he debt payoff
was financed more ambiguously out of general revenues, including a bud-
getary surplus that the government had accumulated in advance.
Winners and Losers in the Same Generation
The transition also involves redistribution within the same genera-
tion. Who wins and who loses depends on whether the old pay-as-you-
go system was progressive or regressive and on whether the reform pack-
age includes measures for the poor. Since many current systems are not
272



T RAN SITA N 
redistributive toward the poor in practice, whatever their intentions.
low-income groups may well be the winners from the transition and
high-inicome groups the losers. Workers as a group gain if productivity
rises with the reduction in labor market distortions and the increase in
capital accumulation that accompany reform-an effect that can im-
prove the welfare of low-income groups in the future. Private entrepre-
neurs gain as a new supply of finds for corporate equities and bonds
flows into the market.
Institutional Winners and Losers
With the pensioni transition, managers of social security institutions
lose some of the power that comes with wielding monopolistic control
over large flows of money, and workers in these institutions may lose
their jobs. The social security bureaucrats may try to mobilize political
parties and pressure groups to oppose the transition. Severance pay may
help to defray their opposition. Private financial institutions gain, espe-
cially those that reap the large profits available to early entrants into the
market, so they can be expected to lobby in favor of a decentralized
funded pension system. In many Latin American countries, unions may
expect to lose and may oppose the transition if they were previously the
sole representatives of the workers in the social security program.
Unions may be won over by letting them establish new pension fiunds,
as in Chile and Argentina.
Countries in Transition
O     'VER THE PAST THREE YEARS, NMANY COUNTRIES HAVE MADE
major changes in their old age security systems. Australia
added a mandatory funded occupational pillar to its means-
tested public pillar. Several Latin American countries are following the
Chilean model of mandatory personal savings accounts, with the public
pillar offering a flat benefit or a minimum pension guarantee. Other
countries with problem-plagued public plans are at a crossroads and are
trying to decide which way to move. China and the transitional social-
ist economies are the most notable examples, but a number of OECD
countries are also in this group. Countries in Africa and South Asia,
273



iAVERTING THE OLD AGE C.RISIS
where informal systems are gradually breaking down, are just beginning
to build up their public plans-and watchinig other countries move in
the opposite direction. Observing older countries in transition should
be a cautionary experience for younger countries, spurring them to eval-
uate carefully where they want to be thirty years from now and how best
to get there.
Australia's Mandatory Occupational Pillar
Australia has long relied on an income- and asset-tested public pen-
sion financed from general revenues. By the standards of most OECD
countries, its public pillar was fiscallv modest and redistributive, costing
about 4 percent of GDP (appendix table A. 5). A second pillar, a manda-
tory funded employer-based retirement scheme, was added in 1991.
This scheme had its origins in a political agreement berween the gov-
ernment and the unions in 1986 that set the national umbrella com-
pensation increase at the inflation rate, with half the increase in the form
of a retirement fund contribution. This arrangement solved several im-
portant political economy problems. It enabled unions to claim a large
compensation increase without creating new inflationary pressures. It
addressed the retirement concernis of an aging population without
adding to the government's fiscal burden. And it was seen as a way to in-
crease national saving and growth. In 1986 only 40 percent of Aus-
tralian workers were covered by occupational schemes. In 1991 occupa-
tional schemes became mandatory for all employees. Simultaneouslv,
the retirement age at which the fuinds could be tapped was raised (Bate-
man and Piggott 1993).'
This superannuation scheme is scheduled to be phased in over ten
years. Starting with a 3 percent requirement in 1992. the employer's
contribution rises to 9 percent by 2002. Toward the end of the period,
a 3 percent employee contributionl will be added, bringing the total con-
tribution rate to 12 percent. This higher contribution rate is expected to
be financed by holding the line on wage hikes as productivity grows. For
example, a I percent annual increase in productivity would cover super-
annuation costs while holding real take-home pay roughly constant.
Contributions to the retirement find must be fully vested, portable,
and funded. Most plans are defined contribution, which facilitates
compliance with these regulations. The funds are supervised by boards
of trustees that include an equal  uLmber of employer and worker
274



TRANSITIONS,
representatives-another reason for union support of the second pillar.
Disclosure requirements and tight prudential standards are specified by
legislation. All workers in a firm must be in the same fund, with a sin-
gle investment strategy, a feature that could cause conflicts between
young and old workers or risk-averse and risk-prone workers.
The tax treatment is complex: contributions, earnings, and benefits
are partially taxed and partially dedLIctible, the result of a pragmatic at-
tempt to reduce tax expenditures, especially those benefiting higher-
income individuals, while encouraging complianice. Employer contribu-
tions are tax deductible up to specified limits that increase with the
worker's age. Fund earnings are taxed but at a low flat rate. Benefits be-
yond a specified floor are taxed but at a lower rate if the benefit is taken
as an annuity rather than a lump sum.
Once the plan is phased in, it will increase annual private saving by
an estimated 0.8 percent of GDP. Public saving may increase in the long
run (as spending on the means-tested pension declines) but decrease in
the first few years (because of tax exemptions for contributions and
interest). Overall, the plan will more than offset the savings decline ex-
pected as the populationi ages. Estimates of the positive impact on
national saving range from 0.5 to 1.3 percent of GDP, in either case a
substantial increment to the current net national saving rate of 5 percent
of GDP.
Australia, like Chile, mandates a funded decentrally controlled pillar
as an important part of its old age security system. Both decentralized
schemes include a detailed regulatory structure. To facilitate regulation,
there are no provisions for splitting a worker's pension accumulation be-
tween two or more funds. Thus risk canniot be reduced through diversi-
fication. This limitation should be reevaluated because it is a large social
cost of the regulatory system. Australia permits retirees to take their pen-
sion accumulation as a lump sum rather than as an annuity or in phased
withdrawals, as required in Chile. If the lump sum is dissipated too
soon, the result could be low incomes and poverty among the very old.
Costs, especially marketing costs, might be lower in the Australian
scheme, where employers choose the pension fund on a relatively long-
term basis. But since most plans are defined contribution-workers bear
the risk while employers choose the investnent manager-the incen-
tives for high returns might be lower in Australia than in Chile. Data on
costs and returns are not yet available for Australia, so these hypotheses
cannot be tested.
27'



THE OLD AGE CRISIS
The public pillars in Australia and Chile are redistributive and fi-
nanced out of general revenues. Australia's public pillar, which pays a
universal income- and asset-tested benefit to about 70 percent of the re-
tired population, is much more generous and expensive than the mini-
mum pension guarantee scheme that constitutes Chile's public pillar. As
a result, Australia's scheme has a greater impact on poverty and a higher
expected wage replacement rate for a typical worker-but it also will
cost more.
Denmark and Switzerland have also adopted mandatory occupa-
tional pillars in recent years, and this trend will probably spread to other
OECD countries as they struggle to cope with aging populations in a time
of slow economic growth and fiscal stringency.
Latin America's New Privatized Pension Plans
Nowhere has the influence of the Chilean experiment been felt more
strongly than in Latin America. During the debt and fiscal crises of the
1980s, Latin America's pension schemes became seriously underfunded.
By the end of the decade falling real pensions, increasing evasion, large
social security deficits, and depleted reserves had irreparably damaged
the credibility of traditional pension schemes. The pension crises coin-
cided with a generalized debate over the role of government. a push to-
ward privatization, and a strong desire to build up domestic capital mar-
kets. As the region entered the 1990s, the movement to privatize
pensions gained momentum, urged on by the success in Chile.
In 1992 governments in Argentina and Peru proposed fundamental
changes that effectively privatized a large share of pension programs. Peru
implemented a new pension law in 1993, and Argentina's pension re-
form, which squeaked by in 1993 with a one-vote majority, is scheduled
to begin in 1994. Both countries were running enormous pension
deficits before making the transition, with implicit social security debts
estimated at about two-thirds of GDP. Colombia, too, is about to intro-
duce a new privatized pension system, though its immature scheme has
no current pension deficit and has a much smaller social security debt be-
cause of lower coverage. All three countries have set up schemes similar to
Chile's and have largely adopted Chile's regulatory structure. Some of
Chile's pension companies (AFPs) are moving into these new markets.
Mexico has also instituted a small compulsory mandatory saving scheme,
and Bolivia is on the verge of adopting a Chilean-type reform (table 8.1).
276



T RANt
Table 8.1 Pension Reforms in Latin America
Chile                Peru             Argentina            Colombia
Year implemented                         1981                 1993                1994                 1994
Transition arrangements
What happens to old system?           Phased out         Continues with       Continues with      Continues with
changes             changes             changes
Is current labor force allowed
to remain in old scheme ?               Yes                  Yesa                 Yes                 Yes
Is new system mandatory
for new labor force entrants?           Yes                  No                   No                  No
Can workers switch back to public                                                                    Yes, every
system after entering AFP?              No             Yes, for two years         No               three years.
Recognition bonds                         Yes                  Yes                 Yesb                Yes'
Profile of new pension sclheme
What role for public pillar?       Minimum pension       Social assistance       Flat and        Minimum pension
guarantee                            minimum pension          guarantee
Social assistance                                             Social assistance
Total contribution rate for new svstem
available for old age annuity            10                   10                   8                   10
disability/survivors/administrative      3                   2.3                   3                  3.5
public pillar and social assistance    General revenues        1                  16d                  1
Total contribution rate: before reform     19                   9                   27                   8
after reform        13                  13.3                 27               13.5-14.5'
Maximum percentage of portfolio allowed in
Domestic equities                        30              to be decided            50              to be decided
Foreign equities                         10              to be decided            10             to be decided
Government bonds in 1994                 45              to be decided            50                   50
a. Workers must decide by 1998.
b. "Compensatory pension" is paid uipon retirement, not as a bond. The value is based on years of contribution and last ten years'
earnings.
c. Workers with fewer than 150 Sveeks of contributions are not eligible for a recognition bond.
d. This is paid by the employer.
e. The rate shown is for 1996 and followiing years. The contribution rate will increase gradually between 1994 and 1996.
Source: Rofman (1994); Virtas (1994a); Colombia (1993); World Bank internal documenlts.
The transition in these countries has key features in common with
that in Chile. For example. Argentina, Colombia, and Peru give work-
ers a choice betveen remaining in the old social security system  and
transferring to the new privatized system. If most workers under the age
of 40 transfer, the assets of the new private pension companies are pro-
277



AMERTING THE OLD AGE CRISIS
jected to grow to 10 to 20 percent of GDP over the next decade. Work-
ers who switch will receive recognition bonds or pensions based on years
of service tinder the old system as a payoff of the social security debt.
All three countries reformed their public pension plans before intro-
ducing the new structure. Argentina raised retirement age by five years
and eligibility from fifteen to thirty years of service and lowered the pen-
sionable wage base. Colombia increased the eligibility period and the
contribution rate for workers who remained in the old system. That en-
couraged workers to choose the privarized pillar and reduced the social
security debt owed to those who switched.
The new schemes also differ from Chile's in certain important re-
spects, a consequence of their unique political climates and institutions.
Argentina includes both a flat benefit and a higher minimum pension
guarantee as part of its new system. All eligible workers receive a flat
benefit from the public pillar equal to about 25 percent of the average
covered wage besides their pension from the second fiunded pillar. Addi-
tionally, the state guarantees workers at least 40 percent of the average
covered wage under the combined pillars. So long as underreporting
does not cut the average covered wage, this guarantee is much larger
than Chile's. But the thirty-year eligibiliry period excludes many work-
ers, including most womiieni. The flat pension in the public pillar plus the
payoff of the old social security debt will be financed by a 16 percent
payroll tax paid by employers. Workers pay another 11 percent into the
new second pillar. The total contribution rate is the same as it was under
the old system (Vittas 1994a; Rofman 1994).
Colombia, like Chile, offers a minimum pension guarantee to redis-
tribute to the lifetime poor and insure workers againist severe investment
failure. Peru's new system has no public pillar; the only backup is social
assistance. Many workers may be reluctant to assume the full investment
risk of the new system; but they will have to compare this risk with the
political risk of the old system, which is also substantial.
Proponents of reform in Mexico found it difficult to challenge the
fifty-year tradition of a dominant public pillar. Mexico compromised by
leaving the public system intact and adding a small mandatory savings
scheme in 1991 that placed 2 percent of wages in individual capitaliza-
tion accounts. This is unlikely to be an equilibrium solution for an aging
population. High transaction costs per account are another drawback.
Probably in the long run contributionIs to the funded pillar will grow-
or it wiII be phased out.
278



TRANSITIONS
While the new Latin American schemes are welcomed reforms, de-
sign and planning flaws may create problems for them in the medium
term. First are the difficulties in calculating the value of the old social
security entitlement. In Peru the absence of reliable records forced offi-
cials to accept the sworn statement of workers to establish their past
contributions-a method obviously subject to abuse. Colombia's for-
mula for calculating the recognition bond is so complex that it may be
impossible to implement uniformly. In Argentina the index that will be
used to revalue past earnings and contributions has not yet been specd-
fied. Calculations of old entitlements may be subject to political pressures
that increase the fiscal costs of the transition substantially or, conversely,
that leave retirees with lower pensions than they thought they wotild be
getting.
A second set of problems concerns the indefinite continuation of the
old system, albeit with reforms. In Chile, new entrants to the labor force
have to join the privatized pension scheme. The other reformers in Latin
America allow new entrants to choose between the new and the old sys-
tems. In Colombia and Peru, they can even switch back and forth. This
freedom introduces incentive problems, uncertainty, and higher admin-
istrative costs for the old age system as a whole. Colombia will offer an
inflation-indexed replacement rate of 85 percent of final wages in the
old svstem after only twentv-three vears of contributiolns. Workers will
probably choose to remain with that system if they believe this promise.
In Argentina, workers can choose to put their 11 percent contribu-
tion into the new privatized pillar or the reformed publicly managed sys-
tem. The public system pays a defined benefit equal to 25.5 percent of
the final ten years' average wage for a worker with thirty years of service.
(This is in addition to the flat benefit of 25 percent of the average cov-
ered wage that everyone gets, financed by the employer's contribution.)
In the privatized pillar, less than 8 of the I I percent worker contribution
gets invested; the rest goes to cover plan expenses and disability and life
insurance. Except for very young and short-term workers, the public
systemii may be preferred because it promises higher expected benefits
than the new private option. A 7 to 8 percent contributioni rate will not
yield an adequate pension in a defined contribution plan unlless the in-
terest rate is very high. But simulationis indicate that the public defined
benefit system may not break even once the population ages, unless
wage growth in the country is very high. These old systems may become
bankrupt in the fItuLre, tist as they did in the past.
279



4;1'YTING THE OLD AGE CRISIS
Also questionable is whether the government's regulatory capacity
and domestic capital markets are up to the job of running a mandatory
saving plan. In Chile the planning process took several years. An elabo-
rate system of governmenit regulations and guarantees was constructed
and a legal framework was developed that permitted a full range of in-
dexed bonds and other indexed financial instruments to be traded. For
the first few years, most pension funds were invested in bank and gov-
ernment debt as financial regulations were modernized, although new
investments are much more diversified. In contrast, Peru has few people
trained to be potential pension regulators or administrators. The short
supply of government bonds and the absence of a secondary market for
public debt raise questions about where the new pension funds can be
invested. Colombia's new legislation does not specify investment restric-
tions. In Argentina, stock market capitalization is low, so the entry of
large new funds may bid up prices sharply until new stock issues enter
the market. Imperfections in domestic capital markets can be avoided
through international diversification, but all these countries, including
Chile, limit that option. If the new private pension companies do not
operate in a reasonably prudenit manner and earn good returns during
their first few years, the new system may be irrevocably discredited.
Bolivia, Brazil, Costa Rica, Uruguay. and Venezuela are contemplat-
ing the future of their pension systems. Bolivia has tied pension reform
to state enterprise reform. Shares of privatized enterprises are slated to be
transferred to the population at large in the form of assets for the new
privatized pension funds. Economies of scale in pension provision pose
a problem for decentralized systems in this small country, especially for
accounts of low-income workers and peasants. In Venezuela tensions
among unions, business interests, and governmenit are stalling reform.
The general distrust of government institutions and the more specific
distrust of social security arrangements make it likely that ani increasing
number of workers will trade in public promises for AFP accouLnts in Latin
America. Whether these new systems will ultimately prove successful de-
pends on a host of design and implementation details, and early indica-
tions are that these will differ from one country to another.
China at the Pension Reform Crossroads
The rapid aging of China's population, accelerated by the one-child
policy and impressive improvements in health care, will severelv strain
280



TRANS,Il
both formal and informal old age support systems in the next few
decades. By 2030 nearly 22 percent of China's one billion people will be
over age 60 and the number of workers per old person will fall from 6 to
2.3, giving China an age profile similar to that of the oldest OECD coun-
trv today. Pension reforms are necessary if China is to restructure its
economy and care for its old.
Informal systems of caring for the old still predominate in rural
China, where more than 80 percent of the old live witlh children or
other family members. Most old people in rural areas continue to work,
and only one person in twenty receives a formal pension (Cangping
1991). In contrast, most urban workers are covered by a complex net-
work of formal retirement schemes administered, until recently, on a
pay-as-you-go basis by the state enterprises for which they work. This
system has become a major impediment to economic reform.
It is impossible to shut down inefficient enterprises without elimi-
nating the mini-welfare state each represents. Potentially profitable en-
terprises, especially those witlh a high proportion of aging workers, are
burdened by the costs of administering benefits for thousands of pen-
sioners. The government has been tinder pressure to bail out companies
that can no longer keep their pensioni promises. Ignorinig the cost of
mounting pension liabilities, enterprises have been encouraged to shed
surplus workers by offering early retirement or disability pensions-but
this ultimately adds to total costs.
In additioln, worker mobility has been discouraged by the system's
fragmentation. Wage replacemenit rates are high-over 75 percent of the
average urban wage-but usually pensions are not indexed. This has re-
duced real pensions as inflationi pressures have grown. Lax enforcement
and benefit formulas that tie pensionis to final year wages have induced
workers and employers to evade and manipulate the system. And the
cost of the scheme is soaring. Berveein 1978 and 1988 pensioni expen-
ditures per covered worker doubled in real terms, and total penisioni ex-
penditures as a share of GDP almost doubled, from  1.4 to 2.7 percent
(ii.o data). Without significanr reform, these expenditures will skyrocket
over the next few decades. (For further discussion) of problems with the
current system, see Friedman i 1994.)
Because the coming demographic shift is so dramatic, China will
sooin face a turling point in its old age security system. It will need to
decide whether to centralize the old age system nationally, allow
provinces or localities to handle it on a coordinated basis, or let the old
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*+  XNN G  THE OLD AGE CR1SIS
enterprise-based system remain. Maintaining the status quo is clearly not
a reasonable option in view of the impediments this presents for labor
mobility and enterprise restructuring. In more than 2,100 cities and
counties around China, pension pooling arrangements among enter-
prises have already been established, and local governments have begun
to assume the management of these pooled schemes. But differences in
contribution rates and benefit formulas have created inequities and
portability problems. China must decide whether to centralize further to
the provincial or national level or to allow local differences to prevail.
One advantage of local or provincial control is greater adaptability to
the vast differences in income and labor market conditions, differences
that will likely wideni over the next decade. Another advantage is that it
allows room for experimentation, which might be useful in a country
that has not vet reached consensus on a single best policy. Indeed, sev-
eral localities are already experimenting with a variety of schemes-
sometimes without carefLl preparation. A compromise would allow
local or provincial plans to operate subject to national guidelines on pru-
dent investment, portability, actuarial, and disclosure requirements.
China also needs to decide whetlher to retain a dominant pay-as-vou-
go system or move to a multipillar system with a large funded compo-
nent. A pay-as-you-go system would be particularlv sensitive to the
upcoming demographic transition, so China would be unwise to put all
its eggs in that basket.
China is fortunate to be experiencing an iinprecedentedly high
growth rate: over 10 percent a year for the last decade, with high growth
expected to continue for the next decade (IMF IFS 1993). Diverting part
of the fruits of its productivity increases to a funded pension pillar
would enable China to build up the capital stock to maintain its growth
and support its aging population. China is well placed to do that, since
it starts out with a relatively small pay-as-you-go system, a flat wage and
benefit structure, and a retirement age with lots of headroom. Tralnsition
costs are low now, compared with what they might be in another ten
years if the pay-as-you-go system expands. The current generation of old
people could be protected by the public pillar, which would continue to
provide a safety net, while younger workers, who will have much higher
lifetime incomes, could finance much of their own retirement savings as
well as pay off the social security debt through taxes.
If China goes the multipillar route, including a funded defined con-
tribution pillar, should it follow the Chilean model (decentralized fund
282



TRANS1T,
management) or the Singaporean model (centralized), and what regula-
tory apparatus should it install? The preconditions for running a pri-
vately managed funded system are present in China-to a greater extent
than in most couLntries at its stage of development. Though capital mar-
kets and financial regulationl are still rudimentary, stock markets are be-
ginning to develop-and banks must undergo a major restructuring in
any event. Many foreign financial institutions would willingly jump
into the enormous Chinese market if given a chance, including those in
Hong Kong, which is about to become part of China. Indeed, overseas
Chinese have already invested heavily in China. Pension funds could en-
courage the development of capital markets and facilitate privatization,
as in Chile.
However, the government may be reluctanit to relinquish control over
these potentially large funds and may therefore prefer the Singaporean
model. Policymakers may be tempted to use the pension funds to subsi-
dize failing enterprises or to finanice expenditures on housing and infra-
structure, both of which are in short supply in China. The cost of this
approach would be the scarcirv of investable fuinds for profitable private
sector growtl.
New occupational schemes that are likely to be offered by multina-
tionals and large domestic firms to attract personnel present another set
of concerns. Basing the second mandatory pillar on these occupationlal
schemes seems a poor idea, since that would perpetuate many of the
problems of the enlterprise-based schemes. Yet voluntary employer-
sponsored plans seem inevitable. To avoid big problems down the road,
Chiina needs to think through a careful regulatory framework for new
occupational schemes from the beginning. Adequate fundinig must be
required to ensure that firms are able to honor their pension promises
when they come due. And vesting arrangements must be worked oLit to
make sure that these plans do not get in the wav of the labor flexibility
needed for continued economic growth.
Chilna also needs to decide on a tax framework for these plans and for
voluntary personal retirement saving schemes. This framework should
balance the usefulness of incentives for voluntary pensions and savings,
the equity implications of these incentives, and the governimenit's need
for tax revenues. Private voluntary saving could be expanded by intro-
ducing appropriate tax policies, reforming the bankinig system, avoiding
inflationary policies, and establishilng reliable savings institutiolls,
preferably with indexed finanicial instruments.
283



ING THE OLD AGE CRISIS
Recently the government has begunl a small contributory pension
program for rural workers. But the formal pension system will not reach
most rural areas for maniy years, and voluntary saving is unlikely to suf-
fice. The informal system in these areas could be bolstered by govern-
ment subsidies (housing and medical allowances) to children or other
relatives who care for aging family members. One promising avenue is
expansion of the Wu Bao program, which provides food, shelter, cloth-
ing, medical care, and other support to the needy old as well as to
orphans and the disabled. This effort could be financed out of general
revenues, both local and national. In 1985 Wu Bao provided help to
about 2.4 million old people. about 5 percent of the old in rural areas
(World Bank 1990). But even as far-reaching pension reforms are intro-
duced inro the formal contributorv svstem, the country's limited re-
sources, large number of old people, and growing income inequality
mean that the informal system combined with social assistance pro-
grams w ill continue to play an important role in Chinas old age support
system.
Eastern Europe-Magnified Problems and Difficult Solutions
Countries in Eastern Europe and the former Soviet Union face the
typical problems of middle-income countries with publicly managed
pay-as-you-go systems: high and rising dependency ratios, overly gener-
ous wage replacement rates (with little or no indexation), liberal early re-
tirement and disability provisions, soaring fiscal costs, bloated contribu-
tion rates, and negative returns on pension reserves (see box 4.7 for
details). But the problems are magnified in the transitional economies
because they have the aging demographic profiles, widespread coverage,
system maturity, and aspirations of high-income countries but the re-
sources, tax systems, and government capacities of middle- and low-
incomiie countries. Old age security programs are much larger in Eastern
Europe and the former Soviet Union than in Latin America. They are an
enormous fiscal drain in these countries and a major drag on labor de-
mand in the formal marker. Solutions will be more difficult as well in
couLntries reeling from declining (GDP, economic and political turmiioil,
and widespread institutionial chanige.
Like China, these countries need to decide whether to maintain a
dominant public pension plan with an earnings-related benefit formula
or to adopt a multipillar system. If they shift to a multipillar system they
284



TRANSIT I
must decide wherher the public component should be flat, means-
tested, or a minimum pension guarantee and whether to phase in the
second pillar gradually, by cutting benefits or increasing contributions,
or to make a radical break and scart up a new system at once. If they
choose the radical route, they will have to figure out how to pay off an
implicit social security debt that is much larger than that in Latin Amer-
ica because their populations are older and coverage is broader.
Reforming public pension plans. Whatever else they decide, the first step
is to reform public pension plans. Although essential reforms vary by
country, the most common include redticing and flattening benefits,
indexing for inflation, raising the retirement age, changing the tax
base, separating the accounts of differ-ent social insurance plans, and
eliminating reserves, which (where they exist) earn a low or negative
rate of return. Quickly lowering the average wage replacement rate
(from 50 to 70 percent, where it now is in many countries) to 35 to 40
percent would bring replacement rates in line with those in many
OECD countries, cut the contribution rate substantially, and lower the
social security debt. The quid pro quo for reducing benefits should be
to replace the current erratic indexation withi automatic indexation
unider clearly stated rules. If a multipillar system is phased in, the wage
replacement rate in the new public pillar could be gradually reduced to
20 percent by using an indexation method in which pensions rise more
slowly than wages or by switchinlg to a minimumi guarantee.
Reducing average benefits makes it all the more important that the
public pillar concentrate on poverty elimilation. Conditions in transi-
tional economies-no employment records, high rates of labor force
participation in the old command economy, relatively flat wage struc-
tures, and little or no personal savings-make a universal flat pension
the best way to go in the short run-maybe the only feasible way. Flat
benefits provide basic insLirance to all, are administratively simple, and
constitute a partial payoff of the social security debt. The shift to a flat
benefit structure ought to be easy since the effective rate is already nearly
flat, thanks to relatively undifferentiated wages and inflation-eroded
benefits that have placed manly retirees at the minimum pension.
The two most important reforms are to raise the retirement age for
women to that for men and to eliminate special early retirement job cat-
egories, bringing the average effective retirement age up from 55, where
it is now in most of these countries, to 60. This step could be achieved
in two to five years. After that, the normal retirement age could be raised
285



FS ~C THE OLD AGE CRISIS
more gradually to 65 (and beyond, as longevity rises). Simulations for
the countries of the former Soviet Union show that pushing up the nor-
mal retirement age six months each year for ten years would cut the re-
quired contribution rate by 30 percent (Cavalcanti 1993). Poland could
save roughly 3 percent of GDfr annually by 201 0 by cutting the number
of early retirees in half (Rashid 1993). Romania could cut projected sys-
tem dependency ratios and costs by 25 percent by equalizing the normal
retirement age at 65 for men and women and at 60 for most early re-
tirees (Romanian government projections). These savings could become
the major source of funds for starting up the second pillar.
The public pillar should also shift to a broader tax base in the long
run, for efficiency and distributional bases. But until these countries es-
tablish a personal income tax and value added tax, the payroll tax is
likely to be the oniv game in town. Workers should bear at least half the
total tax responsibility-the employer pays it all now-as a deduction
from take-home pav (A one-time increase in wage scales, as in Chile,
may be needed to hold disposable income constant.) Nothing creates a
constituency for change as quickly as seeing how expensive the current
system really is.
Establishing a mandatory saving pillar. The downsizinig of the public pil-
lar and the introduction of a decentralized second pillar would have
special political and psychological benefits in transitional economies.
These choices would signal the governm11entIs intention to transfer
responsibility to individuals for their own well-being, backed up by a
public social safety net, and establish a constituency for macroeconom-
ic stability, financial sector reform, and enterprise privatization and
restructurinig. Pension fund assets could help to stimulate foreign
direct investment throtIgl joint ventures with large foreign investment
firms.
Since payroll tax rates need to be lowered, not raised, to stimulate pri-
vate enterprise and trade, how can this transformation be accomplished?
The reform of public pensioni plans just outlined provides a clue about
how to reduce taxes and phase in a second pillar simultaneously. In-
creasing the average retirement age from 55 to 60 and lowering the av-
erage replacement rate from 50 to 40 percent by the year 2000 would
allow a typical older Eastern European country to cut payroll taxes from
30 to 18 percent, freeing up 12 percent to be split between the second
pillar and tax cuts. If 10 percent of payroll went to the funded pillar this
would produce assets equal to about 3 percent of GDI' per year-small
z86



T RAN SI1T
enough for the financial systems of most of these countries to handle
and large enough to help the economy. Indexinig public pensions half to
wages and half to prices would allow productivity increases to cover the
cost of rising dependency rates and further cut the contribution rate
over a period of years. Simulations of a possible transition path for East-
ern Europe are outlined in issue brief 12.
Paying off the social security debt: Equity among age groups. If all goes well,
young workers (under age 35) and their children are likely to be the
big winners, gaining from higher wages thanks to productivity growth,
the accumulated capital in their pension accounts, and the added
insurance that comes from risk diversification. Reform will not get off
the ground, however, unless it deals with obligations to people who
have worked all their lives with the expectation that they would be
taken care of when they grew old.
Taking care of older groups implies shifting some income from
younger to older generations to pay off the social security debt. Esti-
mating this debt is more complicated for the transitional economies
than for Argentina or Chile because the complete change of economic
and political systems demands a renegotiation of the implicit contract
between workers and the state. That contract never envisioned condi-
tions in which per capita income falls abruptly, broad wage differentials
suddenly appear, taxes cannot be collected, and monthly inflation
reaches double digits. A further complication is the absence of employ-
ment records. What can be done under these circumstances?
Older cohorts already retired have nowhere else to turn for old age se-
curity but the public pension plans on which they have counted all their
lives. This group had little opportunity or incentive to save, since most
of their income was earned during the era of central planning, when
salaries were low and pensions were guaranteed. Households that did
accumulate some savings before the transition lost it in the ensuing in-
flationary economic upheaval. This group does not have enough pro-
ductive years left to accumulate pension capital in the private funded
pillar. Renegotiation of the debt owed to this group should recognize
that their income cannot fall much farther. In the transition just out-
lined, this group would be taken care of through a continuation of the
public pillar but with a flatter structure of benefits that maintains its real
value through time and keeps all retirees above the poverty line. Low-
income pensioners would fare about as well as they would have under
the old system. High-income retirees would get somewhat less, but in
287



Jt.JNiG THE OLD AGE CRISIS
compensation thev get automatic indexation- plus the right to reenter
the formal labor force without losing their pensions.
Workers 35 to 55 years old, especially those who were previously eli-
gible for early retirement, bear the brunt of the costs of the proposed
reform: their retirement age is raised while their public pensions are sub-
stantially lowered. But this group is partially compensated by the higher
wages and lower payroll taxes brought about by the reform and by the
capital they manage to accumulate in the funded pillar. The younger the
worker and the more profitable the funds' investments, the greater is this
compensation. This group also benefits from  improved insurance
against inflationi, from productivity growth that occurs after their retire-
menit, since pensions are indexed partially to real wages, and from pro-
tection against political and investment risks through diversification.
This group could be compensated further by depositing some of the
assets of state enterprises in their pension accounts. Several caveats are in
order: The assets of state enterprises could pay off only a small part of
the social security debt. Workers and pension funds would have to re-
ceive a diverse set of assets, not those of a single privatized company, be-
cause some companies will turn out to be profitable and others worth-
less. Fund managers would need to have full autonomy to manage their
investments, and governments or unions would have to refrain from ex-
erting pressures to prevent the restructuring or liquidation of state en-
terprises (box 8.6).
Finally, this group might be further compensated through recognition
bonds that could be cashed in for higher pensions at retirement-
financed from the economic growth that has taken place in the meantime.
Regulating the occupational pillar. Voluntary occupational and other
private schemes are already springing up in Bulgaria, the Czech Repub-
lic, Estonia, Hungary, and Russia, and have been proposed in Poland
and Romania, a response to the lack of confidence in the public
schemes. Countries suffering from administrative overload and a short-
age of financial experts may be tempted to allow these plans to develop
on their owin, witlh minimal government intervention. That would be
a coscly mistake over the long run.
Unregulated occupational plans are, for the most part, underfunded,
promising more than the) can deliver. Companies that are here today
may be gone tomorrow, leaving workers and governments in the lurch.
Without regulation, occupational plans would impose vesting and
portability restrictions that would impede enterprise restructuring and
288



TRANSITIONS
the movemenlt of workers from the public to the private sector. Unin-
formed workers might make employment decisions that are not in their
own best interest. Governments should move quickly to regulate de-
fined benefit schemes by requiring funding, vesting, portability, and eq-
uitable coverage. These regulations will probably retard the growth of
occupational plans, especially defined benefit plans, but the plans that
survive will at least have a fighting chance of being financially sound.
Later, when the second pillar is made mandatory, workers and policy-
makers may choose whether to include regulated occupational schemes
as an alternative to regulated personal saving schemes.
Obstacles to reform. Most Eastern European economies have intro-
duced piecemeal reforms but have not yet attempted an overall restruc-
turing of their old age security systems (box 8.7). Why has reform
stalled in the transitional economies, while moving full steam ahead in
Latin American countries facing similar problems? Countries in Latin
America had the advantage that voters and policymakers knew full well
the weaknesses of the old system after years of high taxes and failed
benefit promises: that market mechanisms, banks, and private invest-
ments were familiar institutions; and that a few politicians were ready
to advocate sweeping change, supported by a cadre of well-trained,
experienced technocrats. In Eastern Europe and the former Soviet
Union such preconditions for a second pillar as well-functioning finan-
cial and legal systems are absent, civil servants and politicians are suf-
fering from reform overload, and citizens at large are bewildered by a
suddenly unpredictable world, while having almost no notion of how
dismally the public pillar has performed or how much it has hurt the
economy. Nor do they appreciate that the large public pillars of some
of their Western neighbors are likely to be in serious trouble five to ten
years from now. Several of the following preconditions to reform are
absent in many transitional economies:
* A legislative framework clearly spelling out property and contract
rights, and a judicial system for enforcing them
* Well-functioning financial institutions and instruments, such as
solvent banks, insurance companies, and stocks and bonds
* Prudential regulations for financial markets
* People trained in financial and regulatory affairs or institutes to
provide this training
* Modern accounting and auditing standards
289



f.iTHE OLD AGE CRISIS
Box 8.7  Wvha Refons Harve Eastern00 Euren
MOST TRANSITIONL 9ECONOMS  AtEINTRODUCE   SOME
: pension trefotms,. rhoih  not in; any; ssensc vay; tha provides a
0:long-trm oigiXon to theix prolemDs. Among them are the following :
* k*PoUnd:intrducda inww eefit formula in 199:1 that abolfished
0 0differencees in betefit levlsbyocuain incrasdthe num-
: b:er ofworkig years used in calculating the earnings base, low-
tied ihe maxi pnsion, and uidee pensions tO the aver-
::* Romia xraisd contribution rates in 1992 for those employed
iA occupations withearly retitmt provisions and raised ben-
efhts in the Ainded scheme. Multip  pension schemes are grad-
ually irlng unified.
* Bulgaria raised contribution rates in 1991 foreenployee s eligible
::t  earlt retmernt. In 192 i:t rais   e minimum retirement
age, reuced the nuniber ofworkeel igible for e arlyr    retirement,
And aded Inc,      fr: those aboe rement age to keep
workinsg.
* H    ?y pldac<eda cng on contributions in 1992, inceased
t  minimum n umbof ontribion years, slightyrevised the
bienefit forrila and peansindintion, and creatednan inde-
pndt tsocial iniur acuhen  which senparates contributions by
a A    aib: esblihedi an ndende  sociat insurance aWncy in
1992, with an indeendent  dget and  financing.The pension
. find wsseaed inM 19   Major eforin legislation was passed
in 19 , c      a     alnein, tem inimum contribu-
t:ionperiodulpiio,'Q,-    on pens o  sions and conrribu-
: t io   employee: contrib: to s, and a flacnton for the
: -; -0 pyed. The benefit    E fnula was restructured and is now
based on years Of contbutionsa  indexdannually.
* Market-determined prices to signal real costs and benefits
* Macroeconomic stability, which lessens the threat of high inflation
* Tax administration capability.
A few countries, such as the Czech Republic, Hungary, and Poland,
have already established many of these preconditions and could soon
290



TRAN.Si
begin to build a imniltipillar system. Several other countries should be in
a position to do so within three to five years. The large demand for fi-
nancial security will prevent the government from scaling back the pub-
lic pillar, so the highi payroll tax, distorted labor markets, and scarcity of
capital will continue to paralyze these economies until a viable alterna-
tive is offered. Once one country in the region introduces a successful
multipillar system, others are likely to follow suit quickly. But it is not
clear whether any country will make the first move, because the most es-
sential ingredients-citizens who believe the old system is unsustain-
able, technocrats and civil servants ready and able to implement a new
system, and policymakers committed to change-may be lacking.
Concluding Thoughts
A     ROUND THE WORLD, COUNTRIES ARE REEVALUATING
their arrangements for providing income security for the old.
As their populations age and their old age security systems
consume an ever-increasing share of national resources, it becomes
mnore and more important to get these arrangements right. Policy-
makers and citizens are finding that the old systems did not always de-
liver what they promised. Although each country has its own story, the
problems of pension systems are surprisingly universal, rooted in de-
mography and political economy. New options are available that
promise to be better.
In evaluating these options, a few basic principles should be kept in
mind. The system should:
*Provide a safety nct for older people who can no longer work to
support themselves or easily adapt to unexpected circumstances-
or turn back the clock to undo earlier mistakes
* Provide incentives and requirements for work and saving behavior
that foster economic growth
* Minimize opportunities for individuals and governments to ma-
nipulate the system for private benefit at public expense
* Take the very long-run perspective-planning for old age covers
sixty years or more for individuals and spouses, and another thirty
to forty years for one's children.
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N  2N,G  THE OLD AGE CRISIS
The experience of many countries with failed systems and a smaller
number of countries with successful systems suggests that the best way
for most countries to meet constructively the challenge of an aging
world is through a multipillar system featuring:
* A  mandatory tax-financed public pillar designed to alleviate
povertv
* A mandatory funded, privately managed pillar (based on personal
accounts or occupational plans) to handle people's savings
* A supplementary voluntary pillar (again based on personal saving
or occupational plans) for people who wanit more protection.
Together, the three pillars coinsure against life's risks and uncertain-
ties. Although the pace of reform must be guided by individual country
circumstances, all countries should begin planning now.
Note
1. The section on Australia draws heavily from the    perannuation Economics Research Group Research Paper
work of Bateman and Piggott and other articles in the Su-   Series, Universiry of New South Wales, Australia.
292



Issue Briefs
Issue Brief 1 How Much Should a Pension Pay Out? The Target Wage Replacement Rate
P        ENSIONS ARE DESIGNED TO REPLACE WAGES    Household Wage Replacement Targets
when a person is too old to work productively.
But how high a wage replacement rate should    According to the life cycle theory of consump-
the household aim for? And how much of that target   tion, people want to smooth their consumption over
should government mandate? If the household's tar-   their lifetime. In a simplified version of the theory,
geted rate is too low, a retiree may become a burden    people want to consume the same amount each year,
on society. If the government's mandatory rate is too    whether they are young or old, so they set aside in-
high, heavy contributions will be required to finance   come in their high-earning years to allow themselves
it. and welfare losses will be accompanied by fiscal   to consume more in their low-earniing years. In this
and labor market problems. But how low is "too    case, workers try to acquire a pension that will pay
low," and how high is "too high"?                 100 percent of their real net average lifetime wage.
Many different bases can be used to calculate the  A more realistic version of the theory assumes that
wage replacement rate. The targeted rate is usually   people will want to consume different amounts at
expressed as a percentage of a worker's final year   different periods in their life. Many want to consume
salary or average salary over several years, such as the   more when they are young, raising children, and
axerage annual lifetime salary. Sometimes it is ex-   forced by job considerationis to live in high-cost areas.
pressed as a proportion of the average wage in the   Others, who have large medical bills or more leisure
economy. Pensions can be calculated as a percentage   time or who have grown accustomed to a comfort-
of gross earnings before pension contributions or of   able lifestyle may waant to consume more as they age.
net earnings after contributions. Many households   In addition, if per capita income in the economy is
might wish to replace about 75 percent of their gross   growing, people will have to consume more as they
average lifetime salary, but the governmllent-mandated   age to maintain their relative standing. Uncertainty
replacement rate should probably be only about half   about health and cost of living further complicates
of the gross average lifetime salary for the average   the picture. Some people will therefore be willing to
worker, with a floor at the poverty line for low-   pay for pensions that exceed 100 percent of their net
income workers.                                   average lifetime wage, while others will take less.
293



ING THE OLD AGE CRISIS
The appropriate replacement rate also depends               of the net average lifetime wage would constiture
on the wage base. For workers in a growing econ-    77.5 percent of the gross average lifetime wage.
omy or those with special skills, earnings rise with              Three conclusions emerge from  an examination
age, so their final year salary will be much higher    of these relationships:
than their average. For them, a pension that pays
100 percent of their average lifetime wage will be a              *  The  "right"  target replacement rate  varies
muLch smaller percentage of their final year wage.                   greatly, depending on the circumstances and
For example, if wages rise 2 percent a year for 40                   preferences of each houtsehold and the rate of
years, the final year wvage is nearly 50 percent greater             economic growth.
than the average lifetime wage. This means that a                 *  Depending on the wage base, the same pen-
pension offering 100 percent of a net average life-                  sion yields different wage replacement rates.
time wage would pay only 70 percent of the net                    a  The replacement rates suggested in issuLe brief
final vear wage (issue brief table 1.1, column 1).                   table 1.1 are probably reasonable targets for
The distinction between net and gross earnings                    many households: about 75 percent of gross
introduces another complication. Because people                      average lifetime salary or half of gross final year
need to put aside some part of their earnings in sav-                salary. This pension target WLould allow a com-
ings or payroll taxes for their old age, gross earnings              fortable standard  of living  for a high-wage
exceed net. If the saving or contribution rate is 22.5               household but would be near subsistence for a
percent. for example, a pension that is 100 percent                  low-wage household.
Issue Brief Table 1.1 Target Wage Replacement Rates
Mandatory target
Peension as percentage of     Household target         Low-income           Middle-income          High-income
Net average lifetime wage            100                    81                    78                    78
Gross average lifetime wage           78                    63                    60                    60
Net final year wage                   70                    55                    53                    53
Gross final year wage                 54                    44                    42                    42
Gross economy-wide wvage             n.a.                   33                    42                    42
ii.a. Not applicable.
Xote: The rable is based on the following assumptions:
* The household target pension is 100 percent of the net average lifetime wage.
* The manidatory target pension is 60 percent of gross average lifetime earnings, with a floor at 33 percent of the economy-wide wage.
The floor takes hold for low-income groups.
* Evervone begins work at age 20, retires at 60, dies ar 80, and there are equal numbers of poor, middle-income, and rich workers.
* Staring wage is 33 percent higher for iiiddle class and 67 percent higher for rich than for poor.
* Annual wage growrh is 2 percenit.
* A saving or contributiois rate of 22.5 percenr is assumed in net-to-gross caLulations.
* In economy-wide average calculations, the population is split between low-, middle-, and high-income groups in the ratio 3:2:1.
Source: World Bank calcirlationis.
294



Mandatory Wage Replacement Targets              exceed basic needs, to remedy insurance market fail-
ures by requiring everyone to participate in the an-
The government should not necessarily mandate   nuity pool.
the full pension thar might be desirable for individ-  For example, the government might require sav-
uaL households. Because people have different pref-  ing or contributions that would replace about 60
erences about relative consumption in youth and old   percent of the worker's gross average lifetime wage,
age, a government can actually reduce some people's   with a floor at about a third of the gross economy-
welfare by setting mandatory saving or contribution    wide average wage (issue brief table I . 1, columns
rates higher than they desire. Some analysts argue   2-4). Some OECD countries have wage replacement
that the government should mandate pensions only   rates of this magnitude. The mandatory plans could
to meet basic needs so that individuals with a low    be publicly or privately managed, although the floor
propensity to save do not become a burden on soci-   might require public transfers. The floor alone
etv. Setting a low mandatory pensioni allows people   would come close to the household replacement tar-
who wanit more to supplement it voluntarily-and    get for many low-income workers. The mandatory
minimizes evasion as well as capital and labor market   pension could be supplemented by voluntary
distortions caused by mandatory pension programs.   arrangements for many middle- and high-income
Other analysts argue that the mandatory level should   workers who have higher household targets.
295






ISSUE BRIt
Issue Brief 2 Pay-as-You-Go or Fully Funded-Which Costs Less?
A        SENSE OF THE RELATIVE COST OF PAY-AS-   the rate of 1 + r each year, where g is the growth rate
you-go and fully funded financing of de-    of wages and r is the interest rate. By the year of re-
fined benefit systems can be obtained bv   tirement the capital accumulation for an average
considering the hypothetical case of a system that   worker is:
aims to provide retired workers with 40 percent of
their final year's gross salary. Pensions are assumed to   (2.2)      CW[(l +    +
be indexed to wages, rising automaticallv with the          (1 + g)l +    + ... (1 + g)n'(1 + r).
average wage in the economy. This discussion ig-       If pensions are indexed to wages at a benefit rate
nores the feedback effects on wage growth of pav-as-   o
*   of B, the presenit value of pension pavoLutsover zn re-
you-go compared with full funding. Wages are as-   tirement years, discounted back to the beginning of
sumed to be unaffected by the choice of pension    the vear of retirement, is:
financing methods.
(2.3)    BU4/(1 +g)'[1I + (1 + g)/(l + r) +
The Pay-as-You-Go Contribution Rate                               ... (I + on-1I/(l + rri'1]
where nz is the nuliiibcr of worlincr years and ms/nz is
The followinig equation shows the case of the hv-   wto                              y
pothetical pension under pay-as-you-go financing,   the passivity ratio; g, ;; n, and in are assumed to be
when pensions are indexed to wages and financed by    constanit over time.
anen payroll n tax:  Inuxcatowags aa  maceaDy          If the interest rate, r equals the growth rate of
a payroll tax:''
wages, g, expressions 2.2 and 2.3 can be simplified to
(2.1)                C= BD                          expressions 2.4 and 2.5, respectively:
where B is the target benefit rate, fixed as a percent-   (2.4)        CW (1 +gi)  n
age of the average wage; D is the system dependency    anid
rate (the ratio of beneficiaries to contributing work-   (2.5)         BW 1I + g)H.
ers); and C is the contribution rate, as a percentage
of wages necessary to cover BD.                        Under fully funded plans, capital accumulation at
retirement must equal the present value of the
The Fully Funded Contribution Rate                   stream of pension payments after retirement. So, ex-
pression 2.2 must equal expression 2.3. and if the in-
Relationships are more complex with fully funded    terest rate equals the rate of wage growth. expression
plans. Workers must acctimulare enough capital dur-   2.4 must equal expression 2.5. The required contri-
ing their working years to pay the targeted flow of   bution rate is then:
pensions during their retirement years. Thus a    (2.6)                 C= Bbii/;;).
worker contributes CWin the initial year, where W
is the starting wage. But in subsequent years wages   If the interest rate is lower than the rate of wage
and contributionis grow at the rate of 1 + g each year.   growth  (r<g,), the required contribution rate is
and the capital accumulated in prior years grows at   higher thani B(Om/,), and vice versa.
297



t~$RTING THE OLD AGE CRISIS
Comparing Contribution Rates                                           percent. Dropping this ratio to one for three re-
duces the tax rate to 13.3 percent. As real wages
When B is fixed at 40 percent and pensions are                     rise, so does the real pension, but the ratio be-
indexed to wages, the required contributioni rate de-                  tween the tw,vo remains constant, so the contribu-
pends on assumptions about the dependency ratio,                       tion  rate  is unchanged  (issue  brief table  2.1,
the passivitv ratio, the interest rate, and the rate of                coluLmns I and 2).
wage growth (see table 1). The required contribution
rate tinder pay-as-you-go financing depends only on                    Under full funding the required contribution rate
the old age dependency ratio. The higher the depen-                depends on two other factors: the passivity ratio and
dency  ratio, the more retirees there are relative to              the difference between the real interest rate and the
wvorkers and  the higher the  contribution  rate  re-              growth  rate of real wages. A  lower passivity ratio
quired to support them.                                            means that workers spend a smaller proportion of
their adult lives in retirement, which reduces the re-
Example: A  dependency ratio of one retiree for                quired contribution rate. The contribution rate also
every two workers requires a payroll tax rare of 20             drops if the interest rate exceeds the rate of wage
Issue Brief Table 2.1 Contribution Rate Needed to Pay a Pension Equal to 40 Percent of Final Year Salary
(inelexed to wages)
Pay-as-you-go                                    Fully finded
(dependency rate)                                 (passivity rate)
1/2         1/3                      1/2                                    1/3
Real wage growth           -            -             0            2            5           0            2            5
Real interest rate
0                       20           13           20          35           77           13          23           49
2.)                     20           13           11          20           46            7           13          30
5                       20           13            4            8          20            3            5          13
Real pension rate
at death;               -            -            40          60           106          40           54          83
Relative pension rate
at deathb               40           40          40           40           40           40           40          40
-Not available.
Note: Real wage growth is assuimed to apply equLally to each cohort, anid rhe average wage for the retiring cohort is the same as the average
wa;ge for the economy as a whole. Under pay-as-you-go niumbers apply to rhe average wage worker, whose penision upon retirement is 40
percentr of his final wage. Under fully funided each worker gets 40 percent of his own final salary at the start. I'lan expenses and disability
and suirsivors' beniefits are not inclIded. These would raise the required contributioni rate about 3 to 5 percentage points in a well-run
miiature systemll. Costs doe to unemployment anid evasioni are also not included. The one-half passivity rate stems from an assumption of
forty working years and twenty years of retirenment; the one-third passivity rate imilplies forry-five working years anid fifteen) years of
retiremenit.
a. Real pension in year of dearh as proportion of final year's salary. For pay-as-youi-go. it depends on wvage growth in the economy.
b. Pensioni relative to average wage in the economy in year of death.
Source: Schwyarz (1992a); Vitras (1993b).
298



ISSUE BR1T
growth. But if wages grow faster than interest rates,   * Full funding costs less than pay-as-Vou-go (or
the required contribution rate rises. Accumulated          yields a higher rate of return) if the interest rate is
pension assets are not increasing as fast as earnings,     higher than the rate of wage growth plus the rate
thus forcing workers to save more to meet the 40           of population growth. If the interest rate is lower
percent benefit rate.                                     than wage growth plus populationi growth, the
cost advantage lies with pay-as-you-go.
Exarmple: If the real interest rate equals the rate of
wage growtlh and the passivity ratio is one to two,   Which Set of Conditions Is More Likely?
the required contribution rate is 20 percent; low-
ering the passivity ratio to one to three reduces    If an economy is dynamically efficient, the interest
the rate to 13.3 percent (issue brief table 2.1,   rate should be at least as high as the rate of growth of
columlns 3 through 8).                             GDP or total earnings (which include growtlh in wages
per worker and growth in the labor force). Full fund-
Several conclusions follow:                        ing in this case would be at least as cost-effective as
pay-as-you-go-and possibly more. Real world data
* When the dependency ratio equals the passiv-    confirm this expectation of the cost advantage of full
ity ratio and the interest rate equals the rate of   funding over long periods for several countries.
wage growth, pay-as-you-go and fully funded        Earningsgrowth and the iinterest rate. Although the
schemes require the same contributionl rate.    relation between earnings growth and the interest
* W\hen the interest rate exceeds the rate of   rate varies over time and by country, the rate of re-
wage growth, fully flunded plans have a cost   turn to long-term capital, especially equity capital,
advantage over pay-as-you-go plans, which do    has been considerably higher than the rate of wage
not benefit from  the high interest rate. The    growth over the last three decades-indeed over the
opposite is true wheni the rate of wage growth   last 100 years (Maddison 1987; Siegel 1992). While
exceeds the interest rate.                      the variation among countries is wide, the unl-
* When the dependeicy' ratio is smaller than    weighted average growth rate of wages for all coun-
the passivity ratio, pay-as-you-go plans require   tries between 1962 and 1990 was less than 2 percent.
a lower contribution rate than fully funded    In some African and Latin American countries the
plaans (and vice versa) if interest and wage    rate was negative for much of tlis period. Real wages
growth rates are equal. In general, if the popu-   in most OECD countries rose 3 to 4 percent a year
lation covered by the system is growing, there    during the 1960s btIt slowed to about 1 percent dur-
are more people for each "young" age group    ing the 1980s. In all these regions the rate of return
than for each "old" age group, so the depen-   to investment, proxied by the return to humani capi-
dency ratio is smaller than the passivity ratio.    tal, was much higher (issue brief table 2.2).
In OECD couLntries the real interest rate on gov-
Under a set of simplifving asstimptions, suchi as   emiienit bonds was slightly below the growth rate of
zero transaction costs and zero feedback effects on    wages during 1971-90 (the exact relationship varies
wage growth, these comparisons may be summed up    by country). But a portfolio with half stocks and half
as follows:                                          bonds would have yielded a rate of return ranging
299



$RTTING THE OLD AGE CRISIS
Issue Brief Table 2.2 Real Earnings Growth versus Returns to Human Capital
Social retuirns               Private returns             Rate of
Real               to education                    to education               return
earnings              investment                      investment             per year of
growthj a      Secondary        Higber        Secondary         Higher        education
Sub-Saharan Africa           -1.4            18.2            11.2           26.6            27.8            13.4
Asia                          2.4            13.3            11.7           18.9            19.9             9.6
Eastern Europe,
North Africa, and
rhe Middle East           2.6            11.2            10.6            15.9            21.7             8.2
Latin America and
the Caribbean             -1.1            12.8           12.3            16.8            19.7            12.4
OECD                          2.5            10.2             8.7           12.4            12.3             6.8
World                         1.5            13.1            10.9           18.1            20.3            10.1
a. Compound real growt h in wages for counrties with data for at least ren years.
Source: Earnings growvth rates calculated using UNIDo data base: dara for Latin America aaid Sub-Saharan Africa come from Maznmdar
(1994). Returns to inivestment in eduication from Psacharopoulos anid others (1993); average of real earnings growth for ClECD includes all
the counitries except Belgium, Franice, Germany, Greece, Iceland, the Netherlands, and Switzerland. For Asia it includes Bangladesh, Fiji,
the Republic of Korea, Malaysia, Nepal, Pakistan, the Philippines, Singapore, Sri Lanka, and Thailand. For Eastern Europe, North Africa.
and the Middle East it includes Afghanistan, Algeria, Cyprus, the Czech Republic, Egypt, Hungary, Iran, Iraq, Israel, Jordan, Kuwait,
Lybia, Malta, Morocco, Tunisia. and the Federal Republic of Yuigoslavia. Latin Anmerica includes Argentina, Chile, Colombia, Costa Rica,
the Dominican Reptiblic, El Salvador, Guatemala. Honduras. Mexico, Panama, and Peru. Sub-Saharan Africa includes Borsaana,
Bsintndi, Eg_,pt, The Gambia, Gliana, Kenya, Malawi, MaulririUs, Sierra Leone, Swaziland, and Zimbabwe.
from  3  to  6 percent, about 3  percentage  points    that stock markets will emerge in countries with fa-
higher than  wage growth  (issue brief table 2.3).    vorable investment prospects. (For further data on
From   the  very  long-term   (100-year)  perspective           wage growth over time see appendix table A.3.)
most relevant to pension plans, labor productivity in              The fact that capital has become far more mobile
the United Kingdom  and the United States appears    than labor (except where there are government re-
to have grown about 2 to 3 percent a year. Again,    strictions) further boosts the expected returns to cap-
this was about the same as the real interest rate on            ital and the potential cost advantage of fully funded
bonds but much less than a portfolio equally divided            pension plans. Full funding permits international di-
betwveen stocks and bonds (Maddison  1987; Siegel    versification of investments, which allovs pensioners
1992). Data for selected developing counliries (those           in slow-growth countries to benefit from  the higher
with emerging stock markets during the 1970s and                yields in high-growth  couLntries. This comparison
1980s) show  that rates of return  to  equities and             suggests that full fLnding has a strong cost advantage
educationi-which  ranged from  6 to 42 percent-                 over pay-as-you-go.
were much higher than the growth rate in earnings,                  The dependenzcy ratio anld the passivcity ratio. In pre-
which ranged friom  -4 to 8 percent (issue brief table          vious decades, the potential cost advantage of full
2.4). The high returnis to capital reflect its scarcity         fuLnding was offset by the fact that the world's popu-
and risk and the selectivity of' the sample; it is likely    lation was growing so rapidly that the dependency
300



ISSUE BRIEF'Z',,
Issue Brief Table 2.3 Real Wage Growth Contrasted with Real Returns on Capital, Selected OECD Countries, 1971-90
(PerCC1rt)
Returns on
Real average        Real average            50-50
Real average       annual return        annual return       portfolio minus
Real wage         annual return        on government         on balanced           real wage
Country                  growth             on equities             bonds             portfolioa            growth
Canada                      1.1                  5.0                  1.1                 3.1                  2.0
Denmark                     2.5                  9.4                 4.5                  7.0                  4.5
France                      4.0                  9.6                  1.3                 5.5                  1.5
Germany                     3.6                  9.3                  2.6                 6.0                  2.4
Japan                       3.0                 11.2                  0.0                  5.6                 2.6
Netherlands                 1.4                  8.6                  1.8                 5.2                  3.8
Switzerlaiid                1.8                  4.7                -1.7                  1.5                 -0.3
United Kingdom              2.4                10.8                   1.6                 6.2                  3.8
United Stares               0.1                  5.9                  1.2                 3.6                  3.5
Note: The numbers showis are simple aninual averages.
a. Balaiiced portfolio consists of 50 percent governmenr bonds and 50 percent equities.
Soutrce: Real earnings growtth in France from NIF International FinanczalStatistics (variouLs years), ocher data from Davis (1993).
Issue Brief Table 2.4 Rates of Return to Labor, Human, and Nonhuman Capital
Rates of return per
Economy                    Real return to equities a           year of education                Real wage growthb
Argentina                      20.5 (1975-92)                         10.3                         1.9 (1963-88)
Chile                          26.4 (1975-92)                         12.0                         6.6 (1963-88)
Colombia                       41.5 (1984-92)                         14.0                         1.0 (1963-88)
India                          11.5 (1975-92)                          4.9                         3.0 (1980-89)
Korea, Rep. of                 11.2 (1975-92)                         10.6                         7.8 (1966-88)
Malaysia                        6.7 (1984-92)                          9.4                         2.5 (1968-88)
Mexico                         14.5 (1975-92)                         14.1                       -3.9 (1980-89)
Pakistan                       16.4 (1984-92)                          9.7                        3.8 (1963-86)
Philippines                    40.6 (1984-92)                          8.0                         0.4 (1963-88)
Taivwan (China)                17.9 (1984-92)                          6.0
Thailand                       14.1 (1975-92)                         10.4                         3.4 (1970-86)
Venezuela                      18.5 (1984-92)                          8.4                       -0.8 (1963-88)
Unweighted average             20.0                                    9.8                        2.3
- Not available.
a. Total returns ate given in real U.S. dollars. Years are given in parentheses.
b. Geometric mean.
Source: Stock market data from IFC files, based on returns for vears since 1975. Rates of return per year ofeducarioni. or Mincerian rates
of rectrn, from Psacharopolous (1993). Real wage growth from UNIDO data base and World Bank (1992d).
301



:TING THE OLD AGE CRISIS
ratio was likely to be smaller than the passivity ratio   passivity ratio in coming decades. Thus, the influ-
in many counltries. Dubbed the "biological rate of in-   ence of the higher rettirn to capital, reflecting its pro-
terest." population growth was used in the 1950s to   ductivity, should dominate.
justify the expansion of pay-as-you-go systems in
industrial countries. An implicit assumption was that   And the Winner Is...
rapid population growth and pay-as-you-go would
not depress earnings. Yet, as noted above, wage       It is possible, of course, that falling birthrates
growth slowed precipitously in OECD countries    could mean scarcer labor and higher wages. It is also
throughout the 1970s and 1980s, as the baby boom    possible that if many countries adopted funded pen-
generation entered the labor force. In Africa, where   sion plans, savings would increase and interest rates
population was growing most rapidly, wage growth    would fall. Both developments would be favorable to
turned negative.                                   pay-as-you-go financing. But in a world of interna-
In recent years demographic conditions have be-   tional flows of capital and goods, this outcome is un-
come less favorable to pay-as-you-go. Today OECD    likely to occur before most countries have stable
countries barely attain the population replacement   populations and funded pension plans-and even
rate, and East Asia, Eastern Etirope, and parts of   then these price changes are far from certain.
Latin America are moving rapidly in the same direc-   In sum, any cost advantage that pay-as-you-go
tion. The demographic dependency ratio is fast ap-   plans might have had in the past was the result of de-
proaching the passivity ratio. In addition, because    mographic factors that no longer hold in many
pav-as-you-go plans break the link between benefits   countries. In the future, if interest rates and earnings
and contributions, they may induce evasion, early re-   growth maintain their relative positions, and espe-
tirement, or other types of strategic manipulation-    cially if pension funds are able to benefit from equity
problems that push the system  dependency ratio   investments, capital mobility, and international di-
above the demographic dependency ratio in many    versification, a fully funded system will require lower
countries (see chapter 4). It is quite likely, therefore,   contribution rates than a pay-as-you-go system to
that in middle- and high-income countries the sys-   achieve the same pension benefits.
tem dependency ratio will be at least as great as the
302



ISSUE  BRt- Eas"y
Issue Brief 3 Pay-as-You-Go under the Demographic Transition
S INCOME RISES, FAMILIES TEND TO HAVE             much smaller cohorts of younger workers. Kenya
fewer children  and  people tend  to live    starts out young, with a rapidly growilng population.
longer. Together, these forces have raised           and remains young until after 1030, when today's
the old age dependenicy ratio in many countries.    children will be bearing children and when its de-
Tlhis demographic transition is already well under    mographic transition is projected to begin.
way in OECD countries, and support ratios-the in-              For each country the projections show the contri-
verse of the dependency  ratio-are  expected  to            bution rate required to finance a 40 percent averagc
plummet in much of Latin America, Central Asia,    benefit rate (that is, the average benefit divided bv
Eastern  Europe, and  China over the  next two              the average wage) and the lifetime transfer that this
decades. By the year 2050 only Africa will still be    type of pension system implies for a program begin-
"vouno,
As the resources of fewer workers are stretched to
Issue Brief Table 3.1 Simulated Pension Schemes
support a larger old  population, pay-as-you-go
schemes will inevitably yield rapidly diminishing           underDifferentDemographicScenarios
payoffs to future generations, unless productivity             Year Argentina  China  Hungary Japan   Kenya
rises fast enough to offset the effects of demography.                           Old ag-e dependenCy rate
Projected  demographic  profiles for Argentina,                1995      0.27     0.16     0.37     0.36    0.12
i                          ZD              ~~~~~~~~~~~2025  0.29  0.34  0.53     0.68    0.10
China, Hungary, Japan, and Kenva illustrate the in-            205       0.43     0.3      0.61     0.79    0.1
'  '  "   '   '                           ~~~~~~~~~~~~~~~~2050  0.43  0.53  0.61    0.79    0.21
creasing costs and decreasing returns to younger co-           2075      0.48     0.60     0.61     0.68    0.44
horts under pav-as-you-go pension plans, with pop-                      Income transfers sesultinr from pezsion system
ulations aging between now  and 2075 (issue brief              1995    13.5      13.5    13.5    13.5    13.5
table 3.1).                                                    2005    10.9      11.8      9.8      9.7    12.4
Japan's population is vounger than those in most            2015      8.3      9.7      5.6      4.5    11.5
OECD countries today, but it will age rapidlv. Al-             2025      5.5      7.0      0.4    -2.0    10.6
2035     2.6      3.1    -5.0    -9.0        9.5
though its population is still growing slightly, growth        2045      1.7      0.3    -6.9   -12.6       9.1
will turn negative after 2005. Hungary, a typical              2055      0.1     -2.9    -8.7   -15.1       8.0
Eastern European country, has a population that is             2065    -1.5      -5.7    -9.6   -16.2       6.2
already old and shrinking, though the decline will be          2075    -3.2      -7.6   -10.4   -16.4       3.6
more gradual than in Japan. The number of people                NVote: This table is based on the followimg assumptionis:
* Pension system begins in 1995 anid coverage is 100 per-
in Argentina, as in many other Latin American                  cent immediarely. Individuals all begini work at age 20 and
countries, is expected to increase for the next cen-           retire at age 60.
titry, thoLtgh at a declining rate. Argentinaas old age          * Age-earnings growth of I percent is assumed over the
tury thugh at   decliing rat. Argetina's  ld age career of each worker.
dependency rate will thus increase less dramatically              Economy-wide real wage growth of I percent per year.
than Hungary's or Japan's. China now has a vounger                The discount rate for calculating present value is asstimed
to be a real 2 percent.
population than the others, but the old age depeni-              * Evasion, uniemployment, early retirement, and adminiistra-
dency ratio will increase precipitously when the large         cive expenses are assumed to be zero.
working age population retires and is replaced by                Source: Schwarz 1994).
303



g-f,ETING THE OLD AGE CRISIS
nin- in 1995. Everyonie is assuLmed to start work at   the benefit rate is held constant at 40 percent (issue
age 20O and retire at age 60. Everyone over 60 receives    brief figure 3.1). To maintain a constant 40 percent
the same pension-including, at the beginning,    benefit rate over this period, the contribution rate
those who never contributed. The real average wage    would have to double in most countries and more
in the economy is assumed to rise I percent each    than triple in China. If evasion, administrative ex-
yearl and wages also grow 1 percent for every yvear of   penses, unemployment, disability, survivors' bene-
experience. Pensions are indexed to the economy-    fits, and early retirement are also taken into account,
wide average wage.                                    the required contribution rate would exceed 35 per-
In all five counltries the dependency ratio rises    cent when today's children have retired. This high
throughout the life span of the individuals born in    contribution rate, in addition to the income tax rate,
1995. when the plan is implemiiented. This effect is   increases the probabilitv that people will evade and
greatest in China, where the old age dependency rate   retire early, making the situation worse.
nearly quadruples. In all five countries the result is a  The first few generations-the grandparents and
sharp rise in contribution rates of later generations, if   parents in 1995-experience large and positive gains
Issue Brief Figure 3.1 Contribution Rates Required to Maintain Pension System Solvency
for a 40 Percent Average Benefit Rate
Contribution rates
30  ..
zs                                   ....                                   ;apan  .......~~~~~~~~~........
, . -.
....  .........   -..-     .
25
20
1995        2005         2015        2025         2035        2045         2055        2065        2075
Sonic,'e SLLWaL Z (1I9)'4).
304



ISSLUE BRIEF 3
(net present value of pension benefits received by   tries, where populations are already aging, is consis-
each generation minus the net present value of its   tent with this pattern of rising tax rates, lower bene-
contribution stream divided by the net present value    fit rates, and intergenerational redistributions. Since
of its lifetime earninlgs, assuming a 2 percent dis-   their systems began many years ago, they are already
count rate). This happens because older cohorts coII-   well along in this process of high tax rates and low
tributed for only part of their working lives but re-   returns.
ceive fuill pensions, and because they have many       While variables such as retirement age, contribu-
young workers to support them. But in Hungary   tion rate, and expected longevity can chanige, the
and Japan the net gain turns negative for cohorts   underlying pattern remainis. When less predictable
who retire in 2035 and 2025, respectively. In Chinla,   perturbations-natural disasters, famines, epi-
children who are born in 1995, the year the program  demics, immigration, and wars-are superimposed
is put in place, and retire in 2055 lose lifetime in-   on this pattern, some cohorts fare better and others
come. If the discount rate is higher than 2 percent-   fare worse than the projections here show. But the
w hich seems plausible-the negative transfer would   trend toward higher old age dependency rates is in-
be greater and wvould start sooner. These cohorts will   evitable, as are higher required contributioni rates or
never recoup in pensions the present value of the    lower pension rates and the redistribution from
taxes they paid to support the pensions of their par-   younger to older cohorts for the next fifty years or
ents and grandparents. Evidence from OECD coun-    more, under pay-as-you-go.
305






ISSUE BRIt `
Issue Brief 4 Impact of Pension Financing on Saving
T       HE IMPACT OF PENSION FINANCING-PAY-   tries. If they anticipate this transfer, they might try to
as-you-go or full funding-on saving has   borrow against their future pensions to consumC
been a subject of considerable controversy    more when they are young, further reducing na-
on both theoretical and empirical grounds. Most   tional saving. If the country has deliberately chosen
analyses start with the life cycle theory: people want   to improve the income of these groups, national wel-
to maintain a roughly constant level of consumption    fare improves, but the price is lower saving and
throughotIt their lives. To achieve that, they save part   growth for future generations.
of their income during their working years-to       Despite the logic of this argument, numerous em -
spend (dissave) when they are too old to work. This   pirical investigations (most of them based on U.S.
motive is considered to be a major source of long-   data) have been unable to prove conclusively tha:
term saving in the economy.                       saving did, indeed, drop once pay-as-you-go pro
grams were established. Part of the ambiguity result.;
Introducing Pay-as-You-Go Funding                 from the inability to estimate accurately what peoplo
would have saved if social security had not been in
Now  suppose the government introduces a   troduced. After all, many other things were changing
mandatory pay-as-you-go old age security plan that   at the same time. Using the same data, some studie;
requires young people to contribute payroll taxes   of the U.S. situation conclude that social securit
(equivalent to their previous saving) to the plan and   substantially reduced private saving, whereas other.;
pays them a pension (equivalent to their previous   find no significant impact. Analyses of saving rates in1
dissaving) later on. Introducing the system reduces   other countries yield similar conflicting results
national saving initially, because the first group to   Studies of the saving impact of old age security pro
benefit from  the program-generally those who    grams in Canada, France, the Federal Republic o-
were 50 to 65 years old when the plan was intro-   Germany, Japan, Sweden, and the United Kingdomr
duced-receives a windfall gain. Those who qualify   found no significant impact, except for a slightly
get a pension for which they had neither planned    positive aggregate effect in Sweden, where the pen
nor paid. The pension is financed by the reduced   sion program is heavily funded. Why don't the fact.
saving of the vounger generation, who now pay the   seem to fit the theory? Several possibilities:
payroll tax instead of saving. Because the increased
consumption by the first generation of pensioners is  * Some young people may be shortsighted o
not offset by reduced consumption of the younger       may not have had access to reliable savings in
generation, fewer resources are left to be saved and   struments, and therefore may not have beer
invested during the initial period, permanently re-    saving adequately for their old age before the
ducing capital stock and national income.              pay-as-you-go program was introduced. If the
This effect is even worse if the younger genera-    payroll tax exceeds their previous saving, young
tions of workers-30 to 50 years old when the new       people have to cut their current consumptior
pension is introduced-receive pensions that exceed     to pay the tax, which mitigates the program';
their contributions, as has occurred in many coun-     negative effect on saving-and implies that
3O0



lwe £t NG THE OLD AGF CRIS].
pay-as-you-go scheme permanently shifts peo-        would otherwise (considerable empirical evi-
ple's consumptioni from youth to old age.            dence supports this view). They might then
* Even if young people were not saving, they           boost their saving rare to finance a longer ex-
might have accumulated some assets that they         pected retirement, offsetting any decline in
could dissave, or they might borrow against         saving.
their future pension income. This would cause
the negative saving effect to reappear. But im-   All these forces reduce the negative effect on sav-
perfect capital markets, includinig restrictions   ing of pay-as-you-go old age security plans. The net
on consumer credit, make this response diffi-   impact is understandably difficult to detect in em-
cult or impossible in many places. especially in    pirical studies.
developing countries. The intertemporal shift
in consumption and the attenuation of the    Introducing Full or Partial Funding
negative effect on saving thus remain.
* The first cohorts of pensioners may not be able    Suppose, instead, that the government intro-
to adjust their spending habits fast enough, or   duces a fully funded scheme that requires people to
they may not want to-so they may save part   save a specified amount. If people were previously
of their windfall gain, perhaps to leave larger   saving this amount voluntarily, they would simply
bequests to their children. The bequest motive    substitute the compulsory pension saving for their
may increase if people foresee the higher taxes   voluntary saving, and net national saving would re-
that their children eventually must pay to fi-   main unchanged. (This also means that the pension
nance the new pension plan.                    plan has not achieved its objective of increasing in-
* Children may cut down on private transfers to   come and consumption in old age.) Buit the sa(me
their parents, who would now receive an unex-   forces that reduced the negative effect ofpa -as-you-go
pected public pension. If private intergenera-   financing on saving intensifi; the positive effect of fuill
tional transfers adjust to offset the public   fiindinga.
transfers, the program will have no impact on
saving. But it will also have no impact on the    * If people are shortsighted, they probably were
consumption or welfare of the old or the             not saving much before, and if financial instru-
young, making the program superfluous.               ments were lacking, people have no accumu-
I People may have little faith in the new pension      lated assets to dissave. So some of the required
scheme or its ability to keep up with inflation,     pension saving must come from reduced con-
so they may continue to save for retirement          sumption, particularly by young people and
just as they did before. This response may be        poor p.ople. Shortsighted people may be
particularly evident among upper-income              tempted to borrow against their future funded
workers (who do most of the saving), especially      pensions, but limited access to credit markets
if they expect the system  to pay pensions           reduces this possibility, especially in develop-
mainly to the poor.                                  ing countries.
* Design features of old age security programs       * Raised awareness of the importance of saving,
could lead workers to retire earlier than they       decisions to retire early, and the lack of credi-
308



I SSUE BRItA
bility of pension schemes all lead people to    Many analysts argue that saving is below opti-
continue to save in addition to their manda-   mum in most countries and, probably, worldwide,
tory pension saving, increasing overall nationial   because capital is mobile. Having a favorable effect
saving. This saving is committed for the long    on capital accumuLlation would thus be an attractive
term-potentially the most productive kind of   feature of fully funded schemes. But if the policy
saving.                                       goal is to increase saving, pension policy needs to be
accompanied by other measures-for example,
If many of these forces apply. full funding in-   keeping inflation under control, increasing the avail-
creases saving. If they are absent, pay-as-you-go will   ability of safe instruments for saving, discoLiraging
decrease saving. This means that although a manda-   consumer borrowing, and possibly providing tax in-
tory pay-as-you-go pension schemne may bave an am-   centives to long-term  savings, such as taxing real
bzi'uous effect on savin-g (relative to the voluntary situa-   rather than nominal rettirns.
tion), its effect should clearly be negative compared with
a ?nandatoryfidlyfiinded scleine. The higher the con-   Impact on Public Saving and Capital Allocation
tribution rate, the greater the positive effect on sav-
ing of a fully funded scheme.                         Old age security schemes may have their strongest
Few empirical studies have meastired the impact   impact by changilng the spending and saving, behav-
of ftilly funded pension schemes on saving-and    ior of governments. For example. the negative effect
eveni fewer have tested the effect of a switch from pay-   of pay-as-you-go schemes on saving coLIld be offset if
as-you-go to fuilly funded. becatise until 1994 only   governments increased public saving by runninig
Chile had made that switch. For funded occupational   budget surpluses. But the opposite has occurred
plans in the United States onlv 60 percent of pension    more often, especially in developing countries: gov-
saving is offset by reductions in household saving. so   ernments have rtin deficits to meet generous pension
the net effect is positive (Munnell and Yohn 1992;   benefit promises. That causes national saving to fall,
Pesando 1991). In Australia a 50 percent crowd-out   even if household saving is unchanged.
effect is expected under the new funded mandatory     Also troublesome are the partially or fully funded
occupational scheme. Private saving would then rise   plans controlled by governments. Typically, the law
bv 0.8 percent of GDP a year, once it has been phased   requires these funds to be invested in public bonds,
in, while the ptiblic pension scheme is expected to de-   which yield low or even negative real returns (see box
crease saving 0.5 percent of GD1r over the same period    4.3). If access to these funds increases public coin-
(Bateman and Piggott 1992b, 1993). Malaysia and    stimlption and deficits, this can more than offset any
Singapore, which have large mandatory retiremenit  increased household saving, causing national saving
saving programs, have high nationial saving rates.   to fall. Even privately managed pension reserves can
When Chile switched its mandatory plan from pay-   be regulated in ways that give government privileged
as-you-go to fully funded, private saving rose sub-   access and thLIs run the danger of increasing govern-
stantially, by much more than the governmenlt dis-   ment spending and dissaving.
saving needed to pay off the old social securitv debt.  The policy conclusioni: Fundedplans have the po-
But numeroLIs other forces were also at work in this   tential to inlcrease househo  savinilg andproductive capi-
period of rapid economic growtlh.                  tal,firnation, whereas pay-as-jou-go plazns do inot. But
309



WpZTIiNG  TH E OLD AGE CRISIS
this potential may not be realized unless pension fiJnd,  For more information on the impact of pensions
are insulatedfro ngoverinment controlandtheir resources    on saving and capital markets, see the For Further
are channeled tlhrouigh the capital market, on a con2peti-   Reading section.
tive basis, with incentivesforproductive investment.
310



ISSUE BRIEF, 51'
Issue Brief 5 Comparing Administrative Expenses of Alternative Pension Schemes
T        HE EFFICACY OF A PENSION SCHEME DE-   more, to attract savings, the private sector incurs
pends greatly on its administrative costs.   marketing costs. But balanced against these higher
Other things constant, high costs Inean    costs is the incentive of private pension fLnds to be-
lower benefits in retirement or higher contributiolns    have efficiently, and to perform a capital allocation
during working years. This is true for any pension    function that would otherwise have to be performed
scheme, whether managed publicly or privately, and    elsewhere in the economy. For all these reasons, it is
whether funded or pay-as-you-go. But some man-    difficult to compare the costs of publicly and pri-
agerial and financing arrangemenits may incur higher   vately managed pension plans, and few such studies
costs than others.                                   have been conducted.
Publicly Managed or Privately Managed               Comparing Publicly Managed Plans
It is not always easy to measure adminiistrative    It is somewhat easier, but still problematic, to
costs. Privately managed companies have an incentive    compare the costs of different publicly managed pay-
to keep track of costs. But publicly managed pro-    as-yoti-go plans. Two frequently cited measures are
grams may omit some inputs and may receive others    biased agrainst developing couLntries with immature
at below-market rates. The pension agency may not   systems. The first is the ratio of adminiistrative costs
pay rent for its premises and may purchase its mail   to benefit expenditures in a given year, a measure ex-
and telephone services at subsidized rates. Deprecia-   tremely sensitive to the maturity of the scheme and
tion and fringe benefits often do not appear on the    to demographic changes. In Belize. a young country
agency's budget. The costs of collecting the payroll   with an immature pension scheme, the ratio of costs
tax may be passed on to another agency. Private pen-   to benefit expenditures in the late 1980s was more
sion plans charge a risk premium for the longevity,   than 50 percent, because few workers had been in
inflation, and interest rate risk they assume. Public   the system long enough to qualify for pensions.
pensioni plans do not charge this risk premium ex-     The second indicator used is the ratio of adminis-
plicitly but instead pass it along to the rest of society,   trative costs to contributions. One obvious problem
implicitlv. For all these reasons, publicly managed old    with this indicator is that contributionl revenues will
age programs may appear much cheaper than they    be higher, making the expense ratio appear lower, in
are, relative to privately managed plans.            countries with higher contributioni rates. Because
Most private schemes accumulate pensioln re-   these countries typically have more mature schemes
serves that they invest, usually in a combination of   and older populations, this measure is also biased
public and private, debt and equity securities-a    against pensioni schemes in developing countries.
process that raises their administrative costs. Most   A better way to compare administrative costs
public plans do not have large pensioni reserves, and    across publicly managed pay-as-you-go plans is to
even if they do they do not carrv out the same func-   calculate the cost per participant (worker plus pen-
rion of evaluating alternative investmenits, because   sioner) in the program. The most important func-
they invest primarily in government bonds. FLirtlher-   tions for these plans are collecting contributions and
3"1



AVERTING  THE OLD  AGE CRISIS
paving benefits, so the number of participants    Issue Brief Figure 5.1 Administrative Costs of Publicly
should determine efficient costs.                        Managed Pension Plans in Selected Countries
Burundi                                   ( 7.25)
Administrative Costs Nonnalized by Per Capita Income           Bia                        (4.49)
Zambia                      (4.49)
El Salvador      (1.54)
For some purposes it is useful to normalize the ad-      Morocco   (0.89)
ministrative cost by the average wage or income per            India   (0.72)
capita-that is, to examine the ratio of administra-        Costa Rica  (0.41)
tive cost per participant to income per capita across           Italy  (0.34)
countries. The average wage or income per capita in-      Switzerland (0.086)
dicates the capacitr of the country to payl for old age    United States (0.069)
pensions and their administrative costs, once the de-          Japan (0.036)
pendency rate is given. The higher the administra-                 0         2         4         6         8
rive cost per participant, the les  s funds will be avail-                   Costs per participant as a
tive cost per participant, the less funcd.s willl be avall-                percentage of income per capita
abJe to pay the beneficiaries. If unskilled labor is the
Vote: Datra are for years ranging from 19S8 to 1992.
predominant administrative input into pensioni             Sotec: Janes and lalacios (1994a).
plans, one might expect this ratio (of administrative
cost per participant to income per capita) to be neg-
atively related to per capita income, because poor    number of participants increase, for both public and
countries have plentiful unskilled labor and low        private plans, suggesting significant economies of
wages. But if skilled labor and capital inputs pre-    scale (issue brief figure 5.2).
dominate, one would expect this ratio to be posi-          If this is the case, lowv-income countries, especially
tivelv related to per capita income.                    small ones, should think twice before they establish
Examination of the data show the latter to be the    complex formal systems of old age security. Indus-
case (issue brief figure 5.1). Apparently, educated    trial countries started their present systems at much
labor, computers, communications infrastructure,    higher levels of per capita income, education, and in-
and other capital intensive inputs are important ele-    frastructure than many developing countries today.
ments in the pension productioll fuLnction, so the    If low-income countries initiate formal old age sys-
administrative cost per participant relative to per    tems, they should keep the record-keeping and other
capita income is much higher in low-income coon-    administrative demands simple and should concen-
tries, wlhere these inputs are scarce and expensive.    trate them  in urban areas and in large firms, where
This number is sixty-five times higher in Zambia    transaction costs will be low.
than in the United Stares; it is eighty-four times         For further reading see Valdes-Prieto (1993);
higher in Butrundi than  in Switzerlanid. Ftirther    Stinden and Mitchell (1994); James and Palacios
analysis indicates that administrative costs fall as the    (1 994a).
312



ISSUE BRIg
Issue Brief Figure 5.2 Administrative Costs as a Percentage of Assets, Private Plans in the
United States and Chile
Administrative costs as a percentage of total assets
6
United States, 1985                                            Chile, 1992
4
2
0
0.000001- 0.25-0.49 0.50-0.99  1-2.49   2.50-4.99   5-9.99   10-24.99  25-74.99    75-                 150-       250-       500
0.24                                                                                   149.99      249.99    499.99   or more
Assets in millions of U.S. dollars
NVote: This figure reters to occupational planis in rhe United States and AFI'S in Chile.
Source. Turner and Beller (1989): ACLfa and Iglesias (1992): AbuLhadba I1994); Provida (1993).
313






Issue Brief 6 The Life Cycle of Pay-as-You-Go Public Pension Schemes
P      AY-AS-YOU-GO SCHEMES HAVE A TYPICAL                Because the population is young and growing and
life cycle-with its stages defined by the old   the ratio of old people to workers is low, the govern-
age dependency ratio and the system depen-    ment can make transfers to old people who have
dency ratio. These ratios, in turn, strongly influence    paid very little into the system. Rates of return to
the required contribution rate, pension expendi-    pensioners are far higher than rates they could re-
tLires, and the current surplus or deficit. The life   ceive for investments in the private market. These
cvcle may be divided into three stages-the young,   generous pension promises are easy to keep when
the expanding, and the mature. Issue brief table 6.1   few people qualifv for benefits.
provides fundamental data averaged across countries       With low coverage rates and a low share of labor
that fall into each of these categories.               in GDP, the implicit social security debt is negligible.
The high ratio of contributors to beneficiaries en-
Stage 1: Youth, Accumulation, Windfall Benefits, and   ables stage I schemes to accumulate large current
Low Contribution Rates                                 surpluses to futid this debt. But these surpluses are
usually invested in government bonds, wlich be-
The youngest countries are in stage 1 of the life    come a cheap source of public sector credit and are
cycle. These countries have more than fifteen peo-    often decapitalized during inflationary periods. That
pie of working age for every old person, and their    happened in Germany in the 1920s and in Ar-
public pillars have an even higher ratio of contribu-    gentina. Brazil, Paraguay, aind Uruguay in the 1950s.
tors to pension recipients (system  support ratio).       Almost all countries in stage I today are in Africa,
Their schemes are immature (the coverage rate    Latin America, and the Middle East.
among old people is much less than the coverage
rate among workers), and labor force coverage is   Stage 2: Coverage Expansion and Rising Contribution
sparse. Less than I percent of GDP is spent on pen-    Rates
sions. Although contribution rates are low, the
schemes run current surpluses that are large relative     The population is somewhat older at stage 2, but
to their revenues.                                     the ratio of workers to pensioners remains relatively
Issue Brief Table 6.1 The Life Cycle of Pay-as-You-Go
Simulated
Pension                                                    social
Support     expenditures!    Payroll      Laborforce   Surplus as share    security
Stage          ratio         GDP           tax rate      coverage      of revenues    debt/GDP 
1            17.5           o.6            8.0           15.7           47.1             5
2            11.8            3.3          13.7           45.4           34.9            40
3             5.3           8.5           24.6           89.4         -19.6            150
a. This is based on a simulation; the other numbers are actual averages.
315



ItrING  THE OLD AGE CRISIS
high-eight to fourteen people of working age for   ered and eligible for full benefits. The population
every old person. The schemes are somewhat older,   has aged-there are fewer than six people of working
too, and cover more than one-third of the labor   age for every old person, and the support ratio coIn-
force. About 2 to 5 percent of GDP goes to pensions.   tinues to fall. Many countries with mature schemes
The first cohorts of workers from the "founding    have experienced a leveling of growth-brought on,
generation"-30 to 50 years old when the scheme was   in part, by high payroll taxes and inadequate saving.
established-begin to collect pensions. Their rates of   Contribution rates average more than 20 percent,
return are high, and the positive transfers they receive    and pensions consume more than 8 percent of GDIP.
are larger than those of the first winidfall generation,   Most schemes run large currenit deficits. The accu-
because they often qualify for full benefits but have    mulated social security liability, now 100 to 200 per-
nor contributed for their full working lives. Though    cent of GDP, signals that higher taxes and deficits are
contribution rates rise and surpluses shrink or disap-   to come.
pear, the schemes are extremely popular, because most  Some OECD and formerly socialist countries, such
members of the founding generation are big wvinners.   as the Netherlands and Romania, have loosened their
Political pressure from older, influential citizens keeps    eligibility criteria to absorb increasing numbers of
benefits high and retirement ages low, threatening the    unemployed workers. Increasing evasion in some
long-run financial stability of the schemes.         countries means that there are fewer contributors for
This stage is often extended by expanding coverage    each of these new pensioners. Workers begin to sus-
to new groups of young workers, usually from lower-   pect that they will not receive the high returns of pre-
income groups. The expanded coverage improves the    vious generations.
svstem's old age support ratio and keeps the promised  Governments dip into general revenues to cover
benefits flowing. Newly covered workers are not re-   pension obligations, reducing spending on other
sentful because they expect generous pensions them-    public programs, such as education, that benefit the
selves. But they mav be disappointed. The growing so-   younger generation. Although at the beginning of
cial security debt-ranging from about a quarter to   stage 3 many countries still allow early retirement
half of GDP-is a harbinger of the difficult times ahead.    and easy eligibility conditions, in the end the share
Brazil and Turkey illustrate problems at this stage.   of GDP spent on pensions reaches double digits, ben-
Their schemes have high evasion rates because as tax   efits are cut, and eligibility conditions are tightened.
rates rise many workers escape to the informlal sector   Because many young people now become losers-
as sooin as they qualify for benefits. The result is a ratio    getting muclh less from  the system thall they put
of contributors to pensioners far lower than would be   in-political pressure builds for a major structural
expected for the age sruLcture of the population-and    change. Change is resisted, however, by old and
a serious threat of bankruptcy.                      middle-aged people. who have built up substantial
entitlements in the old system. Finding vways to pay
Stage 3: System Maturity and the Collapse            off this debt, while shifting to a more decentralized
of the Pyramid Scheme                                funded pension scheme, becomes the challenge at
the end of stage 3.
By this stage the old age security system has ma-    Isstie brief figure 6.1 illustrates a typical life cycle
tured and is over 40 years old. Most workers are cov-   of a public pay-as-you-go scheme, as it evolved in
3I6



ISSUE BRJ1et#
Issue Brief Figure 6.1 Life Cycle of a Publicly        former Soviet Union, to Africa and Central America,
Managed Pension Scheme, Chile, 1945-71                 are considering major reforms of their pension sys-
Percent                                                tems. Knowing the hazards, young countries still
40                                                     have time to choose whether to follow in the foot-
steps of countries that long ago adopted defined
30                                                     benefit pay-as-you-go schemes. The experiences of
Rat,o of pensioners to contributors    the older couLntries suggest the following cautions:
* Pay-as-you-go schemes can obscure the real
state of public finance when short-term  sur-
-_Dernographic ratio
10                              *   65+ to 20-65             pluses provide a false sense of confidenice and
long-term  pension liabilities are not explicitly
o _________________________________________ _ Brecognized.
0                                                               Z
* The financial condition of a pay-as-you-go
'I                scheme always deteriorates as a country moves
-10                                                           through the demographic transition and as the
Net cash surplus as percentage of  '         system   atures-a point that will be reached
-20                  socialsecurityreceipts                   much faster in developing countries than it
was in OECD countries.
* Starting with limited coverage and gradually
30                                                           expanding it delav the reckoning, but this so-
1 945    1950     1955     1960      1965     1971
lution  is regressive under a pay-as-you-go
Soune.' Wallich 11982).                                    scheme, because the first workers covered tend
to be higher-income workers whose generous
reLrns are paid for by lower-income workers
Chile, from  stage I in the 1940s, stage 2 in the            who enter late.
1950s, and stage 3 in the 1960s-until the system          * The increased consumption afforded early
collapsed in the 1970s. In 1981, Chile introduced a          generations of retirees may come at the ex-
new mandatory funded privately managed pension               pense of national saving and growth.
plan, supplemented by a much smaller tax-finaniced        * Labor market distortions and incentives to
public pillar.                                               evade increase as contribution rates rise in later
stages.
What Young Countries Can Learn from Old Countries         * The demographic transition and system matu-
ration make intergenerational transfers in-
More than half the world's people live in coun-           evitable in a pay-as-you-go scheme.
tries with young population profiles. Many of them,       * Pay-as-you-go schemes are easy to put together
from China and India to the young republics of the           but difficult to take apart.
317






Issue Brief 7 Evasion
W     H    HEN BENEFITS ARE NOT CLOSELY    and other forms of evasion increased as payroll tax
linked to contributions, people are   rates rose during the economic downturni of the
likely to evade paying into mandatory    1980s. A World Bank study (World Bank 1994a)
pension schemus.                                  found that because of the increased evasion, a I per-
centage point rise in the contribution rate led to a 2
* Workers may be dissatisfied because their pen-   percentage point drop in total receipts. Under
sions will not increase commensurately with    Uruguay's mandatory pensioni scheme, labor force
their contributions.                         coverage fell 13 percent during the 1980s, as social
* They may value present consumption more   security payroll taxes rose. Business managers in
than future pensions.                        Uruguay cited social security taxes as a major imped-
* They may believe they can get a better rate of   iment to expansion in the formal sector (World
return elsewhere.                            Bank 1994b).
* They may expect to die relatively early.
Other Ways to Evade
The incentives to evade are greater when the social
security tax adds to an already burdensome tax and  Moving to the informal sector is not the only wa'
regulatory structure, when penalties or the probabil-  to evade social security taxes. Underreporting earn-
ity of being penalized are low, and when there is a   ings is another. Estimates for Uruguay in 1988 put
large informal sector where workers can disappear.  unreported working hours at more than 30 percent
of the total, and estimates put revenue losses at 3 per-
Escape to the Informal Sector                     cent of GDP. Managerial personnel in Brazil shift
much of their compensation into ftinge benefits, such
The informal sector is a refuge from the taxes and    as free housing and company cars, not counted by
regulations of the formal economy-workers and   the social security system. Self-employed workers-
enitrepreneurs in the informal sector simply do not   doctors, lawyers, even taxi drivers-keep much of
register in the formal system. The informal sector ac-   their earnings hidden from  the authorities while
counts for more than half the labor force in many    contributing just enough to qualify' for large pension
developing countries (figure 4.4). The large size of   benefits.
the informal sector in developing countries makes   Simply refising to comply is an approach used fre-
evasion easier, which stimulates the sector's further   quently in countries with low penalties and lax en-
growth.                                           forcement. In Brazil more than 50,000 registered
In Caracas, Venezuela, social security payroll taxes   firms have refused to pay into the pension scheme in
represented more than one-third of the costs of be-   recent years-cumulatively the equivalent of 5 per-
coming formal. Hernando de Soto's well-known    cent of GDP or an entire year's worth of contribu-
study of the informal sector in Peru, El Otro Sendero,   tions. Delaying contribution payments can reduce the
shows that entrepreneurs can be very sensitive to   real value of the tax in an inflationary environment.
these costs. In Brazil, escape to the informal sector   In Venezuela the late payment penalty of 1 percent a
319



XiT;I:NG  THE OLD AGE CRISIS
month was lower than the inflation rate, runlning 5    What Evasion Does
percent a month at times during the 1980s. Brazilian
employers also benefited from payment delays dur-      When contributioni rates prompt greater evasion,
ing periods of high inflation, because penalties were   labor allocation decisions are distorted by workers
not filly indexed. The biggest arrears are due from  moving to the informal sector or to other jobs to avoid
the central government and other public agencies in   paying social security taxes. Labor productivity suffers.
many countries-including Brazil, Ecuador, and    Evasion also defeats the purpose of mandatory pension
Venezuela. It is difficult to bring moral suasion to    plans-to make sure that people have some source of
bear on the private sector when the government is   support in their old age. When workers evade contri-
defaulting on its social security contributions.     butions but still qualify for benefits, the pension svs-
During the 1980s, rates of evasion and delayed    tem  runs into serious finanicial difficulties. Evasion
payments soared to 60 percent in Brazil, 44 percent   rates as high as 50 percent in Argentina have driven the
in Barbados and Jamaica, 35 percent in Venezuela,   old age pension scheme deeply into deficit, adding to
and 33 percent in Peru (Schulz 1992). High evasion    the burdeni on the general government budget and
rates are not unique to Latin America. Of a regis-   eventually leading to the adoption of a new system.
tered membership of 12.9 million in the Philip-        In the worst case, evasion can lead to the near col-
pines's system  in 1990, only 2.8 million workers   lapse of the pension scheme. As confidence in the
were contributing to the national social insurance    plan evaporates, more people try to evade contribu-
scheme. In Rwainda in the late 1980s, 15 percent of   tions, increasing the financial strain. Drastic reforms
expected contributions were in arrears. Tunisia's    may be required just to achieve a merely minimal
main public pension scheme received only two-   level of credibility. Countries such as Argentinia,
thirds of expected contributions in 1990 (Vittas    Brazil, and Turkey now face this crisis of confidence,
1993a). In Tuirkey only I percent of registered mem-    and the same vicious circle of loss of confidence and
bers contribute regularly to the Bag-Kur pension    of increasing evasion is beginning to cripple pension
scheme for the self-employed (World Bank 1 993d).    finance in Eastern Europe.
The transitional economies of Eastern Europe are
also beginning to feel the impact of tax evasion on    What to Do
their social insurance schemes. When enterprises are
financially pressed, they allow payroll tax arrears to  When escape to the large informal sector and
mount, knowing that public tax administration has    other means of evasion are easy, it is more important
not kept pace with the growing private sector. Ar-   than ever to keep payroll taxes low and link benefits
rears in Estonia in 1992 were 29 percent of total so-   closely to these taxes. One way to do that is to keep
cial insurance revenues, and arrears in Hungary were   redistributive public pension programs modest,
more than 20 percent (Cavalcanti 1993; World    while supplementing them  with large, mandatorv
Bank data).                                         retirement saving plans that directly link workers'
contributionis to their benefits.
320



ISSUE BRIEF 8
Issue Brief 8 Public Pensions and Retirement
O        NCE PEOPLE ARE COVERED BY A FORNMAL    ment at age 50, Burunldi at 45, China at 55 for men
pension scheme, public policies directly   and 45 for women, and Romania at 50 for men and
influence their decisions about retirement.   45 for women. In Romania and Tunisia a mothe;
The legal retirement age in poor countries is much    with three children can retire early. Morocco, Pak-
lower than that in rich countries, varying from an   istan, Peru, and Portugal permit early retirement fot
average of 64 for men in OECD countries to less than    miners, while teachers can retire early in Brazil, Bul-
57 in Sub-Saharan Africa. Women are often allowed    garia, Nicaragua, Poland, and Uruguay. Most coun-
to retire earlier even though they generally live   tries in francophone Africa allow the "prematurely
longer than men.                                   aged" to retire at 50 or 55. Brazil allows some cate-
In terms of general health  and expected    gories of workers to retire after thirty years of ser-
longevity, a worker in, say, BuruLndi is older at age   vice, regardless of age. Early retirement has been
60 than one in Switzerland. This explains, in part,   used as an alternative to unemploynment and an aid
the lower retirement age in Burundi. Nevertheless,   to enterprise restructuring in China, Eastern Eu-
life expectancy at the legal retirement age is greater   rope, and OECD countries (box 4.4).
in low-income countries than it is in high-income     Promises of early retirement are cheap. Politi-
countries (figure 4.5). The expected retirement pe-   cians can easily promise generous benefits todav.
rnod is probably even longer than the estimates in   knowing that it will be years before anyone tries tc
figure 4.5 show, since the life expectancy of covered    collect on those promises. But when that day
workers is greater than the national average and    comes-as it already has in many parts of thc
many workers retire before they reach the legal re-   world-system  dependency ratios will shoot above
tirement age.                                      demographic dependency ratios and pension
schemes will run into financial difficulty.
Early Retirement
Older Workers Are Dropping Out of the Work Force
A number of countries have liberal early retire-   Earlier
ment provisions that put the average effective retire-
ment age far below the normal legal retirement age.   In Austria, France, Germany, Italy, and Spain.
The average retirement age is 53 in Albania and    fewer than one person in ten over the age of 60 is
Poland, for example. Pensionis for early retirees are   still in the work force. In Argentina. Trinidad and
frequently reduced far less than the actuarially fair   Tobago, Uruguay, much of Eastern Europe, and
amount, which means that people who continue to    most of the remaining OECD countries, four out of
work are penalized.                                every five persons over the age of 60 have retired.
Some countries allow early retirement under spe-   Between 1960 and 1990 the labor force participa-
cial circumstances, such as extended unemployment   tion rate for workers over the age of 65 fell from 33
or disability, loosely defined. In the Netherlands one   to 11 percent in high-income countries and from 56
in five pensioners retires early as "disabled." For   to 33 percent in low-inconme countries (issue brief
people doing "arduoLs xwork," Brazil permits retire-   table 8.1). The old age activity rate is higher in de-
321



*1. TTHE OLD AGE CRISIS
Issue Brief Table 8.1 Changes in Labor Force Participation of Older Men in Selected Countries,
Early 1960s-Late 1980s
Age 65-plus                               Age 55 to 64
1960-66       1986-90        Change        196046         1986-90        Change
OECD countries
Australia                 24.9           9.2         -15.7           86.1          63.3          -22.8
Austria                   15.1           2.2         -12.9           77.5           38.9         -38.6
Canada                    28.5          11.4         -17.1           81.9           64.9         -17.0
Denmarka                 34.5           13.4          -21.1          91.4          67.8          -23.6
Finlanid                 39.7            6.8          -32.9          85.5          45.4          -40.1
France                   27.8            3.5         -24.3           78.7          45.8          -32.9
Germanv                  22.8            6.3         -16.5           81.5          78.4           -3.1
Greece                   43.7           13.6         -30.1           81.5           65.7         -15.8
Ireland                  48.4           16.8         -31.6           90.0          91.0            1.0
Iualy                    23.6            8.1         -15.5           70.4          52.6          -17.8
Japan                     54.3          39.2         -15.1           87.8           86.5          -1.3
Luxenibourg               15.6           2.5         -13.1           66.4          34.1          -32.3
Nerherlands               19.9           3.9         -16.0           87.7          45.7          -42.0
New Zealand              23.6           11.2          -12.4          83.4           56.8         -26.6
Portugal                 62.6           20.0         -42.6           86.1          66.9          -19.2
Spain                    55.5            3.7         -51.8           91.9          61.7          -30.2
Sweden                    23.9          10.7         -13.2           87.5          75.4          -12.1
Switzerland'              41.9          15.1         -26.8           92.7           88.7          -4.0
United Kingdom           23.4            8.6         -14.8           91.3          67.9          -23.4
United States            29.7           15.5         -14.2           83.6          67.1          -I6.5
Average                  33.0           11.1          21.9           84.2          63.2          -20.9
Nooi-OECD countries
Argentina                 38.3          23.5         -14.8           65.3           68.4           3.1
Chile                     51.4          30.3         -21.1           80.6          71.8           -8.8
Ecuador                  85.3           64.3         -21.0           96.5          88.5           -8.0
El Salvador              79.2           47.2         -32.0           94.6           85.4          -9.2
Guatemala                74.4           62.9          -11.5          92.9          92.5           -0.4
HongKongb                39.8           20.8         -19.0           84.2          68.2          -16.0
Hungary                   57.0           1.2         -55.8           82.9          33.2          -49.7
Korea. Rep. of           29.1           40.9          11.8           74.5          78.2            3.7
Mauritius                31.9           14.8         -17.1           75.9           61.4         -14.5
Mexico                   91.7           45.9         -45.8           96.2          74.1          -22.1
Nigeria                  90.2           50.0         -40.2           96.6          89.0           -7.6
Peru                     68.7           32.0         -36.7           94.2          72.2          -22.0
P'oland                  55.5           32.5         -23.0           87.4          63.7          -23.7
Romania                  39.3           13.8         -25.5           79.7          38.0          -41.7
Trinidad and Tobagoc      29.7          18.2         -11.5           79.7          62.3          -17.4
Uruguay                  22.5           16.2          -6.3           63.6          64.8            1.2
Venezuelad                70.1          49.1         -21.0           91.6           82.9          -8.7
Average                   56.1          33.2          -23.0          84.5          70.3          -14.2
Vote: Averages are unweighted. The ranges of years for some countries are the following: (a) 1960-80, (b) 1971-91, (c) 1970-90, (d)
1961-8 1.
Source: ito. Data on activity rare over 65 for 1980-90 for Uruguay are from the U.S. Bureau of the Census, Center for International
Research. International Data Base on Aging. Eekelaar and Pearl (1989).
322



veloping countries, in spite of liberal early retire-   force participation rates for older workers have
ment provisions, perhaps because most people are   fallen less than they have in other OECL) countries.
not covered by pension schemes and many workers
continue working in the informal sector even after   Consequences of Early Retirement
they have officially retired.
Many forces account for the declining labor force  If the labor force participation rate for people
participation rate among older workers-including    55 to 64 years old was the same in 1990 as it was
early retirement provisions in private pension    in 1960, the labor force would have been 1 to 2
schemes and rising real incomes, which some people   percent larger in developing coun1tries and 3 to 6
choose to spend on increased leisure. AlthougL1 it is   percent larger in Eastern European and OECD
difficult to determine exactly how  much public   countries. As populations age over the next three
pension plans have contributed to this decline, there   decades, this employment loss will grow. The loss
is little doubt that they have influenced people's re-   in national output as a consequence of early retire-
tirement decisions. The windfall transfer to older   ment is approximately I percent of GDP for devel-
workers (when pension schemes are introduced) in-   oping countries and 2 to 4 percent of GDP for
creases their income late in life, and earlier retire-   OECD countries, assuming that older workers are as
ment is one of the few ways they can "spend" this   least as productive as younger workers. This loss of
added income. Younger workers may also retire ear-   output is inefficient if its value exceeds the value of
lier because public pension programs have forced   the extra leisure that retired people receive. If re-
them to "contribute" for their retirement more than    captured, this lost GDP would cover more than half
tihey would have otherwise. A high payroll tax that   of total pension spending in many countries.
is not linked to future benefits may have a negative  Early retirement also has undesirable conse-
effect on the labor supply of older workers. Most   quences for the distribution of GDP, because the
countries require people to stop working as a condi-   main beneficiaries are civil servants and other priv-
tion for receiving pensions. In some OECD countries   ileged groups. Added to the fact that upper-
benefits are reduced for workers who continue to   income workers live longer than lower-income
work past the normal retirement age, and these ben-   workers, the result is that better-off workers collect
efits are never recouped.                          pensionis for many more years than their poorer
As evidence of the responsiveness to these finan-   compatriots.
cial incentives: In China, most workers in rural
areas are excluded from  the formal public sector   Policy Implications
scheme, whereas urban retirees receive generous
pensions. Not surprisingly, 85 percent of the urban   The retirement conditions established for public
old, but less than half of the rural old, are retired.   pension plans have important consequences for the
The Republic of Korea, where less than 5 percent of   financial health and distributive impact of these
the old are eligible for public pensions, has a high    schemes and for the economy as a whole. Several
and unchanging activity rate. In Sweden, which    principles should guide policy on this issue:
provides generous partial retirement benefits to
workers who continue workinig part-time, labor        * Avoid excessively long retirement periods.
323



k~1tjltNC  THE OLD AGE CRIS[S
* Don't penalize people who w ork beyond the       * Eliminate special regimes that grant early re-
normiial retirement age.                           tirement for privileged groups.
* Reduce pension levels on an actuarially fair     * Don't use retirement as a remedy for unem-
basis for people who retire early, except for      ployment.
those who are truly disabled.                   * Raise the retirement age regularly as life ex-
* Set the same retirement ages for men and women.     pectancy increases.
324



ISSUE .BR I
Issue Brief 9 Redistribution between Generations
P        UBLIC OLD AGE SECURITY PROGRAMS ARE   of workers, according to the eligibility conditions
often justified on equity grounds. They redis-   set. When the Netherlands adopted its current
tribute income across generations to help co-   scheme in 1957, it provided generous pensions im-
horts whose ability to support themselves in old age    mediately to people who had already retired and to
has been weakened by factors beyond their control:   those who retired sooni after. The windfall gain was
war, inflation, recession. The net effect of these plans    highly concentrated in these cohorts. More often, el-
is difficult to determine, because they may crowd out   igibility restrictions keep transfers small for people
private saving and transfers to some extent (see issue    who are old when the scheme is introduced, stretch-
brief 4). But in most OECD countries they seem to   ing the windfall out over several cohorts of workers.
have improved the income position of the group cur-   In the United States fewer than one in ten old peo-
rentlv old, whose poverty rate decreased faster than    ple was receiving benefits ten years after the first so-
that of any other population group over the past   cial security contributions were collected. Switzer-
thirty years. But these public pension plans will re-   land applied a means test to the old in the first
duce the lifetime incomes of many people working    windfall generation. Most Koreans who were old
todav.                                              when their system was established in 1988 will have
This gain in real income by one generation at the    died by the time the system pays out its first full ben-
expense of a permanent loss to another generationi is   efits. In such cases the scheme accumulates a partial
the intergenerational transfer. (See box 4.5 for a dis-   reserve in its early years, with the largest benefits
cussion of same-generation transfers.) It is an in-   likely to be received by people who are 30 to 50 years
evitable outcome of pay-as-you-go pension systemns.   old when the scheme is introduced-the founding
Every empirical analysis conducted so far has found    generations. They pay contributions for only part of
that the transfers from one generation to another,   their workinig lives but collect generous pensions for
specifically from future generations to generations    manyyears.
that were working wheni the scheme was created, are    Changes in the old age dependency rate (the ratio
far larger than any transfers within generations.   of retirees to workers), and in productivity or real
wage growth, also contribute to the tendency of pay-
Who Gains and How Much?                              as-you-go schernes to redistribute income across
generations. Succeedinig generations of workers get
Intergenerationial transfers always occur in pay-as-   back in benefits more than they have contributed if
yout-go schemes, because the first generations of pen-   the system  support ratio (ratio of contributors to
sioners receive benefits that exceed the value of their   pensioners) is rising and if wage growth exceeds the
contributions over their relatively short periods of   interest rate. But under the opposite conditions they
covered employment. Supporters of pay-as-you-go    lose part of their lifetime income. For the past half
schemes view this ability to help the old immediately    cenmtry the first set of conditionis held. In the next
as an advantage over funded schemes.                 half centt-y the second set will likely dominate be-
This windfall gain from system immaturity can    cause of the combined impact of the demographic
be compressed or stretched out over several cohorts   transition and slow productivity growtlh. Early gen-
325



1,rC THE OLD AGE CRISIS
erations will have been made better off by pay-as-    of return were more than 15 percent for workers re-
you-go schemes, but later generations will be made            tiring in the 1950s and 1960s and close to 8 percent
worse off. Lifetime income is being transferred from          for workers retiring at the end of the 1970s-much
later to earlier generations (see chapter 3 and issue         higher than these workers could have earned in some
brief 3).                                                     other investment, such as the stock or bond market
Studies of the U.S. social security system find that,    (issue brief figure 9.1). Higher-income workers re-
thanks to windfall startup gains and expanding cov-    ceived the largest transfers because of their greater
erage and population, members of the founding gen-    earnings, pensions, and longevity. Many of todav's
erations received three to four times more than they          young workers, however (including low- and middle-
had contributed during their working lives. Real rates    income xvorkers), can expect to earn negative trans-
Issue Brief Figure 9.1 Real Rates of Return on U.S. Social Security (OASI) Contributions versus Stocks and Bonds
for Generations Retiring between 1942 and 2027
Percent
25
20
:15
10
5             .........................
0  '-                                          --*                                   ~ ~ ~~ ~ ~~  ~  ~~  ~  ~~  ~  ~~ Bonds
1942        1947         1957        1967        1977         1987         1997        2007         2017         2027
Year in which generation retires
.'Vote: OASI (Old-Age and Survivor's I istiranice) rates of re[Lrin are based on Moffirt (19841 anid Boskiin and orhers (1'987: stock retuiris (bhlsed
on Standard and Poor's index) anid bonid returins (balsed on, lonig-terimi government bond vields) are fronit Ibborson and SinqLiefield (1989); after
1997, average returni for 192 5-87 is applied.
326



Is UE:
fers, because they are required to contribute more    workers. Without dramatic changes in productivity,
than they will ever receive back in pensions. If, in ad-   today's young workers will receive low pensions and
dition, benefits to these younger workers are cut be-    negative rates of return on their contributions under
cause of fiscal pressures and if real wages fall because    pay-as-you-go systems (see issue brief 3).
of reduced saving and growth, the loss in lifetime in-
come will be even greater (Steurle and Bakija 1994;   What Should Be Done?
Moffitr 1984; Boskin and others 1987).
Germany, the Netherlands, and Sweden have had        Before adopting or expanding their old age secu-
similar experiences (Dinkel 1986; Nelissen 1987;   rity systems, countries should carefully evaluate the
Stahlberg 1989). In Sweden the present value of life-   intergenerational transfers that are likely over the
time benefits for people born between 1904 and    long run. They should establish a system of genera-
1914 was 3.75 times higher than the present value of   tional accounting that traces the projected flows to
contributions, using a 3 percent discount rate. For   and from different generations, as well as the distri-
people born between 1940 and 1944, estimated fti-   bution of these flows within each generation (Auer-
ture lifetime benefits are only 0.6 times the value of   bach and Kotlikoff 1987). They may find that the
contributions. Workers who retire in the future   transfers implied by large pay-as-you-go schemes-
would probably be better off if they were allowed to   as a result of system maturation, increasing coverage,
save their contributions and invest them in a mixed    and changing patterns of population and productiv-
portfolio of stocks and bonds or in the education of   ity growth-are not at all wlhat they intended. Dan-
their children.                                     ger points to be avoided are large positive transfers to
Empirical evidence on intergenerationial transfers   higher-income groups in the first few generations of
in developing countries is more difficult to come by.   retirees and negative transfers to low-income groups
Most of the schemes are immature, so the first wind-    among the later retirees. In general, transfers can be
fall generation is still benefiting. Furthermore, cover-    made more equitable by using a very progressive
age rates are low, so the financial base can be    benefit and tax formula in public pension plans, im-
strengthened for some time simply by expanding    posing a floor but no ceiling on taxable earnings,
coverage to new groups of young workers. This pat-   switching to general revenue finance once coverage is
tern of gradual expansion is usually regressive be-   widespread, and using privately managed funded
cause higher-income workers are brought into the    plans that make benefits contingent on contribu-
program first, and they receive the highest rate of re-   tions, to provide higher pensions to higher-income
turn, while the last groups to join are lower-income    groups.
327






ISSUE BRIEF
Issue Brief 10 Annuity Market Problems and How to Resolve Them
A        N ANNUITY IS A SERIES OF PAYMENTS IN         If annuities are mandatory, an important public
return for a lump sum paid up front. In a   policy issue concerns which risk categories insurance
typical situation the payments are made for   companies will be permitted to use, for differentiat-
the remaining lifetime of the annuitant or the annu-   ing premiums or benefits. In a competitive market,
itant plus survivors (such as a husband and wife).   each company has an incentive to offer better rates to
Sometimes the payment is guaranteed for a specified    people who fall into better risk categories. For exam-
period, such as ten years. If the annuitant dies, pay-   ple, low-income people. whose expected longevity is
ments are continued to a designated beneficiary   lower, might be offered a lower annuities price than
until the end of the period. Often annuities receive    high-income people, and men may be offered a bet-
favorable tax treatments. One reason frequently   ter price than women. Which income, gender, racial,
given for public provision of pension benefits is that   and other characteristics should be permitted for rate
private annuities markets are beset by problems.   setting in mandatory annuities markets? In the
How could these problems be resolved to enable the    United States, for example, race and gender are not
provision of pension benefits by a decentralized    permissible categories for employment-related pen-
mandatory saving scheme?                           sions or life insurance. Differentiated annuities
Annuities markets may stiffer from adverse selec-   prices might become divisive. But uniform  prices
tion, leading to the nonavailability of annuities at an   imply ex ante transfers, from  low-risk groups to
actuarially fair price to "good risks," in this case to   high-risk groups. (In a public scheme, in whiclh
people who expect to die young. Empirical evidence   everyone is placed in the same annuity pool, such ex
from the United States indicates that these markets do    ante transfers are implicit.) In particular. low-income
not completely disappear but that people who buy an-   workers are penalized if differentiated prices are not
nuities tend to have above-average longevity, requiring    permitted for annuities. This effect might be miti-
a commensurately high price that discourages such    gated by offering a variety of contracts for partici-
purchases from those with below-average longevity   pants to choose from. People who expect to have low
(Friedman and Warshavsky 1990). This may result  longevity would self-select contracts that provide a
from adverse selection or from the fact that annuities   death benefit for survivors or that have a guaranteed
are considered a luxury good, purchased primarily by    payotit period for retirees and their beneficiaries. If
high-income people (whose expected longevitv hap-   each type of contract is priced to be self-supporting,
pens to be high). Insuranice companies can handle ad-   this helps to mitigate the adverse selection problem
verse selection, in part, by offering different types of   (see above) and the problem of undesired ex ante re-
annuity contracts that separate people with high and    distribution among groups.
low expected longevity (see below). Or governments    Once permissible risk categories are set, annuity
can solve this problem by making the purchase of an-   companies may try to "creanm" the best risks in each
nuities mandatory, at least up to a limit. Once annu-   category-that is, to sell annuities to those people
ities are mandatory, everyone must buy them. The    with lower-thani-average expected longevity in each
price then reflects average, rather than above-average,   group to maximize their profits. While adverse selec-
risk, making them more affordable.                 tion stems from circumstances in which the insur-
329



4J  TH2E OLD AGE CRISIS
ance company does not have information about the    that is, require a smaller purchase of deferred annu-
individual's risk category, creaming occurs when    ities each year, from the time the worker reaches a
the company does have this information. Consider the    given age such as 50. Still another solution would
case where, by law, evervone of a given age must be    allow workers to take gradual withdrawals from their
charged the same price. Then, cigarette smokers, sky    retirement accounts, such as 5 percent of the assets
divers, miners, and people with poor medical histo-    each year after age 65, in lieu of purchasing annu-
ries would become desirable targets, sought after by   ities. But this voluntary choice between phased with-
annuity companies, while other consumers would be    drawals and annuities brings back the adverse selec-
less desirable. Those who are way above average in   tion problem discussed above and may leave some
risk might even be rejected as consumers, if this is   very old people without adequate financial re-
permitted. So, a policy that makes annuities manda-   sources. (A public defined benefit scheme ordinarily
torv must either prohibit insurance companies from    does not involve investment risk. Nevertheless, dif-
excluding consumers or must set up a special fund    ferent cohorts may be treated differently depending
that covers "bad risks" (such as healthv people). If ex-   on political risk.)
clusion and price differentiation are not permitted,   It is often claimed that private companies cannot
some insurance companies (those located in    credibly' insuire against inflation, especially high
"healthy" areas, for example) may end up with a dis-    unanticipated inflation. (But many public programs
proportionate share of bad risks and may then go    also do not protect against inflation.) As one possible
broke. If a special "bad risk" pool is used, a large pro-   solution, insurance companies could be required to
portion of the population may end up in the special   index their benefits and encouraged to hold indexed
pool. which requires subsidies from the association    securities, real assets whose value is likely to increase
of companies or from the state. (Exclusion is gener-    with inflation, or foreign investments chat are im-
ally ruled out for a mandatory public scheme.)       mune to country-specific inflation. In Chile annu-
A mandatory scheme with a deadline (such as   ities are indexed and backed by such assets. Indexed
date of retirement) for the purchase of an annuity    benefits imply a cost for the worker-for any given
creates a high investmient risk for workers, because of   premium, a lower pensioll will be paid in the early
the possibility that the market value of their accu-   years to cover the probability that a higher pension
mulated assets, or the interest rate on which annuity    must be paid later on. So, it is not clear that workers
prices depend, may be abnormally low on that date.   are better off if full indexation is required.
One possible solution is to encourage the develop-     Longevity, even the longevity of the cohort as a
ment of variable orparticipatin-g annugities in which    whole, is difficult to predict. In recent years, people
people purchase annuity uLits whose prices fluctuate   have been living longer than expected, and some de-
as market conditions chanige, similar to adjustable    mographers believe this disparity in longevity will
rate mortgages. This has the advantage of mitigating    increase in the years ahead. People who purchase an-
the risk associated with requiring a purchase on a    uitites, particularly large annuities, may have longer
specified date. But it has the disadvantage that the   life expectancy than the rest of the population (ad-
retiree must bear the risk of a fluctuating pension    verse selection). This poses a great longevity risk for
amount for the rest of his or her life. Another sobl-   private insurance companies, which will therefore
tion would spread out the purchase of annuities-    charge a high-risk premium. Even with a high pre-
330



IssUE$
mium, some insurance companies might go bank-    ment responsibility because they are public goods.
rupt and be unable to pay pensioners if they under-   And joint ventures should be encouraged in devel-
estimate the growth in longevity. A capital reserve    oping countries that lack the technical expertise for
fund may be important for this reason. Another so-   running insurance companies and other modern fi-
lution to this problem is for companies to match life   nancial institutions.
insurance and annuity exposures. Still another ap-     The complexity of these problems probably limits
proach is to use private annuities only for a limited    the degree to which annuities should be mandatory.
period, such as the first twenty years of retirement,   In a mandatory saving scheme workers should not
and resort to a larger public benefit for the very old.   be required to purchase annuities with their entire
(A public pay-as-you-go scheme implicitly passes the    retirement savings. Other reasons for limiting the re-
costs of higher longevity on to the next generation    qtiired annuity purchase are that people's consump-
and can do so through its power of taxation.)       tion needs in old age may be lumpy (they may have
Because annuity purchases are lumpy and irre-   large medical expenses at some point) and they may
versible, high commissions are often paid to salesper-   wish to leave part of their estates as bequests for their
sons who complete a deal. This in turn gives sales-   children. In Singapore only the purchase of a "mini-
persons an incentive to engage in high-pressure    mum pension" is required, and in Chile a regimen of
techniques that raise costs and lead uninformed con-   scheduled withdrawals is pernitted as an alternative
sumers to wrong choices. Possible solutions here in-   to annuities. In this type of system accumulated sav-
clude regulations that limit these commissions, re-   ings are spread over the worker's expected lifetime,
quirements that salespersons be salaried rather than    though little may be left by the end for workers who
commissioned, the use of standard form contracts   live longer than average. Voluntary retirement saving
that facilitate price comparisons, the imposition of a   plans in Canada and the United States give retirees a
trial period (such as three months) during which the    choice between phased withdrawals and annuities.
workers can reverse their decisions, and the availabil-  Public pension schemes also face many of these
ity of public consumer counselors who help inform    problems, including the difficulty in insuring against
workers about choices.                               higher than expected inflation or longevity and the
Clearly, private annuities markets must be heavily   likelihood that ex ante transfers will be involved, al-
regulated, particularly if annuities become manda-    beit in a somevwhat different, less transparent way.
tory. At the very least, permissible risk categories   The risks in private plans become greater for very
must be defined, pools for bad risks created, sur-   long-term  commitments. Using private insurers to
vivors benefits required, standard contract forms    carry part of the burdeni brings to bear risk diversifi-
used, consumer information provided by some im-   cation and the accumulation of a large pool of capi-
partial organization. variable anluities offered, and a    tal for investment and backup reserves. The best so-
reserve fund created or reinsuranice purchased by in-   lution may be a combination of public pensionis and
suranice companies to ensure that they will be able to    private annuities, with the former assuming a larger
meet their obligations. Reliable mortality tables   role for the very old, and with retirees given a choice
must be constructed-these are lacking in most de-    between annuities and other withdrawal arrange-
veloping countries and should probably be a govern-    ments beyond a specified minimum.
33'






ISSUE BRIEPF.
Issue Brief 11 Simulations of Alternative Multipillar Systems
T         HIS ISSUE BRIEF SUMMARIZES A SERIES OF    is divided into poor (50 percent), middle class (33
simulations to show  the distributionlal ef-    percent), and rich (17 percent). Their relative wage
fects within and across generations of differ-    rates are 1:2:4. All pensions are assumed to be in-
ent pillars and their combinations.                         dexed to wages. The simulations investigate the suc-
cess of alternative schemes In alleviatillg poverty, re-
Simulations Based on Demographic Change                     placing wages, and providing a reasonable rate of
return on saving to deter evasion. Results are pre-
The first set of simulations is conducted for two    sented for 2065, when the system is mature, popula-
scenarios-moderate growvth, moderate aging (2 per-    tion growth is very low, and the grandchildren of the
cent interest rate, 1 percent economy-wide real wage    first retirees retire (issue brief tables 11.1 and 1 1.2).
growth plus 1 percent age-earnings wage growth) and            Aloderate Growth, Moderate Aging. The first simu-
fast growth, fast aging (5 percent interest rate, 3 per-    lation is of a universal flat benefit finaniced on a pay-
cent real wage growth plus 1 percent age-earnings    as-you-go basis set to provide 40 percent of the
wage growth) (Schwarz 1994). In each case it is as-    economy-wide  wage, which was defined  as the
sLnied that the country introduces a new  pension           poverty line. In 2065 this would require a 19 percent
system in 1995 and that the first pensioners covered    tax rate to break even. Four alternative systems were
uLnder the nexv system retire in 2005. The population       then simulated, holding the 19 percent contribution
Issue Brief Table 11.1 Alternative Pillars and Their Combinations: Moderate Aging, Moderate Growth, 2065
10 percent         13 percent        16percent
defined            defined           defined
Flat 40          19 percent        contribution      contribution       contribution
percent of          defined           and 20           and means        and minimum
average wage       contribution      percentflat       testedpension       guaranteed
Contribution rate         19                 19                19                 19                 19
Povertv elimination       *
Lifetime transfer
Poor                      +                   0                 +                 +                  +
Middle                    -                   0                 0
Rich                      -                   0                 -                 -                  -
Wage replaceoent rate offinal wage
Poor                      67                 51                60                 68                67
Middle                    34                 45                41                 39                38
Rich                      17                 41                30                 28                34
Note: The assumptions and definitions for this table begin on p. 336. denores thar poverty has been eliminated. Poverty lille is assumed
to be 40 percenit of econiomy-wide average wage. Plus anid minus denote positive anid negative transfer, respecrively. A zero denotes transfer
of less rhan 0.5 percenit of lifetime wages.
Source: Scliwarz (I994).
333



.THE  OLD  AGE CRISIS
Issue Brief Table 11.2 Alternative Pillars and Their Combinations: Rapid Aging, Rapid Growth, 2065
10 percent        13 percent        16percent
defined           defined           defined
Flat 40         19 percent        contribution     contribution      contribution
percent of         defined           and 20           and means       and minimum
average wage      contribution      percentflat      testedpension      guaranteed
Contribution rate        23                19                21                20                 18
Poverty elimination                         * i
Lifetime transfer
Poor                      0                 0                 0                 +                 0
Middle                    -                 0                 - °
Rich                      -                 0                 -                 -                 -
Wazge replacemenet rate of final wage
Poor                     81                82                84                97                81
Middle                   43                76                61                62                64
Rich                     22                72                49                49                60
Note: The assumptions and definitions for this table begin on p. 336. denotes that poverty has been eliminated. Poverty line is assumed
to be 40 percent of economy-wide average wage. Plus and minus denote positive and negative transfers, respectively. A zero denores trans-
fer of less than 0.5 percent of lifetime wages.
Source: Schwarz (1994).
rate constant: a ftnded 19 percent defined contribu-    horts have higher wages than the middle class in the
tion pillar, a 10 percent defined contribution plan    last few cohorts, yet the latter redistributes to the for-
combined with a 10 percent flat benefit, a means-    mer. It is also perverse because the 19 percent payroll
tested benefit, and a minimum  pension guarantee    tax leaves the poor better off in their retirement years
set to bring everyone to the poverty line or above.    than in their early working years; that is, their pen-
The simulations assume that costs of administration.    sion when old exceeds their net wage when young.
evasion, labor and capital market distortions, unem-    (Since the gross starting wage of the poor is 43 per-
ployment, disability benefits, and life insurance are    cent of the economy-wide average, a 19 percent tax
zero, but more qualitative analysis takes some of    rate leaves them  with a net wage of 35 percent,
these effects into account.                               which is below the poverty line, when their enter the
The flat pay-as-you-go benefit eliminates poverty    labor force.)
but is ineffective as a savings instrument, since it         The  19 percent defined contribution  plan is
yields returns far below the market interest rate and     more effective as a saving mechanism, since it avoids
very low wage replacement rates to the middle and    negative transfers, and it provides the highest re-
upper classes. It generates large intergenerational    placement rate for the top half of the population-
transfers; everyone, including the rich, gets large    but it leaves the bottom half below the poverty line.
positive transfers at the beginning, while the middle    Among the mixed schemes, both the minimum
and upper classes both get negative transfers at the    guarantee and the means-tested scheme eliminate
end. This is perverse because the rich in the early co-    poverty; the minimum  guarantee does so with the
334



best wage replacement for the rich and the lowest   poverty-and increases the preference of the middle
distortionary effect (see below). But the middle   class for the 20 percent flat plus 10 percent defined
class fares better with the combination of 10 per-   contribution-which insures them against income
cent defined contribution plus 10 percent defined   loss from interest rate declines, before they reach the
benefit.                                             poverty line.
Rapid Growth, Rapid Aging. The same defined         If a high value is placed on eliminating old age
benefit, defined contribution combinations were    poverty, the minimum  guarantee scheme will
simulated for the rapid growth, rapid aging case.   achieve this with the greatest degree of certainty, at
Rapid aging raises the costs of the 40 percent flat   the lowest cost, and has the added advantage of
benefit, which is pay-as-you-go financed, and makes    achieving better wage replacement for upper income
it practically impossible to transfer lifetime income    groups at the same time. But a word of caution: the
to the poor. The larger gap between interest rates    high tax rate required for any of these systems leaves
and wage growth raises the replacement rate yielded   low-income groups in greater poverty when they are
by the defined contribution plan. As a result, all the    young, unless a floor is set on taxable earnings.
plans eliminate poverty in this case. But the flat ben-
efit requires a higher contribution rate than before-    How Do Administrative Costs, Evasion, and Efficiency
23 percent-and produces larger intergenerational   Affect These Results?
transfers, while the minimum pension guarantee
eliminates poverty with the lowest required contri-    These results are strengthened once transaction
bution rate and the highest replacement rates for the    costs, evasion, and labor and capital market distor-
middle and upper classes, among the multipillar   tions are taken into account. Although it is difficult
schemes.                                             to predict these effects with precision, the followine
Uncertainty The "best" system therefore depends    seem indicated:
on economic and demographic conditions, as well as
on social objectives. PopLilation aging, whichi is pre-  * Administrative costs are probably higher fot
dictable, makes it very costly to reduce poverty and      the defined contribution scheme (which incurs
replace wages through a single pillar that is pay-as-     investment costs) than for the universal flat
you-go-financed. If one knew for sure that the inter-     and are probably highest for the defined con-
est rate would be relatively high, a strong case could    tribution scheme combined with the means-
be made for a pure defined contribution plan. But in      tested public pillar.
a context of uncertainty, this could leave large pock-  m Costs of evasion and labor market distortions
ets of poverty. Among the various multipillar alter-      are probably lowest for the pure defined con-
natives simulated, the poor get a larger transfer from    tribution plan, where there are no transfers.
the means-tested scheme, the rich would prefer the        and for the defined contribution plus mini-
minimum  pension guarantee, and the position of           mum  pension guarantee (top-up), where taL
the middle class is ambiguous, in a certain world.        rates for the public pillar are only 2 to 3 per-
Nevertheless, once uncertainty is taken into account,     cent and negative transfers are small; they will
this strengthens the preference of the risk-averse        be highest for the flat benefit where large neg-
poor for the guarantee-wvhich is sure to eliminate        ative transfers are involved.
335



t4:VERTING THE OLD AGE CRISIS
* The privately managed defined contributioni   tion in the United Kingdom in 1985. The study as-
scheme may enhance capital accumulation and    sumes a mature pension system and zero population
capital and labor market efficiency; this will in-   growth (so intergenerational transfers are not inves-
crease productivity but will not reduce old age   tigated), average annual wage growth of 1.5 percent,
costs if pensions are indexed to wages. It will   and a net annual interest rate of 2.5 percent.
reduce absolute poverty but not relative        Thlis study, too, finds that poverty among the old
poverty-that is, poverty relative to the    can be completely eliminated through a universal flat
economy-wide wage, so a multipillar system    benefit, but such a system provides very low wage re-
continles to be necessary for this purpose.   placement rates for upper-income groups. Making
* Once costs of administration, evasion, and    the scheme employment-related-based on years of
economiiic distortions are taken into account,   contriburions-rather than universal substantially
this raises the required contribution rate far   lowers the number of people covered and the effec-
higher than 19 percent in all multipillar sce-   tiveness of the flat pension at alleviating povery. A
narios, but least of all in the top-up scheme.  funded defined contribution scheme is effective for
* The defined contribution plan with the mini-   replacing wages, but does not eliminate poverty-old
mum  pension guarantee remains the least   people In the bottom half of rhe income distribution
costlv way to accomplish the dual goals of   get a pension that puts chem below the poverty line.
poverty elimination and saving or wage    The mixed schemes do better but some poverty re-
replacement.                                  mains, except with the top-up scheme, which elimi-
nates poverty and also achieves a reasonable wage re-
Taking Behavioral Differences among People         placement rate for all groups. The universal top-up
into Account                                       scheme helps wxomen in particular, who are disadvan-
taaged in any old age security arrangement based on
The simulations just discussed assume that every-   earnings and employment (box 7.1).
one behaves the same-entering and leaving the
labor force at the same time and being fully em-   Assumptions and Definitions for the Tables
ployed in between. In reality, of course, people have
very different patterns of labor force behavior, and  The followinig assumptions and definitions are
some people never enter the labor force or con-   used for issue brief tables 11.1 and 11.2:
tribute to the pension system. Analyzing these effects
requires detailed information about individual be-    * Columni 1: the public pillar is a pay-as-you-go
havior that is rarely available.                        flat defined benefit pegged at 40 percent of the
Nevertheless, one analysis of alternative old age     economy-wvide average wage; this is defined as
schemes for the United Kingdom  has simulated            the poverty line.
manv of these differences among individuals (Falk-    * Columni 2 is a fully funded 19 percent defined
ingham and Johnson 1993). The analysis uses a dy-       contribution plan.
namic cohort microsimulation model (vIFlMoD)          a Column 3 is a combination of a 10 percent de-
that simulates the life histories of 2,000 men and      fined contribution plan plus a 20 percent flat
2,000 women, who are representative of the popula-      benefit.
336



ISSUE B.RIEF
* Column 4 is a combination of a 13 percent de-      * All pensions are indexed to econon xy-w dx
fined contribution plan plus a meanis-tested        wages.
benefit that pays 20 percent of the economy-      * Since pensions are indexed to wages, theli
wide average wage for the poor and 10 percent        value relative to final salary grows during the
for the middle class.                               retirement period. The value given is the aver-
* Colutmn 5 is a 16 percent defined contributioni      age ratio over this period. Their value relative
plan plus a top-tip scheme (minimum pension          to the economy-wide wage is constant over the
guarantee), financed on a pay-as-you-go basis,      retirement period.
that brings everyone up to the poverty line.      * Lifetime transfers are the present vahlie of
* The population is divided into the poor, the         benefits minus lifetime contributionis, dis-
middle class, and the rich in the ratio 3:2:1.       counted at the prevailing interest rate (2 and 5
The wages of the middle class are double that        percent for slow- and fast-growth scenarios,
of the poor, and the rich are twice as well off as   respectively).
the middle class. These numbers yield an ag-      * The contribution rate is that paid by workers
gregate income distribution similar to that of      in 2065. Under pay-as-you-go it rises each year
many developing and transitional countries.         because of system  maturation and demo-
* Workers enter the labor force at age 20, retire      graphic change, but it remains constanit unlder
at age 60, and die at ages 78, 82, and 84, re-      the defined contribution funded scheme.
spectively, for each income group. Average age    * Revenue losses and expenditures stemming
at death is 80. The assumed mortality differen-      from  evasioni, strategic manipulationi, with-
tial is consistent with empirical evidence from      drawal from the labor force, unemploymenit.
many couLntries. In the defined contribution        survivors' and disability insurance, and admin-
plan, each income group is in its owIn annuity      istrative expenses are ignored. In reality this
pool, so there are no redistributions stemming      would raise total system  costs by varying
from mortality differentials.                        amounts ranging upward from 30 percent.
I In the moderate growth case real wage growth       * Distortionary effects on the labor and capital
is I percent per year for the economy as a           markets are also ignored, as are effects stem-
whole plus a I percent annual return to worker       ming from risk and uncertainty. Thus, these
experience, and the real interest rate is 2 per-     simulations ignore efficiency effects and focuLs
cent per year.                                       on1 distributional effects.
* In the rapid growth case, wage growtvh is 3 per-   * The pension system  is introduced in the
cent for the economy, I percent for experience,      year 1995 with a ten-year eligibility period.
and the interest rate is 5 percent.                  The first pensioners retire in 2005. Their
* The demography of the moderate aging case is          grandchildreni are born in 2005 and retire in
similar to that of Argentina; the rapid aging        2065; this is the cohort considered in these
is similar to that of Chinia.                       simulations.
337






1S5UE ,R(
Issue Brief 12 Simulation of an Eastern European Transition
C        ONSIDER A STYLIZED TRANSITION FROM A             a declining contribution rate to finance the
single pillar to a multipillar system in a typ-    public pillar.
ical Eastern European economy. The de-
mography of Hungary is used for this example. For      This "shock treatment" generates resources to re
the initial situation in 1995 it is assumed that all   duce the tax rate and finance the second pillar. Th
people begin working at age 20 and retire at age 55.   rise in retirement age increases GDP, the total wagc
(Although the statutory retirement age is higher,   bill, and the tax base. In 2000 the reformed publi<
early retirement, disability, and other special provi-   pillar will require a contribution rate of only 17.;
sions have brought the effective retirement age    percent, instead of 30 percent. At that point,
down to 55 in most Eastern European countries.)    mandatory saving pillar is introduced, with a 10 per-
The dominant public pillar offers an average bene-    cent contribution rate. The simulations show the
fit rate of 50 percent of the gross economy-wide av-   benefits derived from  and contribution rates re-
erage wage. A 15 percent overhead charge for ad-    quired by this multipillar system, between the year5
ministrative costs and evasion is added to system    2000 and 2065, under two alternative scenarios-
costs both in the initial situation and after the re-   slow growth (I percent annual wage growth, 2 per-
form. The initial break-even contribution rate is 30    cent real interest) and fast growth (3 percent annual
percent.                                            wage growth, 5 percent real interest). The first pen-
Reform of the public pillar begins in 1995. It has   sion from the mandatory saving pillar is received in
three components:                                    2010 and it is assumed to be wage indexed. The last
year shown is 2065, the year of retirement for chil-
1. The effective retirement age is raised one year   dren born in the first year of the reform (issue brief
per year until it reaches 60 in the year 2000.   table 12.1).
Thereafter, it is raised six months per year until  The major results:
it reaches age 65 in 2010. This means that no
retirement takes place after 1995 until 2002,     1. The current benefit rate is not sustainable with
when all new retirees are 61. (Effectively, this     a 30 percent contribution rate, as the popula-
could be achieved by eliminating special early      tion ages. By 2015 the required rate is 40 per-
retirement regimes.)                                cent, and by 2035 it is 45 percent-on top of
2. Replacement rates in the public pillar are cut      taxes for health and other purposes. The im-
to 40 percent of the gross economy-wide aver-        plied total tax rate could easily exceed 80
age wage in 2000.                                    percent-a political and economic impossibil-
3. After 2000, the real value of the pension is aug-   icy. Thus, benefits will inevitably decline-the
mented by half the rate of real wage growth an-     only questions are how and when?
nually-that is, indexation is 50 percent to       2. As a result of the reform, the dependency rate
prices and 50 percent to wages. So, if growth        and required contribution rate drop sharply by
occurs, the real value of the pension rises, but     2000 and continue to drop thereafter. Even
not by as much as the average wage, requiring       after a 10 percent contribution is allocated to
339



tERTING THE OLD AGE CRISIS
Issue Brief Table 12.1 Simulated Pension Reform in a Transitional Socialist Economy (percentlt)
Slow growth scenario'
Dependency rate                 Contribution rate b                               Benefits
Reformed       New
Paiyroll  Contribution   pblic    mandatory          New       Combined
Payroll      tax for     for new        pillar      savizgs    combined         new
Old       Reformed  tax for old   reformed   mandatory   pension!    pension!    pension!   pension!
dependency dependency   public           public       savings      average      average      average       1995
Year       rate         rate        pillar       pillar       pillar       wage '       waged         wage       pension'
1995        53           53          30           30            10           50            0           50          100
2000        55           38           31           18           10           40             0          40            86
2010        68           28           38           12           10           37             8          45           110
2020        73           36           41           14           10           35           16           51          150
2030        78           38           44           14           10           34           23           57           172
2040        81           41           45           14           10           32           31           63          208
2050        83           44           46           14           10           30           35           65          238
2065        83           44           47           13           10           28           35           63          267
Rapid growth scenario a
1995        53           53          30            30           10           50            0           50          100
2000        55           38           31           17           10           40             0          40            95
2010        68           28           38           11           10           34             8          42           135
2020        73           36           41           12           10           29            16          45           198
2030        78           38           44           10           10           25           25           50          297
2040        81           41           45           10           10           22           35           57          452
2050        83           44           46            9           10            19          40           59          631
2065        83           44           47            7           10            15          40           55          923
A'ore: DependencY rates based oni demographic trends in Hlungary as projected by the World Baiik population data base. The old depen-
dency rate is based oni a retirement age of 55. The newv dependency rate is based on a retirement age of 60 in 2000 and 65 thereafter. Labor
force participation is assumed to begin at age 20. Under the old system, the ratio of average benefits to rhe average wage is 50 percenti. As
discuissed in the text, these benefits would not have been sustainable. Under the reformed public pillar, benefits will drop ro 40 percent tl
2000: after that they are indexed 50 percent to wages anid 50 percent to prices.
a. The slow growrh scenario assumes I percent real wage growth, a I percent age-earinigs profile, and a 2 percenc real interest rate. The
rapid growth sceniario assuimes 3 percenit real wage growth, a 1 percent age-earnings profile, and a 5 percent real interest rate.
b. 'Fhese simtlations assume no unemployment, evasion, or adniihistrarive costs other thani a 15 percent overhead added to the public
pillar.
c. This is the flai benefit received by everyone, relative to the economy-wide wage, in the given year.
d. This is the average benefit rate from the mandatory saving pension, relative to the economy-wide wage received by the cohort retiring
in a given year. Wage indexation is assumned, so this bettefir rate remains constant for each cohort.
e. This is the average benefit rate from both pillars received by the cohort retiring in a given year, relative to the average pension in 1995.
Source: World Banik projections.
the second pillar, the total contribution rate is               3. The actual reduction in contribution rate may
almost cut in half by 2010. Most of the initial                    be greater for three reasons: The  10 percent
decrease is caused by the raise in  retirement                     contribution to the defined contribLution pillar
age. Subsequent decreases  are  due  to  the                       may be considered as saving, noc a tax, so eva-
change in method of indexatioll.                                   sion may decrease. For the same reason, labor
340



ISSUE BRIEF 12:
nmarket distortions may decrease, causing pro-     But offset against this is the loss of leisure time
ductivity and real wages to rise. And the accu-    as a result of their delayed retirement. The
mulationi of capital in the second pillar further  older members of this group are likely to feel
increases productivity. These productivity         they are losers, while the younger members
gains may help the economy shift from a "no-       may feel they have come out ahead. The group
growth" to a "fast-growth" scenario. This is the   of winners increases dramatically if people real-
major reason for making the transition.            ize that the old system was not sustainable and
4. The public pension also drops relative to the      that inflation is likely to erode real benefits
economy-wide average wage. But when the            sooner rather than later.
benefit from  the mandatory saving pillar is     6. The implicit social security debt to these peo-
added back in, the combined replacement rate       ple could be paid off by recapturing part of the
climbs above 40 percent for cohorts retiring in    tax cut and using it to finance higher pensions
2010 and above 50 percent for cohorts retiring     temporarily. For example, a payroll tax of 2 to
in 2020 (slow growth) and 2030 (fast growth).      4 percent between 2000 and 2020 would bring
The combined pension rises above its 1995          the wage replacement rate to more than 50
real value even sooner. The tax rate is thus       percent while keeping the total tax rate below
much lower, and by the time middle-aged            30 percent. Additionally, older workers could
workers retire, benefits are higher tinder the     be paid off by receiving a larger claim on the
new system than they would have been under         assets of privatized state enterprises.
the old system.
5. The determinationi of winners and losers de-   The Bottom Line
pends on how the rise in retirement age is val-
ued, whether the new system  has induced        After a relatively short period of loss, pensioners
growtlh, and for how  long the old system    get more for less-and the higher the wage growtlh
would have been sustainable. Workers who re-   and investment return, the more they receive. If early
tire after 2020 or 2030 (who are under 30 or   retirement was not valued highly, or if the reform
40 in 1 995) are clear winners because they pay    produces productivity gains, it should be possible to
lower taxes and receive higher benefits than    make everyone better off. The shift to a market
they would have unider the old system. Work-   economy has lowered the relative value of nonmar-
erIs and retirees who are aged 53 or older in   ket time and thereby reduced the value of early re-
1995 would seem to be clear losers, since their   tirement. So, productivity gains and their distribu-
retirement age is raised, their pension rate is  tion should dominate. Policymakers should focus onl
cut, and they do not benefit from lower taxes   two crucial questionis: Will the multipillar system
or from a buildup of savings in the second pil-   help shift the economy from  no growth or slow
lar. Workers aged 35 to 52 in 1995 are in an    growth to fast growth? And how can the current
ambiguous category. If the new system enables   group of old people, particularly its lowest-inicome
the economy to move from a no-growth to a   members, be protected from short-term loss from
fast-growth scenario, these workers receive    which later retirees are likely to benefit?
higher monetary benefits and pay lower taxes.
34I






Appendix
Table A.1 Demographic Indicators, 1990
Population    Population     Women
Population    Population    Population    over 65/      over 60/      over 60/
over 60      over 65       over 75     population    population       Men
Economzy                 years old     years old     years old      15-64        20-59         over 60
Percentage                                 Ratio
OECID
Australia                  15.0          10.7          4.1           16.0         27.3           1.2
Austria                    20.2          15.0          7.0          22.3          36.4           1.7
Belgium                    20.7          15.0          6.7          22.4          37.8          1.4
C;anada                    15.6          11.3          4.5           16.7         27.6          1.3
Denmark                    20.2          15.4          6.7          22.7          36.2          1.3
Finland                    18.4          13.3          5.6           19.8         32.8          1.6           I
France                     18.9          13.8          6.5          20.8          35.3          1.4
Germatiy                   20.3          14.9          7.2          21.7          35.2           1.7
Greece                     20.2          14.2          6.4          21.2          37.4          1.3
Iceland                    14.5          10.6          3.9           16.4         27.6          1.2
Ireland                    15.2          11.4          4.6          18.4          31.4          1.2
Italy                      20.6          14.8          6.5          21.6          37.2          1.4
Japan                      17.3          11.9          4.7           17.1         30.9           1.3
Luxembourg                 19.3          13.8          6.1           19.9         33.5          1.4
Netherlands                17.8          13.2          5.6           19.1         31.3          1.3
NewZealanid                15.2          11.1          4.4           16.7         28.6          1.2
Nonvav                     21.2          16.4          6.9          25.4          40.0          1.3
Portugal                   18.0          13.0          5.2          19.5          34.5          1.4
Spain                      18.5          13.2          5.4           19.8         34.8          1.3
Swveden                    22.9          18.0          8.1          27.8          43.5          1.2
Switzerland                19.9          14.9          6.8          21.8          34.5          1.4
United Kingdom             20.8          15.7          6.8          24.0          38.8          1.4
United States              16.6          12.3          5.0          18.7          30.3          1.4
Simple average             18.6          13.6          5.9          20.4          34.0          1.4
Weighted average           18.2          13.2          5.6           19.6         32.9           -
(Table continues on the following page.)
343



*Rt1NA THE OLD AGE CRISs
Table A.1 (continued)
Population    Population      Women
Population    Popuilation    Population     over 65/      over 60/      over 60/
over 60       over 65       over 75     population    population        Men
Economy                   years old     years old     years old       15-64         20-59        over 60
Percentage                                  Ratio
Larin America and Caribbean
Antigua and Barbuda          7.6           5.1           1.3            8.9          18.2          2.0
Argentina                   13.1           9.0           3.2           14.8          26.9          1.3
Bahamas                      6.7           4.3           0.8            6.7          13.6          1.1
Barbados                    14.8          11.3           5.1           17.3          28.6          1.4
Belize                       6.4           4.3           1.1            8.0          16.7          1.0
Bolivia                      5.4           3.4           0.9            6.3          13.1          1.2
Brazil                       6.7           4.4           1.3            7.2          14.1          1.1
Chile                        8.7           5.9           2.1            9.3          17.0          1.4
Colombia                     6.0           4.0           1.2            6.6          12.5          1.2
Costa Rica                   6.4           4.2           1.4           7.1           13.3          1.1
Cuba                        11.8           8.4           3.4           12.1          21.4          1.0
Dominica                    11.1           8.3           2.8           15.0          28.6          1.0
Dominican Rep.               5.5           3.4           1.0            5.7          11.9          1.0
Ecuador                      5.5           3.6           1.1            6.4          12.5          1.1
El Salvador                  5.6           3.6           1.0            6.8          14.5          1.3
Grenada                      9.9           6.6           2.2           11.1          20.9          1.3
Guiadeloupe                11.1           7.8           2.8           12.0          21.3          1.4
Guatemala                    4.9           3.0           0.8            5.9          12.6          1.1
yGuwana                      6.4           4.1           1.3            6.7          13.5          1.1
_   Haici                   6.2            4.1           1.2           7.3           14.4          1.2
uHonduras                   4.8            3.1           0.9           6.0           12.4          1.1
Jamaica                      8.9           6.5           2.8           11.0          19.7           1.2
Martinique                  13.3           9.7           3.6           14.7          24.6          1.4
Mexico                       5.7           3.7           1.2           6.3           12.6          1.2
Nicaragua                   4.2            2.6           0.7           5.1           10.8          1.2
Panama                       6.7           4.5           1.4            7.5          14.3          1.0
Paraguay                     5.2           3.4           1.0           6.2           12.0          1.2
Peru                         5.8           3.7           1.1           6.3           12.7          1.2
St. Kitts and Nevis        20.0           15.0           5.0          26.1           50.0          1.0
St. Lucia                    8.7           6.0           2.0           10.6          22.2          1.6
Suriname                     6.7           4.3           1.3            7.0          14.3          1.3
Trinidad and Tobago          8.3           5.7           2.0            9.3          16.9          1.2
Urugulay                    16.4          11.4           4.4           18.2          33.3          1.3
Venezuela                    5.6           3.6           1.1           6.1           12.2          1.2
Simple average               8.2           5.6           1.9            9.5          18.0          1.2
Weighted average             6.9           4.6           1.5            7.6          14.9
344



APPENo
Population    Population     Women
Population    Population    Population    over 65/      over 60/      over 60/
over 60      over 65       over 75     population    population       Men
Economy                  years old     years old     years old      15-64        20-59         over 60
Percentage                                 Ratio
Eastern Europe andformer Soviet Union
Albania                     8.1          5.3           1.9            8.7         16.7           1.2
Armenia                    11.0          6.9           2.0           10.9         21.7           1.4
Azerbaijan                  9.0          5.5           1.7            9.0         18.5           1.5
Belarus                    17.6         11.9           4.0           18.4         33.3          1.9
Bulgaria                   19.7         13.4           5.0          20.2          37.2          1.2
Croacia                    17.8         12.1           4.6           17.9         32.3          1.5
Czech Rep.                 16.9         11.8           5.0           18.2         32.3          1.5
Estonia                    17.2         11.9           4.3           18.2         32.3          1.8
Georgia                    15.9         10.8           3.5           16.5         30.3          I.6
Hungary                    19.3         13.5           5.5          20.2          35.9          1.4
Kazakhstan                  9.5          6.4           2.0           10.4         19.2          1.8
Kvrgyz Rep.                 8.5          5.6           1.7           10.0         19.6          1.6
Latvia                     17.9         12.4           4.4           18.9         33.3          1.9
Lithuania                  16.2         11.1           3.9           16.8         30.3          1.7
Moldova                    12.5          8.5           2.5           14.3         26.3          1.4
Poland                     14.8         10.0           4.0          15.4          27.8          1.5
Romania                    15.6         10.3           4.0           15.9         29.4          1.3
Russia                     16.5         11.4           3.9           17.5         31.3          2.0
Slovenia                   16.2         11.1           4.3           16.4         29.4           1.6           I
Tajikistan                  6.2          4.0           1.2           7.7          15.9           1.3
Turkmenistan                6.3          4.0           1.2           7.4          14.7          1.5
Ukraine                    18.7         13.5           4.6          20.7          35.7          1.9
Uzbekistan                  6.5          4.2           1.3           7.7          15.4          1.5
Yugoslavia, Fed. Rep. of   13.6           8.5          3.4           12.5         25.0           1.3
Simple average             13.8          9.3           3.3          14.6          26.8          1.6
Weighted average           15.3         10.5           3.7           16.4         29.7
Middle East and North Africa
Algeria                     5.4           3.7          1.3            7.0         13.7           1.2
Bahrain                     4.4          2.8           0.8           4.5           8.3          1.0
Cyprus                     14.5         10.8           4.7           16.8         27.2          1.2
Egypt                       6.4          4.1           1.2            7.3         14.4           1.2
Iran, Islamic Rep. of       4.7          3.1           0.9           5.8          11.6          1.0
Iraq                        4.4          2.7           0.7           5.4          11.3          1.1
Israel                     12.1          8.9           3.7           14.9         25.6          1.2
Jordan                      4.2           2.6          0.8            4.9         10.6           1.0
(Table continues on the following page.)
345



E :    OLD AGE CRISIS
Table A.1 (continued)
Population    Population    Women
Population    Population    Population    over 65/     over 60/      over 60/
over 60      over 65       over 75     population    population      Men
Economy                 years old     years old     years old      15-64        20-59        over 60
Percentage                                Ratio
Middle East and North Afiica (cont.)
KuLwait                    2.7           1.4          0.4           2.3          5.0           0.7
Lebanon                    8.9           5.7          2.1           9.8          20.7          1.1
Libya                      4.0           2.4          0.6           4.6          10.1          0.9
Malta                     14.1           9.9          3.7           14.6         25.4          1.4
Morocco                    5.8           3.6          1.2           6.4          13.7          1.1
Oman                       4.1           2.4          0.6           4.8          10.0          1.1
Qatar                      3.4           1.6          0.5           2.5          6.3           0.4
Saudi Arabia               4.2           2.6          0.7            5.1         10.2          1.0
Syrian Arab Rep.           4.4           2.8          0.9           5.7          11.9          1.1
Tunisia                    6.5           4.1          1.2           7.0          14.3          0.9
Turkey                     7.1           4.3          1.5           7.0          14.9          1.1
United Arab Emirates       3.0           1.6          0.4           2.3          5.1           0.5
Yemen, Rep. of             4.9           3.0          0.8           6.3          13.9          1.1
Simple average             6.2           4.0          1.4           6.9          13.5          1.0
Weighted average           5.7           3.6          1.2            5.7         13.4
Averageb                   7.0           4.7          1.6           10.0         20.0          1.1
Sub-Saharan Afiica
Angola                     5.0           3.1          0.8            5.9         12.5          1.2
Benin                      4.4           2.7          0.7           5.5          11.7          1.2
Botswana                   5.2           3.5          1.2           7.2          14.0          1.2
Burkina Faso               5.0           3.1          0.8           6.0          12.7          1.0
Burundi                    4.6           3.0          0.9           5.9          11.6          1.5
Cameroon                   5.8           3.8          1.1           7.6          15.1          1.2
Cape Verde                 6.7           4.3          1.9            8.4         17.6          1.3
C(entral African Rep.      5.5           3.0          0.6            5.5         13.4          1.1
Chad                       5.8           3.6          0.9           6.6          13.7          1.2
Comoros                    4.2           2.5          0.8           5.1          11.2          1.2
Congo                      6.1           3.9          1.0           7.7          16.0          1.4
C6te d Ivoire              4.2           2.5          0.6            5.0         10.8          1.0
Djibouti                   4.4           2.6          0.5           4.8          10.5          1.1
Equatorial Guinea          6.5           4.1           1.2          7.5          15.2          1.3
Ethiopia                   4.5           2.8          0.7           5.6          11.7          1.4
Gabon                      7.5           4.9          1.5           8.8          16.9          1.2
Garmbia, The               4.5           2.6          0.5           4.9          10.5          1.1
Ghana                      4.5           2.9          0.8            5.7         11.9          1.2
Guinea                     4.3           2.6          0.6            5.2         11.1          1.2
Guinea-Bissau              5.5           3.4          0.8           6.3          13.5          1.2
Kienya                     4.3           2.8          0.9           6.0          12.4          1.1
Lesotho                    5.7           3.6          1.0           6.8          13.8          1.3
Liberia                    4.9           3.1          1.0           6.0          12.2          1.1
346



Population    Population    Women
Population    Population    Population    over 65/     over 60/      over 60/
over 60      over 65       over 75     population    population      Men
Economy                 years old     years old     years old      15-64        20-59        over 60
Percentage                                Ratio
Sub-Saharan Africa (cont.)
Madagascar                 4.8           3.0          0.8            5.8         12.0          1.2
Malawi                     4.2           2.6          0.6            5.0         10.8          1.2
Mali                       4.9           3.1          0.9           6.3          13.1          1.0
Mauritania                 5.4           3.3          0.8           6.3          13.6          1.2
Mauritius                  8.3           5.4          1.6            8.2         15.5          1.2
Mozambique                 5.1           3.1          0.8           6.0          12.5          1.2
Namibia                    5.1           3.1          0.9           6.2          13.0          1.2
Niger                      4.2           2.6          0.6            5.1         10.9          1.2
Nigeria                    3.8           2.3          0.5           4.4           9.8          1.3
Rwanda                     4.0           2.5          0.6            5.0         10.8          1.2
Sao Tome and Principe      8.5           5.1           1.7          8.8          19.2          1.0
Senegal                    4.3           2.6          0.6            5.2         11.2          1.2
Seychelles                10.3           7.4          2.9           12.2         22.7          1.3
Sierra Leone               5.1           3.1          0.7            5.8         12.3          1.2
Somalia                    4.8           2.9          0.8            5.8         12.0          1.1
South Africa               6.2           4.0          1.2           6.9          13.5          1.3
Sudan                      4.6           2.9          0.8            5.5         11.6          1.1
Swaziland                  4.1           2.4          0.6           4.9          11.1          1.1
Tanzania                   4.7           2.9          0.9            5.8         12.3          1.1           I
Togo                       4.8           3.0          0.8           6.2          12.8          0.9
Uganda                     4.5           2.8          0.8            5.8         12.8          1.1
Zaire                      4.2           2.6          0.7            5.1         10.6          1.3
Zambia                     3.6           2.3          0.6           4.7          10.0          1.0
Zimbabwe                   3.9           2.5          0.8           4.7           9.9          1.1
Simple average             5.2           3.2          0.9            5.9         12.5          1.2
Weighted average           4.6           2.8          0.8            5.6         11.7          -
Asia
Afghanistan                3.9           2.3          0.5           4.5           9.8          1.0
Bangladesh                 4.9           3.1          1.0            5.8         12.0          0.9
Bhutan                     5.6           3.4          0.8           6.0          12.7          1.1
Brunei                     5.9           3.5          0.8            5.6         11.5          0.7
Cambodia                   5.0           2.9          0.7           4.7           9.7          1.3
China                      8.9           5.8          1.8           8.7          16.6          1.1
Fiji                       5.2           3.2          0.9            5.4         11.0          1.0
HongKong                  13.0           8.9          3.0           12.7         22.4          1.1
India                      6.9           4.4          1.2           7.4          15.0          1.0
Indonesia                  6.4           3.9          1.1           6.5          13.9          1.1
Korea, Dem. People's Rep. of  6.5        4.2          1.3           6.1          12.2          1.9
Korea, Rep. of             7.7           4.9          1.5           7.1          13.7          1.4
(Table continues on the following page.)
347



%kTlNG THE OLD AGE CRISIS
Table A.1 (continued)
Population    Population      Women
Population    Population    Population      over 65/       over 60/      over 60/
over 60       over 65        over 75     population    population        Men
Economy                   years old     years old      years old       15-64         20-59         over 60
Percentage                                   Ratio
Asia (cont.)
Lao People's Dem. Rep.       4.9           3.0            0.7            5.6          11.9           1.1
Macao                       11.1           7.4            2.4           10.8          19.2           1.1
Malaysia                     5.7           3.6            1.1            6.3          12.5           1.1
Maldives                     4.7           2.3            0.5            4.3          11.5           0.4
Micronesia, Fed. States of   5.8           3.9            1.0            7.1          14.7           2.0
Mongolia                     5.5           3.4            0.9            6.2          12.7           1.1
Myanmar                      6.5           4.1            1.2            7.0          14.3           1.1
Pakistan                     4.6           2.8           0.7             5.3          11.2           0.9
Papua New Guinea             4.9           2.7           0.4             4.7          11.4           1.0
Philippines                  5.3           3.4            1.0            5.9          11.9           1.1
Singapore                    8.5           5.6            1.9            7.8          14.3           1.1
Solomon Islands              4.7           2.8            O.6            5.6          12.7           0.9
Sri Lanka                    7.8           5.0            1.5            7.9          15.4           1.0
Taiwan (China)               9.7           6.l            1.7            9.3          18.2           0.8
Thailand                     6.0           3.8            1.1            6.0          12.2           1.2
Vanuatu                      4.6           2.6            0.7            4.8          11.1           0.4
Viet Nam                     6.7           4.5            1.4            8.1          15.6           1.4
Simple average               6.4           4.1            1.2            6.7          13.5           1.1
Weighted average             7.4           4.8            1.4            7.7          15.3
- Not available.
a. Turkev is included in the Middle East and North Africa.
b. This total excludes Bahrain, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates.
Source: World Bank staff estimates.
348



APPEN
Table A.2 Percentage of Population over Sixty Years Old, 1990-2150
Economy              1990   2000   2010   2020   2030   2050   2075   2100   2125   2150
OECDa
Australia            15.0    15.3   18.1   22.8   27.7   30.4   30.0   30.4   30.8    30.9
Austria              20.2    21.5   24.9   28.9   34.5   33.9   30.6   30.4   30.7    30.9
Belgium              20.7   22.5   24.8   28.7   32.2   31.2   30.1    30.4   30.8    31.0
Canada               15.6   16.8   20.4   25.9   30.2   30.6   30.2    30.5   30.8    31.0
Denmark              20.2   20.4   24.8    28.4   32.1   30.9   29.9   30.2   30.7   30.9
Finland              18.4   19.8   24.4    28.7   30.9   29.9   29.8    30.3   30.7   30.9
France               18.9   20.2   23.1    26.8   30.1   31.2   30.3   30.5   30.8    31.0
Germany              20.3    23.7   26.5    30.3   35.3   32.5   30.4   30.5   30.8    31.0
Greece               20.2   24.2   26.5    29.1   32.5   34.4   30.7   30.5   30.8    31.0
Iceland              14.5    14.9   17.3   21.4   26.0   29.0   29.9    30.2   30.6    30.7
Ireland              15.2   15.7   17.8   20.1   22.9   28.2   29.4   30.1   30.6    30.9
Italy                20.6   24.2   27.4    30.6   35.9   36.5   30.9    30.5   30.8    31.0
Japan                17.3   22.7   29.0    31.4   33.0   34.4   31.0    30.7   30.9    31.0
Luxembourg           19.3   21.2   25.3   29.5   33.0   30.1   30.2   30.1   30.4    30.5
Netherlands          17.8    19.0   23.4    28.4   33.4   31.7   30.2    30.4   30.8    31.0
New Zealand          15.2    15.9   18.9   22.7   26.8   29.0   29.6    30.2   30.7    30.9
Norvav               21.2   20.2   22.4   26.0   29.6   30.2   30.1    30.4   30.8    30.9
Portugal             18.0   19.8   21.4   24.6   29.7   33.0   30.2    30.3   30.7    30.9
Spain                18.5   20.6   22.4    25.6   30.9   34.2   30.3    30.3   30.7    30.9
Sweden               22.9    21.9   25.4    27.8   30.0   28.7   29.9    30.5   30.8    31.0
Switzerland          19.9   21.9   26.6   30.5   34.0   31.6   30.4    30.6   30.9    31.0
United Kingdom       20.8    20.7   23.0   25.5   29.6   29.5   29.7    30.3   30.7   30.9
United States        16.6   16.5   19.2   24.5   28.2   28.9   29.7    30.3   30.7    30.9             I
Simple average       18.6   20.0   23.2   26.9   30.8   31.3   30.2    30.4   30.7   30.9
Weighted average     18.2   19.9   23.1    27.0   30.7   31.2   30.1    30.4   30.8    31.0
Latin Americai and Caribbean
AntiguaandBarbuda     7.6    11.1   10.6   12.3   16.9   29.0   29.3    30.5   31.0    30.8
Argentina            13.1    13.7   15.1    17.2   19.3   25.9   28.6    29.7   30.4    30.8
Bahamas               6.7    7.6   10.1    12.9   18.7   25.7   28.3    29.6   30.2    30.5
Barbados             14.8    13.3   14.9   21.9   28.3   30.3   29.7    30.2   30.9    31.2
Belize                6.4     6.5    6.3    6.2   10.6   18.8   27.7   29.5   30.3    30.6
Bolivia               5.4    5.7    6.4    7.9   10.0   17.6   26.0   28.1   29.6   30.3
Brazil                6.7    7.7    9.7    13.1   16.9   24.2   27.7   29.3   30.2    30.6
Chile                 8.7    9.8   12.2   16.1   20.8   26.4   28.7    29.8   30.4    30.8
Colombia              6.0    6.7    8.7    12.6   18.0   25.5   28.0    29.4   30.2    30.6
Costa Rica            6.4    7.8   10.0    14.3   19.2   26.4   29.2   30.1   30.6    30.9
Cuba                 11.8    13.5   17.0   20.2   27.2   29.8   29.9    30.3   30.7    30.9
Dominica             11.1    11.4    9.9    9.8   14.2   26.0   30.1    30.7   31.9    31.7
Dominican Rep.        5.5    6.7    8.6    11.7   16.3   24.3   27.8    29.3   30.2    30.6
Ecuador               5.5    6.0    7.4   10.1   13.7   22.4   27.3    29.0   30.0    30.5
El Salvador           5.6    6.1    6.6    7.5   10.2   20.3   27.3    29.0   30.0    30.5
Grenada               9.9   10.8    5.7   10.0   16.5   25.2   28.3    29.6   30.5    31.5
(Table continues on the following page.)
349



_,OLD AGE CRISIS
Table A.2 (continued)
Economy              1990   2000   2010   2020   2030   2050   2075   2100   2125   2150
Latmi America and Caribbean (cont.)
Guadeloupe            11.1    12.2   14.8    17.7   24.0   27.9    29.2    30.3   30.8    31.0
Guatemala             4.9      5.1    5.4      6.6    8.8    16.2   26.4    28.7   29.9    30.4
Guyana                6.4      7.3    8.7    11.7   16.6   24.1    27.2    28.9   29.9    30.6
Haiti                 6.2      6.0    5.9      6.7    8.2   13.1   22.1    26.9   29.0    29.9
Honduras              4.8      4.8    5.4      6.7    9.3    17.2   26.7    28.9   30.0    30.5
Jamaica                8.9     9.3   10.4    13.3   19.1    26.7   29.0    30.0   30.6    30.8
Martinique            13.3    14.3   15.9    19.6   27.3   28.4   29.7    30.2   30.4    30.8
Mexico                5.7      6.6    8.3    11.2    15.7   24.6   28.3    29.6   30.3    30.7
Nicaragua             4.2      4.4    5.1      6.8     9.3   17.1   26.9    29.1   30.1    30.6
Panama                6.7      7.8   10.1    13.6   18.5   26.6   28.9    29.9   30.5    30.8
Paraguay              5.2      5.1    5.6      8.0    10.4   16.1    25.8    28.9   30.0    30.5
Peru                  5.8      6.4    7.7    10.2    13.7   21.5    26.8    28.8   29.9    30.5
St. Kitts and Nevis  20.0    14.3    8.8       5.4    14.6   23.9    24.5    26.5   26.0    26.0
St. Lucia              8.7     9.1    8.9      7.9    13.0   24.7   28.8    29.8   30.8    30.9
Surinarme             6.7      7.2    7.8    10.8    16.3   23.3    28.0    29.5   30.1    30.8
Trinidad and Tobago    8.3     9.0   11.2    14.9   19.1   25.6    28.6    29.7   30.5    30.7
Uruguay              16.4    17.8   18.7    20.3   22.5    27.8    29.3    30.1   30.5    30.9
Venezuela              5.6     6.4    8.5    11.7    15.5   23.6   28.1    29.5   30.3    30.7
Simple average        8.2      8.8    9.6    12.0   16.4   23.7   27.9    29.4   30.2    30.6
Weighted average       6.9     7.7    9.3    12.2   16.0   23.5    27.7    29.3   30.2    30.6
Eastern Europe andformer Soviet Union
Albania                  8.1     9.7    11.4    14.9   19.1    25.9    28.8    29.8   30.5    30.8
Armenia               11.0    13.4   14.5    19.6   22.1    27.9   29.1    30.0   30.6    30.8
Azerbaijan             9.0    10.9   11.3    15.9   19.9   26.8    28.7    29.8   30.4    30.8
Belarus               17.6    19.4   20.5    24.1    25.3   27.8    29.2    30.1   30.6    30.8
Bulgaria             19.7    22.8   24.9    26.3   26.7   28.7    29.2    29.9   30.5    30.8
Croatia              17.8    21.2   23.9    26.9   28.7   30.0   29.7    30.1    30.6    30.9
Czech Rep.            16.9    16.9   19.2    22.6   24.0   27.5    28.8    29.7   30.4    30.7
Estonia               17.2    19.0   20.8    23.6   25.1    27.5    29.0    30.0   30.5    30.8
Georgia               15.9    18.2   18.9    22.3    24.4   27.6   29.1    30.0   30.5    30.8
Hungary              19.3    20.9   23.1    26.7   26.8   28.8    28.9    29.6   30.3    30.7
Kazakhstan            9.5    11.5   12.9    16.7   18.8   25.8   28.1    29.4   30.3    30.7
Kvrgyz Rep.           8.5      8.7    8.8    11.8    14.2   22.5   28.1    29.5   30.3    30.7
Latvia                17.9    20.0   21.2    24.2   25.9   27.7   29.0    29.9   30.5    30.8
Lithuania             16.2    18.2   19.7    23.5   26.3   28.3    29.3    30.0   30.6    30.8
Moldova               12.5    13.8   14.7    17.3    17.8   25.3    28.1    29.4   30.3    30.7
Poland               14.8    16.2   17.5    22.2   23.3   26.8   28.5    29.6   30.3    30.7
Romania               15.6    17.8   17.9    20.2   21.9   26.1    28.1    29.4   30.2    30.6
Russia                16.5    18.7   20.5    24.4   24.9   27.6    29.0    29.9   30.5    30.8
Slovenia              16.2    19.4   22.7    26.5   29.1    31.6   30.0    30.2   30.6    30.9
Tajikistan            6.2      6.2    6.0      8.2    10.8    19.3   28.0    29.5   30.3    30.7
Turkmenistan           6.3     6.5    7.0    10.2   13.1   21.8    27.4    29.0   30.1    30.5
Ukraine               18.7    21.3   22.1    24.5   25.5   27.5   29.1    30.0   30.5    30.8
350



Economy              1990   2000   2010   2020   2030   2050   2075   2100   2125   2150
Eastern Europe andformer Soviet Union (cont.)
Uzbekistan            6.5      6.7    7.0    10.2    13.2   22.1    28.1    29.5   30.3    30.7
Yugoslavia, Fed. Rep. of  13.6    17.3   18.8    22.2   24.9   27.5    28.9    29.9   30.5    30.8
Simple average        13.8    15.6    16.9   20.2    22.2    26.6   28.8    29.8    30.4    30.8
Weighted average      15.3    17.0    18.2   21.5    22.7   26.5    28.7    29.8    30.4   30.8
Middle East and North Africa
Algeria                5.4     5.4    5.7      7.6    10.9    19.4   27.7    29.2   30.1    30.6
Bahrain               4.4      5.4    8.7    13.8   14.4   17.4   26.5    29.4   30.2    30.7
Cyprus                14.5    16.0   18.8    22.7   26.2   28.8    29.8    30.3   30.8    30.9
Egypt                 6.4      7.0    7.9    10.6   12.9   20.2    26.0    28.2   29.6    30.3
Iran, Islamic Rep. of  4.7     4.6    5.0      5.8     6.6    9.1    16.2    25.6   29.4    30.3
Iraq                  4.4      4.5    5.0      6.0    7.6    14.1    25.3    28.7   29.9    30.4
Israel                12.1    10.2   12.1    16.4   21.3    27.0   29.5    30.3   30.8    30.9
Jordan                 4.2     4.6    5.2      6.7    10.3   17.1    27.0    29.2   30.1    30.6
Kuwait                2.7      5.6   10.8    17.6   20.4    27.3    29.2    30.1    30.7    30.9
Lebanon                8.9     9.0    7.9      8.5    11.9   20.4    26.9    28.8   29.9    30.5
Libya                 4.0      4.4    5.0      5.5    6.1      9.9    18.9    28.0   29.9    30.5
Malta                14.1    16.4   20.6    24.3    25.6   27.8    29.0    29.7   30.3    30.6
Morocco                5.8     5.9    6.1      8.4    11.3    18.7   26.4    28.4   29.7    30.4
Oman                  4.1      4.4    5.4      6.4    7.1    11.8   23.0    29.2   30.2    30.6
Qatar                 3.4      5.7   10.0    14.0    14.3   17.3   26.4    29.3   30.2    30.6
Saudi Arabia          4.2      4.3    5.1      6.4    7.0    11.6   22.6    28.8   30.0    30.5
Syrian Arab Rep.      4.4      4.3    4.2      5.2    7.0    13.0   24.5    29.0   30.1    30.6
Tunisia                6.5     7.3    7.4    10.5    14.9   23.1    27.7    29.3   30.2    30.6
Turkey                7.1      8.3    9.5    12.1    16.0   23.0   27.6    29.3   30.2    30.6
United Arab Emirates  3.0      5.8   12.7    21.0   20.1    21.5    28.6    29.8   30.4    30.8
Yemen. Rep. of         4.9     4.2    3.4      2.8    3.5    6.1    14.0    23.7   27.3    29.0
Simple average        6.2      6.8    8.4    11.1    13.1    18.3   25.4    28.8   30.0    30.5
Weighted average       5.7     6.0    6.5      8.0    9.8   14.5   21.6    27.3   29.5    30.3
Averageb               7.0     7.3    8.1    10.0   12.4   18.1   25.0    28.6   29.9    30.5
Sub-Saharan Africa
Angola                 5.0     4.9    4.7      4.8    5.3    8.1    16.9    25.3   27.7    29.1
Benin                 4.4      4.2    4.1      4.6     5.7    11.2   20.9    25.8   28.2    29.4
Botswana              5.2      4.8    5.4      7.3    10.3   20.9    27.7    29.2   30.2    30.6
Burkina Faso           5.0     4.6    4.3      4.1    5.1      8.5    17.6    24.9   27.5    29.0
Burundi               4.6      3.6    3.2      4.0    4.7    7.4    16.7    25.3   27.7    29.1
Cameroon               5.8     5.2    5.0      5.5    6.5    12.0   22.3    27.1   29.1    30.0
Cape Verde            6.7      5.4    3.7      4.6     8.6    15.2   26.6    29.0   30.2    30.6
Central African Rep.  5.5      6.1     5.6     5.2    6.1    10.7   20.3    25.6   28.1    29.4
Chad                   5.8     5.8    5.8      6.0    6.5    9.5    18.7    25.3   27.8    29.2
Comoros               4.2      3.9    4.2      4.6     5.7    11.0   21.7    27.0   29.1    30.0
Congo                 6.1      5.1    4.2      4.4     5.6    9.3    19.1    26.8   28.9    29.8
(Table continues on the following page.)
35I



iY~TIN G  THE OLD AGE CRISIS
Table A.2 (continued)
Economy              1990   2000   2010   2020   2030   2050   2075   2100   2125   2150
Sub-Saharan Africa (coont.)
C6ted'lvoire          4.2      4.2    4.2      4.7     5.7   10.5   20.9    27.2   29.1    30.0
Djibouti              4.4      4.5    5.2      5.9     6.5   10.4    19.7    25.7   28.2    29.4
Equitorial Guinea      6.5     6.7    6.6      7.0     7.7   10.9   20.2    25.1   27.8    29.2
Ethiopia              4.5      4.1    3.9      3.9    4.2      6.8   15.1    25.0   27.8    29.2
Gabon                 7.5      7.1     6.5     6.5     6.7    9.2    18.9    26.4   28.7    29.7
Gambia, The           4.5      4.8    4.9      5.2    5.3    7.7    15.8    24.1   26.9    28.6
Ghana                 4.5      4.5    4.7      5.4     6.8   12.3   22.1    26.5   28.7    29.8
Guinea                4.3      4.2    4.0      4.3    4.9    7.6    15.8    24.0   26.8    28.6
Guinea-Bissau          5.5     4.9    4.3      4.1     4.9     8.0    16.0    22.0   25.2    27.6
Kenya                 4.3      3.9    3.6      4.4     5.9    11.7   22.6    27.8   29.5    30.2
Lesotho               5.7      5.7    6.1      6.8    8.2    14.4   24.0    27.2   29.1    30.0
Liberia               4.9      5.0    5.4      6.0    7.5    13.1    22.7    27.1   29.1    30.0
Madagascar            4.8      4.6    4.7      5.4     6.7   11.9   21.3    25.7   28.1    29.4
Malawi                4.2      3.9    3.8      3.8    4.3      6.8   15.0    24.8   27.6    29.1
Mali                  4.9      4.5    4.3      3.9    4.5      7.8    16.1    24.6   27.5    29.0
Mauritania            5.4      5.1    4.6      4.1     4.6     6.9   14.9    24.2   27.1    28.8
Mauritius             8.3      9.4    11.7    17.3   23.4   28.8   29.1    29.8   30.4    30.7
Mozambique             5.1     4.6    4.2      4.2    4.8    7.5    16.6    25.3   27.7    29.1
Namibia               5.1      5.0    5.2      6.0    7.6   14.1    24.3    27.9   29.5    30.2
Niger                  4.2     4.1     3.9     3.9    4.1      5.9    13.2    23.3   27.0    28.8
Nigeria               3.8      4.0    4.4      5.1     6.5   11.7   20.6    25.7   28.1    29.3
Rwanda                4.0      3.7    3.4      3.3    3.8    6.0    14.3    24.3   27.9    29.3
Sao Tome and Principe    8.5   7.3    8.1      9.1    10.8    18.8   26.9    28.6   30.1    30.7
Senegal               4.3      3.7    3.5      3.7    4.3      7.6    17.2    25.1    27.7    29.1
Seychelles            10.3    10.7   10.8    12.0   17.6   24.6    27.7    28.7   28.5    29.0
Sierra Leone          5.1      5.2    5.0      5.0    5.2    7.7    15.6    23.7   26.4    28.3
Somalia               4.8      4.7    4.6      4.8     5.4    8.4    17.1    25.0   27.6    29.0
SouthAfrica            6.2     6.7    7.8      9.8    12.4   18.9   26.7    28.7   29.9    30.5
Sudan                 4.6      4.7     5.0     5.6     6.6   11.2   20.6    25.8   28.2    29.4
Swaziland             4.1      3.9    4.2      4.9     6.1   11.7   22.0    27.0   29.1    30.0
Tanzania              4.7      4.2    4.0      3.9    4.5      7.6    16.7    24.9   27.5    29.0
Togo                  4.8      4.5    4.4      4.7    5.8   10.9   21.0    26.3   28.6    29.7
Uganda                4.5      3.8    3.1      3.1    4.1     7.8    17.0    24.8   27.5    29.0
Zaire                 4.2      4.3    4.4      5.0     6.1   10.7   20.7    26.4   28.7    29.7
Zambia                3.6      3.2    3.0      3.4    4.4    8.9    19.5    26.7   28.9    29.8
Zimbabwe              3.9      4.2    4.9      6.8     9.6    18.3   26.0    28.9   30.0    30.5
Simple average         5.2     5.0    4.9      5.5    6.8    11.2   20.0    26.1   28.3    29.5
Weighted average       4.6     4.4    4.5      4.9     5.9    9.9    18.8    27.7   28.1    29.4
Asia
Afghanistan            3.9     3.9    3.9      4.2    4.7    7.0    14.2    22.5   25.6    27.8
Bangladesh            4.9      5.4    6.0      7.6   10.1    17.4   22.6    26.2   28.4    29.5
Bhutan                 5.6     5.5    5.7      6.3    7.3    11.0   20.1    25.2   27.8    29.1
Brunei                 5.9     7.1    9.6    14.6   18.6   23.9   29.2    30.1    30.6    30.8
Cambodia              5.0      5.6    7.2    10.1    13.0   16.9   23.3    26.6   28.7    29.8
352



APPENI
Economy              1990   2000   2010   2020   2030   2050   2075    2100   2125   2150
Asia (cont.)
China                  8.9    10.2   12.0    16.0   21.9   26.1    28.3    29.6   30.4    30.7
Fiji                  5.2      6.8    9.3    12.6    15.6   23.5    27.2    28.9   29.9    30.4
Hong Kong             13.0    15.6   18.8    27.3   33.9    35.2    30.9    30.6   30.8    31.0
India                 6.9    7.5    8.3    10.3   13.1   20.4    25.7    27.9   29.5    30.2
Indonesia             6.4      7.3    8.3    10.9   14.1    21.7   25.5    27.8   29.3    30.1
Kiribati              4.3      8.3    8.2      7.3    10.7    16.7   23.8    27.5   29.7    30.3
Korea, Dem.
People's Rep. of    6.5     8.2   10.5    14.9   21.9    26.5    28.8    29.9   30.5    30.8
Korea, Rep. of        7.7    10.7   13.9    19.5   25.5    29.8   29.1    29.8   30.4    30.7
Lao People's Dem. Rep.   4.9   4.8    4.9      5.2    5.8    9.4    19.3    25.8   28.1    29.4
Macao                 11.1    11.4   14.4    22.2   27.9    28.2   29.0    30.1    30.8    30.8
Malaysia               5.7     6.5    8.0    11.0    14.5   22.1    28.3    29.6   30.4    30.7
Maldives              4.7      5.7    5.4      5.5    7.0    13.0   23.6    27.9   29.8    30.3
Micronesia, Fed. States of 5.8  6.1    5.5     8.2   10.8   19.8    27.9    29.4   30.3    30.8
Mongolia              5.5      5.9    6.9      8.3    11.1    18.4   26.9    28.8   29.9    30.5
Myanmar               6.5      7.2    7.7      9.9   13.4   20.9    26.5    28.5   29.8    30.4
Nepal                  5.2     5.7    6.4      7.3    8.5    14.2   22.8    26.3   28.5    29.6
Pakistan              4.6      4.7    4.9      6.3    8.4    14.2   22.8    26.7   28.8    29.8
Papua New Guinea      4.9      5.1    5.7      6.5    8.5    15.0    23.9    26.8   28.8    29.8
Philippinies          5.3      5.9    7.3    10.1    13.5   22.3    27.0    28.8   29.9    30.5
Singapore             8.5    10.9   15.6    23.9   29.4   29.8    29.6    30.1    30.6    30.9
Solomon Islands        4.7     4.9    5.4      6.6    8.7    16.3    26.4    28.9   29.8    30.4
Sri Lanka             7.8      9.2   12.0    16.2   20.6   27.0    28.7    29.8   30.4    30.8            I
Taiwan (China)         9.7    12.0   14.1    20.6   26.1    30.8    29.8    30.1    30.6    30.8
Thailand              6.0      7.4    9.1    12.8    18.0   25.3    27.8    29.2   30.1    30.6
Vanuatu                4.6     4.9    5.3      6.9    9.1    15.7   25.2    28.8   30.0    30.4
Viet Nam               6.7     6.6    6.6      9.2    13.7   22.2    27.4    29.2   30.1    30.6
Simple average        6.3      7.3    8.6    11.6    15.0   20.7    25.9    28.3   29.6    30.3
Weighted average       7.4     8.3    9.5    12.3    16.3   22.1    26.2    28.3   29.6    30.3
- Not available.
a. Turkey is included in the Middle East and North Africa.
b. This total excludes Balirain, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates.
Source: World Bank staff estimates.
351



G  THE OLD AGE CRISIS
Table A.3 Average Annual Compound Real Growth Rate of Wages,
Selected Periods
(3)
Longest
(1)       (2)      period    Years for
Country               1970-88   1980-88   available  column 3
Low-income economies
Afghanistan              -         -1.0      -1.0    (1980-88)
Bangladesh              -1.9      -1.5       -1.9    (1970-88)
Burkina Faso             -          -          6.0    (1974-83)
Burundi                             -         -4.9    (1971-83)
Ethiopia                            0.3        0.3    (1980-88)
Haiti                    0.6        5.8        0.6    (1970-88)
Kenya                    -          1.0        1.0    (1980-88)
Nepal                    -          -          0.6    (1977-87)
Somalia                  -          -         -9.3    (1967-86)
Sri Lanka                -          -          1.7    (1966-81)
Togo                     -          -         -0.2    (1974-84)
Simple average          -0.7        0.9
Lower middle-income economies
Argentina                0.1      -0.3         1.9    (1963-88)
Bolivia                 -4.5       -9.3       -4.5    (1970-88)
Cameroon                 -          -          3.6    (1970-84)
Chile                    5.4        0.5        6.6    (1963-88)
Colombia                 0.6        1.6        1.0    (1963-88)
Congo                    -          -          4.7    (1968-85)
Ecuador                  2.7      -0.7         2.4    (1963-88)
Guatemala                -         -1.5      -1.5    (1980-88)
Malaysia                 2.7        3.8        2.7    (1970-88)
Nicaragua                -          -         -5.7    (1972-85)
Philippines              0.3        6.4        0.4    (1963-88)
Turkey                   0.8      -2.8         2.3    (1963-88)
Zimbabwe                 0.9      -0.4         0.9    (1970-88)
Simple average           1.0       -0.3
354



(3)
Longest
(1)        (2)       period     Yearsfor
Country                  1970-88   1980-88    available   column 3
Upper-middle-income economies
Barbados                   -           -           4.2    (1976-87)
Cyprus                      5.2        4.5         4.7    (1963-88)
Czech Rep.                  1.5        0.7         1.5    (1970-88)
Hungary                    -           2.9         2.9    (1980-88)
Korea, Rep. of              7.1        5.3         7.1     (1970-88)
Maltaa                      5.8        1.4         5.6    (1963-88)
South Africa               -           0.5         0.5    (1980-88)
Uruguay                    -           2.2         2.2    (1980-88)
Yugoslavia, Fed. Rep. of   -0.2       -1.4        -0.2    (1970-88)
Simple average              3.9        2.0
High-income economies
Australia                   1.6        0.3         2.1    (1963-88)
Austria                     2.9        2.0         3.3    (1963-88)
Canada                      1.0        0.1         1.5    (1963-88)
Denmark                     1.6        0.6         2.2    (1963-88)
Finland                     2.7        2.6         3.0    (1963-88)
Ireland                     3.4        2.6         3.5    (1963-88)
Israel                     3.4        -4.2         3.9    (1963-88)
Italy                       2.7        1.2         2.7    (1970-88)
Japan                       2.8        1.8         4.3    (1963-88)
Luxembourg                  1.9        0.9         2.9    (1963-88)
Norway                      1.8        1.2         2.1    (1963-88)
Portugal                    2.0        1.2         2.9    (1963-88)
Singapore                   4.0        5.1         3.6    (1963-88)
Spain                       2.6        0.5         3.7    (1963-88)
Sweden                      0.3        0.4         1.1    (1963-88)
United Kingdom              2.4        2.9         2.6    (1963-88)
United States               0.4        0.7         0.5    (1963-88)
Simple average              2.2        1.2
Simple world average        1.9        0.8
- Nor available.
a. Data through 1987.
SoUrces: UNIDO data base, World Bank (1992); World Bank staff estimates.
35'



TiNG; THE OLD AGE CRISIS
Table A.4 Public Pension Scheme Coverage, Selected Countries
(1)              (2)               (3)              (4)
Pensionersl                         Covered
Yearfor       Contributorsl        persons         Pensionersl       wage bill
Count7y                column 1         labor forcea        over 60        contributors        GDPb
Percentage
Sub-Saha ran Africa
Burundi                   1989              4.7               4.7             17.5               5.4
Cameroon                  1989             13.7               -                 -                6.9
Chad                      1989              1.1
C6ie d'lvoire             1989              9.3               5.7              12.3
Ghana                     1989             13.2                -                -               15.7
Madagascar                1989              8.2               4.1               8.0
Mali                      1989              2.5               -                 -
Nlauririus'               1987               -              100.0               -               12.5
Niger                     1990              2.8               -                 -                4.4
R vanda                   1989              9.3               5.6              4.9              10.7
Tanzania                  1990              5.1                -                -                6.3
Zambia                    1989             13.8               -                 -                7.9
Unweighted average        -                 6.4              24.0              8.5               8.7
Asia
Bangladesh                1985              3.5               -                 -
China                     1989             23.7              22.5              13.9
Hong Kong'                1990               -               50.0
India                     1990             10.5               -                 -                3.4
Indonesia                 1991             12.4               9.8               -                1.7
Malaysia                  1991             44.6               -                 -               20.6
Pakisran                  1989              3.8               -                7.7               1.2
Philippines               1990             19.1               7.0              12.5              8.3
Singapore                 1990             75.8               -                 -               35.3
Sri Lanka                 1990             18.4               -                 -               11.4
Unweighted average        -                23.5              22.3              11.4             11.7
Latin America nnd Caribbean
Argentina                 1989             53.2              72.4             66.7
Bolivia                   1985             16.9              17.8             32.3               4.4
Brazil                    1989             50.3              47.1             40.0
Chile                     1992             62.2
Colombia                  1989             24.5              10.0               9.3              9.5
Cosca Rica                1989             54.2              36.4              11.8             23.6
Ecuador                   1989             37.8              21.5               8.8              8.6
El Salvador               1989             12.4               4.3               6.9              9.7
Guatemala                 1986             27.0              13.0               6.0              6.6
Honduras                  1990             18.7               -                 -                9.4
Jamaica                   1991             40.1              27.0              13.2              8.1
Mexico                    1988             40.2                -                -               10.0
356



(1)               (2)              (3)               (4)
Pensionsers!                         Covered
Yearfor        Contributorsl       persons         Pensioners!        wage bill
Country                 column 1         Iaborforcea         over 60        contributors         GDpb
Percentage
Latin America and Caribbean (cont.)
Nicaragua                 1989              22.7              19.9              11.9
Panama                    1990              39.5              31.9              13.0              35.8
Peru                      1992              25.7              17.6               -                 9.7
Trinidad and Tobago       1989              60.7                -                9.4
Uruguay                   1989              68.8              81.7              47.6              22.8
Venezuela                 1990              34.3              30.0              10.9               8.9
Unweighted average         -                38.3              30.8             21.0               12.9
OECD d
Australia'                1990                -               74.3               -
Austria                   1990               -                                  58.8              33.5
Canada'                   1989               -                75.2               -                30.0
Denmarkc                  1990               -                87.5               -
Finlandc                  1990               -                96.9               -
Germany                   1990              93.6              88.0               -                36.3
Icelandc                  1990               -                75.7               -                26.7
Japan                     1990              94.5              68.5              21.7              21.4
Netherlands               1990              93.6              80.7               -                49.3
New Zealandc              1990               -               100.0               -                 -
Norwayc                   1990               -                81.1               -                 -
Spain                     1992              85.3              80.0              45.5              29.4
Sweden                    1990               -                88.4              37.0               -
Switzerland               199(              99.4              98.0              41.7              60.0
United Kingdom            1990              94.2              83.6               -
United States             1989              96.7              82.9              30.3              38.5
Unweighted average         -                93.9              84.1              39.2              36.1
Mliddle East and North Africa
Egypt                     1989              62.2               -                 -                 -
Israel                    1985               -                91.0               -                37.5
Morocco                   1989              17.4              20.0              22.2               5.6
Tunisia                   1990              50.9              42.1              14.9              16.7
Turkey                    1990              34.6              76.9              45.5               3.8
Unweighted average         -                41.3              57.5              27.5              15.9
- Not available.
a. Workers conitributing during the past year.
b. This usually refers only to che main public pension scheme.
c. The maini benefit is a universal flat or means-tested pension financed by general reveniues.
d. Turkey is included in rhe Middle East and North Africa.
Sourlce: Palacios (1994a. b).
357



OLD AGE CRISIS
Table A.5 Public Pension Spending Indicators (percentages)
Pension spentding   Earmarkedpayroll
for public employeesl   tax minus benefit
Public pension      Public pension         total public         spending/
Country                spending /GDP       spending/GOVa        pension spending      benefit spending
OECD'
Australia                   3.9                 16.0                   -                    n.a.
Austria                    14.8                 37.9                 29.9                  -18.0
Belgium                    11.0                 17.6                 30.6                  -17.0
Canada                      4.2                 19.1                  5.8                   n.a.
Denmark                     9.9                 24.8                 11.8                   n.a.
Finland                    10.3                 34.3                   -                    n.a.
France                     11.8                 25.8                 20.5                  -32.0
Germany                    10.8                 34.4                 17.7                  -18.0
Greece                     12.3                 30.6                 18.8                  -80.0
Iceland                     4.8                  -                     -                    n.a.
Ireland                     6.1                 15.7
Italy                      14.4                 37.0                 15.6                  -39.0
Japan                       5.0                  -                    2.5                  -32.0
Luxembourg                 12.0                 25.4                 30.1                  -26.0
Netherlands                 9.8                 17.9                 22.0                  -28.0
New Zealand                 7.5                 15.6                   -                    n.a.
Norway                     10.1                 22.3                   -                    n.a.
Portugal                    7.7                 18.9
Spain                       7.5                 23.2
Sweden                     11.6                 28.1                   -                   -32.0
Swiczerland                 9.9                  -                     -                   -29.0
Unired Kingdom              9.5                 24.1                   -                     -
United States               6.5                 24.5                 25.9                   -3.0
Average                     9.2                 24.7                 19.3                  -29.5
Latin America and Caribbean
Argentina                   4.6                  -                     -                   -17.0
Belize                      1.1                                      92.2                1,028.0
Bolivia                     1.5                  1.1                   -                    22.0
Brazil                      2.9                 10.6
Chile                       5.7                 27.5                   -                   -56.0
Colombia                    0.8                  5.9                 39.3                   23.0
Costa Rica                  3.7                 12.0                 49.5                   91.0
Dorminica                   -                    -                     -                   277.0
Dominican Rep.              0.1                  -                     -                   228.0
Ecuador                     1.1                  5.7                  6.8                   56.0
El Salvador                 0.4                  3.4                 22.5                   13.0
Grenada                     1.5                  -                   92.9                  125.0
Guatemala                   0.4                  2.0                   -                    54.0
Guyana                      1.4                  -                     -                    37.0
Honduras                    0.2                  0.7                 42.4                  324.0
Jamaica                     0.7
Mexico                      1.0                  1.5                 35.6                  117.0
Nicaragua                   0.8                  2.8
358



Pension spending    Earmarkedpayroll
for public employees/   tax minus benefit
Public pension      Public pension         totalpublic          spendingl
Country                spending/GDP        spending/GOV'        pension spending      benefit spending
Latin America and Caribbean (cont.)
Panama                      5.1                 19.7                 10.8                   -9.0
Paraguay                    0.4                  3.7                   -                     -
Peru                        0.7                  4.1                   -                    32.0
Trinidad and Tobago         3.4                  9.6
Uruguay                     8.8                 33.4                   -                   -18.0
Venezuela                   0.5                  1.5                   -                     8.0
Average                     2.0                  8.5                 43.6                  122.9
Eastern Europe andformer Soviet Union
Albania                     7.9                 13.4
Armenia                     3.6
Azerbaijan                  5.6                 18.3
Belarus                     7.3                 14.8
Bulgaria                    7.9                 21.5
Czech Rep.                  8.2                  -                     -                   -50.0
Estonia                     6.9
Georgia                    11.0                 31.0                   -                     -
Hungary                     9.7                 18.6                   -                    -7.0
Kazakhstan                  4.7                 10.3
Kyrgyz Rep.                 6. 1                 -                     -
Latvia                      6.7                                                                              I
Lithuania                   6.6                  -                     -                     -
Poland                     12.4                 24.8                   -                   -50.0
Romania                     6.9
Russia                      7.1
Slovenia                    9.3
Ukraine                    13.0                  -                     -                      _
Uzbekistan                 10.3
Average                     8.0                 19.1                   -                   -35.7
Middle East and North Africa
Bahrain                     0.4                  0.9                 41.6
Cyprus                      4.0                 13.7
Egypt                       3.0                  5.8                 40.0                   93.0
Israel                      4.3                  8.9                 22.3                  -41.0
Jordan                      0.3                  0.8                   -                   528.0
Kuwait                      3.1                  5.3
Malta                       9.5                 23.8
Morocco                     1.2                  -                   72.9                  -30.0
Syrian Arab Rep.            0.3                  0.8
Tunisia                     2.5                  -                   39.7                    6.0
Turkey                      2.4                 11.3                 34.4                  -21.0
Average                     2.8                  7.9                 41.8                   89.2
(Table continues on thefollowing page.)
359



,tT1JNCG THE OLD AGE CRI-SIS
Table A.5 (Continlied)
Pension spending     Earmarked payroll
for public employees!    tax minus benefit
Pitblic pension       Public pension         total public            spendingl
Country                 spending /GDP         spending /GOV,        pension spending       benefit spending
Sub-Saha ran Africa
Benin                         0.3                   -                    64.9                    13.0
Burkina Faso                  0.7                   5.8                  68.7                   133.0
Burundi                       0.3                   0.9                  38.1                   163.0
Carneroon                     0.2                   -                    68.5                   668.0
Central African Rep.          0.3                   -                      -                     28.0
Chad                          0.0                   0.2                    -                    977.0
Ethiopia                      1.1                   2.9                 100.0                    36.0
Gabon                         0.7                   1.7                  30.0                    36.0
Guinea                        0.0                   -                      -                     13.0
Kenva                         0.5                   2.1                    -                    243.0
Malawi                        0.4                   1.3
Mali                          0.7                   2.5                  71.1                     -5.0
Mauritania                    1.4                   -                    84.0
Mauritius                     2.6                   -                      -                      n.a.
Mozambique                    0.0                   -                   100.0                   -43.0
Niger                         0.2                   -                    71.0                    55.0
Nigeria                       -                     -                      -                    485.0
Rwanda                        0.3                   -                      -                    263.0
Senegal                       0.9                   -                      -                     79.0
Sudan                         0.0                   -                      -                    354.0
-   Swaziland                 0.3                   1.3                  41.5                   294.0
Tanzania                      0.2                   1.4                    -                    237.0
Togo                          0.4                   1.0                    _
Uganda                        0.0                   0.0
Zaire                         -                     -                      -                    274.0
Zambia                        0.3                   1. I
Average                       0.5                   1.8                  67.1                   204.9
Asia
Bangladesh                    0.0                   0.1                  84.9                   159.0
China                         2.6                  10.7
Fiji                          8.5                  14.7                    -                     81.0
India                         0.6                   8.3                  75.5
Indonesia                     0.1                   -                      -                    856.0
Malaysia                      1.6                   5.8                   57.3                  192.0
Pakistan                      0.6                   2.3                  95.5
Philippines                   0.6                   3.2
Singapore                     2.2                  34.6                    4.0                   25.0
Sri Lanka                     2.2                   6.9                  89.3                     19.0
Average                       1.9                   9.6                  67.7                   222.0
-Not available.                                             Note: This table refers to penision spending for years
a. GOV denotes government spending for the same year.       ranging from 1985 to 1992.
Source: See Palacios (1994a, b) for ftirther description of data alid sources.  b. Turkey is included in the Middle East and North Africa.
36o



APPEN.l<i
Table A.6 Publicly Managed Pension Scheme Financing,
Selected Countries, 1986
Receipts            Share of receipts from
as a percentage of Payroll    Investment    General
Country          GDP          taxes       income       revenues
OECD
Australia'        4.7          0.0          2.0         98.0
Austria          16.1         79.0          0.2         20.0
Belgium          10.3         76.0          2.1         21.0
Canadaa           6.3         30.0         27.6         42.0
Denmarka          9.6          17.0         7.9         76.0
Finland           7.4         84.0         16.0          0.0
France            9.3         86.0          4.0         10.0
Germanyb          11.4        74.1          0.6         25.0
Icelanda          2.7         20.0          0.0         80.0
Italyc            7.4         73.0          0.4         26.0
Japan             7.6         46.0         20.2         33.0
Luxembourg       14.3         60.0          6.4         33.0
Netherlands       14.8        70.0         28.3          2.0
New Zealanda      -            -            -          100.0
Sweden            14.7        57.0         23.4         19.0
Turkey            2.3         63.0         23.3         13.0
Swirzerlandb      8.0         72.7          5.9         21.4
United States     8.4         68.0         19.4         12.0
Average            9.1        57.4         11.0         35.1
Latin Ameriaa an. Caribbean
Argentina          5.1        74.a          0.0         26.0
Bahamasb          -           59.6         37.3          3.2
Belizec            1.4        63.0         36.6          0.0
Bolivia           1.7         49.0         14.1         36.0
Colombia           1.5        66.0         10.1         23.0
Costa Rica        4.7         64.0         21.6         14.0
Dominica          2.3         72.0         27.0          0.9
Dominican Rep.    0.0         77.0          1.4         21.2
Ecuador           3.0         58.0         15.4         26.0
El Salvador       0.7         55.8         44.2          0.0
Guatemala         0.5         66.0          0.0         33.9
Guyana            6. 1        38.0         62.0          0.0
Honduras           1.5        52.0         45.5          2.0
Jamaicab           1.4        44.0         50.8          5.2
Mexico            1.3         72.0          3.7         24.3
Panama            5.2         68.0         27.2          4.6
Peru              0.0        100.0          0.0          0.0
Uruguay           6.4         92.0          1.1          6.9
Venezuela          1.0        42.0         39.0         20.0
Average           2.4         63.8         23.0         13.0
(Table continuies on the following page.)
361



_1A 9 :OLD AGE CRISIS
Table A.6 (continued)
Receipts             Share of receipts from
as a percentage of Payroll    Investment    General
Country           GDP          taxes       income       revenues
Eastern Europe andformer Soviet Union
Albaniad           -           50.0          0.0         50.0
Bulgariae          6.3         75.0          0.0         25.0
Czech Rep.         7.9          -            -            -
Hungaryd          10.4          9.3          0.1          1.0
Poland            8.5          85.0          1.0         13.7
Romania'           6.2         96.0          0.0          4.0
Yugoslavia,
Fed. Rep. of    8.0         96.0          0.0          4.0
Average            7.9         68.6          0.2         16.3
Middle East and North Africa
Bahrain            2.6         64.0         36.7          0.0
Egypt              8.1         63.0         14.0         22.9
Israel            4.6          69.0         10.5         21.0
Jordan             2.4         83.0         16.7          0.0
Kuwait             7.5         18.0         21.1         61.0
Morocco            1.5         59.0         14.5         26.1
Tunisia            3.8         86.0          8.9          5.1
Average            4.4         63.1         17.5         19.4
Sub-Saharan Africa
Benin               0.4          95.6          4.4          0.0
Burkina Faso       0.8         60.0         39.2          0.6
Burundi            0.4         70.0         30.8          0.0
Cameroonc          0.7         66.0         33.8          0.0
Cape Verde         1.1        100.0          0.0          0.0
Central African Rep. 0.3      100.0          0.0          0.0
Cote d'Ivoire      0.7         65.0         35.5          0.0
Ethiopia           1.5         96.0          4.2          0.0
Gabon'             0.9        100.0          0.0          0.0
Guinea            -            90.7          9.3          0.0
Kenya             -            32.2         66.5          1.3
362



Receipts                Share of receipts from
as a percentage of  Payroll      Investment       General
Country             GDP            taxes         income         revenues
Sub-Saharan Africa (cont.)
Mali                 0.8            94.0            0.0            0.0
Madagascar            0.2           99.5            0.5            0.0
Nigeria               0.1          42.0            57.2            0.0
Rwanda                0.9          66.0            33.2            0.0
Senegal               1.0           86.4           13.6            0.0
Swazilandc            1.1          62.0            36.7            0.0
Tanzania             0.8            61.0           20.6           17.8
Togo                 0.8            80.0           19.6            0.0
Zaire'               0.4            90.0            0.0           10.0
Average               0.7           77.8           20.3            1.5
Asia
Bangladesh           0.0           78.0            20.5            2.0
China                 2.2          99.0             0.7            0.4
Fiji                 8.2           48.0            42.6            9.2
Indonesiar           0.1           68.0           30.7             0.5
Malaysia             7.4           63.0            35.6            0.0
Pakistan             0.7             8.1            8.9           83.0
Singapore           17.2            74.0           25.3            0.0
Solomon Islands       5.4           69.0           30.4            0.0
Sri Lanka             5.8          45.0            22.7           32.0                                                       I
Average               5.2          61.3            24.2           14.1
- Not available.
a. More than 50 percent of toal pension spending is on universal flat or mealns-tested
pensions.
b. Year referred to is 1989.
c. This refers to the main scheme only.
d. Year referred to is 1992.
e. Year referred to is 1990.
Source: Most data are frons ]LO (1992a and forthcoming); see Palacios (1994b) for
othcr sources and explanation of data.
363



Y ING THE OLD AGE CRISIS
Table A.7 Main Publicly Mandated Pension Scheme Design Features, 1991
Pension Automatic
Covered                                 payroll  indexa-
Normal         years                                  tax/total  tion of
retirement age  requiredfor   Payroll taxfor pensionzs     labor   pensions  Benefit
Economy               Women    Men  fullpension  Worker  Employer Combined   costa  in progress  type
Sub-Saharan Afiica
Benin                  55        55      20           3.6       5.4       9         8.5      Prices     CR
Burkina Faso           55        55       15          4.5       4.5       9         8.6     Prices      CR
Burundi                55        55       15          4         4.5       8.5       8.1     None        CR
Cameroon               60        60       15          2.8       4.2       7         6.7     None        CR
Cape Verde             60        65        3          4         3         7         6.8     None        CR
Central African Rep.    50       55      20           2         3         5         4.9     None        CR
Congo                  55        55      20           2.4       3.6       6         5.8      Prices     CR
C6te d'lvoire          55        55       10          1.6       2.4       4         3.9     None        CR
Chad                   55        55       15          2         4         6         5.8     None        CR
Equatorial Guinea      60        60       10          4.5      21.5      26        21.4     None        CR
Ethiopia               55        55       10          4         6        10         9.4     None        CR
Gabon                  55        20      -            2.5       4.5       7         6.7     None        CR
Gambia, The            55        55      -            5        10        15        13.6      n.a.       PR
Ghana                  60        60      20           5        12.5      17.5      15.6     None        CR
Guinea                 55        55       15          1.6       2.4       4         3.9     None        CR
Kenya                  55        55      -            5         5        10         9.5     n.a.        PR
Liberia                60        60        8.3        3         3         6         5.8     None        CR
Madagascar             55        60       15          1         3.5       4.5       4.3     Wages       CR
Mali                   55        55       10          3.6       5         9         8.6      Prices     CR
Mauritania             55        60      20           1         2         3         2.9     None        CR
Mauritius              60        60      -            3         6         9         8.5      n.a.     UF-CR
Niger                  60        60      20           1.6       2.4       4         3.9      None       CR
Nigeria                55        55      -            6         6        12        11.3      n.a.       PR
Rwanda                 55        55      20           3         3         6         5.8      Prices     CR
Sao Tome Principe      60        65      25           4         6        10         9.4     Wages       CR
Senegal                55        55        1          3.5       5.3       8.8       8.4     None        CR
Seychelles             63        63      -            5        10        15        13.6     n.a.        PR
South Africa           60        65        0          0         0         0         0.0      n.a.       CR
Sudan                  55        60       12          5         9        14        12.8     None        CR
Swaziland              45        50      -            5         5        10         9.5      n.a.       PR
Tanzania               55        55      -           10        10        20        18.2      n.a.       PR
Togo                   55        55      20           2.4       3.6       6         5.8      None       CR
Uganda                 55        55      -            5        10        15        13.6     n.a.        PR
Zaire                  60        62        5          3         3.5       6.5       6.3     None        CR
Zambia                 50        50      -            5         5        10         9.5      n.a.       PR
Average                56.0      56.2    13.8         3.6       5.6       9.1       8.5
Asia
China                  55        60       10          0        18        18        15.3     None        CR
Fiji                   55        55      -            7         7        14        13.1      n.a.       PR
364



APPEN.
Pension Automatic
Covered                                 payroll  indexa-
Nornzal        years                                  tax/total  tion of
retirement age  requiredfor   Payroll taxfor pensions     labor   pensions  Benefit
Econom7zy            Women    Men  fullpension  Worker  Employer Combined   cost'  in progress  type
Asia (cont)
Hong Kong              65        65        0         0         0         0         0.0     n.a.     UF-MT
India                  55        55       -         10        10        20        18.2     n.a.       PR
Indonesia              55        55       -          1         2         3         2.9     n.a.       PR
Kiribati               50        50       -          5         5        10         9.5     n.a.       PR
Korea, Rep. of         60        60       20         1.5       1.5       3         3.0     None       CR
Malaysia               55        55       -          9        11        20        18.0     n.a.       PR
Marshall Islands       60        60        6         5         5        10         9.5     None       CR
Micronesia,
Fed. States of      60        60        6         4         4         8         7.7     None       CR
Nepal                  -         -        -         10        10        20        18.2     n.a.       PR
Pakistan               55        60       15         0         5         5         4.8     None       CR
Palau                  60        60        6         3         3         6         5.8     None       CR
New Guinea             55        55       -          5         7        12        11.2     n.a.       PR
Philippines            60        60        10        3.3       4.7       8         7.6     None       CR
Singapore              55        55       -         10        25        35        28.0     n.a.       PR
Solomon Islands        50        50       -          5         7.5      12.5      11.6     n.a.       PR
Sri Lanka              50        55       -          8        12        20        17.9     n.a.       PR
Taiwan (China)         55        60        15        1.4       5.6       7b        0.0     n.a.       CR
Western Samoa          55        55       -          5         5        10         9.5     None       PR            I
Averagec               55.6      56.5      10.4      5.1       7.9      13.0      10.6
Middle East and Nortlh Afirica
Afghanistan             55       60       25         3         0         3         3.0     None       CR
Algeria                55        60        15        3.5       3.5       7         6.8     None       CR
Bahrain                55        60        15        5         7        12        11.2     None       CR
Cyprus                 63        65        3         6         6        12        11.3     Wages      CR
Egypt                  60        60       10        14        26        40       31.7      None       CR
Iran                   55        60        10        7        20        27b        0.0     None       CR
Iraq                   55        60       20         5        12        17        15.2     None       CR
Israel                 60        65        12        2.7       1.2       3.9       3.9     Wages      CR
Jordan                 55        60        10        5         8        13        12.0     None       CR
Kuwait                 50        50       15         5        10        15        13.6     None       CR
Lebanon                55        60       20         0         8.5       8.5       7.8     None       CR
Libya                  65        65       20         2.1       3         5.1       5.0     None       CR
Malta                  60        61         3        8.3       8.3      16.6b      0.0     None       CR
Morocco                60        60         8.9      1.7       3.4       5.1       4.9     None       CR
CR: contribution-related benefit.
DC: defined conitributioni.
MT: means-rested benefit.
PR: provident fund.
UF: universal flat.
(Table continues on the following page.)
365



OLD  AGE CRISIS
Table A.7 (continued)
Pension Automzatic
Covered                                 payroll  indexa-
Normal         years                                  tax/total  tion of
retirement age  requiredfor   Payroll taxfor pensiozns     labor   pensions  Benzefit
Economy               Women    Men  fullpension  Worker  Employer Combined   cost   in progress  type
Ml-iddle East and North Afrca (cont.)
Saudi Arabia           60       60       10           5         8        13        12.0     None        CR
Syria                  60        60      15           7        14       21         18.4     None        CR
Tunisia                60        60      10           1.3       2.5       3.8       3.7     None        CR
Average                57.8      60.4    13.1         4.8       8.3      10.6       9.4
Eastern Europe andformer Soviet Union
Albania                -         -       -           -         -         25        25.0      None       CR
Bulgaria               55        60      25           0        30       30         23.1     None        CR
Czech Rep.             55        60      25           0        25       25         20.0     None        CR
Huingary               55        60      20           6        24.5     30.5       24.5     Net wages CR
Poland                 60        65      25           0        30       30         23.1     Prices      CR
Romania                55        60      30         -          -        21.2       21.2      None       CR
Former U.S.S.R.       -         -        -          -                   30         30.0     None        CR
Armenia            -         -        -          -          -        -           0.0     n.a.        CR
Azerbaijan          55        60      -          -          -         14        14.0      None       CR
Belarus             55       60       -          -          -        42         42.0     None        CR
Estonia             55        60      -          -          -        20         20.0     Prices      CR
Georgia             55       60       -          -          -        38'         0.0     None        CR
Kazakhstan          55       60       -          -          -        22         22.0     None        CR
Kyrgyz Rep.           55        60      -           -         -         31.8      31.8      None       CR
Larvia              55       60       -          -          -        23.4       23.4     Prices      CR
Lithuania           55       60       -          -          -        -           0.0      n.a.       CR
Moldova            -         -        -          -          -        -           0.0     n.a.        CR
Russia             55        60       -          -          -        26.6       26.6     None       CR
Tajikistan         -         -        -          -          -        -            -      n.a.        CR
Turkmenistan       -         -        -          -          -        -           0.0     n.a.        CR
Ukraine             55       60       -          -          -        31.1       31.1     n.a.        CR
Uzbekistan          55       60       -          -          -        33         33.0     None        CR
Average                55.3      60.3    25.0         0.0      28.3     25.5       18.0
Latin A,merica aind Caribbeani
Antigua and Barbuda    60        60       9.6         3         5         8         7.6      None       CR
Argentina              55        60      15          10        11       21         18.9      Partial    CR
Bahamas, The           65        65      14.4         3.4       7.1      10.5       9.8      None       CR
Barbados              65        65        9.6         5.5       5.8      11.3      10.7     None        CR
Bermuda               65        65        4.8       -          -        -           0.0     None        CR
Bolivia                50        55      15           5         2.5      7.5        7.3     Wages       CR
Brazil                 60       65        5           8        21.5     29.5       24.3     None        CR
Colombia               55        60       9.6         2.2       4.3       6.5       6.2     Wages       CR
Costa Rica             59        61       3.5         2.5       4.8       7.3       7.0     None    CR-MT
Chile                  60       65       20          13.3       0        13.3      13.3     n.a.       DC
Cuba                   55        60      25           0        10        job        0.0      n.a.       CR
366



Penrsion Automatic
Covered                                 payroll  indexa-
Normal         years                                  tax/total  tion of
retirementage  requiredfor   Payroll taxforpensions       labor   pensions  Benefit
Economy              Women    Men  fuillpension  Worker  Employer Combined   cost'  in progress  type
Latin America and Caribbean (cont.)
Dominica              60        60        5.7        3         6.8      9.8        9.2     None       CR
Dominican Rep.        60        60       15.4        2.5       7        9 5'       0.0     None       CR
Ecuador               55        55      30           9.4      10.9     20.3b       0.0     None       CR
El Salvador           55        60       14.4        1         2        3          2.9     Prices     CR
Grenada               60        60       9.6         4         4        8          7.7     None       CR
Guatemala             60        60       15          1.5       3        4.5        4.4     None       CR
Guyana                60        60       14.4        4.4       6.6     I lb        0.0     None       CR
Haiti                 55        55      20           2         2        4          3.9     None       CR
Honduras              60        65       15          1         2        3          2.9     None       CR
Jamaica               60        65        3          2.5       2.5       5b        0.0     None       CR
Mexico                65        65        9.6        1         4.9      5.9        5.6     None       CR
Nicaragua             60        60       14.4        2         6.5      8.5        8.(     None       CR
Panama                55        60       15          6.3       2.8      9.1        8.9     None       CR
Paraguay              60        60       15          9.5      13       22.5b       0.0     None       CR
Peru                  55        60       15          3         6        9          8.5     None       CR
Trinidad and Tobago   60        60       14.4        2.8       5.6       8.4       8.0     n.a.     MT-CR
Uruguay               55        60      30          13        16.5     29.5       25.3     Wages      CR
Venezuela             55        60       14.4       -         -          6.75      6.8     None       CR
Average               58.7      60.8    13.9                            10.5       7.1                              I
OECD 
Australia             60        65        0         -         -        -            -      Prices     MT
Austria               60        65       15         10.3      12.6     22.9       20.3     Wages      CR
Belgium               65        65      45           7.5       8.9     16.4       15.1     Prices     CR
Canada                65        65        1          2.3       2.3      4.6        4.5     Prices   UF-MT-
CR
Denmark               67        67        0        -          -        -           0.0     Prices   UF-MT-
CR
Finland               65        65      40           0        16.8     16.8       14.4     Prices   CR-UF
Franced               60        60      37.5        10         9.8      19.8      18.(0    Wages      CR
Germany               65        65        5          8.9       8.9      17.8      16.3     Net wages CR
Greece                60        65       11.1        5.3      10.5      15.7      14.2     Prices     CR
Iceland               67        67       0           0         2        2          2.0     Wages  UF-MT-
CR
Ireland               65        65        3          5.5      12.2     17.7       15.8     n.a.     CR-MT
CR: contribution-related benefit.
DC: defined contribution.
MT: means-tested benefit.
PR: provident fund.
UF: universal flat.
(Table continues ovz the follotting page.)
367



,FWATING THE OLD AGE CRISIS
Table A.7  (con tinued)
Pension  Automatic
Covered                                    payroll  indexa-
Normal           years                                    tax/total   tion of
retirement age  requiredfor    Payroll tax for pensions        labor   pensions  Benefit
Economy                Women    Men  f-illpension  Worker  Employer Combined   cost   in progress   type
OECD (cont.)
Italy                   55         60        15          7.3       18.9       26.2      22.0    Prices and    CR
wages
Japan                   65         65        25         14.6        2.3       16.9       16.5      Prices      CR
Luxembourg              65         65        10          8          8         16        14.8    Pricesand    CR
wages
Netherlands             65         65        49         15.2        0         15.2      15.2      Wages       CR
New Zealand             60         60         0          -          -          -         0.0       Prices      UF
Norway                  67         67        40          7.8       16.7       24,5b      0.0       Prices   UF-MT-
CR
Portugal                62         65        10         11         24.5       35,5b      0.0       Prices     CR
Spain                   65         65        15          2.8       13.9       16.7      14.7    Prices and    CR
wages
Sweden                  65         65         3          8         13         21        18.6       Prices    CR-UF
Switzerlandd            62         65        40         11.7       11.7       23.4      20.9    Prices and    CR
wages
Turkey                  55         60        25          9         11         20        18.0    Prices and    CR
wages
United Kingdom          60         65        40          8.3       10.5       18.8      17.0       Prices     CR
United States             65         65         10          6.2        6.2      12.4       11.7      Prices      CR
Average'                62.9       64.4      18.3         7.4      11.0       16.3      12.6
CR: contribution-related benefit.
DC: defined contribution.
NIT: means-rested benefit.
PR: provident fund.
UF: universal flat.
- Not available.
Note: The contribution structures in manY countries are very complex, distinguishing among different groups of workers. This table
reports the number thought to apply to the largest proportion of workers. It includes payments to mandatory occupational plans (France or
Switzerland) or mandaton, saving planis (Chile).
a. Total labor cost is defined as wages plus employer share of payroll tax.
b. This includes contributions for programs other than old age.
c. Except for the retirement age, averages do not include countries that rely primarily on universal flat or means-tested pensions.
d. The payroll tax pension for France and Switzerland includes mandatory occupational schemes.
Source: U.S. Social Securitv Administration (1993).
368



APPENDIX
Table A.8 Percentage of Recent Average Earnings Paid as a Pension after
Thirty Years of Covered Employment, Selected Countries, 1991
Latin America and Caribbean       Sub-Saharan Africa
Argencina            70           Benin                    60
Ecuador              75           Burkina Faso             40
Guatemala            70           Burundi                  50
Honduras             65           Cameroon                45
Mexico               60           Central African Rep.    45
Panama               88           Chad                    48
Paraguay             67           Congo                    50
Peru                 80a          Gabon                   45
St. Lucia            60           Liberia                  51
Uruguay              60a          Mauritania              40
Niger                   40
Rwanda                  45
AMiddle East and North Africa     Sudan                    50
Algeria              75           Togo                     40
Bahrain              50
Egypt                67           Europe
Iran                 87           Austria                  57
Iraq                 75           Czech Rep.               55
Jordan               60           Portugal                 66
Kuwait               95           Spain                    90
Libya                75           Turkey                  70
Saudi Arabia         60           Fed. Rep. of Yugoslavia   65a
Syria                66
Tunisia              80           South Asia
Yemen                75           Pakistan                 60
a. This indicates the percentage paid for a male.
Source: U.S. Social Security Administration (1993).
369



i0TH~TE OLD AGE CRISJS
Table A.9 Comparison of Administrative Costs of Publicly Mandated Pension Schemes
Per                                                  Per
member          Per                                  member          Per
administrative    member                             administrative    memher
cost/income  administrative                          cost/income   administrative
per capita      cost in                              per capita      cost in
Country        Year    (percent)      U.S. dollarsa    Country       Year    (percent)     U.S. dollarsa
Belgium        1986        0.18          20.6        Luxembourg    1986          0.28         38.1
Burundi        1989        7.25          14.9        Malaysia       1986         0.54          9.2
Canada         1989        0.05          10.0        Mauritius       1986        0.05          0.7
Chile (new)    1991        2.30          50.2        Mexico         1986         0.89         14.4
China          1989        0.20           0.5        Morocco         1989        0.89          8.1
Costa Rica     1992        0.36           7.5        Netherlands     1989        0.13         20.1
Czech Rep.     1989        0.07           2.2        Nigeria         1986        0.89          3.8
Denmark        1989        0.02           3.9        Pakistan        1989        0.86          3.0
El Salvador    1986         1.54         12.3        Paraguay        1987        0.59          6.9
Finland        1989        0.26          63.7        Philippines     1990        1.01          7.3
Germany        1989        0.18          35.9        Rwanda          1989        3.58         11.2
Ghana          1989        3.86           5.0        Singapore       1986        0.16         10.8
Guatemala      1986        0.39           4.0        Spain          1989         0.11         10.4
Honduras       1990        0.59           7.3        Sweden          1988        0.07         15.5
India          1989        0.72           2.4        Switzerland     1991        0.09         28.9
Israel         1989        0.10           9.5        Tanzania        1990        7.96          7.9
Italy          1986        0.34          35.6        Tunisia         1986        1.03         12.1
Jamaica         1989        0.34          5.5        Turkey          1986        0.41          4.6
Japan          1989        0.04           8.3        United States    1989       0.05          11.3
Kenya          1989        0.80           1.8        Zambia         1988         4.49         16.3
a. Thijs uses the average exchange rate during each year.
Source: Data from various sources. SeeJames and Palacios (1994) for methodology and description of data.
370



Table A.10 Expected Duration of Retirement at Official Retirement Age, by Income Level, Selected Countries
Expected duration
Retirement Age                       of retirement
Country                Male             Female             Mak               Female             Year
Countries with GDP per capita greater than $8, 000
Australia               65                60                18.0              23.0              1989
Austria                 65                60                14.5              22.0               1989
Belgium                 65                65                13.0              16.9              1982
Canada                  65                65                14.9              19.2             1985-87
France                  60                60                18.7              23.9              1988
Germany                 65                65                13.8              17.6              1987
Hong Kong               65                65                15.1              18.8              1990
Israel                  65                60                15.1              20.7              1988
Italy                   60                55                17.4              26.3              1985
Netherlands             65                65                14.4              19.0              1989
Spain                   65                65                14.8              17.9              1982
Sweden                  65                65                15.0              18.7              1988
Switzerland             65                62                15.3               -                1989
United Kingdom          65                60                13.6              21.3              1989
United States           65                65                14.9              18.6              1988
Average                64.3               62.5              15.2              18.6
Countries with GDP per capita hetween $4, 000 and $8, 000
Algeria                 60                55                15.9              21.0               1983
Argentina               60                55                15.6              24.1             1980-81
Bulgaria                60                55                15.9              23.3             1987-89
Colombia                60                55                17.3              19.3             1980-85
Greece                  65                60                14.6              20.6              1980
Hungary                 60                55                14.8              23.1              1989
(Table c ontinues on the following page.)
371



%IN1MG THE OLD AGE CRISIS
Table A. 10 (continued)
Expected duration
Retirement Age                        of retirement
Count7y                Male              Female             Male              Female              Year
Countries with GDPper capita between $4,000 and $8,000 (cont.)
Malaysia                 55                55                19.5              22.1               1988
Panama                   60                55                18.8              24.9             1985-89
Poland                   65                60                12.5              20.1               1988
Romania                  60                55                16.1              22.8               1989
Uiruguay                60                 55                16.7              25.0             1984-86
Venezuela                60                55                17.3              24.2               1985
Yugoslavia, Fed. Rep. of   60              55                16.3              23.7               1990
Average                 60.4              56.0               16.8              23.0
Count-ries with GDPper capita less than $4,000
China                    60                55                15.7              22.2               1981
Czech Rep.               60                55                14.9              23.3               1988
Ecuador                  55                55                21.4              23.4               1985
Guatemala                60                60                16.6              17.5               1980
India                    55                55                17.1              19.3             1976-80
Peru                     60                55                15.4              21.1             1980-83
Philippines             60                 60                15.4              17.2               1989
R,wanda                  55                53                16.7              18.2               1978
SriLanka                 55                50                21.5              23.7               1981
Trinidad and Tobago      60                60                15.8               18.4            1980-85
Former U.S.S.R.           60                 55                15.4              24.0               1990
Zambia                   50                50                21.3              22.2               1980
Average                 57.5              55.3               17.3              20.9
- Not available.
Note: Income per capita is calcLtlated in 1990 U.S. dollars as defined in rhe United Nations Internacional Comparison Program.
S6ierce: United Nationls (11992b); U.S. Social SecuritvAdminiistratioll (1993); World Bank (1992d), table 30; World Bank (1990);
Australian Social Security Institute (1989).
372



AP-PE
Table A.11 Public Pension Schemes in Transitional Economies, Post-1990 (percentages)
System          Old age          Pension            Gross           Pension          Overall
dependency       dependency      expenditure!       pension!          payroll          payroll
Country            ratio'       ratio in 1990         GDP           gross wage'         tax               tax
Eastern Europe
Albania             37C              17               12.4d             55               25               26
Bulgaria            77c              37                9.5c             37C           26.7-38           35-50
Croatia             59c              32                -                -                22               -
Czech Rep.          -                32C              10.0d             49d              30               50
Hungary             66e              36               10Y               38e             30.5              62
Poland              49c              28               12.4c             57C              30               48
Romania             63c              30                69d              43c           16.5-25.9         31-41
Slovak Rep.         42               -                 9.9              -               26.5              50
Slovenia            50d              29               11.3d             -                30               41
Former Soviet Union
Armenia             -                22                49d-                              -                -
Azerbaijan          -                18                5.6d             -                14               40
Belarus             49d              34                7,3d             42C              -                42
Estonia             52e              32                6.9              33C              20               20
Georgia             45d              30               l1.0d             70C              -                41
Kazakhstan          40C              19                4,7d             -                22               41
Kyrgyz Rep.         34d              20                6.1d             34C              34               39
Larvia              51d              33                6.7C             33e              23               38
Lithuania           53d              30                6.6'             41c              -                31
Russia              48C              -                 7.1c             34C             32.6              40               I
Ukraine             50C              35               13.0c             39C              31               37
Uzbekistan          34d              15               10.3c             -                33               40
- Not availabte.
a. System dependency ratios are not adjusted for old age pensioner equivalents. The ratio for Esronia is for the firsr quarter of 1993.
b. Replacement rates refer to the average of old age, survivors', and invalidity pensions. Old age replacement rates are higher. For
Romania, this refers to nonagricultural workers only. Ukrainian data are for the first quarter of 1992.
c. 1992.
d. 1991.
e. 1993.
Source: Holzmanni (1992, 1994); Cavalcanci (1993); Rashid (1994); World Bank data; appendix rable A.. See Palacios (1994) for fur-
ther derails.
373



_L OLD AGE CRISIS
Table A.12 Portfolio Distribution of Pension Funds in Eight OECD Countries (percentage of assets)
Share of
portfolio
Private         Public                                         invested
Counnty              Equities         bonds          bonds           Loans           Other          abroad
Canada
1970                22              15             38              11              14              -
1990                29               8             39               4              20                6
Denmark
1970                 0              61             11               7              21              -
1990                 7              56             11               7              19              -
Germany
1970                 4              10              9              50              27              -
1990                18               8             17              45              12                1
Japan
1970                 6                        12-                  52              30              -
1990                27                      47    -                14              12                7
Necherlands
1970                11               3             12              54              20                7
1990                20               4             19              43              14               15
Switzerland
1970                 3                      25a                    48              24              -
1990                16              -  --29                        22              33              -
United Kingdom
1970                49              14             18              -               19                2
1990                  63               3             11              -               23               18
United States
1970                45              38              7               6               4              -
1990                46              16             20               2              16                4
a. This denotes the sum of private and public bonds; data are not available separately.
Source: Davis (1993).
374



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For Further Reading
Full bibliographic information for the works that follow is   (1992); Feldstein aand Samwick (1992); Fernandez Riva
given in the Bibliography. For further reading on tie fol-   (1992); Hurd and Shoven (1985); Leimer and Petri
lowing topics, see:                                 (1981); Meyer and Wolff (1987); Moffitt (1983. 1984);
Nelissen (1987): Petrei (1987); Schioppa (1990);
History of public pension systems: Aaron, Pechman, and    Schwarz (1994): Smeeding (1991): Stahlberg (1989);
T aussig (1968); Atkinson (199 1a, 1991 b); Burns (1944);   Steuerle and Bakija (1994); Vald&s-Prieto (1994).
Esping-Andersen (1990); Gordon (1988); Gracbner
(1980); Johnson (1985); Kohler and Zacher (1982); Leff   The political economy of public pension schemes:
(1987); Petersen (1986, 1991); Rowntree and Lavers   Browning (1975): Cukierman and Meltzer (1989); Hans-
(1951); United Kingdom  (1899); Verbon (1988);   son and Stuart (1989); Hu (1982); Loecwy (1988); Patton
Weaver (1982).                                      (1978); Sjoblom  (1985); Tabellini (1992); Townley
(1981): Verbon (1988).
History of occupational pensions: Dobbin (1992); Esping-
Andersen (1990); Graebner (1980); Hannah (1986);   The effects of pensions on labor supply: Blinder, Gor-
Schieber (1989).                                    don, and Wise (1980); Bodie and Munnell (1992)
Boskin (1977); Boskin and Hurd (1978); Burkhausei
Poverty among the elderly: Cangping (1991); Deaton    (1980); Burtless and Moffitt (1984); Diamond and Haus-
and Paxson (1991); Dreze (1990); F6rster (1993); Fox    man (1984); Fields and Mitchell (1984a); Gustman anc
(1994); Gaiha and Kazmi (1982); Palmer, Smeeding, and    Steinmeier (1984); Hamermesh (1984); Ippolito (1990)
Torrey (1988); Sreuerle and Bakija (1994); Warlick    Kahn (1988); Kotlikoff (1979); Pellechio (1979, 1981)
(1982).                                             Quinn (1977); Quinn, Burkhauser, and Myers (1990)
Reimers (1977); Zabalza. Pissarides. and Barton (1980).
Comparison of administrative costs of pensions: Acufia
and Iglesias (1992); James and Palacios (1994); Sunden    The impact of pensions on labor mobility: Allen, Clark
and Mitchell (1994); Turner and Beller (1989); Valds-   and McDermed (1988. 1993); Barrel and Borjas (1977)
Prieto (1993).                                      Bodie and Munnell (1992); Bulow (1981, 1982); Evei
and Macpherson (1990); Gustman and Steinmeir (1987.
Distributive effects of public pension schemes: Aaron    1989, 1990); Ippolito (1986, 1991); Kotlikoff and Wise
(1977, 1982); Aaron, Pechman. and Taussig (1968);   (1987a, 1987b, 1989); Lazear (1982); Lazear and Moor,
Auerbach and Kotlikoff (1987); Boskin, Kotlikoff,   (1987); McCormic and Hughs (1984); 0. Mitchel.
I'uffert, and Shoven (1987); Britcain (1972); Burkhauser   (1982, 1983); Schiller and Weiss (1979); Wolf and Lev-
and Warlick (1981); Creedy, Disney, and Whitehouse   (1984).
399



AERTING THE OLD AGE CR)SIS
The impact of pensions on saving and capital markets:   Pay-as-you-go pension financing Aaron (1966); Arrau
Atkinson (1987); Auerbach and Kotlikoff (1990); Auer-   (1990); Arrau and Schmidt-Hebbel (1993); Auerbach,
bach and others (1989): Barro (1974); Barro and Mac-   Goklhale. and Kotlikoff (1994); Auerbach and Kotlikoff
Donald (1979); Bernheim and Levin (1989); Blinder,   (1984); Barro (1974); Bernheim (1987); Blanchet and
Gordon. and Wise (1983); Boyle and Murray (1979):   Kessler (1991); Bos and Cnossen (1992); Brever (1989);
Carmichael and Hawtrey (1981); Darby (1979); Dia-   Brunner (1990); Brunner and Wickstrorn (1991);
mond and Hausman (1984); Feldstein (1974, 1977.   Carmichael (1982); Diamond (1977); Greene (1974);
1978, 1980, 1982, 1983); Feldstein and Pellechio (1979);   Hansson and Stuart (1989); Homburg (1990); Lee and
Gokhale, Kotlikoff, and Sabelhaus (1994); King and    Lapkoff (1988); Samuelson (1958); Smith (1982); Veall
Dicks-Mireaux (1982); Kopits and Gotur (1980);   (1986); Verbon (1988, 1990).
Koskela and Viren (1983); Kotlikoff (1979, 1989b); Kot-
likoff, Shoven, and Spivak (1989); Lee and Chao (1988):   Rationale for government intervention: Aaron (1966);
Leimer and Lesnoy (1982); Modigliani and Sterling   Aaron (1982); Barr (1992); Buchanan (1968); Diamond
(1983,;; Munnell (1974, 1982): Novos (1989); Takayama    (1977); James (1992); Korlikoff (1987); Kotlikoff, Spi-
(1990); Yamada, Yamada, and Liu (1992).            vak, and Summers (1982); Samuelson (1958).
400



Data Notes
A full description of the data sources and methodologies    ternational survey conducted by the ILO every few years.
used in this report are presented in the Technical Annex    Most data for the OECD countries are based on expendi
(Palacios 1994b). The data are also available on diskette.   tures on nonhealth spending on the aged as furnished by
This note presents a brief summary.                      the OECD in Paris. These data, which cover the tventy
four OECD countries, are based on Eurostat data for thi
Demographic and labor force data. Historical demo-    European Economic Community countries as well as in
graphic dara were adapted from International Historical   dividual country sources collected by the OECD. The mos
Statistics: Asia andAfrica (B. R. Mitchell 1982), Interna-   recent year for most OECD countries was between 198K
tional Historical Statistics: The Americas and Australbsia   and 1990.
(B. R. Mitchell 1983), and International Historical Statis-  In addition to these publications, country-specific
tics: Europe 1750-1988 (B. R. Mitchell 1990).           sources such as statistical yearbooks and annual reports o
Demographic estimates for 1990 and projections from  administering agencies were used. along with interna
2000 to 2150 are from the World Bank's population data    World Bank reports.
base and were generated using the STARS program.
Data for labor force participation by age group were    Pension revenues. Revenues here refer to combinec
generally taken from the ILO's Yearbook ofLabour Statistics    employer-employee pavroll taxes, income frorn the invest-
(various years). The size of the labor force was taken in    ment of pension reserves, and direct and indirect govern-
most cases from che World Bank's Social Indicators of De-    ment subsidies. The data are taken from the ILO's The
lelopmnent 1991-1992 (1992).                            Cost of Social Security and exclude nonpension programs
such as medical care, family allowances, and so forth. Rev-
Pension spending. In this study, pension spending is de-    enues separated by destination (such as pensions) are not
Fined as old age. retirement, survivors', death and invalid-    available as often as benefit spending, and countries where
ity, and disability payments based on past contriburion    the separation was not available were nlot included. The
records and noncontributory, universal flat, or means-   surplus is defined as payroll taxes for pensions plus in-
tesced programs specifically targeting the old. In-kind ser-   come from capital minus cash benefits. Government sub-
vices such as housing and medical care and povernt assis-   sidies are excluded from  revenues when calculating the
tance not based on age are not included. Data are for years   surplus.
between 1985 and 1993. The sources and years of data in
the spending and receipts tables often differ.          Coverage and system dependency rates. Coverage rati6
Most data come from the ILO's The Cost of Social Secu-   is defined here as the number of workers actively con-
rity. Only the pension part of total social security expen-    tributing to a publicly mandated old age or retirement
ditures is included. The data are collected through an in-    scheme that pays a lump sum or annuitized pension, the
401



FgE~TING THE OLD AGE CRISIS
value of which is a function of past contributions or earn-    tirement ages may differ significantly from average effec-
ings, divided by the estimated labor force. The labor force    tive retirement ages. Comparisons should made with cau-
was normally defined as the percentage of persons ages 15    tion and with a more detailed analysis of each scheme. de-
to 64 who were economically active, whether employed or    pending on the purpose of the analysis.
unemployed.
Data on contributors were taken from many sources,    Pension reserves and investment returns. Two kinds of
including annual reports of the adininistering agencies,   investment returns were listed for publicly managed
unpublished data from the ILO, and internal World Bank    schemes. For defined contribution schemes or provident
studies. In some cases, estimates were made in order to   funds, investment returns represent the nominal rates of
reconcile data on multiple schemes ftrom different years.   retutn credited to members' accounts, after expenses, ad-
Methodology and sources are discussed in the Technical   justed for changes in the consumer price index. For de-
Annex (Palacios I 994b).                                 fined benefit schemes, investment returns were definied as
Estimates of the labor force were usually taken from  the nominal gross returns earned by invested assets ad-
the \Vorld Bank's Social Indicators of Development. In    justed for changes in the consumer price index. For all
cases where data on the labor force and the number of    public schemes, the annual real returns are simple, not
contributors were not available for the same year, interpo-    compounded, returns.
lations or extrapolations were used in order to compute     Real returns on equities and government bonds and
the coxverage ratio.                                     private pension find returns are based on simulated results
System support and dependency ratios refer to the un-    from The Structulre, Regulation, and Performance of Pen,sion
adjusted ratio of active contributors to persons receiving    Funds in iVine Industrial Countries (E. P. Davis 1993).
old age, survivors', or invalidiy pensions in the same 'ear.    These simulations applied average returns by financial
The breakdown of the pensioner population into these    asset type in each country in each year to the known port-
three categories will vary by country and is not taken into    folio distribution of assets of the pension sector.
account here.
Administrative costs. Administrative costs are those re-
Public pension scheme characteristics. Data were   lated to the old age, survivors', and invalidity pension sys-
adapted from  Social Security Program7zs Throughout the   tem. These costs are taken from  the ILO's The Cost of
World, 1991, published by the U.S. Social Security Ad-    Social Security (1992) and unpublished data from  the
ministration in 1993. All data refer to the country's main    fourteenth ILO Costs of Social Security survey (in
pension scheme. Design features vary among different    progress). Other sources include statistical yearbooks
pension schemes in the same country. Schemes were cate-    from  administering agencies. See James and Palacios
gorized by benefit type based on whether the majority of    (1994) for further details.
pension spending was known to be on contribucion-
related, provident, universal flat, or means-rested pen-    Other indicators. Gross domestic product and govern-
sions. Qualifying conditions and contribution rates vary    ment spending in countrv currency were taken from the
across pension schemes within the country. They also will   IMF's International Financial Statistics (various years). In-
vary by factors such as wage level, industry, and work con-    flation estimates and exchange rates are also takeni from
ditions withlin the main pensioni scheme itself. Normal re-   the same source.
402
























l* T  E WORLD B A N K 
1:l, T0; '   X  ' 0 '                     ' l."'''. 0 f ' :': f- '' ' ' 0' -'~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~SS.A if xecac
THE WORLD IS APPROACHING AN OLD AGE CRSIS.            e      expectancies mi   a nd
birthrates decline, the proportion of the population that is old 6s expa    rapidl, s:
the potetial economic burden ont the young Meanwhile,!exiting systems of inan  -.
rity for okil people are headed toward collapse. In developing countriesu nab    on,
increased mobility, famine, and war are eroding extended families and other tradi
means of support. In industrial countries, escalating costs threaten to overwhelm pbli  n-
sion plans-even as these plans fiequently impede overall growthk Nations developing
old age:security systems risk repeating the industrial countrie costly mistakes.
I   This booksounds the ahmn about this potentiat crisis and seeks to.provide answ  to
* urgent questions: How can financial security for the old be ensuredL What are the bes 
of paying for such security. What role should the public and private sectors play. G    sys-.
tems be used to enhance, rather than detract fiom, economic growth>
The study identifies three functions of old age security system-redistribution,s    .
and insurance-and evaluates the policy options for meeting these by two criteria: heirt
-impact on the aged and&their impact on growth. It condudes that a mix of three sot    O
: . pillarsm  ofFers the stongest resul. These are- a publicly managedts enu with man ry
partiapation and the limited g.oa of reducing poverty among the oAL a privately mai
mandatorr saving system; and voluntary saving The firt- covers redistnbutioithe   nb 
and thidcover savingm, and all three  ainst              iol age.- .
AlthougN, the report acknowledges thattemix ofpis;timing and urwtiuo
*   ~   outindstra  onre   il-~sbo'ivl
P-oR   akers i developin  and 5u dus 
ot 1 onSisDts Wil apprecate its       iw      p         t
T                  thirdvolune in a seMres of Pblicy Researchi Rep       t
.fence the results o£Word Bian researon pressing devefopmeirt issue  ^
the series are TheEntAsiim Mirac&- Economic Grouwtb and P ik   and         ¢
bg iAip- AfrzcaR       R;suitt and t/Iekoad'A/iea&
4   u
:.ISBN  03$19.95        t
COVER DESIGN BY BRIAN NOYES / THE MAGAZINE GROUP     _____                       I
L .   ~~~~_ _ _ __ _ _