Social Security Reform Around the World: Lessons from Other Countries

Policy Reports | International | Social Security

No. 253
Friday, August 30, 2002
by Estelle James

The Problems of Pay-as-You-Go Systems

"The percentage of the world's population over age 60 will nearly double over the next 30 years."

Most old age security systems established by governments in the past were financed by payroll taxes on a pay-as-you-go (PAYG) basis. This means that the contributions made by today's workers are used to pay the pensions of those who have already retired. The pension benefits are defined according to a formula based on the worker's earnings and years of service. These systems, including the U.S. Social Security system, have helped many old people live out their senior years with dignity and security. However, these systems also generate many problems. The problems were small when the systems were immature and small, but they can no longer be overlooked as the systems mature and grow. The problems concern sustainability, growth and equity.

Sustainability. Most public attention has focused on the sustainability problems. Pay-as-you-go systems are very sensitive to demographic change and system maturation. Under a pay-as-you-go system,

C = B/S = B*D, where

C = the contribution rate (as a percentage of wages) required to balance the books in a given year,

B = the average benefit (as a percentage of average wage),

S = the support ratio (the number of workers per retiree) and

D = the dependency ratio (the number of retirees per worker).

As the system matures and populations age, which is currently happening almost everywhere, the dependency ratio grows and the revenues are eventually insufficient to pay the promised benefits. Then either B must go down or C must go up.

For example, suppose the benefit ratio is initially 40 percent of the average wage. When the support ratio is 3.3, the required contribution rate is 12 percent. This is approximately where we are now in the United States. But when the support ratio falls to 2 due to increased longevity and decreased birthrates, the contribution rate must rise to 20 percent or the benefit ratio must fall to 24 percent, or some combination of the two must occur. That is roughly the direction we are heading in, under the current system. If we reach 2041 without prior reforms, changes approaching this magnitude will become unavoidable.

Figure III - Gross Implicit Pension Debt%2C 1990

"Pay-as-you-go systems don't work when the number of elderly grows faster than the number of workers paying to support them."

Parametric changes in the system - raising the contribution rate or the retirement age, reducing the pension, modifying the indexation formula - could keep it solvent as demography changes. However, these changes would be very difficult for workers and retirees to swallow and very difficult for politicians to make. What is more, they would have to be made not once, but repeatedly, as changes continue to occur. For example, every time the trustees of the U.S. Social Security system have assessed its fiscal soundness, they have found that people were living longer than had been expected at the previous assessment and therefore some adjustment to the benefit formula or contribution rate was needed to keep the system solvent. In addition, some demographers expect longevity improvement to accelerate, which would also accelerate the required adjustment for Social Security.

Growth. Pay-as-you-go systems also have negative effects on economic growth:

  • High and rising payroll taxes for pensions (exceeding 25 percent of wages in many countries) may increase unemployment;
  • Early retirement on actuarially unfair terms (often below the age of 60) reduces the supply of experienced labor;
  • Giving benefits to the first generation of retirees and continuing to provide public annuities to future generations may discourage private saving; and
  • A large implicit pension debt accumulates, and the need to pay off this debt may crowd out the government's ability to provide other important public goods.

In the United States, the payroll tax is relatively low, the retirement age is relatively high and early retirement is penalized. But many economists consider our national savings rate too low, and we have not used our old age security program to raise it.2

"Pay-as-you-go systems often restrict economic growth by discouraging saving and encouraging early retirement."

Contributions that workers make to pay-as-you-go systems are justified by the promise of pensions when they retire in the future. Unfortunately, no assets back up these promises. Thus, a large unfunded implicit pension debt accumulates - the present value of the benefit promises that have been made to current workers and pensioners. It is an implicit debt because it is not written down or legally binding, but it is a debt in the sense that ethically and politically most of it must be paid. In every industrialized country, this implicit pension debt exceeds the explicit debt (bonds). Usually the unfunded pension debt is more than 100 per cent of GDP and in some cases more than 200 per cent. Figure III shows some examples. Fortunately, the United States is at the low end on this score because our benefits are quite modest and our population is still quite young. But as the baby bulge moves through the system, our pension debt will increase. Most countries would be horrified by an explicit debt that exceeds 100 percent of GDP. But these same countries act as though they are unaware that they are building a much larger implicit debt. Future generations will have to pay off this debt.

"In all developed countries, implicit public pension debts dwarf the traditional public debt -- often they are twice as large."

Equity. Empirical evidence has cast doubt on the equity of many traditional systems. In many countries, rich people gain at the expense of the poor. Rich people live longer, collect benefits for more years and, because of steeper age-earnings profiles, they often collect higher pension benefits per dollar contributed. Although the United States has a relatively progressive benefit formula, this tends to be offset by the greater life expectancy of the rich - a disparity in life span that has been increasing. Under the defined benefit formula in effect in most countries, workers who retire early receive benefits that are subsidized by taxes paid by those who work longer. This is not as big a problem in the U.S., but our system, too, produces fewer goods and services when workers retire before the age of 65 - as has been increasingly the case. The U.S. has other surprising and questionable winners and losers. For example, nonworking spouses of high-earning breadwinners are big winners, taking out of the system much more than they ever put in. On the other hand, unmarried heads of households and dual career families are big losers.3

"More than 80 million workers worldwide have the opportunity to invest in private retirement accounts as part of their social security systems."

The biggest redistribution in the pay-as-you-go systems of virtually all countries stems from the payment of generous benefits to the first generation to retire under these systems. These retirees contributed small amounts for only part of their working lives and received relatively generous benefits for their entire retirement. The money paid to them prevented the buildup of funds in the accounts of younger workers, and left us with a large unfunded debt. While most of us might be glad to pay these redistributions to low earners who suffered through the depression and war, high earners benefited as well. In fact, the high earners benefited more. Today's young and middle-aged workers and future generations of workers, including many low earners who will get a low return on their Social Security contributions, will inherit this debt.4

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