As we grow old we work, produce, and earn less, and therefore need a secure source of income to see us through life. Societies and governmenrs have developed mechanisms 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 world's population ages, old age security systems are in trouble worldwide. Informal community and family based arrangements 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:
• In 1990 almost half a billion people, slightly more than 9 percent of the world's population, were over 60 years old. By 2030, the number will triple to 1.4 billion. Most of this growth will take place in developing countries, over half of it in Asia and more than a quarter in China alone (figure 1).
• The demand for health services increases as countries grow older, since health problems and costly medical technologies are concentrated among the old. Because health and pension spending rise together, pressure on a country's resources and government budgets increases exponentially as populations age.
• Publicly managed funds set aside for the old are often dissipated by poor management. In Zambia, the public provident fund, invested exclusively in public securities, lost 23 percent per year, on average, between 1981 and 1988. More than half the contributions in 1988 were used for administrative expenses.
• High payroll taxes distort labor markets and reduce growth. In Hungary, where more than one-quarter of the population are pensioners, the average effective retirement age has fallen to 54 and the payroll tax needed to pay the pensions is 33 percent, cutting the demand for labor, the supply of experienced labor, and national output.
• Government pensions are rarely fully indexed to inflation, 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 reform these already high percentages will increase further as the population ages.
• In the Netherlands, Sweden, and the United States, workers retiring 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 pension 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.
Everybody, old and young, depends on the current output of the economy to meet current consumption needs, so everybody is better off when the economy is growing—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 during their earlier years, or through informal group action, such as family transfers, or through formal collective action, such as public social security programs.
The choice among alternative arrangements for old age security affects the welfare of the old, because it determines the share of the national pie they can claim. More fundamentally, it affects the welfare of everyone, old and young, by influencing the size of that pie. So this report 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 security. 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.
Age Security Problems around the World
Income 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 population—and have long been cared for by extended family arrangements, mutual aid societies, and other informal mechanisms. Formal arrangements that involve the market or the government are rudimentary. But as urbanization, mobility, wars, and famine weaken extended family and communal ties, informal systems feel the strain. That strain is felt most where the proportion of the population that is old is growing 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 maintenance without accelerating the decline in informal systems and without shifting more responsibility to government than it can handle.
In Latin America, Eastern Europe, and the former Soviet Union, which can no longer afford the formal programs of old age security they introduced long ago, the need to reevaluate policy is even more pressing. Liberal early retirement provisions and generous benefits have required high contribution, leading to widespread 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 contribution rates and evasion still higher, even as limited long-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 now undertaking similar structural changes, and some Eastern European countries are contemplating them. The challenge is to devise a new system and a transition path that is acceptable to the old, who have been led to expect more, while also being sustainable and growth-enhancing for the young.
Countries that belong to the Organization for Economic Cooperation and Development (OECD) face similar problems, as their populations age and their productivity stagnates. Public old age security programs 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 young. 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 between old retirees (some of them rich) who are getting public pensions and young workers (some of them poor) who are paying high taxes to finance these benefits and may never recoup their contributions. Such social security arrangements may, in addition, have discouraged work, saving, and productive capital formation—thus contributing to economic stagnation.
Many OECD countries appear to he moving toward a system that combines publicly managed pension plans designed to meet basic needs with privately managed occupational pension plans or personal saving accounts to satisfy the higher demands of middle- and upper-income groups. The challenge is to introduce reforms that are good for the country as a whole in the long run, even if this involves taking expected benefits away from some groups in the short run.
The Government and Old Age Security
More than half the world's old people are estimated to rely exclusively on informal and traditional arrangements 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 weakens these informal arrangements. Families become smaller and more dispersed. Opportunities for market employment 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 increases. Family-provided assistance continues to play an important role in all societies. Bur 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 down in other spheres, they are replaced by formal market arrangements. Why doesn't that happen for old age subsistence? Why do governments everywhere in the industrial world and increasingly in developing countries intervene so extensively in this area?
Depending purely on voluntary actions by individuals to provide for their own 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 instruments—capital markets are undeveloped and macroeconomic conditions are unstable in many countries.
• Insurance market failures--adverse selection, moral hazard, and correlations among individuals make insurance against many risks (such as the risks of longevity, disability, investment, inflation. and depression) unavailable.
• Information gaps—people may be unable to assess the long-term solvency of private savings and insurance companies or the productivity 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 introduced 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 percent of its old—are covered by formal arrangements for old age, buttressed by government policy. Public spending as a proportion of GDP 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 security 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 pension funds, mandate saving, guarantee benefits, offer tax incentives, create a legal system for reliable financial institutions, dampen inflation to encourage voluntary saving, and so forth. So the important policy questions are not: Should spending on the old increase? And should the public sector be involved? They are: How should the public sector be involved? Are public taxes and transfers the best alternative or are other types of public interventions and old age arrangements better?
Formal arrangements also differ in ways that go beyond the type and degree of government involvement. Pension funds may have either redistribution or saving and insurance as important objectives. They may specify either their benefits or their contributions in advance—defined benefits versus defined contributions. And they may be financed on a pay-as-you-go basis—ie. current pensions are financed by taxes on current workers—or on a largely funded basis—ie. current pensions are financed by prior savings, and liabilities don't exceed accumulated reserves. If trends continue, public spending on pensions will soar over the next fifty years in all regions.