Pension reform and equity

Benedict Clements, Csaba Feher, Sanjeev Gupta 17 July 2014

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Pension reform remains a critical fiscal policy challenge for advanced and emerging market economies. Despite reform efforts in these economies – which have focused on raising retirement ages and reducing benefits – spending is expected to rise as a share of GDP over the medium-term (EC 2012, Merola and Sutherland 2013). But pension reforms, to be politically acceptable, must also be perceived as fair. This column examines key equity challenges in the design of pension reforms, drawing on a new book published by the IMF (Clements, Eich, and Gupta 2014).

Equity challenges

The objectives of recent reforms to public pay as you go systems – such as increasing retirement ages and making pension indexation less generous – were to contain expenditure growth and help reduce budget deficits. But because pensions play such a central role in distributing income both within and across generations, these reforms can have important ramifications for equity.

Intra-generational equity in pension systems is affected by numerous factors, most importantly coverage: even if a pension system is internally equitable, it may aggravate inequality if certain disadvantaged groups do not participate.

Figure 1. Pension Coverage

Source: International Labour Organization.

Although in most advanced economies coverage is high, it can still be improved among women, the self-employed, and part-time workers (for example, in Australia and Japan). In many emerging economies, coverage is generally low (Figure 1), and efforts are underway to bring a higher share of the population into the pension system (as in China, India, Indonesia, Philippines, Thailand, and Vietnam). Pension systems can also aggravate inequality if coverage is limited to certain sectors (such as those for civil servants) which are subsidized from tax revenues – or if similar levels of contribution lead to very different benefit levels according to the type of labour contract, urban vs. rural residence, and citizenship status (as in China, Indonesia, and Singapore).

Within the pension system, equity concerns centre on the relationship between contributions and benefits: horizontal equity requires that individuals in similar circumstances should be treated similarly, whereas vertical equity requires treating individuals according to their needs.

Most defined benefit public pension systems redistribute income from high to low income individuals, from men to women, and from single to married people: indeed, one of the advantages of a defined benefit arrangement is that it can be designed to provide greater generosity to disadvantaged groups. Some redistribution in these systems, however, may be unintentional and can be addressed through parametric reforms: for example, final salary schemes and actuarially unfair early retirement rules may introduce perverse redistribution toward the well-off. Defined contribution schemes, at the same time, have no intentional redistribution, as benefits depend on lifetime contributions and the returns to these contributions. But these systems cannot counterbalance lifetime income differences or provide anti-poverty protection along the entire income distribution.

In part because of equity concerns, both advanced and emerging economies have been moving toward a “mixed model” of both defined benefit and defined contribution systems. Countries with little intentional redistribution within their earnings-related schemes (Australia, Chile, and New Zealand, for example) operate separate pension pillars to take care of low-income individuals. At the same time, defined benefit schemes with strong redistributive features have undergone reforms which strengthen the link between contributions and benefits (Latvia, Estonia, Croatia, Hungary, and Poland). On the other hand, countries where strong contribution-benefit links limit the system’s capacity to protect the elderly against poverty have already introduced or may need to consider social pensions to achieve this objective (Australia, Chile, China, and Singapore).

Inter-generational equity requires that the burden of financing the pension system and the benefits to be paid out are spread fairly across successive generations. In general, pension reforms have made systems less generous over time. In Italy, for example, pension contributions for current workers exceed their expected lifetime benefits (Figure 2), while current retirees enjoy a much better deal.

Figure 2. Net Taxes Paid (or Transfers Received) by Past, Present, and Future Participants (Percentage of Lifetime Income)

Source: Clements, Eich, and Gupta (2014).

Pension reforms to achieve sustainable and equitable pensions

There is no single best approach for achieving fair pension reform, as it depends on preferences and the weight given to different notions of equity. A key priority for many economies will be to maintain or achieve wide pension coverage (including India, Korea, and Singapore). In emerging economies with low coverage and fiscal space, an attractive option is to rely on noncontributory social pensions, financed by tax revenues (as in Argentina, China, Russia, and South Africa). These should be means-tested and set at a level designed to alleviate old-age poverty.

For countries with limited fiscal space that need to strengthen pension balances, the options are to either cut benefits, further raise retirement ages, or increase contributions. Of these options, further increases in effective retirement ages are the most appealing and have been pursued by most OECD countries for two reasons:

  • First, higher retirement ages can help boost growth by increasing labour force participation rates among older workers; and
  • Second, with shorter periods of retirement, governments can provide adequate levels of benefits in a fiscally affordable manner.

Retirement age increases have equity consequences, since lifetime income and education, among other factors, are correlated with life expectancy: thus, a retirement age increase may curtail the redistribution from high to low income people, in terms of total benefits received. In addition, lower-income workers in physically demanding jobs may not be able to continue working into their mid- to late-60s. To prevent higher retirement ages from increasing old-age poverty, it will be important to provide adequate but well-controlled disability pensions, relevant job training, and social assistance.

Reducing average benefits is also an option, although it requires more careful planning in order to avoid potentially adverse effects on poverty and inequality. The three main instruments available are the reduction of starting pensions, lower indexation of benefits already being paid, and subjecting benefits to standard rates of income tax. Most advanced and emerging economies have already introduced price indexation for benefits and reforms, which results in lower starting pensions. However, the tax treatment of benefits and contributions remains an area where much can still be done: public pensions enjoy tax easements in numerous countries (Argentina, Australia, Belgium, Canada, Germany, Korea, Norway, and Turkey). Beyond fiscal considerations, taxing benefits in the payout phase at standard rates has a strong appeal from an equity perspective as well: a progressive income tax regime can help reduce average benefits while protecting those with low pensions against poverty. In addition, this option is attractive from the standpoint of inter-generational equity, as some of the burden is shared by current pensioners.

Putting in place automatic adjustment mechanisms can help pension systems avoid unsustainable promises and ensure inter-generational equity. Notional defined contribution schemes (as in Italy, Latvia, Poland, Sweden), point systems (Germany), automatic benefit or retirement age adjustment mechanisms (Denmark, Greece, Italy, Japan, Spain, and Sweden) can be helpful in achieving this objective.

Final thoughts

In designing pension systems and reforms, equity and adequacy considerations should receive as much attention as fiscal sustainability. The practical implication of this is that simply looking at and modelling averages is insufficient: the effect of reform measures (such as benefit cuts) on low-income groups should be kept in mind. While international best practice is important as a general measuring stick, solutions need to be country-specific in recognition of different macroeconomic circumstances and country preferences.

Disclaimer: The views expressed herein are those of the authors, and should not be attributed to the IMF, its Executive Board, or its management.

 

References

Clements, B, F Eich and S Gupta (2014), Equitable and Sustainable Pensions: Challenges and Experience, International Monetary Fund.

European Commission (2012), 2012 Ageing Report: Economic and Budgetary Projections for the EU-27 Member States, European Commission, Brussels.

Merola, R and D Sutherland (2013), “Fiscal Consolidation and Implications of Social Spending for Long-Term Fiscal Sustainability”, VoxEU.org, 31 March.

OECD (2013), Pensions at a Glance, OECD.

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Topics:  Poverty and income inequality

Tags:  redistribution, fiscal policy

Division Chief for the Expenditure Policy Division of the Fiscal Affairs Department, IMF

Technical Assistant Advisor in the Fiscal Affairs Department, International Monetary Fund

Deputy Director of the Fiscal Affairs Department, IMF