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Solidarity versus Free Market: Is this Opposition Crucial?
Marek Góra 1
1. The reason for quest for pension reform
Pension reforms are on the top of policy agendas throughout EU and elsewhere. The reason
for this is not insufficient protection of interests of retirees as well as the reason is also not
lack of opportunities for additional savings in voluntary pension schemes. Solidarity as well
as free market options are a part of institutional framework in EU countries. The reason for
the quest for pension reform is the loss of control (due to the second demographic transition)
over division of GDP between the generation of workers and the generation of pensioners.
GDP = GDPW + GDP R
(1)
where: GDP W is the part of GDP spent on remuneration of production factors; GDP R is the
part of GDP allocated to the retired generation.
The pension market determines the shares of GDP allocated to each generation. Various types
of pension systems create an institutional framework for intergenerational exchnge.
Irrespective of the pension system design and technique used, the pension system exchanges
rights of the retired generation for a part of the product of the working generation. 2 The
working generation finances contributions in order to purchase the rights; the retired
generation sells the rights in order to get a part of the product of the working generation. The
demand side of the market is determined by the number of workers, their productivity and the
contribution rate. The number of retirees determines the supply side. This can be presented as
a simple model (2).
1
Marek Góra is Professor at the Warsaw School of Economics ([email protected]).
2
The exchange can be organised in various ways and also the rights can be expressed in various ways. In
particular, the rights can be either traded in the financial markets, or defined in relation to some economic
variables, or just based on political promise. In all of these cases there is a kind of market for pension rights.
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D = c w LW
(2a)
S = z w LR
(2b)
where: D – demand; S – supply; c – contribution rate 3 ; z – replacement rate; w (bar) – average
wage; LW – number of workers; LR – number of retirees.
In equilibrium the above can be reduced to equation (3).
z=c
1
d
(3)
where: d – dependency ratio (d = LR/LW ).
Expressing both demand and supply in terms of wages does not narrow the model to nonfunded pension systems as well as it does not narrow the model to mandatory systems. This is
just measuring demand and supply. Given the institutional structure of labour market
determining activity, the relation between contributions and benefits is solely determined by
the demographic structure. In equilibrium division of GDP does not depend on the type of
pension system and its design. 4
2. What does solidarity mean in pension systems?
Solidarity is one of crucial features of developed societies. It is needed and beneficial for the
societies. However, in discussions on pensions and pension reforms the term solidarity is
often reduced to meaning of redistribution. This narrows the discussions and also makes them
more difficult. Using the term solidarity make sense for both inter- and intra-generational
relation within societies. The meaning of redistribution is not so universal.
The meaning of intra-generational redistribution is clear. In many cases redistributing within
generations has very good reasons. The decision whether to do this is left to public choice.
The problem of inter-generational redistribution is more difficult. It can be understood as
transferring a part of GDP produced by the working generation to the retired generation who
have not contributed to this GDP. If this is the meaning of redistribution then it is very natural
since there is no other way for the retired generation to consume. I prefer to call this type of
3
True contribution rate including also possible subsidisation of pension systems.
4
The pension system type and design matters of course for the size of GDP.
2
redistribution “intergenerational exchange” in order to highlight that in fact both ge nerations
buy and sell pension rights (as briefly described in the previous section). The pension system
provides an institutional framework for this exchange.
The inter- generational redistribution can also mean a situation in which welfare of different
generations is not equally important. One generation receives from the system more than it
paid in, another generation receives less (in both cases in terms of present value). While
redistribution can make sense for individuals, it does not make sense with respect to
generations. However, inter-generational redistribution takes place in majority of pension
systems not being a result of any public choice. It is driven by demographic change and leads
– through slowing down growth – to welfare loss for all generations. 5 The part of GDP
allocated to the retired generation is growing. In consequence the part of GDP that is used for
remuneration of production factors is shrinking. To achieve pension system neutrality for
growth it is essential to keep stable the proportions of GDP division between generations.
Inter- generational redistribution of the latter sense should be eliminated from pension
systems. Redistribution in the former sense – we can call it here just solidarity – still exists
when the proportions of GDP division are kept stable (GDP R/GDP = constant). Concluding
the issue of inter- generational redistribution: sharing product of the working generation with
the retired generation is needed, while changing proportion of the shares should be avoided.
Now we come back to intra- generational redistribution. Should it exist in pension systems?
The answer is not as clear as in the case of inter- generational redistribution. Redistribution is
needed in societies to the extent chosen by them. However, a question arises: Are pension
systems a suitable arrangements for redistribution? An alternative is moving redistribution
from the pension system to the state budget. In comparison to redistributing through the
pension system redistributing through the budget has the following advantages:
ü Broader redistribution base (entire GDP, while in the case of the pension system it is
only labour income);
ü Better adjustability to changing social needs (decision each year, while the pension
system creates long-term commitments);
ü More redistribution (the rich usually pay (some) progressive taxes while contributions
to pension systems are linear).
5
If each generation welfare is equally important then it is the only Arrow-Debreu equilibrium (Nash equilibrium
if we define generations as players) that is Pareto optimal.
3
Additionally, intra- generational redistribution can create pressure that in turn can lead to intergenerational redistribution of the latter sense, namely lower valuation of welfare of later
generations of workers. Nowadays interests of retirees are pretty well protected in EU
countries – in many cases much better than interests of workers who share their product with
the retirees.
This brief discussion leads to a conclusion that redistribution should be organised outside the
pension system that should play a sole role of income allocation method instead of combining
an attempt to reach the two goals, namely income allocation and redistribution
simultaneously. Moving redistribution from pension systems to state budgets is probably one
of crucial preconditions for reintroducing inter- generational equilibrium. 6 This leads,
however, to another questions: Can we attribute the name solidarity based to a system that
offers individualised participation, hence, no redistribution? What does solidarity mean in this
case?
Participating in the same scheme people share all costs and risks. Solidarity means they
collectively allocate income over their life-cycles. A contribution of a rich and a poor, a
contribution of a financial expert and a financial laymen, a contribution of a lucky guy and an
unlucky guy are managed together and all participants receive the same outcomes. With
exception to the issue of redistribution, this is close to the definition of solidarity provided by
the conference organisers.
Another issue related to solidarity is whether the type of pension system, namely pay-as-yougo or funded, matters for solidarity within the pension system. Traditional pay-as-you-go
system is commonly described as a solidarity based one contrary to systems called funded that
are not described like that. It is a kind of misunderstanding stemming from the fact that
traditionally pay-as-you- go systems are mandatory, hence universal, while funded schemes
often cover only groups of people, so from the nation-wide viewpoint they are not solidarity
based. Buying and selling financial assets backing pension rights does not matter for
solidarity. What matters in this situation is not pay-as-you- go versus funding but universal
versus non-universal coverage. In a pay-as-you- go system participants are mandated to pay
social taxes. For participants it is similar to paying regular taxes. In a mandatory funded
system workers are mandated to buy financial assets which (ceteris paribus) creates the
6
An example if this way of thinking is the design of minimum pension guarantee in the new Polish and Swedish
pension systems. In both countries the guarantee means a supplement toping the sum of all universal system
annuities to the level legislated as minimum. The supplement is financed out of the state budget.
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demand for assets sold by retirees. In terms of the simple model presented in Section 1, the
effect, namely allocating a part of GDP to retirees, is the same in both cases. As long as there
is no intra-generational redistribution the type of pension system does not determine whether
a particular system is or is not based on solidarity. Either both types of systems can be called
solidarity based (workers share a part of their product with retirees) or both cannot be called
like that.
By the way, pension systems using financial markets have a feature that is very useful in the
context of redistribution. It is easier for participants to understand and internalise the fact that
pension rights originate in our own previous income.
3. Are occupational pension schemes a good solution to the pension problem?
Traditional mandatory pension systems are based on ex ante promises that can, in principle,
be changed ex post (reduction of actual pensions). In practice pension commitments proved to
be pretty rigid. This has lead to large indebtness which is hidden – so we do not see it in
national accounts – but since it has to be paid back it creates burden on the working
generation equivalent to open debt. 7 The quest for pension reform stems from strong
(projected to be soon even stronger) negative externalities they create (unemployment, weaker
growth).
The distinction between universal and non-universal pension systems plays a very important
role in discussions on pension reforms:
ü Universal pension system covers entire population using the same rules of
participation for everybody. Full universality can be reached only via mandatory
participation. Universal systems can be publicly or privately run; they can use or not
financial markets. Participation can be anonymous or individualised. In both cases
participants do not choose whether to participate and to what extent to participate
(contribution). In the latter case the system generates individual liabilities, while in the
former it does not. So anonymous participation allows for intra-generational
redistribution.
7
Unfortunately accounting rules used in EU have not been adjusted yet to the situation in which hidden pension
debts are much larger than open debts. The current rules create incentives to keep as much of pension debt
hidden as possible. In consequence the control over the entire debt, namely the sum of the open and the hidden
debt, is weaker.
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ü Non-universal pension system (scheme) covers individuals or groups of individuals
who decide whether to participate, how much to pay and when to pay.
Voluntary schemes in principle do not create such problems. – In principle – since the relation
between contributions and benefits on average is the same as given by equation (3). This
means particular schemes can generate better effects. However, what matters the most is
willingness of participants to pay higher contributions in voluntary schemes. The more left for
voluntary decision the higher, ceteris paribus, propensity to save since voluntary decision
makes contributions similar to our regular savings outside any pension system. This
hypothesis is illustrated in Figure 1.
It is not clear whether this relationship really exists and what is its strengths. However, if it
does then we will have an additional strong argument for promoting voluntary schemes
especially in times of worsening of demographic indicators. Using notation from Section 1, a
dependency ratio decrease leads to a need to increase scale of income allocation (contribution
rate). Otherwise lower replacement rates will have to be accepted by individuals belonging to
coming generations of pensioners.
UNI
UNI
N-UNI
N-UNI
(anonymous
participation)
(individualised
participation)
(occupational)
(individual)
regular
savings
taxation
Figure 1. Taxation versus savings nature of pension contributions
Universal systems could be:
ü Extended by voluntary schemes
ü Partially exchanged for voluntary schemes
ü Entirely exchanged for voluntary schemes
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In all cases listed above the sum of contributions paid to universal and non-universal should
remain at the level close to optimal. If universal contribution is high the room left for nonuniversal contribution is small. This is the case in many EU countries so expansion of the first
option is unlikely. Also unlikely is probably the third option. Its implementation would mean
drastic reduction of solidarity in the system and it would also open the door for myopia and
free riding. So the only possible option is the second one of the three listed above.
Although partial exchanging unreformed universal systems for non-universal schemes is a
good idea it is difficult to implement since unreformed traditional universal systems
commonly need an increase of contributions, so its reduction is extremely difficult. This leads
to a conclusion saying that expansion of non-universal schemes needs a reform of universal
systems which would stop their ever increasing “hunger”. So deep reforms within traditional
universal systems are needed not only for avoiding bankruptcy of these systems but also for
expansion of additional non- universal schemes that can bring more flexibility to income
allocation as well as open the possibility to increase the overall scale of income allocation.
Non-universal systems are supposed to be based on free market. Similarly to the discussion on
solidarity in pension systems the issue of free market also needs a piece of discussion. Free
market assumes free choice. In non-universal schemes the choice can mean:
ü decision whether to participate or not
if yes
ü decision on the scale of participation (amount of contribution, frequency of payments);
ü decision on the method of income allocation (savings or insurance or a combination of
the two);
ü decision whether to use an intermediary financial institution (the alternative is doing
the job by the person allocating income himself/herself);
if yes (in the latter bullet)
ü decision on which institution to choose.
Typically in universal systems none of these decisions is left for choice. In some systems only
the last decision of the listed above can be left for full or partial choice. Actually, the absence
of free choice is not a disadvantage of universal systems – it is a part of their nature, since
choice within universal arrangements can lead to uncontrolled and in many cases undesired
redistribution.
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In non- universal schemes we assume free choice. However, it would be really free if the
decision was individually taken in all bullets (above). That can be achieved only in regular
savings outside of any institutional arrangements related to pensions. In voluntary pension
schemes there are various restrictions on the way of participation. In occupational pension
schemes the choice is limited. If participation in pension scheme provided by the employer is
obligatory then the decision left for individual worker is reduced to choosing the employer
offering better (closer to individual preferences) scheme, participation in possible changes
within participation rules (if collectively decided), to some extent to choosing scale of
participation (there can be option to contribute more).
The term free market can be applied to occupational pension schemes also from the point of
view of using financial markets to back pension rights – opposite to traditional universal
pension systems not using these markets. However, in universal systems using financial
markets is not impossible. Just contrary, reforming universal systems usually means using
financial markets. Technically it is not difficult. It is difficult for other reasons, including the
discussion on redistribution as well as problems accounting (not discussed here). Using
financial markets in universal systems helps in reintroducing intergenerational equilibrium
(welfare of all generations valuated the same).
The advantage of mandatory industry-based pension schemes is relatively low cost of
participation. This is a strong argument. However, it is the argument leading to reduction of
choice for participants which is somehow against non-universal participation. This does not
lead to any simple conclusion, however, this contradiction should be kept in mind.
Different features of schemes offered in various industries can affect decisions on
employment. People choose better schemes. However, are desired features of pension systems
ofered in an industry correlated with productivity? It is not guaranteed. We can imagine
declining industries that can – due to inertia and/or political reasons – offer better schemes.
This can contribute to slowing down restructuring. Higher mobility is one of key goals. For
the reason mentioned above, as well as for possible constraints on participation portability,
occupational pension schemes can reduce mobility.
Intra- industry (mandated) solidarity can prove to be a trap for next generation of workers.
Restructuring can strongly affect the industry and reduce the number of those who were
supposed to finance the solidarity. Mandatory industry pension schemes have features similar
to universal nation-wide systems. Narrowing the nation-wide systems to industry-wide
schemes goes in the opposite way to the needs of integriation. Actually, it is high time to think
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on how to adjust universal country systems to the increased need for mobility. Harmonisation
of national systems will be insufficient soon and a pan-EU pension system may be needed one
day.
4. Concluding remarks
1) Can solidarity and free market go together? As discussed in previous sections this depends
on how we define these terms. If solidarity means sharing the product of the working
generation with the retired generation and if free market means using financial markets then
the two can easily go together. If the same meaning of solidarity is confronted with the free
market understood as free choice then – although more difficult – it is still possible to
combine the two. So the meanings of solidarity and free market are in the above cases are
almost orthogonal. They do not contradict each other. However, if we define solidarity as
redistribution then it cannot be combined with free market in each of the two meanings.
2) Occupational pension schemes combine features of universal pension systems (though not
offering unique participation rules within the country) and non-universal schemes based on
individual decision and responsibility (though not offering full free choice). Pension systems
typically combine universal and non-universal elements. There can be two different
approaches to this issue. First approach focuses on providing the universal system and nonuniversal options, leaving at the same time the decision on combining them to the people.
Second approach prefers combining the universal and non-universal features and providing
people with the final effect. What is better? The question is open.
3) Irrespective to particular answer to the above question, the main challenge remains the
same. It is the need to design and implement a deep reform (not just a piece of rationalisation)
of universal pension systems. The reform should lead to reaching the following two strategic
goals:
ü the shares of GDP division between generations should be stable over time;
ü participation in universal pension systems should be individualised in order to shift
perception of contributions from close to tax in the direction of savings (well defined
liabilities).
The first goal leads to economic neutrality of pension systems. This means GDP growth will
not be slowed down due to inflation of pension rights. The second goal leads to reducing the
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effective size of the tax wedge contributing to improvement of labour market situation. In
both cases key role is played by individual accounts (not necessarily financial).
4) Universal participation can only be reached by mandating people to participate. Mandatory
(universal) schemes are public by definition. Running the universal pension system can be
public or private but this should not be confused with the system itself.
In each individual case a combination of participation in universal and non-universal schemes
should provide an outcome which is individually perceived as optimal scale of income
allocation over life cycle. The universal system should be kept at the level letting to afford
standard level of consumption after retirement. The standard level is not defined here. It
should be obviously above the social minimum but also not above modal consumption level
in the society. Income allocation generating retirement income above that level should be left
for individual decision.
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