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The Need of Intergenerational Equilibrium:
Going Beyond Parametric Adjustments
within Pension Systems in Europe
Marek Góra
Warsaw School of Economics
AARP and European Centre, Dürnstein, October 2008
Economic and social background for traditional pension systems as
well as the systems themselves originate from distant past.
Since that time population structure passed not only quantitative but
also deep qualitative change.
Quantitative-parametric adjustments within pension systems,
although needed, are insufficient given the scale of the change.
Ageing in OECD countries
Demographic (low fertility, high longevity) as well as policy driven processes (early
retirement) led to a situation in which in 2004 average man in OECD countries drew
a pension for 18 years and average women for 23 years, while in 1970 that numbers
were 11 for men and 14 for women.
In OECD countries one person aged over 65 is per five people aged 20 to 65 years.
In 2050 there will be one per two. This process is strongly advanced mostly in
Europe and in Japan.
Demographic transition
b
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t
h
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n
d
d
e
a
t
h
r
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t
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s
Stage 1
Stage 2
Stage 3
Stage 4
Birth Rate
Population
Death Rate
1700s
p
o
p
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l
a
t
i
o
n
Demographic
Growth
1800s
1900s
2000s
GDP divided between generations
GDPR
_______
GDP
1
A
B
opt. (?)
opt. (?)
C2
C1
0
time
What shall be changed to bring pension systems back to reality?
Country specific response to that questions
„Wealth trap”
The pension system (macro perspective)
The pension system is a way of dividing current GDP between a part kept by
the working generation and a part allocated to the retired generation.
GDP  GDP W  GDP R
If
GDPR/GDP = const.  economic neutrality (production factors
remuneration not affected)
Proportions of the division are subject to public choice.
The pension system (micro perspective)
From the individual perspective, the pension system is a way of income
allocation over life cycle. In the activity period individuals buy pension rights;
after retirement they sell the rights.
If
PV(C) = E[PV(B)]

actuarial neutrality (decisions on
income allocation over life-cycle not affected)
The pension system is an institutional framework for intergenerational
exchange. The system should aim at balancing of interests of the retired
and the working part of population.
In the pension system there are only those who pay contributions and
those who receive benefits. Irrespective to its particular design, the
retired consume a part of GDP produced by the working generation.
The pension problem we face is not the problem of the scale of GDP
but the problem of how to divide current GDP between pensions and
remuneration of production factors (I leave out other transferres).
As long as pensions are related to wages -- even if economic growth
were strong -- the pension problem stays unsolved. By the way, growth
will not be strong if production factors are not remunerated adequatly
to their productivity.
Financial sustainability of pension systems can be improved by:
Increasing retirement age;
Increasing labour participation in working age;
Reducing indexation of benefits;
Increasing the contribution rate or taxes (???)
Rationalisation is needed but insufficient. Even if it is implemented at a
substantial scale it should be followed by a systemic reform.
11
In the past the key goal of pension system was old-age poverty alleviation.
Now this goal is still important but it can be reached more efficiently via
the budget, while publicly or privately run universal pension systems’ goal
is providing people with a method of income allocation over life cycle. At
the macro level that leads to intergenerational equilibrium.
Intergenerational equilibrium if:
GDPR/GDP = constant
(macro perspective)
PV(c) = E[PV(b)]
(micro perspective)
GDP2
GDP1
T1
R1
GDP1
T2
R2
A pension reform can mean:
 Implementation of a mechanism that generates pension rights, hence
also sets pension expectations at the level that can be maintained
without an increase of burden put on the next generation;
 Channelling flows of contributions through financial markets in a way
that generates positive externalities for GDP growth;
In the system based on individual accounts pension rights are
constantly valuated, hence automatically adjusted.
Individual accounts let design the pension system in a way that
interests of the workers and the retirees is equally valued.
Such pension system – being still dependent on demography – can
work in any given demographic situation.
If the system individualises participation then the role left for the state
is regulation and supervision.
Pension systems can be divided into two classes:
 public (universal, mandatory), in which the need to decide is limited
but at the same time responsibility for future outcomes of that
decision is spread over the entire population;
 Private (non-universal, voluntary, additional), in which individual
decisions are crucial and responsibility for their outcomes is on
individual participants.
The above should not be confused with public or private management
of systems.
Key objective for pension reform is to reduce ex ante pension
expectations expressed in relative terms.
The only other option is to adjust pensions ex post, which means
reduction of pension levels in absolute terms.
Four dimentions of discussion on pension systems:
Key objective (redistribution vs. income allocation)
Coverage (universal/public vs. group/private)
Management of the system (public vs. private firms)
Financing method (financial markets vs. real economy)
A universal system can be perceived as and called a public scheme,
while non-universal schemes can be called private. This classification
of systems does not imply public/private ownership of institutions
running pension systems. In particular a private firm can manage a
part of the public pension system. This is a special case of the publicprivate partnership implemented within social security – but not
privatisation of the system. Contrary, the private sector enters social
security taking a role in providing people with social security.
If redistribution is finance via the budget then:
Broader redistribution base;
Social needs can be better addressed (adjustability);
Pension system becomes transparent.
Traditional pension system is typically kept within an etatistic
framework.
Pension system based on individual accounts extended by budgetary
discretional interventions is closer to the principle of subsidiarity.
Traditional pension system focuses on the retirees while the system
based on individual accounts balances interests of retirees and the
interest of the working generation.
Funding (FDC) is not a solution to pension system problems. Funding
is just a useful method pushing the system towards intergenerational
equilibrium.
We can achieve the same goal not using financial markets (NDC).
Both approaches have advantages and disadvantages. We can apply
a combination of the two.
A deep systemic pension reform is inevitable since the Ponzi game is
over.
The sooner the reform is implemented the lower its economic and
social cost.
Individual accounts instead of traditional anonymous system is a
change of method – not giving up the social goals of the system.
Key features of the Polish approach
 Focusing on the mandatory part of the pension system;
Separation of OA and NOA;
Termination of the OA part of the previous system;
Creation of entirely new OA pension system based on saving in the activity
period and insurance after retirement;
Splitting each OA contribution between two individual retirement accounts
per person;
Annuitisation of account values at the moment of retirement;
Minimum pension supplement on the top of both annuities if their sum is
below certain level (paid out of the state budget).
Two DC
arrangements
Two pension arrangements dominate discussions on pension reforms:
 Non-financial (notional) Defined Contribution (NDC) – individual accounts
not using financial markets, generating rate of return equal GDP growth rate;
 Financial Defined Contribution (FDC) – individual accounts using financial
markets, generating rate of return determined in the markets.
Two Accounts: Similarities and Differences
NDC and FDC are almost identical from both individual and macro perspective.
NDC and FDC are managed differently and different are possible positive
externalities they generate.
Neither NDC nor FDC plays any redistributive role
Contributions before and after the reform
Total
NDC
individual account
FDC
individual account
Other parts of the
system
--
--
before 1 Jan 1999
Social security
contribution
36.59
--
after 31 Dec 1998
OA contribution
19.52
12.22
7.3
--
NOA contribution
17.07
--
--
17.07
Phaising-in
New system (people born after 31 Dec. 1948)
People born
after 31 Dec. 1968
People born
before 1 Jan. 1969
Automatically covered Automatically covered
by the new system; OA by the new system; OA
contribution
contribution either
automatically split
split between two
between two accounts accounts or paid into
[NDC+FDC]
one account
[(NDC+FDC) or NDC]
Old system (people
born before 1 Jan.
1949)
Stay in the old system
(no possibility to
switch for the new
one);
no accounts
The choice made by those born after 1948 was kept within the new system and
did not really affect their future pensions
Public-Private Partnership
Pension reform was not privatisation of social security
Entire OA pension system stays public. Its part is just privately managed.
The remaining part of the system could and should also be privately managed –
which would not change the nature of the system itself.
Implementation of pension funds was a part of the method applied, not the goal
of the reform.
Projection of pension expenditure
2004
Belgium
Czech Republik
Denmark
Germany
Estonia
Grece
Spain
France
Ireland
Italy
Cyprus
Latvia
Lithuania
Luxemburg
Hungary
Malta
Netherlands
Austria
Poland
Portugal
Slovenia
Slovakia
Finland
Sweden
UK
2025
10.4
8.5
9.5
11.4
6.7
n.a.
8.6
12.8
4.7
14.2
6.9
6.8
6.7
10.0
10.4
7.4
7.7
13.4
13.9
11.1
11.0
7.2
10.7
10.6
6.6
2050
13.4
8.9
12.0
11.6
5.1
n.a.
10.4
14.0
7.2
14.4
10.8
5.3
7.6
13.7
13.0
10.0
9.7
13.5
9.5
15.0
13.3
7.3
13.5
10.7
7.3
15.5
14.0
12.8
13.1
4.2
n.a.
15.7
14.8
11.1
14.7
19.8
5.6
8.6
17.4
17.1
7.0
11.2
12.2
8.0
20.8
18.3
9.0
13.7
11.2
8.6
Δ(2050-2004)
5.1
5.6
3.3
1.7
-2.5
n.a.
7.1
2.0
6.4
0.4
12.9
-1.2
1.8
7.4
6.7
-0.4
3.5
-1.2
-5.9
9.7
7.3
1.8
3.1
0.6
2.0
Countries marked according to
level of expenditure:
green – low and/or decreasing
yellow – intermediate
purple – high and/or increasing.
Poverty risk by age
EU25
EU15
Belgium
Bulgaria
Croatia
Denmark
Germany
Estonia
Ireland
Greece
Spain
France
Italy
Cyprus
Latvia
Lithuania
Luxemburg
Hungary
Malta
Netherlands
Austria
Poland
Portugal
Romania
Slovenia
Slovakia
Finland
Sweden
UK
0-15
20b
20b
19
22b
18
10
13
21
22
19
24
14
24
12
21
27
20
19
22
16
15
29
24
25
9c
18
10
8
22c
16-24
21b
21b
17
20b
12
29
14
18
19
23
18
18
23
12
19
23
15
17
11
16
13
26
20
22
11c
17
22
23
18c
25-49
14b
14b
11
14b
11
10
12
16
14
15
16
11
16
10
17
19
13
14
13
10
11
21
17
16
8c
14
8
8
13c
50-65
13b
13b
11
10b
6
5
13
18
20
18
17
10
15
14
20
18
8
10
13
8
10
16
18
13
9c
8
9
5
16c
65+
(18b)19
(19b)20
21
16b
5
18
15
20
33
28
29
16
23
51
21
17
7
6
15
5
14
7
28
17
19c
7
18
11
24c