Academic journal article National Institute Economic Review

The Implications of Switching from Unfunded to Funded Pension Systems

Academic journal article National Institute Economic Review

The Implications of Switching from Unfunded to Funded Pension Systems

Article excerpt

I. Introduction

In principle the distinction between unfunded and funded pension systems is simple: in unfunded schemes pensions paid to those currently retired are financed by contributions from current workers and firms; in funded schemes a stock of assets is accumulated from contributions which is used to finance pensions. In practice unfunded schemes tend to be run by the state - for the very good reason that private agents would find it hard to enforce the intergenerational contract implicit in unfunded schemes; in many cases unfunded, state schemes also redistribute income to the less well off because the level of contributions paid by workers (either directly or on their behalf) bears a closer relation to their lifetime income than does the pension they subsequently receive. For example, in the UK all those with a full entitlement to a basic state pension receive the same pension; and a full entitlement is not dependent on the value of contributions paid over the working life but rather upon the number of years in the workforce (either employed or unemployed). In practice most funded schemes are run by the private sector (either occupational pensions or private pensions where contributions are only made by the individual); and while there is often redistribution implicit in these schemes it is not generally from the better off to the less well off. In the UK, occupational pensions redistribution has more normally been from those who move jobs relatively frequently to those who stay put; personal pensions are invariably defined contribution schemes where pensions are dependent on the value of the fund at retirement and there is no redistribution between pensioners.

Because of these institutional facts much of the discussion of the relative merits of funded and unfunded schemes is as much about the relative efficiency of public against private sector provision, and the desirability of redistribution to the less well off, as it is about funding per se. In this paper I will try to be clear about what is intrinsic to funded and unfunded schemes and what is not; my aim is to consider the advantages and disadvantages of reducing reliance on unfunded pensions and moving to a (more) fully funded system. I will assume that unfunded schemes are state run systems because only the state can enforce contracts with future generations. But funded systems can be run by the public or private sector. I will argue that what matters for funded systems is the degree of linkage between contributions and subsequent pension payments and the portfolio composition of funds rather than whether they are run by the public or private sector. High linkage is where pension payments are (given rates of return on funds and after accounting for administrative costs) close to being of equal present value to that of (net of costs) contributions - this is approximately true with defined contribution, personal pensions in the UK. Low linkage would allow for significant redistribution - for example by having pension payments out of funds accumulated by a person's lifetime contributions having a fixed element and rising less than proportionately with fund value.

[TABULAR DATA FOR TABLE 1 OMITTED]

Most state pension schemes in developed countries are unfunded (pay-as-you-go) systems. Table 1 presents information on state pension systems in some of the major economies; it shows total spending, contribution rates, retirement ages and the degree of indexation of benefits. There is substantial variability across countries; Continental European state pension schemes tend to be much more generous that the UK and US systems both in terms of replacement rates (the ratio of typical pensions to current average labour income) and in the rate at which entitlements to pensions accrue. As a result aggregate pension payments and typical contribution rates are also much higher. Few schemes have any significant assets - the US scheme is an exception, though even here forecasts suggest that on current policies the fund will be exhausted within about thirty years (Feldstein 1997). …

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