OECD Countries Face A Looming Crisis In Their Public Pension Programmes

Many OECD countries face potentially enormous fiscal liabilities if they fail to reform their public pension programmes in the immediate future. This is the central message of Professor Richard Disney in a paper published in the latest issue of the Economic Journal.

Disney cites some examples of the growing costs of public pension programmes for some of the major OECD countries, using projections calculated by OECD staff:
Country Public Pension Payments as % of GDP

Canada                                                   5.2                9.0

In countries such as Germany, Italy and Japan, increases in the tax share of GDP to finance these growing liabilities will be of the order of 10% of GDP. Even in the UK, the OECD''s projected increase in the tax burden is 3.5%. With governments committed to holding tax burdens down, these increases will provide major scope for inter-generational conflict, over whether the burden is borne by the elderly in the form of lower pensions, or by wage earners in the form of higher taxes.

What has caused these adverse trends? The demographic transition to an aged society is only one factor among many. Forecasts of the consequences of demographics and of labour supply have often been much too optimistic. Improvements in longevity have been far faster than official actuaries projected: for example, in the UK, the number of pensioners predicted for the year 2020 by the Government Actuary''s Department in 1981 was 10.6 million. On a consistent basis, the predicted figure for 2020 is now well over 14 million – an increase of almost 40%. And the reduction in labour supply of older men has been much more rapid than was predicted in many countries, with few people working in their sixties or even their late fifties.

At the same time, bad management, inadequate cost controls and poor forecasting features are a factor. But a key feature is that most public pension programmes are unfunded: that is, current pension payments are financed by current taxpayers. In funded schemes (such as most private pension plans), assets are accumulated that match liabilities and pension ''rights'' are limited by these asset accruals. In unfunded schemes, rights can be ''claimed'' against the tax payments of future generations, some not yet born. The scope for financial discipline and for pork-barrel politics (for example, using lower pension age as an electoral ''bribe'') in unfunded schemes are considerable, and have been exploited by many governments.

Disney explored three options for reforming pension programmes:

• l The first is to ''tinker'' with the existing scheme, by raising the retirement age, cutting benefits, increasing labour force participation, while maintaining the unfunded nature of the scheme. This reduces the pain of change but is susceptible to political interference and reversal, and relies on behavioural responses that may not happen. For example, if the state pension age is raised from 65 to 70, will people really work for an extra five years? This is the short-run solution, and will be adopted in many countries.
• The second route, is to keep the unfunded nature of the scheme but to link entitlements very closely to amounts paid in contributions. This may well avoid the excessive generosity of previous schemes but it cannot guarantee fiscal sustainability: the government can still interfere with the rules governing contributions and benefits. Furthermore, the ''return'' on an unfunded scheme is intrinsically related to the growth of the labour force and its productivity, whereas a funded scheme can generate much higher returns on the capital market. Increasingly, contributors may feel that they are being ''robbed'' of a higher return.
• This leaves the third route, largely adopted in the UK and some other countries, of introducing a funded component to pensions, usually by ''privatising'' some of the scheme.

The attractions are that assets are created to match liabilities, the scope for government interference is limited (although not eliminated) and investors can benefit from high returns on the world capital market. The drawback is simple: the transition costs some generations a good deal because they will both have to honour most of the existing liabilities and to pay for their own future pensions. How to ''finesse'' this temporary extra cost is a live issue, extensively discussed in Disney''s report. But, one way or another, somebody will have to pay to eliminate these growing liabilities.

''Crises in Public Pension Programmes in OECD: What are the Reform Options?'' is published in the February 2000 issue of the Economic Journal. Disney is Professor of Economics at the University of Nottingham.

Richard Disney