Unfunded pension schemes and intergenerational equity

                In two earlier posts (here and here) I looked at issues involving debt and intergenerational equity. The second attracted a lot of interesting comments. Some had difficulty with the idea of debt as a burden, and I think one way to help here is to look at pension schemes. (I hope to return to other comments later.)

                When I talk about intergenerational equity to students, I go through all the ways that the current generation is exploiting future generations, like climate change, rising house prices, and rising government debt. I also say that of course the older generation could just get the younger generation to pay them directly. I then reveal, to the surprise of some, that that is exactly what happens in many countries because these countries run unfunded pension schemes.

                An unfunded scheme is where the working generation pays social security contributions, and that money goes straight into paying the pensions of the old, rather than buying some kind of asset (hence unfunded). When the scheme starts, the current old receive a windfall: a pension without having contributed anything. The young pay contributions, but then receive a pension when they get old from the new younger generation. So the older generation when the scheme starts are clearly winners, but are there any losers? The answer depends on two things.

                The first is whether the scheme ever stops. If it stops, the young in the period beforehand are clear losers. They paid contributions (which went straight to the then old), but get nothing when they get old. Obviously the scheme is a huge burden on this ‘final generation’. However if the scheme goes on forever, there is no last generation, so there is no loser on that account.

The second issue is whether those who are forced to save by contributing to the pension lose out because they could have done better saving for themselves. That in turn depends on whether the rate of interest (r) is greater than the rate of growth (g). Those who contribute to the pension scheme get back more than they put in because of economic growth. The income of the young as a whole will be higher either because of technical progress which raises income per head (assuming contributions are a fixed proportion of income), or because there are more of them which raises the number of heads. In either case the current young generation contributes more than the old did when they were young, so the old benefit from that extra money. However if they had saved themselves their return would be the rate of interest. So if r>g, each generation of young lose out a bit by being forced to save in a way that produces a return equal to g rather than r.

All that is happening here is that money is passing from one group to another, with the government acting as an intermediary. Society is ‘paying itself’. But this statement says nothing about intergenerational equity. Suppose the scheme only lasted one period. Money passes from the young to the old, but it would be absurd to say that this implied that the young were not losing out.

Those who read this earlier post will see the parallel with the case of government debt. With pensions the young get an implicit promise that they will receive their money back with a return equal to g, whereas those that buy debt get an explicit note saying they will get their money back with some rate of interest r. The implicit/explicit thing is not crucial here – after all the government can default! The key difference is that, if people are to buy the debt voluntarily, they get a return equal to the return on other forms of saving (=r). If r>g, taxes have to rise to make up the difference between the two when debt is issued.

An unfunded pension scheme has the same macroeconomic costs that I discussed before in relation to government debt. In particular, if the young save at least part of their pension this way, they will save less in productive capital, and if the amount of capital in the economy as a whole is less than the optimal level, this will be an important cost. In addition, to the extent that the contributions act like an income tax, it can distort work effort.

Does this mean that an unfunded pension scheme is a bad idea? You can see why it might be introduced even if it was a bad idea – its introduction is great for the current old, so they will always vote for it. There are two potentially important benefits, if the alternative is funded private schemes. First, it takes away a lot of the uncertainty in funded schemes. If you buy your private pension when the stock market is high, and retire when it is low, you could lose out in a big way. You might also want insurance against labour income risk. (See, for example, this paper by David Miles.) Second, it provides a safety net for those who were misguided enough not to contribute to a private pension. (For a useful reference on pension issues, see Oxford Review of Economic Policy Vol 22, No1, Spring 2006.)

                I think this nicely illustrates why intergenerational equity can never be the overriding concern when it comes to issues involving government debt or unfunded pension schemes. There are many other factors to consider that may be more important. If it was decided that the costs of unfunded pension schemes exceeded the benefits (or, more realistically, that the balance should move to funded schemes), then the generations involved in any transition would almost certainly lose out. They would become like the final generation in my discussion above. That issue of intergenerational equity should be important in any decision, but it should never be the only consideration.