Reforming Pensions: Lessons from Economic Theory and Some Policy Directions
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Reforming Pensions:
Lessons from Economic Theory and Some Policy Directions

Pension systems have wide-ranging and important effects. They influence the living standards of older people and hence the welfare of both older people and their children. They can also affect national economic performance through potential effects on the labor supply and saving. The design of pensions therefore matters. In discussing the topic, this paper draws on two of our earlier works. 1 It starts by setting out some central lessons from economic theory. The second section derives some policy implications of particular relevance to Latin America. The policy chapters in our two earlier books focus particularly on two countries in which we have worked: China, which is important because of its size, and Chile, which is important because its 1981 reforms were widely adopted in Latin America and elsewhere and which has become an exemplar in the pension debate. Box 1defines some of the relevant terms. The final section concludes.

Key Lessons from Economic Theory

Economic theory offers a series of conclusions that should frame policy design. Some of them, though apparently obvious, are frequently forgotten; others can be counterintuitive. We focus on five sets of lessons: pension systems have multiple objectives; different pension systems share risks differently, both across people and over time; there is no single best pension system; pensions should be analyzed in a second-best context, that is, taking account of market imperfections and other distortions; and a move to funding may or may not be the right policy. [End Page 1]

. Terminology

Defined-benefit (DB) pensionsare systems in which the pension benefit is determined as a function of the worker's history of covered earnings. The formula may be based on the worker's final wage and length of service or on wages over a longer period (for example, a full career). A DB system may be fully or partially funded, or it may be unfunded. In a pure DB arrangement, insofar as the degree of funding is maintained, the sponsor's contributions are adjusted to meet anticipated obligations; thus, the risk of varying rates of return to pension assets falls on the sponsor.

Defined-contribution (DC) pensionsare systems in which the benefit is determined by the value of assets accumulated toward a person's pension. Benefits may be taken as a lump sum, as a series of withdrawals, or through an annuity. The expected discounted value of benefits is thus equal to the value of assets (in technical terms, the benefits are determined actuarially). 1 A pure DC plan adjusts obligations to match available funds, so that the individual bears the portfolio risk.

Fully funded pensionspay all benefits from accumulated funds. See also partially funded pensions.

A noncontributory pensionis based on age and years of residence.

Notional defined-contribution (NDC) pensionsare financed on a pay-as-you-go or partially funded basis, with a person's pension bearing a quasi-actuarial relationship to his or her lifetime pension contributions.

Partially funded pensionspay benefits both from accumulated assets and from current contributions.

Pay-as-you-go (PAYG) pensionsare paid out of current revenue (usually by the state, from tax revenue) rather than out of accumulated funds. Partially funded pensions are often referred to as PAYG.

A provident fundpays a defined-contribution pension based on the performance of a single, central fund rather than on the performance of individual accounts.


1.The discounted value depends on the relevant interest rate and load factors.

Pension Systems Have Multiple Objectives

For the individual or family, the major objectives of pensions are consumption smoothing (redistribution from one's young self to one's older self) and insurance. Governments have additional objectives, including poverty relief and redistribution. Any analysis of pension reform needs to take account of the full range of objectives alongside other policy goals, such as economic efficiency and output growth.

Different Pension Systems Share Risks Differently

Separate from their redistributive effects, different pension systems share risks differently. Pension systems are subject to multiple sources of risk, and they have different underlying philosophies of who should bear those...