Pension Reform and Incentives for Saving and Retirement

Slowing economic growth and population aging in the major industrial countries have placed increased financial strain on pay-as-you-go (PAYGO) public pension systems. Governments have been forced to increase contribution rates and scale back benefit promises in order to maintain the solvency of their pension programs. Continuing financial pressure in these systems has also stimulated interest in fundamentally reforming the design of public pensions. One proposed reform is to move away from PAYGO financing and toward increased funding of future pension obligations, either within the existing public system or in a new private system. Advance funding of pension obligations is seen as a desirable option from a variety of perspectives. The most appealing argument is that funded pension programs would generate increased aggregate saving. Higher saving and faster capital formation can boost the future national income out of which the consumption needs of the elderly must be financed. Advance funding would thus provide a means by which current workers could provide additional resources for their own retirement, reducing the burden on the consumption of future workers.

The goal of this paper is to examine the implications of greater advance funding of national pension obligations. Increased funding could be accomplished by two different approaches to policy reform. The first would concentrate on building up a financial reserve within existing public pension systems. The second would be directed at scaling back the existing PAYGO system and introducing a new system of private individual accounts. Many critics of existing public pension systems question the viability of the first approach. They doubt that legislators could exercise sufficient discipline to avoid using funds accumulated in the public pension system to finance non-pension operations of the government — implicitly borrowing from the public pension fund to pay for programs that would otherwise be financed with income taxes or other general revenues.1 Therefore, they favor the expansion of private retirement accounts, on either a mandatory or voluntary basis. The buildup of pension reserves in private investment accounts also raises questions, however. As reserves are accumulated in workerowned retirement accounts, there is a possibility that workers would reduce other forms of household saving. Many workers would be in a position to simply incorporate any new government-mandated account within their own preexisting retirement plan. Thus, both public and privately-funded pension plans have uncertain effects on national saving.

The advantages and disadvantages of funded pension systems are discussed in the next section. The following three sections present empirical evidence on the efficacy of funding a pension system within the public sector and preventing the extra accumulation from being dissipated through increased deficits in the non-retirement accounts. The fifth section examines the response of private sector saving to the creation of new individual retirement accounts. It considers the extent to which the creation of new individual saving accounts might displace saving in other private retirement or non-retirement accounts.