Abstract
In this chapter, we analyse the effects of PAYG and funded pension systems on welfare. The debate on the choice between alternative systems focuses on their effects on savings, capital accumulation, labour supply, economic growth and inequality and the potential benefits of mixed systems in which a PAYG system with notional accounts is complemented by a funded pensions system. The main findings are as follows. Firstly, the redistribution of income among individuals makes the PAYG system an important part of any mixed system. Secondly, the design of the pension system should efficiently balance incentives and distortions with equality and insurance against individual idiosyncratic risks. Thirdly, funded systems generate positive effects on the savings rate, capital accumulation, productivity and the labour supply. These effects must be taken into account when PAYG systems are improved with notional accounts. Fourthly, in practice, income distribution among older people does not clearly depend on the relative importance of PAYG over funded pensions systems, suggesting that other factors are even more important. Fifthly, there are significant differences between advanced economies in their social preferences regarding the combination of replacement rates in PAYG systems and contributions to funded systems. Lastly, there is no guarantee that, regardless of social preferences, imposing a target of pension expenditure on GDP maximises social welfare.
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Notes
- 1.
In Sect. 4.4, there will be further discussion on the relationship between the ratio to contributions made and redistribution.
- 2.
The tax rate can be understood broadly as the result of dividing all the income from the social security system (not only social contributions but any other tax with which pensions are financed) by the payroll of the economy as a whole.
- 3.
According to the optimal growth models (see, e.g. Barro and Sala-i-Martin 2003; Blanchard and Fischer 1993), in the steady state the modified golden rule is verified, by which the interest rate is equal to the sum of the discount rate (ρ) and population growth (n), i.e. r = n + ρ. In these models, the steady state is dynamically efficient and capital (k) does not accumulate in excess when r = f ’(k) −δ = ρ + σg > n + g, where σ is the relative risk aversion coefficient, f ’(k) the marginal productivity of capital and δ is the depreciation rate.
- 4.
- 5.
In this chapter, the substitution rate is defined as the ratio between the initial pension and the regulatory base. It is therefore different from the replacement rate, which is the ratio of the initial pension and the last wage before retirement, or the benefit or generosity rate of the system, which is defined as the ratio between the average pension and the average wage of the economy.
- 6.
Other countries, such as Portugal and Finland, have chosen to use the present value of an annuity, rather than life expectancy. From a financial standpoint, it seems more logical to use the present value of an annuity because it seems to suit the purposes of the coverage given by a retirement pension. In fact, life expectancy is the specific case in the present value of an annuity, when the interest rate used for the valuation is zero.
- 7.
The choice of one or other parameter is more a preference question than a technical problem, since obtaining the value of the corresponding parameter does not entail any additional difficulty from an actuarial point of view.
- 8.
For example, in Spain, the reduction coefficients for bringing forward the retirement age vary between 6% and 8% per year, while those who delay retirement find their pension has increased by between 2.5% and 4% per year.
- 9.
For example, in Spain, having contributed for fewer than 15 years does not lead to any contributory pension, and any years in excess of 37 years of contributions do not generate any additional increase, unless they are added to another set of conditions.
- 10.
Devesa et al. (2012) estimated that the replacement rate would have to be reduced by 35% to make the system sustainable.
- 11.
Doménech et al. (2016) apply this type of model, in which both workers and companies have the power to set prices and wages in labour markets and products, in order to perform a breakdown of the structural shocks that explain the movements in the unemployment rate in Spain since the mid-1980s.
- 12.
Specifically, in Spain, the non-permanent Commission on monitoring and evaluation of the Toledo Pact Agreements on the issue of pensions suggests maintaining this separation of the sources of funding.
- 13.
More specifically, the inequality variable shown in this figure is half the variance of the distribution of disposable income, which have been estimated using the Gini index of income:
σ2/2 = (20,5∗norminv((1 + Gini)/2,0,1))/2
where Gini is the Gini coefficient of disposable income for the population aged 65 and over and norminv is the inverse of the cumulative normal distribution function with mean 0 and unit variance. The income level refers to the average disposable income, after taxes and transfers, of the population aged 65 and over in purchasing power parities of private consumption. The data have been obtained from the OECD Income Distribution and Poverty Database. (https://goo.gl/Lefexj)
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Acknowledgements
The authors would like to thank the comments by D. Carrasco and E. Marazuela. R. Doménech acknowledges the financial support of research projects CICYT ECO2014-53150 and GVPROMETEO2016-097.
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Devesa, E., Doménech, R. (2020). Pensions, Economic Growth and Welfare in Advanced Economies. In: Peris-Ortiz, M., Álvarez-García, J., Domínguez-Fabián, I., Devolder, P. (eds) Economic Challenges of Pension Systems. Springer, Cham. https://doi.org/10.1007/978-3-030-37912-4_4
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