6.3 Social Security and Pensions

Social Security and pensions are crucial safety nets for retirees and the disabled. They provide income support and protect against economic risks, aiming to alleviate poverty and redistribute wealth across generations.

These systems face challenges due to aging populations and funding issues. Governments grapple with balancing benefit adequacy and financial sustainability, often leading to reforms in retirement age, contribution rates, and benefit formulas.

Social Security and Pension Systems

Objectives and Design

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• Social security systems provide income support and protection against economic risks for retirees, disabled individuals, and survivors of deceased workers
• Pension systems ensure financial security in retirement by providing regular income to individuals who have ceased active employment
• Primary objectives encompass poverty alleviation, income redistribution, consumption smoothing, and risk pooling across generations
• Social security systems typically operate on a pay-as-you-go (PAYG) basis where current workers fund benefits for current retirees
• Pension systems structure as defined benefit (DB) plans guaranteeing specific retirement benefits or defined contribution (DC) plans where benefits depend on investment returns
• Design involves complex policy decisions regarding eligibility criteria, benefit formulas, contribution rates, and retirement age requirements
• Systems must balance adequacy of benefits with long-term financial sustainability considering demographic trends and economic factors
  • Example: Adjusting retirement age based on increasing life expectancy
  • Example: Implementing progressive benefit formulas to address income inequality

Types of Pension Schemes

• Defined benefit (DB) plans guarantee specific retirement benefits based on predetermined formulas considering factors like salary history and years of service
  • Example: A plan promising 2% of final salary per year of service
• Defined contribution (DC) plans involve individual accounts where benefits depend on contribution amounts and investment returns
  • Example: 401(k) plans in the United States
• DB plans provide greater predictability of retirement income for employees but create long-term financial obligations for employers or governments
• DC plans offer more portability and individual control over investments but expose participants to market risks and potential inadequacy of retirement savings
• Hybrid plans combine features of both DB and DC plans to balance risk-sharing between employers and employees
  • Example: Cash balance plans
• Notional defined contribution (NDC) schemes combine features of PAYG financing with individual accounts to improve sustainability and transparency
  • Example: Sweden's pension system

Funding and Sustainability of Social Security

Funding Mechanisms

• Social security programs primarily fund through payroll taxes, general tax revenues, or a combination of both
• Contribution rates vary across countries
  • Example: United States Social Security tax rate of 12.4% split between employers and employees
• Payroll taxes typically have a wage base limit, above which earnings are not subject to social security taxes
  • Example: Social Security wage base of $160,200 in the United States for 2023
• Some countries supplement payroll taxes with general revenue to fund social security programs
  • Example: Australia's tax-funded Age Pension system

Sustainability Challenges

• Demographic shift towards an aging population in many developed countries poses a significant challenge to PAYG social security systems
• Old-age dependency ratio measures the number of elderly individuals relative to the working-age population
  • Example: Japan's old-age dependency ratio of 48.2% in 2020
• Unfunded liabilities in social security systems represent the present value of future promised benefits exceeding projected revenues
• Parametric reforms address sustainability challenges by adjusting existing system parameters
  • Example: Increasing retirement ages
  • Example: Adjusting benefit formulas to reduce generosity
• Structural reforms aim to improve long-term financial stability through systemic changes
  • Example: Transitioning to fully or partially funded systems
  • Example: Introducing notional defined contribution (NDC) schemes
• Political economy of social security reform presents obstacles to implementing necessary changes due to resistance from various stakeholder groups

Distributional Effects of Pension Systems

Intra-generational Redistribution

• Pension systems can have significant redistributive effects within generations depending on their design and funding mechanisms
• Progressive benefit formulas in social security systems typically provide higher replacement rates for lower-income workers
  • Example: U.S. Social Security benefit formula replaces a higher percentage of pre-retirement income for lower earners
• Minimum pension guarantees ensure a basic level of income for all retirees, regardless of their contribution history
  • Example: Canada's Guaranteed Income Supplement (GIS)
• Caps on pensionable earnings or benefits can limit redistribution to higher-income individuals
  • Example: Maximum pensionable earnings under the Canada Pension Plan

Intergenerational Equity

• Concept of lifetime net transfers measures the difference between the present value of benefits received and contributions made by individuals or cohorts
• Intergenerational equity concerns arise when successive generations face different rates of return or net transfers from pension systems
• Implicit rate of return in PAYG systems influences by factors such as population growth, productivity growth, and system maturity
• Fully funded pension systems can potentially reduce intergenerational redistribution but may face transition costs when implemented in countries with existing PAYG systems
• Choice between DB and DC plans has implications for risk allocation between employers, employees, and future generations
  • Example: Shift from DB to DC plans in private sector pensions transferring investment risk to individuals
• Notional defined contribution (NDC) schemes aim to improve intergenerational equity by linking benefits more closely to contributions while maintaining PAYG financing
  • Example: Italy's NDC system introduced in the 1990s

Defined Benefit vs Defined Contribution Plans

Characteristics and Risk Allocation

• Defined benefit (DB) plans guarantee specific retirement benefits based on predetermined formulas
  • Example: Final salary scheme offering 1/60th of final salary per year of service
• Defined contribution (DC) plans involve individual accounts where benefits depend on contribution amounts and investment returns
  • Example: 401(k) plans with employer matching contributions
• DB plans provide greater predictability of retirement income for employees but create long-term financial obligations for employers or governments
• DC plans offer more portability and individual control over investments but expose participants to market risks and potential inadequacy of retirement savings
• Risk allocation differs significantly between DB and DC plans
  • DB plans: Employer bears investment and longevity risks
  • DC plans: Employee bears investment and longevity risks

Implications and Trends

• Shift from DB to DC plans in many countries has implications for retirement income adequacy, risk allocation, and labor market mobility
• DB plans typically result in more stable replacement rates across income levels
  • Example: A DB plan might target a 70% replacement rate for all employees
• DC plans can lead to greater variability in retirement outcomes based on individual investment decisions and market performance
  • Example: Two employees with identical contributions but different investment strategies may have significantly different retirement incomes
• Portability of DC plans can facilitate job mobility and reduce the risk of pension loss when changing employers
• Hybrid plans, such as cash balance plans, attempt to combine features of both DB and DC plans
  • Example: A plan crediting a fixed percentage of salary annually with a guaranteed interest rate
• Trend towards DC plans has shifted the responsibility for retirement planning and investment decisions to individuals
  • Example: Increased emphasis on financial literacy and education in countries with predominant DC systems