KERI Pensions Eamonn butler There was a time when government-run retirement pension systems looked like a great idea. Like the one created in my own country, the United Kingdom, in 1908, governments promised generous benefits to retired voters, paid for by the taxes on the current working generation. In those days, the age distribution was a pyramid, with very few people aged over 65 at the top, a large centre of people of working age, and an even larger base of children below that. With the centre and base expanding, it seemed that retired people could expect benefits far higher than what (as workers) they paid in: “Nine pence for six pence” as the UK finance minister said at the time. But it was always a ‘pyramid scheme’ — or Ponzi scheme in today’s phrase. It depended on new people coming into the system, in sufficient numbers, to continue paying the benefits of those drawing the benefits. With a pyramid age distribution, that seemed perfectly sustainable. Unfortunately the age distribution in most countries is now more like a cylinder than a pyramid. People are living longer, so there larger numbers drawing benefits at the top. People are staying in education longer and retiring earlier, so there is a declining proportion of taxpaying workers at the centre. And people are having fewer children, so there are fewer future contributors coming along at the bottom. In some countries, such as Japan and Korea, the age distribution looks more like an upside down pyramid. That means that these ‘pay-as-you-go’ or ‘defined benefit’ systems now have a rising ‘dependency ratio’ — with fewer contributors paying for more beneficiaries. In many countries, the numbers are truly frightening. An OECD report from 2021 forecast that by 2060, a median OECD member country will be spending 2.8% of GDP more on pension benefits. With other government expenditures rising too, this would mean a tax rise of 8% of GDP — and of more than 10% of GDP in 11 of the OECD member countries. Some systems are already in deficit, with the volume of total benefits exceeding the volume of total contributions. Many others face the same problem within a decade. And precisely because these systems are pay-as-you-go — with no saved funds to fall back on — that means bankruptcy of those systems, and possibly even bankruptcy of the countries that have them. So what can we do to stave off such bankruptcy? The politicians’ favourite solution is to promise the same generous benefits to older people — politicians love promising things — while raising taxes on the working population. That might initially close the funding gap, but higher taxes are a big disincentive on work and new business creation. That means lower growth, making it increasingly hard to sustain the pension system in the longer term. A second option is to cut benefits, for example by raising the retirement age. But these cuts would have to be massive in order to keep these systems out of deficit, even for just a few years. And as we have seen from the violent protest against President Macron’s bit to raise France’s state pension age just two years, such policies are deeply unpopular. A third option is to borrow the money needed to keep the system afloat. But government debt is already at record highs, and raising it further diverts capital from more productive investments — hitting economic growth again. And it risks the markets losing confidence and falling into crisis. A fourth option is to increase immigration. Migrants tend to be younger, so that helps increase the ratio of payers to beneficiaries. But again, a massive and rising influx would be needed to keep most systems afloat. And it merely postpones the crisis. A fifth option is to increase fertility so that the age distribution becomes more pyramidshaped again. But the obvious way to do that — tax breaks or financial benefits to families with children — adds to the government’s funding problem. And it is unlikely to have much impact on people’s family choices. No, the only sustainable solution is to reform defined benefit systems, and turn them into ‘defined contribution’ systems, where individuals save for their own retirement. One of the first countries to do this was Chile, in 1981. Its pay-as-you-go system was costly and unsustainable. Politicians skewed it to their own advantage. Workers had an incentive to retire as early as they could, since benefits bore no relationship to contributions. Chile’s charismatic Minister of Labour, Jose Pinera, successfully transformed all this into a system based on worker contributions made into personal retirement savings accounts. He argued his case in national media and planned the new system carefully. Workers would pay into their own retirement accounts. They could choose between several funds — some more conservatively managed, others offering more risk but more potential returns. Competition would keep the funds efficient. At retirement, workers could convert their accumulated savings into an annuity that would pay them a regular, inflation-proofed lifetime income, or take annual instalments out of their savings. Because benefits were linked to contributions, political manipulation became harder, the system became financially sustainable, and labour participation rates rose. Chile turned from one of the poorest South American countries into the most capital-rich, generating funds to fuel economic expansion and productivity. Chile’s example led to a number of other countries, from South America to Austalasia to Eastern Europe, to change their pay-as-you-go, defined-benefits systems into save-as-youwork defined-contribution systems. Today, Australia, Denmark, Iceland, Israel, Switzerland, Hong Kong, the Netherlands, Norway and even the Faroe Islands, all have systems that are fully or partly financed by private contributions. Thus, in the reformed Australian system, established 30 years ago, workers who earn more than a certain amount — around 90% of the workforce — are required to set aside 12% of their income into personal retirement accounts. The system is popular, and Australia’s retirement accounts are creating wealth rather than piling up debt like pay-as-you-go systems. Indeed, the total assets in these funds now exceed Australia’s GDP. Sweden faced the same problem in the early 1990s — over-promising of benefits, lower birth rates, longer life expectancy. Projections showed the system would be insolvent a decade later. The political parties agreed an entirely new system based on the principle that pensions should correspond to what the beneficiary pays into the system — that is, defined contributions, not defined benefits. The Swedish government now withholds 2.3% of workers’ income, to be paid into one of five different pension funds which the individual can choose between. Returns exceeded expectations even in difficult times. The Swedish system is ranked high on the adequacy of the benefits it provides, on its sustainability into the future, and even on its reputation. It is arguably the best in the world. Remarkably, though Sweden is normally regarded as a high tax country, projections show that now and in future, Swedish taxpayers face one of the lowest burdens, with old-age spending consuming significantly less than 10% of GDP. Such funding revolutions are not easy. Somehow, countries have to find a way to pay the existing promised benefits while enabling current workers to save for their own retirement — effectively paying twice, for the retired generation and for themselves. But the longer we put off such reforms, the deeper the funding problem becomes, and the greater becomes the likelihood of national and global financial meltdown.