The Public Pension Crisis

Norbert Walter

Council on Foreign Relations

November 15-16, 1996

Pension schemes can be ranked in terms of their sustainability. The number one country in terms of sustainability is the United States. Number two is the Britain. Number three is Australia and number four is Netherlands. Then comes Canada, Sweden, and Japan, and then the list of my basket cases(Belgium, Spain, France, German and Italy.

In order to give you an idea about the level of awareness in my country, Germany, the labor minister responsible for the public pension schemes states that our public pensions are safe, owing to the pay-as-you-go system. It is the safest form of old-age provision in the world. It is a system that lasted for 140 years. He claims it has survived two world wars and two hyper-inflations, so it's robust.

I think he's wrong. As to the demographic factors, a lot has already been said but a few additional numbers may be worth mentioning. From 1990, the percentage of the German population over age 60 will rise, decade by decade, from 20 to 24 to 27 to 30 and by 2030 to 35 percent. This gives you an idea of the magnitude of the demographic change. Practically the same numbers hold true for Italy. This has to do with a similar pattern of birth rates and life expectancy. Europe as a whole is not far different.

Japan is somewhat better off by these measures. Sweden starts with an initially higher percentage of its population over age 60, due to a longer life expectancy. They start with 23 percent over 60 in 1990, increasing, decade by decade, to 25, 28, and 30 percent by 2030.

There is probably not much that can be done to change that situation. So what are the policy options under such circumstances? If, of course, the public pension schemes are in such a bad way, why not talk about the occupational pension schemes and private plans? Since our wage costs are already quite high, we are not exactly competitive. That's true for most of the continental European countries; additional fringe benefits like an occupational pension scheme would just aggravate the situation. Therefore, it is not very realistic to assume that the firms will move in this direction, even if there is a need.

The policy options for the public pension schemes are increasing contribution rates and/or cutting benefit levels. It is safe to assume in all continental European countries that both increasing contribution rates and cutting benefit levels is unavoidable. This holds especially for the countries that are worst off: France, Germany, and Italy.

There is a broad debate about increasing the participation rate. The most marvelous development in participation occurred in the past when women entered the labor force. This bonanza is over. We misused it in our public pension schemes. It didn't help much, and I think it is quite obvious that the restructuring of our economies is not exactly helping to increase the ratio of dependent employees to totally employed.

The ranks of the self-employed are growing everywhere. Now, of course, quite a few have discussed the issue of whether the self-employed could be subject to social contributions. If this takes place, we will probably find that there are other efforts to evade the system. I believe that one has to be quite careful in finding additional people to contribute to the system, because if you do so, you may do harm to your economy. Possibly you give incentives for your entrepreneurs to leave your country. It's obvious that we are not living in closed economies.

Much of what we have heard so far sounds as if there is such a thing as a closed economy. I think that's inappropriate analysis, and if you pursue it, you just make mistakes. We have not yet heard about another important element for addressing our old-age pension problem( immigration. It's obvious that this option is not to be too important for Japan, because of cultural reasons. It's equally obvious that a considerable part of the solution for many of the United States' problems, not just the old-age pension crisis, comes from selective immigration.

Europe is the case in between. We have xenophobia. We declare ourselves not inclined toward immigration, but for the first half of the 1990s, the country with the most pronounced immigration was Germany. We even surpassed Australia or Canada, and by quite a margin. So the question is, is there a chance that immigration helps? The answer is yes if the immigration is selective about age groups and oriented to young people. Of course, this is not a permanent solution because these people grow old as well and are then eligible for benefits. But at least the problem is considerably deferred.

Extending the relative length of the working years has been mentioned as a possible remedy. I deliberately use this more open phrase rather than speaking of increasing the retirement age. Whereas there may be limits to increasing the retirement age because of health reasons, as Laura Tyson mentioned, it seems quite obvious that some European countries--and specifically Germany--could increase entry into the labor force by cutting into years of education, particularly academic education. In Germany, the normal male academician enters the labor force at the age of 29. If you consider not only public pension schemes but also the productivity implications, there may be good reason to improve the system.

When we talk about the European public pension schemes, we have to look into such factors. We also have to understand that in only a few countries--namely the Nordic countries, the Netherlands, and Britain--are there funded systems. Most of the continental public pension schemes are pay-as-you-go, and therefore there is an additional problem. There are those who argue that pay-as-you-go is precisely as good as a funded system for an economy because the active population has to support the elderly and the dependent part of the population. But if you have a different investment profile, you probably have a different productivity profile and a different growth rate. And if you have a different growth rate, of course you could have a different provision for old age. The pay-as-you-go system aggravates the situation for countries like Italy, France, and Germany, which don't have any trust funds to draw from. The debate about privatization, I think, is totally misplaced if you forget about these very important factors.

I mentioned already that the age structure not only has implications for the contributions to the public pension schemes but also has consequences for productivity and growth. In a world confronted with ever faster structural change through technology, countries with a relatively young population and a relatively young labor force will be in a position to implement modern technology at a faster pace.

If you, however, are confronted with an aging population, it's quite difficult to implement a computer program like Windows with any meaningful production consequences. If I'm trying to make use of that new instrument, I probably can use something like 0.7 percent of the total capability of that system after a lot of help. I will forget much within the first four weeks, whereas it will be totally different for a 14-year old. The faster the structural change is, the more handicapped aging societies will be.

Many of our calculations about our old-age pensions are probably ill-founded, because we assume that past growth rates will be continued in the future. I think we are wrong about that. Many of the current debates are nothing but extrapolations of present trends. What we should look into is what the changes may mean for flexibility and what this means in turn for old-age pension systems.

Moreover, we should think not only in terms of a closed economy, but an open economy as well.

Our options are inadequately described if we try to focus solely on public pension schemes. We have to move toward private pension plans. I already mentioned that I do not consider occupational pension schemes as the solution. They might be, but only if there were a competitive structure of firms, which is not the case for Europe.

One solution would be tax incentives for private plans. This is a marvelous idea, but not open to Europe. Countries have public deficits that are high not only in light of the Maastricht convergence criteria, but by any criterion. Therefore, we don't have leeway for such incentives to save. What we probably could do is have obligatory savings for retirement, but allow people to use those instruments for private schemes as well as for the public one. If the private scheme permits higher yields, this should be quite attractive.

There is a theoretical debate about this alternative among economists, but it's not worthwhile. I just observe the market. Young people in most of the European countries follow such a strategy. They don't rely on all the promises by the government, and they don't believe that any public schemes can be trusted. What they do is set up private plans--many of them have life insurance plans--and there is a great expansion of that market. Financial institutions are well advised to be aware of it, as I guess quite a few of us are.

But if I'm talking about such private plans and the fact that the market is moving in this direction, I am not telling the full story. If such private schemes are nothing else but buying government bonds, doing nothing else but subsidizing sunset industries, then they will probably not be very helpful in the long run. Or if our life insurance or other financial investment plans invest in nothing else but real estate in regions of the world that have a shrinking population and ever declining demand for residential buildings, then this is not exactly a high-yielding asset. Any meaningful concept that moves toward private plans has to address not only the issue of extra savings but of how these savings are invested. And if these savings are being properly invested, it will be in equity, and equity directed toward dynamic markets--invested in firms that either have markets or produce in dynamic parts of the world.

We must also consider the political risks that are involved. This brings us back to a very important question. If the g-7 world is not truly interested in supporting the political and economic stability of emerging countries, we will invest in dynamic areas, but with high political risks. This would imply that those who are truly interested in providing substantial and improved old-age pensions through private plans in the g-7 world must help build up systems and institutions in the emerging world that will provide political stability. Technical aid and assistance for good governance in the emerging world will help make our own old-age pensions safer. Unfortunately, this is often--too often--not considered. In addressing this issue at a conference in the world's sole remaining superpower, I think it is important to mention that.