Moving to Funded Pension Schemes: Will the Public Tolerate the Costs of Transition and the Risks of the Capital Markets?

Many proponents of pensions reform argue that by switching from unfunded pay-as-you-go state schemes to a fully funded scheme that takes advantage of the high return on assets such as equities, the solvency of the state scheme could be restored at little or no financial burden to current taxpayers. Speaking at a CEPR/Royal Economic Society public discussion meeting on Thursday 3 February, Professor David Miles of Imperial College, London, and CEPR showed that this is mistaken for two reasons:

• First, making the transition is itself costly. Unless this cost is substantially financed by debt, it will fall on current generations, which are therefore likely to oppose the reform.
  

• Second, potentially higher returns are accompanied by significantly higher risk. Miles explained how an insurance scheme could be designed to mitigate both risk and moral hazard.

Miles noted that the solvency of unfunded state pension schemes is threatened by population ageing. Although the problem has been evident for some time, politicians with short time horizons have faced understandable temptations to leave it to their successors. Now that the issue is on the political agenda, we can take it for granted that its economic significance has already grown to substantial proportions.

Miles documented the increasing deficits being accumulated by pay-as-you-go pension schemes in EU countries and elsewhere. This has led to calls for a switch, wholly or in part, to funded pensions in which contributions are used to purchase a pool of assets to provide income for retirement. Even if such a switch were desirable in the long run, it raises the thorny question of how to manage the transition from one system to the other, an extreme version of which would be to have one generation pay twice. Since this generation would also be voters, such an outcome is politically unlikely.

An unfunded pension scheme is a sophisticated pyramid scheme, dependent on future contributions to sustain present payouts. Unlike crude (illegal) schemes, there is at least some reason to expect future contributions to grow: productivity and wages are rising over time and the government has the power to compel contributions. But the relatively low growth rate of potential contributions - at least in comparison with the way in which portfolios of equities and bonds might grow because of higher rates of return - has led some to argue that a switch from unfunded to funded pensions might generate sufficient surplus that it could be used to buy out the costs of transition.

Miles argued that this view is fallacious, presenting simulations to show both the burden of transition and how it might be distributed across generations. He suggested that, unless governments are allowed to incur current budget deficits and accumulate sufficient debt to tax future generations, current voters will be unlikely to vote for funded pension schemes.

Miles concluded that not only is the transition more difficult than is often maintained, but the eventual benefits of a funded scheme can also be exaggerated because the burden of risk that it imposes is usually neglected. He quantified the additional risks that funded pensions entail and highlighted the dilemma for future governments: would they allow the old to starve if their investments had happened to yield a poor return during their working lifetime? Finally, he discussed how an appropriate insurance scheme could be constructed to cap both the downside and upside of portfolio returns so as to mitigate moral hazard and safeguard retirement incomes.

Note for Editors: David Miles was speaking at a public meeting on ‘Defusing the Pensions Timebomb: What are the Policy Options?’, organised by CEPR and the Royal Economic Society (RES) and supported by Morgan Stanley Dean Witter. His presentation drew on his paper ‘Risk-Sharing and Transition Costs in the Reform of Pensions Systems in Europe’, written with Allan Timmermann of the London School of Economics and published in the October 1999 issue of Economic Policy. Miles is Professor of Economics at the Management School, Imperial College, London.

For Further Information: contact David Miles on 020 7594-9112 (fax: 020 7823-7685; email: d.miles@ic.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 0468-661095 (email: romesh@compuserve.com).