Costing Pension Reform
Funded Pensions are risky and a transition is expensive

Unfunded pay-as-you-go state pension schemes are financially unsustainable in Europe as elsewhere.  Proponents of reform argue that, by switching 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.  David Miles and Allan Timmermann show 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, who are therefore likely to oppose the reform.  Second, potentially higher returns are accompanied by significantly higher risk.  The authors explain how an insurance scheme could be designed to mitigate both risk and moral hazard.

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 and Timmermann document 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 and Timmermann note this is fallacious and present simulations to show both the burden of transition and how it might be distributed across generations. They conclude 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.

Not only is the transition more difficult than is often maintained, the authors argue that the eventual benefits of a funded scheme can also be exaggerated because the burden of risk that it imposes is usually neglected. They quantify the additional risks that funded pensions entail and highlight 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? Miles and Timmermann discuss 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.

Notes for Editors :

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.  

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The Authors :

David Miles is Professor at the Management School, Imperial College, London.

Allan Timmermann is Professor of Economics in the Department of Accounting and Finance, London School of Economics.