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World Faces Pensions Crunch, Reforms Unavoidable

As policymakers in the United States, Europe and Asia grapple with the long-term affordability of their pensions systems, a new World Bank report says that growing demographic and economic pressures are forcing both developing and developed countries to undertake urgent pension reform.

According to the report -- Old-Age Income Support in the Twenty-First Century: An International Perspective on Pensions and Reform, more women in the global workforce, rising divorce rates, changing employment patterns in the global economy, rising budget deficits, and rising numbers of elderly are making the case for pension reform unavoidable.

"This report shows us that while pension reforms in most countries initially are driven by the short-term budgetary woes of keeping costly public systems afloat, the more important longer-term problems of worldwide ageing and social change, along with changes in our global economy are an equally important to the debate," says Robert Holzmann, Director of the World Bank's Social Protection unit, co-author of the new report, and a leading international authority on pension reform.

The report offers a common framework to help countries resolve their pension problems, proposing the diversification of pension systems into a combination of public elements to maintain minimum living standards, and privately managed and funded components, while emphasizing the potential links between pension reform and conditions conducive to growth and development. It says that most public pension schemes were not designed to deliver current benefit levels when confronted with today's major demographic and economic changes. Therefore, keeping existing systems afloat will require either cutting public spending on health and education, or cutting pensions drastically for the next generations of elderly.

In many cases, the report says, actual budget costs are hardly ever calculated in a comprehensive or transparent manner, and in most cases, pensions schemes fail to grasp the standard 'actuarial' principles involved in effective pension systems. The Bank, which has been involved in pension reform in more than 80 countries and provided financial support for reform to more than 60, says if problems like these are not solved, falling economic growth and greater poverty may be the end result.

Holzmann says keeping unaffordable pensions systems afloat, with continual budget transfers, are often the main cause of high and rising budget deficits. These in turn can worsen a country's macro-economic outlook during times of economic crisis. The most drastic recent example so far is that of Brazil in 1998, where a fiscal deficit of more than 6 percent of GDP triggered a crisis in the aftermath of the East Asian and Russian financial crises. Two-thirds of this deficit, some 4 percent of GDP, was due to the cost of pensions.

Second, if the government wants to minimize the destabilizing effects of high budgetary transfers, it has to raise more taxes or make budget cuts elsewhere. Because of the difficulty of raising taxes, governments in many developing countries choose to prune back other social spending, typically for health and education. For example, higher pension costs for retired teachers simply reduce the number of new teachers that can be hired under an already constrained budget envelope for education. In other cases, teachers have to stay on the payroll after retirement age because there are insufficient resources in the retirement fund to pay their pension; as a result, no new teachers can be hired.

Changing societies and employment patterns

Over and above the economic impetus for reform are profound changes in societies and the ways in which people now work.

More women in workforce -- the numbers of women in the workforce worldwide have jumped considerably in recent decades, but pension systems have not adapted to this change. Most pension systems are designed for workers with full, un-interrupted careers, which does not reflect the experience of most women, who may leave their jobs to raise children earn lower wages, and typically outlive their husbands by several years. Lifelong marriage has also become the exception, rather than the rule in many countries. In many OECD countries, for example, divorce rates are so high that some 50 percent of marriages are thought unlikely to survive, resulting in large numbers of older individuals living in single households. All of these trends place women at greater risk of poverty in old age unless pension systems are adapted to meet their needs.

Changing work patterns -- this more recent development refers to the reduction in full-time salaried jobs, and the increase in part-time work, self- employment, and temporary jobs. This trend may be attributed to globalization and its competitive pressures. Whatever the reason, these workers do not fare well under many current pension schemes, which are based on a full-time employment model. Pension systems will need to be extended to provide access and portability of benefits to these 21st century workers or many will be at risk of severe poverty in old age.

Lack of pension coverage -- for poor people, and workers who move in and out of formal employment, pension coverage in most developing countries is still very low. Improving coverage requires reforming expensive and unsustainable system; thinking about the introduction of social pensions if older poor people are more vulnerable than other 'at-risk' groups in the population such as children and disabled people, and the financing can be assured; and introducing, or improving, voluntary and funded systems which are better able to help informal sector workers.

Numbers of elderly on the increase -- the world's elderly population is growing briskly as a result of increasing life expectancy and falling fertility rates. It will result in a steadily rising average age of the population throughout the world, a rising number of elderly (age 65 and above), an even greater increase in the number of very elderly (85 and above), and a rising ratio of elderly (65 and above) to working-age population (15 to 64). This trend is most pronounced in Europe and Japan and least pronounced in Africa and the Middle East, but it is a reality in nearly all countries, and is occurring at a much faster pace in the developing than in the developed world. While nearly 60 percent of the elderly live in developing countries, that share is projected to increase to 80 percent by 2050. The developed economies got rich before they got old, developing countries are getting old before they get rich but both face profound challenges as a result of population aging.

This has two main implications. First, pension systems that collect taxes from one generation to provide benefits to their parents will need to be adjusted to address the realities that elderly people live longer lives today than was anticipated when these systems were first designed. Second, pension systems will need to be more flexible to provide incentives for older workers to delay their retirement until later in life in order to maintain a sufficient workforce to sustain growth. This makes it even more important to offer effective retirement-income support for the elderly, and to assess carefully the trade-offs, as well as synergies, between money spent to achieve growth objectives (such as education and health expenditure), and funds directed to alleviate the vulnerability to poverty of groups such as children and the disabled.

"Pension reforms in a wide variety of countries, from Central and Eastern Europe to Latin America, and Asia, have already led to systems that will provide a solid foundation for future growth and security. Governments in other regions need to learn from this experience to undertake reforms before they are overwhelmed by the fiscal and social costs of not having acted quickly and comprehensively enough," says Richard Hinz, co-author of the new pension report, and a World Bank Adviser on Pension Policy.

{For a comprehensive description of how different regions and countries are coping with the challenges of pension reform, see Chapter 7, Regional Experiences: Developments and First Evaluation of Reform, at page 141}

Solutions -- no one size fits all

According to the new Bank report, the past decade has underscored the importance of pension systems to the economic stability of countries and the security of their aging populations. The experience with reforms over the past ten years has also shown that no one size fits all -- that countries have a number of different combinations of the elements of an effective pension system to choose from, depending on their own national circumstances. What also emerges is the continued relevance of the two main aims of pension systems, namely: reducing poverty, and eliminating the risk of rapidly falling living standards in retirement; and the broader goal of protecting vulnerable elderly people from economic and social crises.

Given these aims, the Bank believes that the multi-pillar design is the best solution to pension reform, being much more flexible and better able to address the different risks that pension systems are designed to manage. Advance funding and market-oriented investments are regarded as key elements of most reforms, but the limits of funding are also seen much more sharply.

The suggested multi-pillar framework is composed of some combination of five basic elements: (a) a noncontributory or "zero pillar" (in the form of a demogrant or social pension) that provides a minimal level of protection; 1 (b) a "first-pillar" contributory system that is linked to varying degrees to earnings and seeks to replace some portion of income; (c) a mandatory "second pillar" that is essentially an individual savings account but can be constructed in a variety of ways; (d) voluntary "third-pillar" arrangements that can take many forms (individual, employer-sponsored, defined benefit, defined contribution) but are essentially flexible and discretionary in nature; and (e) informal intra-family or inter-generational sources of both financial and non-financial support to the elderly, including access to health care and housing.

For a variety of reasons, a system that incorporates as many of these elements as possible, depending on the preferences of individual countries as well as the level and incidence of transaction costs, can, through diversification, deliver retirement income more effectively and efficiently. The key challenge outlined in the report is how to combine these different features into a comprehensive system that both, meets the local needs of each country, and charts a roadmap for feasible reform.

( May 25, 2005)

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