Why a Funded Pension System is Useful and Why It is Not Useful

Abstract

Based on explicit present value calculations, the paper criticizes the view that the PAYGO system wastes economic resources. In present value terms, there is nothing to be gained from a transition to funded system even though the latter offers a permanently higher rate of return. The sum of the implicit and explicit tax burdens that result from the need to respect the existing pension claims is the same under all systems and transition strategies. Nevertheless a partial transition to a funded system may be a way to overcome the current demographic crisis because it replaces missing human capital with real capital and helps smooth tax and child reading costs across the generations.

Political Preferences and the Aging of Populations

“…Any reform of a PAYG system of old-age provision has strong redistributional implications, there is no Pareto improvement possible, as has been argued before by Breyer (1990) and Sinn (2000).…”

“…Yet, this requires some positive growth externality effects that are not necessarily an issue of pension reform and do not necessarily materialize when funding is introduced. Hence, many have concluded that from a present discounted value perspective, a transition to a prefunded system cannot make anybody better off without making someone else worse off (see Breyer (2001) ;Geanakopolos et al (1998);Sinn (2000)). The validity of this claim will be briefly shown next, first intuitively, and then somewhat more formally.…”

“…15 Of course, there are valid arguments for prefunding part of a pension system. However, these arguments emphasize mainly improved diversification (Sinn (2000)), especially if there are many households with only constrained access to capital markets (Geanakoplos et al (1998)). rate therefore consist of two parts:…”

“…20 Just to give but two examples, Diamond and Orszag (2005) advocate, in the context of the American Social Security system, to keep the PAYG scheme and restore its financial balance by a combination of gradual benefit reductions and revenue increases, thus spreading the adjustment costs across current and future generations. Sinn (2000), on the other hand, argues in favor of partial prefunding. He advocates putting the transition costs of this reform on those current worker generations that failed to produce enough offspring.…”

Developments in pension reform: the case of Dutch stand-alone collective pension schemes

“…As generations invest less in the human capital of the next generations by reducing fertility, they should invest more in financial capital. Lower fertility thus calls for gradually shifting from pay-as-you-go financing to funded pension schemes (see Sinn 2000). 1 The large continental European countries that rely almost exclusively on PAYG financing for the provision of retirement income have integrated the two main functions of pensions-poverty alleviation and old-age insurance-into a single comprehensive public pension system.…”