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Retirement reforms are not a mere technical question suitable for technocratic solutions. Due to their effects on assets, expectations and life projects, these reforms are political in nature. They need the approval of state institutions and the support of the population. Without popular support, any reform runs the risk of being formally overturned or circumvented in practice.
TURIN – Retirement reforms are a thankless task, but a necessary one. The issue of pensions is a difficult and emotional issue that affects everyone, and modifying its calculation or the retirement age implies negotiating a complex web of norms, customs and acquired rights that do not fit into exact theoretical models.
In countries with a public pension system, the main component is usually incorporated into legislation and under state administration. In addition to this component, other sources of income after retirement come from occupational funds and individual investments, dependent on the market, but subject to regulatory bodies (such as the European Insurance and Occupational Pensions Authority).
Although the state does not provide the entire pension asset, governments have good reasons to get involved in reform initiatives. There is much more at stake in pension provision than mere efficiency; and the insurance market has limited capacity to protect people in old age. Furthermore, entrusting the market to support the elderly population can lead to an increase in poverty.
The social protection programs of the 20th century were created with these considerations in mind. And despite the huge demographic and economic changes that have occurred, they remain as applicable as ever.
The state pension component is usually financed through a pay-as-you-go system based on an intergenerational contract. The active population makes contributions to social security that are deducted from their salaries, and the public pension agency distributes these resources more or less immediately in the form of a life annuity for the retired population.
Unlike private insurance programs, the pay-as-you-go system is not based on the accumulation of financial reserves, but on the idea that current workers pay for retired workers with the certainty that those who are young today or have not yet been born they will do the same for those who are active. The state, instead of the market, can “guarantee” the contract by tying future pensions to mathematical formulas that take into account the total flow of contributions and a rate of return that corresponds to the growth of income derived from work.
It has sometimes been said that private financing of pensions is better than the public pay-as-you-go system. This argument assumes that the interest rate will be higher than the growth rate of the economy, so that the retirement income corresponding to the same volume of contributions will be higher. But in those Latin American and Eastern European countries where this kind of radical reform was adopted it did not work, and in some cases a difficult reversal of policy was necessary.
Today a mixed system combining public and private options has become more common. But even these systems need reforms to ensure the sustainability and adequacy of pensions. And careful scrutiny is also needed to reduce or eliminate potential distortions in the system, for example the implicit tax on work performed after minimum retirement requirements have been met and the possibility that wealthier workers will benefit more, due to the lack of correlation between contributions and pensions when formulas with defined benefits are applied.
The main problem that pay-as-you-go systems face is the need to adapt them to large changes in the demographic and economic structure. As populations age, fertility rates decline, and migration flows cut off, the intergenerational contract on which PAYGO systems are based becomes difficult to maintain.
In the last quarter of a century, pension reform in Europe has focused on changes aimed at increasing the effective retirement age, equalizing the retirement requirements of women and men and improving the correlation between contributions and benefits. The adoption of some kind of formula with defined contributions makes it possible to adapt the pensions to the contributions of each worker without depending on the capitalization in the financial markets. In this kind of program, the initial benefit at the time of retirement and its subsequent indexation are determined by applying an actuarial factor to the accumulated notional capital that takes into account the expected longevity.
A good reform cannot separate the pension system from the labor market and the economy. The most important prerequisite for an adequate pension system is having dynamic and inclusive labor markets that facilitate job search for workers and recruitment for employers. Higher priority and more resources must be allocated to policies favorable to long-term employment (eg internship systems and lifelong learning).
The reforms should also ensure that public pensions promote social solidarity, so that people disadvantaged by the labor market do not suffer when they reach retirement age. This can take the form of notional, tax-funded contributions to workers who perform dangerous tasks, the unemployed, and those who provide permanent care to family members.
The main variable that determines the adequacy and sustainability of a public pay-as-you-go system is economic growth. Adequate growth rates create additional jobs, reduce unemployment, encourage labor force participation, and increase the likelihood that people of working age (20 to 65 years) will be employed.
But pension reforms are not a mere technical question suitable for technocratic solutions. Due to their effects on assets, expectations and life projects, these reforms are political in nature. They need the approval of state institutions and the support of the population. Without popular support, any reform runs the risk of being formally overturned or circumvented in practice.
To increase the likelihood of success of reforms, workers must understand the financial situation they will have upon retirement. They should be aware of their investment opportunities and retirement options, to make reasonable choices and avoid disappointment (for example, insufficient retirement benefits).
They must also understand the basic motivation for retirement reform. Governments must explain how such reforms will reduce generational imbalances, strengthen the financial sustainability of the pension program, and limit distortions and privileges. And to understand these reasoning, workers need basic financial training. But unfortunately, polls show both poor knowledge about pensions and widespread financial illiteracy.
Preparing for retirement is a lifelong job, and financial literacy is a critical element of that job. Governments must do more to ensure that workers are empowered to make the best decisions regarding their retirement.
The author
Former Italian minister for labor, social policies and gender equality, she is an honorary fellow at the Collegio Carlo Alberto in Turin and scientific coordinator of the Center for Research on Pension and Welfare Policies.
Copyright: Project Syndicate, 2020
www.projectsyndicate.org
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