Why ‘pay-as-you-go’ pension systems are unsuitable for OECD countries unless major reforms are carried out

Having a long and healthy life is perhaps the ultimate aim for all human beings. A long life allows us to make the most out of our time on Earth. “Life is too short” is one of the most popular and translated phrases that people from all around the world often say with a pinch of bitterness and sorrow in their voices. But in the last decades, life expectancy has boosted especially in developed countries. As of today a German national can expect to live 81 years, an Italian one 83 years, and a Japanese one as long as 84 years. On the contrary, fertility rates are following the opposite trend, decreasing particularly in industrialized societies. These two factors combined are gradually leading to an increase in the average age of populations. From a social security perspective, this is posing a serious challenge to the sustainability of pension systems, an issue that governments should start facing today in order to prevent huge problems in the future. Such urge is especially pressing for OECD countries given that they have the highest life expectancy and lowest fertility rates in the world. And it is even more pressing in those nations that adopt ‘pay-as-you-go’ models as in such systems the pensions of those who have retired are paid by the active workforce through contributions. In other words, it is today’s workers who pay for current retirees’ pension checks.

“It is today’s workers who pay for current retirees’ pension checks”

With people living longer and fertility rates dropping, the share of people aged over 65 has increased significantly in the last sixty years. This means that through time countries have experienced a rising number of retirees relying on pensions for longer than ever before, raising questions on the sustainability of social security. Meanwhile, the share of the population aged below 25 has diminished. This translates in a shrinking active workforce in relation to an increasing number of retirees, leading to less contributions being paid to finance pensions in ‘pay-as-you-go systems’. As of today we generally have more people over 65 than people below 25 in OECD countries. Forecasts reveal that such trends are not predicted to revert or stabilize any time soon. Thus, governments have a serious challenge ahead of them.

If the ‘pay-as-you-go’ model is becoming unsustainable in most OECD countries, then why not turn to the ‘fully funded’ pension system? In such system – which is adopted in the US – workers deposit part of their monthly wage in a fund and then redeem those contributions when they retire. In other words, instead of having workers finance somebody else’s pension, everyone saves for their own pension. But guess what: such system is also likely to be affected by the ageing population phenomenon! In fact, with life expectancy increasing, retirees run the risk of outliving their assets. So, while there seems to be no unique solution to the problem, policymakers have the following options on the table:

“With people living longer and fertility rates dropping, the share of people aged over 65 has increased significantly in the last sixty years. This means that through time countries have experienced a rising number of retirees relying on pensions for longer than ever before”

  • Raising the retirement age – Increasing the legal age at which workers can retire is one of the most straightforward interventions to tackle the problem of ageing populations. Such solution has already been implemented in many OECD countries. However, raising the retirement age may create stagnation in the labor market and increase youth unemployment. Thus, while potentially solving one issue, policymakers run the risk of creating a new one, which is arguably even worse. Moreover, an older workforce means a less productive workforce overall.
  • Tightening the link between benefits and contributions – in many ‘pay-as-you-go’ systems, pension checks amount to a given percentage of one’s last salary regardless of the contributions paid. By shifting to ‘defined-contributions’ models – in which pension checks are calculated on the amount of contributions paid by retirees during their careers – policymakers would be able to tighten the link between benefits and contributions, thus improving the sustainability of the system. In the 1990s both Italy and Sweden moved to such system.
  • Encouraging all women to enter the labor market – In order for ‘pay-as-you-go’ systems to be sustainable we need a to enlarge the active workforce. This can be done by adopting policies that may encourage women to enter the labor market especially in those countries where women employment is particularly low. Such policies may include better childcare, family benefits, and after-school programs.
  • Integration of immigrants – Being generally prosperous, OECD countries have been attracting an increasing number of immigrants from developing regions. However, integration has always been difficult also due to the lack of adequate policies aimed at helping foreigners find an occupation. Such policies would result in an expansion of workforce which is crucial to keep ‘pay-as-you-go’ systems sustainable.

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