Countries with more inequality – say the UK compared with Germany – tend to spend little on public provision of pensions, they largely rely on private pension funds and, at the same time, they have adopted a pension formula that redistributes towards the poor.
In contrast, in countries with fewer rich than poor and where the middle class is large, a large amount of GDP is spent on public pensions, there are limited private pension provisions and their pension formulas do not redistribute towards the poor.
These are among the conclusions of new research on the redistributive design of social security systems by Ignacio Conde Ruiz and Paola Profeta, published in the April 2007 issue of the Economic Journal. They expect that the UK programme will become even more redistributive, reinforcing the trend of recent reforms.
In the debate on current ‘pay-as-you-go’ (PAYG) pensions, dominated by the struggle among generations and exacerbated by the aging process, it is often neglected that pensions are not only a way to redistribute income from young to old, but also from rich to poor.
This is especially true for ‘Beveridgean’ systems where contributions paid when young and benefits received when old are only loosely connected, as, traditionally, in Anglo-Saxon countries (the UK, the United States, Canada). The contrast is with ‘Bismarckian’ pension schemes, where there is a tight link between an individual’s contributions and pension benefits, as found in continental Europe (Germany, France, Italy, etc.).
This redistributive feature and the size of PAYG pension systems have a clearly negative relationship. Public pensions as a percentage of GDP are about 8.1% in the UK and more than 11% in Germany, while private pension funds assets represent 73.3% of GDP in the UK and only 3.4% in Germany.
As in many aspects of welfare, the explanation for these features includes politics. People of different age and income have different preferences, and therefore express different votes on the size of the public pension system – the contribution rate – and on its design – redistributive or not.
More precisely, all retirees try to maximise their pension transfer: since they are no longer required to contribute to the system, they prefer a large public pension system.
Among the workers, the rich always ask for a small public pension system, since they prefer to invest their money in private alternatives, where they are usually able to obtain high returns. But they may find it convenient to form a coalition with the poor, against the middle-income, to support a redistributive design (which favours the poor) of the public pension system, as long as the contribution rates are kept low, so that more resources are free to be invested in the private market.
The middle class instead prefers a large public system where contributions and benefits are tightly related and thus redistribution is low.
This idea explains why countries where there are more rich and poor – the Gini index of inequality is above 36 in the UK and 28.3 in Germany – spend little in public provision of pensions, they largely rely on private pension funds and, at the same time, they have adopted a pension formula that redistributes towards the poor.
As it is well known, aging is the main challenge for PAYG pension systems: when there are more elderly, for a given contribution rate, public pensions have to become less generous.
This study suggests that we cannot look at the evolution of the size of the pension system without considering its design. Specifically, more elderly means more support for the Bismarckian, large public pension system. But it also means a lower performance of the social security system relatively to the saving technology. Thus, preferences for a small Beveridgean system may enlarge.
The researchers thus expect that the UK programme, for instance, will become even more redistributive, reinforcing the trend of recent reforms.
They also recommend to countries that are experiencing a severe aging process and want to keep the size of the public pension system under control, to develop alternative pension provisions and their attractiveness, thus increasing the support for a small Beveridgean scheme.
ENDS
Notes for editors: ‘The Redistributive Design of Social Security Systems’ by Ignacio Conde Ruiz and Paola Profeta is published in the April 2007 issue of the Economic Journal.
Ignacio Conde Ruiz is at Fedea, Madrid. Paola Profeta is at the Università Bocconi, Milan.
For further information: contact Paola Profeta on +39-025-836-5309 (email: paola.profeta@unibocconi.it; website: www.econpubblica.unibocconi.it/profeta); or Romesh Vaitilingam 07768-661095 (email: romesh@compuserve.com).