Privatising Pensions: Potential Losses For All Generations

01 Mar 1998

Moving from public pay-as-you-go pension schemes to private fully-funded schemes may involve poverty traps. While shifting to a fully-funded scheme may offer higher returns and improved labour market incentives, according to research by Alessandra Casarico published in the latest issue of the Economic Journal, such privatisation of social security may cause serious economic losses - not only for this generation but for future generations.

Pension reform is one of the dominant issues in policy discussion across the world, Casarico notes. Problems of financial sustainability and equity towards future generations demand changes in the existing pension schemes of many Western countries; while in Eastern Europe, the process of conversion from centrally planned to decentralised market economies calls for wholesale revision of social security systems.

The privatisation of social security undertaken by some developing countries, such as Chile, is often used as a benchmark. It is argued that moving from public pay-as-you-go pension schemes, which nowadays represent the dominant organisational form for old-age security, to private fullyfunded ones would increase savings, eliminate labour and capital market distortions, and enhance long-term growth and welfare.

The impact of social security on economic growth is the major concern emerging from this policy discussion, and Casarico''s analysis focuses on a particular aspect of the issue: what are the effects of pension reform on individual lifetime opportunities and aggregate output? The analysis delivers three results:
• First, if capital markets are ''imperfect'' and education requires a fixed initial investment, mandatory savings under a fully funded pension scheme and private savings are not perfect substitutes, as is usually thought. If people are forced to contribute to the system when they are borrowing on the capital market, their decisions on human capital investment are affected and their lifetime income changes.
• Second, fully funded and pay-as-you-go pension schemes are normally compared by looking at the relationship between the rate of interest and the rate of population growth rate. When the former is higher than the latter, a fully funded pension scheme guarantees higher returns than a pay-as-you-go scheme. The balance between the two rates determines which of the two schemes is associated with a higher investment in education. Casarico finds that investment in human capital is higher under a fully funded system only if the interest rate exceeds the population growth rate.
• Third, the transition path from a pay-as-you-go program to a fully funded one may involve poverty traps. It is currently believed that the higher return paid by a fully funded system and the improved labour market incentives it would guarantee are strong enough reasons to support the privatisation of social security. Casarico''s analysis highlights the fact that such privatisation may cause economic losses. Though it is assumed that transition will be financed entirely by taxes levied on the working generation when the privatisation takes place, its costs affect not only this generation via a decrease in lifetime income, but also future generations via the lower level of bequests they receive.

Casarico's analysis is developed using a model where investment in human capital and capital market imperfections are the key elements. Focusing on human capital (and on how its accumulation is affected by alternative old-age security arrangements) enriches the traditional labour and capital market analysis of social security: the number of hours spent working or the amount of physical capital accumulated are no longer the only relevant variables.

''Pension Reform and Economic Performance under Imperfect Capital Markets'' by Alessandra Casarico is published in the March 1998 issue of the Economic Journal. The paper has been awarded the Sir Austen Robinson Memorial Prize. Casarico is based at Istituto di Economia Politica, Università Bocconi, Via Gobbi 5, 20136 Milano, Italy.

Alessandra Casarico