How pensions are funded
How pensions are funded
How pensions are funded
What are pensions
In 1889 Germany started guaranteeing its elders payment for their old age. In those days the state paid a monthly stipend to citizens over the age of 65. Since average lifespan in those days was 40-50 years, there were very few beneficieries and pensions were not a significant outlay for national treasuries.
Longer lifespan meant that an increasing share of society lived past their working age, and were risking poverty.The trend towards Urbanization and the Nuclear family meant that parents no longer lived with their children al their life, and so could not count on their support.
In this article we shall explore how pensions are funded, and in subsequent ones we shall analyze the problems with the existing models and alternative solutions.
Existing methods of funding
Pay as you go (social security, national insurence, etc.)
In this method pensioners receive their money form taxpayers. Often this involves a special tax, e.g. social security. This means that today's working generation(s) support the generation(s) who are currently retired. When the current generation retires, their children will support them and so on.
Requirements- a welfare state committed to spending billions on the elderly; Clean, un-corrupt government that will not squander the funds or divert them to other uses; Stable or growing population, in which the number of workers is significantly higher than dependents
Save for your future (pension funds, 401k's, etc.)
In this method pensions are paid from a fund that was saved for by the pensioners themselves during their work years. This means that every generation saves money during its productive life, and then uses that money after retirement.
Requirements- Strong and stable legal system with effective property rights, to ensure that a person's saving is secure. Stable, competitive and effectively-regulated financial markets to ensure that the deposited funds are invested properly so they contribute to economic growth, and yet are not being put at risk.
Risk distribution
When working with a pension fund, it is important to know how much money the pensioner needs to deposit in order to receive large enough pension to suffice.
Due to uncertainty inherent in long-term investments, it is impossible to know both the size of deposits and the size of the disbursements. Hence, there is a pressing question of who takes the risk of this uncertainty.
Risk on the Fund (Defined benefits)
This means that the fund (possibly with state back-up) guarantees the size of payments from the fund, regardless of the actual profits it made. Therefore the fund assumes a very big risk.
This method is good for the consumer, because the burden of risk is on the fund. However, if the fund does not have state back-up, demographic changes, such as increased life-span means that commitments and withdrawals can overwhelm deposits, leading to bankruptcy.
Risk on the Consumer (Defined contributions)
In this method the fund does not guarantee the size of pension benefits. Instead, the worker decides how much he can deposit, and can only estimate the size of payment according to projected yields. The fund managers only commit to fiduciary managing the fund, attempting to maximize returns while minimizing risk.
This method is clearly inferior for the consumer, as he bears the risk. However, it is practically impossible for such a pension fund to fail (except if they employ Eti Alon).
(In South America this is the most common form of pensions. Chile is considered a good model in 1980 it reformed its pensions system and now workers are required to pay 10% of their annual income into private retirement accounts, which they own and control).
Governmental back-up
Governments sometimes back up pension funds. This is important because uncertainty means that consumers may be saving too much or not enough, because they are too optimistic or pessimistic about returns on investment (for example during bubbles). In addition, having a population that is insured for old age and can care for itself carries wider social benefits, and is thus considered an economic 'externality' which the government should fund and encourage in the same way it does of academic studies.
Government can back the fund in two ways: specialty bonds sold to the funds to guarantee a specific REAL (inflation adjusted) return. This means that if the fund invests a portion of its money in these bonds, it hedges the risks. Alternately, Guaranteeing the fund's returns means that the government will fill-up any shortcomings.
Theoretically, the state can assume such risks and use its superior ability to spread risks over time, thus reducing uncertainty and improving efficiency. Unfortunately, bureaucrats can fail in two ways: they are often incompetent managers who are not at risk of losing money and thus have no incentive to professionalize. Politically, they might be pressured by interest groups to give better deals to certain segments of society.
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