Introduction
In most of the European Union countries, the issue of unfunded social security pensions has been of major debate for a long time. Aging increases the proportion of those who are retiring and in turn reduces the available workforce. With fewer people contributing to the Pay-as-you-go social security system and more people registering for it, there is a high possibility that the government may not be able to cater to the aging population in the future. This means that the ability to pay the social security benefits to future retirees is diminishing with time and there is a need to look into those factors that will promote the future sustainability of these pension schemes (Cremer 2005).
Studies have shown that unless economic productivity goes up or sufficient financial provision is given to these systems, there is a possibility that the Pay-as-you-go social systems may not fully sustain the high number of retirees because the amount of money contributed is not enough to cover all the benefits that come with the pension schemes.
How aging population can affect the sustainability of EU pension systems
Pension systems are aimed at distributing incomes both across generations and within the generations. Cremer (2005) argues that the impact of the aging population on pension schemes depends mainly on the prevailing political factors. On the other hand, early retirement among the European Union workers is also affecting greatly the sustainability of the EU pension schemes. The key issue that has been arising is the way to deal with the aging population.
It has been noted that there is increased average retirement age in most parts of Europe from 60.5 to 61 years in the past year. On the other hand, countries with higher retirement ages such as the UK which is at 62.6 years, Sweden at 63.7 years, or even Denmark which is at 61 years tend to perform better than those with low retirement ages like France at 58.8 years or Italy at 59.8 years.
To be able to cope with the high rates of demographic changes, reforms have been continuously enhanced to lower the state schemes and make the private schemes more effective and sustainable. There has, in this respect, been a considerable rise in the participation of the private pension schemes over the last few years in the European countries, with most of them focusing their attention on the aging population and coming up with ways in which the pension schemes can help workers once their retirement period becomes due (Boldrin 1998).
According to Boldrin (1998), the pension system can be considered a saving channel that can easily distribute incomes across and within generations. The aging population can be said to affect the social security system in terms of two aspects: the economic aspect and the political aspect. The economic aspect of the aging effect is represented by the rate of dependency among workers. That is, the dependency ratio of retirees to employees and since the return of a social security system depends on the dependency ratio as well as on the rate of productivity aging normally lowers the profitability of the system in the long run.
The impact of aging on the long-term profitability of the system in turn causes the savers to go for the private pension schemes and this reduces the size of the pension scheme (Breyer 1989).
The political aspect that brings about the effect of aging on the pension schemes can be related directly to the prevailing political conditions. An old person with voting rights increases the importance of the agenda of pension spending among the policy-makers (Possen 1998). Consequently, this results in a rise in the efficiency and sustainability of the pension systems. According to Feldstein (1992), the average age of voters is likely to go up in most countries to reduce the negative impact of the aging population on the social security systems.
In order to identify the extent to which political systems in respect to the aging of a population affect the structure of the social security systems, individual decisions in terms of economic and political factors need to be taken into consideration. It is important to note that as economic agents, individual people decide the nature of their consumption, the means of saving as well as the availability of labor; and as political agents, they make the decision to vote towards the rates of the social security contribution.
The impact of the aging population through the political and economic aspects may be noted as follows: An increase in the rate of political influence among the old generation will increase the size of the pension scheme (Galasso 2002). On the other hand, the process of aging affects the labor supply and results in high rates of employment for the elderly employees and hence reduces the participation of younger people in the labor workforce.
Other factors that may affect the sustainability of pension systems
Besides the aging population, other major factors have a significant impact on the sustainability of the European Union’s pension schemes. These factors include (Miles 2002):
The countries’ demographics
This implies the fertility and life expectancy rates and the dependency rates among the total population of a particular country. According to Miles (2002), there has been a high decline in the fertility rates in most of the European Union countries while the life expectancy rate has continued to rise. This has resulted in a high rate of dependency and with an expected rise in the old-age dependency ratio the level of contribution towards the pension schemes is likely to drop significantly.
A rise in the youth dependency ratio is likely to improve the sustainability of the pension schemes while its fall and a consequent increase in the old-age dependency ratio will lower the sustainability because there will be reduced contribution and increased claims for payments (Breyer 1989).
The labor market
Most countries in the EU have a falling labor force participation rate mainly among the young generation and a high rate of unemployment among people in all age groups. This has resulted in less contribution to the pension systems. The rate of labor force participation among the old people has also dropped, especially with men and this has led to reduced contribution periods and increased demand for pensions. This is likely to have a future adverse effect on the ability of the pension schemes to sustain the high numbers of people applying for the pension schemes (Cremer 2005).
According to Cremer (2005), the incidence of unemployment among the old people has also gone up, resulting in high pressure towards the schemes to provide unemployment benefits so that the old people who are not employed may have a source of income.
Government policies
The government is coming up with various policies that are aimed at supporting the strategy of early retirement in order to promote youth employment and hence increase the contribution of pension towards the Pay-as-you-go systems. This would imply retiring a proportionate number of elderly employees in respect to the number of unemployed youths. From research carried out in the European Union countries, the substitution of retirees with young employees would not change the rate of youth unemployment and would only negatively affect the sustainability of the pension schemes’ contribution (Miles 2002).
Tax effects
The impact of taxation on pension schemes relates to how much it affects the income of the savers. For those people with relatively high incomes, taxing the incomes will mean that the individuals have enough to save for pension (Cremer 2005). On the other hand, those with low incomes will not have enough for contributing to the pension schemes and this will imply less contribution to the schemes. All people, on the other hand, will still require to be provided with a pension at the end of their employment regardless of the level of their incomes. Hence the tax levels will affect the pension systems mainly the compulsory pension system, which will become regressive as the tax rates go up and progressive as they go down.
Policies that have been or could be implemented to make pension systems sustainable
These are the reforms that have been put in force or are to be enforced in order to create a sustainable pension scheme. These reforms, according to Cremer (2005), include:
Parametric reforms
One way of creating sufficient reforms in the pension schemes is to adjust the system’s major parameters. These include adjusting the retirement age, increasing the amount of income that is subject to taxation, or reducing the pension benefits. Countries have to come up with ways of creating flexibility in the retirement age so that it can easily be adjusted to cater to the existing conditions with respect to the demography and the country’s economic conditions.
Moving towards the fully funded scheme’s strategy
There is a debate on the issue of the Pay-as-you-go system as most economists are advocating for a fully funded system. The rate of return on the fully funded pension system is higher than that of the PAYG system and shifting to the fully funded system would therefore imply investing a significant amount to the stock market and hence raise its sustainability.
Creation of optimal reforms
These will be focused on enhancing social welfare. Pension schemes should be focused on taking into consideration the consumption effects of all households so that their contribution to the schemes is not affected by changes in taxation and other factors like changes in the retirement age.
Increased accountability of policymakers
The greater impact of the aging population on the sustainability of pension schemes is a result of the political accountability of most policymakers. If they were to enhance sustainability, they would be required to improve their policies so that they may positively impact the population that is contributing to the pension schemes.
Likely benefits and costs of different policies
Galasso (2002) points out that, different policies have been identified to help pension reformers come up with sustainable pension schemes, and the implementation of these policies results in different implications. One major policy reform is that the social security pensions should not be financed by a tax on earnings scheme but rather by the annuities that are earned through the financial assets. The benefit of this is the fact that the total earnings on financial assets have a higher growth rate than the earnings on taxes. On the other hand, this is likely to increase the risks that are involved in relying on financial assets especially the stock markets (Breyer 1989).
Another policy reform that has been implemented is the shift from the unfunded or the PAYG systems to the funded systems. The benefits derived from this include ((Feldstein 1992):
- A rise in the country’s economic growth rate.
- An increased rate of return on capital in comparison to the increase in national income.
- Increased rate of return on capital in comparison to the rate of time period preference.
According to Feldstein (1992), shifting from an unfunded system to a fully funded system is however likely to lead to an increased level of government deficit especially if there was the issuance of the public debt. This will mean the benefits will not be felt and the reform may result in the conversion of the pension schemes into major country’s debts.
Conclusion
In a conclusion, it has been noted that the European Union countries have had a major challenge trying to make their pension schemes sustainable for the increasing number of retirees. Most economists and other policy reformers have carried out several studies to identify the factors that result in low rates of sustainability and it is from this that pension reforms have been established to improve the schemes.
Bibliography
Aaron, H. and Shoven, J (1999). Should the United States Privatize Social Security? The MIT Press, Cambridge.
Belan, P, and Pestieau, P. (1999). Privatizing Social Security Reform: A Critical Assessment: Geneva Papers on Risk and Insurance.
Boldrin, M. and Montes, A (1998). Intergenerational Transfer Institutions: Public Education and Public Pensions: Mimeo, Universidad Carlos III de Madrid.
Breyer, F. (1989). On The Intergenerational Pareto Efficiency of Pay-As-You-Go Financed Pension Systems: Journal for Institutional and Theoretical Economics.
Casamatta, G., Cremer, H. and Pestieau, P. (2005). The Political Economy of Social Security Reform: Mimeo, University of Toulouse.
Feldstein, S. and Samwick, A. (1992). Social Security Rules and Marginal Tax Rates: National Tax Journal.
Galasso, V. and P. Profeta (2002). Political Economy Models of Social Security: A Survey: European Journal of Political Economy.
Miles, D. and Sefton, J. (2002). Optimal Social Security Design: Centre for Economic Policy Research, Discussion Paper no. 3290.
Pestieau, P. and Possen, U. (1998). Investing Social Security in The Stock Market Does It Make A Difference: National Tax Journal, in press.