Demography as Destiny

Like many others, I once associated the coming age wave with the retirement of America's baby boom generation. But in fact, it is a global phenomenon brought about by two more fundamental demographic trends: rising longevity and falling fertility. The entire developed world is aging, and the crisis is due to hit Japan and Europe sooner and harder than it hits the United States. Consider, for example, the following "demographic tidbits."

• Until the Industrial Revolution, the chances of encountering an elderly person were about one in 40. Today, in the developed world, they are one in seven; by 2030, they will be at least one in four, and they may be as high as one in three.
• Worldwide, life expectancy has risen more over the past 50 years than over the previous 5,000.
• By 2030 in the United States, the retirement age would have to be raised to 73 (and continue to "head north" thereafter) for people to receive the same number of publicly subsidized retirement years as when Social Security first began.
• Today, in Europe, the median age (i.e., the age that divides the older and younger halves of the population) is 38 years. By 2050, unless fertility rises, it will be 51. And that's the average. In Germany, it will be 53; in Italy, 57.

A Falling Ratio of Workers to Retirees. To express the phenomenon of aging in graphic terms, I use the phrase the "Floridization" of the world's population. In my research, I calculated the dates at which the percentage of various countries' populations that is made up of the elderly would equal what it is in Florida today. The U.S. population won't reach its point of Floridization until 2023, but Italy will be there in 2003, and Germany in 2006.

These aging trends will soon put an unprecedented burden on working-age people. In Japan, which did not experience a baby boom, the number of workers who are under 30 years old will fall by a stunning 25 percent by 2010. By the 2020s, the total working-age population will be shrinking in every developed country, with the possible exception of the U.S.

This has profound implications for the economy. Because health care and pension systems almost everywhere are designed on a pay-as-you-go basis, it is very important to look at the ratios of workers (who pay taxes) to retirees (who receive the benefits). The average ratio in the developed world as a whole today is about 3 to 1. In countries such as Germany and Italy, this ratio may well fall to 1 to 1, or even less, by the 2030s.

Explosive Growth in "Old" Old. Consideration should also be given to a statistic that is heartening in humanistic terms but daunting in its fiscal impact: a population explosion of the "old" old (those who are over 85). The official projections--which do not include the possibility of revolutionary biomedical breakthroughs--indicate that, over the next 50 years, there will be a six-fold increase in the number of people who are over 85 and a 16-fold increase in those over 100.

The implications for health care spending of this "aging of the aged" are truly staggering. Overall in the United States, per capita health spending on the old elderly (aged 85 and over) is three times greater than spending on the young elderly (aged 65 to 74); for nursing home care, the ratio is over 20 to 1. Already today, before the age wave rolls in, the roughly 15 percent of the population that is elderly consumes roughly 40 percent of all health care dollars.

Declining Fertility Rates. Another demographic trend that aggravates the situation is the very large drop in fertility rates. Thirty years ago, the average global fertility rate was about 5.0 births per woman. Today, it is barely half this rate.

The reasons for this decline may not be fully understood, but they include a combination of affluence, urbanization, an increase of women in the work force, and the legalization of abortion and birth control. In order to keep a population stable, a replacement rate of 2.1 births per woman is necessary. Today, the average fertility rate for the world's developed countries is about 1.6, and the rates for many of the European countries are well below that number. For example, Germany has only 1.3 births per woman. The fertility rate in Italy is just 1.2, and in the north of the country, it is less than 1.0.

The United States finds itself in quite a different situation. Its higher fertility rate--now 2.0--together with our higher immigration rate means that America, alone among the major developed countries, will see significant population growth in the decades to come.

The outlook for developing countries is radically different from that of most developed countries. Although the average birth rate for developing countries has fallen, it is still substantially above the replacement rate. In 1950, of the 12 most populous nations in the world, seven were developed countries. By 2050, only the United States will remain on that list. Replacing the others will be Nigeria, Pakistan, Ethiopia, Congo, Mexico, and the Philippines.

The Fiscal Impact of a "Gray Dawn"

Graying means paying. Spending on public pensions is due to rise by 4 percent to 6 percent of GDP in most developed countries over the next 30 years, and this may be a conservative estimate since the official projections assume that the historical pace of improvement in longevity will slow and that fertility rates will rebound from today's low levels. Pensions, moreover, are not the only public cost that will be rising. Add in health benefits, and the fiscal burden is due to rise by 9 percent to 16 percent of GDP in most of the developed countries.

In the United States, programs like Social Security are discussed euphemistically with language that suggests that they are funded when, in fact, they are not. The term "Social Security trust fund" should be near the top of the list of oxymorons of our time. There are, in truth, no assets in trust: There are only liabilities. The concept of a trust fund may be a remarkably convenient accounting and political fiction, but it has no impact in the fiscal or economic arenas. For all practical purposes, when pension payments are due, the options for action are identical, with or without a "trust fund:" Benefits must be cut, taxes must be increased, or money must be borrowed.

It is often claimed that Americans have no need to worry because the trust fund will keep Social Security "solvent" until the year 2038. Granted, that's a year that seems to be too far away to be worried about, but the real-world situation is clearly different from that claim.

Simply put, the government is faced with the challenge of financing the operating deficits of a pay-as-you-go system. In the period between 2016 (when the boomers retire) and the 2038 "magic date," the nation will owe more than $12 trillion in aggregate Social Security deficits. Even in today's dollars, that's nearly $5 trillion--a figure that would be at least twice as large if we include Medicare.

Spending Cuts: Not Enough to Meet the Need
The projected growth in benefits--between 9 percent and 16 percent of GDP by 2030 in most of the developed countries--is several times what the United States currently spends on defense alone.

Some people assume that this increase in spending can be balanced by cutting expenditures in other areas, but the idea of solving the crisis by cutting other spending is not realistic. By the 2020s, the projected expenditures for senior benefit programs would, in many countries, crowd out all other government spending.

Tax Increases: Also Not Enough
Another way of looking at the problem is to determine the level of tax increases that would be required to pay current benefit promises. A country-by-country analysis reveals that increases in the payroll taxes in each of the developed countries would have to be between 25 percent and 35 percent of payrolls.

In Europe, this increase would be added to payroll taxes that often approach 40 percent already. In the case of Italy, for example, payroll taxes would claim nearly 70 percent of a worker's pay. This is unthinkable--politically, economically, and morally.

Borrowing to Pay for the Age Wave: Also Not an Option
Needless to say, all developed countries cannot simultaneously run deficits equivalent to 9 percent to 16 percent of GDP. By the 2030s, government borrowing to finance rising pension and health benefit costs would consume the total savings of the developed world, leaving nothing for private investment. Long before then, global financial markets would bring the experiment to an unpleasant halt.

Some people claim that these projections are too pessimistic. In fact, they are optimistic. Many biogeneticists who have reviewed the aging trends have said that the official estimates on longevity are, in fact, extremely low. Recently, a group of experts of the Organisation for Economic Co-operation and Development studied longevity trends in a number of developed countries and concluded that the odds are very high that longevity, indeed, is going to be much greater than official estimates indicate. For example, they projected that the average life span in Japan in 2050 will be eight years longer than the official estimates upon which the above fiscal projections were made.

Another factor that could influence the accuracy of projections is the fertility rate. Nearly all of the official estimates assume, for reasons that are not clear, that the fertility rate is going to go up in the developed world from 1.6 to between 1.8 and 2.1. In light of current sociological trends, this is not necessarily a prudent assumption.

"Growing Our Way Out" vs. the Facts
Lacking an adequate response to the crisis, there are those who simply say that we will "grow our way out of this problem." They had better confront the following facts.

• In the first place, senior benefits in most of the countries are correlated with wages, which in turn are correlated with productivity. That is to say, as productivity goes up, benefits will also increase in most of these countries.
• Second, GDP growth is a function of the growth in workers and the growth in productivity. Projections indicate that stunning drops in the number of workers will occur in the future.

When confronted with these projections, many people complain that they are unsustainable. But that is exactly the point. A humorist in the Nixon era, economist Herb Stein, once said, "If something is unsustainable, it tends to stop," and, taking it a step further, "If your horse dies, we suggest you dismount."

The point that I'm trying to make is that we're going to have to reform these programs in order to make them sustainable. The question is not "Should we reform them?" but "How? When? And under what circumstances?"

Avenues For Reform

Social Security
I am a strong supporter of moving Social Security toward a system of funded personal accounts, but some of the advocates of such reform in America tend to minimize the huge transition costs that such a move would entail. In the process of transition, there will be a period in which two systems--the old system and the new system--must be funded at the same time. Thus, while I favor moving toward personal accounts of the type that Chile and Singapore and several other countries have, I want to ensure that they are funded.

Funding will require hard choices. Diverting a small percent of the existing payroll tax cannot provide adequate funding. The hard truth is that some combination of benefit reductions and new contributions is required. In the case of Social Security, these reductions can be humane and gradual, such as a staged increase in the retirement age or an "affluence test."

Unfortunately, any discussion of even the most gentle benefits cuts tends to generate an outcry. For my suggestions of reforming Social Security and other programs, I have been called an "intellectual Dr. Kevorkian" and my plan, the "intellectual bridge to the 16th century."

The fiscal impact of global aging is certainly more daunting for Europe than for the United States. But even in Europe, prompt, gradual, and humane changes would go a long way to address the problem.

Health Care
Regarding the issue of health care in the United States, the reform of Medicare is an even more thorny issue than the reform of Social Security. This is because health care reform raises deeply ethical, moral, and philosophical issues, not just fiscal ones.

Much of what has been said about health care reform is based on rather fallacious assumptions. One assumption is that there is currently a lot of waste in this system. But what appears to be waste in the eyes of a stranger tends to be essential care from the perspective of a loved one. One physician's idea of waste is another's idea of good medicine. While eliminating waste may be one aspect of solving the problem, it is only one among many. There are more fundamental reasons why heath care costs are going up so rapidly--above all, new technologies and rising expectations about care and cure.

Public opinion policy specialist Dan Yankelovitch has coined the phrases "maximum rights" and "minimum rights" in discussing the public benefits offered in America. Although Americans consider it unconscionable to let people go hungry (all people have a minimum right to sustenance), we don't say that the needy should dine at the Four Seasons.

Yankelovitch says that, with regard to health care, the nation is moving close to a "maximum rights" concept. We switch on multimillion-dollar MRI units more or less at random. Our terminally ill patients are in intensive care units getting all sorts of heroic intervention. We perform heart bypasses on septuagenarians at rates no other country does. Compared with Canada, the United States has seven times the radiation therapy units and eight times the MRI units per capita. Compared with Germany on a per-capita basis, it has four and a half times as many open-heart surgeries.

A comparison of an intensive care unit in Europe and the United States reveals sharp differences. From what I have witnessed, the intensive care units in Europe account for between 1 percent and 5 percent of hospital beds; in the United States, between 15 percent and 20 percent. As one health care expert wrote, "The common patient in an American ICU unit is an 85-year-old whose heart is failing, whose lungs are failing, and who is in need of artificial respiration."

It strikes me that Americans are inverse Victorians. We're very happy to talk about our sex lives and the most private details of our lives, yet we have great trouble discussing the issue of dying. The British, in contrast, have developed a whole profession around wills and discuss the issue of death freely, but they don't discuss their sex lives with nearly the same abandon that many Americans do.

Leo Durocher once said, "I don't want to achieve immortality by being inducted into the Hall of Fame. I want to achieve immortality by not dying." We have almost reached the point in America where we think there's an option not to die.

The vast majority of experts say that new technologies (and the more intensive use of existing technologies) accounts for the unprecedented rise in health care costs in America, where approximately 15 percent of GDP (nearly double the percentage in other developed countries) is spent on health care.

Issues That Must Be Addressed

The issue of senior benefits--and especially health benefits--involves a difficult combination of sociological, cultural, psychological, philosophical, and ethical considerations. I do not pretend I know the answers, but I do want to clarify the questions that the experts must deal with.

Spending Priorities
One of the first decisions that must be made is how the size of the overall health care budget should be determined. How do we make the trade-offs between public spending on health care and public spending on other collective national priorities? What criteria do we use to decide that it is more in the national interest to spend an additional dollar on health care than on education, cleaning up the environment, or defending democracy?

In an aging society, health care expenditures will surely grow as a percentage of the national product, but just as surely, we are also going to have to devote more resources to educating the young workers whose productivity we expect will support us in our old age.

Allocation of Resources
Second, within the budget, how do we allocate limited resources? How do we go about thinking of the health of the young versus the old--how much to invest in prevention versus treatment, how much to invest in acute care versus chronic care, and, once we've made these decisions, who pays? Today, most public health benefits for the elderly are paid by young workers. Can we continue to move further and further in that direction?

Implementation
Third, how will we implement any concept of a global budget when it comes to real-life decisions? Who will have the most say--the patients, the providers, or the bureaucrats? If we adopt a government-managed program, will there be an explicit list of maladies and treatments that will be covered? If we move toward a pure voucher system, will we insist on requiring and enforcing minimum standards of care? And, under any system that allows individual choices, how will we deal with the vexing problem of adverse risk selection?

Providers' Attitudes
Fourth, the transition to global budgeting is going to be very difficult unless we change the culture of the providers. How do we do this? How do we get professionals who have been steeped in the admirable and idealistic idea of the Hippocratic Oath to make cost-effectiveness an important criterion?

Study after study in America has shown that physicians respond to identical symptoms in very different ways with very different price tags. The history of technology in health care reveals that we rarely get rid of old diagnostic and treatment techniques. New ones are simply added to the old ones. One of the reasons for this is the potential for litigation. A doctor who had the option of using two tests, one of which may be more accurate, may still be sued if he did not use both.

Public Acceptance
Public acceptance is another issue to be faced. Any transition to global budgeting is going to be slow and difficult and may even result in a political crisis. Americans, as I suggest, are blessed and cursed by their refusal to accept limits. We expect our doctors to do everything that can be done. In European countries and elsewhere, citizens entrust their doctors to decide what the appropriate treatment should be.

Probably the most toxic phrase in American politics is "health care rationing." Former Governor Richard Lamm of Colorado dared to ask why we spend such extraordinary amounts without significantly improving quality of life in the last few months of life. Claude Pepper, I think it is fair to say, "nuked" him very effectively. We haven't heard a word about the issue since.

In George H. W. Bush's presidency, the state of Oregon came up with a list of 714 diagnostic categories that had been ranked by doctors, labor unions, clergy, nurses, and business people. The idea was to prioritize runaway Medicaid spending. In essence, the reaction from the White House was, "My God, that is rationing!"

But this is inescapable. Rationing can be done in a variety of ways: implicitly through vouchers, and explicitly through Oregon-like lists. But at some point, we have to give up some potentially beneficial medical services if we are to address the problem of skyrocketing costs.

Nobel Prize winner George Stigler once observed curtly, "If you have no alternative, you have no problem." It does seem to me that we have no alternative but to reform our old-age benefit systems. Sooner or later, we will have to invest ourselves, our energy, and our expertise in making some very tough, but very necessary, choices.

Peter G. Peterson is Chairman of The Blackstone Group in New York. He is also President of The Concord Coalition and author of Will America Grow Up Before It Grows Old? and Gray Dawn: How the Coming Age Wave Will Transform America--and the World.

Reform through a Multi-Pillar Structure

The most common type of structural pension reform involves implementing a "multi-pillar system." Specifically, these new systems contain three pillars (see Chart 1):

• A mandatory, publicly managed tax-financed pillar for poverty prevention;
• A privately managed funded pillar (personal accounts) for retirement saving; and
• A voluntary pillar for people who want more protection for old age.

The second pillar is the newest and most controversial aspect of reform. It is based on the premise that a significant part of old age security can be provided by personal savings. Greater reliance on saving can reduce many of the incentive problems associated with tax-and-transfer systems, thereby having a positive impact on the overall economy. The use of part of the social security tax to establish personal retirement accounts, as proposed in the United States, is a typical form that such a structural reform might take.

Over the past few years, many countries have adopted multi-pillar old age security systems. Although structural change is always difficult, preliminary empirical evidence suggests a positive impact on efficiency and growth.

The move toward a multi-pillar system has taken different forms in different countries, but it usually involves transition costs that are spread over several generations. This can be accomplished through some initial borrowing, but with a repayment plan designed to ensure that the transition debt is eventually repaid; otherwise, the increase in personal saving could be canceled out by public dissaving.

During the past decade, with the pace accelerating during the past five years, more than 20 countries throughout the world have adopted variations on the multi-pillar theme. This includes several Western European countries such as the United Kingdom, the Netherlands, Switzerland, and Sweden, and countries as far afield as Australia, Hong Kong, and Chile. This number is likely to increase substantially as the movement toward reform spreads throughout Eastern and Central Europe and the former Soviet Union over the next few years. Examples now show that pension reform is possible, even in democracies and even in welfare states.

Structural social security reforms have certain commonalties but also many differences, as a result of different initial conditions and political economies. The most important commonalties are:

• A partial shift from defined benefit plans to defined contribution plans;
• A partial shift from pay-go to pre-funding;
• Shared responsibility between the public and private sectors; and
• Separate arrangements or "pillars" for the poverty-prevention part of the old age system (the public pillar) and the retirement savings part (the private pillar).

The term "privatization" of social security has been applied to these reforms because of the key role assigned private pension and investment companies. However, it would be more accurate to call them "public-private partnerships" since both sectors play an important role.

The reforming countries also exhibit important differences, especially with regard to the nature and size of the public pillar and agent who chooses the investment managers in the private pillar.

The Public Pillar

The public pillar in most reforming countries is publicly managed and largely unfunded but smaller and more focused on redistribution than traditional pay-go defined benefit plans (PAYG DB). Its primary responsibility is to provide a social safety net for the old, particularly the old whose lifetime income was low.

Although the general characteristics remain constant, there are significant differences among the public pillars of different countries. In some countries--for example, Chile, Mexico, El Salvador, and Kazakhstan--the first pillar simply provides a minimum pension guarantee (MPG), a promise that the government will top up the pension from an individual's retirement savings account if it fails to provide an annuity that is at least 25 percent of the average wage. Australia and Hong Kong offer a public benefit that is means- and asset-tested. It is similar to the MPG but takes all income and assets into account for eligibility. This may be fairer, but it is harder to administer.

In the Netherlands, Denmark, Argentina, and the United Kingdom, the benefit is flat (uniform for everyone or uniform per year of covered employment), while in Uruguay, Hungary, and Poland, the public benefit rises sharply with earnings, up to a limit. The first alternative is obviously the least expensive and chiefly targets low-wage earners. The latter alternative is more expensive, but it provides additional co-insurance for middle-class workers. In Denmark, Australia, Hong Kong, Chile, and Mexico, the public pillar is financed through current general tax revenues, while in Switzerland, it is financed by a payroll tax with no ceiling on taxable earnings.

In the United States, proposals abound for each variation of the public pillar. It should be kept in mind that the public pillar is the instrument that shapes the distributional impact of the entire system. Some proposals would put greater emphasis on the new funded pillar of personal savings accounts and would simply rely on the public pillar to provide a minimum pension guarantee.

The plan that would be likely to have the most public support would include a PAYG pillar that would be a downsized version of our current Social Security system--where benefits rise with earnings, but slowly, making it more progressive. This might be buttressed by measures such as a floor on benefits, which is not present in our current system, or possibly by raising the ceiling on taxable earnings.

The Private Pillar

The second pillar differs dramatically from traditional systems. Its most important characteristics are: It is mandatory; it links benefits actuarially to contributions, often through a defined contribution (DC) plan; it is fully funded and privately, competitively managed.

The funds of the second pillar are referred to in the United States as personal retirement accounts. Contribution rates to the second pillar vary widely, but they range between 7 percent and 12 percent of payroll in most countries. Since this is the newest and most controversial of the three pillars, it is worthwhile to examine the rationale for its fundamental characteristics.

Why Mandatory?
The rationale for mandatory second-pillar contributions is to address a combination of myopia and moral hazard. A significant number of people may be shortsighted, may not save enough for their old age on a voluntary basis, and may become a burden on society when they grow old. In countries that have adopted structural reforms, retirement savings pillars have been adopted as part of the mandatory scheme in order to keep the PAYG tax-and-transfer system small.

Why Defined Contributions?
"Defined contributions" is actually another term for personal saving accounts with a fixed contribution schedule. The worker simply accumulates his or her defined contributions, as well as any returns earned on investments, and eventually converts this into retirement income. In a DC plan, benefits depend linearly on the contribution rate; there is no intervening DB formula that cuts this link. This close link between contributions and benefits is designed to discourage evasion and labor disincentive effects.

Evasion and escape to the informal sector are big problems in many countries, especially developing countries. With DC plans, those who evade payments will bear the cost because they will have less funds accumulated and, therefore, lower benefits. This avoids passing the costs on to others and undermining the financial viability of the scheme.

Importantly, the pension that is eventually acquired through the market is likely to be actuarially fair, meaning that workers who retire early bear the cost themselves, in terms of lower monthly benefits. For this reason, DC plans are likely to discourage early retirement. In essence, this would raise the average retirement age automatically as longevity increases without requiring a legislative mandate that could be difficult for politicians to make.

Why Fully Funded?
For several reasons:

• First, for countries with relatively young systems, pre-funding makes costs clear up front so that policymakers will not be tempted to make promises today that they will be unable to keep tomorrow.
• Second, pre-funding avoids large payroll tax increases that are needed in a PAYG system as populations age.
• Third, it prevents large inadvertent intergenerational transfers from young people to older workers.
• Fourth, funding may be used to help build and mobilize long-term national saving. In countries where savings are sub-optimal due to public or private myopia or a tax wedge between social and private returns, an increase in savings increases efficiency as well as growth and can improve the general welfare of the populace.

Many economists believe that saving is too low in the United States and pre-funding could help to change this. Moreover, empirical analysis suggests that saving that is committed for the long term, as retirement savings are, is especially productive. Such savings can be invested productively at home and abroad, can enhance worker productivity and output, and can later be redeemed by individuals to finance consumer purchases. Thus, saving can be an important ingredient of a long-term strategy for increasing productivity and stimulating additional domestic consumption when the ratio of retirees to workers increases.

However, pre-funding retirement accounts will increase national saving only if it does not crowd out other private savings. If workers believe that a pre-funded system is more credible than a PAYG system, they may save less on a voluntary basis for their own old age or borrow more for current consumption, thereby offsetting some of the increased mandatory saving. In the United States, since few people save voluntarily, this offset is likely to be small, except among high earners. The fact that the saving constraint will be more binding for low earners is a reason for targeting the public pillar more closely toward this group.

If the build-up of pension reserves relaxes fiscal discipline, or if the government finances the transition by issuing additional bonds, increased public deficits will absorb the increased personal saving. The largest contribution to saving in the United States is likely to come from the use of the current Social Security surplus--and in the future, hopefully, from a budget surplus--to finance the transition, reducing the funds available for increased government spending or tax cuts.

Why Privately Managed?
Private-sector management of the pension funds will maximize the likelihood that economic rather than political objectives will determine the investment strategies and would help to ensure the best allocation of capital and the highest return on savings. Empirical data show that, throughout the world, publicly managed pension reserves typically earn low returns, far below the bank deposit rate or the growth of per-capita income. This is largely because public managers have been required to invest in government securities or other politically motivated loans that pay low rates of return.

Politicians are also subject to pressures to raise benefits if publicly managed funds are available, which is what happened in the United States in the early years of the Social Security system. Moreover, the hidden and exclusive access to these funds makes it easier for governments to run large deficits or to spend more wastefully than they could if funds were managed by an agent with more accountability.

Competitively managed funded pension plans are more likely to be invested in a mixture of public and corporate bonds, equities, and real estate, thereby earning a higher rate of return. (See Chart 2.) They enjoy the benefits of investment diversification, including international diversification, which enables them to increase their yield and reduce risk. They also build constituencies that help them resist political manipulation. In addition, they spur financial market development by creating a demand for new financial instruments and institutions, which are especially important in middle-income countries.

How the Investment Managers Are Chosen
The most important difference among countries regarding the private pillar is in the arrangements they make for choosing investment managers. Three different patterns have emerged:

• The Latin American model, where individual workers choose;
• The group model, found in many OECD countries, where the employer and/or union representatives choose the manager for an entire company or industry; and
• The institutional model, now being explored in Bolivia and Sweden, where small contributions are aggregated into large money blocs and fees are negotiated centrally in an effort to keep administrative and marketing costs low.

If a system of mandatory retirement accounts is set up in the United States, the key decisions that would have to be made are: Who should choose the investment managers, how much should we constrain worker choice, and what are the criteria for firms to enter that market?

How Pre-Funding Increases the Private and Social Rate of Return
The rate of return in a PAYG system is approximately the sum of the rate of wage growth and the rate of population growth, both of which raise the payroll tax base. With a stable population, a wage growth rate of 2 percent, for example, would yield a 2 percent rate of return on contributions. In contrast, the rate of return in a funded system is the return on investments, which historically has been over 5 percent in real terms.

This means that an individual would get a larger pension from his contribution in a funded system. In the current situation, it means that total benefits will not have to fall as far as they would under a PAYG structure--and may not have to fall at all. Moreover, if pre-funding increases national saving, this increase in rate of return also corresponds to an increase in real output, which eventually makes it possible for a relatively smaller working-age population to support a relatively larger older-age population.

Reducing Risk
While investment in the financial market involves risk, so does every other form of old age security. For example, the public pillar involves substantial political risk. The government has the right to change the benefit formula and has done so many times in every country.

The three pillars, taken together, reduce the totality of risk that old people face by diversifying across types of management (public and private), sources of finance (from labor and capital), and investment strategies (equities and bonds, domestic and international). Risk diversification is especially important given the long time periods and great uncertainty involved. Thus, even though each pillar poses its own kind of risk, a multi-pillar system is likely to reduce risk overall, and therefore to increase the risk-adjusted return.

--Estelle James is principal author of Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth (World Bank, 1994). She is a consultant to the World Bank and Director of its Flagship Course on Social Security Reform. She can be reached at [email protected].