Pension Reforms: An Illustrated Basic Analysis

Abstract: The paper examines pension reforms under population ageing. The concepts of “implicit pension debt”, “implicit tax” and “internal rate of return” are first introduced with the help of a three-period model. Using stylised facts, ageing is traced to low fertility and increasing longevity. Formulating a benchmark for intergenerational fairness leads to a framework for designing pension reforms such that leaving an unfair burden to future generations is avoided. Secondly, a yearly simulation model is used to arrive at the following main results for reform blueprints: (1) In a Defined Benefit (DB) system, partial pre-funding is needed to achieve intergenerational fairness unless benefits are sufficiently reduced; partial privatisation
is an option for the management of the accumulating funds. (2) Transition from a DB to a Notional Defined Contribution (NDC) system is another reform option; it reduces the replacement rates to levels which match prescribed contribution rates; an NDC public pillar can be accompanied by a second pillar, managed by the private sector. (3) An effective increase in the retirement age is necessary to moderate the increase in pension expenditure and to preserve adequate pension levels. (4) Pension reforms have important effects on public finance target setting.