When Poorly Designed Pensions Threaten the Future

Macroeconomics - Economic growth - Monetary Policy
Fiscal Policy - Public and Welfare Economics

This article was previously published in the Ideas Matters Blog, on June 2, 2017.

Over the last three months, tens of thousands of demonstrators have poured into the streets of Brazil’s major cities, blocking roads, clashing with police, and bringing public transport to a halt in protests in which pensions loom large. But Brazil’s pension crisis, which has the government trying to raise the minimum retirement age and workers angrily pushing back, will not be fixed easily.

Brazil’s retirement system allows citizens on average to retire when they are 58, eight years earlier than people in the United States, and receive on average 80% of their pre-retirement income (compared to an OECD average of 60%). Pensions, currently making up around one third of government spending, scarcely cover the lowest earners. Yet, they are so generous to those that receive them that they crowd out investments in critical areas like health and education and threaten the retirement system with eventual catastrophe. The current path is unsustainable.

In this, Brazil is hardly alone. Latin America and the Caribbean still has a relatively young population. But it pays out overly abundant pensions to those that are eligible, while leaving huge numbers of people in the informal sector uncovered. That not only results in a highly unequal system. It means that the region will likely face grave financing problems in the latter part of the century when its population ages and it surpasses Europe to become the region with the highest share of elderly to working inhabitants.

A comparison with OECD countries, detailed in the 2016 edition of the IDB’s flagship study Saving for Development: How Latin America and the Caribbean Can Save More and Better, illustrates the problem. Argentina and Brazil spent roughly 6% to 8% of their GDP on pensions when 11% of Argentina’s population and 8% of Brazil’s was 65 or over. Those are roughly similar shares of GDP to what France and Italy spent in 1980 when they were much greyer countries, with 14% of their populations in that age range.

Most countries in the region, of course, don’t spend that much. Their outlays on pensions are between 1.5% and 4% of GDP, with the figure closer to 1%-2% in Central America. But that isn’t a reflection of better management or sustainability. It is a function of low coverage. Indeed, according to a simulation we ran in the course of our flagship study, increasing coverage in the region to 75% with the minimum mandated pension for each country would raise spending levels to those of the United States, Canada and the United Kingdom, which similarly have much older populations.

The need for reform is urgent. Given current conditions and rules in the pay-as-you-go systems common in Latin America and the Caribbean, countries on average are committed to paying pensions equal to 67% of a worker’s salary, when in fact they can afford 37%. By 2100 when the transition to a much older society has taken place, that percentage will drop to 15%.

Labor informality also will take its toll. More than half the labor force in the region works in informal jobs and doesn’t pay into a pension system, causing many countries to establish “non-contributory” systems that provide government-funded pensions to retirees without pension plans. But that coverage, ranging from around 5% of income per capita to around 30% in Brazil and Argentina is low and expensive, as discussed in a previous blog. And it leads to tremendous inequality in quality of life in old age.

No solution will be easy. But tackling labor informality, as well as benefit rules, retirement ages and contribution rates is essential so that huge numbers of uncovered seniors don’t enter retirement with miserly or non-existent incomes. That, as shown in the current crisis in Brazil, is better done sooner than later, so that consensus can be built and sacrifices spread over time. The region has benefitted hugely from a young population. In its growing maturity, it must look to the day when it is old.

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