Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom


Projecting State Pensions

WP 2013-04

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Projecting State Pensions

by • Kevin Dowd

The critical situation of most state-pension schemes plays a key role in explaining the public-finance crises that characterize many West-European countries. Although most observers refrain from advocating full privatization, it is now widely accepted that pension schemes – both private and public — should be run according the Defined Contribution (DC) principle, as opposed to the Defined Benefit (DB) one. In particular, the DC principle prescribes that the amount of the pension must be an uncertain sum that depends on the stream of contributions during the worker’s lifetime, rather than a certain amount (the DB) set by the policymaker and subsequently topped up by the tax payer.

In this light, the policymaker who aims at moving from an underfunded DB system to a DC scheme must know how much the transition is going to cost – either as an increase in tax pressure or in terms of default on earlier, irresponsible promises. In this contribution, Kevin Dowd develops a model in which all the relevant variables are taken into account. He then applies the model to the United Kingdom in order to compute by how much a hypothetical British DB state pension system is underfunded. However, since this gap is already too large to be absorbed by reforms, a partial default of any such schemes would seem to be all but inevitable; moreover, the shortfall is going to grow larger as the incumbent policymakers put off the day of reckoning.

For example, under the present conditions, a British citizen aged 65 needs some £ 300,000 in order to retire after 40 years of contributions with a pension equal to approximately 2/3 of his last salary. Yet, according to the current rules of the game, the system is funded only for about half that amount. Put differently, nowadays British taxpayers must be ready to transfer some £ 150,000 to each new pensioner, possibly more.

As mentioned earlier, there are remedies to the funding shortfall. Governments might decide to increase the age of retirement, and/or increase the amount of the yearly contributions, and/or change the investment strategy, and/or reduce the yearly amount handed out to the retirees (a hidden default). In fact, a credible policy will probably consist of a mix of all these measures. Doing nothing might by expedient in the short run, but will lead to a hard landing (default) in the future.

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