Barr: We cannot choose pension systems like mobile phones

Jan Smoleński, Political Critique: Are pension systems being consumed by the crisis?

Prof. Nicolas Barr*: I’ll answer this way: the greatest achievement of the 20th century is the fact that we live longer, much longer than before. A hundred years ago somebody of my age would have been very old and very tired. I don’t feel tired. And this is very good news. However, if people live longer it follows that they also have to work a bit longer. If people work till 65 and live longer and longer, pensions become too expensive. There’s no problem of ageing, but rather a problem of early retirement. When pension systems were being designed, the retirement age was not linked to life expectancy. If it weren’t for that, we wouldn’t have the problem. That is the only reason why we may talk about the pension crisis.

Is it then possible to design a universal pension system? The World Bank created the report titled Averting the Old Age Crisis, which was supposed to fulfill that function. As a matter of fact it underlies the current Polish pension system.

The World Bank was and still is wrong. There’s no such a thing like the universal pension system and I can explain why. For the last seven years of my research into pension systems I have been worked together with Peter Diamond, last year’s Nobel Prize winner. In 2004 the Chinese government asked us to provide an expert advice regarding pensions. This resulted in quite a substantial book and its main conclusion is that there are some rules of pension system designing, but there’s no universal pension system suitable for all countries.

Pensions and annuities have many purposes such as preventing the elderly poverty, insurance, arranging consumption in time and redistribution. When designing pension systems, countries encounter different constraints – financial, institutional etc. In different times politicians attach different importance to different purposes, which imply different constraints. If purposes and constraints differ, then also the optimum will be different. The World Bank’s mistake lay in placing emphasis on individual accounts and prioritizing consumption distribution, when ignoring other purposes of pension system.

Is designing a pension system a technical or political matter? In Poland pensions are presented as a strictly technical issue: people live longer so they have to work longer, and the pension saving system needs to be individualized to make them do it.

The fact remains that people live longer. The fact remains that pensions at a specified age become too expensive. The retirement age increase is just an inevitable consequence of that. However, the completely different matter is how you will design your pension system. Each country needs to ask the question: ‘capital system, repartition system or a mixed one’ – although there’s no good answer. When someone asks me for advice on pensions I draw a circle: outside there are some completely crazy ideas, whereas inside there are solutions that, as long as they are connected and implemented appropriately, make sense. The distinction between the inside and outside of the circle is technical, but the choice between different solutions from the inside is, to the great extent, political.

Pension systems of democratic countries vary markedly. The Netherlands, Canada, Sweden or New Zealand, they all have the capital pension systems, but yet very different. Although Germany still has mainly the repartition system, nobody sane would say that Germany is not a democratic country or its economy is weak. This was their political choice. It is also a matter of choice how the capital system can be organized. In the Netherlands there are collective capital accounts; not individuals, but investment managers for a given sector decide how the money are allocated. There’s also a national system with defined contribution, the state fund, where pension benefits depends on payments made over lifetime. It doesn’t have to be a fully capital system; it can be partially capital or repartition.

The main argument against PAYG system (pay-as-you-go, repartition system) is that the politicians could manipulate pension amounts depending on what they would consider more profitable. It is so-called political risk, but the market risk is rarely mentioned.

When it comes to pensions, two things are essential: a good government and production increase. Good governments will manage the PAYG system reasonably, creating regulations and macroeconomic conditions in which private funds can thrive. Bad governments will make irresponsible promises about pensions and steal money form the individual accounts. Each pension system is at risk, if there is a bad government. The World Bank considered private funds to be safer.

The counterargument in favor of PAYG system is that any disreputable government, which thinks of stealing the money, will be able to take one year’s contributions only. In case of capital systems many years’ contributions may be taken over. Examples? Argentina or even Hungary. If someone asked me what I would prefer: being an Argentinian private or state pensioner, I would say that I would rather not be an Argentinian.

If you were asked to design a pension system today, what would it be like?

I would introduce a retirement at more advanced age, but much more flexible. What do I mean by that? When pensions were invented, their main goal was to get old workers out of factories because they were decreasing the productivity of their younger colleagues. It made sense. However two things have changed since then. Firstly we live longer, so we should work longer. Secondly we became richer so we can afford to pay people for their leisure at the end of their lives. These two things exclude each other. But it also means that the purpose of pension has changed. Even if there was no problem with pension payments, this is a good idea to give people a choice – from a permanent job to a full pension. I would link the retirement age with life expectancy, for example the retirement time would equal a half of the estimated length of working time. In such a case the retirement age would increase by two years for every three years of life expectancy increase.

And if you could create your dream pension system?

It’s funny. After I wrote the book with Peter Diamond, I often heard that, from an academic point of view, we were right in saying that there’s no optimal pension system, but thereby we avoid the necessity of making a choice. Therefore I will say that my dream pension system would include a first pension pillar funded from taxes, which would provide everyone with the same level of pension benefits and allow living above the poverty threshold. Everyone would get it regardless of his length of service. The second pillar would be partially a state capital system with a defined contribution. Sweden has a system like that with the buffer fund, which is meant to reduce fluctuations of birth and mortality rates. The crisis has shown that this fund was not big enough so the contributions would have to be high. But I would like to stress that this is my dream pension system, not the only possible one.

The system stability is a fetish in Poland. The system has to be balanced and a capital system is to ensure it.

I know this argument and think it’s a misconception. Pensioners don’t want money; they want consumption – clothes, food, transport and tickets to the theatre or football match. They want to consume products, which will have to be produced by the next generation of workers. It is true either for PAYG or capital system. If there is production, we can afford pensions. If there is no production, pensions will be always too expensive.

The idea of the capital system was like this: you save money and you fund your own retirement. Although the problem is that if there’s no production then the excessive spending will lead to higher inflation, the money will fall in value and pensioners won’t be able to afford the expected level of consumption. I don’t attack the capital system in principle. I only attack this belief that capital systems can do more than they actually can or they are futureproof.

What about the blessing of free choice? After all, it should stimulate competitiveness – at least that’s what the doctrine says.

I’ve been arguing with the World Bank about this for twenty years now. You can’t just enter a pharmacy and pick any medicine you like. For some of them you need to have a prescription, because an expert knowledge is needed to make reasonable choices. I think that pensions resemble medicines rather than food or clothes. They’re very complex. I wrote a few books about pensions and I understand certain principles, but I still wouldn’t be able to select a good pension fund. This is an absolute nonsense to expect that individuals, with work, family, holiday planning and car under repair on their minds, will spend the spare time for studying these matters. That’s why I support the state capital system with a defined contribution and no choices with the frames of the mandatory pension.

Usually the availability of choice, in areas where people are poorly informed, results with their losses. It’s really great that we may choose between various mobile phones, computers or clothes, but pensions are something completely different. Additionally, there’s a problem of information asymmetry between an individual, a prospective pensioner with little knowledge, and a pension fund distributor with its substantial commission. Also a conflict of interests can be clearly seen. This is simply a bad project.

Does the welfare state have any future? It’s said that its fall in the Western Europe is only a matter of time.

The welfare state exists because of two reasons: to protect the poor, as we all know and – it’s less common knowledge – to do what the market would do badly or what it wouldn’t do at all. It’s not an accident that all the developed countries, excluding the United States, didn’t introduced the private health insurance as the main source of health service funding. It’s not some kind of ideology, but a catastrophic failure of the market in the insurance field, resulting from the information asymmetry.

Apart from its redistribution function, the welfare state also fulfills an efficiency function. Can any of these disappear? Of course not. Still there will be the poor, who need protection, and the market will still make mistakes, which will have to be fixed. However, the welfare state itself will change. It is not (and has never been) a static institution. Obviously, if there’s no change, the system won’t hold. If we don’t increase the retirement age, we’ll have a problem. But countries of the Western Europe are generally well governed and the welfare state will adapt to the new conditions. It is possible that this combination of the increase in the average life expectancy, decrease in the birth rate and competition from Asian countries may lead to a less generous welfare state. But it won’t disappear.

Aren’t the new EU members a threat to the welfare state? In many cases they push through the policy of tax competition, which leads to social dumping.

This is a serious problem. Generally I think that the welfare state will have to become less generous, but these changes may be done better or worse. Decreasing the welfare state’s generosity through the increase of the retirement age and, at the same time, keeping the same level of living standard at retirement is, in my opinion, acceptable. If the British government, on the other hand, decided that the generosity of the welfare state should be restricted by the introduction of private health insurance, then I would join Labour MPs protesting on the barricades. One ought to known where the market failures are so profound that the institutions of the welfare state can’t be abandoned. I think that the problem is that the tax and social policy have been left under the control of individual member states. I also think that some coordination of EU’s actions in this matter will emerge.

As for the Polish context, the uncertain working conditions pose a serious threat: self-employment and temporary agreements decrease contributions to the Social Insurance Fund.

People should have the access to healthcare regardless of their work history. They should have the access to pensions regardless of their work history. And they should have the access to education. Linking the welfare state’s social benefits with work history made sense when people were working in the same factory for their whole life. Nowadays the job market is much more flexible, therefore social benefits need to be separated from employment history. The welfare state need to adapt to the more floating job market and move the emphasis from funding social benefits and services through contributions to funding them through taxes. I think that pensions should be funded mainly from taxes.

* Nicholas Barr is a professor of economic sciences at the London School of Economics and Political Science. He researches the welfare state economics and pension systems. He stands against dogmatic imposing of the capital pension system by the World Bank. He’s an author of the following books: Economics of the welfare state, The Welfare State As Piggy Bank: Information, Risk, Uncertainty, and the Role of the State and Reforming pensions: Principles and Policy Choices (with Peter Diamond). Nicholas Barr visited Poland as a member of an international conference ‘Modern social policy’.

Translated by Agnieszka Ochman

Photo: “Work Or Retire” by SalFalko, cc, flickr.com