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The simple(r) algebra of pension plans

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  • Vittas, Dimitri

Abstract

Chile's success with pension reform in the early 1980s and the continuing financial pressures facing the social security systems of many developing (and some industrial) countries have elicited considerable interest in the mechanics of pension systems that are based on fully funded individual capitalization accounts. The author sets out the simple(r) algebra of both defined contribution and defined benefit plans. The author notes the following results: (a) unless the real rate of interest exceeds the growth rate of real wages by a significant margin, payment of a reasonable pension rate requires a high contribution rate or a high active worklife ratio (the ratio of working life to retirement life); (b) it is more difficult for a high-growth economy to provide a high pension rate, although the absolute level of the pension could be higher than the pension level in a low-growth economy with a high pension rate; (c) when pensions are indexed to prices, the level of interest rates and growth rates affects positively the level of the pension rate. But when pensions are indexed to wages, only the difference between interest rates and growth rates has an effect on pension rates. In all cases, the active worklife ratio has a positive effect on the pension rate; (d) the timing of contributions, and therefore the pattern of earnings over a person's full career, has a significant but not major effect on pension rates; (e) employer-based, final-salary, defined-benefit plans penalize early leavers and favor late high-fliers; (f) full funding with universal coverage and full lifetime careers would lead to a massive accumulation of capital, especially if the demographic structure resembles a pillar rather than the more traditional pyramid. This would have major implications for the productivity of capital and the functioning of financial systems; (g) a mixed system -- combining a redistributive first pillar and a fully funded defined-contribution second pillar -- represents a more prudent, perhaps more equitable, approach to reforming pension systems; (h) variable contribution and pension rates, within specified limits, might be preferable and more consistent with greater reliance on personal choice.

Suggested Citation

  • Vittas, Dimitri, 1993. "The simple(r) algebra of pension plans," Policy Research Working Paper Series 1145, The World Bank.
    • Handle: RePEc:wbk:wbrwps:1145
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    References listed on IDEAS

    as
    1. Vittas, Dimitri & Iglesias, Augusto, 1992. "The rationale and performance of personal pension plans in Chile," Policy Research Working Paper Series 867, The World Bank.
    2. repec:ucp:bknber:9780226062815 is not listed on IDEAS
    3. Bodie, Zvi, 1990. "Pensions as Retirement Income Insurance," Journal of Economic Literature, American Economic Association, vol. 28(1), pages 28-49, March.
    4. Davis, E.P. & DEC, 1993. "The structure, regulation, and performance of pension funds in nine industrial countries," Policy Research Working Paper Series 1229, The World Bank.
    5. Zvi Bodie & John B. Shoven, 1983. "Financial Aspects of the United States Pension System," NBER Books, National Bureau of Economic Research, Inc, number bodi83-1, March.
    6. Vittas, Dimitri & Skully, Michael, 1991. "Overview of contractual savings institutions," Policy Research Working Paper Series 605, The World Bank.
    7. James, Estelle, 1992. "Income security for old age : conceptual background and major issues," Policy Research Working Paper Series 977, The World Bank.
    8. Vittas, Dimitri, 1993. "Swiss Chilanpore : the way forward for pension reform?," Policy Research Working Paper Series 1093, The World Bank.
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    Cited by:

    1. William McGreevey & Francisco Eduardo Barreto de Oliveira & Kaizô Iwakami Beltrão, 2015. "State-level Pension Reform: the Case of Rio Grande do Sul," Discussion Papers 0073, Instituto de Pesquisa Econômica Aplicada - IPEA.
    2. Vittas, Dimitri, 2002. "Policies to promote saving for retirement : a synthetic overview," Policy Research Working Paper Series 2801, The World Bank.

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