Pension Systems and Pension Reform in an Aging Society. An Introduction to the Debate

Traditionally, pension systems aim to fulfill a number of functions which include income security and consumption smoothing in old age, as well as income redistribution. The main rationale for pension reform lies in the interaction between current demographic trends (e.g. increasing old age dependency ratios) and the design of existing pension systems (particularly, the so called Pay-As-You-Go public systems). Under certain conditions, population aging can in fact undermine the ability of a pension system to fulfill those very aims for which it was created, putting pensioners at risks of higher poverty and inequality, besides creating large fiscal pressures on governments and threaten economic growth. In the literature, we find two main approaches to this debate. On the one hand, economic theory helps us formalize the mechanisms through which aging affects a pension system, given its possible features (e.g. type of benefit offered, degree of actuarial fairness or type of financing); it also helps us quantify costs or returns associated to different pension designs and, consequently, to different pension reform options. On the other hand, the policy debate is centered on models of reform which take from concrete country experiences; overall, it focuses mostly on whether funding pensions (i.e. privatizing and individualizing retirement savings, away from Pay-As-You-Go systems) is the best option for reducing many of the negative economic impacts associated to population aging. After having illustrated both sides of the debate – the theoretical and the empirical - our paper makes two main claims. Firstly, the debate should be re-framed away from whether funding is the best option for pension reform in the face of population aging, towards a redefinition of the problem which rather focus on the type of benefit offered, its coverage, its eligibility conditions and actuarial design (as this controls important behavioral and efficiency implications). Secondly, and relatedly, the final impact of a given pension system or reform on future economic variables (i.e. growth, poverty, inequality, financial sustainability) cannot be inferred only by using the tools of economic theory, or the lessons of policy experience. Rather, it requires the ability to quantify the net effects of several interacting explanatory levels, such as country-specific demographic, economic and institutional trends. To this end, we propose the adoption of micro simulation modeling as a well-suited methodology for shedding more light on this important policy debate.