A Numerical Optimization Algorithm for Identification of Policy Options to Rehabilitate a Publicly Managed, Pay-As-You-Go Based Pension System

As population aging sets in, publicly managed pension systems operating on the basis of pay-as-you-go (PAYG) schemes face difficulties in maintaining contribution/replacement rate-retirement age configurations. The changing age composition of societies during demographic transition gradually makes these configurations irreconcilable with the requirements for a fiscally sound management of pension institutions. This implies that, unless central budget funds could be used for continuous transfers to pension administrations, the sustainability of PAYG-based pension systems would depend critically on the ability of policy makers to respond to demographic and other exogenous changes by making timely adjustments in the values of policy parameters. In other words, if a deterioration in fiscal balances is to be avoided, new configurations of contribution and replacement rates and minimum retirement ages must be introduced. It can be shown, however, that there are infinitely many such configurations/vectors that are compatible with the maintenance over time of a selected balance between the present values of contributions to be collected from workers and pension payments to be made to the retirees. The availability of information on all configurations satisfying this criterion would make it possible for policy makers to choose the one that is most desirable from a policy making point of view. This paper introduces a numerical optimization algorithm to identify all possible 3-dimensional vectors of contribution/replacement rates and retirement ages enabling pension administrations to achieve a targeted balance (or minimize the difference) between payments and receipts over a selected period of time into the future. The algorithm is quite efficient computationally and can easily be implemented using demographic projection data that is readily available for most countries. In addition to its flexibility and large data-handling capacity, a salient feature of the algorithm is that it can simultaneously solve for optimal values of all three policy parameters without requiring separate simulation experiments used in previous literature. The paper also illustrates the use of this algorithm with reference to the pension reform debate in Turkey, a country whose PAYG-based pension system already faces a severe financial crisis. The results indicate that for contribution and replacement rates to remain around their current values, the minimum retirement age must be increased substantially beyond its present level.