The Failure of the Pay-as-you-go Pension System *

Nowadays, most countries are dominated by the so-called pay-as-you-go (PAYG) pension system, called in Bulgarian “expenditure-covering”. The principle of PAYG is simple: the pensions of today's retirees are paid for with a portion of the taxes collected from the working population

Nowadays, most countries are dominated by the so-called pay-as-you-go (PAYG) pension system, called in Bulgarian “expenditure-covering”. The principle of PAYG is simple: the pensions of today’s retirees are paid for with a portion of the taxes collected from the working population. If the money from pension insurance exceeds the total amount of pensions paid out in a given month, the surplus is invested according to certain rules and the money is kept for rainy days, providing a buffer for the system. However, if the system is in deficit (as is the case in most places), the government must cover the difference by redistributing from other taxes or by issuing debt. In both cases, this leads to higher taxes now or in the future when the debts have to be paid off.

The problems with this type of pension system are many, but the main ones are two: it is economically unsustainable and morally wrong. From an economic point of view, the PAYG system assumes that the working population of a country must at any given time be large enough to fully cover the current costs of pensions. As you can guess, however, this is a very wrong assumption, and this can easily be seen in the demographic crisis that the Western world is facing today. The equation of the PAYG pension system looks like this:

N ^w *w*c = N ^p *p, where

N ^w– number of working people who pay taxes

w – the average wage for the entire working population paying taxes

c – the amount of social security contributions intended for pension payments

N ^p– number of pensioners receiving pensions

p – average pension

For this equation to be in balance, the number of workers must grow at the same rate as the number of pensioners. Let me give an example of the pension system in Serbia. In our neighbor, there are approximately 1.69 million pensioners, 1.675 million workers who pay social security contributions, the average gross taxable salary is 440 euros, social security contributions for pensions amount to 22%, and the average pension is 200 euros. Substituting these figures into the equation, it turns out that the pension system in Serbia is in a deficit of 175.86 million euros per month or just over 2 billion euros per year. That is, the state redistributes an additional 24% from other taxes in order to be able to pay pensions every month. In the end, it turns out that on average, almost half of the taxable income of every working Serbian goes to paying pensions. By shifting the variables in the equation, different assumptions can be made to reach a balance in the system. For example, at the current tax rate of 22%, for the system to be in balance, the average pension should be just under 100 euros per month. It can also be shown that the ratio of workers to pensioners should be 2.07 to 1 (currently this ratio is less than 1 : 1), or that the number of workers in Serbia should be 3.5 million. This corresponds to an employment rate of 70% - something that is completely unattainable in the current market situation, even in developed and growing economies. In short, purely economically, the PAYG pension system makes unrealistic assumptions and the chance of its survival in the long term tends to 0.

From a purely moral point of view, the PAYG pension system has a number of shortcomings. It gives no choice to the citizens of a country how to ensure a peaceful old age - everyone who works is obliged to pay the government. Furthermore, workers pay for someone else's pension, with the promise from the state that when it comes time to retire, it will take care of survival. In this case, there are no private property rights and we have a distortion of incentives, and one direct consequence of this is that everyone strives to make the smallest possible contribution to the system. There is also no clearly traceable relationship between the amount of each individual's contribution and the benefits (pension) that he/she will receive in time. The fact that every reasonable person saves additional funds for the years when he/she will no longer be able to work is clear evidence of the failure of the public pension system.

In general, the Great Recession and the worsening demographic picture around the world have shown us that the dominant PAYG pension system cannot exist for much longer and that serious reforms are needed in this area. Of course, the best substitute is a fully private system (existing in quite a few countries nowadays and first introduced in Chile), where each worker sets aside a part of his salary every month and this money goes into a fund of his choice. This money is then invested according to the client's risk preferences and at any time the account holder can check what is happening with his savings. In this system, the so-called moral hazard does not exist, since the same person bears the benefits and the risks. But the problem is not in identifying the economically sustainable and morally fair pension system, but rather in the transition to it.

*The commentary is based on the presentation "Unsustainable Pension" by Pavle Mihajlovic, presented at the Students for Liberty regional conference in Belgrade, held on 03.11.2012. You can download a paper on the topic here. You can watch a video of the presentation here

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