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Vol. XLV
No. 2
June 2011
DOI 10.2753/JEI0021-3624450208

Uncertainty and Pension Systems Reforms

Jesus Ferreiro and Felipe Serrano

Abstract: Public pension systems have long been a focus of special attention by
neoclassical economics. In a context of intense aging processes, mainstream
economists argue that the replacement of the pay-as-you-go pensions systems by
unfunded individual savings accounts will have a positive impact, at a
microeconomic and at a macroeconomic level, and will protect pension systems of
the negative consequences of aging. However, these conclusions depend
dramatically on the assumptions of rational expectations and perfect information.
When we accept the existence of uncertainty, the presumed positive consequences
of these reforms disappear, showing the advantages of pay-as-you-go over funded
pension systems.
Keywords: institutions, pension systems, pension systems reforms, uncertainty
JEL Classification Codes: D81, E21, G23, H55

Public pension systems have long been a focus of special attention by neoclassical
economic theory. The central recommendation of this theory is to change the model,
that is to say, the replacement of the present systems based on a pay-as-you-go system
by funded individual savings accounts.
Three main arguments have been developed to justify the change. First, the
attainment of higher rates of return, since in a dynamically efficient economy,
financial profitability is always higher than the economic growth rate. Second, the
change of model would bring about an increase in economic growth rates boosted by
an investment increase generated by the rise in the private savings rate. Third, the
impossibility to keep the current systems in the future due to the dramatic effect
population aging will have on pension expenditure in the following decades.

Jesus Ferreiro is an associate professor and Felipe Serrano is a professor in the Department of Applied Economics V at
the University of the Basque Country, Spain. Financial support from the Basque Government (Consolidated Research
Group GIC10/153) is gratefully acknowledged. This paper was presented at the annual meeting of the Association for
Evolutionary Economics, January 7-9, 2011 in Denver, Colorado.

2011, Journal of Economic Issues / Association for Evolutionary Economics


Jesus Ferreiro and Felipe Serrano

The first two arguments are theoretical, whereas the third one places the debate
on a field that is subjected to a good deal of uncertainty and discretion in the
projection of future scenarios of revenues and expenses. Nevertheless, the problem
cannot be avoided, so the first part of this paper will be focused on the issue of
pension systems reform. The rest of the paper is mainly theoretical. This means we
will avoid all the undoubtedly relevant aspects related to the difficulties arising when
moving from the current systems to other systems based on individual current
The Problem of Population Aging
Pension systems, whether they are pay-as-you-go systems or funded systems, are tools
to transfer income from the employed population to the retired population. In public
systems this transfer is carried out by means of social contributions and pension
benefits, whereas in the systems based on capitalization the transfer is more opaque.
The retired population sells assets, which are bought by the employed population.
Then, it is the income, and not the population, that is the key determinant variable of
any pension system.
The negative effects upon the future financial equilibrium of pension systems
can only be understood if we accept the hypothesis that the expected GDP growth
rate will not be enough to compensate the expected increase of the pension
expenditure, keeping the present conditions of access to pensions and the
contribution rates constant. With the information currently available, this hypothesis
is feasible, thus, the debate on the reform of pension systems responds to a reasonable
In the context of an aging population, as has been pointed out repeatedly
(Brooks, 2002; Geanakoplos, Magill and Quinzii 2004; Takts 2010), the profitability
of financial (and real) assets is negatively affected. Therefore, the change of model is
not justified by the demographic problem but by the micro and macroeconomic
advantages of funded pension systems over pay-as-you-go systems.
Bounded Rationality and Retirement Savings
The neoclassical recommendations have moved to the policy arena, and, thus, a
number of countries have recently reformed their pension systems, although the
intensity of the reforming process has been different. One of the main points of the
current reforms is a group of changes oriented to give more importance to individual
savings, preferably through mandatory defined contribution systems (DC). In most
cases, these systems aim to offer benefits that replace, partially or totally, the benefits
obtained by the public pay-as-you-go systems. So far, seven Organization for Economic
Cooperation and Development (OECD) countries (Australia, Denmark, Hungary,
Mexico, Poland, Slovak Republic, and Sweden) have introduced mandatory funded
pension plans. These reforms have also extended to some Latin American countries
(Chile, Peru, Argentina, Colombia, Uruguay and Bolivia), as well as to some countries
of former Eastern Europe (Bulgaria and Slovenia), India and the Russian Federation.

Uncertainty and Pension Systems Reforms


However, in the development of these reforms, some problems that had not
been considered initially have arisen, thus making it essential to complement them
with new regulations that try to correct the undesired effects that bounded rationality
brings about. The behavioral economics literature has shown that individuals make
mistakes systematically when trying to plan their decisions on retirement savings.
These mistakes, which cause welfare losses, can be the result of multiple factors:
insufficient financial culture, excess of offers among which they can select the suitable
portfolio, or the absence of stable preferences.3
The consideration of bounded rationality problems that agents are faced with is,
no doubt, a relevant fact in the reform of pension systems. Until they were taken into
account, neoclassical theory had tackled these reforms by confronting the reality with
the results that were obtained in some equilibrium models where a flawless world was
described. In the excellent work by Barr and Diamond (2008) it is shown how this
method provides a framework for reflection unsuitable to solve the problems pension
systems have to encounter, whether there is population aging or not.
Nevertheless, the problems individuals have to overcome when trying to plan in
the present for the savings they need to meet the needs of their retirement age, do
not arise only from their limited capacity to process the available information. If this
were the main problem, we would accept that a sound financial education combined
with experience and a suitable regulation, would result in optimum behavior
guidelines, that is to say, would end up reproducing in the real world the conditions
that are supposed to exist in equilibrium models. We know this convergence is not
possible, since the environment in which the individuals operate is not static but has a
dynamic and evolutionary nature. Convergence, then, would only be possible if we
assume that the transformation speed of the environment is lower than the learning
capacity, something that experience proves to be impossible.
Uncertainty and Saving
The dynamic nature of the environment makes us regard the problem of uncertainty
as an analytically relevant problem that cannot be ignored in the discussion on the
reform of pension systems. The existence of uncertainty means that all the decisions
we make at the present time including expectations of future events, are subjected,
with a high level of probability, to subsequent adjustments of uncertain direction and
quantity if we wish to remain in the selected option. It can also be true that the
unfulfillment of expectations make us change such options. If we apply this reflection
to the subject under discussion, we could set the following criterion to discriminate
between pension systems: the best system will be that which minimizes the costs of
adaptation to the changes in the environment. In Serrano and Ferreiro (2007), it is
shown that under this criterion, current pay-as-you-go systems have advantages over
funded individual account systems. Consequently, we will not return to that issue.
What we intend to highlight now is a problem we may be faced with in the future if
we continue advancing in this line of reform while ignoring the existence of the
problem of uncertainty.


Jesus Ferreiro and Felipe Serrano

The economic theory, and at this point there are no differences between the
different paradigms, predicts that an increase in uncertainty generates an increase in
precautionary savings. This increase can be observed in the forms of a decrease in
consumption and/or as an increase in the labor supply. The empirical evidence
available shows this prediction is correct when the effect that the reforms of pension
plans have on family savings is measured (Attanasio and Rohwedde 2003; Guiso,
Japelli and Padula 2009).4 This effect is detected even when reforms do not envisage a
partial replacement of a system for another (Giavazzi and McMahon 2008). Then, let
us accept that this rise in the savings rate of families increases the aggregate savings
rate of the economy as time passes by, and, consequently, as agents start to perceive
more clearly the effects of the reforms.5
The increase in savings rates, though, is not necessarily associated with an
increase in investment rates. Instead, the opposite could happen. Investment depends
mainly on benefit expectations that in turn, are influenced by demand expectations.
An increase in savings is equivalent to a decrease in the current consumption and
consequently, to a decrease in demand. The reforms of pension systems that cause a
rise in the uncertainty of agents such as, for example, practical replacements of
current benefits by the ones obtained by means of mandatory defined contribution
systems, could have adverse effects upon investment and, as a corollary, upon
economic growth rates. The downward pressure on assets profitability due to
population aging would be reinforced by lower economic growth rates. In short, the
reform would result in future pensioners having lower incomes than the ones initially
It can also be assumed that the fall in financial wealth could cause increases in
the labor supply, for example, working longer years and, thus, delaying the retirement
age. This hypothesis is based on the assumption that the relation between both
variables (financial wealth and labor supply) is significant. The research carried out to
measure this relation does not support such a hypothesis. The empirical evidence
available actually shows that retirement age is insensitive to the changes of that wealth
(Coile and Levine 2006), even in situations like the ones we are going through at
present: significant losses in accumulated wealth (Goda, Shoven and Slavov 2010).
Nevertheless, it could be accepted that this lack of relation between financial
wealth and retirement age could be influenced by the scarce significance that the
financial wealth has today as a source of potential income during the years of
retirement. In a hypothetical situation where such wealth had more relevance we
could claim that the increase in savings could materialize in an increase in the years
worked rather than in a decrease in consumption. Actually, this formula is equivalent,
in the current pension systems, to a modification (an increase) by law of the legal
retirement age.
Reforms to Preserve Present Systems
There are many different research efforts that are centered on the estimation of
probable financial disequilibrium of current pension systems. However, there is

Uncertainty and Pension Systems Reforms


hardly any research on the effects that the necessary reforms to balance those systems
would have on the welfare of future generations of retired people. The research,
though, is fundamental to advancing the design of reforms.
Peinado and Serrano (2011) make an estimation of the effects of reforms
required to balance the Spanish pension system6 using dynamic duration models that
reflect the life of individuals during the years they receive their pension. Their results
show that requiring reform measures (an increase in legal retirement age from 65 to
67 and a 4% decrease in the average pension) have a minimum effect upon the
welfare of future generations of pensioners. Butrica, Smith and Steuerle (2006) for the
case of the United States, and Gonand and Legros (2009) for France, also show that
the increase in retirement age, besides contributing to the balance of the system,
would not have a negative impact on the welfare of future generations of pensioners.
Therefore, we have observed that the main reform measure to preserve present
systems (increase in legal retirement age) is similar to, in a hypothetical scenario, what
we would be faced with if the change of model brings about an increase in saving not
compensated by an increase in investment. It seems relevant to wonder about the
final sense of the reforms at which such change is aimed.
Conclusions and Remarks
The current crisis is the result of an experiment, that of the liberalization of financial
markets, which was based on a mix of ideology and economic theory. There was no
empirical evidence that could support the deregulation of financial markets. The same
happens with the subject under discussion. The change of model is also the result of a
mix of ideology and economic theory. The economic theory is the same that
originated the theory of capital market efficiency and so is the ideological component:
it is public regulations that prevent markets from performing correctly. The change of
system, as the neoclassical theory defends, is a leap in the dark and, thus, we ignore
the relation between the costs we may incur (including the costs associated with the
transition from a system to the other) and the benefits of these reforms.
Population aging, especially in developed economies, poses a challenge to
present public pension systems. The reform line that supports the complete or partial
replacement of those systems by mandatory defined contribution systems is based on
an economic theory that ignores essential elements of the reality. The parametrical
reforms that present systems require, do not cause socially costly losses of welfare
apart from the fact that they can be estimated and their effects can be adjusted. On
the other hand, present systems provide an intervention framework where measures
can be reversible if, eventually, the future does not turn out as expected.

Arenas de Mesa and Mesa-Lago (2006) present an interesting analysis of these problems for the Latin
America countries, particularly for Chile, which has advanced in this kind of reforms.
Serrano, Eguia and Ferreiro (2011), taking the Spanish social security system as a case study, estimate
the future of such a system under a very optimistic hypothesis. The result obtained is that the system
would enter a structural deficit in the late 2020s and early 2030s.


Jesus Ferreiro and Felipe Serrano

In Tapia and Yermo (2007) we find a detailed survey on these problems, as well as the legal solutions
implemented to try to correct the undesired effects they may cause.
This result is not right, though, for the lowest income groups, since they do not have enough saving
capacity. Therefore, the reforms that affect the replacement of models can be associated with an
important decrease in the coverage rates of the population (Arenas de Mesa and Mesa-Lago 2006).
The increase in the savings rate may be only temporary, until individuals observe, for example, that
the estimated loss of income is much higher than the one that actually takes place. In this case,
individuals could readjust their savings rate until it comes back to the values it had before the reform.
The aging process of the Spanish population is the largest among the European Union countries.
Therefore, the affect of financial tensions will be more intense on Spains pension system if reforms
are not undertaken.

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