By P. Desmond Brunton & Pietro Masci –
Expenditure on pensions is frequently the highest single item in the public sector budgets of most countries. At the same time, demographic trends in almost every country show that populations are aging rapidly, due to lower fertility rates and improvements in life expectancy. The implications of these trends
are that budget deficits are becoming unsustainable, with significant negative effects on competitiveness and economic growth. Inefficient management and underfunding of public pension systems as well as mismanagement of private accounts present a daunting challenge for pension systems that need to meet the objectives of providing financial security in old age, including for those with exceptional longevity, and smoothing the distribution of consumption over people’s life span.
In most countries exhibiting a pension crisis, pension schemes are publicly managed. Benefits are allocated using a formula based on the highest past salary, and employee and employer contributions are in effect perceived as taxes. These public schemes are pay-as-you-go pension systems in which funds are not accumulated but transferred from current contributors to current pensioners (see Box 1.1). Introducing
a tighter link between workers’ old-age pension benefits and past contributions is considered a sensible alternative available to policymakers because it would enhance the system’s transparency and performance. Many countries are gradually implementing this solution together with a pay-as-you-go publicly managed pillar that provides pension coverage for those who are not able to accumulate enough to provide a minimum pension. It is becoming increasingly important for policymakers to define a
reform of the pension system that would help to insure individuals against the risk of outliving their assets after they retire (that is, longevity risk) and against the risk of depleting the assets while they are still alive (that is, over-consumption risk). Financial arrangements and instruments have to be established to limit risks in the accumulation phase (while assets are building up) as well as in the payout period (when
the resources are being withdrawn).
This chapter examines the policies and politics of pension reform. Based on the experience of several developed and developing countries, the analysis seeks to provide a public policy framework for pension reform in general and for reforms in small developing economies in particular. The main conclusion is that policymakers need to achieve consensus and a comprehensive approach to pension reform that allows incremental policy changes. An incremental approach would facilitate more effective review of the various tradeoffs and allow the formulation of feasible advances in the pension reform process.

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