Retirement Systems

Pay-as-You-Go Systems

Initially most programs were pay-as-you-go (PAYGO)—workers were required to pay contributions that were used to finance benefits to current retirees. Then, when current workers retired, the contributions of future workers were used to pay them. There was no retirement saving or investment in the typical public old age program. Contributions took the form of a payroll tax; because pensions were supposed to replace wages, a payroll tax was relatively easy to collect from large employers, and it was hoped that workers would be willing to pay because they would regard this as a premium for valuable old age insurance. The required tax rate was very low at first because there were many young workers and few eligible retirees. Benefits took two alternative forms: a flat (uniform) benefit at the poverty floor or a defined benefit that rose with wages and years of contributions.

However, several problems have become apparent in these programs. The number of retirees has grown faster than workers; as the schemes have matured, birth rates have fallen and longevity has increased. As a result, the current contribution rate will be insufficient to cover promised benefits. In the United States and many other countries, expenditures already exceed contributions.

In some cases, governments have bailed out their pension schemes but have created general fiscal deficits as a result. In other cases, they have defaulted on their pension promises to the elderly or have dramatically raised the payroll tax (sometimes to 30% or more). The high payroll tax rate diminishes [Page 1483]workers' incentive to work and contribute. Instead, they evade paying by underreporting wages, becoming self-employed (often the self-employed are not covered), and working off the books in the “informal” sector that escapes taxes and regulations. This evasion exacerbates the fiscal problem.

Benefit formulas in many countries further discourage work—for example, benefits rise little if at all with additional work or pension postponement, so workers start the pension and stop work as soon as they can. Early retirement, sometimes as early as age 50 or before, became common in Europe and most developing countries. This makes the system more costly and reduces a country's labor resources. Empirical evidence indicates that people are less likely to save for their old age than they would be in the absence of such programs. This reduces national saving, which is essential for building capital resources for economic growth.

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