Financing a fair and efficient pension system: Issues and solutions

Aging population, slow productivity growth and increasing uncertainty in financial markets have brought about pessimistic views on both public and private pension systems. Current reforms have mainly been focused on transferring risk burdens from state or corporate sponsors to individual workers. This chapter examines how aging population, slow productivity growth and financial market uncertainty will affect the sustainability of a pension system and how these factors will interact with a society's political decision making process in reforming the pension system. The current popularity of defined contribution (DC) pension schemes with corporate sponsors reflects an expectation of decreasing asset returns and increasing financial market volatility in future. Purchases of life annuities upon retirement will transfer longevity risk from retirees to life offices and insurance firms, which in turn will offer retirees poor valued products to compensate the increase in (longevity) risk. Notional individual accounts or benefit determination at retirement in the state pension system can solve the underfunding issue caused by financial market uncertainty and lower than expected productivity growth and population growth, but they will not address the issue of longevity risk, and the state still has to bear the longevity risk. Moreover, transferring the responsibility of financial market risk from the state and the corporate sponsors by replacing defined benefit (DB) pension schemes with DC pension plans has been viewed as unfair by many employees, although DC plans might generate a higher level of pension incomes. In order to: (1) solve the perceived unfairness, (2) reduce the impact of financial market risk and longevity risk on pensions, and (3) make the pension system conducive to economic development, instruments linked to longevity, productivity and financial market risks need to be fully developed and traded on capital markets.