There are two global forces on a collision course.  How, when or if these forces collide will impact economies around the world.  Hanging in the balance are living standards, international strategic relationships and our very way of life.  No one will escape, everyone will be affected in some way.  And, presently, most people are totally unaware.
 
The first force is the aging of society.  This is not the fact that each of us is getting older, it is rather the reality that the population of elderly people is increasing more rapidly than the population as a whole.  The world is getting top-heavy with old folks. 
 
The second force is the government systems that provide for the elderly, mainly Social Security, are not viable.  As presently structured they will collapse.
 
How nations choose to address these realities will be one of the greatest financial challenges the world will face over the next 25 years.  There is much to gain and just as much to lose.
 
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Most countries provide for their elderly through some form of Social Security financed through a payroll tax.  This system was adopted in the United States in 1935 but was actually first established in Germany in the 1880s.   There are now about 130 countries that have such a structure. 
 
In order to keep taxes affordable it is important that there be many workers relative to each retiree, a ratio determined by life expectancy and birth rates.  If people live longer or women have fewer children, the ratio of workers to retiree declines.  Unfortunately, at least from a financing point of view, this is exactly what has happened in most countries. 
 
Most governments have responded to this demographic vice-grip by raising taxes enough to pay benefits.  Such a response, of course, has no effect on birth rates or life expectancy—the sources of the problem.  The resulting taxes have in many cases reached prohibitive levels; in some European countries the payroll tax rate is above 50 percent.  And in Europe particularly the demographic challenges are severe.  As has been pointed out by others, “there is now no European country where people are having enough children to replace themselves when they die.”  
 
As few as five years ago discussing the implications of societal aging on Social Security systems was not common in public discourse.  Indeed, when the issue was broached it was often considered odd, in some venues even impolite.  In the last half decade all of this has changed.  The financial strains of such tax-based systems are now subject to frequent commentary across much of the world.  We have awakened to the reality that financing social services through taxing a shrinking labor force is not sustainable in the long run.  This recognition is a necessary first step to reform.
 
Although the aging of society is the impetus of this now open debate, demographic concerns, per se, are not new.  In the United States, for example, there were 16 workers per beneficiary in 1950, there are now only 3.4.  While we aged, our response was to raise the maximum payroll tax by about 1200 percent.  And even after doing this, promised benefits are greater than anticipated payroll taxes by the tune of trillions of dollars.  Raising taxes is not a long-run solution.
 
There is a point at which increasing taxes further is not a politically acceptable option.   At this stage one of the often-proffered suggestions is reducing benefits.  Reducing benefits, if applied in isolation, is the flip side of raising taxes.  It approaches the financial challenge in strictly cash flow terms.  From this perspective raising taxes or reducing benefits makes obvious sense.  But neither appropriately addresses broader long-run societal concerns.  And neither changes below-replacement birth rates or increasing life expectancy.  Reducing benefits, much like raising taxes, is a financial patch.
 
Another solution, which has only recently gained ground, is the fundamental restructuring of pay-as-you-go systems to market-based financing—the saving and investing in stocks and bonds.  Strictly moving to market-based financing, however, is not a panacea.  Market-based systems can be poorly designed and it is important that they not be.
 
Beyond the policy of pension reform, there are many structural issues that must be considered.  The transition cost, or bridge financing to which it is sometimes referred, should be addressed.  From a cash flow point of view moving to market-based financing, in whole or part, will cause greater strains in the early years than staying with pay-as-you-go financing.  This is often characterized as some will have to pay twice, once for their own retirement and once for those retired.  From a broader perspective, however, the all-in cost of market-based financing will under all reasonable assumptions be less than the all-in cost of staying with pay-as-you-go financing.  Cash flow should not be the only metric of concern.  Unfortunately, political pressures are often focused more on cash flow realities than long-run accruals.  Much work is needed to explain clearly the differences and why it is politically advantageous to think further out than a single year’s budget.
 
Success in market-based systems will hinge on the assets that are allowed for investment.  A portfolio of only domestic government bonds is a portfolio of contingent tax liabilities.  Such a so-called market-based system is roughly equivalent to the pay-as-you-go system it purports to replace.  Success requires the investing in wealth-producing assets.  Not only that, such investments should be diversified across asset classes, national borders and time.  Should it be determined that the sole purpose of the accumulated assets is to provide for retirement security, then well established portfolio practices and risk management should play a central role.  Otherwise, it is possible—perhaps even probable—that the accumulated wealth will be used for other needs, political or otherwise. 
 
Workers through their individual accounts should have personal property rights over their accumulated wealth.  When there is a direct relationship between one’s saving and one’s wealth there is a buy-in on the part of individuals.  Non-compliance, a common problem in many pay-as-you-go systems, is much less of a concern when individuals have property rights. 
 
Having said this, if the system incorporates personal property rights and modern portfolio practices but is highly taxed, as is the case in some countries, compliance is compromised.  People save and invest for after-tax, not pre-tax income. 
 
Administrative costs must be reasonable.  Unnecessarily high administrative costs act like a tax for they reduce one’s after-cost wealth.  Few countries presently have the administrative infrastructure in place to support a defined contribution national saving and investment system.  To build one is a significant undertaking but quite feasible.  In all likelihood no single system will work for all countries.  But basic design features are applicable to most.
 
Other issues such as portability, distribution choices at retirement, spousal equity, redistribution, labor market mobility and investment choice—to name but just a few—should also be considered in any funded system.  The details are not endless, but nearly so.
 
The time has come to face the reality of population aging and unsustainable tax-based retirement systems.  The challenges are daunting as the demographic clock continues to tick.  But the opportunities are unprecedented.  As more and more countries move from tax-based to market-based systems we will be entering a global financial renaissance wherein taxes will be less, wealth will be greater and people finally will be secure during their retirement years.

William Shipman Biography
  

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