Nicholas Barr is a Professor of Public Economics, London School of Economics
Times have changed. During the second half of the 20th century contributory pensions were popular in industrial countries. These pensions involved pensioner contributions, often matched by the employer. Today social pensions — also called a citizen's pension or a non-contributory pension — are starting partly to replace them. Social pensions are financed from taxation and paid at a flat rate on the basis of age and residence rather than of contributions. As Latin America debates the best way forward, this blog argues that social pensions offer the greatest promise — a position also being taken by the Inter-American Development Bank (see the JKP's debate on the topic, which just began with Mariano Bosch's blog, "It's Time for Universal Pension Coverage for Latin America".
An elderly vendor making change in Cuzco, Peru. Photo: © DHuss
Pros and cons of different types of pensions
Social policy in 1950, when contributory systems were being reinforced after the Second World War, assumed that workers would have a long, stable history of employment, so that coverage would grow. In particular, contributory systems assumed: (i) independent nation states; (ii) full-time employment for the whole of a person's career; (iii) limited international mobility; (iv) a stable nuclear family, where people got married, stayed married, the husband earned the money, and the wife looked after the children; and (v) skills that would last for a lifetime.
None of those assumptions was strictly accurate even in 1950, although they were accurate enough for good social policy. And certainly, none of those assumptions is any longer true. Two in particular stand out. First is the changing nature of work: people are not necessarily in full-time employment for their whole career; they have spells of full-time employment, spells of self-employment, spells of part-time work, and spells outside the labor force. Thus a typical worker has a less complete contributions record than in the past, which translates into less coverage. Second, family structures have become more fluid: the association between marriage and children is weaker and divorce more common. Thus basing a woman's entitlement to a pension on a husband's contributions is no longer feasible — an approach that may or may not have been a good idea in 1950 but at least it worked; today it no longer works.
The new thinking is that a social pension is not only more appropriate for today's world but also a way to strengthen poverty relief. It can cover everybody, with a benefit high enough to provide genuine poverty relief. It improves gender balance, since it is typically women who have the most fragmented contributions records. Plus it offers better work incentives than income tested poverty relief; it is fairly well targeted, because age is a useful indicator of poverty; and it can be made internationally portable more easily than other formulae.
The idea of a non-contributory pension makes ministers of labour and social policy happy but causes fear and trembling among ministers of finance, who worry about the fiscal sustainability of such an arrangement. The question is how to have a social pension that is simultaneously high enough and affordable. There is a range of instruments for making the two objectives compatible, notably (i) the size of the monthly pension and (ii) the age at which the pension is first paid. If policy makers wish to pay a non-contributory pension at a rate that makes a genuine contribution to poverty relief without causing fiscal problems, one option is to pay the benefit only from the age of 70, lowering the age of eligibility as fiscal capacity increases.
Why the UK and Chile are trying social pensions
The United Kingdom illustrates the problems of coverage in a contributory system. Until 2010 workers needed more than 40 years of contributions to get a full basic state pension. As a result, only 80 per cent of men had a full contributions record and only 35 per cent of women. The problem was not the lack of capacity to collect contributions but the inherent nature of the contributory principle in the context of today's labor markets and family structures. Thus it is not surprising that in 2011 the British government announced a reform that starting in 2015 will involve what looks very much like a non-contributory pension for new pensioners.
In Chile, a similar turnaround occurred aimed explicitly at addressing elderly poverty. In 1981, the government introduced mandatory fully-funded individual accounts, which by design primarily provide consumption smoothing. But over time the supporting arrangements for poverty relief proved inadequate. As a result, the Marcel Commission (appointed by Michelle Bachelet at the start of her first term as President) recommended the introduction of a social pension – which was introduced in 2008 (with parallel benefits for disability and survivors) — alongside the existing system of individual accounts. The pension is payable at age 65 (the same for men and women) and is not subject to any contribution conditions. The basic pension is withdrawn as income rises such that the best-off 40 percent of households do not receive the benefit.
Lowering elderly poverty
Several other OECD countries have also instituted non-contributory pensions, including Australia, Canada, the Netherlands, and New Zealand. What is the record so far? Given the earlier discussion, it is not surprising, that Canada, the Netherlands, and New Zealand, as the table shows, have among the lowest rates of elderly poverty — far below the OECD average of 13.5 percent.
Moreover, there are also wider benefits beyond poverty relief, especially on the health front. In South Africa, Duflo (2003), shows that where (usually) the grandmother lives with children and grandchildren, the social pension has gains for the wider family, including health gains for the children. More generally, Fishback et al. (2007) show the improved health outcomes that followed surprisingly rapidly after the introduction of a federal safety net in the United States as part of the New Deal.
In sum, introducing social pension in Latin America, at a level and from an age compatible with budgetary constraints, would reflect a growing trend across OECD countries.