Reforming pensions: Principles, analytical errors and policy directions

This article, sets out a series of principles for pension design rooted in economic theory: pension systems have multiple objectives, analysis should consider the pension system as a whole, analysis should be framed in a second-best context, different systems share risks differently, and systems have different effects by generation and by gender. That discussion is reinforced by identification of a series of widespread analytical errors — errors that appear in World Bank work, but by no means only in World Bank work: tunnel vision, improper use of first-best analysis, improper use of steady-state analysis, incomplete analysis of implicit pension debt, incomplete analysis of the impact of funding (including excessive focus on financial flows, failure to consider how funding is generated, and improper focus on the type of asset in trust funds), and ignoring distributional effects. The second part of the article considers implications for policy: there is no single best pension design, earlier retirement does little or nothing to reduce unemployment, unsustainable pension promises need to be addressed directly, a move from pay-as-you-go towards funding in a mandatory system may or may not be welfare improving, and implementation matters — policy design that exceeds a country’s capacity to implement it is bad policy design. We illustrate the ranges of designs of pension systems that fit the fiscal and institutional capacity constraints typical at different levels of economic development. The potential gains from Address for correspondence: Professor Nicholas Barr, Professor of Public Economics, London School of Economics, Houghton Street, London WC2A 2AE, UK. Email: [email protected]; Professor Peter Diamond, MIT Department of Economics, 50 Memorial Drive, Building E52, Room 344, Cambridge MA 02142-1347, USA. Email: [email protected]. 5 © 2009 The author(s) Journal compilation © 2009 International Social Security Association International Social Security Review, Vol. 62, 2/2009 Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA simplicity imply that a country capable of implementing an administratively demanding plan does not necessarily gain from doing so. New Zealand has a simple pension system through choice, not constraint.