Research brief on pension systems – 3: Objectives, constraints and instruments in the design of pension systems: some analytical errors

 In Pension Systems, Welfare & Labour
,

Nicholas Barr and Peter Diamond, two renowned scholars on pension systems, point out that discussions on the subject are prone to analytical errors.1 Such errors are not only widespread but also lamentable. They argue that errors appear in but are by no means limited to the World Bank’s work. They emphasize that the errors are not due to different value judgments or different views about empirical magnitudes, but are rather simply flawed analysis. Also, the errors matter not because they offend logical aesthetics, but because analytical errors lead to policy errors. According to Barr and Diamond, a number of errors are related to three pivotal elements in pension policy design, namely objectives, constraints and instruments. Given the pivotal roles of these three elements in policy design, some basic understanding of the errors made in relation to these elements in pension policy design is necessary.

 

The error of considering objectives in isolation

  • Pension systems usually have multiple objectives. As will be explained in the next research brief, common objectives that associate with pension systems are these: poverty relief, redistribution, consumption smoothing, and insurance. The ultimate aim of pension systems is to provide economic security in old age through achieving these objectives.
  • Considering one objective in isolation is erroneous because, of necessity, this implies little consideration of other objectives.
  • To illustrate, an exclusive focus on consumption smoothing suggests a system in which benefits bear a fairly exact relationship to a worker’s accumulated contributions; but such a system would fail to relieve old-age poverty for low-paid workers and would not offer insurance against adverse labour market outcomes.
  • On this error, the World Bank’s Independent Evaluation Group which assesses the Bank’s involvement in pension reform around the world has made the following critique:
    • “…the Bank acted too quickly to support multi-pillar reforms in other countries without examining options for complementary safety-net programs to protect informal sector workers from poverty in old age.”2
  • Admittedly, the multiple objectives of pension systems may not all be fully achievable at the same time.
  • Good policy analysis thus needs to consider the full range of the objectives of pensions and seek the best balance among the objectives; the balance should reflect the relative weight that a society attaches to each of the objectives.

 

The error of failing to distinct between objectives and constraints (for example, fiscal costs)

  • The discourse on pensions tends to be preoccupied with the issue of fiscal sustainability.
  • Preoccupation with fiscal sustainability in policy analysis may not only obscure the objectives of pensions but may also risk misplacing fiscal sustainability as one of the objectives to be achieved.
  • This may in turn easily lead to the view that fiscal sustainability should be given precedence over all other objectives of pensions. Such would be a mistaken view however.
  • The point is not that fiscal sustainability is not relevant but that the proper analytical relation between pension objectives and fiscal sustainability (and/or other constraints) in policy design should be understood.
  • The proper analytical relation between pension objectives and fiscal sustainability should take this form: achieving all objectives within constraints. Except in the extreme case of a constraint rendering some objectives totally impossible, the constraint should not exclude a particular objective from consideration.
  • On this error and the proper relationship between objectives and constraints, the World Bank’s self-evaluation writes:
    • “… the Bank’s preoccupation with fiscal sustainability tended to obscure the broader goal of pension policy, that is, to reduce poverty and improve retirement income adequacy within a fiscal constraint.”3

 

The error of failing to distinct between objectives and policy instruments

  • One typical example of this error is adoption of the multi-pillar pension system formulated and advocated by the World Bank.
  • It is important to note that the multi-pillar model involves a predetermined choice of instruments.
  • In other words, basing pension policy design on this model implies tacitly accepting the pension objectives behind the model.
  • This amounts to putting the cart before the horse in policy design – choosing the instrument first and tacitly accepting the related pension objectives (or choosing the instrument without choosing policy objectives).
  • The multi-pillar model may also risk narrowing policymakers’ outlook about the possibilities of pension structures.
  • A given mix of pension objectives may in fact be achievable through different mixes of instruments.
  • The right approach should therefore be to first decide on the mix of pension objectives a society endorses and then to choose the best instrument-mix for achieving the chosen objectives.

 

Regarding the proper relationships among objectives, constraints and instruments in policy design, Barr and Diamond summarize as follows:

  • Policy design should reflect the weights a society wants to attach to the different objectives and the key constraints, and should then consider instruments for achieving the chosen objectives in ways that respect the constraints.

 

 

Prepared by Winston Ng ()

Hong Kong Democratic Foundation (香港民主促進會)

20 March 2012

 

 


Endnotes:

The discussion in this research brief is mainly based on the works of Nicholas Barr and Peter Diamond. Nicholas Barr is Professor of Public Economics at the London School of Economics. He has worked for the World Bank, been a visiting scholar at the IMF and has advised governments on pensions and on higher education finance in a number of post-Communist countries, Australia, Chile, China, Hungary, New Zealand, South Africa and the United Kingdom. Peter Diamond is Institute Professor and Professor of Economics at MIT and was awarded the Nobel Prize in Economics in 2010. He first consulted for the US Congress on social security in 1974. He has consulted for the World Bank on social security and written about social security in Chile, China, France, Germany, Italy, the Netherlands, Spain, Sweden, the United Kingdom and the United States. Much of the contents of this brief is paraphrased or directly quoted from their works. Contents of this brief must not be directly quoted for other uses.

2 Emily S. Andrews. 2006. p. 19.

3 Op cit., p. xvii; emphasis in original.

 

 


References:

Andrews, Emily S. 2006. Pension Reform and the Development of Pension Systems: An Evaluation of World Bank Assistance. Washington, D.C.: World Bank.

Barr, Nicholas. 2004. Economics of the Welfare State. 4th ed. Oxford: Oxford University Press.

Barr, Nicholas. 2002. Reforming Pensions: Myths, Truths, and Policy Choices. International Social Security Review 55(2): 3-36.

Barr, Nicholas. 2000. Reforming Pensions: Myths, Truths, and Policy Choices. (IMF Working Paper WP/00/139). Washington, D.C.: International Monetary Fund.

Barr, Nicholas.1979. Myths my grandpa taught me. Three Banks Review 124(Dec.): 27-55.

Barr, Nicholas and Diamond, Peter. 2009a. Reforming pensions: principles, analytical errors and policy directions. International Social Security Review 62(2): 5-29.

Barr, Nicholas and Diamond, Peter. 2009b. Pension Reform: A Short Guide. Oxford: Oxford University Press.

Barr, Nicholas and Diamond, Peter. 2008. Reforming Pensions: Principles and Policy Choice. Oxford: Oxford University Press.

 

 

 

 

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