Revising our outdated pension systems

In November 1942, William Beveridge published his famous report on social insurance, laying out the foundations for the social security systems which were developed over the following decades. The report’s recommendations were based on a number of guiding principles, one of which was that social security was not the responsibility of the state alone, that individuals would have to play their own role. Another recommendation was that the system should not stifle private incentives. To the contrary, the system should stimulate people to seek their own opportunities.

With the benefit of hindsight, the importance of this last principle was understated. At that time, workers would usually be employed full-time for the going wage, and social security would provide benefits for exceptional spells of sickness or unemployment. It was also expected that workers would retire at a pre-set age; the social security system would have to provide pensions for those above 65. Unemployment benefits and pensions were treated as separate systems. This transparent structure made the task of a social security system rather easy. Today, however, society is much more complex, with a great variety of working hours, labour contracts, wage rates, compensation schemes and retirement patterns.

The simple pattern of work, sickness and unemployment underlying the Beveridge system does not capture real life patterns of how people earn money any more. Short spells of unemployment, when people tend to find new jobs after some time, are minor challenges. More problematic is when people who are specialized in particular types of skill find that demand for their expertise has gone down, putting a permanent drag on his or her earning capacity. This type of situation is much more important for lifetime labour income than short spells of unemployment. The current Beveridge-style system of social security doesn’t have much to offer for workers facing this type of uncertainty.

Given today’s environment, the basic design of social security needs to change from a system focused on current income that treats unemployment and retirement separately, towards a system that adopts an integrated approach and takes total lifetime income as a point of reference.

Workers should feel safe in the course of their career about their pension. An expected drop in earning capacity halfway through their working life will then be offset partially by using part of the savings from the first half of their career. Hence, providing pensions and ensuring income through the working years are dealt with in an integrated system. This is a form of “self-insurance”, where people use their own pension savings to smooth shocks in labour income. A progressive tax system can provide additional insurance, as part of the fall in labour income is paid for by lower taxes. A modernization of social security would also ask for an integration of unemployment insurance and the provision of old age pensions into one integrated social security system. Such integration would be a major social innovation.

The Netherlands has one of the most extensive capital funded pensions system in the world. The total wealth of its pension funds is about 1.5 times its GDP. Recently, the system has moved from defined benefit (where future benefits are defined apriori by the contract) to defined contribution (where total future benefits within a subgroup depend on the accumulated wealth of that particular subgroup). This is just a first step towards a system of individual accounts, which is helpful for setting up a fully individualized scheme of pension entitlements. The Netherlands might be a natural testing ground for this type of ideas.

Author: Coen N. Teulings is a Professor of Economics at the University of Amsterdam and a Member of the World Economic Forum’s Global Agenda Council on New Economic Thinking.

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