The fiscal impact of government employees’ pension is fast becoming a ticking time bomb. The demographic transition – the aging of the population due to declining fertility and increasing life-expectancy – is not going to help in the long run. According to a thesis completed at PIDE, it is estimated that Pakistan will lose 4% of GDP towards the latter part of this century. Due to the demographic transition, pension expenditures are also expected to rise from 1.2% of GDP to 3.5% of GDP in the long run. For a country that is already grappling with fiscal imbalances, the situation is a delicate one, requiring serious thought and action.
The youth bulge in Pakistan, with people below the age of 30, constitutes 64% of the population is a popular discussion point. Aging of the population is not. One expects that aging will cause a decline in the projected labor force. The ramifications are serious for output growth and fiscal sustainability in Pakistan; especially because the aging is likely to result in an increasing number of pensioners.
The research on the issues related to the demographic transition in developed countries started when they started facing the transition. Learning from their experience developing countries should also start putting efforts to tackle the issues related to demographic transition before the ticking bomb explodes. Currently, Pakistan’s youth bulge offers the potential of a demographic dividend. On the flip side, however, this bulge will eventually enter the unproductive ages, adding an economic burden on society if not managed properly. The issue then becomes of how to improve or at least maintain the standard of living of the old age population through social security schemes.
Our government pension system taxes the current working population to pay for the pensions of the retirees. This system is the pay-as-you-go (PAYG) pension system. But as the demographic transition is going to take place, fewer workers will have to bear the burden of a larger old population due to the increasing old-age dependency ratio. We need to reassess this system.
An alternative to the PAYG system is a fully funded pension system. Workers are taxed a particular amount from their income which is invested by the government on their behalf. The return from those investments are given to the same workers when they retire. Moreover, the pension system and formal social security system benefit workers employed in the formal sector mostly and specifically employed in the government sector. There is room for a reassessment of the social security and pension systems.
If the PAYG system is not dispensed with, the demographic transition in the long run is going to result in a rising proportion of pensioners in the population. Workers in the future will be taxed more than today to provide the same standard of living to the dependent population. Clearly this system will become fiscally unsustainable. This fact advocates transition from the PAYG system to a fully funded pension system. Policymakers must start thinking of reforming the social security system.
Though the rising portion of pension payments in the budget is slowly becoming a cause for concern, the current PAYG system is not raising alarm because of the current low old-age dependency ratio. When a country has low old-age dependency ratio reserves build up as population making the contribution is more than the population receiving pension benefits. But after the demographic transition old-age dependency ratio increases, the PAYG pension system becomes fiscally unsustainable as there will be fewer workers who will bear the burden of the larger aged population.
In fully funded system pension, expenditures are borne by the individuals themselves when they were working. Just like in the PAYG system, a portion of salary is deducted for pension benefits. But rather than giving those contributions to the retired population, the returns are invested and pension benefits provided from the returns of that investment.
The problem with the PAYG system is that the burden of pension expenditures lies on the working population. We will need higher taxes to meet expenditures as the old-age dependency ratio rises.
This creates inefficiencies in the labor market. People revise their decisions regarding labor force participation, degree of effort, and retirement plan among other things. The contribution is a saving rather than a tax in a fully funded pension system. Thus the government will not have fiscal responsibility.
There is also the question of the quality of life of the poor and elderly in the present system which covers only government employees plus a very minor proportion of private employees in the formal sector whereas the informal sector remains out of reach. The informal sector workers have to rely on other systems including civil society organizations such as mosques, NGOs, and private philanthropists. Such sources are uncertain.
However, the transition from the PAYG system to a fully funded pension system involves cost because the government will have to bear pension expenditures of already retired workers, to whom the government had made generous promises when they were working. But the cost of transition is rising with time because the proportion of the retired population is increasing with time. So, this cost must be considered as temporary.
There is not all gloom and doom, though. There are ways to improve the situation. One is to increase female labor force participation. Adoption of technology and innovation can lead to an increase in the productivity of the employed labor force. A positive impact on the overall labor force will increase our output. Special attention to these factors will also help weaken the negative impacts of the demographic transition on output. By making enough savings and investments during working age, the issue of financing the elderly will be taken care of. Based on those savings, there is now talk of even a “second demographic dividend”. The first demographic dividend, for that matter, is based on the income generated by the working ages.
To quantify the costs of demographic transition and a possible move from the PAYG system to a fully funded one, a detailed study is needed that explores the transition from the PAYG system to a fully funded pension system. We also need to explore the costs associated with transition. We must also investigate other fiscal responsibilities affected by demographic transition. These include health expenditures and social security schemes for the elderly population other than pension schemes.