Optimal strategies for pay-as-you-go pension finance: A sustainability framework

New research from the University of Liverpool and Cass Business School proposes a means of limiting the impact on sustainability that the current trend of decreasing birth rates and increasing life expectancy may have on pay-as-you-go pensions systems.

Public pension systems are usually financed on such a pay-as-you-go (PAYG) basis. Here, pensions for retirees are paid by the contributions of the working-age population. The success of this system depends on a balance existing between the expenditure on pensions and the income from contributions made by the active workers over time. Yet with people living longer, pensions are paid over a longer time. This can prove deleterious for pension finances and raises serious concerns about the sustainability of pay-as-you-go pension systems. Studies in the US and Europe already point to expenditure on pensions exceeding contributions for a significant period at current rate. Furthermore, the increase in unemployment rates, resulting from the recent global crisis, has exerted additional stress on pension systems.

Restoring the long-term sustainability of a pay-as-you-go pension system is a goal for most governments. The option of making tough decisions on social security to tackle the problem is not seen as viable for governments whose tenure might not outlive the inherent political risks to see the benefits. Parametric reforms, normally encompassing changes in legislation, are usually taken as an emergency approach to restoring financial equilibrium. This research proposes another solution; namely Automatic Balance Mechanisms that focus on restoring sustainability based on changes in the main variables (such as rate of contribution, normal retirement age, and indexation of pensions) while keeping the system liquid at all times.

The research paper details two different automatic balancing mechanisms, developed using non-linear optimisation techniques, to restore the sustainability over a 75-year time horizon into a Defined Benefit pay-as-you-go pension system. The mechanisms identify and apply an optimal path of the variables mentioned, absorbing events such as fluctuations in longevity, fertility rates, and salary growth. The functional objective function is set to guarantee that the net present value of income from contributions is sufficient to cover the pension expenditure in the long run.

The Automatic Balance Mechanisms are presented here as a possible alternative to the parametric pension reforms currently seen. The paper concludes that future research applying the mechanisms to different countries that have instated parametric reforms could complement and extend its findings. The authors are currently working on an application to China, which relaxed its "one child" policy in 2013.

A final version of the paper, dated 21st March 2016, is available to download at the link below. The paper has been accepted for publication by the journal Insurance: Mathematics and Economics.

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