A Fully Funded System

Finally, let us investigate a fully funded system. Imagine that the pension is changed to a funded system in period 3. Then, we have Table 7.6.

Alternatively, we have

In the fully funded system, changes in population do not affect the net benefit of each generation. Since the rate of interest is assumed to be zero, generation 4 pays 10 and receives 10. Thus, generation 4’s net benefit becomes zero rather than being negative. Thus, it gains from the reform. So, too, does generation 5 compared with the pay-as-you-go scenario. Hence, this reform is beneficial to the young and future generations. For them, it could fully solve the problem of intergenerational inequity in an economy with a declining population.

With regard to generation 3, this generation has to take care of generation

2. Generation 3 pays 5 to generation 2 and pays 10 for its own fund accumulation. Thus, it pays 15 in total and receives 10. Its net benefit becomes —5. This situation involves a per capita contribution of 5 because generation 2 does not accumulate assets for its old age.

Hence, this seemingly attractive reform has a serious problem in that it significantly impairs generation 3. When the public pension is moved to a funded system in period 3, generation 3 saves for its own old period and at the same time has to pay contributions to generation 2’s benefits because generation 2 becomes old in period

3. This is because in period 2, when generation 2 is young, it does not save for its old age in the pay-as-you-go system. Generation 3 has to pay twice. This is called the double burden of transition from pay-as-you-go to funded systems.

Table 7.6 The transition to a funded system

Generation

1

2

3

4

5

Net return

10

0

—5

0

0

As long as generation 3 attends to generation 2’s benefits, the net benefit of generation 3 is negative. With regard to generation 4, generation 3 is in the funded system from its young period; thus, generation 4 does not have to support generation 3. Consequently, an aging population does not affect the net benefit for generation 4. Future generations after generation 4 may enjoy a rate of return that is equal to the interest rate in the funded system.

From the viewpoint of generation 4, a transition to a funded system is desirable. However, from the viewpoint of generation 3, it is undesirable because generation 3’s net benefit changes from positive to negative. In period 3, generation 4 does not exist. Generation 3 is young and can vote against the reform. Generation 2 is indifferent about the two systems. Thus, politically speaking, such a reform is unfeasible because generations 2 and 3 do not support it. This is a major problem of the transition. Namely, after the transition, future generations gain; however, during the transition, at least one generation loses to a significant extent.

 
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