Pensions: A Wordwide, But Avoidable Crisis

Nationalized Pensions Are Going Bust


Contributing editor Norman Barry is professor of social and political theory at the University of Buckingham in the U.K. He is the author of An Introduction to Modern Political Theory (St. Martin’s Press) and Business Ethics (Macmillan).

Almost every country in the economically advanced world is worried about nationalized pensions. American statisticians have some grisly fun predicting on what day of the week and in what year the Social Security system will finally go bust. Or whether Medicare will be broke first. And most young Americans think that there is as much chance of picking up Social Security when they retire as there is of a sighting of Elvis.

The Europeans are not that realistic: they really do think that they will be as well looked after in old age as their parents have been. That is why, just to make sure, French workers went on strike when reform was first threatened in 1995 and again, in May of this year, when the changes looked a little more serious. They might now be compelled to work an extra two and a half years, but will still retire on 70 percent of salary.

The problem with state schemes is that they cannot repeal the laws of nature. The laws of nature relevant here are longevity and relative infertility. The European and American schemes are financed on a “pay as you go” (PAYG) basis: this working generation promises to pay the retirement costs of the currently aged on the understanding that a succeeding generation will return the favor to it, and so on indefinitely. But if people live longer and do not reproduce at the same rate as before, the alleged “contract between the generations” cannot be kept.1 One generation in particular will lose out: those people who will have to pay the costs of the existing retirees while saving for their own retirement when reality finally breaks in and governments are compelled to fund their promises with real money.

Most European countries have very generous old-age pensions. In France, Italy, and Germany, among others, people retire at an early age, often below 60, and with pensions, as in France, that amount to 70 percent of their salaries. These are the same countries that are experiencing alarming reductions in the birth rate. In Italy and Germany it is rapidly heading toward the non-replacement rate; that is, their populations will suffer a net fall. Elderly Germans are advised to cross the road carefully when young drivers are around. Americans face the same problem, and the figures are only slightly more encouraging. There will be a drop from an astonishing 40 workers per retiree, as there were in 1945, to just over two when the baby boomers retire after about 2010. But at least they don’t expect the state to honor its promises. The Europeans do. It always has, hasn’t it?

Americans have had compulsory old-age pensions since 1935. The system was originally intended to be self-financing, paid out of the Social Security (payroll) tax, but it is now a full-fledged PAYG scheme and has been from its early days. Like all socialist schemes, it has steadily got more costly. The combined employer and employee contributions now amount to 15.3 percent of income. (It was originally 2 percent.) Of course, the payments are so meager that many Americans have made private arrangements, with welcome tax concessions.

President Reagan produced a scheme that would eventually build up a fund from which future generations could draw. But this has not been allowed to happen, and by the middle of the 21st century there will be nothing for those generations other than future taxpayers’ generosity. Indeed, when the budget deficit finally began to be reduced in the mid-1990s and the returns from the payroll tax began to swell, that fund was deliberately used for other government spending. If the PAYG system continues, it is quite likely that the future will feature, in America and Europe, a war between the generations far more intense than any class war predicted by Marx.

Politics and the Aged

Let us not forget that the elderly are politically powerful. The American Association of Retired People (AARP) is one of the most important pressure groups in the country, and its officials are eager to highlight any threat to Social Security posed by either of the two political parties. It is a tribute to the hidden power of the AARP that no serious threat has ever arisen. Indeed, there is a great disparity in federal and state spending between the young and old.2 There is an implicit and unexamined prejudice in political debate on behalf of the elderly. To question that prejudice is a sure sign of immorality and egoism. This automatic prejudice undoubtedly springs from the fact that there was once a close connection between being old and being poor, so that welfare measures designed to alleviate suffering would help the aged disproportionately. But this is no longer true. In all advanced Western democracies the retired are quite well off, certainly in comparison to their predecessors.

Equally important, advocates of the retired have managed to persuade American public opinion that Social Security isn’t welfare; it has been paid for by past contributions. But it hasn’t. And although Americans think Social Security is not generous, they still get more than they paid in. It has the feature of all welfare policies—redistribution. As Carolyn Weaver said, in discussing the raising of the payroll tax: “a decision to increase the tax rate represents a collective decision to alter the distribution of rates of return between generations.”3

But politicians know very well that the old vote in greater proportion than the young. And the spokesmen for the aged seem immune from the normal criticism that occurs in political and ethical argument. Thus how many of the contemporary advocates of “social justice” for the aged ever realize, least of all point out, that Social Security operates against blacks? But it clearly does. They do not live as long as whites and therefore draw less from the system. This kind of inequity is bound to occur in a socialist system.

Oddly enough, the United Kingdom has been rather virtuous in this matter. One of the many unheralded achievements of Margaret Thatcher’s reign was the privatization of the bulk of pensions. There is still a basic, very low, unfunded pension, but the potentially ruinous State Earnings Related Pension Scheme (or SERPS, a full implementation of which would have ruined the economy) was run down and people were given incentives to leave it. Now nearly 70 percent of the workers (well over 40 percent of actual pensioners) are in privately financed schemes. SERPS has been replaced by the Second State Pension, but the problem here is that the original aim of getting everybody out of a second state pension has wavered a little in recent years. People are now being encouraged to contract back into it.

It is true that the British are in a bit of trouble at the moment because of the fall in the stock market, and the number of people privately covered has recently begun to fall. But this is because another social phenomenon is taking over: “moral hazard.” The basic flat-rate pension is so derisory that those solely dependent on it have to have their incomes topped up from extra welfare payments. So they are now saying, quite rationally: “I will get paid anyway, so why should I save”? Of course, the moral hazard could be alleviated if the supplementary payments were not so generous and if there were greater incentives for people to get covered privately. But the situation in Britain is still very much better than in mainland Europe, where in most countries only 10 percent of workers are in private plans.

Alas, Britain’s prudence faces a new threat—and it is not from demography. The Europeans are now engaged in a pale imitation of Philadelphia 1787: they are trying to construct a constitution. What has such heady metaphysics got to do with the tedious actuarial problems of pensions? A lot, actually. The document has something deadly tacked on the end: a Charter of Fundamental Rights, which includes welfare rights, in particular, entitlements to social security benefits and protection in maternity, illness, and old age (Article 34). These are not anodyne ideals but legally enforceable claims.

It is worth noting that, despite having welfare, Americans do not have a constitutional right to it. If they did the 1996 reforms would never have survived in the Supreme Court. But a European from any country in the Union will soon have the right to take his government to court if, say, he is not provided with a pension of 70 percent of his salary and if he is made to work till he is 65. Who will pay for such largess? It is likely that Britain’s funded pensions will be invested in a European-wide pension scheme. Isn’t that what “ever closer union” (the mantra of the Europhiles) means?

The Logic of Pensions

The whole pensions business illustrates all too well the dangers of government involvement in what is essentially a private decision: how much to save for old age. In a free society this is a consequence of time preference. How much does each person value the future over the present? A person with a high time preference does not value the future all that much and will spend his present income on immediate consumption. But most people do care about the future and save accordingly. Indeed, our time preferences begin to fall as we get older.

The original rationale for state involvement in pensions was that people’s time preferences were too high, which would present the state with a massive welfare bill in their old age. Yet to pay it would produce another moral hazard by rewarding the failure to save.

Moreover, it’s the politicians who have time preferences that are too high. They do not think beyond the next election, and when in government they build up debt that future generations will have to pay. Moreover, they do not use revenue wisely. It has been calculated conclusively that if money collected for Social Security had been invested in the stock market it would have yielded a significantly higher return than the current payments.4

The real danger of PAYG pensions is that they involve the imposition of “promises” that cannot be kept on behalf of unwilling generations. The longer a state-run system has been in operation, the more expensive it is to wind up, unless we are willing to see people who have paid their taxes (no doubt unwillingly) suffer in their old age. It is difficult morally to leave people who have been forced into a system unprotected when we, rightly, want to end it.

One of the many achievements of the much-maligned Pinochet regime in Chile was its solution to the country’s burgeoning pensions problem. Chile was one of the earliest countries with a PAYG scheme, established in 1924. By the 1970s it was getting extremely costly, but it was calculated that the cost of winding it up, if historic commitments were to be honored, was 3 percent of gross domestic product.

Nevertheless, a radical reform was successfully introduced.5 All people entitled to the existing pension could keep it or go private (as 90 percent did). All new workers, however, would have to join one of the new competing private pension funds and save at least 10 percent of their incomes so that eventually the state scheme would wither away. Now almost everyone is covered privately, with the returns from their investments exceeding the state pension by 40–50 percent. No one has been hurt by the changeover, and thanks in part to the privatization of state-owned assets, it was carefully worked out so that it did not lead to a tax rise.

It should be possible to reform similarly the American and European systems without too many, if any, people being made worse off. George Bush once promised to liberalize partly the American old-age provisions.

During the last presidential election he announced plans to allow citizens to invest a proportion of their Social Security taxes in the private market. It was an anemic imitation of the Chilean scheme, but it does not seem to have got very far.

In Europe the prospects are even dimmer. Yet there is an oddity here. The French and Germans are used to paying for health care out of an (almost) fully funded social-insurance system with competing suppliers. It is not genuine private insurance, and it is compromised by all sorts of statist interventions. But health care is not funded from general taxation, like the British system, an (almost) entirely state monopoly of which Stalin would have been proud. Yet it seems to be as hard to persuade Europeans of the absurdity of their almost entirely state monopoly on pensions as it is to convince the British of the inefficiency and injustice of their socialized medicine. If they are still speaking, the British, French, and Germans can learn from each other.

One way out of the present imbroglio is mass immigration. America has the advantage here for one of the keys to its economic success has always been the continued inflow of immigrants. The European Union is expanding, but one of the fears of its citizens is that immigrants will only come into the countries to take advantage of their ruinously generous welfare systems. As a prelude to the abolition of all welfare programs in America and Europe, a condition for immigration should be the forgoing of all welfare claims, including pensions. I can’t imagine that rule being a serious disincentive to the industrious Chinese and other Asians anxious for a Western lifestyle. Such a policy would lead to two things essential for free societies: unrestricted movement of labor and the end of the welfare state.


  1. For a philosophical critique, see Norman Barry, “The State, Pensions and the Philosophy of Welfare,” Journal of Social Policy, 14, 1985, pp. 468–90.
  2. See Norman Barry, “The New Right and Provision for the Elderly,” in Grant Jordan and Nigel Ashford, eds., Public Policy and the New Right (London: Pinter, 1993), pp. 257–59.
  3. “The Economics and Politics of the Emergence of Social Security,” Cato Journal, Fall 1983, p. 364.
  4. Martin Feldstein, “Social Security, Induced Retirement and Aggregate Capital Accumulation,” Journal of Political Economy, 82, 1974, pp. 905–26, and Peter J. Ferrara and Michael Tanner, A New Deal for Social Security (Washington D.C.: Cato Institute 1998).
  5. See Eamonn Butler and Madsen Pirie, The Fortune Account (London: Adam Smith Institute, 1995), pp. 7–9.

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October 2003

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