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FIAP > Boletín – Recientes > Pension Notes No. 59 – Individual funding or PAYGO: The opposing paths of Europe and Latin America – January 2022
19 January, 2022

Pension Notes No. 59 – Individual funding or PAYGO: The opposing paths of Europe and Latin America – January 2022

What is happening in the matter of pensions in Europe is a clear example for Latin America, which is experiencing the same demographic changes that Europe experienced, but with decades of lag.

While European countries are today adopting funded mechanisms to face the challenge of the aging of their population, in Latin America measures are being taken that go in the opposite direction and aim to weaken the individually funded system. Two opposing routes that were analyzed by Santiago Montenegro in his presentation “Individually funded pension systems vs. PAYGO systems in Latin America” and Rafael Doménech through his presentation entitled “PAYGO pension systems in the current demographic context”.

Santiago Montenegro maintains that the individually funded systems are superior to the PAYGO systems for basically two reasons:

  1. PAYGO systems are pyramid schemes that are unsustainable over time due to the aging of population (people having fewer children and beginning to live longer) which will result in that, when today’s young people are older adults, there will not be enough young people to finance their pensions.
  2. The returns of the individually funded system are higher than those of the PAYGO system because in the first case there is a return on investments, while in the second case increases only occur if there are increases in the wage bill.

Rafael Doménech, for his part, argues that European countries to face the challenge of aging population are:

  1. Increasing the retirement age: Gradually through reforms until 2050, to raise it on average from 63.7 to 66.5.
  2. Reducing the generosity of the pension system: through automatic adjustment mechanisms or revaluation criteria.
  3. Increasing the wage bill: Incorporating more people into the workforce so that employment is as productive as possible.

To compensate for the drop in the replacement rate, which is defined as the percentage of income received in retirement with respect to previous income as an active worker, in the European PAYGO systems more complementary savings will be needed, whether in the first, second or third pillar. European countries cannot currently make the transition from a PAYGO system to a funded one, due to the very high cost for the State of continuing to pay PAYGO pensions to an aging population, without receiving the contributions of active workers who would go to the funded system.

Therefore, there is a contradiction between Europe that is strongly adjusting its PAYGO systems to face the aging of its population and is gradually integrating funded components, and Latin America that managed to make the change from PAYGO systems to fully funded systems in a timely manner (with a population not yet aged), where there is concern about the political decisions that are being taken that aim to weaken the individually funded systems, and even in several countries it being proposed to return totally or partially to PAYGO systems.

Please download here this Pension Note.

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