One of the reasons for establishing PAYGO pension systems in the past (or Average Premium systems, as we call them in Colombia), or for creating PAYGO pillars in mixed systems, is what is denominated “intergenerational solidarity.”

In these average premium systems (APS), there are no savings, and retirees’ pension are paid directly with money from the contributions paid in by active workers in the labor market. Most workers are young, which is why they say that young people are more supportive of retirees. But for the system to be fair and sustainable over time, there must, in turn, be sufficient young people at the time today’s young people retire, to pay their pensions with their contributions.

These notes contend that this intergenerational solidarity can unfortunately not justify a reform that converts our pension system into a PAYGO system, or that justifies a pure PAYGO pillar in a mixed system. The reason is relatively simple: there is no such thing as intergenerational solidarity For two reasons. First, because such intergenerational solidarity no longer exists, due to the dramatic demographic transition the country has undergone, and will continue to undergo; and, secondly, because the enormous labor informality currently existing in the labor market makes it even more unfeasible. In order to prove these conclusions, the following section will first address the demographic transition, then the effects of labor informality on the viability of the average premium system will be discussed, and thirdly, the political implications will be presented.

1.-The demographic transition

Demographics play an essential role in the development of countries, in the social security systems, but above all in the design and viability of pension systems. Population aging has become a risk to the sustainability of the PAYGO pension systems worldwide, in with pensions are paid monthly with the contributions of young people, or from the public budget. If we consider the above taking high labor informality into account, we have a huge problem, since not all workers effectively contribute to social security.

The effects of this demographic transition for Colombia are illustrated in Graph 1, which shows the ratio of the economically active population to senior citizens aged 65, for Colombia, Spain and Japan. In the middle of the last century, Colombia had more than 11 active workers for each senior citizen, which is reflected in a population pyramid with many young people, very few senior citizens, a very high birth rate, and low life expectancy. With the improvements in health systems, birth control, and the incorporation of women into the working population, families began to have fewer children, life expectancy began to rise, and the ratio of active workers to senior citizens began to fall, leading to the current ratio of 6.8 (point A). Although this figure has dropped, considering reasonable pension parameters, if we assume that all active workers were to contribute, a PAYGO system could, in principle, finance monthly pensions for retirees for a couple of years. The problem is that this ratio will be only 4.0 by 2030, and 2.0 by 2060 (point C in the graph). Towards the end of the 21st century, Colombia will tend to converge to the ratios of countries such as Spain and Japan. This trend clearly makes a PAYGO system unsustainable over time. Even without taking the existing pension deficit into account, given the current contribution rates and the replacement rates of pension payments, the system would soon be entering a growing deficit over time.

Graph No. 1: Workers per elderly

In other words, if we were to calculate future obligations and income and convert them to present value, the system would have a very high net positive debt. In order to maintain a balanced system and keep the deficit under control, contributions would have to be increased to exaggerated levels, or replacement rates would have to be reduced, or a combination of both. According to recent estimates, contributions would have to be increased to 30% of salaries by 2050 to ensure replacement rates of 60%, assuming that there is no informality, that all workers contribute to the PAYGO system, and all senior citizens receive some kind of pension. This situation makes a PAYGO system unviable, but informality makes it impossible.

2. The labor market and informality

In addition to the demographic transition, labor informality is the great scourge affecting social security, and contributes to making the PAYGO pension systems and pillars unviable. The reason is that informal workers do not contribute to social security and are therefore not a source for financing the pensions of the elderly.

Colombia has one of the highest labor informality figures in Latin America, amounting to 65% of the employed population, approximately 22.3 million workers. Only 7.9 million of them contribute to pensions. In terms of Graph 1, this means that we do not currently have an active worker-to-senior citizen ratio of 6.8, but only a ratio of 2.4 (point B). In other words, we rank in a position similar to Spain, approaching Japan, which is considered a country of “elderly people.” The effects of informality on the financing of pensions (as well as health) are so serious, that it is as if we were aging prematurely: it imposes a situation on us today that we would have reached by 2057.

These levels of informality (point B in Graph 1) are one of the reasons why Colombia has such a large deficit in the PAYGO pension system. As we will see further on, it is not the only reason, but it is one of the most important. In principle, this situation could be corrected, at least partially, with a labor market reform that drastically reduces informality. Unfortunately, the effects would not be positive even with such a reform. If we were to make an enormous formalization effort that reduced informality in Colombia by 10 percentage points every five years, from 65% of informality to 25% by 2040, we could achieve the path illustrated by the dotted line in Graph 2. In that scenario, we find that the demographic transition defeats the favorable trend of the labor market and the ratio between active workers and senior citizens; although it rises slightly above its current level, it drops again after 2040. This result confirms the non-viability of a PAYGO system in a country like Colombia, but – even more seriously – it indicates that Colombia is losing the demographic bonus, and has perhaps already lost it irretrievably. This entire analysis translates into the fact that young people today are supportive of senior citizens, but when they are old, no one will be supportive of them.

Graph No. 2: Workers per elderly in Colombia

But, in order to illustrate the havoc that informality causes in Colombia, it would be useful to make a brief comparison with Spain, a country with labor market and population figures very similar to ours, as shown in Graph 3. The Colombian population was 47.7 million inhabitants by 2017, very similar to that of Spain (46.4 million), and the working-age (WAP) and economically active population (EAP) figures are similar. But on reviewing the figures of workers who contribute to the Social Security system, the difference is abysmal, because while 18.1 million individuals contribute in Spain, only 7.9 million do so in Colombia. With an EAP very similar to that of Colombia, more than 19 million people declare income in Spain, whereas only 2 million do so in Colombia. These figures are alarming and reflect the number of informal workers, which number only 316,000 in Spain, whereas in Colombia they number 14.4 million (equivalent to 65% of the employed population). In other words, informality also explains our fiscal problems, since we only collect 14% of GDP in taxes, a third of which is consumed by the deficit of the public system.

Graph No. 3: Demographic statistics

3.- Conclusions and policy options

Since it is impossible to increase the retirement age, strongly increase contribution rates and/or reduce replacement rates indefinitely, many countries are switching to individual account pension systems, in which pensions are proportional to lifelong contributions. In some countries, individual accounts are funded, while in others, notional accounts have been introduced. In countries like Colombia, the demographic transition and labor informality justify this transition.

But there are other reasons that also justify it. First of all, the returns of the PAYGO systems compared to those of the individually funded systems. This is a structural reason that is seldom mentioned, but Thomas Piketty himself incorporated it into the discussion of social security in his book ‘Capital in the 21st century.’ Whereas, the returns of the PAYGO systems are equal to the population and salary growth rates, the returns of the individually funded systems are the returns on capital. The gap between them favors the individually funded systems. Secondly, the enormous fiscal deficit of the public system (Colpensiones, Armed Forces, teachers and others), which is 4% of GDP, and consumes a third of the revenue that the National Government collects in taxes, is another powerful reason for a pension reform. Thirdly, a reform is justified in Colombia due to the enormous inequality prevailing in the public pension system, which grants huge subsidies to people with the highest incomes and which, furthermore, does not acknowledge real interests in the reimbursement of contributions of members who failed to complete 1,300 weeks of contributions, and who, in general, comprise the poorest segment of the population. These are all very powerful reasons for justifying a reform. What would not be justifiable in any way would be to disguise a tax reform as a pension reform to provide the National government with a cash flow to ease its fiscal difficulties. Based on the foregoing discussion, a PAYGO pillar would be justified only if it is self-financed in a fund built with cross-subsidies. The latter considerations will be analyzed in an upcoming article.

SANTIAGO MONTENEGRO

Exclusively for EL TIEMPO

One of the reasons for establishing PAYGO pension systems in the past (or Average Premium systems, as we call them in Colombia), or for creating PAYGO pillars in mixed systems, is what is denominated “intergenerational solidarity.”

In these average premium systems (APS), there are no savings, and retirees’ pension are paid directly with money from the contributions paid in by active workers in the labor market. Most workers are young, which is why they say that young people are more supportive of retirees. But for the system to be fair and sustainable over time, there must, in turn, be sufficient young people at the time today’s young people retire, to pay their pensions with their contributions.

These notes contend that this intergenerational solidarity can unfortunately not justify a reform that converts our pension system into a PAYGO system, or that justifies a pure PAYGO pillar in a mixed system. The reason is relatively simple: there is no such thing as intergenerational solidarity For two reasons. First, because such intergenerational solidarity no longer exists, due to the dramatic demographic transition the country has undergone, and will continue to undergo; and, secondly, because the enormous labor informality currently existing in the labor market makes it even more unfeasible. In order to prove these conclusions, the following section will first address the demographic transition, then the effects of labor informality on the viability of the average premium system will be discussed, and thirdly, the political implications will be presented.

1.-The demographic transition

Demographics play an essential role in the development of countries, in the social security systems, but above all in the design and viability of pension systems. Population aging has become a risk to the sustainability of the PAYGO pension systems worldwide, in with pensions are paid monthly with the contributions of young people, or from the public budget. If we consider the above taking high labor informality into account, we have a huge problem, since not all workers effectively contribute to social security.

The effects of this demographic transition for Colombia are illustrated in Graph 1, which shows the ratio of the economically active population to senior citizens aged 65, for Colombia, Spain and Japan. In the middle of the last century, Colombia had more than 11 active workers for each senior citizen, which is reflected in a population pyramid with many young people, very few senior citizens, a very high birth rate, and low life expectancy. With the improvements in health systems, birth control, and the incorporation of women into the working population, families began to have fewer children, life expectancy began to rise, and the ratio of active workers to senior citizens began to fall, leading to the current ratio of 6.8 (point A). Although this figure has dropped, considering reasonable pension parameters, if we assume that all active workers were to contribute, a PAYGO system could, in principle, finance monthly pensions for retirees for a couple of years. The problem is that this ratio will be only 4.0 by 2030, and 2.0 by 2060 (point C in the graph). Towards the end of the 21st century, Colombia will tend to converge to the ratios of countries such as Spain and Japan. This trend clearly makes a PAYGO system unsustainable over time. Even without taking the existing pension deficit into account, given the current contribution rates and the replacement rates of pension payments, the system would soon be entering a growing deficit over time.

Graph No. 1: Workers per elderly

In other words, if we were to calculate future obligations and income and convert them to present value, the system would have a very high net positive debt. In order to maintain a balanced system and keep the deficit under control, contributions would have to be increased to exaggerated levels, or replacement rates would have to be reduced, or a combination of both. According to recent estimates, contributions would have to be increased to 30% of salaries by 2050 to ensure replacement rates of 60%, assuming that there is no informality, that all workers contribute to the PAYGO system, and all senior citizens receive some kind of pension. This situation makes a PAYGO system unviable, but informality makes it impossible.

2. The labor market and informality

In addition to the demographic transition, labor informality is the great scourge affecting social security, and contributes to making the PAYGO pension systems and pillars unviable. The reason is that informal workers do not contribute to social security and are therefore not a source for financing the pensions of the elderly.

Colombia has one of the highest labor informality figures in Latin America, amounting to 65% of the employed population, approximately 22.3 million workers. Only 7.9 million of them contribute to pensions. In terms of Graph 1, this means that we do not currently have an active worker-to-senior citizen ratio of 6.8, but only a ratio of 2.4 (point B). In other words, we rank in a position similar to Spain, approaching Japan, which is considered a country of “elderly people.” The effects of informality on the financing of pensions (as well as health) are so serious, that it is as if we were aging prematurely: it imposes a situation on us today that we would have reached by 2057.

These levels of informality (point B in Graph 1) are one of the reasons why Colombia has such a large deficit in the PAYGO pension system. As we will see further on, it is not the only reason, but it is one of the most important. In principle, this situation could be corrected, at least partially, with a labor market reform that drastically reduces informality. Unfortunately, the effects would not be positive even with such a reform. If we were to make an enormous formalization effort that reduced informality in Colombia by 10 percentage points every five years, from 65% of informality to 25% by 2040, we could achieve the path illustrated by the dotted line in Graph 2. In that scenario, we find that the demographic transition defeats the favorable trend of the labor market and the ratio between active workers and senior citizens; although it rises slightly above its current level, it drops again after 2040. This result confirms the non-viability of a PAYGO system in a country like Colombia, but – even more seriously – it indicates that Colombia is losing the demographic bonus, and has perhaps already lost it irretrievably. This entire analysis translates into the fact that young people today are supportive of senior citizens, but when they are old, no one will be supportive of them.

Graph No. 2: Workers per elderly in Colombia

But, in order to illustrate the havoc that informality causes in Colombia, it would be useful to make a brief comparison with Spain, a country with labor market and population figures very similar to ours, as shown in Graph 3. The Colombian population was 47.7 million inhabitants by 2017, very similar to that of Spain (46.4 million), and the working-age (WAP) and economically active population (EAP) figures are similar. But on reviewing the figures of workers who contribute to the Social Security system, the difference is abysmal, because while 18.1 million individuals contribute in Spain, only 7.9 million do so in Colombia. With an EAP very similar to that of Colombia, more than 19 million people declare income in Spain, whereas only 2 million do so in Colombia. These figures are alarming and reflect the number of informal workers, which number only 316,000 in Spain, whereas in Colombia they number 14.4 million (equivalent to 65% of the employed population). In other words, informality also explains our fiscal problems, since we only collect 14% of GDP in taxes, a third of which is consumed by the deficit of the public system.

Graph No. 3: Demographic statistics

3.- Conclusions and policy options

Since it is impossible to increase the retirement age, strongly increase contribution rates and/or reduce replacement rates indefinitely, many countries are switching to individual account pension systems, in which pensions are proportional to lifelong contributions. In some countries, individual accounts are funded, while in others, notional accounts have been introduced. In countries like Colombia, the demographic transition and labor informality justify this transition.

But there are other reasons that also justify it. First of all, the returns of the PAYGO systems compared to those of the individually funded systems. This is a structural reason that is seldom mentioned, but Thomas Piketty himself incorporated it into the discussion of social security in his book ‘Capital in the 21st century.’ Whereas, the returns of the PAYGO systems are equal to the population and salary growth rates, the returns of the individually funded systems are the returns on capital. The gap between them favors the individually funded systems. Secondly, the enormous fiscal deficit of the public system (Colpensiones, Armed Forces, teachers and others), which is 4% of GDP, and consumes a third of the revenue that the National Government collects in taxes, is another powerful reason for a pension reform. Thirdly, a reform is justified in Colombia due to the enormous inequality prevailing in the public pension system, which grants huge subsidies to people with the highest incomes and which, furthermore, does not acknowledge real interests in the reimbursement of contributions of members who failed to complete 1,300 weeks of contributions, and who, in general, comprise the poorest segment of the population. These are all very powerful reasons for justifying a reform. What would not be justifiable in any way would be to disguise a tax reform as a pension reform to provide the National government with a cash flow to ease its fiscal difficulties. Based on the foregoing discussion, a PAYGO pillar would be justified only if it is self-financed in a fund built with cross-subsidies. The latter considerations will be analyzed in an upcoming article.

SANTIAGO MONTENEGRO

Exclusively for EL TIEMPO