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Pension systems

This month is graduation season, which formally marks the commencement of young Filipinos’ new lives in the world—in other words, the beginning of their professional or working lives. At the same time, news reports feature the Social Security System (SSS), whose fund life is projected to last for just seven more years (until 2026), if the second tranche of pension hike were to be implemented next year without a corresponding contribution hike. Understandably, retirement planning might not yet figure prominently in a fresh graduate’s list of priorities, but it pays to be aware of some basic concepts regarding pension systems as early as now.

By definition, a pension is a financial product where one puts money to build up a fund to use upon retirement. This retirement pot is built up by investing over a number of years—say, 40 years, if one begins to save regularly from age 20 (graduation age) to age 60 (retirement age). The money saved into a pension gets a boost from tax relief such that people save out of untaxed earnings.

It is useful to distinguish between a fully funded pension system and a pay-as-you-go pension system. In a fully funded system, one will get back whatever he paid into the fund. This simply means that the pension is based on one’s previous contributions and the interest rate. In a pay-as-you-go system, one still pays into the fund, but the income he will receive as a retiree will be based largely on the contributions and taxes from the young workers in the economy then. So, in principle, young people pay their contributions and taxes, while old people receive their pensions. In the Philippine context, the SSS operates as a pay-as-you-go pension system.

Four criteria can be used to compare these two pension systems. First, there is fairness. Some argue that it is unfair to just let young people pay for old people. One should get exactly what he pays into the system, plus interest. In terms of intergenerational fairness, a fully funded system could be considered fair in an absolute sense. However, some argue that as the economy grows, it is only fair to let old people partake of that growth and enjoy a higher standard of living. After all, the economy would not have been able to grow without old people’s valuable contributions during their economically active years. So, as one gets richer, it is a small sacrifice to pay a little bit more so that old people get to benefit, as well. In a relative sense, a pay-as-you-go system could be considered fair because intergenerational transfers are based on a percentage of income.

Second, there is sustainability. On the one hand, a fully funded system is more sustainable because people simply get back their contributions. On the other hand, a pay-as-you-go system might not be as sustainable due to a changing demographic profile where there are more elderly persons for every 100 working-age persons (an increasing elderly dependency ratio). Ageing economies like South Korea, for example, are in a situation where there are more elderly people and fewer young people. The sustainability problem can be addressed by reducing pensions, hiking contributions, or both. These solutions are obviously painful and politically unpalatable.

Third, there is uncertainty. In a fully funded system, people know their payments and can predict future income receipts, although there is some risk with interest rate changes. In a pay-as-you-go system, payments and future income receipts might be harder to determine because of changes in government policies, although risks can be mitigated by clarifying rules regarding payments and receipts. In the Philippine context, such rules are spelled out in the Social Security Law of 1997 (Republic Act 8282).

Last, there is macroeconomic impact in terms of savings and economic growth. In theory, both pension systems generate savings, which are channeled into investments, which, in turn, could lead to economic growth. Nevertheless, in a fully funded system, it will take about 40 years before people get to enjoy the fruits of their savings, while in a pay-as-you-go system, there is a first-generation advantage, implying that the pension system can be implemented immediately. The young people are taxed, and the old people receive pensions right away.

So, which system is better? There is no straightforward answer to this question, although one can have a mixed system where part of one’s savings goes to a fully funded system, and another part goes to a pay-as-you-go system. One of the key features of the ongoing tax reform is the adjustment of tax rates that effectively puts more money in the hands of more people. This should be seen as a golden opportunity for Filipinos, especially fresh graduates, to save and invest more. After all, social security should be seen as not just a state obligation but also a personal responsibility.

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Ser Percival K. Peña-Reyes is a faculty member of the Ateneo de Manila Economics Department.

 

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