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The transition from payg to funding: Application to the Luxembourg privat sector pension system

Numéro23
DateJuly 2006
AuteurMuriel Bouchet
Résumé

The Luxembourg private sector pension system (“régime général de pension”) is at crossroads. On the one hand, the current budgetary situation of the system appears extremely favourable. On the other hand, projections based on reasonable assumptions suggest that the pension regime is not sustainable over a long-term horizon. Pension benefits are indeed bound to increase steeply when large contingents of crossborder and immigrant employees will retire.

The primary objective of the paper is to assess whether a solution proposed by Modigliani and Muralidhar, where pensioners are gradually transferred from pay-as-you-go (PAYG) to a public fund in accordance with the defined benefit principle, is suitable to the Luxembourg situation. A baseline funding scenario designed in a stepwise manner and under reasonable return assumptions illustrates how fruitful such a solution could be in Luxembourg, provided that a significant prefunding effort takes place at the beginning of the transition period. In the steady state, this scenario would lead to very comfortable reserves and budgetary surpluses with no additional cost in terms of long-term, equilibrium contribution rates. These very favourable results would be achieved in spite of a continuously increasing pension cost ratio induced by ageing and by the gradual retirement of large contingents of cross-border workers. Another particularly attractive feature of the baseline funding scenario presented in the paper – especially in the context of a small and very open economy – is that it would mitigate in an effective way the impact on the pension regime of adverse GDP growth developments. By contrast, PAYG does not provide a sound basis for a social security scheme as contributions are very sensitive to small changes in the key macroeconomic variables. Finally, the baseline funding scenario is reasonably resilient to alternative return or demographic assumptions. However, even the funding system would have to be monitored in a rigourous way. To sum up, the currently favourable situation of the private sector pension regime should be considered as a window of opportunity during which the pension system should set aside the large assets required in order to cover future pension liabilities. This would mark the onset of a virtuous circle, where increasing assets and the related property incomes would offset the rising cost of pension benefits and at the same time mitigate adverse macroeconomic developments.

Keywords: Pensions, funding, defined-benefits, sustainability.

JEL classification: E62, H55, J11.

 

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