Sustainability of government finances in sub-Sahara countries

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Literature Review

Since their introduction by Bismarck in Germany in 1891, retirement programs have been widely implemented worldwide. Bismarck’s main objective was to provide old age retirees with a certain standard of living, thus assuring that individuals’ income does not drop below a certain minimum level after retirement. The rapid growth of retirement programs since then (in number and quality of services) provides important evidence that individuals are risk averse, as they grow older. Hagemejer (2000) provides a list of nine risks and needs covered by a broad range of social protection expenditures, of which retirement benefits take a major slice (40 per cent) of these expenditures. Next the rationale and functions of social security schemes available are investigated.

The Rationale and Functions of Retirement Programs

Social security in the narrow definition of retirement programs basically entails the financing of retirement. Individuals receive benefit payments in the form of annuities during retirement until they die, allowing for a total or partial lump sum at the retirement date. Many of the retirement programs allow for surviving spouses and/or children to receive annuity benefits (Kotlikoff, 1987). The value of the benefits varies from one individual to another depending on the extent of their lifetime earnings. Retirement benefits are also paid to disabled individuals, providing for longevity, due to uncertainty of time of death. This uncertainty allows for possible substitution effects between lump sum (the one sum benefit from social security) and annuities.
Retirement programs also provide an important vehicle for intergenerational transfer of wealth. The PAYG system involves an efficient intergenerational transfer of resources if it is assumed that the economy follows Solow’s (1956) model of balanced growth or Samuelson (1958) and Diamond’s (1965) models of golden rule. The balanced growth or golden rule implies that once population growth has equalised to the growth in capital, government does not have to resort to debt under the PAYG system. In this case population growth is assumed to raise sufficient tax revenue to pay the benefits of retirees. This implies that the growth rates of wages and other outputs are equalised to the growth rate of the population implying the Pareto equilibrium where all generations (present and future) are better off.
In the steady state economy it is assumed that government accumulates sufficient trust funds to pay for retired individuals, which in reality is not the case. In addition, population, capital, output and wages do not grow at the same rates, which means that the economy cannot maintain the golden rule or balanced growth of output. The result is that there is a surplus or deficit in the government collected tax revenue, implying higher or lower saving in the economy as in Solow’s (1956) model. If an economy saves more it accumulates more capital than the population growth and, therefore, wages increase more rapidly. More taxes can be collected for social security purposes and the government need not resort to debt to finance retirement obligations, with the result that future generations are better off. The reverse is true if the economy saves less, in which case the government is forced to resort to debt to finance expenditure on social security. It is evident that social security is to some extent closely related to government deficit, resulting in future generations bearing the burden of lack of savings of present generations (Kotlikoff, 1987). All this provides the rationale (covering risk) and the function (improving the society’s status) of retirement funds.
Inadequate private saving (Diamond, 1977) and purchases of life insurance (Auerbach and Kotlikoff, 1986) provide an important incentive for government intervention in order to secure social security and ensure that the economy continues to follow its growth path⁴. Inability in foreseeing the future health status of an individual obviously complicates the provision of social security to provide for all the different kinds of risks and needs. These difficulties also limit private insurance companies to provide products that would cover such risks, which raises the problem of adverse selection⁵. It is also argued that retirement funds contribute toward a Pareto improvement of the society by allowing intergenerational transfers of wealth with a risk sharing arrangement (Kotlikoff, 1987). Another reason for the introduction of social security systems as known today is the failure of family insurance systems to provide for old age security (Ehrlich and Lui, 1998). This is especially true of SSA countries where modest economic growth rates accompanied by many other exogenous factors have resulted in large scale migration of the labour force to other regions. The result is that traditional safe family insurance structures were weakened, and formal social security systems have become more viable⁶.

A brief overview of retirement schemes around the world

In this paragraph an overview is presented of different social security systems in a number of selected countries. Old age security is featured by a variety of complex systems around the world and varying from country to country. However, most of these retirement schemes tend to be similar in nature regarding the form of administration and provision of old age income. The characteristics of each of these systems have evolved over time and with the changing demographic patterns since the late 1970s and early 1980s, developed countries were induced to reconsider the efficiency of their systems by reforming them (in some case in-depth reforms) to take into account the changing characteristics of their population. The majority of such reforms took place during the 1980s and 1990s but the process is still continuing.
In the majority of these countries social security systems tend to be dominated by PAYG defined benefit systems administered by government with contributions subsidised through tax incentives and payment of benefits includes a means-tested procedure. The problem with this type of social security system is that it constrains government finances which could impose large implicit debts. However, in most recent years countries have been considering alternative forms of social security systems in order to reduce the strain on government finances. In this regard there has been a significant move of social security types, most of them designed to be of the PAYG type, to a new model of social security administration with the objective of lessening the burden both on government finances and the tax obligation on future generations. This section considers the existing social security schemes around the world and where possible reforms will also be reported.

Chile

The first Chilean social insurance system was introduced in 1924 (being the first country in the Americas to introduce social insurance). The Chilean system consists of a mandatory individual account, social insurance and social assistance system. The new system includes mandatory private individual accounts which were compulsory for workers entering the labour force as from December 31, 1982. It covers all private-sector employees, provides voluntary coverage to the self-employed, a wage earners’ program with a minimum wage of 127,500 pesos, a salaried employees’ program with special systems for railroad employees, seamen and port workers, public-sector employees, the armed forces, police and more than 30 other occupations (www.socialsecurity.gov).
The funds come from a mandatory individual account with the insured person contributing 10 per cent of gross earnings for old-age plus 0.75 per cent for disability and survivor insurance and an average of 1.55 per cent of gross earning for administrative fees. The employer does not contribute to any of these accounts, except 1 or 2 per cent of gross earnings for employees working under arduous conditions. For social insurance the insured person contributes 18.8 per cent of wages, while salaried employees contribute from 20 to 30 per cent of gross earning depending on the nature of occupation (a reduction of 7.75 per cent is granted to some workers with at least 40 years of contributions) and the employer is not required to contribute to this system (www.socialsecurity.gov).
Chile has the most cited reforming social security system, with a funded defined contribution (FDC) introduced in 1981 considered to be the most important development.
This FDC system is considered to have had a strong influence on the course of social security systems in the rest of the world. By the 1970s this scheme had covered about 70 per cent of the labour force (Williamson, 2005). The crisis the scheme experienced by late 1970s induced the Chilean government to divide it into separate PAYG plans each with its own rules with respect to eligibility and benefit levels. For example, full pension benefits after 35 years of contributions for some categories of workers and 30 years for government employees (Kitzer, 2000; Williamson, 2005; Myers, 1992). Williamson (2001) indicates that by 1980, the Chilean government was subsidising 28 per cent of pension payments. The new Chilean scheme is basically a fully funded scheme, but Williamson (2000) prefers to define it as a mixed or partially funded model since government still is contributing towards the funding of the system.
For new employees and also those who opted to shift from the old system to the FDC the contribution of wages is 10 per cent. This contribution is made to one of several privately management pension companies of their choice with an additional fee of between 2 and 3 per cent to such companies to cover the management costs and also to pay for survivors and disability insurance (Williamson, 2000). For employees covered by the old scheme (pre-1981 PAYG) who agreed to switch to the new scheme, employers had to increase wages by 18 per cent to ensure a real income increase of 11 per cent (Williamson, 2000; Kritzer, 1996).
The most recent changes in the Chilean FDC scheme include the 1999 reform with a shift from the use of 12 months to a 36 month accounting period when assessing compliance with rate return regulations (Williamson, 2000; Kritzer, 2000). In 2000 another reform was to allow asset managing companies to introduce a second fund (Fund 2) in addition to Fund 1 (the pre-existing fund) (see Williamson, 2000). Fund 2 was only for those who were within 10 years of retirement allowing for investment in fixed-income securities (Kritzer, 2002). In 2002 multi-funds were introduced in order to allow flexible investment in other markets such as the stock market that were not allowed before. These multi-funds encompass higher risk choices and lower risk choices of investment allowing workers to choose among the available investment alternatives.

United Kingdom

Old-age pension scheme (social insurance and social assistance system) was introduced for the first time in the UK in 1908 while in 1911 and 1925, disability insurance and old-age and survivors’ insurance schemes respectively were introduced. The current laws on retirement were introduced in 1992 (consolidated legislation), in 1995 pensions, in 1999 welfare reforms and pensions and in 2000 child support, pensions, and social security. It covers all persons aged 16 to 65 (men) or aged 16 to 60 (women). The source of funds is from contributions by insured persons (11 per cent) and employers (12.8 per cent), with self-employed and voluntary contributions also allowed (www.socialsecurity.gov).
The United Kingdom (UK) state pension scheme is three-tiered: the basic state pension, the state earning-related pension scheme (SERPS) and the income support and invalidity benefits. The first tier of the state pension is a flat-rate contributory benefit payable to people aged 65 for men and 60 for women. The individual meets the qualifying conditions if he/she has made contributions to the National Insurance Fund for 90 per cent of their working lives but since the introduction of Home Responsibilities Protection act in 1978 the number of years of contributions can be reduced by the time spent on caring for children or dependents (Blundell and Emmerson, 2003). By April 2003, the basic state pension was worth £7.45 a week for a single pensioner. Before 1978 married women were allowed to opt to pay only a reduced amount to National Insurance Fund and, therefore, did not qualify for the basic state pension. Since 1989 there has not been an earnings test for a basic state pension.
Introduced in 1978 the SERPS scheme pays a pension equal to a proportion of an individual’s annual earnings per year. The intention is to pay a pension worth one-quarter of the contributor’s best twenty years of earnings, up to a specific upper earnings limit. Women who opt for a reduced payment to the National Insurance Fund do not qualify for the SERPS scheme (Blundell and Emmerson, 2003). However, widows can currently claim their husbands’ SERPS pension in full if they receive no additional pension in their own right. SERPS pension is updated each year after retirement in line with inflation.
Another state benefit paid to elderly non-workers is an income support and incapacity grant. The income support grant is a non-contributory means-tested benefit payable to those aged 60 and above who fall into the lower income groups (Blundell and Emmerson, 2003). The beneficiaries of this flat-rate means-tested benefit are not required to show that they are not actively seeking work in order to qualify. In 1999, the income support was renamed to a minimum income guarantee. The generosity of the means-tested benefits was extended with the introduction of a pension credit in October 2003, payable to lower income individuals aged 65 and above (Blundell and Emmerson, 2003).
While the minimum income guarantee is non-contributory, an incapacity benefit was introduced in 1995 as a contributory benefit paid to the long-term sick and disabled and can be paid only to individuals aged under the state pension age. During the 1980s the rapid growth in receipts motivated the change from invalidity benefits to incapacity benefits, which before April 2001, did not follows the means-tested benefit procedure and could be received in conjunction with private pension income. However, since then means-tested benefit payments are applicable regard to individual occupational pension income (Blundell and Emmerson, 2003; www.socialsecurity.gov).
The reforms to SERPS introduced in 1986 and 1995 reduced its generosity for those qualifying for state pension after 2000. This reform came along with a choice to individuals to opt out of SERPS to join the defined contribution scheme from 1988 or individual retirement accounts (Blundell and Emmerson, 2003; www.socialsecurity.gov). Members of the defined benefit and contribution occupational schemes pay a reduced rate of National Insurance while those with personal stakeholder pensions receive a National Insurance rebate paid directly into their funds. There was a decline in coverage of occupational pension plans from 11 million to 10.1 million between the mid-1980s and 2000. According to Blundell and Emmerson (2003) such a decline reflects the employment patterns and a shift to smaller employers, but also the wide range of pension choices among individuals working for employers offering occupational pensions.
Most of the reforms introduced in the UK retirement schemes were meant to improve the social status of the aged and also reduce the generosity of existing schemes. Moreover, these reforms offered possibilities for working individuals to choose among the different retirement schemes and, therefore, giving individuals the chance to change schemes if not satisfied. Such behavioural responses to reforms are currently considered in a number of studies with some implicating that an increase in the retirement age would lead to a significant increase in government revenue ((Blundell and Emmerson, 2003).

Chapter 1 
1.1 Introduction.
1.2 Defining Social Security
1.3 Justification of the Study
1.4 Problem Statement
1.5 Objectives of the Study.
1.6 Significance of the Study
1.7 Hypothesis
1.8 Limitations
Chapter 2: Literature Review
2.1 The Rationale and Functions of Retirement Programs
2.2 A brief overview of retirement schemes around the world
2.3 Empirical Literature
2.4 Main Insights and concluding remarks
Chapter 3: The Nature, Problems and Potential of Social Security Programs in Sub-Saharan Africa
3.1 Regulatory Framework and Coverage
3.2 Funding Retirement Systems and Qualifying Conditions for Benefit Payments
3.3 Replacement Rates in Sub-Saharan African Countries
3.4 Why reforming retirement systems?
3.5 Alternatives for Retirement Finance
3.6 Sustainability of government finances in sub-Sahara countries
3.7 Main Insights and Concluding Remarks
Chapter 4: Theoretical Framework 
4.1 Financing and Managing Retirement Programs
4.2 The Effects of Retirement Funds in the Life Cycle Model
4.3 Deficit Finance and Retirement Funds .
4.4 The Effects of Social Security on Fertility
4.5 The Labour Market and Retirement Funds.
4.6 Main Insights and Concluding Remarks
Chapter 5: Methodology 
5.1 Model Specifications
5.2 Data
5.3 Econometric Technique
5.4 Bootstrapping Steps
Chapter 6: Empirical Results .
6.1 The Saving Model
6.2 An Example of Country Specificity – The Case of South Africa
6.3 Growth Model
6.4 Model for Fertility.
6.5 Main Insights and Concluding Remarks
Chapter 7: Policy Implications and Conclusions
7.1 Introduction
7.2 An Overview of the Effectiveness of Current Social Security Systems on the Economies of SSA Countries
References
Annexures
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