Beyond Pay-As-You-Go and Full-Capitalization Pension Systems

Why Notional Accounts Are a Suitable Option for Latin America

Research Fellow and Graduate Student Working Paper No. 62

Eduardo Lora
August 2014


This paper discusses the viability of three alternative pension systems for Latin America: full-capitalization, pay-as-you-go (PAYG) and notional account systems. Making use of a set of simulations, the pros and cons of each option are discussed for an "average" Latin American country. The results indicate that a system of individual notional accounts should be an attractive option, for several reasons. With contribution rates constant around 15 percent of wages, the system would be financially sustainable for the "average" Latin American country over the projection period (2015-2065), as it would generate surpluses until the early 2040s, which would be used to finance the subsequent deficit. The pay-as-you-go option (which, on average over the period would require approximately the same contribution effort) would imply frequent increases in contribution rates, which would be politically impracticable, and it would not create strong incentives for individuals to contribute as the notional accounts system. The full-capitalization system requires much lower contribution rates and may create the right incentives for workers to contribute but exposes them to high pension uncertainty. Furthermore, full-capitalization imposes a huge fiscal burden which, under most scenarios, could not be fully covered with the funds accumulated in the individual accounts, and would imply significant income redistribution from taxpayers to workers and pensioners and important transfers from the current to future generations.

JEL codes:D31, D19, H55, I38

Keywords: Pay-as-you-go; full-capitalization pension system; notional account pension system; pension deficit; pension system sustainability

Affiliated Research Program: Growth Lab