Can Europe AffordCan Europe Afford
Finance & Development June 200420
Across major industrial countries,
populations are aging.
Sources: European Union Economic Policy Committee 2001;
UN Population Prospects Publication (Revision 98); and
IMF staff estimates.
(elderly dependency ratio; ratio of population aged 65 and over
to population aged 15­64)
European UnionUnited States
Japan
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
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In the European Union, the share of the
elderly in the population will double
by 2050 . . .
Sources: European Union Economic Policy Committee, 2001;
and IMF staff estimates.
(elderly dependency ratio; ratio of population aged 65 and over
to population aged 15­64)
0.2
0.3
0.4
0.5
0.6
0.7
European Union
Germany
France
Italy
United Kingdom
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and the share of the employed in the
population will decline sharply.
(employment rate; percent of total population)
Authorities' projections
Sources: European Union Economic Policy Committee, 2001;
and IMF staff estimates.
0.38
0.40
0.42
0.44
0.46
0.48
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Assuming constant labor force
participation rates
PICTURETHIS
OVER THE coming decades, an increasing share of the
European Union's (EU's) population will turn elderly as
baby boomers reach retirement age and life expectancy rises.
This is true of both the 15 original members and the 10 new
ones. Enlargement will, at best, have a brief rejuvenating
effect, given the current, much younger age profile of the
new members. Projections indicate that, by 2020, the share
of older people in the EU-25 will approach that of the
EU-15, reflecting a plunge in these new members' fertility
rates over the past decade or so. In fact, the onset of serious
population aging in the EU is no longer a distant event, as it
will start as early as 2010.
For most EU countries, aging populations will
cause major fiscal headaches--chief among them,
fiscally unsound pension systems. Europe recognizes
that dramatic pension reforms are urgently
needed. Currently, public pensions financed on a
pay-as-you-go (PAYG) basis dominate in most
countries. These schemes pay pensions out of current
contributions or taxes. The problem with
PAYG systems is that they are in danger of becoming
massively underfunded when the number of
people drawing pensions begins to markedly
increase relative to the number in the active labor
force paying into the systems. By contrast, prefunded
pensions--both private and public--play
a subordinate role in most countries. These
schemes make pension payments from a fund that
is an accumulation of financial assets built up over
a period of years from its members'contributions.
So what are Europe's options? Three stand out:
* Closing PAYG financing gaps on a year-byyear
basis through "parametric" reforms that
boost pension revenue (increasing pension contribution
rates or the number of contributors) or
cutting pension spending (reducing benefits or
the number of pensioners), or both.
* Shifting to public prefunding of pensions,
which would imply running surpluses in the
public pension system, at least over the next two
decades or so.
* Shifting to private prefunding of pensions,
which would lead to deficits in the public pension
system during the transition period as contributions
are diverted to private pension accounts
(assuming the diversion of contributions cannot
be fully offset by parametric reforms).
So far, different EU members favor a range of
strategies that embrace all of these options.
Some member countries plan to cut public debt
and use the resulting interest savings for extra
aging-related spending; adopt labor market
reforms to raise employment rates, especially
for older workers and women; and, particularly
among the new member states, rebalance the
public-private pension mix by shifting to private
prefunding. However, the reality is that,
given the size of the problem, public pension
benefits will also need to be cut--and substantially--which,
at the political level, would
require a graying electorate to accept an erosion
of its promised benefits. No doubt then, resolving
these tensions in a forward-looking way
would require more reliance on option three--
that is, starting to build up a private pension
component now so that it will eventually help
to compensate for the unavoidable future cutbacks
in public pension benefits without pitting
younger and older generations against each
other. 
Finance & Development June 2004 21
The growing number of elderly threatens
to undermine the financial sustainability
of the welfare state . . .
(European Union public pension spending; percent of GDP)
Sources: European Union Economic Policy Committee, 2001;
and IMF staff estimates.
1That is, all pension system parameters---such as generosity
and eligibility--and the employment rate are left unchanged; only
the change in the dependency ratio is reflected in public pension
spending.
9
10
11
12
13
14
15
16
17
18
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Full aging pass-through1
Authorities' projections
while boosting the political power of its
main beneficiaries.
(share of older voters in voting-age population; ratio of population
aged 50 and over to population aged 18 and over)
0.40
0.45
0.50
0.55
0.60
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Sources: European Union Economic Policy Committee, 2001;
and IMF staff estimates.
to Grow Old?to Grow Old?
Prepared by Albert Jaeger, Division Chief in the IMF's
European Department.