Pension Reform: Is There a Tradeoff between Efficiency and Equity?

The pension reforms being undertaken in Latin America seem to be improving efficiency and growth, but they should also be designed to improve equity. It is possible for pension reform to improve both equity and efficiency - producing a winwin situation rather than a tradeoff. In the past decade, Latin America has taken the lead in structural pension reform which replaces a publicly managed pay as you go defined benefit system with a system of privately managed, fully funded defined contribution accounts supplemented by a social safety net. This arrangement is designed to improve efficiency and growth, and preliminary evidence suggests that it has been successful in doing so.

But traditional social security systems have been justified on the grounds that they are equitable and redistribute to low income groups. Are we in danger of exchanging equity for efficiency?

James argues that in fact traditional systems produce many inequities, both within cohorts and across cohorts. So it is possible for pension reform to improve both equity and efficiency - a winwin situation rather than a trade-off. The reforms undertaken thus far have indeed reduced existing equity problems, but some old equity problems remain and some new ones have been created.

The main policy lesson is this: Pension reforms should be carefully designed to improve equity as well as efficiency and growth. Only further empirical analyses will determine whether the redistributional goal has been achieved.

This paper - a product of the Poverty and Human Resources Division, Policy Research Department - was prepared for the Conference on Inequality Reducing Growth in Latin America's Market Economies, Inter-American Development Bank, January 1997. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Selina Khan, room N8024, telephone 2024733651, fax 2025221153, Internet address skhan8@worldbank.org. (24 pages)

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