C10.1- Social Security Systems

Question 1

How to finance a social security scheme

Answer 1

• Set initial and future contribution rates are levels that are affordable and acceptable for parties involved
• Match the accumulation of any reserves built up to the investment needs and capacity of the economy

Question 2

In which circumstances does the financing method used become important?

Answer 2

• System matures
• Benefits change
• Population ages

Question 3

Arguments for and against funding social security systems in advance

Answer 3

+ Increased level of savings
+ Develops capital markets
+ Eases pressure of ageing population
+ Investment returns reduce long term cost of benefits
- Overall savings may not rise, are just redirected.
- Even if they do, may not create real investment
- Doesn’t solve problems of ageing population
- Transition to funding in advance can be problematic
- Fund may be a political temptation

Question 4

Name three approaches to financing social security systems

Answer 4

• Pay as you go
• General average premium
• Terminal funding

Question 5

Give the contribution rate for PAYG

Answer 5

CR = (benefits paid in the year) / (total salaries of contributing population in the year)

Question 6

Problems with funding a social security scheme using PAYG

Answer 6

As the population ages or system mature the contribution rate tends to rise and is likely to vary each year so is not practical administratively

Question 7

Describe two variants of PAYG

Answer 7

Smoothed - contribution rates are set in advance and a contingency reserve is built up to maintain cashflows

Equalised - an equalised contribution rate is calculated in advance so expected income covers expected benefits over a control period. For a mature system, a fund is built up at the start of the period and drawn down later in the period

Question 8

Give the contribution rate initially set under GAP

Answer 8

CR = (PV of all future benefits) / (PV of total salaries of contributing population in all future years)

Note this allows for new future entrants

Question 8

How does the GAP contribution rate differ at future valuations

Answer 8

The contribution rate is set such that a level rate will be payable throughout the lifetime of the scheme

So a relatively high rate will be payable when the scheme is first established compared with PAYG

At future valuations the contribution rate needs to take account of the fund built up

Question 10

How does the GAP contribution rate compare to that under PAYG?

Answer 10

For new schemes with no pay service, then initially and until the system matured the GAP CR > PAYG CR

So annual contributions and investment income will exceed the benefit outgo and a fund is built up to meet future expenditure

Question 11

Give conditions required for a stable contribution under GAP?

Answer 11

• Assumptions borne out in practice
• Assumptions not changed over time
• No change in contribution or benefit structure

Question 12

Give the contribution rate under terminal funding

Answer 12

CR = (PV benefits awarded in year t) / (PV of total salaries of contributing population in year t)

Ie the contribution income required in a period is the amount required to finance the capital value of benefits awarded in that period

So benefits are prefunded at the time they are awarded

Question 13

Changing from PAYG to funded

Answer 13

Funded approach requires transition during which contributions are required to provide benefits for both current and future generations. May be politically bad

Could make a gradual change by making a gradual adjustment though the general tax system. Only acceptable if level of tax would otherwise been reduced

Could issue government debt. Avoids double payment but debt needs to be serviced and relies on investment market