The impact of pension systems on fertility rate: a lesson for developing countries

27-Jul-2010    This paper aims to illustrate the impact that the introduction of a fully-funded pension system (and in particular of a micro-pension scheme) has on developing countries' fertility rate, i.e. the number of children “desired” by families.

There is a wide scope of literature that empirically analyzes the correlation between fertility rate and different measures of the size of a public pension system. Empirical evidence has indeed demonstrated that public pension system programs have a negative effect on the fertility rate of a country. Also the level of development of financial markets has a similar effect on the number of children "desired" by families. How may this fact influence the family size in developing countries? May the economic growth benefit from this trend? This article aims at answering those questions and disclose new opportunities for micro-pension programs to be economically helpful in developing countries. 

There is a wide scope of literature that empirically analyzes the correlation between fertility indices and different measures of the size of a public pension system. Hohm (1975) examines 67 countries, and by using data from 1960 to 1965 he concludes that public pension system programs have a negative effect on the fertility rate of a country, consisting of the same magnitude as the more traditional long-run factors determining fertility (i.e. infant mortality, education and per capita income).

Cigno and Rosati (1992) study the potential impact of both the availability of public pensions, and the increasing access to financial instruments providing retirement income for old people. They conclude that “[...] both social security coverage and the development of financial markets, controlling for the other explanatory variables1, have a negative effect on fertility.”

Boldrin, De Nardi and Jones (2005) estimate the size of the effect of social security on fertility decisions by studying and calibrating several theoretical models. They find that 50% of the drop in the fertility rate in the U.S. and Europe (and 80% of the difference between American and European fertility rates) from the 1960s on was accounted by a growth of the national public' pension systems. In particular, the authors argue that an increase in the size of the social security system of 10% in GDP is associated with a reduction in the total fertility rate between 0.7 and 1.6 children.

The above evidence is theoretically supported and explained by two main models frequently used to study the effects of changes of government pension plans on fertility: the Barro and Becker (1989) model of fertility (called the BB model from now on) and the Caldwell-Boldrin and Jones (2002) model (labelled the BJ model from now on). The BB model starts from the hypothesis that parents desire children because they perceive their lives as a continuation of their own. In the BJ model, instead, parents procreate because the children will take care of their parents once they are retired, providing them with old age financial support. In other words, children are perceived by parents as a component of their optimal retirement portfolio (Boldrin et al., 2005). This hypothesis is well-known by researchers in demography as the “old age security” motivation for childbearing. Moreover, when the “old age security” hypothesis prevails over the BB's one, an increase in the size of public pension system decreases fertility rate. This explains: (i) the fertility drops in the U.S. and Europe in the past 50 years, (ii) 80% of the difference in fertility rates between countries with low public expenditure and countries with high public expenditure in pension schemes.

Other authors in the demographic and sociologic literature have provided evidence of the strong link between parental dependence on children's support during retirement and fertility rates (the “old age security” hypothesis of fertility decisions). Of particular note for this paper are the studies done by Rendal and Bahchieva (1998) and Ortuno-Ortin and Romeu (2003). The former use data on poor elderly in the U.S. to estimate the market value of the transfers they receive from relatives. Their most relevant conclusion is that children are an economic investment for the poorest fifty per cent of the population, even in the presence of current old age pension and welfare programs. Ortuno-Ortin and Romeu (2003) come to the same conclusion by using micro data measuring parental health care expenditure. These conclusions reinforce the thesis that the fertility rate is higher amongst the poorer part of the population, since children are considered as a “natural insurance” by their parents. This means that the phenomenon according to which children take care of their retired parents, is mostly widespread within the lower-income-earning part of the population.

The “old age security” reason for “procreating” is currently still very strong in African and other developing countries with poor financial market institutions and instruments and without a universal public pension system. At the same time, researchers like Bloom (2003), Ross (2004) and Lee and Mason (2006) have demonstrated that lower fertility rates are followed by higher economic growth in a developing country. This is the “demographic dividend” effect: when the fertility rate decreases, families have fewer children and become richer; the older generations have already passed away, so society has a disproportionate large number of working-age adults. This fast-growing economically active population boosts industrial production. Furthermore, due to urbanization, new workers coming from villages can make a country more productive. In the past, demographic dividend accounted for about a third of East Asia’s speedy growth over the past 30 years.

Now the question is: how can Governments promote small size families in a context where the “old age security” motive for fertility is very strong? The optimal solution would be implementing a universal coverage pension system that, from what has been pointed out before, would help in decreasing fertility rate of a country. In many developing countries, public pension schemes only address workers in the public sector, “forgetting” the employees in the informal sector, although they represent almost 80% of the working force. Due to its structure, the informal sector is also the sector that is exposed to external risks the most (like dangerous weather conditions, wars, famine, etc.), and thus workers within this sector suffer from a high volatile income.

However, Governments in developing countries usually undergo large budget constraints and often bear a huge budget deficit. In such a context, an extension of the pension system to universal coverage seems to be too risky: this transition would require sustainable social and economic policies.

To summarize, this article has focused on two major problems involving developing countries' economic growth and their demographic issues:

  1. developing countries need to cash a demographic dividend in order to grow. This may only happen by boosting the demographic transition (lowering fertility rate and family size in order to free resources to be invested also in retirement income) and create employment for young workers;

  2. since the public budget of a developing country is usually not large enough to provide population with an universal covering pension system, an alternative to the universal state pension system, that would alleviate huge public deficits, needs to be found.

Furthermore, a higher saving rate is needed in order to increase investments, capital accumulation and economic growth. A higher saving rate is possible only by making the access to financial markets and instruments easier and more transparent. This is not the case within developing countries' financial markets.

One solution to the above problems may come through providing the informal sector with a third “voluntary” pillar2: micro-pension provisions. In very broad terms, a micro-pension provision is a financial instrument that invests voluntary contributions from poor households in order to build up assets for their old age income. A micro-pension product is usually designed as voluntary defined-contribution scheme. This means that the worker's periodical contribution is pre-determined, while benefits rely on the amounts deposited on workers' pension accounts and on investment earnings on the contributions. A professional fund manager typically manages these savings which are invested in financial markets in order to obtain a return. At a pre-agreed retirement age (normally 58 - 60 years), the accumulated capital plus investment earnings can be withdrawn as a lump-sum amount, as an annuity or some combination of these methods. The difference between micro-pension provision and regular pension scheme lays in the fact that operational costs and required savings amount of micro-pension plan are kept low in order to make it affordable for poor people. The micro-pension instrument is thus tailored on poor clients with low income level. The main goals of micro pension systems are:

  1. reducing poverty and combatting the rapidly decreasing living standards once workers retire;

  2. reducing the role of children as a natural insurance in order to free familiar resources that are then allowed to be invested in human and physical capital (as concluded by the previous model);

  3. safeguarding the elderly from economic and social crisis.

Besides the above goals, a micro-pension program has several externalities on the economy and society as a whole. Micro-pension provisions: 

  1. create awareness among the poor, with regard to the importance of saving and investing in long-term projects, providing them with a retirement income;

  2. improve the financial literacy of the poor. More financial literacy increases the transparency of the financial markets: people are more aware of the risks, costs and benefits that the financial products and services provide. Therefore it is hard for financial products provisioners cheat and hide twisted clauses. More transparency makes also financial markets more competitive thus lowering operational costs.

  3. generate a large amount of savings, which can be channelized into investments in the local market and economy;

  4. reduce the burden on the Government's budget. A third-pillar may allow Governments to reduce pension provisions to the whole population and to redirect them towards other sectors like infrastructures or even support to the poorest share of total population. 

A micro-pension scheme should have the following characteristics: 1) self-sufficient and sustainable3; 2) universally accessible, in order to reach the large number of uncovered workers in the informal sector; 3) efficient and available throughout the country; 4) equitable, pro-labour and pro-poor; 5) well-regulated by financial market authorities.

To conclude, past experiences and studies demonstrate that a growing welfare system and growing accessibility to financial markets have reduced the fertility rate in developed countries from the 1960s on. There are assumptions that this negative impact may be replicated successfully in developing countries, where a reduction in fertility rate is fundamental for boosting economic growth (cashing the demographic dividend) (Mason and Lee, 2004). However, developing countries' Governments may have some problems in promoting universally coverage pension scheme because of their constricting and limited public budget. Micro-pension plans, as voluntary defined benefits products, may have a fundamental role in reducing the “old age security” reason for fertility hypothesis, allowing families to have less children and thus freeing resources that can be invested in human and physical capital (i.e. education).

 
About the author
Mr. Andrea Colombo worked as an intern for the Pension & Development Network between April and July 2010.
 

1 In order to clearly understand the effect of the size of the welfare state on the fertility rate, it is fundamental to isolate the effects that other variables may have on the number of children to whom families give birth. Otherwise, the estimates would be biased and not reliable.

2 The first pillar of a pension system is represented by defined mandatory contributions to pension funds while a second pillar is made of a defined contribution schemes based on voluntary contributions from the workers covered.

3 A micro-finance institution providing a micro-pension provision has to be independent from external subsidies that may influence the process of selection of clients and other operational strategies

 

 
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