Demographics are rewriting the balance sheets of developed countries around the world—and pushing traditional pension systems beyond their limits.
The pressure is particularly evident in OECD countries. For these nations, the average ratio of older citizens (65 and older) to younger citizens (ages 15 to 64) will increase on average 2.5 times by 2050 from 2000 levels. That translates into a growing economic burden on the working-age population, as those younger workers will need to contribute an increasing share of their income to fund pensions. By 2060, total pension expenditures as a share of combined GDP for 31 of the 38 OECD nations is projected to hit 10.3%, up from 8.9% for the period 2020 through 2023.
Some countries have taken action to confront the challenge. Sweden, Denmark, and the UK, among others, have reformed their pensions systems over the last 20 years and put them on a firmer financial footing. Still, many of the changes have come with trade-offs, such as benefit reductions that disproportionately impact low-income groups.
So how can developed nations remake their pension frameworks to meet the needs of their aging societies? Our in-depth study of the pension challenge reveals that governments have an opportunity to act in two primary areas. First, they can rethink pension design by incentivizing funded pension schemes, supported by automatic adjustment triggers and poverty-floor guarantees. Second, they can ensure effective implementation of those reforms, including through citizen-focused engagement.
Pension reform is an inherently complex and politically difficult undertaking. Because the costs of inaction—and any benefits of reform—are not always immediately felt, inertia often prevails. However, delaying reforms to avoid public controversy only magnifies fiscal and political risks. Countries that develop thoughtful policy designs and robust strategies for implementation will be far better positioned to meet this urgent challenge.
Components of a Sound Pension System
The demographic pressure on pensions today stems from multiple factors—notably, increased longevity, decreasing birth rates, and slowing immigration. Reform can strike the right balance between the objectives of the pension trilemma (see Exhibit 1):
- Sustainability. Maintaining a financially sound system over the foreseeable time horizon.
- Adequacy. Ensuring benefits are sufficient to provide income stability throughout people’s retirement and prevent older citizens from slipping into poverty.
- Equity. The fair distribution of costs, benefits, and risks among individuals or groups—are particularly relevant to pensions.
While financial unsustainability is typically the immediate challenge, safeguarding adequacy and equity levels is equally important. And although pension redesigns have typically prioritized only one or two of these objectives, the most successful will strike a balance between all three.
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Two Dimensions of Pension Design. Pensions systems are defined along two primary dimensions: financing methods and benefit design. Financing methods fall into two categories: pay as you go (PAYG), where current contributors pay for existing retirees’ benefits; and funded, in which people contribute in advance the money that will subsidize their own benefits, thereby enhancing both sustainability and equity. Benefit design also falls into two categories: defined benefit (DB), where the provider carries both investment risk (tied to how investments perform over time) and longevity risks (related to whether recipients live longer than expected); and defined contribution (DC), where payouts are not fixed but instead depend on contributions made by employees, employers, or both.
Building a Balanced Pension System
Pension reform success rests on two foundational elements: sound system design and smart implementation.
Rethink System Design. Three fundamental elements can be built into pension systems (see Exhibit 2):
- Shift toward funded DC systems. Because contributions from young workers are becoming insufficient amid rapidly expanding payouts to current retirees, it can make sense to shift away from the PAYG DB model toward funded DC plans. When the political environment makes this move difficult, more modest steps—for example, transitioning to a funded DB or PAYG DC plan—can be a move in the right direction. Shifting toward a funded DC system on its own may not fully balance the three pension objectives, making complementary mechanisms to ensure minimum benefit levels necessary.
- Establish automatic adjustments mechanisms. Designing the system to automatically adjust benefits and contributions based on factors such as life expectancy or socioeconomic changes can reinforce financial sustainability, adequacy, and equity. These triggers can stabilize the system by insulating pension systems from short-term political swings, potentially avoiding the need for more drastic action in the future.
- Integrate poverty-floor guarantees. Building in mechanisms to prevent poverty among retirees is vital, since individuals with low incomes or minimal assets can have insufficient retirement contribution rates and personal savings. A poverty floor ensures a minimum level of income protection for vulnerable elderly populations. To ensure long-term sustainability, it may include design parameters like eligibility age, benefit indexation, and income-adjusted benefit scaling.
Drive Smart Implementation. Implementing new pension systems effectively is as important as designing them intelligently. There are two essential areas to be considered (see Exhibit 3).
- Build a citizen-focused engagement plan. Such plans would comprise four key elements. The first is providing clear explanations of the proposed changes and why they are needed. Second, along with the data, the use of relatable stories, simple symbols, and trusted voices can build acceptance and show that change is necessary, fair, and forward-looking. Third, providing support and the tools needed to navigate the new system can mitigate low levels of financial literacy. Fourth, countries can embed a continuous feedback loop as they roll out a new system to help identify potential issues.
- Smooth the transition. To ease into the new system, countries might introduce it in phases to help people plan for the change and minimize political fallout. Protecting retirees by avoiding benefit disruptions and supporting the working-age population with smart policies, including tax breaks, can also smooth implementation. Finally, all pension systems will require adjustments over time as circumstances evolve. Capturing feedback, as noted above, can help identify early signals, enabling decision makers to effectively adapt systems as social structures, labor markets, cultural norms, and socioeconomic trends continue to evolve.
While effective implementation, along with smart design, increases the chances of successful pension reform, broader societal shifts are also important. Chief among these is enabling people to extend their working lives. Achieving this will require efforts beyond government policy alone. Companies can support this change—and create value—by optimizing work environments to enhance older employees’ well-being and engagement. Meanwhile, individuals can embrace new ways to continue their careers.
Governments have an opportunity to proactively address pension sustainability. Delaying action might be appealing in the short term but can lead to greater costs later. Taking timely, measured steps today offers a chance to put pension systems on a more sustainable, adequate and equitable footing for the future.
The authors thank the following BCG colleagues for their contributions to the research: Cesar Sanchez, Eiichi Hasegawa, Toshihiro Takeda, Vincent Chin, Daiki Miura, Germaine Tan, Mayuki Yaso, Nagi Cao, Saaya Nakano, Shunsuke Ochi, and Yoshiki Kasuga.
