Wednesday 16 April 2025
A recent study has shed new light on a decades-old paradox in social insurance, revealing that traditional pension systems may not be as effective as they seem. The research challenges long-held assumptions about the role of asset accumulation in ensuring financial sustainability.
The Aaron paradox, named after economist Henry Aaron, suggests that introducing a pay-as-you-go (PAYG) pension system can increase welfare when population growth and wage increases outpace interest rates. However, this apparent advantage stems not from any inherent superiority of PAYG systems but rather from reduced asset accumulation.
To understand the issue, let’s consider two types of pension systems: PAYG and capital-funded systems. In a PAYG system, current workers contribute to fund the pensions of retirees, while in a capital-funded system, contributions are invested and grow over time to provide for future pensions.
Researchers have long argued that capital-funded systems are more effective because they allow assets to accumulate, providing a buffer against financial shocks. However, this view is based on a fundamental misunderstanding of how PAYG systems operate.
The study reveals that when population growth and wage increases exceed interest rates, PAYG systems can actually reduce asset accumulation, leading to increased sustainability. This occurs because the system’s accounting framework is designed to match contributions with benefits in each period, eliminating the need for asset accumulation.
In contrast, capital-funded systems require assets to accumulate over time, making them more vulnerable to financial shocks and less sustainable in the long run.
The implications of this research are significant. Traditional sustainability metrics often prioritize asset accumulation, but the study shows that this focus is misguided. Instead, policymakers should consider alternative measures that account for the fundamental equivalence of PAYG and capital-funded systems.
One such measure is alpha-stability, which evaluates pension systems based on their ability to maintain a consistent number of index shares over time. This framework provides a standardized method for comparing different pension systems, acknowledging that they are part of a broader fiscal framework rather than isolated entities.
The study’s findings have far-reaching implications for pension policy and reform. By recognizing the limitations of traditional sustainability metrics, policymakers can develop more effective and sustainable pension systems that prioritize long-term financial stability over short-term gains.
Ultimately, this research highlights the importance of understanding the underlying mechanics of pension systems to ensure their long-term viability. By shifting our focus from asset accumulation to alpha-stability and other alternative measures, we can create a more robust and sustainable social insurance system for future generations.
Cite this article: “Unlocking the Paradox: A New Framework for Assessing Pension System Sustainability”, The Science Archive, 2025.
Pension Systems, Asset Accumulation, Payg, Capital-Funded, Sustainability, Financial Stability, Alpha-Stability, Pension Policy, Reform, Social Insurance.
Reference: Martin Drees, “Resolving Aaron’s Social Insurance Paradox” (2025).
