Pension Funds and Income Redistribution

The purpose of pension funds is to ensure that the wealth created by an individual is invested and distributed in such a way that they can afford to maintain their standard of living throughout their lifetime.

Pension funds have become a very important tool for retirement planning. An average pensioner plans to survive almost twenty years of their life with the money received from pension funds.

A basic assumption is that pension funds will distribute the income in a fair and equitable manner. However, this is not the case. Pension funds have come under heavy criticism because many people believe that pension funds end up redistributing the personal wealth of an individual.

In this article, we will have a closer look at some of the redistributive effects of pension funds.

1. Wealth Based Income Transfer: Pension funds all over the world are designed to pay out at least a portion of the funds in the form of an annuity. This annuity is paid for as long as the pensioner is alive. It is a well-known fact that poor people do not live as long as wealthy people.

   It has been statistically proven that there is a significant difference in the life expectancy of people belonging to different socio-economic classes. Hence, in effect, pension funds take an equal amount of money from everyone. However, they pay more money to the wealthy. This ends up redistributing the income from the poor to the wealthy making it a form of regressive taxation!

2. Reverse Wealth-Based Income Transfers: There are some countries in the world that provide a basic pension to every individual regardless of their income and contributions in the past.

   Such pensions are paid out based on a single criterion which is the age of the pensioner. Now, here too, there is redistribution of income taking place. Only the wealthy income earners are making contributions to the pension funds. However, everyone is getting pay-outs in return. This amounts to a transfer of wealth from the wealthy to the poor.

   The pension system is not supposed to be a means of progressive taxation. It is for this reason that pension funds face a lot of criticism.

3. Gender-Based Income Transfer: As mentioned above, pension funds make payments to pensioners as long as they live. Now, the lifespan of a pensioner can vary based on many factors. The gender of the pensioner is one such factor.

   There are several studies that have shown that women tend to have a longer average life than men. Now, men and women contribute to the pension fund in equal amounts. However, when it comes to withdrawing money from pension funds, women are able to have higher pay out. Hence, the entire system can be seen as a mechanism that transfers wealth from male contributors to female contributors.

4. Redistribution Based on Marital Status: Most pension funds in the world make payments to pensioners as well as their spouses. In a lot of cases, the pension payments are reduced to 50% if one of the spouses passes away and is completely stopped after the death of the second spouse as well.

   Now, when it comes to people who are not married, they do not have a spouse. Hence, their pension payments stop immediately after their own death. This is considered to be unfair by many because all pensioners contribute in equal amounts. However, people who have spouses are able to withdraw from the fund for a longer time duration. This coupled with the fact that women live longer than men, makes the odds stacked against unmarried pensioners.

5. Intragenerational Income Transfer: The most famous redistributive effect of pension funds are the intragenerational transfers of income.

   In many parts of the world, pay-as-you-go schemes are followed. This means that an individual does not contribute to their own pension account. Instead, their contributions are used to pay out the benefits of the previous generation. Therefore, if there are a large number of workers in a particular generation, the per head contribution becomes lower.

   On the other hand, if the population is on the decline, the per head contribution being to rise. The dangerous and potentially catastrophic side effects of the intragenerational transfer of wealth have become known to the entire world because of the demographic changes taking place in countries like China as well as Western Europe.

   Many critics consider the intragenerational transfer to be a crippling burden that can have a huge negative effect on the financial well-being of the next generation.

6. Redistribution Throughout the Lifetime of Investor: Not all redistribution done by the pension firms is bad. Pension funds also help people redistribute their own incomes across their own lifetimes. The purpose of pension funds is to enable individuals to transfer money from their working years to their non-working years.

All the above points of criticism are valid to some extent. It is true that pension funds lead to transfers of wealth between various groups. However, this distribution is a game of chance.

If the funds start charging different rates to different groups, then that will be considered to be discriminatory. Hence, it can be said that the pension fund is better than the alternatives even though it is not perfect.