Adequacy Issues on Social Security Pensions
Takayama, N. Prof. Dr.
President, RIPPA, Japan
Professor Emeritus at Hitotsubashi University
February 2021

1

Introduction
Pension adequacy is one of two major requirements for social security pensions tosatisfy ultimate desires of the public. This paper demonstrates the basic contents ofpension adequacy from an economic perspective.
Section 2 defines the concept of pension adequacy with the simplest way. It is the
widely-used traditional one, different from the 3-dimentional complex concept proposedby a holistic document; the 2018 Pension Adequacy Report of EU. Section 3 discusses
major factors governing pension adequacy other than the level of income. Section 4
explains a wide variety of relationships to poverty alleviation. Section 5 refers tochallenges ahead for inventing new indicators of pension adequacy on the macro basis.
2

Defining Pension Adequacy
In this paper, the present author adopts the traditional definition of pension adequacy,
which has long been used in the pension academia.
Pension adequacy is identified with an adequate level of pension benefits for eachindividual (and/or couple) on the micro basis,1, 2 which ensures the decent standard ofliving in dignity as old-age pensioners. In other words, pension adequacy can be referred
to as consumption smoothing before and after retirement.
The conventional index to measure pension adequacy is the replacement ratio, i.e., thelevel of pension benefits (in cash) compared to the income from work before retirement(excluding income in kind). In the strict since, benefits are confined only to social security
pensions, but in a much broader sense, benefits from non-mandatory occupational and/or
personal pensions can be also included. The denominator is usually specified by lifetime
Some others include cost elements, as well, in discussing pension adequacy by taking financial
sustainability into account. This approach may complicate its discussions; it requires considerations
both on the micro- and macro-basis, arguments of different objectives with different policy
instruments, and handlings of trade-off problems (二律背反問題: see Section 2 of Takayama (2019)).
Thus, it may induce a hard-to-understand explanation for a majority of non-experts in pensions. The
present author rather separate pension adequacy from financial sustainability, setting the respective
papers.
2 Following the 2018 Pension Adequacy Report by EC, Zhao et al. (2019) wrote an excellent paperand examined three indicators of pension adequacy, reflecting poverty prevention, consumption
smoothing, and financial sustainability. My understanding is that poverty prevention or financial
sustainability can be measured appropriately to a greater extent by the more direct indicators suchas the poverty line, the headcount ratio of poor people, their poverty gap ratio, and the present valueof pension benefits divided by the present value of future contributions and tax revenues plus
accumulated reserves, shown in the balance sheet of social security pensions of the society as awhole, taking the future 75 or even100 years into account. Thus, in a narrow sense, only
consumption smoothing seems to be the right objective for measuring pension adequacy.
11average wages and salaries (converted to their present value), while those amounts
immediately before retirement are optionally used.3
An appropriate value of pension adequacy is given uniformly throughout the nation,
ignoring regional differences. 4 This makes a sharp contrast with measures of poverty
relief (public assistance). Incidentally, poverty relief requires immediate policy responses,
whereas pension adequacy is a problem of prolonged administration.
Lower incomes yield higher reference standards of pension adequacy. This is because
the propensity to consume in old age decreases as the income level of wages and salaries
in the past went higher.
Furthermore, for the existing old-age pensioners, the higher the level of their incomein the past is, they can have much greater availabilities of other income sources thansocial security pension benefits, such as wages and salaries, non-mandatory occupational
and/or personal pensions, asset income (rent, interest, dividend, parking charges, etc.)
and asset withdrawals. Then, the standard value of pension adequacy declines still more
for the middle and higher income-classes who have other income sources than wages andsalaries.
Figure 1 depicts varying values of pension adequacy. If the amount of consumption
expenses is above the 45-degree line, then the standard value of pension adequacy
indicates 100% or more, while if it is below the 45-degree line, the reference value lies
down under 100%.
(Insert Fig. 1 about here)
In principle, the targeted replacement ratio as pension adequacy lies within 100% for
the middle- and higher-income group. If someone of them with a peculiar privilege
actually enjoys the replacement ratio of more than 100%, then it implies that he/she
receives too generous pension benefits.
The most popular standard of pension adequacy is demonstrated by focusing on
individuals with the median or average amount of wages and salaries.5, 6 Their modal
amount has rarely been used, though it may present one of typical examples.
International Labor Organization once recommended three degrees of 40%, 45% and
55% as the reference standard of pension adequacy for typical workers at the point of theirretirement (see ILO (1952) (1967a) (1967b)). The ILO standards were often referred to in
the past to measure the degree to which the consumption is smoothed.
As for non-salaried persons (farmers, merchants, craftworkers, professional free-lancers, etc.),
remunerations or earnings after deduction of expenses are used as the denominator.
4 China might be an exceptional huge nation in the world. Each Province in mainland China might
be equivalent to each nation in other major countries.
5 For example, Pension Adequacy Report 2018 of European Union, uses the median amount before
tax and social security contributions deducted (in gross terms), while Japan currently adopts theaverage amount in gross terms, both as the numerator.
6 Regarding economic variables, the median is higher than the mode, while it is lower than the
average, in general. Consequently, the standard value of pension adequacy using the median will bea little bit higher than that obtained by the average.
32

There are several major factors other than income levels, which govern the standard
degree of pension adequacy. Their examples are: balance of length between working years
and retired years, net or gross income, early or later stages after retirement, individual
or married couple unit, different components of consumption expenses between pension
contributors and beneficiaries, and balance between solidarity and self-reliance. The next
section describes these factors, respectively.
3
Other Factors Governing Pension Adequacy
3.1 Balance of Length between Working Years and Retired Years
The value of the reference standard for pension adequacy is higher, if a person works
as an employee for longer years and receives pension benefits for shorter years. For
example, let’s assume that he/she works for 40 years and retires to receive pension
benefits for 20 years. Then the required monthly amount of pension benefits will be twothirds (66.7%) of monthly amount of wages and salaries for him/her to attainconsumption smoothing throughout his/her lifetime. In a polar case where he/she works
for a much shorter period of 30 years and receives pension benefits for 30 years, then thestandard value of pension adequacy will be 50%, which is much lower than 66.7% in theformer case.
Thus, the year of entrance to and exit from the labor market does matter. The
normal pensionable age is also decisive.
Needless to say, the examples shown above are simplified ones. They assume nowage increases, no tax and social security contributions, no benefits indexation, nor any
family formation. If these factors are taken into account, the reference standard forpension adequacy has to be accordingly adjusted.
3.2

Net vs Gross
Usually, income tax and social security contributions are imposed on wages andsalaries, while the amounts of their payment from pension benefits are much smaller, oreven just about nil in many cases. Consequently, pension adequacy in net terms is, moreor less, higher than that in gross terms.
3.3

Early or Later Stages after Retirement

Consumption activities require physical energy which diminishes little by little overtime in old age.
This fact will justify an implementation of CPI indexation of pension benefits, which
is seen in many countries. The wage escalation rate is often higher than the increase of
CPI. In these circumstances, the value of the standard for pension adequacy will decline
gradually after retirement.
It should be borne in mind that in later stages after retirement, some special
consumption expenditures on healthcare, long-term care, transportation, housing,heating, etc. may become huge, instead. But these expenses are better paid in kind by3

respective programs. As stated above in Section 2 of this paper, pension adequacy is
traditionally measured by income in cash (and not by income including in-kind benefits).
3.4

Individual or Married Couple Unit
There is a household scale of economy in consumption expenditures. The value ofreference standards for pension adequacy then varies depending on whether theindividual unit or the married couple unit is applied. The equivalized income is normallyused for individualization, which is influenced by living habits and policy arrangementsof life-related programs in each country. Take old-age Japanese pensioners, for example.
On average, their monthly amount of basic consumption expenditures for a married
couple is estimated to be equal to 1.4 or 1.5 times larger than that for an individual, andnot be twice.
3.5

Different Components of Consumption Expenses
For actively working generations, consumption expenses generally contain raisingand educational costs of their children, repayments of land and housing loans, necessary
costs for daily works and commuting, all of which old-age pensioners can dispense with.
3.6

Balance between Solidarity and Self-reliance
In designing social security pensions, some redistributive elements are incorporated
to mitigate the gap in past work income within generations. A universal flat-rate portionof benefits is the typical example. Other examples are guaranteed minimum pensions,
supplementary pensions, progressive pension formulas, credits for family care periods,
non-contributory social pensions, contributions based on upper earnings limits, andreduced or exempted contributions.7 Means-testing or income-testing or even pensionbenefits (of earned entitlements)-testing are introduced in some cases.
Each country has its own perceptions on income inequality in old age. The strengthof solidarity among the members of a society varies from country to country, and levels
and categories of income redistribution in social security pensions are consequently
different, mainly due to the history, culture, and geographical conditions of the country.
4

Relationship to Poverty Alleviation
Consumption smoothing throughout a long lifetime requires young- and middle-aged

persons to do forced savings. Social security pensions are invented to work as the major
system to achieve this goal.
No funded reserves are not necessary for the social security pension program to
perform this mission well. Indeed, almost all developed countries basically manage theprogram in the pay-as-you-go financing, and not by a funded scheme.

Levying personal income tax on pension benefits, can be another example, though this belongs intax policy tools, beyond the framework of pensions.
7

4

The longer a person contributes, the more his/her monthly amount of benefits getspromised to be paid. Together with the tax advantages, these secrets operate as strong
incentives to forced savings.
Successful achievements in consumption smoothing eventually meet with poverty
prevention. However, not a few persons fail to enjoy consumption smoothing. Examples
are low-wage earners, females with longer family-care periods, immigrants, and those
persons in unemployment or in poor health. They are forced to receive other benefits
such as no-contributory minimum and/or social pensions, special pension credits, or evenpublic assistance, as well, after retirement. These pension benefits/credits and public
assistance are regarded as policy tools for poverty relief.
Regarding old-age pensioners, poverty prevention requires additional policy
instruments from youth. More generous educational policies with grants andscholarships, effective employment machines, and health promotion measures, are alsoessential. Forced savings are not the exclusive means.
Poverty relief has to be provided to poor individuals and households, regardless ofage. So many causes trigger the poverty problems. The harshness of nature, a large
family with many children, marriage at a too young age, unexpected death of a father at
his/her young age, incompetent parents, famine, malnutrition, ill health, injury, disease,
low educational standards, economic slump, unemployment, old-age etc. are the typicalcauses. Each case should be treated with its relevant policy tool of a wide variety. It
includes not only uniform benefits in cash through the nation, but also benefits in kindand area-specific or age-specific services. These benefits and services are financed bytransfers from general revenue, with a means-test8 in almost all cases.
The main policy-tool for poverty relief is public assistance, with which a sense of
stigma is often associated. More or less, young- or middle-aged persons haveopportunities after a period of time for getting away from receiving public assistance,
whereas old-age pensioners have few opportunities for doing it. Due and valid reasons
are there for many countries to have additional and complementary schemes for poverty
relief within their pension program for old-age persons. They often set up top-ups of aminimum guaranteed pension, non-contributory supplementary pensions, and social
pensions (allowances). In some cases, these pension benefits become eligible for them toreceive from a higher age of 75 or 80.
As for the index of poverty, the poverty line and the poverty gap are commonly used.
Needless to say, the poverty line is a level of income, and a person with income below theline is considered as poor. The poverty gap of any individual is defined to be thedifference between the poverty line and his/her income. In addition, there are three
more indices of poverty on the macro basis; the head-count ratio, the poverty-gap ratio,
and the Gini coefficient of income distribution among the poor. The head-count ratio is

Means testing may have disincentive effects on savings for retirement before the normal
pensionable age and/or on working longer.
85

the percentage of people below the poverty line. The poverty-gap ratio is the per-person
aggregate short-fall of income of all the poor taken together from the poverty line.
These three indices are all insensitive mutually to the others, however. In order toavoid these shortcomings, Takayama (1979) derived his measure of poverty from an
ordinalist axiomatic approach. That is, the Gini coefficient of the censored income
distribution truncated from above by the poverty line (貧困線で切られた打ち切り所得分布),
which includes three indices mentioned above as its indispensable components.
5

Challenges Ahead
The indicator of pension adequacy is currently given only on the micro basis by thereference standard of the replacement ratio. No indices of consumption smoothing on themacro basis have yet been invented.
A similar way of thinking in deriving the new measure of poverty on the macro basis,
mentioned above, could be a great help to propose a new index of inadequacy (forconsumption smoothing) on the macro basis.
【Acknowledgements】
The present author is deeply indebted to the valuable comments and helpful advices
from Dr. Xinmei Wang and Mr. Susumu Yamamoto for writing this paper. The author isvery grateful for research grants from the JSPS KAKENHI (19H01496).

6References
European Commission (2006), Adequate and Sustainable Pensions: Synthesis Report
2006, European Communities.
European Commission (2018), Pension Adequacy Report 2018: Current and Future
Income Adequacy in Old Age in the EU, Vol.1, European Union.
ILO (1952), C102—Social Security (Minimum Standards) Convention.
ILO (1967a), C128—Invalidity, Old-age and Survivors’ Benefits Convention.
ILO (1967b), R131—Invalidity, Old-age and Survivors’ Benefits Recommendation.
Takayama, N. (1979), “Poverty, Inequality and Their Measures: Prof. Sen’s Axiomatic
Approach Reconsidered,” Econometrica, 47 (3), pp. 747-759, available on thewebsite below:
http://takayama-online.net/English/pdf/Poverty1979.pdf
Takayama, N. (1997), “Summary Comments by Rapporteur,” presented at ILO-OECDworkshop on Development and Reform of Pension Schemes, Paris, December,available on the website below:
http://takayama-online.net/English/pdf/eng-1.pdf
Takayama, N. (2019), “How to Make Pension System Financially Sustainable?”available on the website below:
http://takayama-online.net/pie/stage3/Japanese/d_p/dp2019/dp679.pdf
Its Chinese version is published in China Labor, DOI:10.19390/j.cnki.chinalabor.
2019.05.006
Zhao, Q., Li, Z. & Wang, Y. (2019), “Adequacy Analysis of the Basic Old-age Pension
System Based on Local Administrative Data in China,” a paper presented at the
7th workshop on China-Japan Joint Research Project on Pensions, 25-26
November, RIPPA, Tokyo.

7

Figure 1

Consumption Function and Degrees of Pension AdequacyC
the 45-degree line

C = f (Yw)

C = f (Yt)0

Yw, YtNote: C, Yw, and Yt denote the monthly reference standard (amount) of consumption
expenses in old age, the monthly amount of lifetime-average wages and salaries,
and the monthly amount of lifetime-average wages and salaries combined withincome from other sources, respectively. It is assumed that the numerator of thereference standard of pension adequacy is given by the amount of consumption
expenses.

【Acknowledgements】

8