Sustainability of pension reforms: An EU-wide political stress test

Abstract Many countries have implemented a variety of pension reforms in response to the challenges posed by an aging population. These reforms typically involve a trade-off between ‘refinancing’ (i.e., increasing contributions) and ‘retrenchment’ (i.e., reducing benefits). The primary question addressed in this study is whether policymakers in the European Union (EU) possess the necessary capacity to sustain legislated pension reforms, particularly given the growing political influence of the elderly. To examine this issue, we develop a bargaining model designed to optimally allocate the economic burden of aging between successive cohorts of workers and retirees, incorporating retirement incentives. In a scenario where bargaining power remains constant, the optimal allocation rule dictates a fixed-contribution system, effectively shifting the full burden of aging onto the elderly. However, when bargaining power is allowed to fluctuate in response to changes in the relative size of the retiree population (i.e., the dependency rate), the optimal allocation rule involves a compromise between increasing contributions and reducing benefits. In the empirical analysis, we compare these theoretical optimal allocation rules with projections of pension benefit rates and dependency ratios from the 2021 Economic Policy Committee. By calculating the implicit bargaining power required to align projected pension benefits with the optimal sharing rule for each year, we demonstrate a growing divergence between projected pension benefits and the optimal levels in many EU countries, as demographic shifts progress. Furthermore, our findings indicate that for most countries, projected pension benefits are increasingly falling below optimal levels when bargaining power adjusts in accordance with population aging.