Financing social security

The financial, economic and administrative cost to the poorest countries of establishing or expanding a publicly funded social security system is substantial. There is always a risk that such schemes will become a drain on revenue and distort the allocation of resources while at the same time serving only a limited and already privileged sector of the population. Most developing countries have social security systems which provide social insurance against individual loss of income by sharing the risk among the population. Schemes most commonly cover at least work-related injury and retirement pensions for those leaving work because of age or disability. However, many such schemes are small and limited to urban workers in the formal sector. Usually less than 10% of the population is covered, that coverage beings closely related to income, work skills and the influence of pressure groups. By contrast, the more urbanized, middle-income countries have social security arrangements covering most of the work force, receipts exceeding 5% of GDP.

Disability, unemployment and maternity benefits are financed by mandatory contributions from workers and their employers. For pensions, current contributions to the scheme may be used to finance current benefits, or there may be a system of reserve funds equalling future benefit payments, or there may be a combination of the two systems.

The payment of benefits in most developing countries is substantially below the income received, especially where the scheme is new or where those contributing far outnumber those benefiting. Nevertheless, social security systems easily become insolvent and this can have implications for broader public finance. Surpluses generated at the early stage of a scheme can quickly be dissipated if they are used to fund low-return general government activities or if they become eroded through high inflation (governments may invest reserves in nominally fixed assets such as government bonds). Governments tend to see social security reserve funds as a readily available source of long-term financing and may use them for projects that misfire. Demographic factors are also important. The dependency ratio (the number of beneficiaries for each contributor) can alter due to decline in birth rate, increased life expectancy or increased emigration. All these can adversely affect the scheme's financial position. Finally, a balance has to be achieved between adequate benefits for the poor financed by redistribution from the rich and individual equity (providing benefits based solely on an individual's own contributions).

The use of general funds to subsidize social security can be inequitable, since those covered tend to be those already in a better financial position. In order to reduce the burden and extend the coverage of a social security scheme a government may: (a) instigate sustainable benefit bases. Thus the age at which a worker may receive benefits may be increased; social security programmes can be structured so that growth in benefits is tied to growth in revenue (indexed benefits mean indexed revenue); and benefits may be brought into line with an individual's whole earning history rather than basing it on the last few years (peak) earnings; (b) introduce autonomous social security funds. Current contributions would equal actuarial premiums and managers of funds would be responsible for providing benefits which were actuarially fair and based on social insurance principles; managers would be accountable to beneficiaries and the funds (which would be subject to government oversight) would receive incentives to promote high-return investment; (c) target social assistance. The provision of social assistance for redistributive purposes through social security risks financial insolvency and lack of autonomy. The World Bank recommends that social assistance should rather be funded from general revenue and kept apart from social security funds.