The impact of ageing population on pay-as-you-go pension systems: The case of Luxembourg

Financing of the Luxembourg pension system is based on a pay-as-you-go system and hence on an intergenerational contract.
As is the case for most other European countries, this system will be exposed to the effects of demographic aging over the coming decades.
The aim of this paper is to evaluate the impact of this demographic deficit on the long term sustainability of the Luxembourg pension system.
We proceed in two steps. In a first step, we highlight the evolution of salaries in Luxembourg. To this end, we use the recent statistical group based trajectory model of D. Nagin (Nagin 2005).
We estimate model parameters from a single database, provided by the general social security inspection office (IGSS) and containing annual salaries of all wage earners in the Luxembourg private sector.
As a result we divide up the population into nine groups, each with its own mean salary trajectory in time and its relative weight in society.
In a second step, we evaluate the pension system by means of a new criterion. This is the sustainability coefficient, which we define as the average amount (in euros) that the labor force has to earn to fund one euro of pension payments,
based on current legislation. Our estimations show the high sensitivity of the coefficient to demographic variables and highlight the risks threatening the Luxembourg pay-as-you-go system.
To this aim, we develop a theoretical model consistent with our statistical analysis. This model allows for the determination of both the initial level and the evolution of the pensions for each of the groups identified in the first step of our work.
Knowing the weight of each of the groups within the Luxembourg population, we are then able to evaluate the sustainability coefficient of the system.
This corresponds to comparing the sum of all incomes of the labor force to that of all the pensions paid to pensioners at a given date while taking into account the growth rate of the population in time.
Finally, we interpret our results in the light of other sustainability criteria, such as the rate of contributions which ensures long-term stability of the pension level under the current legislation or the pension level that current contributions are able to finance in the long run.