Rational Pension Policies

Börsch-Supan, Axel Article Rational Pension Policies Swiss Journal of Economics and Statistics Provided in Cooperation with: Swiss Society of Economics and Statistics, Zurich Suggested Citation: Börsch-Supan, Axel (2016) : Rational Pension Policies, Swiss Journal of Economics and Statistics, ISSN 2235-6282, Springer, Heidelberg, Vol. 152, Iss. 2, pp. 103-124, https://doi.org/10.1007/BF03399424 This Version is available at: https://hdl.handle.net/10419/186058 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ © Swiss Society of Economics and Statistics 2016, Vol. 152 (2) 103–124 a Keynote speech at the Annual Congress 2015 of the Swiss Society for Economics and Statistics on “The Solvency of Pension Systems” Basel, 3 June 2015. b Munich Center for the Economics of Aging (MEA) at the Max-Planck-Institute for Social Law and Social Policy; Technical University of Munich (TUM); and National Bureau of Economic Research (NBER), Cambridge, Mass. Rational Pension Policiesa Axel Börsch-Supanb SUMMARY Aim of this keynote is to develop a framework how to approach the design of pension policies as rationally as possible. The first step is to realize and accommodate endogenous adjustments. The second step is to align the root causes of demographic change with corresponding reform steps which include but are not confined by pension reform. The third step is to separate the issues as best as possible to strengthen the political feasibility of reform. The paper shows that relatively few and moderate reform steps suffice to solve the demographic problem in countries such as Germany and Switzerland. This is in striking contrast to the widespread resistance to reform. We falsify some of the myths, prejudices and misperceptions which make reforms politically so hard to put into place. 104 Axel Börsch-Supan Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) 1. Introduction In all countries, pension policies stir great controversy and provoke often explosive and highly emotional reactions. Pension reform is called the “third rail” in politics, referring to the high voltage rail in underground transportation (Safire, 2007). Touching it spells trouble. Pension reform attempts have caused violent demonstrations in countries with a strong leftist movement such as France and Greece, but pension reform has also failed in the archetypical capitalist country of the United States, where the last significant reform took place in 1983, followed by 25 years of debate and several commissions without producing a tangible result. Even in this country, Switzerland, which is known for its sober and realistic attitude towards economic issues, pension policies are difficult to enact because voters with many different interests have to be convinced if a new policy should pass the necessary referendum. Aim of this keynote is to develop a framework how to approach the design of pension policies as rationally as possible. It is an analytical approach for policy designers, not necessarily a communication strategy for policy makers. Hence, the lecture starts with a brief description of the problem to be solved and a macroeconomic analysis of what turns out not to be a problem. The second part, which is the core of the lecture, structures the demographic problem by the various root causes and aligns them with the corresponding reform steps, including pension reform but also much broader policy changes. I will map these reform steps into examples of pension reforms which have already been done across the world. As it turns out, only relatively few and moderate reform steps are necessary to solve the demographic problem in most countries, including France, Germany, Italy, and this country. The third part then attempts to answer the question: Why is it so hard to solve a problem which could be solved with a few moderate reform steps? This leads us into the field of political economy and the myths, the prejudices and the lack of understanding how the fundamental developments in our aging world work. 2. Demographic Background The demographics of ageing population are well known. Figure1 depicts the old age dependency ratio (the number of persons aged 65+ divided by the number of persons aged 20–64) and how it will change from 2010 to 2030 and from 2030 to 2050. There are two groups of countries: relatively young countries (e.g.: US, Rational Pension Policies 105 Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) Figure 1: The demographic challenge: Old-age dependency ratio 2010–2050 40/100 80/100 49/100 } } } } } } 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 United States United Kingdom Norway Denmark Sweden Estonia Ireland Canada Hungary Netherlands Finland Switzerland Belgium France Slovakia Czech Republic Poland Austria Slovenia Greece Portugal Germany Spain Italy Japan 2050 2030 2010 Note: Number of individuals aged 60+ divided by number individuals aged 20–59. Source: Own depiction based on data from Eurostat (2013) 106 Axel Börsch-Supan Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) 1 Since one minus the square root of two is 0.41. UK, Scandinavia) and relatively old countries (e.g.: Mediterranean countries, Japan, Germany). Switzerland is in between the two groups. While the levels of dependency are quite different across these countries, the change over the next 15 to 35 years is about the same, an important insight: the dependency ratio will about double. What does this mean? If a burden doubles and has to be divided among two parties– here the young generation and the old generation– then the additional burden is about 40% for each party.1 Translated into pension financing, this means an about 40% increase of contributions and an about 40% reduction of benefits. These are serious changes. There is the danger that the benefit cuts will drive some people into poverty and that the increase in contributions will reduce labor supply such that the pension system nevertheless fails to regain solvency. Even worse, both could happen. There is a serious trade-off– or conflict– between the adequacy of pension benefits and the solvency of the pension system. The situation is even more dangerous because not only the pension system but the entire economy of a deeply aging country will get under pressure. To see this it is helpful to visualize the magnitude of the underlying demographic forces in macroeconomic terms. As a rough first approximation, we do the following hypothetical exercise and very simplistically equate the number of workers with the productive capacity of a country. If this were the case, then economic growth would decline in proportion to the decline of the number of workers per capita of the population. This is shown in Figure2 for the European Union, the US and Japan. First, the large swings are noteworthy. They reflect the demography of the baby boom/baby bust transition and its secondary and tertiary effects on the children and grandchildren born by the baby boomers and missing from the baby bust generation. Second, the annual percentage loss in working age individuals per capita of the population would be substantial in some periods, namely up to two percentage points, i.e., about as large as the usual productivity gains. This would bring economic growth more or less to a halt during these periods. Rational Pension Policies 107 Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) 3. The Power of Endogenous Macroeconomic Adjustments Fortunately, the bleak picture derived from Figures1 and 2 will only become reality if nothing else except demography will change. However, this is unlikely to happen for two reasons. First, even in the absence of policy interventions, there will be endogenous macroeconomic adaptations to an aging population. Demography does not translate one to one into economics since there are forces within economics which tend to moderate demographic shocks. This is important for a rational policy approach. Part of the problem will be solved by itself if only market forces will be allowed to work themselves out freely. There is thus less left for structural reform than suggested by the 40%/40% back-of-the-envelope calculation of the previous section. Second, even given the widespread recent resistance to reform by the populace, we do observe a slow but steady adjustment of policies to an aging world. I will address the endogenous macroeconomic adjustments in this section and the policy adjustments in Section4. “Nothing else changing” is impossible in an economy which is aging as dramatically as described by the doubling of the old age dependency ratio. Very fundamentally, dramatic aging will not leave relative prices unchanged. The Figure 2: The macroeconomic challenge: Annual percentage loss of workers per population, 2010–2050 – 0.030 – 0.025 – 0.020 – 0.015 – 0.010 – 0.005 0.000 2010 2015 2020 2025 2030 2035 2040 2045 EU3 Japan USA Source: Own depiction based on the data in Eurostat (2013). 108 Axel Börsch-Supan Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) 2 Since the stock of productive capital adjusts slowly to the number of workers. 3 Since labor mobility tends to be slow. 4 These models follow the tradition of Auerbach and Kotlikoff (1987). Earlier versions with international exchange are Attanasio et al. (2007), Börsch-Supan et al. (2006) and Fehr et al. (2003). most important price signal will be increasing wages relative to the price of consumption goods since in an aging economy there are more old people and fewer young people, thus also fewer workers per consumer. In addition, wages will increase versus the rate of return of capital because the number of worker will decline faster than the stock of productive capital.2 Third, domestic wages in an aging country will increase versus the wages in more youthful countries, since labor will become scarcer in old relative to young countries.3 The relative price changes will then change the allocation of labor, capital and consumption both within and between countries. These endogenous adaptation mechanisms will make the aging problem substantially less severe than the simplistic conclusions from pictures such as Figures1 and 2 suggest. One cannot directly translate demographics into macroeconomics. More sophisticated economic models are required which describe the substitution between labor and capital within a country and the shift in production from old to young countries, two mechanisms which are of particular importance for Switzerland. These mechanisms are endogenous in the sense that they will happen automatically even without policy interventions at least in a free market situation. Figure3 is based on such a macroeconomic model for the combination of France, Germany and Italy, representing the three largest economies of an aging Europe. The model takes the US as the counterpart of a relatively young country. The model is explained in Börsch-Supan et al. (2014) in more detail; it is a conventional model of overlapping generations augmented by international trade and capital flows and frictions in the labor market typical for the three countries on which it is based. While the model is highly stylized, it is calibrated to reproduce economic growth and international trade of the recent decades.4 Figure3 shows four trajectories. The lowest one is the essence of demographic aging for a macroeconomy, namely the number of workers per capita of the population, usually called the support ratio. It declines by about 20 percent for the average of the three countries between now and 2050. Based on the same demographic projection as Figure2, this is exactly the same loss of productive capacity which was shown in that figure. Rational Pension Policies 109 Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) GDP per capita, however, does not decline as quickly as the support ratio but about 5 percentage points less. This reflects the substitution of labor by capital. Since wages go up because labor becomes scarce in an aging population, and rates of return decline relative to wages, capital intensity will increase. The relative lack of young workers is therefore partially compensated by an increase in the number and sophistication of machines, computers etc. in the production process. This first endogenous mechanism is no surprise to an educated economist; it is, however, quickly ignored in the public discussion. Moreover, its size is substantial, solving about a quarter of the macroeconomic aging problem. The second beneficial endogenous mechanism is international diversification. Figure3 shows gross national product (GNP) per capita in addition to gross domestic product (GDP) per capita, i.e. total world income earned by French, German and Italian residents as opposed to total production generated within French, German and Italian borders. Differences between GDP and GNP can get substantial in aging countries because of wage and rate-of-return differences. For aging countries, it is worthwhile to shift production of consumption goods to abroad because labor is scarce in the home country and returns to productive capital are higher abroad. The foreign direct investment creates income for the aging countries. Figure 3: Endogenous adaptation mechanisms: support ratio, GDP, GNP and consumption per capita (international diversification: 2005 100%, detrended) 75% 80% 85% 90% 95% 100% 105% 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 consumption/capita GNP/capita GDP/capita Support ratio GER ITA FRA compared to USA Source: Börsch-Supan et al. (2014). 110 Axel Börsch-Supan Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) GNP per capita will still increase for some while during which the support ratio already is in decline. Afterwards, GNP declines less and at a slower pace than the support ratio. The baby-boom generation will first participate in foreign direct investment and then repatriate the returns. This, in turn, permits to dampen the decline in consumption per capita, the fourth trajectory in Figure3. While the support ratio declines by about 20 percent until 2050, consumption per capita only declines by about 10 percent during the same time. Hence, half of the macroeconomic aging problem will actually be solved by endogenous forces– at least if one allows for a significant increase of the capital intensity within the aging country and if one lets capital move freely across borders. This is an important message for public policy and puts purely demographic scenarios in some perspective. On the one hand, as already emphasized, the economic problem is substantially smaller than demography suggests; less has to be done by structural reform. On the other hand, these two conditions (free adjustment of capital intensity and free trade and capital movements) are by no means trivial and often highly political. The first condition requires the installation of more capital intensive production technologies -- but not all unions support this. The second condition requires open borders for capital, goods and services -- but we often observe protests against globalization, e.g. at the G7 summit in Bavaria at the same time as this keynote speech. 4. The Power of Policy Adjustments While about half of the demographic problem can be solved endogenously by macroeconomic adaptation, for the other half one actually has to change the underlying structure of labor markets and pension systems. Figure4 uses the same macroeconomic model underlying Figure3 and shows projections of living standards (here: GDP per capita) under various policy scenarios. Scenario A, the lower of the three trajectories, represents the status quo, i.e. no policy changes. The decline of 15 percentage points corresponds to the scenario which was depicted in Figure3. In Scenario B a lot will change and many of the current labor market restrictions in the three countries will be released such as mandatory retirement age in Germany, the 35-hour week in France, and the unavailability of child care for many Italian women who want to work and have children. This is modelled in a very stylized way by imposing the labor market participation rates that are currently observed in Denmark. Rational Pension Policies 117 Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) and the duration during which benefits are being paid which is determined by the retirement age. We argue that establishing an indexation rule minimizes the problems of the political process for both dimensions. So the level of annual benefits should be indexed to the demographic pressures on the pension system, and the duration of retirement benefits should be indexed to the expected duration of life. There are many ways to do this in practice. They will be discussed below along several country examples. While fully funded systems are, by definition, always solvent with respect to demography, there is nevertheless need for reform. We observe breakdowns of private and public pension funds, very low returns to the invested contributions and similar problems which may be summarized as governance failures. Many of these issues are related to poor transparency, and they are, unfortunately, not confined to individual accounts and occupational pension schemes but also include public provident funds (Palacios and Pallarès-Miralles, 2000). Note that these issues can and should be discussed quite separately from the issues of poverty prevention and PAYG reform. This holds even more for the third layer of necessary reform steps: offsetting the lower number of children by their higher productivity through better education and a consistent approach to life-long preventive health care. 5.3 Country Examples Since pension policies have been developed over time in different cultural, economic and historical circumstances, examples for policies in each layer of Figure6 differ from country to country. Regarding the first layer of reforms, the introduction of a means-tested base pension was actually the first step of the pension reform sequence in Germany from 2001 to 2007. It turned out to be politically very helpful that this thorny issue was out of the way before the next reform steps– introduction of Riester pensions, indexing the PAYG system and increasing retirement age– were legislated, see Börsch-Supan and Wilke (2003). In turn, the Swiss and Dutch first pillars combine poverty prevention with the base pension for a “normal worker” in the PAYG part of their multi-pillar pension systems. This appears to make reform harder for each of the addressees. Since it is a combined pillar, reducing it in order to solve the sustainability problem cannot be separated from creating higher old-age poverty. Indexing to life expectancy, pioneered by Norway, has now been successfully introduced in parts of the French system. Note that increasing the retirement age by the same amount as life expectancy increases amounts to over indexing. 118 Axel Börsch-Supan Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) The essential point is to keep the proportions in life constant. Roughly speaking, working life lasts twice as long as life in retirement. Hence, if we were to live 3 years longer, then it would be perfectly fine to enjoy one more year in retirement but this year has to be financed by two more years of working. This rule has been implemented in Germany in a long gradual transition from 2007 through 2029. Indexing benefits to the system dependency ratio is a way to preserve the “defined benefit” character of a PAYG pension system at the same time as it is shrinking in order to make it sustainable. This was the idea of the so called “sustainability factor” in Germany (Kommission, 2003). It indexes the replacement rate with respect to the number of recipients of benefits from the pension system, divided by the number of contributors to the pension system who finance these benefits. Such an indexation system creates an automatically stabilizing system which, if consistently applied, will be always solvent. There are more elegant ways to introduce both indexation mechanisms in one stroke. A good example was the introduction of a notional defined contribution (NDC) system in Sweden and Italy after several parametric reforms failed (Palmer, 2000; Holzmann and Palmer, 2003; Franco and Sator, 2003). It is interesting to observe that from a purely economic point of view, the “sustainability factor” in Germany will roughly create the same path of future benefits and contributions as the Swedish NDC system does (Börsch-Supan, 2005). Politically, however, a Swedish style reform was unfeasible in Germany because a NDC system smelled too much like a fully funded system which is distrusted by Germans. This is a good example why pension reform is so country specific. Rational pension reform has to take such irrationalities into account. In addition, governance may be easier in a small country like Sweden where social control is tight than in a large country like Germany. This may also be the reason why the occupational funded systems are working reasonably well in Sweden and Switzerland. Larger countries, such as Germany and the US, have relied more on individual account systems. In Germany, they have produced a very large range of rates of return, see Gasche et al. (2013). This study emphasizes the lack of transparency of the account information and computes life-time cost factors. Some plans have very low costs, less than 2% of lifetime contributions, but there are other plans in which administrative costs, including marketing and profits, make up for more than 80% of life-time contributions. Discussing the third layer of reforms (improving education and preventive health care) along country-specific examples would require a lecture by itself. Based on international comparisons such as PISA, TIMSS and PIAAC, countries like Germany and Switzerland fair ok in education but not top. The small Asian countries, e.g. Taiwan, are performing much better according to these studies. Rational Pension Policies 119 Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) 6. Perceived Obstacles to Rational Pension Policies Sections3 and 4 have shown that relatively few and moderate reform steps are necessary to “solve” the demographic problem in countries such as France, Germany, Italy, and Switzerland. Section5 has shown that there exists a well-defined structure how to think about pension reform and how to separate the various issues and problems underlying pension reform. Moreover, there exist a lot of examples how specific countries translated the general principles into separate building blocks of pension reform which can be recombined to fit another country’s preferences and restrictions. Then why is it so hard to solve a problem which could be solved with a few moderate and well-defined reform steps? This leads us into the field of political economy, the lack of understanding how developments in our aging world actually work, and the many myths and prejudices which make a rational pension policy so hard (Galasso, 2007; Boeri et al., 2002) and often produce timeinconsistent policy paths (Kydland and Prescott, 1977). These problems are much more general and fundamental than applicable only to pension reform (Rowe et al., 2009). We will only sketch these here and refer to Börsch-Supan (2014) for details. Many people share the misconception that health is declining quickly after age 60 such that most people cannot work anymore at the later retirement ages currently under discussion. This is not true for the majority of the population. Health declines very slowly between age 60 and 70, and the variation of health within each birth cohort is much larger than the difference of the average health between age 60 and age 70 (Avendano et al., 2005). This is therefore another example why separating issues is so important: declining health does not set limits to work for most of the population– but it does so for a substantial minority. Hence, declining health is not an obstacle to increasing the retirement age in general. However, accompanying policies are necessary to help the minority of individuals who suffer from work disability. A second prejudice concerns productivity. Many claim that it decreases with age such that it does not pay to keep older workers in the company. While it is correct that physical and cognitive performance peaks at relatively young ages, experience, management and networking abilities peak much later and show no decline at ages relevant for employment. Taken together, productivity stays relatively flat over the relevant age range. There is no evidence that productivity declines in normal production processes; neither in services nor in the manufacturing industry (Malmberg et al., 2008; Göbel and Zwick, 2009; BörschSupan and Weiss, 2013). 120 Axel Börsch-Supan Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) Then there is the wide-spread myth that if one creates more jobs for one group of the population then there are fewer jobs left for all other groups. This “lump of labor fallacy” is applied to old workers, immigrants or women, taking jobs from the young, the natives or men. It may apply for single sectors where output is restricted but grossly false for an entire economy which can grow and create additional jobs. Increasing the retirement age actually helps younger workers since it reduces their tax and contribution burden which would otherwise have to finance costly early retirement (see the country studies in Gruber and Wise, 2010). Finally there is the hope that retirement is bliss after an arduous working life. Indeed, retirement tends to improve health for those in stressful and physically demanding jobs. It has, however, also negative side effects, especially on cognition; e.g., Inactivity leads to a faster decline of memory functions (Adam et al., 2007; Rohwedder and Willis, 2010; Behnke, 2012; Coe et al., 2012; Mazzonna and Peracchi, 2012; Börsch-Supan and Schuth, 2014). Hence, early retirement is more of a two-sided sword than most people are aware of. 7. Conclusions The experience collected from pension reforms since the mid-1980s forms a body of knowledge from which one can distill a rational and effective multi-dimensional strategy for pension reform. Its main elements are: – to index the retirement age and the level of pay-as-you-go benefits in order to keep the proportions of life and the proportion between generations intact, – to introduce some extent of pre-funding in order to reduce the peak burden of aging, – to make sure that old-age poverty is prevented by a base pension which is insulated from demographic changes, and – to improve education and preventive health in order to compensate for low fertility. These building blocks can be recombined to fit each country’s preferences and restrictions. Not all problems have to be solved by active reform. There are endogenous macroeconomic adjustments which -- if left to work freely -- will reduce the incisiveness of discretionary reform. The most important mechanisms are substitution of labor by capital and international diversification. The strategy of a combination of active pension reform steps and endogenous macroeconomic Rational Pension Policies 121 Swiss Journal of Economics and Statistics, 2016, Vol. 152 (2) adjustments works even in “Old Europe” since there is– in theory– sufficient labor supply and saving capacity to offset aging in Europe. It only has to be mobilized. The resistance to reform in many countries appears to be rooted in strong prejudices about aging which are contradicted by evidence. Health at older ages is actually good and getting better for most individuals; productivity in standard jobs is essentially independent of age; the employment of older workers actually strengthens the job chances of the young rather than reducing them; and early retirement is not only a blissful salvation from work but also entails negative side effects, especially on cognition. 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