the macro-economics of pensions
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The Macro-Economics of Pensions. Adair Turner September 2 nd , 2003. Pensioner Income as a % of GDP. Today. 2030. If we assume Average retirement age unchanged Average pensioner income a constant proportion of average income. 13.5. - PowerPoint PPT PresentationTRANSCRIPT
The Macro-Economicsof Pensions
Adair TurnerSeptember 2nd, 2003
2
Pensioner Income as a % of GDP
If we assume
• Average retirement age unchanged
• Average pensioner income a constant proportion of average income
2030Today
3.8
8.0
5.5 5.5
Private
State
9.3
13.5
+4.5
3
Pension Claims Against Future Output –Three Current Models
Nature of Claim Risks PAYG STATE SYSTEM
Against totality of GDP Enforced via
contributions/ taxes
Political Indirectly – Demographic and
Macro-economic
FUNDED DC Against profits Volatility of: o Profit slice of GDP
Via ownership of equities and bonds
o Market price of equities and bonds
FUNDED DB Against profits Volatility of: o Profit slice of GDP
Via ownership of equities and bonds in the fund
o Bond and equity prices
But also via bond-like promise of the individual company
Bankruptcy of the individual firm
4
Two Near Equivalences
Compulsory DC scheme invested in Government index linked bonds
DC scheme invested in corporate bonds
and and
Tax financed PAYG DB average salary scheme
If the rate of return on index-linked government bonds is equal to rate of growth.
Still different in respect to
•Life expectancy risks
•Diversification of bond portfolio
But similar since DB schemes are bond-like liabilities
5
Key Question: How Best To Structure Pension Claims?
Against Future GDP
PAYG
Funded in government bonds
Against Future Profit Slice of GDP
DC in equities
DB
DC in corporate bonds
6
Two Possible Routes To Increased Pensioner Income
• Investment and future output unchanged, but some other group of savers relinquishes a matching claim on future assets and profits
• Savings and investments increase, and as a result, so does future output
7
1
3
7 7
2
4
2
3
5
8
3
7
3
2
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10-11 11-12 12-13 13-14
% Cumulative Average Return Over 20 Year Periods
Real Return On Large Stocks: US 1926 - 2000
Med
ian
7.9
____________________Source: Ibbotson Associates: 2002 Yearbook
Mean
7.2
No. of 20 Year Periods with Return in Range (57 Periods)
8
1
4 45 5
8
10
16
6 6
3 3
10
-12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27
% Cumulative Average Return Over 5 Year Periods
No. of 5 Year Periods with Return in Range (72 Periods)
Real Return On Large Stocks: US 1926 - 2000
Med
ian
8.5
5
Mean
7.6
4
____________________Source: Ibbotson Associates: 2002 Yearbook
9
8
6
10
7
9
43
2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10-11 11-12 12-13
% Cumulative Average Return Over 30 Year Periods
Mean
6.8
6
Med
ian
7.0
4
____________________Source: Ibbotson Associates: 2002 Yearbook
Real Returns on Large Company Stocks: US 1926 – 2001
No. of 30 Year Periods with Return in Range (47 Periods)
10
1
4
9
7
4
2
2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10-11 11-12
% Cumulative Average Return Over 50 Year Periods
Med
ian
6.9
9
____________________Source: Ibbotson Associates: 2002 Yearbook
Real Returns on Large Company Stocks: US 1926 – 2001
No. of 50 Year Periods with Return in Range (27 Periods)
11
Claims And Risks
Claim Against Inherent Risks
PAYG OR FUNDED IN
GOVERNMENT BONDS
Totality of future GDP — Wages and profits
Unanticipated variations in future GDP
FUNDED IN CORPORATE
CAPITAL Profit slice of
future GDP Unanticipated
variations in future profits
12
Dividend Valuation Model: Inherent Uncertainty
PV = Rational value of equitiesD0 = Current year dividends
r = risk free rate
PV =D0 (1 + g)1 + r + p + +
D0 (1 + g)2
(1 + r + p)2 (1 + r + p)3
D0 (1 + g)3
PV = r + p - gD0
p = equity risk premiumg = rate of growth
13
Risk Management And Risk Sharing In Funded Schemes
1. DC schemes – Managing the crystallisation risk
2. The DB to DC Shift Is it concerning or desirable? Is it inevitable?
3. Should DB schemes invest in equity?
14
Risks In Final Salary DB Schemes
CATEGORY OF
RISK
ABSORBED
BY
EMPLOYER
ABSORBED
BY
EMPLOYEE
CONSEQUENCE
Investment return
x
Changes in life expectancy
x No incentives for later retirement
Individual salary progression
x Complex accrued rights and transfer values – to disbenefit of early leavers
Overall risk borne
by employer is high
15
DB / DC Hybrids –Risk Sharing Alternatives
CATEGORY OF
RISK ABSORBED BY
EMPLOYER ABSORBED BY
EMPLOYEE
Investment return risk
x
Changes in life expectancy
x Pensionable ages increasing over time in line with life expectancy estimates
Individual salary progression
x Average salary based not final
16
Who Killed DB?
• Unanticipated increases in life expectancy Slow response to 1980s and 1990s mortality declines
• Increased life expectancy not matched by later retirement ages or increased contributions
• Irrational exuberance, apparent “surpluses” and contribution holidays
• Tax and residual ownership disincentives to very large surpluses
• “Costless” tax increase of 1997
17
How To Increase Resources For Future Pensioners
With aggregatesavings, investmentand output unchanged
Via increased savings, investment and output
Future pensioners claimhigher share of future capital and profits ….
Profits rise as % of GDP…
Domestic investment rises and thus GDP (and GNP)
Overseas investment rises and thus GNP (but not GDP)
OPTION 1:
OPTION 2:
OPTION 3:
OPTION 4:
At expense of other savers
At expense of future workers
18
Option 1: Pension Saving Up, Some Other Saving Down
Either• Increased pension saving, but offsetting dissaving by
the same people
• Increased pension saving but offsetting dissaving by “others”
19
UK Pension Fund Assets As a % Of GDP
____________________Note: Occupational schemes only
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
(est
)
Per
cent
20
% of UK Equities owned by individuals &UK pension funds 1963-93
____________________Note: After 1993 the % owned by individuals continued to fall, but so too did the % owned by UK pension funds. But the growing category in 1993-2002 was overseas investors (1993: 16%, 2002: 32%), many of whom are pension funds; and conversely UK pension funds have invested more overseas. The overall pension fund role in the market has therefore probably continued to grow
0
10
20
30
40
50
60
70
1963 1969 1975 1981 1989 1990 1991 1992 1993
Per
cent
UK Pension funds Individuals
21
Capital Investment And The Marginal ProductOf Capital
Quantity of capital invested
Rate of return
Savings Schedule 1
Savings Schedule 2
22
Fishing Boats, Fish And A Falling Population
Steady State
•1,000 population•500 per generation•500 working, 500 retired•Workers work
Half time fishingHalf time building a boat
•Boats wear out over one working life
Demographic Change
•500 generation of
retirees followed by
250 generation of
workers•Retirees would like to
sell 500 boats they
have built•Workers only need to
buy 250 boatsRelative price: 1 boat = ½ of catch for one working life
Price of boats, relative to fish, will fall
23
Funded Pensions in Corporate Capital: Two Dimensions
Claim on future Cash Profits
• Selling price of accumulated assets must equal the discounted value of future cash profits thereafter
• Funded pensions are a claim on future profits
Inter-Generation Funds Flow
•Value of Generation 1’s asset decumulation must equal Generation 2’s asset accumulation
•Future pensioners consumption is financed from future workers’ consumption deferral
24
Rising Longevity, Constant Fertility
Same trade-off in each generation
No change in retirement age
• G 1 saves more
• Capital stock increases, returns decline
• Asset prices unchanged since
G 2 has same target capital stock as G 1
Required returns fall in line with actual
Different trade-off
G 2 chooses later retirement
• G 1 saves more
• Capital stock increases, returns decline
• Asset prices fall since G 2 has lower target
capital stock than G 1 G 2’s required returns
have not fallen (relative to the no rise in longevity base case)
25
Falling Fertility, Constant Longevity
• Generation 1 keeps saving as before (since longevity unchanged)
• In Generation 2, unchanged capital stock but less labour
Lower returns to capitalHigher real wages
• Value of assets falls becauseReturns down, discount rate unchangedG 2 has lower target capital accumulation than G 1
26
Demographic Impacts on Returns to Capital: Model Results
Garry Young: Baby-boom generation -0.1%Increased longevity -0.1%Falling fertility -0.3%
David Miles: Given future actual trends in UK demographics, returns fall:
• 4.56% (1990) to 4.22% (2030)• 4.56% (1990) to 3.97% (2060) if
PAYG phased out
27
Financial Asset Prices – Transitional Effects
Long-Term Impact – Higher Capital Stock– Lower Long-Term Returns
Transitional Impact– Increased demand for initially sticky supply– Rising financial asset prices
Increase inAggregate SavingsRate
Long-Term Impact – Fall in long-term equilibrium returns– e.g. 4.6% 4.2%
Transitional Impact– From PV=
– To PV=
– Fall of 10% if r and p unchanged
Fall in AnticipatedFuture Rates of Return 4.6
r+p
4.2r+p
28
Overseas Investment as the Solution –Conditions Required
Other countries to invest in which have
•Different demographics – dependency ratios not rising
•Economic success – growingper capita GDP
Increasing numbers of productive and prosperous future workers able to:
• Provide future output available for consumption
• Buy capital assets from decumulating savers in the investor countries
+Small numbers of domestic decumulating pensioners also trying to sell assets
29
25
65
10
19
60
21
Demographic Change in UK and China –UN Medium Variant% Population by Age Band
20502000
UK
China
26
60+ 15-59 0-15 Years
16
54
30
16
54
30
30
The Fundamental Choice
Increasing longevityplus falling fertility
Some mix of:
• Future pensioners poorer relative to average income than today
• Future workers must give up more consumption in savings, contributions or taxes
• Retirement ages must rise