The Need of Intergenerational Equilibrium:

Going Beyond Parametric Adjustments

within Pension Systems in Europe

Marek Góra

Warsaw School of Economics

AARP and European Centre, Dürnstein, October 2008

Economic and social background for traditional pension systems as well as the systems themselves originate from distant past.

Since that time population structure passed not only quantitative but also deep qualitative change.

Quantitative-parametric adjustments within pension systems, although needed, are insufficient given the scale of the change.

Ageing in OECD countries

Demographic (low fertility, high longevity) as well as policy driven processes (early retirement) led to a situation in which in 2004 average man in OECD countries drew a pension for 18 years and average women for 23 years, while in 1970 that numbers were 11 for men and 14 for women.

In OECD countries one person aged over 65 is per five people aged 20 to 65 years. In 2050 there will be one per two. This process is strongly advanced mostly in Europe and in Japan.

Demographic transition

1900s1800s1700s

Stage 1 Stage 2 Stage 4Stage 3

Birth Rate

Death Rate

2000s

DemographicGrowth

Population

birth and death rates

population

GDP divided between generations

time

GDPR_______

GDP

1

0

A

B

C1opt. (?)

C2opt. (?)

What shall be changed to bring pension systems back to reality?

Country specific response to that questions

„Wealth trap”

The pension system (macro perspective)

The pension system is a way of dividing current GDP between a part kept by the working generation and a part allocated to the retired generation.

If GDPR/GDP = const. economic neutrality (production factors remuneration not affected)

RW GDPGDPGDP

Proportions of the division are subject to public choice.

The pension system (micro perspective)

From the individual perspective, the pension system is a way of income allocation over life cycle. In the activity period individuals buy pension rights; after retirement they sell the rights.

If PV(C) = E[PV(B)] actuarial neutrality (decisions on income allocation over life-cycle not affected)

The pension system is an institutional framework for intergenerational exchange. The system should aim at balancing of interests of the retired and the working part of population.

In the pension system there are only those who pay contributions and those who receive benefits. Irrespective to its particular design, the retired consume a part of GDP produced by the working generation.

The pension problem we face is not the problem of the scale of GDP but the problem of how to divide current GDP between pensions and remuneration of production factors (I leave out other transferres).

As long as pensions are related to wages -- even if economic growth were strong -- the pension problem stays unsolved. By the way, growth will not be strong if production factors are not remunerated adequatly to their productivity.

11

Financial sustainability of pension systems can be improved by:Increasing retirement age;Increasing labour participation in working age;Reducing indexation of benefits;Increasing the contribution rate or taxes (???)

Rationalisation is needed but insufficient. Even if it is implemented at a substantial scale it should be followed by a systemic reform.

In the past the key goal of pension system was old-age poverty alleviation. Now this goal is still important but it can be reached more efficiently via the budget, while publicly or privately run universal pension systems’ goal is providing people with a method of income allocation over life cycle. At the macro level that leads to intergenerational equilibrium.

Intergenerational equilibrium if:

GDPR/GDP = constant (macro perspective)

PV(c) = E[PV(b)] (micro perspective)

GDP1

GDP2

GDP1T1

R1 R2

T2

A pension reform can mean:

Implementation of a mechanism that generates pension rights, hence also sets pension expectations at the level that can be maintained without an increase of burden put on the next generation;

Channelling flows of contributions through financial markets in a way that generates positive externalities for GDP growth;

In the system based on individual accounts pension rights are constantly valuated, hence automatically adjusted.

Individual accounts let design the pension system in a way that interests of the workers and the retirees is equally valued.

Such pension system – being still dependent on demography – can work in any given demographic situation.

If the system individualises participation then the role left for the state is regulation and supervision.

Pension systems can be divided into two classes:

public (universal, mandatory), in which the need to decide is limited but at the same time responsibility for future outcomes of that decision is spread over the entire population;

Private (non-universal, voluntary, additional), in which individual decisions are crucial and responsibility for their outcomes is on individual participants.

The above should not be confused with public or private management of systems.

Key objective for pension reform is to reduce ex ante pension expectations expressed in relative terms.

The only other option is to adjust pensions ex post, which means reduction of pension levels in absolute terms.

Four dimentions of discussion on pension systems:

Key objective (redistribution vs. income allocation)

Coverage (universal/public vs. group/private)

Management of the system (public vs. private firms)

Financing method (financial markets vs. real economy)

A universal system can be perceived as and called a public scheme, while non-universal schemes can be called private. This classification of systems does not imply public/private ownership of institutions running pension systems. In particular a private firm can manage a part of the public pension system. This is a special case of the public-private partnership implemented within social security – but not privatisation of the system. Contrary, the private sector enters social security taking a role in providing people with social security.

If redistribution is finance via the budget then:

Broader redistribution base;

Social needs can be better addressed (adjustability);

Pension system becomes transparent.

Traditional pension system is typically kept within an etatistic framework.

Pension system based on individual accounts extended by budgetary discretional interventions is closer to the principle of subsidiarity.

Traditional pension system focuses on the retirees while the system based on individual accounts balances interests of retirees and the interest of the working generation.

Funding (FDC) is not a solution to pension system problems. Funding is just a useful method pushing the system towards intergenerational equilibrium.

We can achieve the same goal not using financial markets (NDC).

Both approaches have advantages and disadvantages. We can apply a combination of the two.

A deep systemic pension reform is inevitable since the Ponzi game is over.

The sooner the reform is implemented the lower its economic and social cost.

Individual accounts instead of traditional anonymous system is a change of method – not giving up the social goals of the system.

Key features of the Polish approach Focusing on the mandatory part of the pension system;Separation of OA and NOA;Termination of the OA part of the previous system;Creation of entirely new OA pension system based on saving in the activity period and insurance after retirement;Splitting each OA contribution between two individual retirement accounts per person;Annuitisation of account values at the moment of retirement;Minimum pension supplement on the top of both annuities if their sum is below certain level (paid out of the state budget).

Two DC arrangements

Two pension arrangements dominate discussions on pension reforms:

Non-financial (notional) Defined Contribution (NDC) – individual accounts not using financial markets, generating rate of return equal GDP growth rate;

Financial Defined Contribution (FDC) – individual accounts using financial markets, generating rate of return determined in the markets.

Two Accounts: Similarities and Differences

NDC and FDC are almost identical from both individual and macro perspective.NDC and FDC are managed differently and different are possible positive externalities they generate.Neither NDC nor FDC plays any redistributive role

Contributions before and after the reform

TotalNDC

individual accountFDC

individual accountOther parts of the

system

before 1 Jan 1999

Social security contribution 36.59 -- -- --

after 31 Dec 1998

OA contribution 19.52 12.22 7.3 --

NOA contribution 17.07 -- -- 17.07

Phaising-in

New system (people born after 31 Dec. 1948) Old system (people born before 1 Jan.

1949) People born after 31 Dec. 1968

People born before 1 Jan. 1969

Automatically covered by the new system; OA

contribution automatically split

between two accounts [NDC+FDC]

Automatically covered by the new system; OA

contribution either split between two

accounts or paid into one account

[(NDC+FDC) or NDC]

Stay in the old system (no possibility to

switch for the new one);

no accounts

The choice made by those born after 1948 was kept within the new system and did not really affect their future pensions

Public-Private Partnership

Pension reform was not privatisation of social security

Entire OA pension system stays public. Its part is just privately managed.

The remaining part of the system could and should also be privately managed – which would not change the nature of the system itself.

Implementation of pension funds was a part of the method applied, not the goal of the reform.

Projection of pension expenditure

Countries marked according to level of expenditure:

green – low and/or decreasingyellow – intermediatepurple – high and/or increasing.

Poverty risk by age