Remodeling Public Funding of Pensions in response to Demographic Change - Research Paper Example

Order 424219 Remodeling Public Funding of Pensions in response to Demographic Change Demographic changes appear to threaten the viability of several pillars of the welfare state in particular with respect to public funding of pensions. How might the funding of and spenidn on state pensions be reformed to take account of falling population and longer life expectancy. How important are differences between the current pension arrangements of OECD countries in shaping their responses to demographic change. Introduction The theory of demographic transition presents the relationship between the demographic change and economic development in structured and stylized form. The process of demographic transition starts with a decline in mortality and decline in fertility which lead to first increased and then decreased population growth. The last phase of the demographic transition is characterized by the slow population growth and hence falling population. This last phase is again featured by the aging of the population. The decreased birth rate and decline of mortality causes falling population and increased life expectancy. The speed and depth of the demographic transition are influenced by the factors like migration, health, political and cultural issues. Aging has become an important issue in most of the developed and developing countries challenging the whole social security system. The larger proportion of world population are becoming more and more elderly. It has been estimated that 26% of the OECD population will be over 60 years of age while at present the proportion is only 19%. By losing earned income and deteriorating health, aging causes economic insecurity to the people. Family support continues to be the most important financial support in most of the Asian Countries. But in other parts of the world majority of elderly find difficulty to avail family support and hence they are compelled to depend on the assistance provided by the state, pensions and also charity. Aging and the need of Social Security Network The responsibility of providing security and adequate standard of living for older people becomes the responsibility of individuals as well as of society. A social security system is the main way through which a society can construct a protection net for its elderly people to help them for making the future plans and protect them from and to protect them from dearth. The future demographic developments would present significant challenges for social security systems. Besides, the recent financial crisis has shown that social security networks may be affected seriously during economic turmoil. Hence under the changing demographic conditions of a volatile country, optimization of pension financing continues to be an important issue. The recent economic crisis also points out the importance of proper investment and government policies for social security networks based on the Defined Contribution Principle so that the retired people can avail an adequate income to maintain a decent standard of living. The issues of sustainability of social security systems and pension systems in particular and the impacts of demographic changes on the social security systems attract the attention of professional organizations as well as of governments. OECD countries and Demographic Changes The current fertility rates are estimated to be below 2.1 children per woman in all OECD countries except Turkey and Mexico. In 11 OECD countries including Switzerland, Japan and Germany, the rate is even below 1.5 children per woman. Countries which were traditionally known for high fertility rate now belong to the group of countries with lowest fertility rate in the world (that is, the fertility rate is 1.2 children per woman). The demographic change seriously affects the dependency ratio of the population. The dependency ratio means the proportion of children younger than 15 and elderly people of age 65 and above to the working age-population (that is the people aged 15 to 64). The major impact of demographic change is the alarming increase of dependency ratio. In most of the regions, the dependency ratio is increased not because of the younger population instead ageing causes to increase the dependency ratio. It is said that in Europe, there will be one older inactive person for each and every working age person. It is expected that the share of old-aged population will be doubled over the next 50 years in OECD countries. This demographic effect goes along with a trend towards earlier retirement. The overall effect of this demographic transition is the rapid increase of elderly inactive population on the one side and on the other, the sharp decline of active labour force in absolute and relative terms. The skilled labor is increasingly scarce and hence companies have to higher costs for skilled labor. Hence demographic transition affects the productivity of the labor force. There is an argument that increasing immigration would solve the problem. But a declining population requires immigration at an increasing rate. The global reservoir of specialized workers willing to emigrate is limited. Again, society’s capacity to include and integrate the emigrants are also limited. Because of these factors, compensation through increased migration can solve the problem but alleviate it. Thesis 4: Public Finance and Ageing A declining labor force would reduce the total income and thus the tax revenues of the government, ceteris paribus. At the same time, governments will face changing demands from the society with high dependency ratio of population. The cognitive and physical capabilities decline with age, which implies that declining productivity as well as increased medical needs. Then, it will be the duty of government to meet the increased and diverse demands of health care services, public transportation, security systems etc. with decreased revenue. Increased social needs on the one side and reduced government revenue on the other will raise the costs per person of public goods. Then it is required either for a reduction of the services provided by governments or an increase of the per capita tax burden. If the government choose to withdraw from public provisioning and social security networks, opportunities arise for private suppliers which may not be feasible and suitable always. Provision of financial support and other aids to the elderly has become an important problem and issue of concern all over the developed nations especially among the OECD countries. Fundamental and basic pension reforms are necessary where the retirement plans are based on a transfer system. Crucial reforms are required in countries where retirement is based on a funding principle and if defined benefit plans exists. The reforms are infuriated by the things that they would create distribution effects by reducing the income of some generations. Retirement plans with defined contribution plans will require more resources to be set apart today in order to meet the requirements of the retirees with long life expectancy. Long Life Expectancy and Challenges for Pension Fund- OECD Experience The extend and depth of the longevity risk of a pension fund depend on the types of pensions it is offering. In Defined Benefit Schemes, the pension fund provides a fixed benefit to all its members at an increased rate in accordance with the rate of inflation. The risk directly affects the financial position of Defined Benefit Funds. Under a Defined Contribution Scheme, the members’ contributions are invested in the pension fund and returns of the contributions are augmented with investment income. Defined Contribution Pension Funds are not exposed to longevity risk and under this scheme, the longevity risk together with investment risk are transferred to the invested persons or fund members themselves. Increasing years of life expectancy throughout the developed world creates pressure on the pension systems which had initially been formulated on the basis of low life expectancy figures and of models in which the value of the pension was not affected by the duration of retirement. For example, Defined Benefit Schemes are that type. Now the pressure is on governments to take the life expectancy risk into consideration and reject or adapt the existing systems in accordance with the changes. In a paper presented at the International Conference of Actuaries and Statisticians in Ottawa, Canada, Edward Whitehouse, head of the OECD’s Pension Policy Analysis Team suggested that 17 of the 30 OECD countries could ensure that there was a “ better balance of risk management towards pensions costs if governments were to implement an automated link between pensions and life-expectancy”. He argued in his paper on ‘Life Expectancy Risk and Pensions’, that “it is hard to think of a convincing reason why people approaching retirement should not bear at least some of the cost of their generation living longer than previous generations” and he stressed that it would be ‘unlikely to be optimal’ to pressure retirees to take all of these risks. Whitehouse viewed that about thirteen out of thirty OECD countries have incepted the link between life-expectancy and the retirement income systems. First country which made such link was Denmark (Whitehouse 2007). OECD report listed different approaches taking into consideration life-expectancy risk and effect on retirement fund/ costs. 1. Launching Defined Contribution Scheme Under this scheme, pension lump sum grant or annuity in future relies solely on the capital saved and invested. 2. Introduction of Notional Accounts: This is a ‘hypothetical account’ created by the government for each insured individual and this account consist of all contributions made during the employee’s working time and measured/calculated to a particular index such as wage growth. By dividing “the amount credited to that account by the insured’s average life expectancy at the time of retirement, effectively providing an annuity”, the final pension is calculated. Notional accounts are generally financed on Pay-As-You- Go basis, unlike individual and occupational accounts in which the pension benefits are financed by assets created during the person’s working years. 3. Adapting Defined Benefit Public Schemes It is proposed to adapt defined benefit public schemes (through pay-as you- go) but where the final level of benefits will depend on life-expectancy. 4. Introduction of qualifying conditions Another proposal is introduction of qualifying conditions that change according to life-expectancy. For example, the pension age or the number of contribution years to be entitled to receiving a full pension. In many OECD countries the pension age has been enhanced so as to reduce the burden of dependency ratio of the population on the working population as well as on government or society. Raising the Pensionable Age Since the beginning of 1990s most of the OECD countries have enacted legislation in order to rise the age of retirement for men and about two-thirds have enhanced the pensionable age of women too. Now the majority of the countries have made legislation that the retirement age would be 65 or higher, although the enhancement of age would yet to be effective in many countries. It is said that as there are differences in the determinants of pensionable ages, the pensionable ages would be distributed over a range of ages, or perhaps it would be distributed around a central age. Many countries have followed a pattern of ‘counting by five’ with retirement ages at 55, 60, 65, and even 70. It is more common that countries have enacted major reforms involving increases of five years of retirement age. For example, Belgium, Japan and New Zealand have raised the retirement ages by five years for both men and women, while Australia and United Kingdom have raised the pensionable age of women so as to equalize it with the age for men. A survey of Social Security Pensionable Ages Around the World (Gillion et al.2000) revealed several conclusions on the pensionable ages of the OECD countries. First, most of the countries’ social security pensionable ages have remained unchanged for many years. Second, during the beginning of 20th century a number of OECD countries reduced their retirement ages. Third, recently, some OECD countries have reduced the benefits available to workers retiring at the pensionable age. Fourth, many countries have lower retirement age for women than their male counterparts, but there is a converging trend towards the equalization of pensionable ages of both men and women. Fifth, in countries where there exist a number of different level of social security programs, some privileged section of people tend to establish low pensionable ages for them selves. Lastly, during the late 1990s some countries have increased their social security pensionable ages but with the effective date of the full increase would generally occur in the twenty first century. Other Changes to Pension Systems- An Experience of OECD Countries Other changes to pension systems are mostly related to the calculation of the earnings base for pension entitlements. Pension calculations experimented in Hungary was on gross of the earnings base for pension entitlements. It was based on gross earnings rather than net earnings. Another example in this regard is Japan. Japan extended retirement earnings to include the bonuses. The period over which earnings are taken into account have been extended in seven OECD countries. Australia is gradually extending the averaging period from 15 to the 40 best years while France is moving from the best 10 years to the best 25 years. Finland, Poland, Portugal, Slovakia and Sweden are all moving to a lifetime average earnings measure. As a result of these reforms, most of the OECD countries will use a lifetime earnings measure. Further, pension systems of some countries revalue past earnings to take account of changes in living standards between the time pension rights ensued and when they are claimed. For example, France moved to price revaluation in the public scheme as early as 1985 and in the occupational schemes in 1996. Finally, the ways in which the payments of pensions are adjusted have been reformed. This process is called pre retirement Indexation but is also known as ‘valorization’. Many OECD countries have moved from adjusting pension benefits to earnings (earnings valorization) towards full or partial indexation to prices. That is known as ‘rice valorization’. This preserves the purchasing power of pensions, but means that pensioners do not share to the same extent as workers. A number of countries adopted for wholesale or systemic reform (Whitehouse , 2007). The most common policy is to remove fully or partly the Public Defined Benefit Schmes and replace it with Defined Contribution Provision. In Defined Contribution schemes, the pension system depends on contributions and the interest earned on them. Hungary, Mexico, Poland and Slowakia are some the countries who introduced mandatory and privately managed individual accounts to replace part or whole of the public pension systems. Another change is the acceptance of notional accounting systems. These schemes are adopted in Italy, Poland and Sweden. Hence they are often called Notional Defined Contribution Schemes. The notional interest rate is set by government and often linked to wage or GDP growth. Conclusion All pension reforms in OECD countries share one important feature., that is, in future pensions will automatically adjust to changes in life expectancy. If longevity increases, the number of pensioners per contributor will increase and pension benefit will fall automatically. If pension capital is accumulated in an individual account, it will automatically or usually be transferred to a regular pension payment- an ‘annuity’- at retirement. As the pension has to be paid for longer period for higher life expectancy situation, these annuities are fixed as lower. In Finland, Portugal and France, these types of adjustments to pension systems have been made in accordance with high life expectancy and financial sustainability. References References 1. OECD, 2008. Pension Markets in Focus. December 2008, issue 5, Paris. 2. Martin, J.P and E. Whitehouse, 2008. Reforming Retirement-Income Systems: Lessons from the Recent Experiences of OECD Countries, OECD Social, Employment and Migration Working Paper 66. 3. OECD, 2007. Pensions at a Glance, Public Policies across OECD Countries, Paris 4. Whiteford, P and E.R Whitehouse, 2006. Pension Challenges and Pension Reforms in OECD Countries, Oxford Review of Economic Policy 22 (1) 5. Whitehouse E R , 2007. Life Expectancy Risk and Pensions: Who Bears the Burden? OECD Social, Employment and Migration Working Paper 60. 6.Hemming, R.1999. Should Public Pensions be funded? International Social Security Review, Vol.52, No.2 7.Latulippe, D. 1996. Effective retirement age and duration of retirement in the industrial countries between 1950 and 1990 (Issues in Social Protection-Discussion Paper, No. 2). Geneva, International Labour Office. 8. OECD. Statistical base. Paris, Organisation for Economic Cooperation and Development. Office of the Superintendent of Financial Institutions. Actuarial report of the Canada Pension Plan as of 31 December 2000. 9. Thompson, L. 1998. Older and Wiser: The Economics of Public Pensions, The Urban Institute Press, Washington, D.C. 10. United Nations. 1997. World Population Prospects: The 1996 revision, New York, NY. 11. http://www.ssa.gov/policy/docs/ssb/v66n1/v66n1p31.html Read More