Chapter 9: Consumption smoothing: Old age pensions

1. Barr: Economics of the Welfare State: 4e Chapter 9: Consumption smoothing: Old age pensions

2. Organization of the chapter 1. Introduction and institutions 2. Methods of organizing pensions 3. Efficiency arguments for state intervention 4. Social justice 5. Assessment of old-age pensions

3. 1. Introduction and institutions • The purpose of pensions • Poverty relief • Insurance • Consumption smoothing • The state pension scheme • Private pension schemes • Occupational • Personal

4. 2 Ways of organising pensions 2.1. The logic of the issue 2.2. Funded schemes 2.3. Pay-as-you-go schemes 2.4. Pros and cons

5. Methods of organising pensions • Store current production • Build a claim to future production • Pay-as-You-Go pensions, usually organised by the state, are paid out of current tax revenues • Funded pensions are paid out of an accumulated fund • Different types of funded schemes • Defined benefit (e.g. final salary schemes) • Defined contribution • Key point: funded and PAYG are simply methods for organising claims on future production

6. Some advantages of PAYG schemes • Cope well with inflation • Allow pensioners to share in post-retirement economic growth • Allow a full pension to be paid immediately

7. Some disadvantages of funded schemes • Vulnerable to unanticipated post-retirement inflation • Do not allow pensioners to share in post-retirement economic growth • It takes a long time to build up rights to a full pension

8. A problem with PAYG Effects of ‘blips’ in the birth rate

9. 3. Efficiency arguments for state intervention

10. 3.1. Public-versus-private provision Private pensions: there are two sets of risks • Probability of age at death (the life expectancy risk) • The inflation risk

11. 3.2 Addressing the demographic problem

12. Static output: effects of demographic change on funded pensions • Money accumulation: desired pensioner consumption exceeds desired saving by workers. Excess demand in the goods market causes price inflation, reducing the purchasing power of annuities. • Financial asset accumulation: desired asset sales by pensioners exceeds desired purchases of assets by workers. Excess supply in the assets market reduces asset prices, reducing pension accumulations and hence the value of the resulting annuity.

13. Growing output: effects of demographic change on funded pensions • Money accumulation: a decline in the savings rate increases aggregate demand. But if supply has increased in parallel, there is no effect on prices. Thus period 2 pensioners get the real pension they expect. • Asset accumulation: wages generally keep pace with output. If workers’ pension target is (say) 50% of their earnings, rising wages imply rising demand for assets, hence no effect on asset prices. Again, period 2 pensioners get the real pension they expect.

14. 4. Social justice • Public versus private provision: the main arguments are about efficiency • The redistributive effect of pensions • From young to old • From rich to poor • From men to women

15. 5. Assessment of old-age pensions

16. 5.1. Efficiency and incentives • Do pension savings increase economic growth? • Three links in the argument • Does funding increase saving? • Is that saving translated into efficient investment? • By how much does that investment increase output? • Each link needs to be tested • How do pensions affect labour supply?

17. Sources of output growth Two strategies for raising output • Increasing the productivity of each worker, through (1) more and better capital equipment (2) better labour • Increasing the number of workers from each age cohort (3) increased labour force participation (4) increased age of retirement (5) import labour directly (immigration) (6) import labour indirectly (export capital)

18. How should pensions be financed? Approaches to pension finance • Increase output • Reduce the living standards of workers by increasing pension contributions • Reduce living standards of pensioners • By paying a lower pension • By increasing the age at which pension is first paid, i.e. reducing the duration of retirement

19. 5.2. Equity issues • Redistribution over the life cycle. Nearly two-thirds of total benefit spending is on consumption smoothing (see Table 7.3) • Redistribution from rich to poor occurs in many PAYG schemes • Redistribution from men to women occurs in most schemes, PAYG and funded

20. 5.3. Conclusion • Empirical investigation suggests that funding does not have a large impact on growth rates • ‘The ageing problem’ – a horrendous concept. The problem is not that people live longer (which is a triumph) but that they retire too early given their longer life expectancy