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Measuring the Impact of Pension Reform on Old Age Incomes: a microsimulation approach for Ireland . Elisa Baroni and Cathal O´Donoghue IFS Seminar, April 10th 2007. Research Question. “The world Population is growing older… …Will the old grow poorer ?”. PhD Research Objectives.

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measuring the impact of pension reform on old age incomes a microsimulation approach for ireland

Measuring the Impact of Pension Reform on Old Age Incomes: a microsimulation approach for Ireland

Elisa Baroni and

Cathal O´Donoghue

IFS Seminar, April 10th 2007

research question
Research Question

“The world Population is growing older…

…Will the old grow poorer ?”

phd research objectives
PhD Research Objectives
  • Theoretical:
    • To identify economic criteria for evaluating pension systems and pension reform, in the context of population aging
  • Empirical:
    • To quantify the effects of demography + pension systems + pension reforms on future poverty + inequality, for aging countries (Ireland, Sweden)
    • To develop micro-simulation tool for theory validation and policy making
  • Population Aging = lower mortality + lower fertility + higher life expectancy
  • By 2050, in EU:

 proportion of +65 projected to double

    • average projected increase in dependency ratios (Old / Young, Pensioners / Workers) from 24% to 49%
    • average projected increase in retirement years
    • average projected increase in pension expenditure by 3-5 %
economic consequences of aging
Economic Consequences ofAging
    • Higher pension / health care costs ?
    • Higher taxes ? Lower Savings ? Lower Private Transfers ?
    • Lower Output Growth ?
    • Higher pensioner poverty ?
    • Higher inequality ?
  • Aging implies more pressure for redistribution from shrinking active population to growing inactive population, especially in PAYG pension system:
  • PAYG:PNt = t (WL)t
aging and pension system
Aging and Pension System

Pension Systems redistribute resources for:

  • Insurance / Income Security / Consumption Smoothing
  • Poverty Reduction
  • Inequality Reduction
  • Aging can undermine the performance of a pension system relative to its aims
  • Aging motivates Pension Reform
economic principles of pension systems and pension reform
Economic Principles of Pension Systems and Pension Reform
  • Efficiency: impact of system on aggregate savings / labour supply / growth
  • Equity: impact of system on income distribution, e.g. between generations
  • Financial Stability: impact of system on public finances
  • Political Sustainability: is the system going to be supported by future generations ?
what future
What Future ?
  • Future welfare of pensioners will depend on complex interactions between Demography + Labour + Pension System.
    • Aging can affect sustainability / efficiency / equity of a Pension System
    • Pension System can also induce behavioural changes e.g. increased retirement age which can counterbalance demographic effects
  • Economic consequences of Aging and Pension System need to be analysed together net effects.
  • We need a model for net effects  what pension system is better to address consequences of aging?
i the theory typologies of pension systems
I. The TheoryTypologies of Pension Systems
  • Pension Pillars = Public + Occupational + Private
  • Each Pillar can vary in:
    • Type of Benefit: Defined Benefit vs. Defined Contribution
    • Degree of Actuarial Fairness: Non-Actuarial (DB) vs. Actuarial (DC)
    • Type of Financing: Funded vs. Unfunded
  • A Pension System consists of a given combination along these 3 dimensions
  • Pension Reform usually entails moving along any of these dimensions.
typologies of pension reforms
Typologies of Pension Reforms
  • Parametric Reforms:
    • Changes to retirement age, replacement ratio, contribution rate, indexing, or taxation of pensions
  • Systemic Reforms:
    • Changes to system structure or financing of the system
      • Moving to Funding
      • Making benefit more actuarial (DC)
the economics of pensions
The Economics of Pensions
  • Conditions for Balanced + Equitable DB Public PAYG:
    • t (WL)2t = (NP)1t t*=(P/W) / (L/N)= implicit tax rate
    • t (WL)2t = (NP)2t+1 / (1 + r)

r* = P2 / c (W)2 = c(WL)jt+1 / c (WL)it – 1

r* = g (Samuelson, 1958) = implicit rate of return_

  • Aging (L down and N up) + (DB) PAYG …..
    • affects system balance: c up or P down (unless W up)
    • can harm growth if raising c, discouraging savings and work, or raising national debt.
    • can increase old age poverty if lowering P
    • can redistribute unfairly between generations if r ≠g
    • can be politically unsustainable
economic theory systemic reforms
Economic Theory: Systemic Reforms
  • Making PAYG term actuarial (DC)

Pt+1, i = (1 + g)*c (W)t,1

 ti = cj (1 + r)/(1+g)

 for (r=g), t = c, no tax

 otherwise lower effective tax  less distortion

  • Moving to Funded system 

Pt+1, i = (1 + r)*s(W)t,1

 s > r

 no explicit tax, no distortion, more savings + growth, less costs.

ii the policy approach
II. The Policy Approach
  • “Anglo-American” view:
    • PAYG unsustainable in face of Aging
    • PAYG create disincentives to savings (Feldstein, 1974), labour supply and growth
    • PAYG can be regressive and inequitable
    • PAYG are politically unsustainable
    • Funding stimulates savings, investments + growth, esp. if privately managed
  • “Multi-Pillar” Model (World Bank):
    • 1st: Minimum State Pension (flat)
    • 2nd: Mandatory Occupational Pension (funded)
    • 3rd: Voluntary Private Pension Savings (“ “ “)
ii the policy approach15
II. The Policy Approach
  • Opponents of the Anglo-American view claim:
    • Transitional costs: implicit tax τ reduces rate of return s of funding (Sinn, 1999)
    • Funding penalises low income workers
    • Funding requires some handling of stock market risks
    • Funding is not a necessary condition for fiscal sustainability, problem is type of benefit offered (DC might solve it)
    • Funding ≠ increased savings: (mandatory) pension savings could crowd out voluntary savings  net effect ?
    • Link between funding and output growth controversial
    • Funding is not immune from Aging
    • If more savings + more pensioners: higher demand in asset market from retirees  higher annuity prices + lower returns (unless output grows enough)  more pensioner poverty ?
    • Key for aging is output growth and productivity (e.g. through labour market interventions, not pensions)
iii dynamic microsimulation pension reforms
III Dynamic Microsimulation & Pension Reforms


  • to simulate income distribution under pension system P
  • to simulate future public + private pension accumulation and de-cumulation over the life cycle, under pension system P,given population changes
  • to simulate effects of reforms to P on (life-cycle) incomes distribution + costs.
iii dynamic microsimulation
III. Dynamic Microsimulation
  • Use longitudinal micro data as inputs to simulate future synthetic “histories” for every individual in the population, by (yearly) simulating stochastic life transitions (education, marriage, fertility, labour market status) + exogenous parameters (e.g. macro assumptions and policy rules)  future distribution of key variables e.g. disposable income.
  • Effects of different policies can be measured together with effects of demographic or economic changes (e.g. aging or labour participation).
  • Suited for redistributive analysis of pensions (since pension is tied to life earnings history, life expectancy etc)  who gains and who looses
original phd contributions
Original PhD Contributions
  • Using LIAM dynamic micro-simulation model to produce distributional analysis up to 2050 under actual and simulated pension reforms in Ireland.
  • Adapting LIAM to Swedish data and producing a comparative analysis between the Irish and Swedish pension systems.
part ii aging in ireland
PART IIAging in Ireland
  • Currently, Ireland is young: + 65 “only” 11.1%. But…
  • Proportion of +65 projected to be 28% by 2056.
  • Dependency ratio (L /P) will increase  from 5 down to 2 working age people per pensioner by 2050.
  • Pension Bill projected to increase from 2.2% to 9% of GNP by 2050
irish pension system
Irish Pension System
  • State pension
    • 80 % of +65 receive it
    • 80% of total income for 3 bottom deciles of retirees.
  • Benefits are flat rate + offer low replacement rate:
    • ca. 30% of average industrial earnings,
    • below the poverty line in 2004
    • Not indexed to earnings
  • Occupational + Private Pensions
    • 22% of + 65 receive it
    • 6% of total income of +55 on average
  • Average drop in disposable income at retirement 50%
pensioners poverty in ireland
Pensioners’ Poverty in Ireland
  • Since 1990s, highest poverty risk in EU for elderly (36 – 40%), excluding housing assets
  • Occupational Pension Membership among current workers low (50%)
  • Personal Pension Saving low (13 % of workers)
pension reforms in ireland
Pension Reforms in Ireland
  • 1998 Objectives:
    • Ensuring Adequacy of Pensions: √
      • RR at 50% of pre-retirement income
      • State Pensions at 34% of average industrial wage
      • Indexing State Pensions to Earnings
    • Increasing supplementary pension Coverage to 70% by 2013
    • Addressing Financial Sustainability by introducing some Funding in public pension system √
simulated reforms
Simulated Reforms
  • Parametric Reforms:
    • Increasing / Indexing State pensions
    • Introducing an earnings related State pension
    • Raising Retirement Age
    • Indexing pensions to life expectancy
  • Systemic Reforms:
    • Move to mandatory funded system
    • Apply Pension system from a different country

 Dynamic Micro-simulation model to quantify effects of existing + suggested reforms and compare

output measures
Output Measures
  • For each reform, we compare with baseline in terms of :
  • Life Time Redistribution / Inequality:
    • Income Replacement Ratios
    • Incomes over Life Cycle
    • Gini
  • Poverty
    • Poverty Head Count
    • Poverty Gap
    • FGT Index
    • Poverty Efficiency Measures
part iii the liam model
Part III: The LIAM Model

Output Data, t + 1 (up to 2050)

pensions model in liam
Pensions Model in LIAM
  • For working age individuals  must simulate pension coverage:
    • Is person accumulating State Pension rights ?
    • Is person member covered by an Occupational Pension plan? If so which are plan characteristics / contributions ?
    • Is person saving in a Personal Pension ? How much?
  • For retirees  must simulate pension participationand retirement income:
    • Is retiree receiving what type pensions ? How much from each type? Replacement rate ?
  • For deceased  must simulate pension inheritance by spouse / dependents
  • For all  must back simulate relevant work history
pension estimations
Pension Estimations
  • Historical Panel: from 1939 – 1994, imputation or estimation of missing values based on LII (past work + earnings + pension history)
  • Public Pension Eligibility + Amount: based on S.I. contributions (incl. before 1996) and family characteristics
  • Membership to Occupational or Private pension: based on fixed effect Logit f( sex, educ., age, employment characteristics, firm size, occ. change and work status in previous year) on LII  Pseudo R2= 0.76. Aligned to 2002 CSO statistics.
  • Amount of 2nd/3rd Pillar Pensions: based on total predicted contributions + annuity price (DC) or final benefit formulas B)
intended phd structure i
Intended PhD Structure I
  • Part I
    • Pension Systems and Pension Reform in an Aging Society √
  • Part II
    • Aging and Elderly Living standards in Ireland √
    • The Irish Pension System. √
  • Part III
    • Dynamic Microsimulation of Pension Systems
    • Our model: LIAM
    • Baseline Study: Simulating the long term effects of the Irish Pension System: Baseline assumptions and results using LIAM
    • Reform Study: Simulating Irish Pension Reforms: Results under hypothetical reforms / assumptions, and comparisons with baseline.
  • Part IV
    • Comparative Pension Systems Analysis using LIAM: Results from Sweden and Ireland. Separating the effect of different institutional, demographic and labour market characteristics on poverty risks.