Research brief on pension systems – 2: How frightening is the ageing crisis? How far can it be averted?

 In Pension Systems, Welfare & Labour
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It has been projected that the old-age dependency rate (population aged 65 and over as percentage of population aged 15 to 64) in the developed world will increase from 20% in 2000 to 35-40% in 2035. This trend of population ageing has been portrayed as a crisis. One manifestation of such a crisis is the pension crisis, particularly in the form of public PAYG pension schemes.

 

In public PAYG schemes, pension benefits are paid by the working population either in the form of taxes or social security contributions. In an ageing society with a public PAYG pension scheme, as the relative proportion of older people increases, higher tax rates or social security contribution rates are bound to be levied on the working population in order to finance increasing pension expenditures. Concerns have been raised that as a result of ageing, financial burdens on working populations will eventually become unbearable and many pension systems will become unsustainable.

 

  • How frightening is the depicted pension crisis?
  • To what extent can the crisis be managed?
  • How far can labour market policies, such as higher retirement age and increased female labour participation, relieve the financial burdens of ageing?

 

An estimation by the International Labour Organization may shed some light on these questions.1

  • The estimation is based on the following basic understanding regarding economically active and inactive people in an economy:
    • the entire group of inactive people constitutes a body of dependants who must be supported, one way or another, from the incomes of the economy as a whole – chiefly from the incomes of active people
  • This entire group of inactive people comprises retirees, children, students, non-working wives, people with disabilities, unemployed workers.
  • The estimation calculates the proportion of incomes of active people that is required to contribute to support the entire group of inactive people in a number of countries in 2035. (In the estimation, such proportion is termed as “contribution rate”.)
  • Incomes of all kinds earned by active people are included in the calculation.
  • The level of expenditure for supporting inactive persons is set at 60% of the average income of an active person (or 60% of GDP per active person). Thus, for retirees, the average replacement rate of their pensions is 60%.
  • The 60% level of expenditure is set according to the costs of supporting inactive people in OECD countries.
  • The countries included in the estimation are: Japan, France, Germany, Norway, USA, Australia, Italy.
  • Contribution rates under different policy scenarios in 2035 are estimated and compared. The estimated contribution rates in 1995 are set as the base levels for comparison.
  • The different policy scenarios are:
    • No policy change.
    • Policy change 1: the male actual retirement age for all countries is increased to the actual average retirement age in 1995 in Japan, which has the highest participation rate of older male workers. The actual average retirement ages and pensionable ages in these countries in 1995 are shown in the table below (Table 1).

 

Table 1: Actual average male retirement ages and male pensionable ages in selected countries in 1995

Country Actual average retirement age Pensionable age
Australia 62.3 65.0
France 59.3 60.0
Germany 63.0
Italy 59.6 55.0
Japan 70.9 60.0
Norway 64.6 67.0
US 64.2 65.0

Source: OECD

 

    • Policy change 2: the labour participation rates of women for all countries are increased to the 1995 level in Norway, which has the highest female labour participation rate. The female labour participation rates (% of female population ages 15-64) in these countries in 1995 are shown in Table 2 below.2

 

Table 2: Female labour participation rates (% of female population ages 15-64) in selected countries in 1995

Country Female labour participation rate
Australia 64.2%
France 60.4%
Germany 61.3%
Italy 42.5%
Japan 58.5%
Norway 71.3%
US 69.0%

Source: World Bank

 

    • Policy change 3: both changes 1 & 2 are applied simultaneously.
    • Policy change 4: changes 1 & 2 are combined with a reduction in the level of expenditure for supporting inactive people – from 60% to 54% (a 10% reduction; for pensioners, this means a 10% reduction in their pensions).

 

The estimation results are shown in the Table 3 below.

 

Table 3: Estimated contribution rates (%) in 2035 under alternative policy scenarios

Japan France Germany Norway US Australia Italy
a. 1995: base level 33.8 42.9 38.2 35.8 36.2 39.4 47.2
b. 2035: no change 43.1(+9.3) 50.8(+7.9) 48.9(+10.7) 43.8(+8.0) 44.3(+8.1) 51.2(+11.8) 58.2(+10.0)
c. 2035: higher male retirement age 43.1(+9.3) 44.6(+1.7) 42.1(+3.2) 40.2(+4.4) 40.8(+4.6) 43.4(+4.0) 49.5(+2.3)
d. 2035: increased female participation 40.2(+6.4) 46.5(+3.6) 44.7(+6.5) 43.8(+8.0) 43.3(+7.1) 46.0(+6.6) 47.8(+0.6)
e. 2035: both c and d 40.2(+6.4) 40.5(-2.4) 38.2(–) 40.2(+4.4) 39.9(+3.7) 38.6(-0.8) 39.9(-7.3)
f. 2035: both c and d plus lower expenditure level 37.7(+3.9) 38.0(-4.9) 35.7(-2.5) 37.7(+1.9) 37.4(+1.2) 36.2(-3.2) 37.4(-9.8)

Note: Figures in parentheses are changes in contribution rates in percentage points relative to the base rates.

 

A number of observations and conclusions can be drawn from the estimation.

  • Because of population ageing, the increases in contribution rates in 2035 in order to finance increased expenditures on the no-policy-change basis are quite substantial. The increases are in the order of 8-10 percentage points (or an increase by 20-30%).
  • However, it is important to note that the estimated increases in contribution rates on the no-policy-change basis are much less than might otherwise appear if one looks simply at projected changes in old-age dependency rates from 1995 to 2035 in the countries examined. The projected changes in old-age dependency rates in these countries are in the order of 15-20 percentage points (or an increase by 75-100%). In comparison, the corresponding contribution rate increases are significantly less.
  • Labour market policies – higher retirement age and increased female labour participation – can each or in combination significantly reduce the contribution rates in most of the countries examined.
  • In the face of adverse demographic changes, the gains from taking these policies in comparison with doing nothing are striking.
  • In effect, labour market policies of the types used for the estimation, together with a relatively small adjustment of benefits, can completely wipe out the adverse consequences of ageing populations.
  • In economic terms, the policies proposed are eminently feasible: they amount to no more than persuading countries to adopt the best-practice measures already in place in Japan and Norway.
  • The implementation of labour market policies would be helped by the relatively long period during which they are gradually put in place and adjusted over time.
  • Increasing life expectancy, especially increases in life expectancy in good health, will make higher retirement age easier to adopt.
  • Also, there is already a strong trend towards greater female participation which would reinforce expanded employment of women.
  • Finally, reasonable economic growth will make a small downward adjustment of benefits easier to accept: an annual growth rate of only 1.75% from 2000 onwards would imply a doubling of average incomes in the year 2035 compared to those in 1995.

 

In addition to the observations and conclusions above, the estimation of the ILO also brings out a couple of commonly committed analytical errors in policy analysis.

  • Focusing too much on the cost side while ignoring the revenue side.
    • To the layperson, the increase in the old-age dependency rate and the associated increase in pension expenditures in the next 30 years or so can be very alarming.
    • However, as the ILO estimation shows, it is quite misleading to enlarge the focus on the cost increases of ageing while ignoring the revenue side of the financial ledger.
    • The estimation shows that in fact, the magnitude of the revenue increase actually needed for financing the cost of ageing is much less than the magnitude of the cost increase itself.
    • When the revenue side is included, the financial cost of ageing becomes much less alarming.
  • Focusing too much on problems while ignoring the policy options available for coping with the problems.
    • The ILO estimation shows that eminently feasible policy options are available for coping with the problems of ageing.
    • The policy options can significantly mitigate or even completely wipe out the adverse consequences of ageing.
    • Most importantly, the estimation shows that with the introduction of appropriate policies, only a small increase in contributions and/or a small reduction in benefits will suffice for such purposes.
    • Once again, ageing becomes much less alarming if policy options for coping with it are included in the analysis.
    • This error illustrates the importance of relating costs to available policy measures.

 

Finally, let us not overlook that alarming cost figures will blind people’s eyes to what the cost is paid for. Emphasizing too much the pension costs of ageing while ignoring the improved well-being from pension payments is an equally egregious error in policy analysis. A more balanced approach is to relate costs to benefits and to ask whether the benefits are worth the costs.

 

 

Prepared by Winston Ng ()

Hong Kong Democratic Foundation (香港民主促進會)

October 2012 (new version)

 

 


Endnotes:

1 Colin Gillion. 2000. The development and reform of social security pensions: the approach of the International Labour Office. International Social Security Review 53(1): 35-63 and Colin Gillion. 1999. The macroeconomics of pension reform. Economic Survey of Europe 3: 63-65. The discussion below is either directly quoted or paraphrased from these two articles. Please do not directly quote for publication use. No details of the procedures of the estimation are provided in Gillion’s articles.

2 The corresponding figures in Hong Kong in 1995 and in 2010 are 54.3% and 59.3% respectively. (Data source: World Bank.)

 

 

 

 

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