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AI MAIM Adequacy of old age Income Maintenance (AIM) in the EU Elsa Fornero University of Turin and CeRP AIM final meeting Brussels, 20 October 2008.

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Presentation on theme: "AI MAIM Adequacy of old age Income Maintenance (AIM) in the EU Elsa Fornero University of Turin and CeRP AIM final meeting Brussels, 20 October 2008."— Presentation transcript:

1 AI MAIM Adequacy of old age Income Maintenance (AIM) in the EU Elsa Fornero University of Turin and CeRP AIM final meeting Brussels, 20 October 2008

2 Elsa Fornero - CeRP - October 2008 2 Motivation and relevance Declining fertility rates and increasing longevity are expected to hamper economic growth, and to challenge the (still rather generous, in Europe) welfare states Old-age dependency ratios (Visco 2006)

3 Elsa Fornero - CeRP - October 2008 3  Ageing needs not be a burden on society, especially on young and future generations; however:  the higher risk aversion of the elderly and their more limited capacity to adjust to shocks are grounds to ensure them more income security than the rest of society (Shiller, 1998)  the shrinking of the traditional pervasive state intervention and the weakening of long established family ties imply less “paternalism” and greater personal responsibility in many fields (work, health and social interactions), but particularly in retirement income provision  These changes happen at a time of growing uncertainty and far reaching complexity (for example, in financial matters)  A major public concern is how to control pension (and health care) expenditure while at the same time preventing poverty and discontent among the elderly

4 Elsa Fornero - CeRP - October 2008 4 Adequacy: a multidimensional concept The concept of aim combines two dimensions: An individual dimension:  refers to a sensible intertemporal allocation of resources in a given market and institutional context (e.g. presence of saving instruments and generosity of public provision)  The life cycle model is the natural normative benchmark: “a household is said to be saving adequately if it is accumulating enough wealth to be able to smooth its marginal utility of consumption over time in accordance with the optimizing model of consumption” (Engen et al. 1999, p. 70) A pension system dimension:  refers to a well structured institutional design, entailing:  intergenerational and intragenerational risk sharing (Shiller, 1998)  a mixed system (Lindbeck and Persson, 2003), combining PAYGO and funding  an appropriate combination of DB and DC formulae (Gomes and Michaelides, 2003)  enhancement of individual responsibility, through information and financial education (Lusardi 2007)  an appropriate design of workers’ choice situations, e.g. default options (Madrian and Shea, 2001; Holzmann et al, 2005)

5 Elsa Fornero - CeRP - October 2008 5 W Pension provision C Y Age Consumption income wealth Retirement W/Y C r /C a P/Y Definition and measurement of “AIM”: the conceptual framework Individual accumulation Consumption smoothing

6 Elsa Fornero - CeRP - October 2008 6 Features of pension systems Multiple Objectives Covered risksMeasures/ Indicators Models Consumption smoothing (Individual) Longevity Myopia Time inconsistency (individual/ households) RRs: gross/net comprehensive Micro simulation models Prevention of poverty in old age (Individual) Earning risks Health and disability risks (Individual/ group/gender) RRs: Poverty and inequality indexes Micro simulation and semi-aggregate models Maintaining a compact between generations (aggregate) Demographic and economic risks Internal rate of return (Net) present value ratio General Equilibrium Models

7 Elsa Fornero - CeRP - October 2008 7 Reforms have made future pension more elusive While retirement planning is difficult in a stable environment, pension reforms have greatly complicated the task by downsizing past promises and limiting both guarantees and indexation mechanisms  promises in the PAYGO pillar have been reduced  retirement ages have been raised  replacement rates have been reduced  benefits have been de-indexed from wages to prices  occupational and personal pension plans, where workers have greater choice but also greater responsibility and risks, have been given a greater role  DB pension formulae have been replaced by DC formulae within both PAYG and pension funds, based on financial accumulation and actuarial principles

8 Elsa Fornero - CeRP - October 2008 8 Retrenchment of pension provisions are not necessarily a cut back on adequacy Assessing adequacy of pension systems is difficult because of lack of a suitable normative benchmark and because pension systems are never in a steady state:  A reduced generosity may seem to shrink adequacy, but by restoring financial sustainability it could indeed reinforce it  The move from DB to DC equally serves the “sustainability cause” but at the expense of more risks onto the workers; how will they respond? (by working longer? by saving more?)  The greater flexibility of retirement introduces a further adjusting margin, as workers are not forced to leave at a certain age, neither induced (through an implicit tax on working) to leave as they reach the minimum requirements, but it also increases uncertainty From an empirical point of view:  the relevant issue is the degree of risk diversification  however, given the difficulties in assessing the overall adequacy of pension systems, approximations such as poverty and aggregate replacement rates are frequently used

9 Elsa Fornero - CeRP - October 2008 9 Actual and Prospective Theoretical Replacement Rates (%) CountryFirst PillarSecond Pillar 2004/520502004/52050 France6649N.A. Germany4334615 Italy7964015 Netherlands30 4139 Spain9085N.A. Sweden534015 UK171950 Decline in prospective RRs, and changes in composition

10 Elsa Fornero - CeRP - October 2008 10 RRs based on “representative” workers:  ignore the distribution of risks (the same RR can result from very different compositions of pension wealth: Paygo vs funded, DB/DC)  can hardly account for the great variability in workers’ earnings and contribution profiles  …or for the changes in the composition of the family (single vs couples, with or without dependents)  …or for the changes in the consumption needs of the elderly as they age (different weight on money and care)  provide less than full indexation to both inflation and real income growth  tend to convey a “false” sense of certainty Drawbacks of simple RRs

11 Elsa Fornero - CeRP - October 2008 11 In an ideal LC model, given:  an earning profile  a Pension RR (P/Y), obtained through compulsory participation  a preferred Consumption RR (C r /C a ), reflecting optimization (i.e the smoothing of mg utilities) a Wealth RR (W/Y) is derived which, transformed at retirement into an (actuarially fair) annuity (A), exactly supports the optimal consumption path for the rest of the individual’s life  W/Y and (A+P)/Y are the optimal wealth and comprehensive RRs From an empirical point of view:  if the individual is saving anything “nearby” (± 10%?), then her saving behavior is “adequate”, the difference accounting for uncertainty, mkt imperfections and flaws in households behavior The individual dimension: implementing a LC model

12 Elsa Fornero - CeRP - October 2008 12 Real life complications Uncertainties on life expectancy on health and disability conditions on financial returns (a financial crisis may be costly in terms of resources; an annuity bought in nominal terms can turn out to be insufficient due to inflation) and difficulties in planning time inconsistency tendency to postpone difficult choices, such as saving, participating in a pension fund, etc; financial illiteracy can explain why households – regardless from their income – risk reaching retirement unprepared

13 Elsa Fornero - CeRP - October 2008 13 … and facilitations Is consumption smoothing a wise rule?  A drop in consumption is typically observed at retirement, but does not necessarily correspond to inadequate wealth (the same consumption level may cost less)  Utility can increase – even at constant or reduced consumption – because of greater leisure time  The reduction of household members can ease the budget constraint  The health care system usually covers medical expenses due to “catastrophic” events

14 Elsa Fornero - CeRP - October 2008 14 W P C Y Age € Ret A more realistic life-cycle Imperf annuity mkt Illiquidity (house) Investment risk Longevity risk Smoothing of mg ut/cons Bad health outcomes Economies of scale in hh Home production Work-related expenses Progressivity Indexation Household composition - Children in & out - Divorce Early ret (health or job shock)

15 Elsa Fornero - CeRP - October 2008 15 Heterogeneity of individual situations  Typically poor individuals have higher pension RRs because of progressivity in both the pension and the tax system  Cohort and gender aspects are also important determinants of adequacy (women’s longer longevity) In empirical research lower SES groups risk not to accumulate the resources needed to maintain living standards, while having income above the 6th decile, a college degree or more, being older and married reduce the probability to fall below targets (Scholz and Seshadri, 2008); singles are less adequately prepared than married couples; lower educated households are more poorly prepared than educated ones (Hurd and Rohwedder, 2008)

16 Elsa Fornero - CeRP - October 2008 16 A new puzzle?  Most works on individuals’ ability to adequately finance their retirement agree that under saving is rather limited and concentrated among specific groups  On the other hand, evidence points to:  Scarce economic and financial knowledge  Insufficient knowledge about own public / private pension  Inadequate ability to plan ahead  Mental accounting, hyperbolic discounting, procrastination, projection biases are at odds with the life-cycle hypothesis How do most households manage to adequately accumulate, knowing so little (if anything at all) about financial matters? Evidence about European countries is still scarce, also because most countries used to provide, until very recently, almost all retirement income through Social Security, leaving a reduced need for individual planning

17 Elsa Fornero - CeRP - October 2008 17 What to do to reduce risks of inadequacy Policy measures  Reduce uncertainty in the public schemes, by building a clear and possibly stable normative framework  Inform workers (in particular the young) about pension innovations, future rules and benefits  Support the development of supplementary pensions, by defining appropriate choice options  Stress the importance of forward looking behavior and increase financial education  Recognize limits to individual responsibility (not everybody can become a financial expert) Market measures  Improve transparency in pension products, so as to enable workers to compare different products  Innovate in products, so as to adapt them to the workers’ needs  Keep costs down

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