The Second Inernaional Workshop on The Balance Shee of Social Securiy Pensions Acuarial Neuraliy across Generaions Applied o Public Pensions under Populaion Ageing: Effecs on Governmen Finances and Naional Saving by Heikki Oksanen Direcorae-General for Economic and Financial Affairs Heikki.Oksanen@cec.eu.in Organised by PIE and COE/RES, Hiosubashi Universiy Hiosubashi Collaboraion Cener, Tokyo, Japan, 15 h December 2005 Absrac In welfare saes, collecive saving has declined o a persisenly negaive level, while reduced feriliy and increasing longeviy lead o an increase in he relaive size of pension liabiliies. Acuarial neuraliy across generaions is presened as a benchmark for designing pension reforms o mee he challenges of populaion ageing. I is shown ha his condiion can be respeced by a wide range of pension reforms, wih very differen consequences for public finance arge seing. The rules for public pensions in naional accouning are also discussed. Finally, he combined effecs of populaion ageing and public pension rules on naional saving are discussed. JEL Code: H1, H5, H6. Keywords: pensions, acuarial neuraliy, public deb, naional accouns. Acknowledgemens A previous version has been published as Oksanen (2005a). I would like o hank paricipans of he CESifo Area Conference on Public Secor Economics, 22-24 April 2005, and of he Second Inernaional Workshop on he Balance Shee of Social Securiy Pensions, 15 December 2005, in Tokyo, especially Seirisu Ogura, for heir very useful commens and suggesions for furher revisions and clarificaions. I would also like o hank Andràs Simonovis for his valuable commens and advice. - Karel Havik deserves warm hanks for his valuable help in compuing he repored simulaions and ediing he graphs, as does Cecilia Mulligan and Jeanee Bell for careful ediing of he ex. I am solely responsible for remaining errors and omissions. Views expressed in he paper are hose of he auhor and do no necessarily reflec he official posiion of he European Commission. European Communiies, 2005 and 2006 102
Table of conens 1. Inroducion 2. The principle of acuarial neuraliy across generaions exended o public pensions 3. Public finance arges under acuarial neuraliy and alernaive accouning rules 4. Illusraions wih sylised daa 5. Implicaions for governmen finances and naional saving 6. Conclusions and suggesions for furher work REFERENCES 103
1. Inroducion Governmen saving conribued o oal naional saving and growh in he European welfare saes from he 1950s o he mid-1970s, bu since hen, has (on average) been negaive (Figures 1.1 and 1.2). Feriliy has declined seadily since he 1970s (Figure 1.3), while longeviy has increased and is expeced o coninue o do so. Public pension sysems, prescribing Defined Benefis (DB) and financed from curren conribuions on a pure Pay-As-You-Go (PAYG) basis, were esablished in he 1950s and early 1960s. These facs can be inerpreed o mean ha he generaion working from he 1950s o he mid 1970s saved collecively, hereby conribuing o economic growh boh for iself and for fuure generaions. I also esablished a public pension sysem, hereby exracing some of he increased wealh for iself during reiremen. The generaion working from he mid-1970s o he presen day, on he conrary, reduced collecive saving o a persisenly negaive level. I also reduced feriliy below replacemen, herefore leaving a coninuously declining working age populaion o pay for is pensions. Furhermore, is increased longeviy means ha, for any given reiremen age, i will enjoy longer ime in reiremen. All his has led, no only o an increase in explici governmen deb, bu also o an increase in fuure pension liabiliies o be covered from increased pension conribuions or axes o be paid by fuure generaions. I is also obvious from he saisics ha his increase in governmen deb (explici and implici) has no been compensaed for by increased privae saving. The purpose of his paper is o analyse public pensions under populaion ageing and presen a framework for analysing and designing pension reforms. As noed by Nishiyama and Smeers (2005), here is surprisingly lile analyical work ha looks ino pensions under populaion ageing, while mos of he work on privaisaion ec. assumes a saionary populaion by consrucion. Such resuls migh be ineresing bu i is asonishing ha so lile work has been done on he combinaions of changing populaion srucure and pension sysem rules, even hough i is he former ha has riggered he need for he laer. To conribue o filling his gap he formal analysis in Secion 2 is made as simple as possible o deal wih he dynamic, inergeneraional aspecs highlighed here: people in each generaion are homogenous, all work, give birh o he nex generaion and enjoy reiremen; successive generaions differ wih respec o feriliy and longeviy; pension righs are assumed o be deermined by earnings, i.e. accrued by working and paying conribuions and indexed o wage rae. 1 Secion 2 firs describes he dynamics over successive generaions of a public pension sysem wih fixed parameers under populaion ageing. Secondly, acuarial neuraliy across generaions is defined. I shows ha his condiion can be respeced by a wide range of pension reforms under populaion ageing, wih drasically differen mandaory sysem sizes, poenially shared managemen beween he public and privae secors, and consequenly, wih very differen effecs on governmen finances. Secion 3 discusses he rules for public pensions in naional accouning, including proposals o revise hem o cover pension liabiliies more sysemaically han hihero. Public finance arge seing under alernaive pension reforms and naional accouning rules is also analysed. 1 The analysis could also be inerpreed o cover fla rae pensions, in which case accrued pension by a generaion is replaced by he fuure (expeced) average pension of a generaion as a percenage of average wage a he ime of reiremen. Under a fla rae sysem here is no link beween pension and conribuions or axes for individuals. However, his is no an issue here as only inergeneraional aspecs are sudied. 104
Figure 1.1. General governmen ne invesmen and ne saving in 11 EU Member Saes*, 1960-2003 5 4 3 2 percenage of GDP 1 0-1 -2-3 -4-5 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Ne invesmen Ne saving * EU-15 excep EL,E,L and S due o unavailabiliy of daa Source: Commission services Figure 1.2. Ne saving in 11 EU Member Saes*, 1960-2003 20 15 percenage of GDP 10 5 0-5 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Toal economy General governmen Privae * EU-15 excep EL,E,L and S due o unavailabiliy of daa 105
Figure 1.3. Compleed feriliy* and oal feriliy** in EU-15 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 1940 1970 1945 1975 1950 1980 1955 1985 1960 1990 1965 1995 1970 2000 1972 2002 Compleed feriliy Toal feriliy * number of children by birh year of he moher, 1940-1967, ** number of birhs in a given year per number of women, weighed by age-specific feriliy raes of he respecive calendar year, 1970-2001. The wo ime scales overlap by 30 years reflecing he average childbearing age. Secion 4 illusraes he resuls wih simulaions using yearly sylised daa. Secion 5 discusses he public pension rules and public finance arges under populaion ageing on naional saving. The main message is ha populaion ageing (by definiion a ransiion o he new populaion age srucure) has drasically differing effecs on saving under differen pension sysem rules. The perspecive is also exended o commens on he conroversy regarding privae reiremen accouns for he US Social Securiy, while assering ha he challenges facing he relaively generous pension sysems in Europe dwarf hose in he US. Secion 6 concludes wih suggesions for furher work. 2. The principle of acuarial neuraliy across generaions exended o public pensions Noaions and key conceps for a public pension sysem A simples possible 3-period model is used o analyse wha happens o pensions under an ageing populaion and o provide a framework for designing pension reforms. The populaion is composed of children (E), workers (L) and reirees (R). Each of hese phases of an individual s life is, for he purpose of managing he mahemaics, se o be of equal lengh, which is se as he uni period: (1) = L+ 1 = R+ 2 E. To keep a rough correspondence wih real life, he uni period is bes considered o las 30 years: his is currenly he average childbearing age of women, and also, by chance, roughly he difference beween he average age of a pensioner (70) and ha of a worker (40). 106
Parameer f expresses he number of children per worker in period (assuming f <1 means ha L decreases a a rae of 1-f ): (2) f L E =. The pension sysem delivers Defined Benefi (DB) pensions accrued a a specified rae of he wage by working and paying pension conribuions. Pensions in paymen are indexed o he nominal wage rae, w, assumed o be uniform for all. Pension per reiree for he uni period, as a percenage of uni wage, is (3) s = π 1 σ, where π -1 is he accrual rae valid for period -1 workers deermining heir pension as a percenage of uni wage in he nex period when reired (replacemen rae), and σ is a scale facor which, firsly, akes ino accoun ha in he formal analysis we arificially assume ha he period a work and in reiremen are of equal lengh; for example, if in realiy he former is 40 years and he laer 17, hen σ is 0.425 (= 17/40). Secondly, an increase in longeviy, assuming a consan reiremen age, can be inroduced by assuming an increase in σ : if people work for 40 years and longeviy increases by six years, hen σ increases o 0.575 (= 23/40); assuming, for example, an accrual rae of 1.5% per annum, gives π -1 = 0.6 and s = 0.255 in he former case and 0.345 in he laer. To consruc a case which is more general han a pure PAYG sysem, we allow ha he sysem may have financial reserves, A (which can be negaive). The ineres rae applied on asses in he previous period is assumed o be uniform. The ineres facor ρ is decomposed o he increase in he wage bill and a margin, d, as follows: w L ρ. w L (4) = (1 + d ) 1 1 Implici pension deb (IPD ) is defined as he presen value of nex period pensions accrued in period, discouned a he ineres rae in period +1: (5) s IPD = w R ρ + 1 + 1 + 1 + 1. Denoing IPD as a proporion of he wage bill in he same period as θ and subsiuing from equaions (1)-(5) we can wrie (6) IPD s θ = =. w L f 1+ d ) ( Degree of funding, z, is defined as he raio of financial reserves A o IPD : (7) A z =. IPD The conribuion rae in period is c. Sysem revenue includes pension conribuions and ineres on is asses, and pensions are he only expendiure iem. Thus, budge balance equaion for period reads as (8) w L + ( 1) A 1 = s w R + A A 1 c ρ. Subsiuing from he populaion dynamics equaions (1) and (2), pension accrual equaion (3) and equaions (4)-(7) for he definiions, he conribuion rae c can be expressed as 107
(9) s s + 1 c = (1 z 1) + z. f f (1 + d ) 1 + 1 This equaion shows how he conribuion rae is relaed o feriliy ha deermines he raio of reirees and workers in each uni period, pensions deermined by he accrual rae and he raio beween ime a work and in reiremen (s = σ π -1, ), he ineres rae margin over he wage bill growh in period +1 (d +1 ), and he degree of funding boh in he pas and in he curren period (z -1 and z ). The exreme case of full funding comes ou by seing z o 1 for he firs period: he conribuion rae is hen equal o he presen value of pension in he nex period, and he sysem remains fully funded as long as his rule is followed. The elemenary case of pure PAYG sysem is derived by seing z o zero for all : he conribuion rae is hen equal o he replacemen rae divided by he relaive number of reirees o workers ha is deermined by pas feriliy of he reired generaion. Pure PAYG pension sysems (or more generally, less-han-fully-funded ones) emerge as some age cohors receive pensions under a Defined Benefi rule (DB) having conribued less han he capialised value of wha hey will receive, hus, in general, having paid no conribuions a all or receiving on heir conribuions a reurn higher han he marke rae of ineres. In his case, laer on, conribuions need o be increased o cover he expendiure under he given benefi rule. As he sysem maures, workers as conribuors will have o pay in conribuions ha exceed he presen value of heir own fuure pensions. This excess is called implici ax. Expressed in erms of he wage bill, implici ax rae, τ, can be wrien as (10) s s + 1 τ = c θ = (1 z 1) (1 z ). f f (1 + d ) 1 + 1 Under pure DB PAYG he implici ax is negaive for he firs generaion by he full amoun of is pensions. Laer, i is posiive for all fuure generaions aken ogeher, bu i is imporan o noe from equaion (10) ha i can be negaive for a paricular generaion if is longeviy is sufficienly increased and/or feriliy decreased as compared o he previous generaion. Inernal rae of reurn in he pension sysem in period, i, is defined as he rae of reurn on he conribuions (c w ) of a represenaive individual in erms of his/her fuure pension (s +1 w +1 ): w s i. w s s + 1 (1 z 1) + z f f (1 + d ) + 1 + 1 (11) = 1 1 + 1 In general, he resul depends on all pas and fuure demographic and pension sysem parameers and he ineres rae margin in period +1. Under full funding (z is always equal o 1) equaion (10) gives zero for implici ax and equaion (11) gives for he rae of reurn he marke rae in he period of reiremen. In he paricular case of pure DB PAYG he resul for inernal rae of reurn is w s i ' = 1. w s (11 ) + 1 + 1 f 1 Thus, under a pure DB PAYG sysem he inernal rae of reurn depends on he change in longeviy, bu no on he feriliy of he generaion in quesion; as a consequence, if f <f -1, he nex generaion(s) will have o pay higher conribuions for he same benefis, hus, he inernal rae of reurn for hem will fall. Noe also ha he uni wage increase and feriliy in he previous period deermine he growh of he wage bill. Thus, equaion (11 ) shows ha he famous resul by Samuelson (1958) ha, under a pure PAYG sysem, he inernal rae of reurn is equal o he wage bill growh, is valid no only under sable populaion srucure (as 108
he originally presened i) bu also if longeviy is consan (or more generally, if s +1 =s i.e. if he accrual rae is reduced o neuralise he effec of longeviy increase on pension expendiure). 2 Acuarial neuraliy exended o less-han-fully-funded public pensions For privaely managed pension insurance, acuarial neuraliy means ha he presen value of (expeced) fuure pension enilemens equals he presen value of conribuions. Such conracs esablish a fully funded pension sysem, eiher volunary or mandaory by law. The implici ax is zero and rae of reurn is equal o he marke rae. If a pure PAYG pension sysem is fully maured wih a fixed accrual rae, and he demographic srucure is sable due o consan feriliy and longeviy, hen all curren and fuure generaions pay he same conribuion rae and receive he same benefis as a percenage of uni wage in each period. This arrangemen can be regarded as neural across generaions in he sense ha all succeeding generaions equally share he burden of pas no-fully-funded pensions and cover he capial value of heir own pensions. These wo cases are very resricive indeed. In wha follows we exend he analysis o a less-han-fullyfunded public pension sysem under populaion ageing which is, by definiion, a change in he age srucure due o a decline in feriliy and/or o an increase in longeviy changing he raio of ime in reiremen/a work (for a given reiremen age). For defining acuarial neuraliy across generaions i is insrucive o noe ha he burden of explici public deb and implici pension deb are parallel hough no idenical. As Diamond and Orszag (2004, pp. 37-38) pu i, explici public deb reflecs he accumulaed difference beween he spending and revenue from he beginning of he naion o he presen, and in parallel, under he public pension sysem, implici pension deb reflecs he accumulaed difference beween pension benefis for and conribuions paid by previous and curren generaions. Boh require ha axes (including pension conribuions) are higher han in he case where expendiure was covered by revenue and pension benefis were pre-financed when righs were accrued (i.e. fully funded). Wih regard o serving public deb in a growing economy, discarding for simpliciy borrowing for he accumulaion of capial, neuraliy across generaions can be defined as mainaining he given deb level as compared o he scale of he economy. In he presen conex, looking only parially ino he public pension sysem, we do no formally cover explici public deb alhough insering i as a negaive componen o A above would make his sraighforward. Wih he above principles in mind, he concep of acuarial neuraliy can be exended o public less-hanfully-funded pensions by defining as acuarially neural he pension conribuion rae, c a, so ha he conribuion revenue covers (1) he ineres on he pas ne deb, including is implici and explici componens minus is growh in nominal erms allowed by he growh facor, and (2) he presen value of he fuure pensions of curren workers. One more addiional simplifying assumpion will prove o be useful: he rae of ineres over he rae of growh of he wage bill, d, is consan, i.e. (12) d = d for all. Wih his addiional assumpion he resuls will urn ou o be very clear and simple. The more general case for changing d will be discussed separaely. Furhermore, he raio of asses o he wage bill is denoed by q : 2 The conceps of IPD, implici ax and inernal rae of reurn for pure PAYG sysems are worked ou, for example, by Uebelmesser (2004). Above, heir definiions and derivaions are more general, as any degree of funding is allowed for. 109
(13) A q =. w L Subsiuing from (4)-(7) and (12)-(13) we can wrie (14) c IPD A IPD s d s 1 = d( θ 1 q 1) + θ = (1 z 1) +. f (1 + d) f (1 + d) a 1 1 + = d + w 1L 1 w L 1 The firs wo expressions give c a as he sum of he implici ax in his paricular case and IPD as a percenage of he wage bill, and he las formula gives i as a funcion of he demographic and pension sysem parameers and he ineres rae margin in periods and +1. Insering (14) o he general equaion (8) for he conribuion rae gives a clear cu implicaion for acuarial neuraliy: (14) IPD A w L IPD = w 1 A L 1 1 1 or q = θ 1 q 1 θ. Thus, under acuarial neuraliy he ne deb, i.e. IPD minus financial asses of he sysem, relaed o he scale of he economy, remains consan, regardless of any changes in demographic facors and/or pension sysem parameers. Similarly, he implici ax o be paid by all fuure generaions will remain he same. 110
The more general cases wih a variable d and unexpeced change in longeviy The rule of acuarial neuraliy can be exended o cover a changing ineres rae margin d relaively easily, wihou enering ino any formal reamen. The key is a each poin in ime o apply he same (currenly prevailing) assumpion on is value boh for serving he pas deb and for calculaing he presen value of fuure pensions. One implicaion of his rule is ha he picure of a pure PAYG under a sable populaion is consisen: even if d changes, he conribuion rae remains consan and he revenue covers expendiure; only he composiion of he conribuion rae alers as he changes in implici ax and in he presen value of fuure pensions mach each oher. I is also insrucive o see wha happens under Defined Benefis and full funding: if he reurn on asses is higher (lower) han expeced, he pension provider incurs a gain (loss). Sicking o he rule of acuarial neuraliy, given he expecaions in each period, his gain (loss) is shared equally across all fuure generaions. In he case of a privae provider, sharing a loss is generally no possible as he provider may go bankrup. In such a case, some adjusmen would need o be made in which case he sysem de faco would move owards a Defined Conribuion (DC) sysem. Under he general case of a parially funded public DB pension sysem, a change in d from -1 o leads o an unexpeced reurn on asses. If he rule of acuarial neuraliy is followed in seing he conribuion rae in period, he gain (loss) is shared equally beween all curren and fuure generaions. The IPD -1 is revalued a he ineres rae in period, and, as a resul, he ne deb raio changes and an impued capial gain (loss) occurs. This new deb raio and he new d are he basis for seing he conribuions rae. Similar principles apply o oher unexpeced changes. Noe, however, fuure feriliy does no ener ino he equaions and he accrual rae is se as a policy parameer. Thus, under he hree-period model here, longeviy incorporaed in σ above is, in addiion o d, he only genuinely uncerain facor ha needs o be projeced for period +1. If he realisaion differed from he assumpion, a gain (loss) occurs, and he oucome differs from acuarial neuraliy ex pos. Again, if acuarial neuraliy were o be followed from his poin onwards, he recalculaed ne deb should be he basis for curren and fuure decisions. 3. Public finance arges under acuarial neuraliy and alernaive accouning rules Fiscal arges under acuarial neuraliy and curren naional accouning A pure PAYG sysem is, by definiion, always in financial balance in erms of convenional accouning, hough his plaiude is no very helpful for undersanding he economic and poliical issues a sake when populaion ageing pus pressure on he pension sysem and necessiaes changes o is rules. As pure PAYG is generally no acuarially neural under populaion ageing, i is useful o work ou wih he help of equaion (14) above, he implicaions of his laer principle for he explici governmen ne deb and he budge balance. Under convenional accouning for explici asses (and deb), mainaining he assumpion of a consan d, he change in he asse raio under acuarial neuraliy reads as: (15) q a q 1 = θ 1 θ. Denoing he rae of growh of he wage bill by g, i.e. + (16) 1 + g = 1 1 w L w L we can express he convenionally defined budge balance under acuarial neuraliy as a percenage of he wage bill, b a, as 111
g θ. 1+ g (17) b a = θ 1 + q 1 The las erm gives he budge balance in a seady sae where he demographic facors, pension sysem parameers and he ineres margin d are consan and he firs wo erms herefore cancel each oher ou. Under populaion ageing and changes in pension sysem parameers, acuarial neuraliy implies, as expressed in equaion (15), ha he increase in financial asses/wage bill raio q is equal o he increase in IPD/wage bill raio θ. Noe ha his increase does no depend on he pas value of asses/wage bill raio, and ha his is valid for any degree of funding, including a fully funded sysem. The inuiive explanaion is ha people need o conribue more ino he fund as longer life expecancy increases he capial value of pension required for any given replacemen rae and as he rae of reurn falls (as he decrease in feriliy causes a decline in he number of workers). In his way, a fully funded sysem is equally exposed o populaion ageing as any oher sysem, and he increase in q is he same as in any oher case complying wih acuarial neuraliy. Thus, according o (15), under ageing populaion and acuarial neuraliy, he raio of financial asses o wage bill generally changes; for example, he sysem moves from pure PAYG o parial funding unless generosiy of pensions is sufficienly reduced. The condiion for he laer, derived from equaion (3) and he budge balance for a pure PAYG wih a fixed conribuion rae, is: (18) π π σ = σ f f 1 + 1 1. In his case, he size of he pension sysem measured by he conribuion rae remains unchanged, while generosiy measured by he replacemen rae adjuss downwards. If fuure benefis are reduced furher han his, i.e. he IPD/wage bill raio is reduced, an increase in governmen deb raio is implied by he neuraliy rule. The resul in equaion (15) helps o clarify he issue of double burden, ofen referred o wih regard o moving o (parial) funding of public pensions: acual neuraliy, wihou adequaely decreasing he replacemen rae and/or increasing he reiremen age will require a move o parial funding. Thus, here is no necessarily any excessive double burden for he curren generaion of workers even if he sysem moves o parial funding, while acuarial neuraliy can be undersood o deermine a hreshold beyond which pension conribuions (or axes) become excessive. 3 Noe ha hese equaions do no in any way deermine he fuure size of he public pension sysem, i.e. he level of benefis in period +1 and onwards. They only give an acuarially neural se of pension sysem parameers (accrual rae and conribuion rae) under each se of demographic parameers. Moreover, acuarial neuraliy is no presened here as an ulimae norm for public finance arges, bu as a useful benchmark only. I does no bring ino quesion he legacy of IPD from he pas bu raher recognises i as a burden o be shared equally beween he curren and all fuure generaions. This is no o deny ha reasons migh well exis o depar from acuarial neuraliy and share his burden differenly, bu he presen framework merely provides a ool for arguing abou such opions. Noe however, ha he approach here direcly challenges he view ha coninuaion of a pure PAYG public pensions should be aken for graned. Equaion (18) above shows ha, under pure PAYG, acuarial neuraliy is respeced only if he benefis are sufficienly reduced. As his migh, under populaion ageing, be in conflic wih adequacy, especially if a significan increase in reiremen age is no envisaged, a deparure from pure PAYG migh be jusified. The rule of acuarial neuraliy can also be compared wih Musgrave s (1986) fixed relaive posiion rule for deermining a fair pension formula, referred o in recen discussion, e.g. by Esping-Andersen e al. (2002). I means ha pensions under a pure PAYG sysem are indexed o he wage rae afer pension conribuions. I is rue ha his Musgrave rule, like he rule of acuarial neuraliy above, disribues he benefis of an exogenous change in produciviy of labour equally beween curren workers and reirees hrough he wage 3 The resuls above reierae hose in Oksanen (2004). Sinn (2000) gave he inspiraion o look ino he argumens for moving o parial funding under populaion ageing. 112
index. However, i deviaes from acuarial neuraliy and leads under populaion ageing o an increasing burden for fuure generaions. This could be mos simply proven wih a case where feriliy decreases and longeviy increases permanenly: he firs generaion wih he new demographic characerisics will have paid less for he same benefis han he similar generaions which follow. 4, 5 Finally, acuarial neuraliy as developed here gives a direc inpu for seing public finance arges also for a more general case wih legacy of explici public deb. The increase in pension fund asses from equaion (15) should ener as a arge for he reducion of he ne public deb raio, and he budge balance from equaion (17) should be added o he (negaive) budge balance arge ha would keep he ne deb raio consan. This ype of framework for seing public finance arges, which consisenly inegraes he public pension sysem o he res of governmen finances, is indispensable for any pension financing rules - prescribing acuarial neuraliy or oher principles - o have heir inended effecs (for furher commens, see Secion 5 below). Acuarial accouning for public pensions The curren Sysem of Naional Accouns 1993 (SNA-93) and, in parallel, he European Sysem of Accouns (ESA-95) neiher recognise he implici pension deb of public DB pension sysems in he balance shees nor he effecs of is changes for budge balance. Thus, governmen commimens o fuure pensions (or changes herein) do no affec a governmen s financial posiion a he ime of making hem. For companies, he naional accouning rules currenly recognise he pension obligaions as employer liabiliies only if hose obligaions are funded, i.e. if hey are (fully or parially) mached by segregaed asses. As he naure of his obligaion does no qualiaively depend on he mode of meeing i, and as such liabiliies considerably affec he value of a firm, he main exising company accouning sandards require heir recording, wheher funded or no. For example, since 2005, all lised companies in he European Union are required o record all heir pension liabiliies according o he Inernaional Accouning Sandards provision IAS19. Since 2001 he inernaional saisical communiy has prepared a revision of naional accouning rules for pensions, aimed a (1) a rapprochemen of he reamen of employer pension schemes in company accouns and in naional accouns and (2) consisency of naional accouning rules for all pensions in all secors. 6 4 Myles (2003) assers ha people who were advised in he 1960s no o have oo many children in order no o overburden he earh should no be punished for heir reduced feriliy. This is beside he poin here as he consequences of declined feriliy on pension sysems should be reaed regardless of he underlying reasons. The righ quesion is why he firs generaion wih declined feriliy should be reaed more favourably han any hypoheical idenical generaion laer. See also Schokkaer and Van Parijs (2003). 5 Noe ha, in he simple framework above, parameer σ for he raio beween ime a work and in reiremen capures, in addiion o increasing life expecancy, an increase in reiremen age. This is applicable for describing he new seady sae afer such a change. However, he ransiional effec of he rae of change in work force due o such a change is no conained in his simple framework. Thus, he equaions above are fully applicable only under he assumpion of a fixed reiremen age. This issue will be furher explored wih he help of yearly daa simulaions below. 6 Beyond he general aim of harmonising corporaions and governmen secor rules o a maximum, an imporan pracical reason also exiss: pension liabiliies are someimes shifed from a corporaion o he governmen agains a compensaory paymen, ofen a lump-sum; his has recenly happened in cases of public corporaions, especially in he conex of heir reorganisaion or privaisaion. In such cases, he way hese ransacions are recorded has a crucial impac on governmen defici, which is why Eurosa - he saisical arm of he European Commission - has in he recen pas deal wih such cases in he conex of validaing governmen defici figures. I came o he conclusion ha he mos consisen way under he curren rules is o record he paymen received by he governmen as governmen revenue, hus wih a posiive impac on governmen budge balance. The problem is ha he pension liabiliy aken over by he governmen as he counerpar of he lump sum received is no recorded in he accouns (Eurosa news release of 21 Ocober, 2003, on cases wih an unfunded company scheme, and ha of 25 February, 2004, on he corresponding cases where i is funded). - Pension liabiliies can also be ransferred in he oher direcion, causing similar accounancy problems of consisency. These cases appear under parial privaisaion of he public pension sysem, as a porion of pension conribuions is divered o a privae secor managed pension fund, hus causing an immediae decrease in governmen revenue, while public pension expendiure decreases gradually. Eurosa has clarified he reamen of hese cases and confirmed ha such an operaion has a negaive impac on governmen budge balance (Eurosa news release of 2 March, 2004). 113
Therefore, i has been proposed ha all employer pension liabiliies be recorded as deb, including hose of governmen, regardless of wheher segregaed asses back hem or no (de Rougemon, 2003, OECD Saisics Direcorae, 2004, Saisics Deparmen, IMF, 2004; also Oksanen, 2005b). This change alone would have a significan effec on governmen accouns. If and when naional accouning rules would be revised so ha all public pension liabiliies (i.e. social securiy and social assisance) would be reaed as public deb, has remained conroversial, he main reason being he difficuly in esimaing governmen IPD as i is ofen open o inerpreaion and is sensiive o small changes in assumpions (fuure ineres rae, for example). Consequenly, i has been proposed ha, a leas for he ime being, esimaes for governmen IPD will be presened separaely, ouside he main body of governmen saisics, hereby providing saisics o be used for specific purposes wihou effecing daily monioring of public finances (Lequiller, 2005). Wheher public pension liabiliies are evenually recorded in core accouns or no, cerain concepual issues mus noneheless be resolved o creae a consisen se of accouning rules. The conceps defined above provide he required concepual framework o exend acuarial accouning principles o public pensions, albei recognising he main differences beween company pension schemes and public social securiy pensions. In he former, pension liabiliy is a negaive enry in he ne worh of a corporaion, wheher segregaed asses mach his liabiliy or no, and pension conribuions, wheher explicily paid or impued, are recorded as a financial ransacion. A ypical unfunded public pension scheme differs from a corporae one in ha i is mandaory by law and is obligaions are mosly covered by compulsory pension conribuions or oher axes imposable by governmen. Alongside IPD, implici ax inheren in public pure or less-han-fully-funded pension schemes is a key concep o arrive a consisen acuarial accouning for boh corporaions and governmens. Firs, including IPD in he balance shee as a componen of public deb is a sraighforward consequence of acuarial (or accrual) accouning. Possible financial asses, oher han governmen bonds ha are need ou under consolidaed accouns, held by he public pension scheme are naurally a negaive public deb enry. Thus, in he presen framework, ne oal public deb is IPD -A (again, i would be easy o include here explici public deb and he consequen primary surplus componen o serve i). The corresponding budge balance under acuarial accouning is negaive of he change in his deb from he previous period. Sill mainaining he assumpion on a consan d, his can be expressed as a percenage of he wage bill, b(ac), as follows: g θ, 1+ g a (19) b( ac) = θ 1 + θ 1 where g is he wage bill growh rae. Under a seady sae he firs wo erms cancel ou, hus he budge balance is he produc of he growh rae and he deb raio. More imporanly, his same resul is valid for acuarial neuraliy, as he firs wo erms are hen equal, wih an infinie number of possible combinaions of pension sysem and demographic parameers. Therefore, fiscal arges under acuarial neuraliy and accrual accouning become simple: consan oal deb raio and budge balance ha is consisen wih i (changing only wih he change in he rae of growh of he economy, g ). To sum up, he budge balance under he acuarial accouning sysem can be decomposed, wih he help of he conceps and equaions above as follows: revenue includes he implici ax and he reurn on asses, and expendiure is he impued ineres paymen on he conribuions less implici ax in he previous period. Conribuions less implici ax are reaed as a financial ransacion, giving rise o a governmen liabiliy o he household secor, and he paymen of a pension is a depleion of his liabiliy. Exending acuarial accouning o public pensions would allow for consisen reamen of pension liabiliies of governmen and corporaions and of he corresponding pension asses of households. I also draws aenion o pension policies and warns of an increase in fuure expendiure already when he righs are accrued. 114
The effec of he proposed explici recording of public pension liabiliies is naurally ha he figures for oal public deb increase o a new order of magniude and ha any policy rules linked o public deb and defici need o be horoughly reviewed. In European welfare saes IPD of he pure PAYG sysems migh be 300% of GDP. If growh of nominal GDP is a moderae 3.3% per annum (see he illusraions below), and if a pension reform respecing acuarial neuraliy prevens he ne deb of he sysem from increasing as a percenage of GDP, defici under acuarial accouning is nearly 10% of GDP! This follows from he sheer definiion of budge balance: i is he change in ne asses in nominal erms. As acuarial accouning displays a large sock of deb, is change is significan also in he case ha he sock as a percenage of GDP is consan (which could be a benchmark for an economically balanced and accepable scenario). 4. Illusraions wih sylised daa In line wih he 3-period model above he resuls here are illusraed wih sylised yearly daa. The gradual mauraion of a pure PAYG sysem providing Defined Benefis is firs described by assuming a saionary populaion (i.e. feriliy is 2.1 per woman and longeviy is consan). All people live 20 years as children, work for 40 years unil he age of 60, and enjoy reiremen for 17 years. Each year, workers earn pension righs equal o 1.5 percen of heir salary, so ha working for 40 years gives a 60 percen replacemen rae. I is also assumed, as is normally he case under public pension sysems, ha each year all workers pay he same conribuion rae irrespecive of heir age. The real wage growh rae is assumed o be 1.75 percen per annum. Inflaion is assumed a 1.5 percen p.a. Ineres rae is assumed o be uniform a 1.5 p.p. above he rae of change of he wage bill. 7 To illusrae he gradual mauring of he pension sysem ha akes 57 years, i.e. he full working life and reiremen of a 20-year old member, i is assumed o be esablished in 1920. The conribuion rae in 1977 is 25.2% and he IPD 568% of he wage bill. Then, we firs assume ha feriliy sars o decline in 1971 and gradually falls o 1.7 in 2000. This is roughly he observed decline in Wesern Europe 8. From 2000 onwards i is assumed o be consan (his is roughly wha is assumed for populaion projecions). Secondly, longeviy is assumed o increase by one year in every decade from 1990 o 2050. We wan o express some of he key variables as percenages of GDP. For his, wage bill afer pension conribuions is se a 40% of GDP in 2000; for he fuure, i is se o decrease o allow for he increase in pension conribuions. These simple assumpions imply a pension expendiure of 10.9% of GDP in 2000 and 15.3% in 2050. The former figure corresponds o he daa in he Economic Policy Commiee (EPC) repor of 2001. The laer figure gives he full effec of populaion ageing under he parameers assumed here. I is higher han projeced in he EPC repor, which assumes various changes in pension sysems and employmen paerns. Figure 4.1 gives he IPD as a percenage of he wage bill for he saionary populaion, declined feriliy and he combinaion of declined feriliy and increasing longeviy. The seady sae under boh of hese populaion ageing facors is reached in 2050. Pension expendiure is hen 43.1% and IPD 1045% of wage bill. Nex, we display he effec of implemening he principle of acuarial neuraliy from 2005 onwards, assuming firs ha he iniial pension benefis are mainained (including reiremen age a 60), see Figure 4.2. The conribuion rae is increased o cover he implici ax se o serve he implici deb accumulaed by 2004 and he newly accrued righs (NAR/wb) from 2005 onwards. In 2005 he conribuion rae jumps well above 7 This assumpion means ha real ineres is firs 3.3% and hen declines o 2.6% along wih he falling rae of growh. As for sensiiviy of he resuls, for example, IPD is 1045% of wage bill under populaion ageing in he firs scenario below, while i is 891% if ineres rae differenial were 1 percenage poin higher. 8 This refers o compleed feriliy indicaing he number of children of women who have passed ferile age. I is disinc from oal feriliy, which gives he raio of birhs o women of ferile age. As he average age a which women give birh has recenly increased, oal feriliy has been lower han compleed feriliy. 115
pension expendiure as a percenage of he wage bill and hen gradually increases o 39%. Under pure PAYG i would increase o 43.1%. Figure 4.1. Implici pension deb under alernaive populaion scenarios (per cen of wage bill) 1200 1000 800 600 400 200 0 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100 Saion. Populaion Fer. down & Longe. cons Fer. down & Longe. up For assumpions, see he main ex. Figure 4.2. Acuarial neuraliy from 2005 onwards under iniial benefis 50 45 40 35 30 25 20 15 10 5 0-5 -10-15 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080 2085 116 2090 2095 2100 Conr. rae Pens. exp./wb NAR/wb B/GDP B(ac)/GDP (-)dipd/gdp Conr. rae = conribuion rae as a percenage of wage. NAR/wb = presen value of newly accrued righs as a percenage of wage bill. Pens. exp./wb = pension expendiure as a percenage of wage bill. (-)dipd/gdp = negaive of he change in Implici Pension Deb as a percenage of GDP. B(ac)/GDP = budge balance under acuarial accouning rules as a percenage of GDP. B/GDP = budge balance under curren naional accouning rules as a percenage of GDP. For assumpions, see he main ex.
Figure 4.3. Acuarial neuraliy from 2005 onwards, accrual rae reduced o 1.125% 40 35 30 25 20 15 10 5 0-5 -10-15 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080 2085 2090 2095 2100 Conr. rae Pens. exp./wb NAR/wb B/GDP B(ac)/GDP (-)dipd/gdp Conr. rae = conribuion rae as a percenage of wage. NAR/wb = presen value of newly accrued righs as a percenage of wage bill. Pens. exp./wb = pension expendiure as a percenage of wage bill. (-)dipd/gdp = negaive of he change in Implici Pension Deb as a percenage of GDP. B(ac)/GDP = budge balance under acuarial accouning rules as a percenage of GDP. B/GDP = budge balance under curren naional accouning rules as a percenage of GDP. For assumpions, see he main ex. Noe ha in each year all workers pay he same conribuion rae. This means ha during he adjusmen period acuarial neuraliy canno be perfecly aained: for example, if feriliy declines and he conribuion rae is herefore increased; his also has repercussions on older workers wih he iniial feriliy rae as well as allowing younger workers o pay less han hey should. This is a consequence of he usual resricion ha here is no age-discriminaion wih regard o he conribuion rae. Therefore, for he ransiion period, he calculaions show resuls ha approximae o acuarial neuraliy. Figure 4.2 also displays he annual IPD change and shows ha i is well above 12% of GDP hrough he lae 2020s, which indicaes ha under pure PAYG IPD/GDP is sill increasing considerably. By definiion, acuarial neuraliy means ha asses are accumulaed o keep he oal deb/gdp raio a is 2004 level of 311 % GDP. Convenional budge balance peaks a 4.5% of GDP around 2020 and hen adjuss o is seady sae level of 2.3%. Asses/GDP raio increases o 95% of GDP, which, by definiion of acuarial neuraliy, is he increase in he IPD/GDP raio from 2004 o is seady sae value. Budge defici under acuarial accouning immediaely reduces o is acuarially neural level; noe ha he smooh decrease aking place afer 2005 only sems from he decrease in he rae of growh of he economy as he oal ne deb/gdp raio is consan. Significan accumulaion of asses in he pension fund as such may no make his scenario grossly unrealisic as figures above 100% of GDP are found for quasi-mandaory sysems in Denmark and he Neherlands, and privaely managed pension provisions in he UK. Wha makes he scenario unrealisic is he huge increase in he conribuion rae. However, his illusraes he cos of he assumed benefi rules, comprising of he replacemen rae and reiremen age. Disribuion of his cos across generaions should be seriously addressed and acuarial neuraliy gives a useful benchmark. 117
Acuarial neuraliy across generaions does no, however, prescribe he fuure size of he public pension sysem deermined by pension accrual from now onwards. A simple illusraion is given in Figure 4.3 where he accrual rae is assumed o have decreased from 1.5% per annum o 1.125%, leading o a replacemen rae decline o 45% afer he full career of 40 years. Acuarial neuraliy implies ha he conribuion rae jumps from 28.1% in 2004 o 30.5% in 2005 and hen smoohly increases o 32.2%, deermined by he demographic changes aking place. Over he ransiion, limied asses are firs accumulaed and hen depleed. In he seady sae oal ne deb is equal o IPD in 2004. Budge defici under acuarial accouning is he same as in Figure 4.2 or in any oher case respecing acuarial neuraliy. Figures 4.4 a-b illusrae an exreme case where acuarial neuraliy is respeced and he pension sysem is gradually scrapped by reducing he accrual rae o zero in 2005. From 2005 onwards he workers pay a ax for serving he implici deb, bu his is he only revenue of he sysem. Pension expendiure gradually reduces and he sysem explicily goes ino deb. Afer he ransiion, lasing 63 years, he 2004 IPD of 311% of GDP has become explici deb. Budge balance under curren naional accouning firs reduces as pension conribuions are suddenly reduced from 28.1% o 11.8%, and hen he defici increases furher as he effecs of he ongoing populaion ageing coninue o increase pension expendiure unil he opposie effec of he cessaion of pension righs accumulaion sends pension expendiure o a decline. All hese dynamic facors mean ha he convenionally defined budge defici reduces o is seady sae value only afer 63 years afer he change. Again, budge defici under acuarial accouning is he same as in he case above. The same paern of budge defici under he wo parallel accouning rules would recur under any newly deermined accrual raes in beween he cases in Figures 4.2 and 4.4. This would happen under a parial privaisaion of he pension sysem by divering par of he pension conribuions o a newly esablished mandaory privaely managed fully funded pillar and reducing he accrual rae in he public pillar consisenly wih acuarial neuraliy. Noe ha a consisen reform requires ha he implici ax due o he pas accumulaion of IPD is mainained as public secor revenue, and he res of iniial conribuions is shared beween he public and privae pillars consisenly wih he new accrual rae in he public pillar. Under an assumpion of a uniform ineres rae he oal replacemen rae is no affeced by he esablishmen of a wopillar sysem. Noe also ha in he case in Figure 4.2 above where iniial accrual raes are mainained and asse accumulaion herefore akes place, he sysem could be privaised up o a cerain proporion wihou incurring deb: under an acuarially neural reform, he asses would hen accumulae in he privaely managed sysem. This observaion links he assessmen of he meris of privaisaion o he views abou ime consisency of economic policy. The quesion is, do people rus he public secor as manager of heir pension asses? Various insiuional arrangemens - including involvemen of labour marke organisaions - exis o draw a line beween asses in he mandaory or quasi-mandaory pension sysem and governmen s coffers. 118
Figure 4.4. Acuarial neuraliy from 2005 onwards, accrual rae zero a. IPD, oal deb and explici deb as per cen of GDP 350 300 250 200 150 100 50 0 1920 1930 1940 1950 b. Oher variables 35 30 25 20 15 10 5 0-5 -10-15 1920 1930 Toal deb/gdp IPD/GDP Explici deb/gdp 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100 Conr. rae Pens. exp./wb NAR/wb B/GDP B(ac)/GDP Conr. rae = conribuion rae as a percenage of wage. NAR/wb = presen value of newly accrued righs as a percenage of wage bill. Pens. exp./wb = pension expendiure as a percenage of wage bill. (-)dipd/gdp = negaive of he change in Implici Pension Deb as a percenage of GDP. B(ac)/GDP = budge balance under acuarial accouning rules as a percenage of GDP. B/GDP = budge balance under curren naional accouning rules as a percenage of GDP. For assumpions, see he main ex. 119
Figure 4.5. Reiremen age increase from 2005 onwards, accrual raes adjused 45 35 25 15 5-5 -15 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080 2085 2090 2095 2100 Conr rae Pens. exp./wb NAR/wb B/GDP B(ac)/GDP Conr. rae = conribuion rae as a percenage of wage. NAR/wb = presen value of newly accrued righs as a percenage of wage bill. Pens. exp./wb = pension expendiure as a percenage of wage bill. (-)dipd/gdp = negaive of he change in Implici Pension Deb as a percenage of GDP. B(ac)/GDP = budge balance under acuarial accouning rules as a percenage of GDP. B/GDP = budge balance under curren naional accouning rules as a percenage of GDP. For assumpions, see he main ex. Wih regard o naional accouning rules, i should be emphasised ha acuarial accouning provides a robus base o cover a wide range of cases. Firsly, budge defici under acuarial accouning gives he informaion abou fuure pension expendiure a he momen of esablishing he pension righs. If his defici is higher han wha was acuarially neural, fuure generaions pay an increasing burden. Secondly, defici under his definiion is he same irrespecive of a wide range of insiuional arrangemens. This is in conras o he sensiiviy of he defici under he curren naional accouning rules. The mandaory pension sysem is classified wihin governmen accouns if i provides defined benefis, even if parially funded, while a mandaory privaely managed fully funded Defined Conribuion (DC) sysem falls ouside he governmen accouns. Insiuional changes may herefore have a dramaic effec on governmen fiscal variables even in cases where he changes are acuarially neural. Increasing reiremen age In all scenarios above eiher he conribuion rae increases or he replacemen rae decreases significanly. If neiher of hese is accepable, an increase in he age of reiremen age is herefore riggered. As saed in Secion 2, he 3-period model is adequae o calculae new ses of parameers for he new seady sae wih a higher reiremen age, bu no for he ransiional period. This is also valid for he simulaions using yearly daa, as acuarial neuraliy canno generally be unambiguously defined for all such cases. To undersand why, i is useful o noe ha full acuarial neuraliy would be achieved in an exreme case where people reire from he public less-han-fully-funded pension sysem bu coninue working and paying conribuions o a (mandaory or volunary) fully funded and fully acuarial sysem. In his case hey earn an addiion o heir replacemen rae when hey ruly reire, bu avoid paying he implici ax o he basic public sysem. This case may have some relevance for grey economy aciviies of reired people bu i is generally no he case under public pension sysems, where i is, however, common and reasonable o prescribe specific 120