Aging and Pension Reform in a Two-Region World: The Role of Human Capital

Aging and Pension Reform in a Two-Region World: The Role of Human Capital University of Mannheim, University of Cologne, Munich Center for the Economics of Aging 13th Annual Joint Conference of the RRC Washington D.C., August 4 5, 2011

Questions & General Setup Effects of population aging on Factor prices Welfare How do answers change 1. With endogenous human capital 2. Under different social security regimes / pension reforms 3. More interesting: interaction of 1.) and 2.) Two-region open economy OLG model with endogenous Consumption/saving decision Labor supply Human capital accumulation

Household Setup Agents start making decisions at age 16, retire at age 65 (benchmark) and live at most until age 90 They choose each period Consumption/saving Labor supply Time investment into human capital... and like consumption and leisure Receive labor income or pensions Linear contribution rate τ to social security Pensions are a fraction ρ of current net wages Formal Representation

Macroeconomic Setup & Government Aggregate production with physical capital and effective labor Effective labor L t = jr 1 j=0 l t,jn t,j h t,j Factors earn marginal products Regional labor markets, international capital markets, exogenous technical progress Balanced budget PAYGO social security with two scenarios 1. Benchmark Retirement: replacement rate ρ or contribution rate τ fixed 2. Pension Reform: increase retirement age given τ/ρ regime

Pension Reform & Calibration Increasing the Retirement Age Simple rule: for additional 1.5 years of life expectancy at age 65 retirement increases by one year Retirement age of 71 years U.S. Life Expectancy at Age 65 Calibration Demographics: United Nations Old : basically OECD Young : rest of the world Targets: K/Y, avg. labor supply, I /Y, region-specific wage profiles, and region-specific growth of GDP/Capita Retirement Age & Wage Profiles WAPR

Thought Experiment & Results Thought experiment Exogenous demographics induces economic transition Two human capital specifications Exogenous human capital Endogenous human capital during calibration identical, then diverging Results Macroeconomic variables Rate of return Detrended GDP per capita Welfare of households alive in 2010 Effects of pension reform Focus on Endogenous vs. exogenous human capital Results for old countries, open economy

Benchmark Retirement Age: Rate of Return Figure: Rate of Return 8 Rate of Return 8 Rate of Return 7.5 7.5 r in % r in % 7 7 Endogenous Exogenous 6.5 Constant Replacement Rate Endogenous Exogenous 6.5 Constant Contribution Rate Open vs. Closed

Benchmark Retirement Age: Figure: 110 108 Endogenous, BM Exogenous, BM 110 108 Endogenous, BM Exogenous, BM 106 106 104 102 100 98 96 104 102 100 98 96 94 94 92 92 90 Constant Replacement Rate 90 Constant Contribution Rate Open vs. Closed

Pension Reform: (1) Figure: 115 Endogenous, BM Endogenous, PR 115 Endogenous, BM Endogenous, PR 110 105 100 110 105 100 95 Constant Replacement Rate 95 Constant Contribution Rate Rate of Return

Pension Reform: Decomposition of Effects Effects of increasing retirement age on GDP/Capita Exogenous human capital 1. Mechanical effect more working people 2. Higher labor supply if τ Endogenous human capital 1. Mechanical effect more working people 2. Higher investment into human capital 3. Higher labor supply (to make use of 2.) 4. Higher labor supply and human capital if τ effects are not additive

Pension Reform: (2) Figure: 115 110 Endogenous, BM Exogenous, BM Endogenous, PR Exogenous, PR 115 110 Endogenous, BM Exogenous, BM Endogenous, PR Exogenous, PR 105 100 105 100 95 95 90 Constant Replacement Rate 90 Constant Contribution Rate XXX

Welfare Evaluation Concept Define a base year (here 2010) Compute (remaining) lifetime utility V GE given GE prices Freeze prices/transfers from base year and recompute V 2010 Welfare difference expressed as Consumption Equivalent Variation (CEV) Positive numbers are welfare gains from GE effects Welfare Evaluation - Graph

Welfare Effects of Reform: Agents alive in 2010 Figure: Welfare: Agents alive in 2010 1 0.5 Consumption Equivalent Variation Cohorts alive in 2010 Endogenous, BM Endogenous, PR 2 1 Consumption Equivalent Variation Cohorts alive in 2010 0 0 0.5 1 CEV 1 1.5 2 CEV 2 3 2.5 4 3 5 3.5 4 20 30 40 50 60 70 80 90 Age Constant Replacement Rate 6 Endogenous, BM Endogenous, PR 7 20 30 40 50 60 70 80 90 Age Constant Contribution Rate Open vs. Closed

Welfare Effects of Reform: Agents alive in 2010 Table: Maximum Welfare Losses - Agents alive 2010 Open Economy Pension System Constant ρ Constant τ Endog. Exog. Endog. Exog. Benchmark -3.0% -3.6% -4.4% -6.5% Pension Reform -1.9% -3.0% -3.6% -6.0% Difference 36.7% 16.7% 18.2% 7.7%

Welfare Effects of Reform: Agents alive in 2010 Table: Maximum Welfare Losses - Agents alive 2010 Open Economy Pension System Constant ρ Constant τ Endog. Exog. Endog. Exog. Benchmark -3.0% -3.6% -4.4% -6.5% Pension Reform -1.9% -3.0% -3.6% -6.0% Difference 36.7% 16.7% 18.2% 7.7%

Conclusions & Policy Implications Investment into human capital substantially dampens effects of aging on factor prices welfare losses PI: Important to keep this adjustment channel flexible A generous pension system is more redistributive but lowers welfare of future generations Higher retirement age can substantially increase welfare, especially when distortions are already high PI: Small distortions are magnified: human capital is multiplier effects are not additive PI: Inequality best decreased by increasing retirement age Warning: we assumed a frictionless world results are only upper/lower bounds of true effects

Model Parameters Table: Model Parameters Young Old Preferences σ Inverse of Inter-Temporal Elasticity of Subst. 2.00 β Pure Time Discount Factor 0.985 φ Weight of Consumption 0.370 Human Capital ξ Scaling Factor 0.176 0.166 ψ Curvature Parameter 0.576 0.586 δ h Depreciation Rate of Human Capital 1.4% 0.9% h 0 Initial Human Capital Endowment 1.00 1.00 Production α Share of Physical Capital in Production 0.33 δ Depreciation Rate of Physical Capital 3.5% g A Exogenous Growth Rate Calibration Period 1.5% 1.9% Final Steady State 1.9% 1.9% Notes: Young and Old refer to the region. Only one value in a column indicates that the parameter is identical for both regions. Back

U.S. Life Expectancy Figure: U.S. Life Expectancy at Age 65 20 Remaining Life Expectancy U.S. Remaining Life Expectancy in s 19 18 17 16 15 14 1950 1960 1970 1980 1990 2000 2010 Sources: Human Mortality Database (2011). Back

Welfare Evaluation Graph Figure: Constant vs. Variable Prices 7 Rate of Return 6.5 6 Rate of Return in \% 5.5 5 4.5 4 3.5 General Equilibrium Constant Prices 3 2010 2020 2030 2040 2050 2060 2070 Back

Benchmark Retirement Age: Net Foreign Assets Figure: Net Foreign Assets 50 Foreign Assets as Percentage of GDP 60 Foreign Assets as Percentage of GDP 40 Foreign Assets / GDP 0 50 Foreign Assets / GDP 20 0 20 40 Endogenous Exogenous 100 Constant Replacement Rate Endogenous Exogenous 60 Constant Contribution Rate Back

Benchmark Retirement Age: Net Foreign Assets Figure: Net Foreign Assets 50 Foreign Assets as Percentage of GDP 60 Foreign Assets as Percentage of GDP 40 Foreign Assets / GDP 0 50 Foreign Assets / GDP 20 0 20 40 Endogenous Exogenous 100 Constant Replacement Rate Endogenous Exogenous 60 Constant Contribution Rate Back

Benchmark Retirement: Comparison GDP/GNP per Capita Figure: Comparison GDP/GNP per Capita 115 Detrended GDP/GNP per Capita 115 Detrended GDP/GNP per Capita 110 110 GDP/GNP per Capita 105 100 GDP/GNP per Capita 105 100 95 GDP, Endogenous GDP, Exogenous GNP, Endogenous GNP, Exogenous 90 Constant Replacement Rate 95 GDP, Endogenous GDP, Exogenous GNP, Endogenous GNP, Exogenous 90 Constant Contribution Rate Back

(Inter)National Capital Markets Compute equilibrium transition path for closed economies We then surprise agents by opening up the economy in 1975 Compute the transition to the open economy steady-state Agents alive in 1975 re-optimize for their remaining lifetime, newborns use prices and transfers from open economy Back

Benchmark Retirement Age: Rate of Return Figure: Rate of Return 8 Rate of Return 8 Rate of Return 7.9 7.8 7.8 7.7 7.6 7.6 r in % 7.5 r in % 7.4 7.4 7.3 7.2 7.2 7.1 Endogenous, Closed Exogenous, Closed Endogenous, Open Exogenous, Open 7 Constant Replacement Rate 7 Endogenous, Closed Exogenous, Closed Endogenous, Open Exogenous, Open 6.8 Constant Contribution Rate Back Net Foreign Assets

Household Setup Formal Representation Formally, agents maximize subject to max J β j 1 π j 1 σ {cφ j (1 l j e j ) 1 φ } 1 σ }{{} j=0 a j+1 = leisure { (a j + tr t )(1 + r t ) + w n t,j c j if j < jr (a j + tr t )(1 + r t ) + p t c j if j jr w n t,j = l j h j w t (1 τ t ) human capital formation using Ben-Porath (1967) technology h j+1 = h j (1 δ h ) + ξ(h j e j ) ψ Back

Benchmark Retirement Age: Figure: 110 110 108 108 106 106 104 102 100 98 96 104 102 100 98 96 94 92 Endogenous, Closed Exogenous, Closed Endogenous, Open Exogenous, Open 90 Constant Replacement Rate 94 92 Endogenous, Closed Exogenous, Closed Endogenous, Open Exogenous, Open 90 Constant Contribution Rate Net Foreign Assets Comparison GDP/GNP Back

Welfare Effects Benchm. Retirement: Agents alive in 2010 Figure: Welfare: Agents alive in 2010 1 0.5 0 Consumption Equivalent Variation Cohorts alive in 2010 Endogenous, Closed Exogenous, Closed Endogenous, Open Exogenous, Open 2 1 0 Consumption Equivalent Variation Cohorts alive in 2010 0.5 1 CEV 1 1.5 2 CEV 2 3 2.5 4 3 3.5 4 20 30 40 50 60 70 80 90 Age Constant Replacement Rate 5 Endogenous, Closed Exogenous, Closed 6 Endogenous, Open Exogenous, Open 7 20 30 40 50 60 70 80 90 Age Constant Contribution Rate Back

Retirement Age & Wage Profiles Statutory Retirement Age 73 1.7 Benchmark (Constant Retirement) 72 Pension Reform (Rising Retirment Age) 1.6 71 Productivity Profiles Retirement Age 70 69 68 67 66 65 64 63 1900 1950 2000 2050 2100 2150 Labor Market Cohort Retirement Age Productivity 1.5 1.4 1.3 1.2 1.1 Old Countries Young Countries Observed US Profile 1 20 25 30 35 40 45 50 55 60 Age Life Cycle Productivity Back

Pension Reform: Rate of Return Figure: Rate of Return 8.1 Rate of Return 8.1 Rate of Return 8 8 7.9 7.9 r in % 7.8 7.7 r in % 7.8 7.7 7.6 7.6 7.5 Endogenous, BM Endogenous, PR 7.4 Constant Replacement Rate 7.5 Endogenous, BM Endogenous, PR 7.4 Constant Contribution Rate Back

Stylized Facts Figure: Working Age Population Ratio 1 Working Age Population Ratio Working Age Population Ratio in % 0.95 0.9 0.85 0.8 0.75 0.7 Industrialized Countries (old) Transition Countries (young) 0.65 1950 2000 2050 Sources: United Nations (2007) and own computations. Old includes USA, Canada, Japan, Australia, New Zealand, Switzerland, Norway and the EU15 Young all other countries Back