A special report on ageing populations (extracts)

Scrimp and save

Jun 25th 2009

Pensions will have to become far less generous

THE past few decades have been the cushiest time ever to be a pensioner in a developed country. Not only has the world been getting ever richer (at least until very recently), which rubbed off on pensioners too; but as a group they have also become much more comfortable relative to the rest of the population. In recent years mandatory pensions across the OECD, net of taxes and social-security contributions, averaged over 70% of previous net earnings for people on average pay and over 80% for the low-paid. For the better-off the replacement ratio was lower, but they can cope.

The official retirement age in most countries has stayed much the same even though people are living a lot longer, so pensioners have been getting more years in which to enjoy themselves without the pressures of work. In fact, many of them stopped working well before it was time for their gold watch because they were offered irresistible inducements to go early. In Austria, for instance, the official retirement age for men is 65 but the average actual age is 59, which means that many of them leave even earlier.

Being generous to pensioners was affordable in 1980, when in the rich world there were only about 20 people of retirement age for every 100 people of working age. But that ratio has already risen to 25% and by 2050 it will be around 45%, meaning that there will be only about two workers for every pensioner. In some countries things will be much worse: Japan is heading for a ratio of over 70%. Something has to be done.

The most urgent need for reform will be in public pensions, which in most developed countries are the biggest source of retirement income. They usually make up most if not all of the pensions of low and medium earners. Most of these pensions work on the pay-as-you-go (PAYG) principle, whereby today’s workers pay for today’s pensioners, on the understanding that the next generation will do the same for them when their time comes.

Now that labour forces are starting to contract and the number of pensioners is rising, these schemes are rapidly becoming unsustainable. One theoretical answer is to move to funded schemes, in which pensions are paid out of a big pot of accumulated savings. Such schemes are common in the private sector, but a public PAYG scheme is very hard to turn into a funded one because one generation of workers would have to pay both for themselves and their parents’ generation.

Unsustainable

Many rich countries already spend around 8% of GDP on public pensions, and some—Germany, Italy, France—a lot more. Richard Jackson at the Centre for Strategic and International Studies (CSIS), a think-tank in Washington, DC, calculates that if nothing is done the cost of state pensions in developed countries will almost double, from an average of 7.7% of GDP now to about 15% by 2050. In Japan and some “old” western European countries it could rise to well above 20%.

In a “no-change” scenario public expenditure on health would also rise steeply, so by 2050 the developed world would be spending nearly a quarter of its GDP on these two items alone. To prevent increases on that scale, about half the rich countries have already introduced various reforms over the past decade that have made their pensions less generous. Many more cutbacks are bound to follow.

The most obvious thing that needed reconsidering was the retirement age. When America introduced its Social Security (public pension) scheme in 1935 to prevent poverty in old age, the retirement age was 65 and life expectancy at birth was 62. In 1983 a decision was made to raise the official retirement age to 67, but in steps so tiny that the move will not be completed until 2027. Life expectancy at birth in America now averages about 78, so the promise of a pension is worth a great deal more than it was back in the 1930s. As it happens, America’s public pension system is among the rich world’s less generous (which means that financing it should remain manageable), but it still accounts for more than half the average pensioner’s income.

In the past few decades a number of governments offered various carrots to encourage people to start drawing their pensions before the official retirement age. They often claimed that this would free up jobs for younger people. Any economist could have told them that this was a prime example of the “lump-of-labour” fallacy (the idea that there is only a fixed number of jobs in an economy at any one time) and would not work. It didn’t, but the workers were happy to go and their employers were happy to lose them. Private defined-benefit final-salary schemes (explained below), where they existed, also encouraged early retirement because they did not impose an actuarial penalty on people leaving before the due date.

All this meant that the actual (“effective”) retirement age in many rich countries, particularly in Europe, dropped well below the official one. By 2004 in the OECD as a whole only 60% of people aged between 50 and 64 were working (compared with 76% for those aged 24 to 49). It was the opposite of what was needed to deal with rising life expectancy, so in recent years governments in many countries have started to dismantle some of the incentives to leave early, against fierce political resistance. This has halted, and in some cases reversed, the trend towards ever earlier retirement.

But that is only a beginning. Italy, which had a particularly unaffordable public pension scheme, has not only raised the retirement age but also increased the number of contribution years needed to qualify for a pension and cut back on benefits for the highest earners—though the effects will be felt only by people who retire from 2017 onwards. A number of other countries are gradually reducing the replacement rate of their pensions, particularly for the better-off, though most of them have been careful not to squeeze the poorest pensioners too hard.

Good try, but it didn’t work

Britain, unusually, found itself having to move the other way. Its state pension had become impossible to live on, thanks to a little-noticed decision by a Conservative government in 1980 to link the rise in the state pension to living costs instead of average earnings. In 2006 a government-appointed commission chaired by Lord Turner recommended reinstating the link with earnings, which is due to happen in 2012. Britain’s solution to the problem of unaffordable public pensions—to downsize them and hope that the private sector would fill the gap—had proved untenable.

Now the debate about sustainable pension systems for the future is all about spreading the load over several pillars. There should be a basic state pension to meet basic needs in old age, perhaps with an earnings-related element on top of it; a private occupational pillar, with employers and employees both making contributions; and a voluntary pillar, with private individuals saving for their retirement through a variety of instruments. Governments are expected to do their bit not only by providing the state-funded part, but also by offering tax incentives for the second and third pillars.

To take the pressure off public pensions, many governments have encouraged private pension plans, which have expanded rapidly in the past ten years. In half the members of the OECD private pensions are now either mandatory or cover the vast majority of the workforce. In some countries, including America, Australia, Denmark and Switzerland, private pensions now account for up to half of total retirement income.

But even before the recent financial crisis it was clear that shifting more responsibility for retirement income to the workers themselves raises big problems. In countries where public pensions are relatively small, such as America, Britain and Ireland, people are simply not saving enough to maintain their living standards in retirement. McKinsey, a consultancy, recently looked at the finances of a large sample of baby-boomers, due to start drawing their pensions soon, and found that about two-thirds of them had failed to make enough financial provision for their retirement to maintain their previous standard of living, even though as a group they had always earned well. That fits with the trend of a steady decline in American personal saving rates in the past 20 years.

And even those who had been putting money by for their old age may now be having second thoughts. In America one of the main vehicles for occupational pensions are 401(k) plans, named after a section in the Internal Revenue Code that allows employees to make tax-free payments into a defined-contribution plan. Employees can choose from various investment options, usually a range of mutual funds. Last year’s stockmarket crash caused a huge drop in the value of most such plans. Many people who had planned to retire in the near future found they had to carry on working. Suddenly prudence did not seem such a good idea.

In countries where private occupational pensions play a large part, such as America and Britain, they have become less opulent and more uncertain. In recent years there has been a big shift from defined-benefit schemes (where the eventual pension depends on a formula that takes into account the level of pay and years of contributions) to defined-contribution schemes (where a certain level of contribution is agreed on and the money invested, with the eventual pay-out depending on the return on that investment).

Defined-benefit schemes worked fine as long as stockmarkets were rising, enabling companies with such schemes to take “pension holidays”—putting a freeze on further contributions because their investments had done so well. But when markets turned down, large holes opened up in companies’ pension funds that had to be filled from current operations. Life expectancy also proved longer than forecast.

Defined-contribution schemes avoid such problems for the companies by handing all the risks to employees. It is the employees who have to worry about how their pension investments will perform and whether they will have enough to live on when they retire. If their pension funds are invested in their own company (not recommended, but it happens), they could lose everything, as workers at Enron, an energy company that collapsed spectacularly in 2001, found to their cost. Most people do not know enough about finance to make informed investment decisions.

In America, which began to move away from defined-benefit schemes two decades ago, defined-contribution plans already account for the great majority of private-sector pension schemes. Companies in Britain started later but advanced faster. Earlier this month two large British companies, BP and Barclays, announced they were closing their defined-benefit schemes, respectively, to new and existing members. Defined-contribution plans are not only riskier for the employee, but companies often contribute less to them and the resulting payouts are smaller.

In future, a growing number of people will have to manage on less generous and more uncertain occupational pensions. The big exception are public-sector workers, typically accounting for 10-20% of the total workforce in rich countries, who for the most part continue to enjoy good defined-benefit pensions. But their privileges are now coming under fire.

Work till you drop

Jun 25th 2009

Retirement has got out of hand

HOW much golden leisure can you expect at the end of your working life? The OECD has calculated for how many years people in its member countries are now likely to be drawing their pensions, starting not from their official but their actual retirement age. It found that men could look forward to between 14 and 24 years in retirement and women between 21 and 28 (see chart 6). In many countries that was half as long again as in 1970, and in some of them twice as long. And the figures are probably an underestimate because they are based on life expectancy as it is now, not as it will be in future.

Retirement has been overdone. The original idea was that people should enjoy a bit of a rest after a life at work, but nobody imagined that the rest would stretch to almost a quarter-century. Some countries have already raised their official retirement age; others are debating whether it still makes sense to have a specific retirement age at all. One widely touted idea is to phase in retirement over a number of years. It does not seem like a good idea for people to be working at full tilt one day and twiddling their thumbs the next.

From an economic point of view, getting people to work for a few more years would solve many of the problems associated with ageing populations. By carrying on, those workers will not only save the public purse money by not drawing a pension but will also continue to pay taxes and social-security contributions, so those extra years are doubly valuable.

Moreover—though it seems an outlandish thought in the middle of a deep recession and rising unemployment—ageing populations are likely to cause labour shortages. In some countries and some sectors these are showing up already. In Germany, where the labour force is due to start shrinking from next year, a study by the Institute for the German Economy in Cologne identified a shortage of about 70,000 engineers in 2007, a rise of nearly half on the year before. The obvious place to look to fill such gaps is among well-qualified older people, and indeed the institute found that companies had stepped up their recruitment of engineers over 50.

Many countries already have laws to prevent discrimination on age grounds. America led the way with its Age Discrimination in Employment act in 1967, designed to make sure that the over-40s (greybeards of their day) were given the same job chances as younger people. Among other things, it prohibited reference to age in job advertisements. The act has since been amended a couple of times and now rules out mandatory retirement on age grounds for most jobs. That seems to have helped keep older workers in jobs.

The European Union in 2000 issued a directive that obliges member countries to ban discrimination in employment on a number of grounds, including age. France imposes a tax called the Delalande contribution (now being phased out) on employers who sack older workers. Although this can be quite hefty—up to a year’s pay—it does not appear to have saved many jobs. Rather, it has discouraged employers from hiring older workers.

Various countries have concocted an alphabet soup of initiatives and pilot projects to get older people into work and keep them there, with mixed results. Advocacy groups for older people such as America’s powerful AARP, and a growing number of similar organisations that are springing up in other rich countries, have helped to raise awareness of the issue. But survey after survey finds that where employers have a choice, they prefer to hire younger workers. Are they right?

On the face of it, there are plenty of reasons to plump for youth. In most countries, pay goes up as workers become more experienced and productive, and then declines again towards the end of their careers. But in some places—for example, France, Germany and Spain—pay just keeps rising. So even assuming that workers remain just as effective as they get older (see below), at some point they end up being too expensive for what they offer.

But employers are also doubtful that older workers can still hack it. Vegard Skirbekk of the International Institute for Applied Systems Analysis near Vienna has reviewed a large number of studies about the relationship between age and individual productivity and found a fairly broad consensus that productivity in many jobs declines substantially in mid-working life.

Now that so-called “3D jobs”—the dirty, dangerous and demanding sort in, say, mining or steelmaking—have become thinner on the ground, it may not matter so much if workers become physically less vigorous; besides, older people are in better general health these days. But there is plenty of evidence that by the time people are 50, some of their cognitive abilities have also started to decline. In particular, a quality called “fluid intelligence”—including numerical skills and the ability to adjust rapidly to new situations—begins to go downhill in middle age. Very brainy people generally do their most innovative work before they are 40. Nobel prizes are usually awarded for achievements fairly early in life. By contrast, “crystallised intelligence”—general knowledge, experience, verbal ability—continues at much the same level almost indefinitely.

Employers think that older people may find it harder to pick up new skills, particularly in IT, which have become indispensable for many jobs. But that may be partly because they are invariably offered less training than younger ones. The argument is that they will be leaving soon and are not worth investing in. But younger employees might leave too.

All these reservations are linked to older workers’ individual capabilities. But Axel Boersch-Supan at the Mannheim Research Institute for the Economics of Ageing and his team have argued that what matters in a modern economy is the productivity of teams of workers, not individuals. The best solution may be to employ a mixture of vigorous young and experienced older workers.

Older workers’ knowledge and experience can easily be lost to the company when they retire. In a recent article in the Harvard Business Review based on his work with RWE, a German energy company, Rainer Strack of the Boston Consulting Group advises managers to conduct an audit of how the ageing of their workforce will affect them in years to come and develop a strategy to make sure they maintain the right skills mix.

Show me the colour of your carrot

But even if employers were happy to keep or recruit older workers, how enthusiastic would those workers be to carry on? That would depend on the circumstances. In the past few decades, when pensions in most rich countries were reasonably generous and early retirement was positively encouraged, only the most workaholic (or improvident) continued working. But now that money is getting tighter and early-retirement deals are off, the balance may well have shifted.

Most of America’s baby-boomers now say that retirement is not for them, partly because they fear they may not be able to afford it and partly because they actually like work. In Europe too there has been a change of heart from the retirement-minded 1980s and 1990s. In a recent FT/Harris poll 45-60% of respondents in the big European countries favoured working longer for a bigger pension (except in Germany, where only about a quarter wanted to carry on). But many older people would like a less onerous workload than they had at their peak, perhaps working part-time.

Japan, where it is customary to work well beyond the official retirement age, has found ways to allow people to step into less demanding roles. For example, at the head office in Tokyo of Hitachi, a giant global electronics company, over two-thirds of those who reach the company retirement age of 60 apply to be rehired. The company can usually find jobs for them, explains Takane Miwa from the company’s human-resources department, but often in a different division, sometimes part-time and always minus their former job title and seniority. The company pays the employee about 80% of his previous salary, which includes his public pension and a government subsidy, so it gets him at a bargain price.

Most other rich countries have not been good at making use of older people willing and able to work. The names of a few companies that have consistently recruited staff past retirement age—mostly retailers such as Britain’s B&Q and America’s Wal-Mart—pop up time and again, but the list never seems to get much longer. In the absence of a good choice of jobs, some newly retired people manufacture their own, turning themselves into self-employed consultants to do much the same thing as before, though perhaps at a less punishing pace.

It is worth bearing in mind that if many more older people were to stay on in the formal economy, some of the things they now do outside it and without monetary reward would fall by the wayside. Many newly retired folk sign up for voluntary work, and many more get drafted into family duties, looking after grandchildren or frail old parents. Such unpaid work does not show up in the GDP figures. If the people who do it held down regular jobs, much of those things would have to be paid for—or would not get done at all.

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