Pension Reform, Capital Markets and the Rate of Return

Abstract. This paper discusses the consequences of population aging and a fundamental pension reform – that is, a shift towards more pre‐funding – for capital markets in Germany. We use a stylized closed‐economy, overlapping‐generations model to compare the effects of the recent German pension reform with those of a more decisive reform that would freeze the current pay‐as‐you‐go contribution rate and thus result in a larger funded component of the pension system. We predict rates of return to capital under both reform scenarios over a long horizon, taking demographic projections as given. Our main finding is that the future decrease in the rate of return is much smaller than often claimed in the public debate. Our simulations show that the capital stock will decrease once the baby‐boom generations enter retirement, even if there were no fundamental pension reform. The corresponding decrease in the rate of return, the direct effect of population aging, is around 0.7 percentage points. While the capital market effects of the recent German pension reform are marginal, the rate of return to capital would decrease by an additional 0.5 percentage points under the more decisive reform proposal.     

Endogenous retirement and public pension system reform in Spain

Population aging has spurred developed countries around the world to reform their PAYG pension systems. In particular, delaying legal retirement ages and reducing the generosity of pension benefits have been widely implemented changes. This paper assesses the potential success of these policies in the case of the Spanish economy, and compares them with the results obtained by the (rather modest) reforms already implemented in 1997 and 2001. This evaluation is accomplished in a heterogeneous-agent dynamic general equilibrium model where individuals can adjust their retirement ages in response to changes to the pension rules. We check the ability of the model to reproduce the basic stylized facts of retirement behavior (particularly the pattern of early retirement induced by minimum pensions). The model is then used to explore the impact of pension reforms. We find that already implemented changes actually increase the implicit liabilities of the system. In contrast, delaying the legal retirement age and extending the averaging period in the pension formula to cover most of the individual's life-cycle can reduce the implicit liabilities substantially. These findings reveal the failure of the Spanish political system to distribute the costs of population aging more evenly across the generations.     

GROWTH AND WELFARE EFFECTS OF AN ENVIRONMENTAL TAX‐BASED PUBLIC PENSION REFORM*

This paper presents an overlapping generations model in which: (i) firms create emissions as by‐products of production; and (ii) tax revenue from the working young is transferred to the retired elderly as pay‐as‐you‐go pension benefits. The paper focuses on a replacement ratio, which measures the proportion of after tax work earnings replaced by the public pension, and considers a replacement ratio neutral reform in which the newly introduced environmental tax is devoted to cutting the social security tax, keeping the replacement ratio unchanged. It is shown that the reform may improve growth, environmental quality and the nonenvironmental utility of every generation.     

Public Pension Programs in Southeast Asia: An Assessment

This paper assesses public pension programs in select Southeast Asian economies (Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Vietnam – henceforth referred to as the SEA6) and the key issues facing them. The criteria used in assessing pension systems are the philosophy of pension design, the extent of coverage, investment policies and performance, and administrative and compliance costs. The paper argues that three broad reform directions to strengthen public pensions merit consideration. The first direction is to enhance the professionalism of the existing provident and pension fund organizations, including their governance practices. The second direction is to strengthen the role of noncontributory budget‐financed pensions (e.g. social pensions). The third is to adopt a systemic perspective to pension reform that includes reforms in complementary areas (labor markets, public financial management practices, and the civil service); developing a financing‐mix of pensions; and lastly, improving effective coverage by exploring complementarities between health care and pension programs.     

How should a government finance pension benefits?

Based on an earlier report by Ono (2010), this paper presents consideration of a consumption tax and examines how tax reform to maintain the neutrality of pension benefits affects the income growth rate and the employment rate. A decrease in the rate of worker contribution (labour income tax rate) with an increase in a consumption tax raises employment, but the effect on income growth is ambiguous. A decrease in the rate of firm contribution with an increase in the consumption tax decreases employment and facilitates income growth. Therefore, if the unemployment rate must be decreased, then pension reform with a decrease in the rate of worker contribution should be selected. The results derived through the study described in this paper are consistent with the empirical facts. Moreover, for these analyses, we assume the other production function and confirm the robustness of the obtained results.     

National culture and the configuration of public pensions

This paper explores the determinants of public pension plan configurations. It is argued that the level of intragenerational redistribution in public pension plans is related to a country's cultural background. The level of intragenerational redistribution is measured by Krieger and Traub's Bismarckian factor. The countries’ cultural background is operationalized using cultural dimensions developed by Hofstede. The empirical results are in line with our hypotheses. Uncertainty avoidance appears to have a significant, positive association with the Bismarckian factor (low intragenerational redistribution in public pensions), whereas the relation with individualism is negative (high intragenerational redistribution). Moreover, a positive association is found between the Bismarckian factor and inflation shocks in the first half of the 20th century. While the sample size is limited, the results are robust to the inclusion of different economic, institutional, and demographic control variables as well as to using alternative model specifications. These findings have important public policy implications. We argue that pension reform proposals suggesting a transformation of public to private pension provision should consider the cultural background of countries.     

Micro simulations on the effects of ageing-related policy measures

In the Netherlands, like in most OECD-countries, the ageing of the population endangers the sustainability of public finances. In this paper a dynamic micro simulation model is used for calculating the financial and economic implications of the ageing problem and the policy measures considered. The model uses micro datasets of all Dutch pensions and pension entitlements. The retirement decision is modelled by using an option value approach.     

Social Desirability of Earnings Tests

Abstract. In many countries, pension systems involve some form of earnings test; i.e. an individual's benefits are reduced if he has labor income. This paper examines whether or not such earnings tests emerge when pension system and income tax are optimally designed. We use a simple model with individuals differing both in productivity and in their health status. The working life of an individual has two 'endings': an official retirement age at which he starts drawing pension benefits (while possibly supplementing them with some labor income) and an effective age of retirement at which professional activity is completely given up. Weekly work time is endogenous, but constant in the period before official retirement and again constant (but possibly at a different level), after official retirement. Earnings tests mean that earnings are subject to a higher tax after official retirement than before. We show under which conditions earnings tests emerge both under a linear and under a non-linear tax scheme. In particular, we show that earnings tests will occur if heterogeneities in health or productivity are more significant after official retirement than before.     

Social Security and Family Support

This paper shows how the role of the market, the state and the family in providing old‐age support has evolved over time with changes in factors such as the reliability and the effectiveness of family support, the interest rate, the cost of public funds, and earning inequality. Agents with different productivity vote over the size of a Beveridgian pension system. When children assistance is certain, agents may rely exclusively on family and prefer no pension. However, when the size and the probability of family generosity decrease, social security is more likely to emerge.     

An inter-temporal general equilibrium analysis of the Australian age pension means test

The Australian age pension is somewhat unusual among developed countries in that it is means tested against both the claimant’s income and assets. While means testing of age pensions facilitates the aims of directing public pensions to those senior individuals most in need and of containing pension expenditures by governments, it also has the effect of changing the incentives of individuals to work and save. This paper examines the implications of the Australian means tested age pension for incentives of individuals to save and work, for government financial commitments and for the welfare of individuals. To this end, we develop an overlapping generations model of the Australian economy that incorporates the essential features of the Australian pension, superannuation and taxation policy settings and use it to explore the implications of several hypothetical policy changes that relax the means test of the age pension. Our results confirm that the existing means-tested, age pension represents a disincentive for some older Australians to work.     

Welfare Analysis of Pension Reforms in an Ageing Japan

This paper uses a computable general equilibrium model with overlapping generations to explore the effects of different public pension schemes on economic welfare, and intergenerational and intragenerational equity. Besides the benchmark case based on the 2004 public pension reform, the present paper considers two alternative reforms: financing the basic pension benefit through a consumption tax, and eliminating the earnings‐related pension benefit. The simulation results suggest that even the consumption‐tax financing of only the basic pension, namely, the combination of both reforms, might not improve overall economic welfare, although it increases economic output by inducing capital formation.     

The health implications of social pensions: Evidence from China's new rural pension scheme

This paper estimates the causal effect of income on health outcomes of the elderly and investigates underlying mechanisms by exploiting an income change induced by the launch of China's New Rural Pension scheme (NRPS). Using this policy experiment, we address the endogeneity of pension income by applying a fixed-effect model with instrumental variable correction. The results reveal that pension enrollment and income from the NRPS both have had a significant beneficial impact on objective measures of physical health and cognitive function of the rural elderly. Pension recipients respond to the newly acquired pension income in multiple ways: improved nutrition intake, better accessibility to health care, increased informal care, increased leisure activities, and better self-perceived relative economic situation. These in turn act as channels from pension income to health outcomes of the Chinese rural elderly.     

Self‐Directed Pensions: Gender,Risk, and Portfolio Choices*

In this paper, I investigate gender differences in financial risk‐taking from a new perspective, and I show that gender plays a different role across the risk distribution. To evaluate risk‐taking, I exploit portfolio choices following a reform that entitles almost the entire Swedish workforce to choose a risk profile for a part of their public‐pension contributions. The novel finding is that portfolio risk does not differ much between the men and women who choose less risky portfolios, while the men who choose risky portfolios take on significantly more risk than do the women who choose risky portfolios. The findings are robust to investors choosing the default alternative, chasing past returns, rebalancing, and different measures of risk‐taking.     

Risk Sharing and Efficiency Implications of Progressive Pension Arrangements*

This paper aims to quantify the welfare effects of progressive pension arrangements in Germany. Starting from a purely contribution‐related benefit system, we introduce basic allowances for contributions and a flat benefit fraction. Since our overlapping‐generations model takes into account variable labor supply, borrowing constraints as well as stochastic income risk, we can compare the labor supply, the liquidity and the insurance effects of the policy reform. Our simulations indicate that it would be optimal to introduce a flat benefit share of 50 percent and a basic allowance that amounts to 30 percent of average income. Such a reform would yield an aggregate efficiency gain of 3.3 percent of resources.     

Hiring Older Employees: Do the Age Limits of Early Retirement and the Contribution Rates of Firms Matter?

We examine the effects of a Finnish pension reform on firms' incentives to hire older employees. The reform restricted the eligibility ages for early retirement and changed the size‐related contribution rates of firms. According to our theoretical model, the positive effect on the values of new hires extends to age groups younger than those directly affected by the reform, and the effects are strongest in the largest firms. These model predictions were confirmed in a difference‐in‐difference‐in‐differences analysis on the probability of the hiring of workers of different ages in firms of different sizes.     

Taxation of early retirement windows and delaying retirement: The French experience

This paper investigates the effect of the 2003 French pension reform on hiring, firing and employment rates among older workers. This reform increased the mandatory retirement age and simultaneously it set a tax levied on early retirement windows paid by firms to their older workers, to encourage them to leave their job early. We use a matching model with endogenous job destruction extended to account for a mandatory retirement age and we calibrate the model with data drawn from the French Labor Force Surveys for the years 2002 and 2003. We show that in the case of a high tax rate, delaying retirement raises job separation rates, which partially offsets its positive effect on job finding rates. Consequently, the combination of an increase in the retirement age and a taxation on early retirement windows may have negative effects on the employment rate among older workers.     

Public pension and household saving: Evidence from urban China

We relate household savings to pension reform, to explain the high household savings rates in urban China from a new perspective. We use the exogenous – policy-induced – variation in pension wealth to estimate explicitly the impact of pension wealth on household savings, and obtain evidence of a significant offset effect of pension wealth on household savings. Although the size of the effect depends on the parameter values assumed, the finding that household savings are affected by pension reform is robust. Our estimates show that, under plausible scenarios, pension reform boosted household savings rates in 1999 by about 6–9 percentage points for cohorts aged 25–29 and by about 2–3 percentage points for cohorts aged 50–59. Our results also indicate that declining pension wealth reduces expenditure on education and health more than on other consumption items.     

Consumption,welfare, and stochastic population dynamics when technology shocks are (Un)tied

The impact of uncertainty on consumption and welfare seems obvious; because of the precautionary saving motive, higher uncertainty reduces consumption, and subsequently, deteriorates welfare. Recent several studies, however, find that this intuitive narrative is not necessarily true. This paper provides the analytical underpinnings for this. In the absence of technological progress, I find that the larger demographic shocks always reduce consumption, but improve the welfare of households. Moreover, when demographic shocks are negatively tied to technology shocks, there emerges an inverted-U relationship between the size of two shocks and consumption, and a U-shaped relationship between the size of two shocks and household welfare. These results are all characterized analytically in the framework of the stochastic two-sector growth model featuring the correlated Brownian motion process. The findings suggest that demographic policies should not be implemented with no reference to the state of technology.     

ACHIEVING FISCAL BALANCE IN JAPAN*

Japan is aging and has the highest government debt‐to‐output ratio among advanced economies. In this article, we build a micro data‐based, large‐scale overlapping generations model for Japan in which individuals differ in age, gender, employment type, income, and asset holdings, and incorporate the Japanese pension rules. Using existing pension law, current fiscal policy, and medium variants of demographic projections, we produce future paths for government expenditures and tax revenues, with implications for government debt and the public pension fund. Additional pension reform, a higher consumption tax, and higher female labor force participation help achieve fiscal stability.