Public Pensions. Economics 325 Martin Farnham

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1 Public Pensions Economics 325 Martin Farnham

2 Why Pensions? Typically people work between the ages of about 20 and 65. Younger people depend on parents to support them Older people depend on accumulated wealth, kids, and/or society to support them Pensions provide income support for people in retirement Can alternatively be thought of as savings or insurance (but best to think of them as insurance)

3 Basics of Canadian Pension System 3 components Old Age Security Program (financed out of general revenues) Old Age Security Pension (OAS) Guaranteed Income Supplement (GIS) Allowance program These programs provide basic income support (most people get the same amount, regardless of earnings during working years) Canada/Quebec Pension Plans (CPP/QPP) Benefits tied to contributions; those who earn more and pay in more, earn higher benefits (kind of like EI) Provides disability insurance

4 Basics of Canadian Pension System CPP/QPP (continued) Financed from employee contributions Private pensions make up third component of Canadian system Registered Retirement Savings Plan (RRSPs), Registered Pension Plan Registered pension plans can be defined contribution (like a savings account) or defined benefit (insurance against living too long) Long-term viability of these programs is cause of some concern Public components (OAS, CPP/QPP) are partly pay as you go systems Most contributions today don t get put in a bank account; they get paid out as benefits immediately

5 Why Public Pensions? Asymmetric information (adverse selection) People don t know how long they will live, though they know better than an insurance company People would like to purchase insurance against living too long (running out of money) Called an annuity. You pay a lump sum now, and in exchange the insurance company pays you a stream of income until you die. If actuarily fair, then on average the stream of payments will be the capitalized value of the lump sum payment But companies will be reluctant to sell annuities to people who claim they won t live for long Just like other insurance; those with greatest risk (of living long) are most likely to buy the annuity

6 Why Public Pensions? Paternalism Maybe the government feels people are myopic. Don t plan well for future Assumes people are not fully rational Government holds peoples hands by forcing them to save (by forced contributions to CPP, for example) Figures people will thank them someday Also prevents people from failing to save and so then going on welfare when they run out of money

7 Why Public Pensions? Missing information; costly planning Maybe people lack the skills or knowledge to plan Government could plan for them, hence saving them the costs of figuring it out themselves Why isn t this a particularly good argument? Government could just provide people with needed information; put pension calculators online and offer financial advice to those who need it Arguably, with this information and assistance, people could best plan for themselves, rather than having government decide for them what their savings should be

8 Redistribution The public pension system provides another way to redistribute income Wealthy get lower ratio of benefits/contributions than poor in CPP. OAS gives everyone a basic amount (yet income taxes are higher for wealthy which implies some redistribution); plus poor elderly get GIS Public pensions don t discriminate against people on basis of gender, for instance Private market would charge more to women for an annuity, because they live longer; so public pensions redistribute toward women (who tend to be poorer in retirement) from men Some debate in US over indexing benefits to life expectancy (i.e. pay less to people who will live longer)

9 Why Are Many Public Pensions Pay-asyou-go? Pay-as-you-go financing pays current benefits out of current contributions Your and your parents CPP contributions finance your grandparents benefits Your benefits will be paid out of your kids and grandkids contributions Under alternative financing arrangement, government could manage a big bank account where everyone s contributions go to earn interest until they retire System of individual accounts (Bush tried to push this in US)

10 Pay-as-you-go Finance Pay as you go financing is sometimes called Ponzi financing Charles Ponzi was a con artist who went around running pyramid investment schemes. Sign on a few investors, then pay them high returns by signing on more investors and handing the new investors money over to the old investors Scheme generates money for old investors until new people refuse to sign on Need a bigger crowd of new investors in each stage hence the name pyramid scheme Eventually new round of potential investors worries they won t get paid back and so refuse to contribute--pyramid collapses

11 Is CPP/QPP a Ponzi-Scheme? Under growing population and productivity growth, CPP/QPP flourished Both sources of growth have declined Now there is some concern that young generation will pull out; system would certainly collapse if they did Why would young pull out? If they believe they won t get benefits, why should they pay in? Many young people would rather take their chances with private accounts put their own money where they re (virtually) guaranteed to get it back. This has lead to reforms in Canada and calls for reform in the US. CPP now has a reserve fund (hybrid pay-as-yougo); doesn t cover all future liabilities

12 Why Choose Pay-as-you-go over Private Accounts? Politically it s more viable to start Voters alive today can shift costs to unborn generations If the economy is growing fast, then contributions can grow more quickly than money in a bank account This worked well for Canada and US in 1960s, not so well after 1970s productivity slowdown In some cases, exigent circumstances required establishing benefit payments immediately (e.g. US in Great Depression)

13 Effects of Public Pensions on Behaviour Saving (could go up or down) If government is forcing you to save, your private saving is likely to decline in response If your benefits are tied to choice of retirement age, this may affect your decision to retire If rules don t allow you to work and collect benefits at the same time, you may quit work earlier; in anticipation of this you may save more earlier in life Some people like to transfer wealth to their children in the form of an inheritance CPP/QPP reverses this transfer, by giving money from young to old Parents may try to undo this transfer by increasing bequests; will save more to do this.

14 Effect on Saving: Empirical Evidence Results generally suggest some negative impact on saving overall (most studies on US) Feldstein (1974) found strongly negative effect of US Social Security on saving Famous paper, because the initial result was due to a programming error His RA s fault (supposedly!) Revised results found smaller effect Other studies have disputed his revised findings Munnell finds much smaller effect when controlling for unemployment (though effect on saving is still negative) Burbidge suggests small negative effect in Canada

15 Effect of Public Pensions on Retirement Timing Certain program rules can create incentive for people to retire early If government claws back benefits for people who continue working, people will be more likely to retire early Retirement ages in Canada have decreased since the 1960s when public pensions were implemented But this decrease is part of a 100 year trend started long before the introduction of such programs.

16 Effect of Public Pensions on Retirement Timing There are penalties for collecting CPP before age 65 Example: By 2016, someone who retires at age 60 will receive 36% less benefits than they would if they retired at 65. There are also rewards to delaying retirement up to age 70 (benefits rise by 8.4% per year delayed) Tweaking these incentives to discourage early retirement is a key focus of policymakers.

17 Some Details on Canadian System Old Age Security Program Started in 1927 with Old Age Pension Act Originally pensions were means tested (more you earn, the less you get) 1952 Universal pension (no longer means tested) of $40/ month Full indexation of benefits introduced in 1973; attempts to back away from this were shouted down OAS benefits (around $550/month) are taxed

18 Details on Canadian System Old Age Security Program (cont) GIS (guaranteed income supplement) is an add-on to Old Age Security Program Means-tested program that operates like negative income tax Gives grant (maximum $740/month) to poor retirees; taxes away that benefit according to level of other earnings Allowance Means tested benefit to widows, widowers, spouses, partners of OAS recipients Originally, OAS Program provided basic income for all retirees (universal program); regardless of earnings during working years

19 OAS Challenges In 1989, partial clawback of OAS benefits was introduced Points to basic debate over whether programs should be universal or targeted Universal programs are viewed as easier to get political support for But it doesn t make sense to redistribute to everyone Further attempts at increasing clawback in 96 failed Population aging threatens viability of OAS. Leading edge of baby boom reached age 65 in 2010 (many more retirees on the way) If productivity growth remains strong enough, this won t be a problem

20 Some Details on Canadian System Canadian Pension Plan (CPP/QPP) Established in 1965 under Lester Pearson Differs from OAS Program in that people receive benefits proportional to their contributions High earners receive more benefits than low earners Basic components Retirement benefits (regularly claimed starting at age 65; options for early or late retirement exist) Disability benefits (can collect these before regular retirement age if you become disabled) Survivor benefits (for spouse of primary income earner) CPP is more like an annuity than OAS

21 Contribution Rates to CPP Have Grown Over Time Contribution rate in 1966 was 3.6%; more than funded current benefits Founders expected contribution rates would increase to 5.5% in 2030 By 1996 contribution rates of 14.2% were expected for 2030; why the increase? Benefits expanded Birth rates fell (so fewer paying in than expected) Lifespans increased more than expected Productivity slowed starting in mid-1970s Disability claims have risen

22 1998 CPP Reforms Contribution changes Contribution rate raised from 5.6% in 1996 to 9.9% in 2003; set to hold there for rest of this century Investment of reserve fund in securities Benefits changes (reductions) Stricter eligibility rules for disability Benefits based on Year s Maximum Pensionable Earnings of past 5 years (as opposed to past 3 years)--likely to reduce benefits paid out Limits on survivor and death benefits

23 Intergenerational Redistribution Different generations have fared differently under CPP Those born in 1915 received $5.50 in benefits per dollar contributed Those born after 1975 are expected to receive less than $0.50 per dollar contributed Recent reforms make things worse for your generation (at least on the contributions side) Political opposition to intergenerational redistribution may not be as strong as it could be, if young voters feel ties to older voters who benefit from such redistribution

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