Live Long and Prosper? Demographic Change and Europe s Pensions Crisis

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1 10 November 2015, Brussels Live Long and Prosper? Demographic Change and Europe s Pensions Crisis Key Note Speech Dr. Jochen Pimpertz Head of Research Unit Public Finance, Social Security, Income and Wealth Distribution Cologne Institute for Economic Research Revisions reserved. Check against delivery.

2 When we first met in summer 2014 for a brainstorming about old age provision in times of demographic change and the need of fiscal consolidation, we discovered two aspects which I would like to discuss separately. Of course the first challenge is to identify adequate measures to reform public pension schemes in order to handle the demographic challenges the EU28 will have to face. However, we quickly arrived to a full agreement that we cannot expect a kind of blueprint for reform proposals, because too many nation-specific aspects have to be taken into account. At the same time the European Commission s role has changed significantly since the recent crisis emerged. Today, the European Commissions analysis offer an early warning of macroeconomic imbalances. Besides reporting within the European Semester especially the EU ageing report projects public pension expenditure in the long term and thereby, reveals the influence of pension systems on the governments ability to handle the aftermath of the crisis. In this way a second question occurs beyond the focal point of reforming pension schemes: What part should European institutions play in the reform process? Demographic change within the EU28 Before answering these questions I would like to start with a short review about demographic challenges in Europe. There Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 2

3 are three drivers of demographic change, which occur in almost all 28 EU member states, which are rising life expectancy low fertility rates and the ageing of numerical strong cohorts followed by smaller ones, which results from an abrupt shrinking of the fertility rate in the past These trends will lead to a rapid ageing of the European society. The old age dependency ratio will nearly double by By reason of sustainability this development is not only important due to the rising number of pensioners, but at the same time the labour force will shrink dramatically. The EU28 s labour force will decline by 45 million people to 290 million by Certainly, the demographic challenge is not the same for every member state which is shown by the next figure. It illustrates the development of the old age dependency ratio of each member state in the coming decades. Magnitude, speed and timing of population ageing vary significantly. However, none of the member states will be spared of demographic challenges. If public pension schemes remain unchanged especially pension level and retirement age the ageing of the member states societies will cause significant increases in public pension expenditures illustrated by the next figure which Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 3

4 shows the development of public pension expenditures as a share of GDP among the EU28 member states. A solely fiscal perspective is too narrow However, as the national pension systems differ in many aspects, it is doubtful that suitable reform measures can be based on fiscal indicators alone. I would like to explain this by four aspects: 1. National pension systems are characterised by a particular combination of PAYG and capital-funded elements, whereas demographic change will affect both elements differently. As shown in a simplified model a PAYG pension scheme is balanced if contributions paid by employees in one period equal pension payments in the same period. Thus, PAYG pension schemes organise income redistribution between different cohorts within one period. That is why any variation in the numerical size of cohorts causes financial imbalances in the following period in the case of ageing numerical strong cohorts as well as in the cases of low fertility rate or rising life expectancy. Capital-funded schemes also redistribute income, but within the same cohort and over two periods. They do so by saving premiums paid during the period of Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 4

5 employment and building up a capital stock, which will be melt down afterwards during the period of retirement in order to finance monthly payments. Therefore, capital-funded schemes are not affected directly by the ageing of numerical strong cohorts or by low birth rates. Only in the case of rising life expectancy it becomes necessary to adjust either the retirement age or the premium level and/or the pension level. 2. Fiscal consolidation can also be achieved by other reform measures. Concentrating on public pension systems might neglect these alternatives, for example cutting costs of public health care or long-term care systems which are affected by demographic change in a similar way. 3. Pension systems do not only differ in their specific combination of PAYG and capital-funded elements, but they also pursue different normative aims. Therefore, alternative strategies might be suitable depending on whether income maintenance or poverty prevention is the main purpose of the system. 4. At last, nation specific preferences might lead to different reform strategies. These differences cannot be explained by the type of pension scheme alone, but by the society s choice which generation should mainly be Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 5

6 burdened with the effects of demographic change. One fits for all In the light of these different criteria our first conclusion is that public pension policy should remain a national issue. With regard to nation specific preferences as well as to the different purposes and designs of pension systems the national governments are much closer linked to the societies preferences than any EU institution can be. However, there is one measure that fits for all member states. This is the adjustment of the effective retirement age in line with the increasing life expectancy. This measure is able to rebalance PAYG operating schemes as well as capitalfunded ones. Moreover, deferring retirement age is able to strengthen the productive potential of the economy and thereby will help to bear the burden of social expenditure in general. Different systems, different paths of reform Nevertheless, beyond this one measure fitting for all we found different reform paths in our four case studies. I would like to present some of the most salient characteristics. Germany and Italy represent public pension schemes that pursue income maintenance. Both have established social welfare systems separately with means-tested benefits. Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 6

7 In Germany the pension reforms of the last decade lead to a continuously shrinking pension level by This becomes necessary in order to mitigate the expected increase of the contribution rate. In this respect the German pension reform can be understood as a political compromise between the older and the younger generation about bearing the burden of demographic change. The reform was accompanied by two additional strategies on the one hand eliminating incentives for early retirement, on the other hand supporting voluntary private pension schemes by supplements and tax allowances. In Italy the established public pension scheme is quiet similar to the German case, but a completely new mandatory pension scheme was introduced for younger cohorts in 1995 a notional defined contribution system. This still operates like a PAYG scheme but it mimics the effects of a capital-funded scheme. For each employee the contributions paid are registered in an individual account which generates notional interest. The virtually accumulated stock is converted into an annuity when pension age is reached. As a consequence, the individual annuity, which is nothing else than the monthly pension payment, depends on the age of retirement which the employee chose. The earlier an employee retires the lower his Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 7

8 annuity will be due to a smaller notional stock and a longer period of time receiving pension payment. In that way notional defined contribution systems prevent incentives for early retirement in a similar way to capital-funded schemes, but without accumulating a stock actually. By contrast, the Danish and the UK public pension schemes only guarantee a basic protection. That is the reason why public pension expenditure as a share of GDP will stay below the German or Italian level although the Danish and British population will grow old in a similar way. On the other hand, private and occupational pension schemes are much more important to achieve income maintenance in these countries. In Denmark, for instance, occupational pension schemes become quasi-mandatory as pension plans have been negotiated as part of collective agreements by the relevant employer associations and unions. Therefore, in 2013 almost 9 out of 10 full-time employees were covered by an occupational pension scheme. The UK pension system is quite similar to the Danish one. In order to achieve income maintenance both occupational and private pensions traditionally play an important role in retirement income in the UK. In 2013, about half of the working age population was enrolled in a voluntary private pension plan. Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 8

9 In order to encourage individuals to save even more for their retirement, automatic enrolment in an occupational pension plan was introduced in Employers are required to automatically enrol all employees who are not already covered by a private pension. People can choose to opt out within one month, but employers will automatically re-enrol those who have opted out on a three-year cycle so that there will be no way out of additional private or occupational saving. EU s part to play As reforming pension systems should remain an issue of national responsibility and competence, the question left is which part European institutions should play during the reform process. The European Commission already supports national reform strategies by monitoring public pension systems and by evaluating reform measures which are already introduced. Furthermore, the Commission might simulate the effects of different reform strategies in the run-up of reform debates. At last, a non-negligible issue is to foster the single market strategy in other sectors. Monitoring public pension systems is helpful in identifying conflicts which result from demographic change and the need of fiscal consolidation. For example, this is exactly what the EU ageing report does. Transparency about these conflicts might force Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 9

10 national governments to evaluate their social policy in general and their pension policy in particular. Furthermore, the Commissions reporting might help to induce necessary debates about intergenerational justice within the member states. Additional to the existing method of the EU ageing report, simulating of the effects of alternative reform options might be helpful to enable national governments to launch adequate reforms. Moreover, this might be helpful to encourage more innovative approaches. At last, one of the core responsibilities of the EU is the promotion of other single markets. By carrying out this task European institutions can also support the member states public pension schemes indirectly. As economic prosperity has a positive impact on fiscal sustainability, a successful single market strategy can help to extend the ability of the national governments to take action on social policy. Thank you for listing. Key Note Speech, : Live Long and Prosper? Demographic Change and Europe s Pensions Crisis 10

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