A pension system with points as an instrument to implement intergenerational and intragenerational justice. Erik Schokkaert (CORE and KU Leuven)
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1 A pension system with points as an instrument to implement intergenerational and intragenerational justice Erik Schokkaert (CORE and KU Leuven)
2 Introduction Introduction 1. Introduction This is not a neat theoretical paper with a well-dened research question, a deep theoretical analysis and a convincing empirical application. An attempt to sketch a possible architecture for a pension system, with still many loose ends and without empirical estimates for crucial parameter values. I will only talk about the pay-as-you-component in the system, and not about the desirability of a funded pillar. The ideas in my presentation are closely related to the proposals of the Pensions Commission, but do not completely coincide. The latter was a consensus report.
3 Introduction Introduction Pensions and justice A reform of the pension system is not a merely technical choice, but necessarily reects an ethical perspective on what is a good society. Basic objective of any pension system: to guarantee citizens an adequate standard of living after the end of their working life. Equal opportunities for everybody: citizens are responsible for their own choices, but have to be compensated for dierences in their external environment and in their innate talents.
4 Introduction Introduction Intergenerational equity The pension system must nd a balance between intragenerational and intergenerational equity. Justice is between cohorts and not between the old and the young. Financial sustainability of system necessary if we want to treat younger cohorts in a fair way. A pay-as-you-go system is only politically and socially sustainable if younger cohorts trust the system, i.e. if there is a credible intergenerational social contract.
5 Introduction Introduction Intergenerational equity The pension system must nd a balance between intragenerational and intergenerational equity. Justice is between cohorts and not between the old and the young. Financial sustainability of system necessary if we want to treat younger cohorts in a fair way. A pay-as-you-go system is only politically and socially sustainable if younger cohorts trust the system, i.e. if there is a credible intergenerational social contract.
6 Introduction Introduction A points system Individuals collect points throughout their career: π ti. At the moment of retirement, the pension is some function of the number of points collected: P Ti = f (Π Ti ) with Π Ti = t π ti. The points system does not solve any problem. It is just a transparent and exible method to calculate pensions. Transparency is important for incentives. Transparency is important for the perception of justice (legitimacy). Flexibility means that the architecture creates room for a broad social debate.
7 Introduction Structure Structure 1 Introduction. 2 Intragenerational justice and the points system. 3 Intergenerational justice and the points system. 4 Overall justice. 5 Some notes on incentives. 6 Conclusion.
8 Intragenerational justice and the points system 2. Intragenerational justice equally endowed cohorts dierent cohorts equally endowed individuals no problem of justice intergenerational justice dierent individuals intragenerational justice overall justice
9 Intragenerational justice and the points system Responsibility Principles: responsibility Individuals make choices with respect to their labour supply and eort. These choices must have consequences: relationship between eort (number of years worked) and pension. relationship between contribution (mainly labour income) and pension (insurance function). exibility of the moment of retirement, but with consequences for the pension.
10 Intragenerational justice and the points system Responsibility Points system: responsibility and insurance In year t, individual i collects points proportionally to her labour income S ti (with S t denoting the average income of the full-time working population in t): π ti = (S ti /S t ). An individual who is working full-time at the average wage gets 1 point. This is an attractive normalization (easy to interpret). This approach automatically implements two ideas: 1 pension calculation is based on the whole career (and not only on the last years); 2 incomes received in the past are revalued for income growth in the past.
11 Intragenerational justice and the points system Solidarity Points system: solidarity Additional points can be allocated for assimilated periods (if not resulting from free choices: sickness, involuntary unemployment). Specic modalities can be chosen in a exible way. Maxima and minima can be imposed on the total number of points that can be collected. The function P Ti = f (Π Ti ) can be made progressive. Illustration: Belgian Pension Commission proposed to introduce a minimum number of points Π min for everybody who has been working for a whole career. Bonus points can be allocated for those that have physically (or psychologically) demanding jobs.
12 Intragenerational justice and the points system Solidarity Points system: solidarity Additional points can be allocated for assimilated periods (if not resulting from free choices: sickness, involuntary unemployment). Specic modalities can be chosen in a exible way. Maxima and minima can be imposed on the total number of points that can be collected. The function P Ti = f (Π Ti ) can be made progressive. Illustration: Belgian Pension Commission proposed to introduce a minimum number of points Π min for everybody who has been working for a whole career. Bonus points can be allocated for those that have physically (or psychologically) demanding jobs.
13 Intragenerational justice and the points system Solidarity Points system: solidarity Additional points can be allocated for assimilated periods (if not resulting from free choices: sickness, involuntary unemployment). Specic modalities can be chosen in a exible way. Maxima and minima can be imposed on the total number of points that can be collected. The function P Ti = f (Π Ti ) can be made progressive. Illustration: Belgian Pension Commission proposed to introduce a minimum number of points Π min for everybody who has been working for a whole career. Bonus points can be allocated for those that have physically (or psychologically) demanding jobs.
14 Intragenerational justice and the points system Solidarity Flexibility As emphasized before, the points system does not settle the dicult questions of (a) which solidarity?; (b) how much solidarity?; (c) trade-o between solidarity and insurance? Anything goes. It oers a transparent architecture by which many dierent answers to these questions can be implemented. Remember the attractive normalization: allocating 1 point is equivalent to a rise in the pension claim corresponding to that of an individual who is working full-time at the average wage. Note on splitting in case of divorce.
15 Intragenerational justice and the points system Solidarity Flexibility As emphasized before, the points system does not settle the dicult questions of (a) which solidarity?; (b) how much solidarity?; (c) trade-o between solidarity and insurance? Anything goes. It oers a transparent architecture by which many dierent answers to these questions can be implemented. Remember the attractive normalization: allocating 1 point is equivalent to a rise in the pension claim corresponding to that of an individual who is working full-time at the average wage. Note on splitting in case of divorce.
16 Principles 3. Intergenerational justice equally endowed cohorts dierent cohorts equally endowed individuals no problem of justice intergenerational justice dierent individuals intragenerational justice overall justice
17 Principles Principles Dominant criterion: the global welfare position of cohorts. Two non-starters: neutrality or equal tax burdens for all cohorts (as suggested, e.g., in generational accounting exercises). acquired rights of the pensioners. We need an acceptable reference point to divide the eects of economic and demographic changes over the dierent generations.
18 Principles Dividing the burden Four dierent possibilities: 1 Fixed contribution 2 Fixed benet 3 Fixed (gross) replacement rate 4 Musgrave rule Taking into account the budget constraint of the pension system, these imply dierent ways of intergenerational burden sharing: P T L p T = τ T S T L w T P T D T = τ T S T
19 Principles Dividing the burden Four dierent possibilities: 1 Fixed contribution 2 Fixed benet 3 Fixed (gross) replacement rate 4 Musgrave rule Taking into account the budget constraint of the pension system, these imply dierent ways of intergenerational burden sharing: P T L p T = τ T S T L w T P T D T = τ T S T
20 Principles FC FB FR M (Musgrave) FIXED τ P δ = P/S m = P/(S(1 τ)) contribution rate τ τ P D S δ D m D 1+m D pension P τ S D P δ S Sm 1+m D net wage S(1 τ) S(1 τ ) S P D S(1 δ D) S 1+m D eect of S shared workers shared shared eect of retirees workers workers shared D
21 Principles FC FB FR M (Musgrave) FIXED τ P δ = P/S m = P/(S(1 τ)) contribution rate τ τ P D S δ D m D 1+m D pension P τ S D P δ S Sm 1+m D net wage S(1 τ) S(1 τ ) S P D S(1 δ D) S 1+m D eect of S shared workers shared shared eect of retirees workers workers shared D
22 Principles Remaining normative questions P = Sm /(1 + m D) Implementing the Musgrave rule implies two normative questions: m : what is the optimal allocation of consumption over the life cycle? D: what is the optimal choice of leisure in a life-cycle perspective? IMPORTANT! The sustainability of a pay-as-you-go system requires that the younger generations can trust the system. This requires the acceptance of clear rules that can be applied in the future. The Musgrave-rule is one possible way of doing that. This requires that application of the rule can be believed to be sustainable in the long run.
23 Principles Remaining normative questions P = Sm /(1 + m D) Implementing the Musgrave rule implies two normative questions: m : what is the optimal allocation of consumption over the life cycle? D: what is the optimal choice of leisure in a life-cycle perspective? IMPORTANT! The sustainability of a pay-as-you-go system requires that the younger generations can trust the system. This requires the acceptance of clear rules that can be applied in the future. The Musgrave-rule is one possible way of doing that. This requires that application of the rule can be believed to be sustainable in the long run.
24 The value of a point Calculating the pension General formula to calculate pension of person i at the moment of retirement T : in period T. P it = ν T.r Ti.Π Ti, r Ti a correction in case of early retirement. Π Ti the total number of points collected by individual i. ν T the value of one point - common for all individuals retiring r Ti captures individual retirement behaviour with r T = 1. This is interpreted as part of individual responsibility. How to set the value of a point ν T? What is the optimal replacement rate?
25 The value of a point Calculating the pension General formula to calculate pension of person i at the moment of retirement T : in period T. P it = ν T.r Ti.Π Ti, r Ti a correction in case of early retirement. Π Ti the total number of points collected by individual i. ν T the value of one point - common for all individuals retiring r Ti captures individual retirement behaviour with r T = 1. This is interpreted as part of individual responsibility. How to set the value of a point ν T? What is the optimal replacement rate?
26 The value of a point Calculating the pension General formula to calculate pension of person i at the moment of retirement T : in period T. P it = ν T.r Ti.Π Ti, r Ti a correction in case of early retirement. Π Ti the total number of points collected by individual i. ν T the value of one point - common for all individuals retiring r Ti captures individual retirement behaviour with r T = 1. This is interpreted as part of individual responsibility. How to set the value of a point ν T? What is the optimal replacement rate?
27 The value of a point The value of a point Fix a target dependency ratio D T. Dene Π REF T target D. T as the average career length that corresponds with that Take a reference individual with r Ti = 1 and Π Ti = Π REF T. That individual gets a reference pension, i.e. P T = δ S T. In general, the pension for any individual i then becomes: P Ti = (Π Ti /Π REF T ).δ.s T.r Ti
28 The value of a point The value of a point Fix a target dependency ratio D T. Dene Π REF T target D. T as the average career length that corresponds with that Take a reference individual with r Ti = 1 and Π Ti = Π REF T. That individual gets a reference pension, i.e. P T = δ S T. In general, the pension for any individual i then becomes: P Ti = (Π Ti /Π REF T ).δ.s T.r Ti
29 The value of a point The value of a point Fix a target dependency ratio D T. Dene Π REF T target D. T as the average career length that corresponds with that Take a reference individual with r Ti = 1 and Π Ti = Π REF T. That individual gets a reference pension, i.e. P T = δ S T. In general, the pension for any individual i then becomes: P Ti = (Π Ti /Π REF T ).δ.s T.r Ti
30 The value of a point The value of a point Fix a target dependency ratio D T. Dene Π REF T target D. T as the average career length that corresponds with that Take a reference individual with r Ti = 1 and Π Ti = Π REF T. That individual gets a reference pension, i.e. P T = δ S T. In general, the pension for any individual i then becomes: P Ti = (Π Ti /Π REF T ).δ.s T.r Ti
31 The value of a point The value of a point Fix a target dependency ratio D T. Dene Π REF T target D. T as the average career length that corresponds with that Take a reference individual with r Ti = 1 and Π Ti = Π REF T. That individual gets a reference pension, i.e. P T = δ S T. In general, the pension for any individual i then becomes: P Ti = (Π Ti /Π REF T ).δ.s T.r Ti
32 Adjusting to demographic changes Automatic adjustments: a change in life expectancy When we assume that the pension system in each period has to be in budgetary equilibrium, the following three equations must hold (assume independency between Π Ti and r Ti ): (budget) P T D T = τ T S T (Musgrave) P T = m (1 τ T )S T (pension formula) P T = (Π T /Π REF )δ T T S T Suppose life expectancy increases and we accept that this should not aect the level of pensions and of the contribution rate. Then this means that D T must remain unchanged, i.e. that people work longer. However, if they work longer the number of points collected will necessarily increase: if we want to keep P T invariant, this means that Π REF will has to be adapted, so that the ratio (Π T /Π REF ) remains T the same.
33 Adjusting to demographic changes Automatic adjustments: a change in life expectancy When we assume that the pension system in each period has to be in budgetary equilibrium, the following three equations must hold (assume independency between Π Ti and r Ti ): (budget) P T D T = τ T S T (Musgrave) P T = m (1 τ T )S T (pension formula) P T = (Π T /Π REF )δ T T S T Suppose life expectancy increases and we accept that this should not aect the level of pensions and of the contribution rate. Then this means that D T must remain unchanged, i.e. that people work longer. However, if they work longer the number of points collected will necessarily increase: if we want to keep P T invariant, this means that Π REF will has to be adapted, so that the ratio (Π T /Π REF ) remains T the same.
34 Adjusting to demographic changes Automatic adjustments: a change in life expectancy When we assume that the pension system in each period has to be in budgetary equilibrium, the following three equations must hold (assume independency between Π Ti and r Ti ): (budget) P T D T = τ T S T (Musgrave) P T = m (1 τ T )S T (pension formula) P T = (Π T /Π REF )δ T T S T Suppose life expectancy increases and we accept that this should not aect the level of pensions and of the contribution rate. Then this means that D T must remain unchanged, i.e. that people work longer. However, if they work longer the number of points collected will necessarily increase: if we want to keep P T invariant, this means that Π REF will has to be adapted, so that the ratio (Π T /Π REF ) remains T the same.
35 Adjusting to demographic changes What if the target is not reached? The economic dependency ratio is an endogenous variable. It is not sucient to set a target to be sure that it will be reached! entry conditions can be imposed, but remember that we introduced exibility with respect to moment of retirement. changes in Π REF create an incentive to work longer. If the target D is not reached, budget equilibrium can again be restored through the Musgrave-rule (slightly adapted). If D t > D t Π t < Π REF t, this yields and τ t = (D t m /(1 + D t m ) δ t = (m Π REF t /((1 + D t m )Π t )
36 Adjusting to demographic changes What if the target is not reached? The economic dependency ratio is an endogenous variable. It is not sucient to set a target to be sure that it will be reached! entry conditions can be imposed, but remember that we introduced exibility with respect to moment of retirement. changes in Π REF create an incentive to work longer. If the target D is not reached, budget equilibrium can again be restored through the Musgrave-rule (slightly adapted). If D t > D t Π t < Π REF t, this yields and τ t = (D t m /(1 + D t m ) δ t = (m Π REF t /((1 + D t m )Π t )
37 Adjusting to demographic changes What is the role of Π REF? Acts as an incentive to work longer. Introducing a notion of career length in the pension formula is a second-best way to take into account dierences in life expectancy. Less educated individuals in heavier jobs tend to start working at younger ages. MOST IMPORTANT: SIGNAL. The system gives conditional guarantees to the younger generations. IF you accept to work longer (so that D is reached), then the system guarantees you a pension that will be a xed fraction of the average income of the active population at the moment of retirement. This is a crucial element of the intergenerational social contract.
38 Adjusting to demographic changes What is the role of Π REF? Acts as an incentive to work longer. Introducing a notion of career length in the pension formula is a second-best way to take into account dierences in life expectancy. Less educated individuals in heavier jobs tend to start working at younger ages. MOST IMPORTANT: SIGNAL. The system gives conditional guarantees to the younger generations. IF you accept to work longer (so that D is reached), then the system guarantees you a pension that will be a xed fraction of the average income of the active population at the moment of retirement. This is a crucial element of the intergenerational social contract.
39 Adjusting to demographic changes Welfare adjustments for the already retired 1 If the burden of adjustment falls fully on the increase in the working career, only the active population is hit. The already retired should also bear part of the burden. This can be taken into account through an adaptation in the process of adjustment of pensions to welfare increases.
40 Adjusting to demographic changes Welfare adjustments for the early retired 2 Those who retired in period (T 1) will have a pension in period T, given by P T 1 Ti = (Π (T 1)i /Π REF T 1 )δ T 1S T 1 r (T 1)i w T 1,T Dene the welfare adjustment factor as to get w T 1,T = (S T /S T 1 )(δ T /δ T 1 )(Π REF T 1 /ΠREF T ) P T 1 Ti = (Π (T 1)i /Π REF T )δ T S T r (T 1)i.
41 Adjusting to demographic changes Welfare adjustments for the early retired 2 Those who retired in period (T 1) will have a pension in period T, given by P T 1 Ti = (Π (T 1)i /Π REF T 1 )δ T 1S T 1 r (T 1)i w T 1,T Dene the welfare adjustment factor as to get w T 1,T = (S T /S T 1 )(δ T /δ T 1 )(Π REF T 1 /ΠREF T ) P T 1 Ti = (Π (T 1)i /Π REF T )δ T S T r (T 1)i.
42 Overall justice 4. Overall justice equally endowed cohorts dierent cohorts equally endowed individuals no problem of justice intergenerational justice dierent individuals intragenerational justice overall justice
43 Overall justice Two steps Intragenerational equity is taken up by the variation in the number of points collected by individual i. Intergenerational issues are taken up in the value of a point ν T. This value is the same for all individuals retiring at moment T. Changes in ν T keep relative inequality within the cohort unchanged.
44 Overall justice Transparency Intragenerational solidarity elements are linked in a natural way to the average productivity of the economy. The same is true for the minima. If the minimum number of points is dened as Π min, then P min =(Π min /Π REF )δ Sr i, The minimum pension is a xed proportion of the average gross labour income in the economy and is changing over time with changes in that wage.
45 Some notes on incentives 5. Some notes on incentives My whole presentation has been completely uneconomical. Purely mechanical reasoning, nothing about incentives and about behavioural reactions. Dierent instruments must/can be used to realize the dierent objectives. Parameters can only be set after careful empirical analysis. Points system: transparency essential for incentives! If people do not understand the consequences of their decisions for their future pension, changing the structure of the pension system will aect incentives in an unpredictable way. example: part-time pension.
46 Some notes on incentives Incentives within the points system Points system itself can be used to create incentives: changes in Π REF. actuarial corrections. bonus points for those who work beyond their moment of early retirement (generates dierence with alternative exit routes and relatively more important for lower incomes).
47 Conclusion 6. Conclusion Only an architecture. The real economic work still has to begin. Basic remaining questions about the architecture: what about cyclical eects? It does not seem meaningful to impose a period-by-period budget constraint. justice within the pension system versus overall justice (taking into account, e.g., environmental burden that is shifted onto future generations). how to nance the pension increase due to the pappy-boom?
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