The following papers are being discussed:
Lecture 1 and 2; Introduction
- Barr, N. and P. Diamond, “Reforming Pensions: Principles and Policy Choices”, Oxford University Press (2008). Chapter 1,2 and 3.
Lecture 3: Heterogeneity and choice
- Beshears, J., J.J. Choi, D. Laibson and B.C. ...
Papers - The economics and finance
of pensions
L1 & L2: introduction
Book by Barr & Diamond (2008): Reforming pensions: principles and policy choices
chapter 1,2 and 3
The primary cause of the pensions crisis: failure to adapt to very long-run trends; increasing life
expectancy, declining fertility and earlier retirement.
DB systems can be designed to adjust automatically to demographic variables. With funded &
notional DC (DC, NDC) the problem is different. Both adjust benefit levels to available finances – the
problem is not sustainability but the possibility of inadequate benefit levels.
PAYG: paid out of current revenue (usually by the state, from taxes) rather than out of accumulated
funds.
Funded pensions: use an accumulated fund built from contributions by or on behalf of its members.
Fully-funded pensions pay all of benefits from accumulated funds. Partially-funded pensions pay
benefits both from accumulated assets and from current contributions (often referred to as PAYG)
A non-contributory universal pension is based on years of residence.
Notional defined-contribution (NDC) pensions are financed on a PAYG or partially funded basis, with
a person’s pension bearing a quasi-actuarial relationship to his or her lifetime pension contributions.
Economic theory suggests a number of conclusions about pensions:
Pension systems have multiple objectives: individual objectives are consumption smoothing
and insurance. Government included more objectives: poverty relief & redistribution. Other
goals need to be taken into account as well like economic efficiency & output growth
Analysis should consider the pension system as a whole; the pension design affects a lot:
labour market, economic growth, distribution of risk and income etc. This is why we need to
look at the combined effect of the whole system. There is no efficiency gain from designing
one part of the system without distortions if distortions are then placed elsewhere to
accomplish insurance and redistributive goals.
Analysis should be framed in a second-best context; simple theory assumes markets and
institutions function ideally and individuals make the best choices. This is not true and that is
why we should not frame our analysis in this unrealistic world: but base it on a world with
limited policy tools and market imperfections.
Deviations from first best: imperfect information (individuals have too little financial knowledge)
incomplete markets (asym info insurances, adverse selection – make it mandatory) & progressive
taxation.
Behavioural economics: people do not save enough voluntarily because they: procrastinate, avoid
explicit choice (automatic enrolment leads to much higher participation) and immobilization
(complex and confliction info can lead to passive behaviour: too many choices results in people not
choosing at all)
,When people do choose, their choices make little sense: short-term gratification (many people retire
at the earliest age permitted, even if this is too early for their own good or that of their spouses);
framing (choices are influenced by how they are presented); familiarity (people don’t understand risk
diversification and tend to invest in their own company: but when this goes bankrupt, they loose
both their income and investment..!) and excessive trading
These findings suggest a number of implications for policy design in employer and public plans: keep
choices simple, use automatic enrolment, design a good default option and in voluntary plans:
further option is to allow people to commit now to action the future, making use of procrastination
to assist policy.
Different systems share risks differently
Funded system: in a pure system of funded individual accounts the risks of bad outcomes is imposed
on the individual worker. The allocation of risk in the pure case can be altered by government
guarantees or government bailouts
In a pure DB the risk is borne by the employer unless there is bankruptcy. The employer may spread
the risk across current and future workers (as wages adjust); across shareholders (if profits decline)
and across customers risk is shared more broadly. This can also be altered by government bailouts
Pure PAYG DB system: risks are shared across contributors (current working generation)
A system with a PAYG element allows intergenerational risk sharing; this does not happen in a fully
funded individual account system
The level of funding affects intergenerational distribution
Funding that affects savings effects the intergenerational distribution of resources. To evaluate such
a policy, we need to evaluate the positions of different generations (changes in wages, mortality &
morbidity rates)
Different systems affect men and women differently
Analytical errors
tunnel vision: when you focus on a single objective like consumption smoothing this might be flawed
because you ignore other objectives like poverty relief.
First-best analysis is improperly used: any optimal program has distortions as well.
improper use of steady state analysis: the steps needed to come to a steady state are ignored.
incomplete analysis of implicit pension debt: only looks at future liabilities while ignoring explicit
assets
Incomplete analysis of the effects of funding:
- Excessive focus on financial flows; the effects of funding on future output will depend on the
answers to a series of questions that are ignored.
- Failure to consider how funding is generated; 1. increase funding by increasing contribution
rates or reduce benefits or 2. place assets with the pension authority rather than hold them
elsewhere. The 1st approach raises national saving and thus output. The 2 nd one, transfer of
assets does not create additional output but only changes the distribution of the burden of
paying for benefits.
- Improper focus on trust fund assets: the type of asset in a trust fund is not informative of the
impact of trust fund activity on the ability of government to finance benefits.
, Ignoring distributional effects: it is wrong to present the gain to pensioners in later generations as a
pareto improvement because it comes at the expense of the 1 st generation.
Implications for policy: there is no single best pension design. Pensions have multiple objectives:
consumption smoothing, insurance, poverty relief and redistribution. Getting to these goals faces
some constraints.
Countries have successfully implemented very different pension systems: systems that vary from
more or less pure consumption smoothing in the form of mandatory saving with little or no insurance
or a primary concern for poverty relief, achieved through a non-contributory flat-rate pension with
consumption smoothing on a voluntary basis.
Earlier retirement does little or nothing to reduce unemployment. It is widely believed that earlier
retirement will free jobs for younger workers. This would be correct if the number of jobs in an
economy were fixed, but this is not true.
Finance and funding
- Unsustainable pension promises need to be addressed directly
Not true: PAYG pensions face major fiscal problems; therefore they should be privatized the only
solution is to make it sustainable by increasing contributions and/or reducing benefits.
- A move from PAYG towards mandatory funding may or may not be welfare improving
Whether a move towards funding raises welfare depends on how the change in pension system is
designed and on country specifics. However, all countries should bear in mind the following
conclusions:
1. Explicit public debt is not equivalent to implicit pension debt; While explicit public debt is defined
as liabilities that are government loans and bonds, implicit public debt includes all other government
liabilities – i.e. obligations for future expenditures that are written in the current law, like pensions
and health insurance.
2. Funding can be organized in a variety of ways: with (notional accounts) and without (central trust
fund) funded individual accounts
3. A move to funding generally has major fiscal costs. In a PAYG system the contributions of younger
workers pay the pensions of older people. But if a country moves to a funded system, the
contributions of younger workers will instead go into their individual accounts and so the pensions of
retired people must come from some other source: higher taxation. A move toward funding
generally imposes an added burden on today’s workers > pay both their own contributions and the
taxes that finance current pensions.
One way to spread (but not eliminate) the fiscal costs of the transition is to phase funded pensions in
gradually. A country that wants to introduce individual accounts but cannot absorb the fiscal costs of
transition, has the option of introducing mandatory notional defined-contribution pensions,
supplemented by voluntary funded accounts
Page 16 – 21 not summarized.
Conclusion of this book: the roots of the problems of pension finance are long run trends, not a short
run crisis. Pension systems have multiple purposes, diverse institutions, diverse histories, diverse
politics and diverse constraints. Thus there is no single best system, pension systems differ widely.
There are benefits from keeping choices simple. Examples of bad policies include staying too long
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller tessbremer. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $4.34. You're not tied to anything after your purchase.
