Pensions crisis

The pensions crisis is a predicted difficulty in paying for corporate, state and federal pensions in the U.S. and Europe, due to a difference between pension obligations and the resources set aside to fund them. Shifting demographics are causing a lower ratio of workers per retiree, while retirees are living longer. There is significant debate regarding the magnitude and importance of the problem, as well as the solutions.[1]

For example, as of 2008 U.S. states had underfunded their pension programs by an estimated $1 trillion.[2] The present value of unfunded obligations under Social Security as of August 2010 was approximately $5.4 trillion. In other words, this amount would have to be set aside today such that the principal and interest would cover the program's shortfall between tax revenues and payouts over the next 75 years.[3]

Reform ideas are in three primary categories: a) Addressing the worker-retiree ratio, via raising the retirement age, employment policy and immigration policy; b) Reducing obligations via shifting from defined benefit to defined contribution pension types and reducing future payment amounts; and c) Increasing resources to fund pensions via increasing contribution rates and raising taxes.

Contents

Background

The ratio of workers to pensioners (the "support ratio") is declining in much of the developed world. This is due to two demographic factors: increased life expectancy coupled with a fixed retirement age, and a decrease in the fertility rate. Increased life expectancy (with fixed retirement age) increases the number of retirees at any time, since individuals are retired for a longer fraction of their lives, while decreases in the fertility rate decrease the number of workers.

In 1950, there were 7.2 people aged 20-64 for every person of 65 or over in the OECD countries. By 1980, the support ratio dropped to 5.1 and by 2010 it was 4.1. It is projected to reach just 2.1 by 2050. The average ratio for the EU was 3.5 in 2010 and is projected to reach 1.8 by 2050. Examples of support ratios for selected countries in 1970, 2010, and projected for 2050:

Pension computations

Pension computations are often performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. One area of contention relates to the expected investment return rate. If this rate (expressed as a percentage) is increased, relatively lower contributions are demanded of those paying into the system. Critics have argued that investment return percentage rate assumptions are artificially inflated, to reduce the required contribution amounts by individuals and governments paying into the pension system. For example, the U.S. stock market (adjusted for inflation) did not have a sustained increase in value between 2000 and 2010. However, many pensions have annual investment return assumptions or estimates in the 7-8% range, which are closer to the pre-2000 average return. If these rates were lowered 1-2 percentage points, the required pension contributions taken from salaries or via taxation would increase dramatically. By one estimate, each 1 point reduction means 10% more in contributions. For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Attempting to sustain better-than-market returns can also cause portfolio managers to take on more risk.[5]

United States

U.S. Social Security program

The number of U.S. workers per retiree was 5.1 in 1960; this declined to 3.0 in 2009 and is projected to decline to 2.1 by 2030.[6] The number of Social Security program recipients is expected to increase from 44 million in 2010 to 73 million in 2030.[7] The present value of unfunded obligations under Social Security as of August 2010 was approximately $5.4 trillion. In other words, this amount would have to be set aside today such that the principal and interest would cover the shortfall over the next 75 years.[8] The Social Security Administration projects that an increase in payroll taxes equivalent to 1.9% of the payroll tax base or 0.7% of GDP would be necessary to put the Social Security program in fiscal balance for the next 75 years. Over an infinite time horizon, these shortfalls average 3.4% of the payroll tax base and 1.2% of GDP.[9]

U.S. State-level issues

In financial terms, the crisis represents the gap between the amount of promised benefits and the resources set aside to pay for them. For example, many U.S. states have underfunded pensions, meaning the state has not contributed the amount estimated to be necessary to pay future obligations to retired workers. The Pew Center on the States reported in February 2010 that states have underfunded their pensions by nearly $1 trillion as of 2008, representing the gap between the $2.35 trillion states had set aside to pay for employees’ retirement benefits and the $3.35 trillion price tag of those promises.[10]

The Center on Budget and Policy Priorities (CBPP) reported in January 2011 that:

The pension replacement rate, or percentage of a worker’s pre-retirement income that the pension replaces, varies widely from state to state. It bears little correlation to the percentage of state workers who are covered by a collective bargaining agreement. For example, the replacement rate in Missouri is 55.4%, while in New York it is 77.1%. In Colorado, replacement rates are higher but these employees are barred from participating in Social Security.[12]

The Congressional Budget Office reported in May 2011 that "...most state and local pension plans probably will have sufficient assets, earnings, and contributions to pay scheduled benefits for a number of years and thus will not need to address their funding shortfalls immediately. But they will probably have to do so eventually, and the longer they wait, the larger those shortfalls could become. Most of the additional funding needed to cover pension liabilities is likely to take the form of higher government contributions and therefore will require higher taxes or reduced government services for residents."[13]

Solutions

Reform ideas are in three primary categories: a) Addressing the worker-retiree ratio, via raising the retirement age, employment policy, and immigration policy; b) Reducing obligations via shifting from defined benefit to defined contribution pension types and reducing future payment amounts; and c) Increasing resources to fund pensions via increasing contribution rates and raising taxes.

Proposed solutions to the pensions crisis include ones that address the dependency ratio – later retirement, part-time work by the aged, encouraging higher birth rates, or immigration of working aged persons – and ones that take the dependency ratio as given and address the finances – higher taxes, reductions in benefits, or the encouragement or reform of private saving.

In the U.S., since 1979 there has been a significant shift away from defined benefit plans with a corresponding increase in defined contribution plans, like the 401k. In 1979, 62% of private sector employees with pension plans of some type were covered by defined benefit plans, with about 17% covered by defined contribution plans. By 2009, these had reversed to approximately 7% and 68%, respectively. As of 2011, governments were beginning to follow the private sector in this regard.[14]

Research indicates that employees save more if they are automatically enrolled in savings plans (i.e., enrolled and given an option to drop out, as opposed to being required to take action to opt into the plan). Some countries have laws that require employers to opt employees into defined contribution plans.[14]

Criticism

Other sources of income

Some claim that the pensions crisis does not exist or is overstated, as pensioners in developed countries faced with population ageing are often able to unlock considerable housing wealth and make returns from other investments or employment.

Demographic transition

Some argue (FAIR 2000) that the crisis is overstated, and for many regions there is no crisis, because the total dependency ratio – composed of aged and youth – is simply returning to long-term norms, but with more aged and fewer youth: looking only at aged dependency ratio is only one half of the coin. The dependency ratio is not increasing significantly, but rather its composition is changing.

In more detail: as a result of the demographic transition from "short-lived, high birth-rate" society to "long-lived, low birth-rate" society, there is a demographic window when an unusually high portion of the population is working age, because first death rate decreases, which increases the working age population, then birth rate decreases, reducing the youth dependency ratio, and only then does the aged population grow. The decreased death rate having little effect initially on the population of the aged (say, 60+) because there are relatively few near-aged (say, 50–60) who benefit from the fall in death rate, and significantly more near-working age (say, 10–20) who do. Once the aged population grows, the dependency ratio returns to approximately the same level it was prior to the transition.

Thus, by this argument, there is no pensions crisis, just the end of a temporary golden age, and added costs in pensions are recovered by savings in paying for youth.

However, if a country's fertility rate falls too far below replacement level, in future there will be unusually few workers supporting the still large retiree population, and the dependency ratio will rise above historical levels, possibly causing an actual crisis.

A complicating factor is that support for the youth and support for the aged may be provided by different agents, funded in different ways, making the hand off difficult. For example in the United States, care for the youth is provided by parents, with the primary government expense being education, which is primarily provided by local and state governments, paid for by property taxes (a form of wealth tax), while care for the aged is commonly provided by hospitals and nursing homes, and the expenses are pensions and health care, which are provided by the federal government, paid for by payroll taxes (a form of income tax). Thus, local property taxes and the untaxed labor of parents cannot be directly handed off to fund pensions and health care, creating a coordination problem.

Visual explanation

Visually, in a classic population pyramid (Stage 1 and 2), the base (youth) is wide, and the peak (aged) is short and narrow. As the population ages, it passes through the demographic window (not pictured) where the pyramid is almost vertical from youth through working age, then tapers in the aged. Once the population has passed through the window and stabilized (Stage 3), youth is less significant (because much slower taper, so a smaller fraction), but aged are more significant (because taller and wider) – however, the overall dependency ratio is roughly the same in both cases.[15]

If, however, the birthrate falls below replacement level, then the bottom shrinks, and as this baby bust works up the pyramid, a narrower base of workers supports a still-large peak of aged, and the dependency ratio does increase; this is particularly the case if there is a sharp (sudden, significant) drop in fertility rate.

Key terms

See also

References

External links