Pensions Lecture Notes

Flashcards focusing on key terms and concepts related to pensions and their economic implications.

Transfers

Support or benefits provided from one group to another, such as resources from the rich to the poor through the tax system.

Pensions

Regular payments made to retired individuals, funded through private contributions or public tax revenues.

Pay-As-You-Go (PAYG)/unfunded

• A method of pension funding where current workers' contributions fund current retirees' benefits, paid out of current tax revenues

• basic idea, e.g in uk £180 a week that people get from state pensions, paid by taxes

  • if youre a pensioner with a good high pension, you alsop pay taxes which contoirbute towards this

Funded pensions

• Pensions that are paid out of an accumulated

  fund, typically managed through investment funds.

• in a fully funded plan theres no dependence on others, everyone funds themself

Intergenerational redistribution

The transfer of income or resources across different age groups, typically from the working population to retirees.

Crowding out

A situation where government spending leads to a decrease in private sector investment or savings.

Wealth Substitution Effect

The change in saving behavior induced by the existence of social security benefits, often leading to decreased personal savings.

purpose of private pensions

• consumption smoothing: you save income in the good times for the worse times like when youre sick

  • a rational person should prefer to invest in a pension

• insurance: youre insuring yourself to have a nice old age

  • e.g if you knew youd die at 65 no ppint in having a pnesion

private pensions as annuity

• if you build up your annuity and then die the day after, your money can be used to help others

• shown as discounting value

• A is the present value of the pension stream y for the rest of life (assume 0 inflation)

annuities

• person exchanges lump sum for annual payment of income for life (defined benefit or defined contribution)

• its a form of insurance, since individuals pool the risk of dying younger or older

• those who fail to achieve life expectancy subsidise those who live longer than expected

• because people dont know how long thye’ll live for, risk pooling can improve individual welfare

  • adverse selection could be a slight problem, but not really

defined benefit

• what you want, but none of us will get

• this means the risk is on the employer, and youre paid an agreed amount - u have no risk

defined contribution

• most pension schemes are like this. private sector firms, life expectancy has shot up and many people are retiring, so beneift schemes have become unaffordbale

  means whatever is in your annuity will be determined on the day by the stock market - all the risk if on you

• e.g if the stock market crashed on the day, tough luck

supply side sources of market failure that night lead to the gov wanting to get involved

• incomplete insurance

  • annuities, is life expectancy a risk or an uncertainty, can be hard to insurance companies to set premiums

  • unanticipated inflation destroys pensions, so government might have to step in and top up pensions

demand side sources of market failure that night lead to the gov wanting to get involved

• information and behavioural problems

  • we want to make sure eveyone has in income when they retire, but want to ensure they spend it on pensions - paternalisitc argument

  • theres costs of choice, info and behavioural problems

rationale for state involvement

• market failure combined with paternalistic concern for poverty/equity mean that Govs become involved in pension provision

• degree of involvement open to debate

advantages of PAYG schemes

• cope well with inflation, if it occurs then pensions go up bc wages go up

• incentivises generations to leave good economci conditons, becayse the ones that come after them have to work and payv taxes to fudn their pensions

• allows full pension to be paid immediately

• vertically equitbale, the people who pay the most are the rich but the people who get the most are the poorer ones

problems with PAYG schemes

• disincentives to save and work, if you know you have the pension coming up, it might affect your incetives to save - you may put more money into a funded scheme if you had to provide for yourself, but you dont

  • does this lack of saving have an affect of economic growth

• maybe you retire earlier if you think u have enough to last you until your state pension comes in

• sensitive to blips in birth rate, but so are funded schemes

  • if you have a large cohort of pensioners relative to workers like we do now, implies taxes go up or benefit go down

  • not a very strong argument

first tier pensions

• aimed primarily at poverty relief

• state pension, main aim is so everyone can live

• can be contributory or non contributory

  • non contributory means everyone gets the same, contirbutory means you can add more

second tier pensions

• Intended to strengthen consumption smoothing

• Mandatory, public or private

  • can insist you have to have a pension, can use the you have to opt out instead of opt in

• May be combined with first tier

• e.,g NEST in UK

third tier pensions

• Intended to allow for differences in preferences

• Voluntary

• can be organised by industry, firm or individual

pensions in the UK

• PAYG

• established 1948

• retirement age for women: 60

• retirement age for men: 65

• planned to rise to 68

pensions in the US

• almost all workers in US pay FICA tax on earnings

• person must have worked and paid tax for 40 quarters (10 years) over their life and must be over 62

  • retiring at 62 gets u a smaller pension, normally those with good private pensions retire this early

social security

• A federal program that taxes workers to provide income support to the elderly PAYG

how are social security benefits calculated

• The amount of this annuity payment is a function of the recipients average earnings over the persons 35 highest earning years where each months earnings expressed in todays dollars

replacement rate

ratio of benefits received to earnings prior to the entitling event

intergenerational redistribution equations

• Nb = number of pensjoners x B, the beenfit

• tax x number of workrs x average wage w

• increasing in taxes, number of workers and economcu growth, captured by wage increases

• divided by number of pensioners

• recently nw, nb has been increasing, w is flatlining and this is creating a lot of strain

• So growing population and wage growth increase benefits for fixed taxes

  • so retired generations share in growth

budget constraint for present and future consumption

utility maximising choice of present and future consumption

crowding out of private saving due to social security (wealth sub effect diagram)

3 ways social securtiy can affect savings

• Wealth Substitution Effect

• Retirement Effect

  • Retire early (increase savings in anticipation)

• Bequest Effect

  • Save more to offset effect of social security

    payments on children

does social security consumption smooth

• social security may crowd out savings that individuals would’ve set aside of retirement

  • might crowd out private savings by allowing people to count on gov transfer to support old age income

• the larger the crowd out, the less consumption smoothing it provides for retired individuals

alternative: means testing pensions

- adminsitrativly this is rellay dificult, becayse youre measuring assets

- if youre well off, you dont need a state pension

- but lower middle class may vastly reduce their savings and get the state pension

- so this could affect savings badly

- unviersal benefits are easier and better politically, because the middle class will want you to favour them

effect of social security on consumption smoothing

• can be seen in elderly poverty rates

• he steepest reductions in poverty occurred during the

  1960s and 1970s, when the program grew the fastest.

• the point of pensions is to alleovate poverty, but study by Gallani et al. (2016) of a cash transfer in Mexico finds that theres no crowding out - if youre poor and you get extar money, you increase your consunption

social security wealth and retirement decision

Weigh up cost of delay (tax and forgone benefits) vs benefit of above average earnings and higher benefits due to delay

• evidence: age at which pension is first available is important

implicit social security taxes

• across countries, lots of variant in implicit tax rate

  • close to 0 for 62 year olds in US

  • 91% in netherlands

• countries with higher taxes have less elderly labour force participation

• evidence that potentially very costly to design Social Security systems that penalize additional work beyond the retirement age.

  • Adjusting systems to more fairly reward work at old ages can mitigate much of the moral hazard effect of Social Security.

pensions and economic growth

Three links in the argument

• Does funding increase saving?

• is that saving translates into efficient investment

• By how much does that investment increase output?

need to test each link

long term stresses on pensions

funding savings and growth

• life expectancy is increasing in most counties while birth rates are falling

• this can create issues off pension finance, but funding is only part pf the solution

• what matters moree is size of the cake

static output: effects of demographic change on funded pensions

• financial asset accumulation, desires asset sales by pensioners exceeds desired purchases by workers

• excess supply in asset market reduces asset prices

• this reduces pension accumulation and hence value of annuity

• similar to PAYG issue

growing output: effects of demographic change on funded pensions

• Asset accumulation: wages generally keep pace with output.

• rising wages imply rising demand for assets, hence no effect on asset prices

• period 2 pensioners get the real pension they expect

• key question: whether funded pensions are more likely

  to generate growing output than PAYG

transitional costs of changing pension

there will be double taxation of generation paying PAYG but told they must fund their

own pension (us)

Political economy aspects: Funding and property rights

• Are funded pensions safer from government

interference than PAYG pensions?

• Does full funding impose greater financial

discipline?

• Is greater discipline optimal? Is the ability to

change future benefits simply a source of risk

to workers and retirees, or an opportunity to

do a better job of sharing the risks inherent in

pension systems

2 strategies of raising output

• Increasing the productivity of each worker, through

  (1) more and better capital equipment

  (2) more productive labour

• Increasing the number of workers from each age

  cohort

  (3) increased labour force participation

  (4) increased age of retirement

  (5) import labour directly (immigration)

  (6) import labour indirectly (export capital)

to what extent is funding a solution

• In the face of demographic problems the key

  variable is output

• From a macroeconomic perspective the choice

  between PAYG and funding is secondary

how should pensions be financed

can address issue of pension finance by:

• Increase output

  • Reduce the living standards of workers by

  increasing pension contributions

  • Reduce living standards of pensioners

  • By paying a lower pension

  • By increasing the age at which pension is first paid, i.e.

  reducing the duration of retirement

summary: arguments for increased use of funded pensions rest on":

• increased growth bc such. move would necessarily trade off with equity consdierairtons

• Intergenerational redistribution

• Redistribution from rich to poor

• Redistribution from men to women

UK triple lock pensions

• A policy ensuring that UK state pensions increase each year by the highest of inflation, average wage growth, or 2.5%, aimed at protecting pensioners' living standards.

• paul jonson says if this continues then pensions will become very geneorus in the future

• Is this too generous.

• Is this because pensioners are politically too

  powerful?