Lecture 7: Pensions Flashcards
The theory of life cycle
Individuals use savings to smooth consumption over time as a tool to transfer resources toward periods with a lower income and saving in periods with high income
The higher the saving rate the higher the GDP growth: A higher GDP growth implies that the young generation has a higher income
Saving rate depends on the demographic structure of a country and on the life expectancy
The ratio between accumulated wealth and GDP depends on the average length of the retirement (High retirement period -> higher wealth, and lower GDP -> higher share of non-working population)
Social Security Systems
Types of funding schemes
Fully-funded: Each worker makes contributions toward social security via a social security tax which are then invested by the security program -> In retirement each individual receives a pension equal to the amount they contributed
Pay-as-you-go: Current contributions through taxation of those in employment provide pensions of those who are retired -> Current retired generation relies on younger generation for their pension
Comparison: Exogenous Shocks
Demographic Shock: population growth slow-down -> lower n
Productivity Shocks: drop in growth of average productivity -> lower u, increase of unemployment rate -> lower n
Increase in real interest rates
Problems with the pay-as-you-go system
Too low retirement age, early retirement, too high ratio pensions/contributions
Mix of social security with social programs: use of pensions (long-run policy instrument) to face short-term phenomena (e.g. unemployment)
Why?
Political opportunism and myopia (Kurzsichtigkeit) on long-term effects
Over-estimation of growth rate of the economy
Transition from Pay as you go to Fully Funded
A fully funded system induces a per-capita social security payment higher than the pay-as-you-go
Incentive to reform the system to move in the direction of a fully-funded system (by also allowing the private market to supply this insurance)
Problems with transition
Problem of the cost of transition: Who is going to bear the cost?
Who is taking the financial risk?
Would the private market bear the inflation risk?
Problems of the fully funded system
Financial risk: Risk of losing the real value of funds invested due to high inflation or financial crisis
Limited flexibility on the management of funds due to the “compulsory” nature of the pension system
