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Public Economics > Pensions > Flashcards

Pensions Flashcards

1
Q

Objectives of pensions

A
  1. Consumption smoothing (maximise well-being over time)
  2. Insurance (don’t know life expectancy, so pool risk w/others)
  3. Poverty relief (people poor over lifetime can’t save for retirement)
  4. Redistribution (cross-generational redistribution)
  5. Economic growth (increase savings and thus capital)
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2
Q

What is a funded pension?

A
  1. Workers’ contributions invested, which will pay for benefits when they retire
  2. Current benefits = past contributions * (1 + market return)
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3
Q

What is an unfunded pension?

A
  1. AKA PAYG
  2. Benefits paid out of contributions from current workers
  3. Current benefits = current contributions
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4
Q

What is a defined benefit pension scheme?

A
  1. Service length and pay history determine pension (e.g. final salary scheme)
  2. PROVIDER BEARS RISK
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5
Q

What is a defined contribution pension scheme?

A
  1. Worker/employer make contributions into investment account
  2. Converted to annuity upon retirement
  3. INDIVIDUAL BEARS RISK
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6
Q

Features of Swedish ‘notional defined contribution’? Explain system

A

Unfunded; defined contribution

A. Workers contribute x% of earnings to ‘notional individual account’
B. Account credited w/notional interest rate (e.g. wage growth/inflation)
C. At retirement, notional accumulation converted to an annuity

But system actually PAYG

D. Notional contributions not actually going into individual account, but straight into government coffers
E. Money received not actually from individual account, but from contributions of current tax-payers

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7
Q

Why does state need to intervene in pensions market wrt consumption smoothing function?

A
  1. Information problems (plans complex and hard to understand)
  2. Behavioural problems (myopic agents, sensitive to nudges)
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8
Q

Why does state need to intervene in pensions market wrt insurance function?

A
  1. Adverse selection (healthier people more likely to buy annuities)
  2. Moral hazard (people w/large pensions can invest in their health to live longer)
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9
Q

Why does state need to intervene in pensions market wrt poverty relief function?

A
  1. Many can’t save

2. Many don’t save knowing that state will ultimately bail them out (Samaritan’s dilemma; commitment problem for state)

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10
Q

No. elderly per 100 working age people in 1960 (OECD average)?

A

15

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11
Q

No. elderly per 100 working age people in 2010 (OECD average)?

A

20

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12
Q

No. elderly per 100 working age people in 2030 (OECD average)?

A

35

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13
Q

No. elderly per 100 working age people in 1960, 2010 and 2030 (OECD average)?

A 
1960 = 15
2010 = 20
2030 = 35
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14
Q

In OLG models, what 2 ways are there for a generation that is born and works in period ‘t’ to consume in retirement in t+1?

A
  1. Save and obtain market return

2. Transfer money from generation t+1 (when t+1 young and working)

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15
Q

If r > n+g, how does a PAYG pension redistribute income?

A

Redistributes from all generations to 1st generation

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16
Q

Why are most pension systems unfunded/PAYG?

A

Original priority was to alleviate old age poverty

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17
Q

Why is universal forced saving better than means-tested forced saving?

A

W/means-testing:

(i) Responsible individuals subsidise myopic
(ii) Incentives to under-save to get means-tested pension

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18
Q

Under what condition are rational individuals unaffected by forced saving?

A

unaffected as long as forced saving tax less than individual optimum

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19
Q

Evidence FOR myopia wrt pensions and saving?

A

Bernheim et al (2001)

  1. Significant consumption drop at retirement (consistent w/myopia)
  2. Drop sharply correlated w/wealth (consumption declines faster in old age for poorer people)
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20
Q

Evidence AGAINST myopia wrt pensions and saving?

A

Scholz et al (2006)

  1. model of rational savings w/uncertainty and based on reasonable parameters:
    (i) 80% of families over-save
    (ii) 20% under-save
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21
Q

Evidence of lack of financial rationality wrt pensions saving

A

Chetty et al (2014)

Default options have very large impact on overall levels of saving

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22
Q

Evidence of lack of financial rationality wrt pensions enrolment

A

Madrian and Shea (2001)

Default options have very large impact on 401(k) enrolment

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23
Q

Evidence of lack of financial rationality wrt investment decisions of pensions

A
  1. Many divide contributions equally into invest options (1/N heuristic), regardless of riskiness/returns etc (unlikely to be optimal)
  2. People often invest 401(k) in own company stock (v. risky!)
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24
Q

Evidence of substantial adverse selection in the (pre-2014) voluntary UK annuities market, compared to the compulsory market

A

Finkelstein and Poterba (2002)

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25
Q

Finkelstein and Poterba (2002)

A
  1. Pre-2014 – 2 private pensions markets:
    (i) People for whom annuity purchase = compulsory
    (ii) People for whom annuity purchase = voluntary
  2. Substantial adverse selection in voluntary market
  3. Adverse selection in compulsory market ½ as important compared to voluntary market
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26
Q

Compare funded and PAYG pensions wrt uncertainty about life expectancy?

A
  1. Funded:
    (i) If life expectancy can’t be accurately predicted, costs may fall on individuals (poor value annuities), insurers (might fail), or the taxpayer
  2. PAYG:
    (i) automatically insured by tax-payer (though contributions/benefit levels may have to change)
27
Q

Possible state intervention in pensions market to combat uncertainty about life expectancy?

A
  1. State could offer ‘longevity bonds’ to annuity providers

2. If people outlive official estimates, taxpayer pays out

28
Q

Why is it not possible to insure against inflation shock risk wrt pensions?

A

Joint shock; risk not independent

29
Q

Compare funded and PAYG pensions wrt uncertainty about inflation?

A
  1. Funded:
    (i) Reduces real value of savings
    (ii) Joint shock (not insurable)
    (iii) Annuities can be inflation-linked, but only up to a certain point (insurer may go bust) and then permanently lose value
  2. PAYG
    (i) Inflation irrelevant
    (ii) Only real wage growth matters
30
Q

Key points of comparison between funded and PAYG pension systems?

A
  1. Total pay-offs
    (i) May be higher w/funded model, if r > n+g
  2. Uncertainty
    (i) PAYG easier to cover uncertainty in life expectancy (risk effectively automatically insured by tax-payer)
    (ii) PAYG eliminates inflation uncertainty risk
  3. Distortions
    (i) PAYG effectively a tax and therefore distorts economic activity/harms efficiency
  4. Risk bearer
    (i) Funded – individuals bear risk of lower pension pot if rate of return low when buying annuity
  5. Current system
    (i) Moving from PAYG to funded system involves double-burden for current generation (pay for pensions via tax and must themselves save for retirement)
31
Q

2005 UK pensions commission option for reform of PAYG pensions

A
  1. Reduce benefits (direct cut not politically feasible, but could index retirement age to life expectancy)
  2. Increase contributions (higher tax rate unlikely to be politically feasible and may harm economic efficiency)
  3. Raise retirement age
  4. Increase output (government already trying to do this, so not clear any obvious reforms could sustainably boost output growth)
32
Q

Who gains/loses if shift from PAYG to funded pension?

A
  1. Current generation loses (fund current pensioners and save own contributions)
  2. all future generations gain, if r>n+g
  3. Only way funding generates real changes = hurting transitional generations that double-pay
33
Q

Are funded schemes less sensitive to demographic change than PAYG systems?

Use example of negative population growth (n)

A
  1. PAYG
    (i) revenue falls
    (ii) increase tax/reduce benefits
  2. Funded
    (i) Retirees spending pot exceeds what current workers want to save (due to negative n)
    (ii) Excess consumption demand increases prices
    (iii) Real value of annuities falls

3.

(i) Fallacy of composition - pensions ultimately just divide current output between young and old
(ii) can only make everyone better off if output itself higher

34
Q

Compare DWL in funded vs PAYG pension systems?

A

Funded - workers simply save for retirement, so no DWL

PAYG = workers taxed to pay for pensions of old, leading to DWL

35
Q

Which pension system combines the benefits of PAYG w/o harm economic efficiency via DWL?

A

Swedish notional defined contribution

36
Q

A state is dynamically efficient if it is…

A

Pareto efficient

37
Q
  1. Is capital-labour ratio above golden rule level (k > k*) dynamically efficient?
  2. Why/why not?
A
  1. NO - not Pareto-efficient

2.

(i) Make young better off w/additional consumption (k - k*)
(ii) Allow old same consumption (no worse off)
(iii) All subsequent generations on golden rule ratio and so better off

38
Q
  1. Is capital-labour ratio below golden rule level (k < k*) dynamically efficient?
  2. Why/why not?
A
  1. Yes

2. Can only raise capital stock by reducing current consumption, so no Pareto-improvement possible

39
Q

Evidence that private saving in absence of gvt intervention not rational?

A

Chetty et al (2014) – study of government mandated saving in Denmark

(i) £1 mandatory saving led to £1 increase in pensions and total savings
(ii) no offsetting reduced private saving

40
Q

Formula for net flows from firms to consumers? (i.e. the dividend)

A
  1. (r – n) * K

2. difference between return on capital and new investment = dividend (which flows from firms to consumers)

41
Q

Why is optimal saving a complex calculation for individuals?

A

Due to uncertainty over:

  1. Returns to saving
  2. Life-span
  3. Future ability to work
  4. Future health/tastes
42
Q

OECD average - no. elderly per 100 working age people in:

1960 = .....
2010 = .....
2030 = .....
A

OECD average - no. elderly per 100 working age people in:

1960 = 15
2010 = 20
2030 = 35
43
Q

OECD average - no. elderly per 100 working age people in:

..... = 15
..... = 20
..... = 35
A

OECD average - no. elderly per 100 working age people in:

1960 = 15
2010 = 20
2030 = 35
44
Q

Bernheim et al (2001)

A
  1. Significant consumption drop at retirement (consistent w/myopia)
  2. Drop sharply correlated w/wealth (consumption declines faster in old age for poorer people)
45
Q
  1. Significant consumption drop at retirement (consistent w/myopia)
  2. Drop sharply correlated w/wealth (consumption declines faster in old age for poorer people)
A

Bernheim et al (2001)

46
Q

Scholz et al (2006)

A
  1. model of rational savings w/uncertainty and based on reasonable parameters:
    (i) 80% of families over-save
    (ii) 20% under-save
47
Q
  1. model of rational savings w/uncertainty and based on reasonable parameters:
    (i) 80% of families over-save
    (ii) 20% under-save
A

Scholz et al (2006)

48
Q

Chetty et al (2014)

A
  1. Default options have very large impact on overall levels of saving
  2. Study of government mandated saving in Denmark

(i) £1 mandatory saving led to £1 increase in pensions and total savings
(ii) no offsetting reduced private saving

49
Q

Default options have very large impact on overall levels of saving

A

Chetty et al (2014)

50
Q

Madrian and Shea (2001)

A

Default options have very large impact on 401(k) enrolment

51
Q

Default options have very large impact on 401(k) enrolment

A

Madrian and Shea (2001)

52
Q

Evidence for lack of financial rationality/literacy

A
  1. Chetty et al (2014)

Default options have very large impact on overall levels of saving

  1. Madrian and Shea (2001)

Default options have very large impact on 401(k) enrolment

  1. Many divide contributions equally into invest options (1/N heuristic), regardless of riskiness/returns etc (unlikely to be optimal)
  2. People often invest 401(k) in own company stock (v. risky!)
53
Q

UK 2014 pension reforms

A
  1. Affects fully funded, defined contribution private pension schemes (workplace + personal)
  2. Pre-reforms – tax relief on pensions savings given, but at retirement pension pot had to be annuitised (compulsory)
  3. Post-reforms – much greater flexibility, w/people able to annuitise savings or draw as lump-sum
54
Q

Problems with 2014 UK pension reforms

A
  1. Samaritan’s dilemma (commitment problem for government; what stops people blowing their pension pot after drawing as lump-sum, expecting government to still support them in retirement?)
  2. Adverse selection in annuities markets means people may face worse choices than before
  3. Worries about mis-selling
55
Q

Why do PAYG pension systems generate economic inefficiency/DWL, but notional defined contribution systems don’t?

A

PAYG – workers taxed to fund benefits of elderly, but individual benefits not linked to contributions, reducing incentives to work + creating DWL

NDC – reduces wedge between contributions and benefits, removing disincentive to work + thus DWL

56
Q

What levels of capital-labour ratio are dynamically efficient/not?

A
  1. k > k* NOT dynamically efficient
  2. k = k* dynamically efficient
  3. k < k* dynamically efficient
57
Q

Abel et al (1989)

A

World data suggests dynamic efficiency, though not at golden rule

58
Q

How can an ‘early retirement age’ be seen as a device to keep myopic working?

A
  1. Rational – wants to retire at 60 (but benefits start at 62=ERA)
    (i) Saves to fund retirement 60-62
    (ii) ERA doesn’t affect rational person (if perfectly forecasted)
  2. Myopic – can’t resist retiring as soon as benefits available
    (i) Typically has no savings (so can’t retire before ERA)
    (ii) ERA positively affects myopic person to prevent excessively early retirement
59
Q

Evaluate whether life expectancy uncertainty is a market failure in pensions

A

NO

  1. Individuals can buy annuities to insure against this risk
  2. Annuity providers have detailed actuarial information to reasonably accurately predict changes in life expectancy
60
Q

Evaluate whether a common inflation shock is reason for government intervention in pensions

A

NO

  1. Widespread and successful adoption of inflation targeting by most CBs
  2. Widespread availability of inflation-proof assets, like index-linked bonds
61
Q

Key incentive problem in government pension policy?

A
  1. Want to provide non-contributory pension option for low-income earners who are unable to save during lifetime
  2. But need to do so without undermining incentives of higher-income earners to save during their lifetime (incentive compatibility problem - they may choose not to save, despite being able to do, and opt for non-contributory pension)
62
Q

Famous theoretical result from Diamond (1965)

A
  1. In OLG economy w/capital and saving, PAYG system generates Pareto improvement iff n + g > r (economy dynamically inefficient and has excess capital)

2a. If r > n + g, PAYG redistributes from all generations to 1st generation
2b. PAYG bad for current/future generations if r > n + g

63
Q

Famous theoretical result from Samuelson (1958)

A

In OLG economy w/no capital and no ability to save (chocolate economy), PAYG system generates Pareto improvement (by allowing inter-generational trade)

64
Q

How can you show the Diamond (1965) result that:

In an OLG economy w/capital and saving, PAYG system generates Pareto improvement iff n + g > r

A

Generational accounting

Public Economics (9 decks)

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