Public 5: Pensions

Question 1

What is a funded pension scheme? What is a PAYG pension scheme?

Answer 1

A funded pension scheme holds and invests the assets accumulated by its members, and uses these funds to pay pensions when these members retire. A PAYG scheme, by contrast, uses current contributions to pay the pensions of current pensioners. It holds no assets.

Question 2

What is a defined benefit pension? What is a defined contribution pension?

Answer 2

A defined benefit pension plan is defined in terms of what will be paid out in retirement. For example, the state pension is a defined benefit plan.

A defined contribution pension plan is defined in terms of what will be paid in working age. How much will be paid out in retirement depends on how investments perform. For example, most private company pensions are defined contribution plans.

Question 3

Give an example of a PAYG DB pension scheme; a funded DB pension scheme; a PAYG DC scheme; a funded DC scheme.

Answer 3

PAYG DB: the state pension

Funded DB: teachers’/public sector pensions

PAYG DC: Sweden’s notional DC

Funded DC: most modern company pensions

Question 4

What is consumption smoothing? Why is it desirable?

Answer 4

Saving and borrowing to move consumption from periods of working to periods out of work (such as studying, unemployment or retirement) is called consumption smoothing. If intertemporal consumption preferences are convex, it makes individuals significantly better off. The ability to do it also provides an insurance function for risk-averse agents.

Question 5

In what ways are pension schemes systems of insurance?

Answer 5

• If a pension is converted into an annuity, or is a defined benefit scheme, a pension provides insurance against the risk of living too long.
• State pensions (or any other pensions not linked to contributions) are insurance against the risk of retirement poverty.
• Defined benefit pensions provide insurance against the risk that market investments will perform poorly.

Question 6

Why are unregulated private annuity markets unlikely to function well?

Answer 6

Adverse selection problems, since individuals know more about how long they are likely to live than an insurer.

Question 7

What redistributive functions do pension systems have?

Answer 7

• Redistribute intergenerationally (in the case of PAYG systems)
• Redistribute intragenerationally (for all systems)
  
  • If the pension entitlement curve is more flat than the earnings curve, it will be redistributive from high earners to low earners.
  • Pensions are often redistributive from men to women, since women live longer.

Question 8

Can all forms of pension system redistribute intergenerationally?

Answer 8

No. The benefits that a funded scheme can pay are restricted by the value of that generation’s resources paid in during working age, so we cannot redistribute from the current working age generation to them. By contrast, PAYG schemes can easily transfer resources from workers to pensioners.

Question 9

Why does Samuelson (1958) argue that intergenerational redistribution can be a Pareto improvement?

Answer 9

Suppose real wages grow uniformly over time. Then, a PAYG scheme can redistribute intergenerationally such that each generation can enjoy the living standards of the subsequent generation, which they could not have funded themselves. Since this is possible for all generations, this is a Pareto improvement.

Question 10

How are pension systems designed to address bounded rationality?

Answer 10

Retirement seems a long way off, and so people usually undersave compared to what they would do ‘rationally’. They may also exhibit inertia - they will pay in if it is an ‘opt-out’ system, and not if it an ‘opt-in’ system. Therefore, many pension systems are set up as an ‘opt-in’ scheme with minimum contribution levels and recommended contribution levels. Employers are also compelled to contribute. This is also one of the functions of the state pension.

Question 11

What is dynamic inefficiency? What is the ‘golden rule’ of capital saving in an economy?

Answer 11

The savings rate determines how much capital is accumulated in an economy. Undersaving leads to a low capital stock and low growth, but oversaving leads to unnecessarily constrained consumption today. The ‘golden rule’ of capital saving is the rate which maximises steady-state consumption per capita. If we are not at this level, and we can reach it by making all generations better off, the situation is dynamically inefficient.

Question 12

In the Diamond (1965) model, can a PAYG pension prevent oversaving?

Answer 12

Yes. A PAYG pension can be introduced that discourages saving, restoring the Golden Rule and making everyone better off.

Question 13

In the Diamond (1965) model, can a PAYG pension prevent undersaving?

Answer 13

No. A PAYG pension will simply discourage saving even more.

Question 14

Can funded pensions help governments achieve the golden rule level of saving?

Answer 14

No. Funded pensions replace private saving with public saving and cannot change savings levels.

Question 15

Are funded pensions more able to respond to demographic change than PAYG pensions?

Answer 15

No. Under any form of pension scheme, consumption by pensioners will need to be funded by current workers. If there are fewer workers than pensioners, there is a problem for any pension scheme; the claims on future production are just organised differently between the two schemes.

Question 16

How can pension systems impede labour market mobility? Is this desirable?

Answer 16

If pensions are strongly linked to a particular job (eg those which provide 1/60th of your final salary for each year spent there), there are incentives not to switch jobs. This is economically inefficient, as it will mean people stay at jobs that are not the best match for them.

Question 17

Is forcing retirement at 65 (or some other age) a good idea?

Answer 17

No. It is false to say that there is a ‘lump of labour’ that is partly taken up by over-65s, which would be freed up for younger workers if they were forced to retire. If people wish to continue working - and not taking a state pension - it hurts nobody to allow them to do so.

Question 18

Do we expect compulsory pension saving to act like an income tax on work incentives? Or is it more like private saving?

Answer 18

This will depend on (i) how contributions are linked to benefits, and (ii) behavioural biases.

If benefits are fully actuarial, and consumers are fully rational, compulsory saving will exactly displace private saving. If the compulsory savings rate is above what would have been saved, they will substitute away from saving at other points in life.

If benefits are not linked at all to contributions (like the state pension), rational consumers will treat it like an income tax.

Intermediate schemes will result in a balance of these two responses.

Imperfectly rational consumers may be induced to save by compulsory saving when they should have done anyway. Depending on how they view this saving, they may choose to work more or less.

Question 19

Who bears most of the risk in the pension system in the UK? Is this desirable?

Answer 19

50 years ago, when most pensions were defined benefit, risk fell on the employer (and, in last resort, the state). If life expectancies got unexpectedly longer or investments performed unexpectedly badly, the employer had to bear the risk. Employees only faced the risk of their employer and pension scheme going bust.

Now, employees face almost all of these risks. Although the state pension is guaranteed, the majority of their saving will be through DC schemes. They therefore bear the risk of living too long or of poor investment performance.