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Perspective

Why Time Is Running Out for Pay As You Go-Based Pension Systems

August 21, 2018| By Dr. Winfried Heinen | Life | English | Deutsch

None of us is getting any younger, just ask an actuary - or an economist, if it comes to that. Mortality is going down in almost all countries, and life expectancy is going up. At the same time, generally, fertility rates are falling.

The sum effect is that the older generation is growing in size and the number of people in the younger generation, the most economically active segment, is at best stable, sometimes even decreasing.

This worsening trend in what’s called the old age dependency (OAD) ratio - the number of seniors divided by the number of working people - is very worrying for society and for policymakers.

How should we continue to provide for citizens in their retirement in a way that is fair for everyone? What kind of pension system can best cope with big demographic changes?

It’s an almost universal problem and across mature economies the rate of change is more or less the same. In France and Germany, for every three active people there is now one retired person; in the UK and the U.S. it is not much better, more like 4:1.

We’re all headed in the same direction. In Germany and France, by the middle of the century there will be one retired person for every two “active” people if current trends persist; in Japan where it has already reached 2:1, the OAD ratio will eventually reach 1:1.

For countries that rely on a pay as you go (PAYG) pension system - whereby current workers finance current pensions - the status quo is clearly unsustainable without action.

If no action is taken, two options are possible: there will have to be an increase in the contributions of the economically active or, alternatively, a reduction in the level of benefits for retirees. Or maybe both.

Additionally, to further reduce the burden on the PAYG system the working age could be extended. All of these measures could stabilise the situation - but none will be very popular.

Longevity

Clearly, a standalone PAYG system is untenable in the long term, and future pension provision must have a funded element whereby individuals save for their own retirement in an invested fund.

It’s easier said than done, of course, and a funded system has its own risks. If pensions are completely market linked, a situation could arise where the market crashes (as happened in 2008), with obvious and serious implications for retirees.

Equally, there’s the issue of governance and the safeguarding of pension fund assets: It’s not unknown for a government to sequester monies intended for citizens’ pensions.

Personally, I believe that the multi-pillar approach favoured by the World Bank is a good model. It’s a combination of the PAYG and funded systems, but with an element of obligation on workers and/or employers in the private pillar.

The mandatory aspect takes account of the fact that while in many countries some industries have well-organised pension schemes, other parts of the economy do not. It’s the latter segment where the greatest need usually exists.

The life insurance industry can contribute a lot to making adequate pension systems more sustainable, providing a strong, funded pillar.

For old age income provision, security and reliability of income is paramount. The industry’s collective approach does more than enable it to assume longevity and mortality risks. Its collective approach to accumulating funds also has the effect of buffering volatility over time. In other words, the insurance industry’s collective approach provides exactly the stability needed for old age income.

I sometimes think that we as an industry do not talk enough about these unique selling points, but we should. Policymakers have to respond urgently to the demographic changes taking place and make pension systems fit for purpose. Let’s show them what we can do to help.

This is a summary of my presentation at the World Congress of Actuaries, June 2018 in Berlin.

 

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