The Macro-Economics of Pensions

The Macro-Economicsof Pensions

Adair TurnerSeptember 2nd, 2003

2

Pensioner Income as a % of GDP

If we assume

• Average retirement age unchanged

• Average pensioner income a constant proportion of average income

2030Today

3.8

8.0

5.5 5.5

Private

State

9.3

13.5

+4.5

3

Pension Claims Against Future Output –Three Current Models

Nature of Claim Risks PAYG STATE SYSTEM

Against totality of GDP Enforced via

contributions/ taxes

Political Indirectly – Demographic and

Macro-economic

FUNDED DC Against profits Volatility of: o Profit slice of GDP

Via ownership of equities and bonds

o Market price of equities and bonds

FUNDED DB Against profits Volatility of: o Profit slice of GDP

Via ownership of equities and bonds in the fund

o Bond and equity prices

But also via bond-like promise of the individual company

Bankruptcy of the individual firm

4

Two Near Equivalences

Compulsory DC scheme invested in Government index linked bonds

DC scheme invested in corporate bonds

and and

Tax financed PAYG DB average salary scheme

If the rate of return on index-linked government bonds is equal to rate of growth.

Still different in respect to

•Life expectancy risks

•Diversification of bond portfolio

But similar since DB schemes are bond-like liabilities

5

Key Question: How Best To Structure Pension Claims?

Against Future GDP

PAYG

Funded in government bonds

Against Future Profit Slice of GDP

DC in equities

DB

DC in corporate bonds

6

Two Possible Routes To Increased Pensioner Income

• Investment and future output unchanged, but some other group of savers relinquishes a matching claim on future assets and profits

• Savings and investments increase, and as a result, so does future output

7

1

3

7 7

2

4

2

3

5

8

3

7

3

2

0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10-11 11-12 12-13 13-14

% Cumulative Average Return Over 20 Year Periods

Real Return On Large Stocks: US 1926 - 2000

Med

ian

7.9

____________________Source: Ibbotson Associates: 2002 Yearbook

Mean

7.2

No. of 20 Year Periods with Return in Range (57 Periods)

8

1

4 45 5

8

10

16

6 6

3 3

10

-12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27



Real Return On Large Stocks: US 1926 - 2000

Med

ian

8.5

5

Mean

7.6

4


9

8

6

10

7

9

43

2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10-11 11-12 12-13


Mean

6.8

6

Med

ian

7.0

4


Real Returns on Large Company Stocks: US 1926 – 2001


10

1

4

9

7

4

2

2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 10-11 11-12


Med

ian

6.9

9


Real Returns on Large Company Stocks: US 1926 – 2001


11

Claims And Risks

Claim Against Inherent Risks

PAYG OR FUNDED IN

GOVERNMENT BONDS

Totality of future GDP — Wages and profits

Unanticipated variations in future GDP

FUNDED IN CORPORATE

CAPITAL Profit slice of

future GDP Unanticipated

variations in future profits

12

Dividend Valuation Model: Inherent Uncertainty

PV = Rational value of equitiesD0 = Current year dividends

r = risk free rate

PV =D0 (1 + g)1 + r + p + +

D0 (1 + g)2

(1 + r + p)2 (1 + r + p)3

D0 (1 + g)3

PV = r + p - gD0

p = equity risk premiumg = rate of growth

13

Risk Management And Risk Sharing In Funded Schemes

1. DC schemes – Managing the crystallisation risk

2. The DB to DC Shift Is it concerning or desirable? Is it inevitable?

3. Should DB schemes invest in equity?

14

Risks In Final Salary DB Schemes

CATEGORY OF

RISK

ABSORBED

BY

EMPLOYER

ABSORBED

BY

EMPLOYEE

CONSEQUENCE

Investment return

x

Changes in life expectancy

x No incentives for later retirement

Individual salary progression

x Complex accrued rights and transfer values – to disbenefit of early leavers

Overall risk borne

by employer is high

15

DB / DC Hybrids –Risk Sharing Alternatives

CATEGORY OF

RISK ABSORBED BY

EMPLOYER ABSORBED BY

EMPLOYEE

Investment return risk

x

Changes in life expectancy

x Pensionable ages increasing over time in line with life expectancy estimates

Individual salary progression

x Average salary based not final

16

Who Killed DB?

• Unanticipated increases in life expectancy Slow response to 1980s and 1990s mortality declines

• Increased life expectancy not matched by later retirement ages or increased contributions

• Irrational exuberance, apparent “surpluses” and contribution holidays

• Tax and residual ownership disincentives to very large surpluses

• “Costless” tax increase of 1997

17

How To Increase Resources For Future Pensioners

With aggregatesavings, investmentand output unchanged

Via increased savings, investment and output

Future pensioners claimhigher share of future capital and profits ….

Profits rise as % of GDP…

Domestic investment rises and thus GDP (and GNP)

Overseas investment rises and thus GNP (but not GDP)

OPTION 1:

OPTION 2:

OPTION 3:

OPTION 4:

At expense of other savers

At expense of future workers

18

Option 1: Pension Saving Up, Some Other Saving Down

Either• Increased pension saving, but offsetting dissaving by

the same people

• Increased pension saving but offsetting dissaving by “others”

19

UK Pension Fund Assets As a % Of GDP

____________________Note: Occupational schemes only

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

(est

)

Per

cent

20

% of UK Equities owned by individuals &UK pension funds 1963-93

____________________Note: After 1993 the % owned by individuals continued to fall, but so too did the % owned by UK pension funds. But the growing category in 1993-2002 was overseas investors (1993: 16%, 2002: 32%), many of whom are pension funds; and conversely UK pension funds have invested more overseas. The overall pension fund role in the market has therefore probably continued to grow

0

10

20

30

40

50

60

70

1963 1969 1975 1981 1989 1990 1991 1992 1993

Per

cent

UK Pension funds Individuals

21

Capital Investment And The Marginal ProductOf Capital

Quantity of capital invested

Rate of return

Savings Schedule 1

Savings Schedule 2

22

Fishing Boats, Fish And A Falling Population

Steady State

•1,000 population•500 per generation•500 working, 500 retired•Workers work

Half time fishingHalf time building a boat

•Boats wear out over one working life

Demographic Change

•500 generation of

retirees followed by

250 generation of

workers•Retirees would like to

sell 500 boats they

have built•Workers only need to

buy 250 boatsRelative price: 1 boat = ½ of catch for one working life

Price of boats, relative to fish, will fall

23

Funded Pensions in Corporate Capital: Two Dimensions

Claim on future Cash Profits

• Selling price of accumulated assets must equal the discounted value of future cash profits thereafter

• Funded pensions are a claim on future profits

Inter-Generation Funds Flow

•Value of Generation 1’s asset decumulation must equal Generation 2’s asset accumulation

•Future pensioners consumption is financed from future workers’ consumption deferral

24

Rising Longevity, Constant Fertility

Same trade-off in each generation

No change in retirement age

• G 1 saves more

• Capital stock increases, returns decline

• Asset prices unchanged since

G 2 has same target capital stock as G 1

Required returns fall in line with actual

Different trade-off

G 2 chooses later retirement

• G 1 saves more

• Capital stock increases, returns decline

• Asset prices fall since G 2 has lower target

capital stock than G 1 G 2’s required returns

have not fallen (relative to the no rise in longevity base case)

25

Falling Fertility, Constant Longevity

• Generation 1 keeps saving as before (since longevity unchanged)

• In Generation 2, unchanged capital stock but less labour

Lower returns to capitalHigher real wages

• Value of assets falls becauseReturns down, discount rate unchangedG 2 has lower target capital accumulation than G 1

26

Demographic Impacts on Returns to Capital: Model Results

Garry Young: Baby-boom generation -0.1%Increased longevity -0.1%Falling fertility -0.3%

David Miles: Given future actual trends in UK demographics, returns fall:

• 4.56% (1990) to 4.22% (2030)• 4.56% (1990) to 3.97% (2060) if

PAYG phased out

27

Financial Asset Prices – Transitional Effects

Long-Term Impact – Higher Capital Stock– Lower Long-Term Returns

Transitional Impact– Increased demand for initially sticky supply– Rising financial asset prices

Increase inAggregate SavingsRate

Long-Term Impact – Fall in long-term equilibrium returns– e.g. 4.6% 4.2%

Transitional Impact– From PV=

– To PV=

– Fall of 10% if r and p unchanged

Fall in AnticipatedFuture Rates of Return 4.6

r+p

4.2r+p

28

Overseas Investment as the Solution –Conditions Required

Other countries to invest in which have

•Different demographics – dependency ratios not rising

•Economic success – growingper capita GDP

Increasing numbers of productive and prosperous future workers able to:

• Provide future output available for consumption

• Buy capital assets from decumulating savers in the investor countries

+Small numbers of domestic decumulating pensioners also trying to sell assets

29

25

65

10

19

60

21

Demographic Change in UK and China –UN Medium Variant% Population by Age Band

20502000

UK

China

26

60+ 15-59 0-15 Years

16

54

30

16

54

30

30

The Fundamental Choice

Increasing longevityplus falling fertility

Some mix of:

• Future pensioners poorer relative to average income than today

• Future workers must give up more consumption in savings, contributions or taxes

• Retirement ages must rise

Date post:	12-Jan-2016
Category:	Documents
Upload:	winter
View:	45 times
Download:	0 times

The Macro-Economics of Pensions

Documents