Pension Shock

IMF Blog, August 24, 2017

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Public pensions have been an important source of retirement income and poverty reduction for the elderly in advanced economies, accounting for more than 60 percent of elderly income in OECD countries.
Government spending on pensions in advanced economies rose from an average of 4 percent of GDP in 1970 to close to 9 percent in 2015—largely reflecting population aging.
Life expectancy at age 65 is projected to increase by about one year a decade.
Since the 1980s, public pension expenditure per elderly person as a percent of income per capita (the economic replacement rate) has been about 35 percent; it is projected to decline to less than 20 percent by 2060.
For those born between 1990 and 2009, increasing retirement ages by five years—from today’s average of 63 to 68 in 2060—would close half of the gap in the economic replacement rate relative to today’s retirees.
Simulations indicate that if those born between 1990 and 2009 put aside about 6 percent of their earnings each year, they would close half of the gap in economic replacement rate relative to today’s retirees.

Population aging increases the ratio of elderly beneficiaries to younger workers who contribute to funding benefits.
Increasing longevity raises the duration of benefit payments.
Policy responses have generally aimed at containing the growth in the number of pensioners (for example, increasing retirement ages or tightening eligibility rules) and reducing pension size (for example, adjusting benefit formulas).
Projected decline in replacement rates implies younger generations will need to work longer and save more to achieve replacement rates similar to today’s retirees.

Extending productive work lives can offset pension shortfalls: a five-year increase in retirement age for cohorts born 1990–2009 would close half the replacement-rate gap.
Justifications and benefits:
- Increased longevity supports longer working lives.
- Longer work lives enhance long-term economic growth.
- Longer work lives help governments sustain tax and spending policies.
- Continued work can help maintain physical, mental, and cognitive health.
Protection needs:
- Policies promoting longer work lives should include protections for the poor, whose life expectancy tends to be shorter than average.

Required saving: putting aside about 6 percent of earnings each year for cohorts born 1990–2009 would close half the replacement-rate gap.
Practical challenges to relying on private savings:
- Individuals need continuous and stable earnings over careers to save sufficient amounts.
- Workers must decide how much to save and how to invest their savings.
- Investment-return risk is borne by individuals.
- Individuals must decide how fast to consume savings during retirement.
- Multiple complex decision points create opportunities for mistakes.

Encourage earlier and sustained action by younger cohorts to secure retirement income through a combination of working longer and increased savings.
Make it easier for individuals to remain in the workforce at older ages by reviewing taxes and benefits that might favor early retirement.
Use nudges to increase savings participation, for example by automatically enrolling workers in private retirement saving plans.
- Example provided: starting in 2018, the United Kingdom will require employers to automatically enroll workers in a pension program.
Boost financial literacy to help individuals make better saving and investment decisions.
Make workplaces more friendly to older workers to facilitate longer working lives.

Millennials have about four decades before retirement, providing time to plan for longer careers and to accumulate savings.
Because many governments are retrenching their role in providing retirement income, millennials need to work longer and step up retirement savings beginning now.

Originally published in Finance & Development magazine, June 2017, Vol. 54, No. 2.