Alessio Mitra // 2 October 2018
Even though the ageing of the European population is not a new phenomenon, its potential effect on European Welfare systems is often under-estimated. According to The 2018 Ageing Report of the European Commission’s Directorate-General for Economic and Financial Affairs, the total EU population is predicted to rise from 511 million (2016) to 520 million (2070), but the working-age population (15-64 ages) is estimated to fall from 333 million (2016) to 292 million (2070).
This means that the “(the ratio between people aged above 65 and the working-age population), will increase from 29.6% in 2016 to 51.2% in 2070. In 2070 there will be only 2 working-age people every person aged above 65 years. This demographic trend implies serious healthcare questions for retirement.
European governments should be aware of the policies and institutional reshaping which will be needed to tackle such widespread phenomena. It is purpose of this article to set out the functioning of the main pension systems and present a series of policy suggestions that may enhance the adequacy and sustainability of pension schemes.
From a theoretical perspective, the mandatory nature of pension schemes is enforced due to the so-called “ hyperbolic”. Individuals weight differently their utility today from tomorrow. Moreover, individuals often are time inconsistent: their choices and preferences are not stable along time. For this reason, individuals may fail to make reasonable predictions and responsible choice about their future, saving too little and procrastinating over saving money. These pension systems can be both public or private, pay as you go or fully funded schemes, defined benefit schemes or defined contribution schemes (for a deep explanation of the cited systems refer to the LSE research The economics of pension).
Despite the fact that pension systems are different between Member States, all of them have relevant public sector involvement. In most countries, the main difference is how much space is left to the private and individual initiative of individuals and firms. Briefly, in “pay as you go” systems, tax payments and contributions to pension funds are used for the payments of current pensions rather than collected and invested for individual old-age retirement.
In defined benefit schemes, the pension payment is determined as a percentage of income (final salary or overage salary received during working history) and employment career. The employee does not bear the risk of longevity and the risk of investment. On the other hand, defined contribution scheme pension payment depends on the level of defined pension contributions, the career and the returns on investments. In other words, employee contributions are invested, and the employee has to bear the risk of longevity and the risk of investment.
Any of these structures present different weaknesses, in particular the “pay as you go” system’s suffering from the ageing of the population issue; indeed, if the working population pay the pensions of the retired population, given an ageing trend, the future generation will face difficulties obtaining their promised pension. For this reason, many countries are moving to mixed and more balanced models. The dossier Jobs Act. The labor market two years later (by Neos Magazine, Luigi Einaudi Centre and CEST) suggests that when pension expenditure becomes a mere form of social protection, instead of retirement planning, it is liable to lead to intergenerational injustice.
In particular, the IZA research report Pension Systems in the EU – Contingent Liabilities and Assets in the Public and Private Sector (for the European Parliament, 2011) lists a series of policy recommendations:
1. Increasing labour force participation rates across the EU. Labour policies that allow a dynamic and flexible job market may decrease unemployment and allow retirement planning.
2. Working longer. Pension benefits should be adjusted to demographic changes.
3. Mixed public-private system. To ensure a sound financial basis for the standard of living and at the same time reduce the pressure on the public pension budget.
4. The crucial nature of sustainability has to be made clear from the beginning of retirement planning. Calculations and projections should state the risk level and likelihood of plans and expected returns.
Further research has also pointed out the importance of culture and financial literacy. In the paper Financial literacy around the world: an overview by Annamaria Lusardi and Olivia S. Mitchell, a strong link between financial literacy and retirement planning/wealth accumulation is empirically shown. Using data from eight different countries through the Instrumental Variable method, the two economists show how financially literate individuals are more likely to plan for retirement.