In a pure market economy hypothetically populated by selfish individuals, access to the goods and services supplied entails drawing on wages derived from the sale of labour services, or rents or interest thanks to ownership of valuable assets, or alternatively using the proceeds from selling those assets. In any case, owning one or the other form of capital, human, real or financial, is a necessary condition to satisfy one’s needs and wants. Such a condition is necessary but not sufficient, given that the mere possession of either form of capital does not ensure that there is a demand for it. The typical case is when, in a downturn, workers’ human capital and firms’ physical assets remain unemployed, thus depriving their owners of any source of income. Besides these, there are cases in which individuals lack any form of capital irrespective of market failures. Take the case of people lacking financial or real assets whose health or physical conditions are so poor as to reduce the ‘marketability’ of their human capital, thus requiring some sort of solidarity, in the past possibly provided within the family or by charitable organizations. It is, therefore, hardly surprising that modern market economies have developed specific institutions designed to replace those occasional and unsystematic forms with a State-managed system of solidarity. It was in particular with the development of the welfare state that many countries around the world decided to create a series of programmes to ensure a minimum level of well-being for all the members of society. Free access to public schooling and health care ensures that human capital is fairly distributed among individuals regardless of ‘initial conditions’. Moreover, the welfare state provides individuals with monetary benefits whenever they are deprived of their usual sources of income. Disability and unemployment allowances are typical forms of subsidies protecting individuals when accidents and adversities reduce the marketability of their human capital during working age. Moreover, the marketability of human capital progressively decreases with age.
In fact, reaching old age has its blessings but in most cases it also eventually leaves individuals with no marketable human capital and, hence, with no labour services to sell. In principle, rational and forward-looking individuals could voluntarily ‘save for retirement’, i.e. accumulate assets during working age, such that during retirement the absence of proceeds from the worn-out human capital can be offset by those from physical or financial capital. However, individuals are not immune to myopic behaviour, leading to saving too little for retirement. Conversely, even forward-looking individuals face difficulties in drawing up an efficient saving plan for retirement. In fact, since most individuals are risk-averse, they would be inclined to protect themselves from the longevity risk, i.e. from the risk of having no income in the event of surviving well above the average age of death. On the other hand, by definition, only a part, let’s say a half, of the members of each birth cohort can be of above-average age at death, the remaining half being destined to be of below-average age at death. As a consequence, if all individuals are risk-averse, given the uncertainty surrounding individual life expectancy, many of them will have ex post saved too much, thus (regrettably) leaving assets as bequests on their demise. One of the efficient solutions to this problem is risk-pooling through insurance against the longevity risk. The higher the number of individuals who join the insurance pool, the easier will it be to match the required annual savings rate (the premium) with the average age at death, thus avoiding saving too much. In fact, myopic behaviour and risk-pooling account for the widespread public, compulsory old-age insurance plans paying a pension, i.e. a lifelong annuity to all individuals reaching retirement age.
This book deals with the economic problems involved in the organization of a pension system. Chapter 2 spells out the basic concepts and the meaning of the various expressions used in the jargon of pension economics. Chapter 3 is devoted to a short and fairly elementary technical digression. Chapter 4 describes the essential properties of alternative pension designs in highly simplified economies where individuals are assumed to live two periods only, one as active workers and one as retired. Chapter 5 analyses the redistributions implied by different pension designs in the context of real lifetime spans while Chapter 6 addresses population ageing and how the different types of pension plans can meet the challenge. Chapter 7 concludes.
The idea of a compulsory old-age insurance plan managing the longevity risk had already emerged with the enlightened thinkers of the late eighteenth century. According to Condorcet the Government should secure “to him who attains old age a support, arising from his savings, but augmented by those of other persons, who, making a similar addition to a common stock, may happen to die before they shall have the occasion to recur to it” (Condorcet 1795, p. 331). It took around a century for Condorcet’s idea to be put in practice, given that the first public, compulsory pension system based on insurance principles was set up in 1889 when the Prussian Chancellor Otto von Bismarck extended the compulsory insurance for work accidents and sickness, introduced a few years before, to invalidity and old age. In the Bismarckian model both pensions and contributions—the latter paid by both workers and employers—are based on individual earnings. The Bismarckian earnings-related principles began to be adopted by other European countries in the early twentieth century and in the United States after the Great Depression with the Social Security Act of 1935, one of the most significant elements of Roosevelt’s New Deal. A few years later, a different approach, based on flat-rate benefits and contributions emerged in the UK with the well-known Government Report on Social Insurance and Allied Services conceived and drafted by the economist and civil servant William Beveridge (1942). Most of the ideas included in the Beveridge Report were to be implemented a few years later with the 1946 National Insurance Act introducing the Basic State Pension in the UK.
2.1 The Different Aims of a Public Pension System
Bismarckian earnings-related pension systems provide individuals with a tool for consumption smoothing throughout the lifecycle (see Focus 2.1). On the other hand, Beveridgean flat-rate pensions aim to provide only a minimum pension, a safety net preventing poverty during old age. Moreover, pension systems may aim to achieve redistributions during old age in favour of ‘deserving’ groups of the population (Barr 2006). In the past, protected categories have included the armed forces, civil servants, and women or workers employed in particular industries. Besides these redistributions that are transparently declared, it is not infrequent for redistributions to be generated opaquely by the complexity of the pension system.
Universal protection against poverty during old age as well as compulsory insurance against the longevity risk so as to achieve consumption smoothing raises the issue of how much paternalism and protection is optimum for society. Shouldn’t individuals be left with freedom to choose whether and how much they want to save for old age? Isn’t excessive and widespread protection an incentive for individuals to behave as free-riders, leaving society with the burden of their improvident conduct? In his report, Beveridge warned that “the State in organising security should not stifle incentive, opportunity, responsibility; in establishing a national minimum, it should leave room and encouragement for voluntary action by each individual to provide more than that minimum” (Beveridge 1942, pp. 6–7). Beveridge favoured universal flat-rate cash payments ‘in return for’ a flat-rate contribution, opposing means-testing precisely because it clashes with the contributory principle. In fact, “payment of a substantial part of the cost of benefit as a contribution irrespective of the means of the contributor is the firm basis of a claim to benefit irrespective of means” (ibid., p. 12). The Beveridge Report sketched an overall social insurance system covering several risks together. The idea of a comprehensive insurance system has inspired many social security plans around the world that generally provide an overall insurance for old age, disability and survivor (OASDI). It is worth mentioning, however, that the inclusion of a lifelong pension to be paid to the surviving spouse of the insured, now widespread around the world, was explicitly rejected by Beveridge, whose proposal was not to grant permanent pensions to “widows of the working age without dependent children” but rather to provide them only with “a temporary benefit at a higher rate than unemployment or disability benefit, followed by training benefit when necessary” (ibid., p. 11).
In what follows we will disregard survivors and disability insurance and concentrate on the economic properties of alternative retirement plans. In particular, we will focus on the conditions for old-age pension systems to be financially solvent and the extent to which they achieve redistributions both among individuals with different career patterns belonging to the same cohort (or generation), and among individuals with similar career patterns belonging to different cohorts. In the jargon of pension economics, the issue of redistributions is often referred to with the highly debatable word ‘fairness’, preceded by the label intra-generational when assessing redistributions among members of the same birth cohort or intergenerational when assessing how the system performs through time toward different cohorts.
2.2 Computing Old-Age Benefits
When setting up a public, compulsory pension system, policymakers need, among other things, to define a rule to determine the amount of the annuity to be paid to retirees, the choice depending on the specific aim they want to achieve.
Typical Beveridgean, poverty-preventing pension benefits amount to the ‘subsistence’ wage or to a fraction of average earnings in the economy.
On the other hand, a typical Bismarckian pension annuity aims to ensure consumption smoothing. It is essentially earnings-related, i.e. a share of the individual’s reference earnings, computed as the average of a number of either end-of-career or best earnings, while the share is generally a multiple of workers’ years of service. The multiple, say 2%, is called the accrual rate, representing the percentage of reference earnings paid as a pension for each year of service. While last earnings rules are meant to ensure some sort of continuity in the standard of living when moving from work to retirement, best earnings rules protect the workers whose earnings tend to decline in the last years. Given their scope, after being first awarded to any new retiring worker, earnings-related pensions should be adjusted or indexed, annually, according to growth in average earnings, whereas flat-rate pensions are generally indexed according to the cost of living.
A variant of earnings-related rules can be found in the ‘point systems’, which assign to each insured worker a certain number of points for each year of work. Points can be accumulated in proportion either to individual earnings (as in the German system) or to contributions (as in the French version). At retirement, the first pension is calculated through multiplication of accumulated points by the value of a point, arbitrarily chosen each year by the policymaker or by a board of actuaries. The yearly percentage change of the point value also determines the rate at which pensions already being paid are indexed through time.
An alternative way of computing a pension benefit is to use personal accounts, i.e. to open an account in the name of each insured worker recording all their old-age contributions plus interest. Credits can be earned also for non-marketable deservin...
