Towards an Understanding of the Pensions Crisis
It is usual in the economics literature to motivate pension arrangements for individuals by reference to consumption smoothing and insurance. The problem for the (average) individual may be illustrated with a simple comparison of the age profiles of individual labour income and consumption, as in Chart 1:
Chart 1: Per Capita Consumption and Labour Income
The problem for the individual is the replacement of labour income in retirement to enable continuing consumption. The chart above shows, at a single point in time (2007), the average labour income (including self-employment) of individuals of different ages and their consumption profile. Of direct relevance for pensions, an income in retirement is that no individual knows their own longevity, the point at which their consumption will cease, which introduces the concept of a pension as insurance.
The individual may provide for their own retirement by saving through their working lifetime and then realising and consuming these savings in retirement. Economically, the individual saves in order to acquire claims on future production, and the claims in positive net supply are private sector equity and government obligations. The individual must buy these assets in financial markets.
There are many advocates of this simple form of self-provision. However, the individual faces the problem that he does not know his own longevity and to provide for this uncertainty needs to over-provide or face penury at some point in old age. In retirement, consumption cannot be financed by an individual from borrowing as he lacks the income from which to service and repay this debt. Over-provision is not efficient.
Of course, an individual may purchase a life annuity to resolve this longevity uncertainty, but that introduces explicit dependency upon a financial institution, the life assurer. This contract, of course, is costly to the individual. It is also problematic from the stand-point of individual planning. Unless the annuity is bought directly with savings at the points in time when the individual has surplus income, both the value of these savings at and after retirement and the cost of an annuity at those future times is unknown to the individual. This represents a significant problem for the form of saving known as (individual) defined contribution ‘pensions’.
The situation looks very different from the perspective of the economy or society overall, as may be seen from chart 2. Aggregate consumption in this diagram is the result of applying the UK population structure to individual income and consumption profiles.
Chart 2: Aggregate Consumption and labour Income
It is immediately obvious that the post-retirement income problem is greatly mitigated in aggregate. Collective arrangements, which pool the uncertainties of longevity are inherently superior to individual provision, though, of course, such collective arrangements are exposed to increases in longevity in the population at large.
The effects of such increases are predominantly located in the post-retirement ages. As increasing longevity is such a frequently-cited cause of the pensions ‘crisis’, some rudimentary mathematics is appropriate. A one year increase in longevity for all when life expectation was 82 is an increase of 1.22% at birth but at retirement, say 60, it is an increase of 4.55% (1/22). Now if this improvement takes five years to occur these rates decline to 0.24% and 0.91% respect
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