Global pension plans collectively are estimated to sustain a multi-trillion dollar shortfall. Demographic changes, years of political standstill and the great recession have led to pension obligations being underfunded worldwide. If this retirement income crisis is not addressed adequately it will not only have serious economic consequences, but will lead to political and social issues as well.
In developed economies, the post-war years saw an increase not only in living standards but also in employment benefits, which included generous pension plan promises. When these plans were originally created in the 1950s, the average old-age support ratio, the number of 15–64 year old individuals relative to those aged 65 and over, was about 12:1 for developed countries. Due to decreased birth rates and increased life expectancy, this ratio has fallen to 8:1 today. It is expected to decrease to 4:1 by 2050, and to as low as 2:1 in Japan and certain developed countries in Europe.[i] Individuals over the age of 65 are projected to exceed the number of younger individuals under 15 by 2047 according to Dr Anita Schwartz, World Bank lead economist for Europe and Central Asia. The outlook is even direr when observing dependency ratios: the number of individuals working versus those not working. The demographic structure under which pension plans were originally designed has changed and will continue to change.
Countries will have to try to tackle two problems: financial sustainability of their programs and adequacy of the incomes provided to retired constituents. Many have already started to take measures to reduce their present and future financial obligations by raising the age of both retirement and early retirement, and reducing retirement benefits. Private companies have also reduced their pension obligations. The cost of pension plans has led to a gradual shift from company defined benefit plans to defined contribution plans or, in some cases, no pension plans whatsoever. This shift has been made to ensure the sustainability of individual corporations.
Unlike defined benefits though, which provide a guaranteed monthly income, defined contributions may not. Uncertainty exists in the size of the invested contribution at the time of retirement and the replacement rate: the percentage of the annuity received in the long run, compared to pre-retirement income. This raises old age poverty concerns. Women are most at risk because their lifetime earnings are less, they live longer than men and, in some jurisdictions, they are actuarially penalised for years spent in childcare. This leaves them with a smaller pot to last a longer time.
The pre-recession years also saw large portions of the developed-world population spend freely and save little, while the recession diminished whatever wealth they had accumulated. With fewer retirees therefore expected to get a guaranteed income throughout their retirement or to be able to rely on saved wealth, a greater burden has and will continue to fall on the state. It has become apparent that more reforms are needed to provide adequate and sustainable retirements.
Certain countries have acted to fill the gap between mandated schemes and required retirement income by adding or bolstering voluntary pension schemes, tax-free savings accounts and changing tax regulations to encourage retirement saving. The problem with these initiatives is that individuals do not take advantage of them because of lack of will, lack of understanding or lack of income to do so. Individual intertemporal substitution is low as, behaviourally, present consumption is preferred to future consumption. Others have acted by expanding private pension schemes and increasing contribution rates to ensure retirement income adequacy. Greater diversification of pension options though will need to be encouraged to ensure coverage and adequacy.
Despite these early reforms, many OECD individuals are left with basic mandated pension schemes and/or government benefits as their only source of retirement income. At present, governments provide 59% of retiree income on average. As projected pension expenditures are expected to increase from the present 8.4% of GDP to 11.4% of GDP in 2050, more reform will be needed to ensure sustainability.[ii] Should retirement savings and pension plans be inadequate, greater societal contribution will be needed. This has already led to intergenerational as well as private vs. public sector tensions for some jurisdictions. Individuals increasingly question why they should subsidise pension benefits that they themselves do not or will not enjoy.
Societies will need to make tough decisions to ensure this shortfall is tackled. They must accept that demographics have changed and therefore that what societies can afford has changed as well. Burdening or depending on the next generation will not work, either financially or demographically. Adequate income must be ensured as lack of income in retirement will lead not only to an increase old age poverty but could result in ’ageing recessions’ further aggravating funding problems. This is a policy problem that societies will need to address collectively because they are better equipped to act together than individually.
[ii] OECD (2011), Pensions at a Glance 2011: Retirement-income Systems in OECD and G20 Countries, OECD Publishing.