Monday, August 15, 2011

Sustainable retirement pension reform?

With increasing longevity, it is obvious that something needs to be done to keep pension systems around the world sustainable. The main options are postponing the normal retirement age, lowering retirement benefits or increasing contributions. The typical studies that compare these options and are thrown around in the public arena are done by accountants and actuaries, who do not take into account the changing incentives of market participants. Economists can do better.

Peter Haan and Victoria Prowse take up the challenge and estimate a very complex life-cycle model for Germany. It includes idiosyncratic risk, consumption and labor supply decisions and a complex tax structure. They find that the 6.4 year increase in life expectancy over the next 40 years needs to be met either by an increase in the full-pension age by 4.3 years or a reduction of benefits by 38%. The first approach markedly increases the unemployment rate. This is ironic in Europe where a reduction of that age is typically viewed as a way to reduce chronic unemployment among the young. The other option would markedly increase savings, as people have to fend for themselves more. Consumption of retirees is higher in the first option though.

Am I satisfied with this study? It is much better than what you typically see, yet I want more. The easy bit is that one could actually determine whose welfare increases under which option. That could help in understanding the (political) feasibility of such reforms. And maybe a combination of them turns out best. More critically, the model does not attempt to consider the consequences in the changes in aggregate supply. Lengthening the work age this much increases the work force dramatically and must have consequences for aggregate, and thus individual, wages. Also, while the matching probabilities and wages of retirement age workers are estimated from current data, I do not think these estimates apply once more previous retirees are forced into this pool. The new ones have different qualities compared to those who would have continued working anyway. Therefore, I see more work to be done.

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