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Maintaining Prosperity
n the advanced countries of North America, Europe, Japan, and Australasia, the reform of public pension systems has been a topic of public debate for years, but not because these systems work badly. By and large, they are comparatively inexpensive to administer. They effectively prevent seniors from slipping into poverty. In several OECD (Organization for Economic Cooperation and Development) countries, seniors who qualify for full state pensions are able to maintain a comfortable standard of living during retirement, which now can last for 20 years or more. Therein lies the problem. High pensions for many years mean high taxes for those still working because public pensions are almost always pay-as-you-go (PAYGO). Pension contributions by employees are used directly and immediately to pay the pensions of those in retirement. There is no fund. Children pay the pensions of their parents. Because birthrates have fallen, there are fewer children and the burden on them will grow. This demographic shift means that societies in the future will contain much higher proportions of retired people, and possibly very much higher proportions of frail elderly people. This raises a number of policy issues.
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Nevertheless, all desirable reforms address three objectives: encouraging people to work longer, implementing policies that make them more productive while they are working, and encouraging diversification away from public PAYGO pension systems that are too generous.
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a declining industry. Unemployment benefits can be used to finance a year (or more) of inactivity until the worker reaches the minimum retirement age. Such benefits are not generous. In most countries they represent well under half of previous earnings. Where they are generous, the eligibility criteria are usually strictly imposedbut may be enough to finance a transition to official retirement, if complemented by accumulated savings or the earnings of other family members. Disability pensions are another route. It is remarkable that, despite improving health and the declining importance of jobs requiring robust physical strength, the number of workers drawing partial or full disability pensions is high and rising. OECD research shows that, in the early 1990s, more than half of all male Austrians over age 55, for example, igh pensions for were drawing some form of disability pension. many years mean In most other European countries for which high taxes for data exist, the figure is 15-30 percent (and approximately 10 percent in the United those still working. States). This development also reflects high structural unemployment rates, especially in Europe. In some countries, medical panels are legally obliged to take into account prevailing labor market conditions when deciding whether someone is fit to work at all, or part time. Even in countries in which this obligation does not exist, it is clear from data that new claims for disability benefits rise when economic conditions deteriorate. This implies either that medical panels take into account the likelihood that a claimant will find a job, if he or she is assessed as able to work, or that those with a genuinebut not cripplingdisability make more effort to claim benefits when they know the job market is precarious (or both). Again, disability benefits are usually not generous, being equivalent to between a quarter and three-quarters of previous earnings and generally at the lower end of this range. It follows that typical older workers, especially those with low skills, find that working until the official retirement age is not financially rewarding. If they continue to work, they pay payroll and other taxes without receiving a higher pension. If they stop working, they have access to various social benefit programs. In effect, continuing to work is subject to an implicit tax as well as normal taxes. OECD calculations for the mid-1990s put the implicit average tax rates as high as 80 percent for Italy, with most other European countries in the 15-60 percent range. The United States is at the very bottom of this range. Such high implicit tax rates provide strong disincentives to continue working, and the OECD analysis shows that there is a clear re-
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lationship between the size of this tax and the age at which people retire from the labor force. From a public policy perspective, the appropriate remedy is to reduce the implicit tax on work by those over age 55 to encourage them to remain in the labor force. If more people are working, there is more output to be shared with seniors, and because the tax base is higher and pension payments lower, fiscal problems are easier to manage. Reducing the implicit tax on continued work can be achieved in a variety of ways, and several countries have instituted reforms that have this effect. One of the simplest reforms is to raise the minimum age at which full public pension rights accrue. Several countries are doing this. For example, the retirement age will gradually be raised to age 67 in the United States. A similar reform is under way in France, where the number of years spent working to qualify for a full pension is gradually being raised from 37.5 to 40 years over a 12-year period. Other reforms, as in Sweden, can relate pensions to lifetime earnings rather than earnings in the final year or so of working life. This increases the incentive to continue working and accumulate higher pension rights. Pensions for early retirement can be made actuarially neutral, as in the case of the United States. This also increases the incentive to remain in work. An associated reform is to pay actuarially fair higher pensions to those who retire after the official retirement age. Few countries do this, and indeed some of them in effect impose high tax rates on incomes from work once a person has passed the official retirement age. In all these reforms aimed at encouraging people to remain in the workplace until (at least) the official retirement age, three factors have to be kept in mind: Financial incentives work better than legal restrictions. If people are to work longer, they must be employable and jobs must be available. Experience shows that legislating a higher official retirement age simply encourages older workers to access other social programs, thus partly nullifying the intent of the pension system reforms.
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cuts in wages to find a new job. Several arguments explain the disadvantage of older workers compared with their younger counterparts: higher costs owing to seniority wages and more absence from work, lower productivity and lesser flexibility, and shorter employment periods in which training costs can be recuperated by the employer. A recent OECD-sponsored study casts doubt on the validity of these arguments. The relationship between age and wages may be less pervasive than earlier thought. The rate of employer-sponsored training received by older workers is in fact quite respectable: Employees age 45-54 receive as much training as those age 26-45. And while productivity does deteriorate with age in some occupations, such as hard physical labor, it is doubtful that this is a general pattern. The older worker should be orking until the well situated in a knowledge-based economy. official retirement Although surveys show that literacy skills deage is not financially cline only modestly between ages 40 and 45, rewarding. the employment problems of older workers seem to be rooted in their relatively low levels of foundation skills, such as literacy and numeracy. The recent OECD-Canadian International Survey on Adult Literacy shows that low skills are more prevalent among older workers than among younger workers in the countries surveyed, because older workers today had less full-time education than younger workers of today. In turn, this makes them less apt to be selected for training that would maintain or increase their skills. Because new cohorts of older workers will be better educated than in the past, the skill disadvantage of older workers may be considerably reduced. Whereas close to half of all workers age 50-64 in the OECD area had less than an upper secondary education in 1995, the proportion is expected to drop to only a quarter by 2025. This educational improvement should provide the basis for workers to acquire skills throughout their working life and thus enter their older age relatively well equipped. Nevertheless, if the duration of schooling continues to increase, provided it is relevant to the workplace, incoming younger workers will continue to have educational advantages compared with older workers, especially because their education may be perceived to be more relevant to the job market. The increased opportunity to change careers in mid-life would also increase the employability of older workers. Those who start their careers in jobs that require skills that may diminish with age (motor skills) could transfer to jobs that require skills unaffected by age or that even increase with age (communications skills). Such an opportunity would also reduce the adverse effect of structural changes on the employability of older workers, with
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those whose skills had been rendered obsolete being retooled for a new career instead of becoming candidates for early retirement. For such greater flexibility to be realistic, the potential need for job changes in late career must be anticipated, and the training must occur at an early stage of life. In the majority of cases, abrupt changes in career are not needed. Most people can adjust to new work by building on skills acquired over their working life, provided learning opportunities exist and the workplace is adaptable. But governments can help speed the process. One practical reform is that career structures and options at all ages need to be adjusted to maximize the capacity of labor ne simple reform: markets to adapt to labor-force aging. It is raise the minimum age better to reinforce the skill base of older at which full public workers as they enter the later stages of their careers than rely heavily on remedial pension rights accrue. training of older workers after they encounter employment difficulties. Thus it is important that training and other personnel practices of employers, as well as the career planning of workers, begin now to adapt to the prospect of labor-force aging. Governments could play an important educational and coordinating role. Payoffs may well be high from simply gathering and disseminating information about employment prospects for workers as they grow older, information about available training opportunities, and information that counters myths about older workers that create stereotypes. Another theme is enhancing employment opportunities for older workers within the context of overall labor-market conditions. The evidence does not point to any large factors that would automatically lead to a lack of demand for older workers in the future on the grounds of age. The main concern should be a lack of total demand. In particular, the potentially beneficial effects of increased labor supply among older workers will be difficult to realize in labor markets characterized by high and persistent unemployment. The prospect of labor-force aging increases the importance of developing and implementing comprehensive structural reforms that can achieve high levels of employment and labor-market adaptability. Reforms along the lines necessary have been identified by the OECD in its Jobs Strategy published in 1996 and subscribed to by member governments. The policies apply especially to European countries, where structural unemployment is highest. Nevertheless, even in countries such as the United States, which have maintained comparatively low levels of structural unemployment, older workers have more difficulties than do younger ones
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REDUCING GENEROSITY
It was emphasized above that the most serious fiscal problems in the future are likely to arise in countries in which individual public pensions are generous, that is, high relative to average wages. In a few continental European countries, the disposable income represented by public pensions can be equivalent to 60 percent or more of disposable income before retirement (adjusted for differences in household size). Because expenses for retired households are generally lower than for working households (lower costs for transportation, meals outside the home, and a wide range of services), the real living standards for old-age pensioners in those countries need not drop appreciably on retirement, even if the state old-age pension is the sole source of revenue. Also, in most countries (the United States is to some extent an exception) retired households continue to save, even well into old age. It follows that reducing the generosity of old-age pensions does not need notimply poverty for the recipients, especially if they have time to adapt. Hence moves to reduce generosity need to be announced years in advance to permit and encourage those affected to take steps to offset their lower pension entitlements. And households do adapt. OECD research shows that, in a wide range of countries, retired households typically have disposable incomes from all sources equivalent to 60-80 percent of their disposable incomes before retirement, adjusted for size of household and other factors. All sources include public pensions, private pensions and savings, income from work, and rent savings on owner-occupied residential accommodation. The uniformity of the total across countries is striking and so is the variability in the public pension component. It is clear that in countries in which public pensions are low, retired households succeed in receiving income from other sources (notably privately funded pensions). In countries in which public pensions are generous, households have little incentive to provide in advance for their old age. Encouraging people to work longer is one reform that effectively reduces the generosity of public pensions, in that those involved receive a pension for a shorter period. There are other, more direct, methods. A maximum
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ceiling on the size of the pension encourages those who enjoy high incomes while working to complement their public pensions with private ones, or private savings. For this to be perceived as fair, there must also be a ceiling on contribution rates. Pensions can be related to lifetime employment earnings rather than earnings in the last year or two of employment, when they are often the highest. Another reform is to base pension benefits on net wages, not gross wages, so that any future increases needed in pension contribution rates will be partly offset by lower pensions. A major reform, which will be introduced by several countries in the future, is indexing pensions to prices but not to growth of real wages. In other words, when someone retires, the purchasing power of his or her pension will not be eroded by inflation, nor will it increase during retirement. This is generally the case on paper for public pensions in most countries, but in practice there have been periodic discretionary upward revisions to existing pensions. Freezing pensions in real terms has a marked impact on their cost. On plausible assumptions, the total payout for a person would be 15 percent lower than if pensions were adjusted to the evolution of real wage earnings. But freezing the real incomes of a sizable and growing proportion of the electorate for 20 or more years of their lives could be politically difficult.
PREFUNDING
Because the most important factor regarding the sustainability of public pensions is the cost of financing them in the future, a component of the solution is to finance them partially in advance. With the prefunding option, the current generation of employees pays more than is necessary to service the current costs of public pensions. The surplus is put in an interest-bearing fund. In future decades, the accumulated funds are gradually drawn down as the aging process peaks, so that payroll taxes on future generations do not have to rise steeply. In effect, the current generation is paying for the pensions of those already retired and partly for their own pensions. This double burden at first sight seems unreasonable, but the alternative is an unreasonably high burden of payroll taxes on future generations.
Funded Pensions
The ultimate alternative to PAYGO public pensions is funded pensions, which can be private or public, individual or collective, and defined benefit or defined contribution. In a wholly funded system, pension contributions are accumulated through ones working life, together with employers contributions, in a fund that earns interest and dividends. Upon retirement, the
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fund pays a pension that can be fixed either in advance, although related to the history of contributions (a defined benefit) or relative to the size of the accumulated fund at the age of retirement (a defined contribution). The important distinction vis--vis PAYGO systems is that there is no direct financial burden on those still working: people pay for their own pensions, not for those of existing retirees. Hence there is no fiscal burden. For these reasons, many analysts recommend that PAYGO systems be replaced, wholly or partially, by funded systems. The OECD is strongly in favor of having both systems (first pillar and second pillar) and considers complete concentration on one system risky. Currently, and for the past decade or so, pension funds have reported high earnings, whereas PAYGO systems are strained. The financial performance of pension funds depends on financial market f people are to performance, but they have not always registered these high returns and might not do so work longer, they in the future. PAYGO systems have the admust be employable vantage of being independent of the financial and jobs must be market and can more easily be adapted to fulfilling social goals, avoiding old-age poverty. available. And completely replacing a PAYGO system with a funded system will be very expensive or very slow. If it is to be quick, all workers need to be credited with a quantity of capital in the fund that corresponds with their earnings to date. An average worker employed for 40 years must be credited with about 20 years of pension contributions plus accumulated interest that could amount to more than 2 years of annual salary. Otherwise the PAYGO system has to coexist with the funded system until the last beneficiary under the old system dieswhich could be 60 years after reform starts. Nevertheless, funded pensions need to be considered a useful adjunct to PAYGO systems in countries where funded systems do not exist, or cover only a small number of employees. The role for government in these cases is to implement frameworks that permit pension funds to flourish, maximizing the returns to the ultimate beneficiaries, under a set of prudent investment policy regulations by fund managers. Governments have regulated private pension funds by either asset restriction or prudent person (usually referred to as prudent man) investment rules. In the asset restriction approach, authorities impose quantitative restrictions on the assets that can be included in the portfolios of pension funds. They may request that funds hold a minimum amount of safe assets, such as government bonds, limit the share of foreign assets in general or assets from
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certain geographic areas in particular, and/or restrict the extent of investment in nonquoted companies. Under the prudent person principle, quantitative restrictions are not applied, but fund managers are expected to behave like careful professionals in making investment decisions. Financial returns covering more recent periods show that pension funds in countries with the prudent person rule outperform those from countries with quantitative investment limits. Thanks in large part to booming stock markets in most OECD countries (with Japan being the exception), the difference in financial returns between prudent person and asset restriction countries has widened markedly in the past five years. he older worker New financial techniques have made should be well many of the conventional risk controls less situated in a effective or even obsolete (e.g., investment only in high-grade securities, quantitative knowledge-based limits on asset allocations, restrictions on economy. average maturity, currency prohibitions). Against this backdrop, the role and scope of existing regulations of pension funds should be assessed, taking into account the extent that implementation of sound risk-management standards for pension funds can be linked to relaxation of regulatory constraints concerning asset allocation. In doing so, one would ensure that those making risk-return trade-off decisions on behalf of pension beneficiaries would be well informed, have proper incentives, and be adequately supervised. In this context, a supervisory framework best suited to dealing with investment risks in the new financial landscape characterized by financial engineering and more complex risk situations should be considered. The preferred regulatory approach in the age of financial engineering seems to be prudent person principles and risk management standards for both asset managers and pension plan sponsors that adequately address risk-management activity. The question of whether a prudent man rule is better suited than quantitative restrictions on asset allocation also depends on the specific circumstances of the countries concerned. The prudent man principle can be better implemented in countries with a modern financial infrastructure, including a professional asset management industry and the availability of sophisticated models and techniques to measure risk adequately. Most OECD countries have made considerable progress developing a solid regulatory and supervisory framework, although progress has been uneven. Nonetheless, important weaknesses remain. Several OECD countries
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have not established the proper legal and regulatory basis for dealing with takeovers, minority shareholder protection, insider trading, and institutional investor operations.
Investing Abroad
Pension funds often must be invested preferentially in domestic financial assets, the assets of the countries in which they operate. In theory, they should be able to obtain a superior combination of risk and return by also being invested in foreign securities, and increasingly many of them are. In the early 1990s, there was also strong sentiment for large-scale investment in dynamic emerging markets, especially in Asia. It seemed that OECD countries might be able to offset many of the adverse economic consequences of their aging population by gradually acquiring real and financial assets in these countries and liquidating them in future decades. The financial crisis in Asia late in the decade emphasized that all forms of investment are risky and that high returns usually go hand-in-hand with high risks. That having been said, a strong case remains in principle for greater geographic (and other) diversification of pension fund assets than is currently permitted or practiced.
PROMOTING GROWTH
The coming impact of aging on living standards could in principle be alleviated if more people are working and also if labor productivity rises more quickly. Together, they point to the desirability of faster economic growth. Note that great wealth does not automatically solve the aging problem: Whatever the level of output in a country, the issue is how to share it between producers and dependents, young as well as old. But a rich society has the advantage of a variety of sharing options without anyone living in absolute poverty. Independent of the level of income, a faster rate of growth of income can make political choices easier. As long as output is growing fast enough (at least as fast as the growth of the population), it is possible to give one section of society more without other sections having to accept less. Hence policies that encourage growth are desirable because of aging populations as well as for the usual reasons. Why some countries grow faster than others is not known with certainty. The empirical analysis in the past couple of decades indicates that economies that are market oriented, and that favor entrepreneurship, seem able to sustain noninflationary growth over the long haul, especially if macroeconomic policy favors low real interest rates and stable medium-term fiscal
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programs. This points to the continuing need for countries to pursue ambitious programs of regulatory reform and deregulation to release the inherent capacities of market economies to create value and satisfy consumers. The OECD has done a great deal of research and policy analysis in recent years on regulatory reform, and there is an ongoing program to review the progress and policies of individual countries in selected areas. It is clear that there has been a great deal of progress in the 1990s in most OECD countries, and even earlier in the United States, but much unfinished business remains. Case studies and, increasingly, sophisticated analysis from data show unambiguously that stronger competition yields lower prices, more choice, more innovation, and faster growth.
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or migraine may lead to a much greater reduction in functional limitation than comparable efforts in other areas. This suggests targeting more outcome-oriented medical and social interventions to make older people more independentparticularly those directed to maintaining functional independence and avoiding hospitalization.
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dence suggests that the difference between the costs of home and institutional care may not be as great as originally thought. Moreover, despite the best efforts, institutionalization is not always easy to avoid. For example, in most OECD countries, the leading cause of institutionalization of the elderly is loss of intellectual faculties due to senile dementia linked with Alzheimers disease, where alternatives to institutions are not promising. But new institutions are emerging in some countries to fill this gap. They are not in the home, but still provide a homelike setting, with emphasis on personal care rather than skilled nursing. Several OECD countries have developed reforms consistent with their own traditions that foster individual responsibilities. A basic element in reform is that long-term care be increasingly seen as a normal circumstance of life. Sharing this increasing burden is required. Countries are attempting to find the best balance between public and private responsibilities as well as between working age and older populations. Bringing health insurance and pension systems closer together would be useful. Keeping financial transfers on independent tracks fails to recognize that the onset of dependence transforms both health needs and the daily life of individuals.
Conclusion
The expected sustained rise in the proportion of older people in OECD countries in the next decades will provide many policy challenges. I have concentrated on economic and fiscal issues, which are only part of the whole. Nevertheless, some issues such as health care, although not strictly economic, have economic consequences that need to be taken into account, and economic insights can help solve some of these noneconomic issues. Perhaps the most important fact about aging is that it will happen. It cannot be avoided. The sorts of policies that will be necessary and desirable will not by themselves solve the aging problem, they will help to manage it. If properly implemented with advance warning, they should ensure that the negative economic implications of aging will be minimized and that a major disruption of our societies will be avoided. Fortunately, virtually all the policies that will help are desirable by themselves on other grounds. Higher growth, more employment, continued investment in training and skill upgrading, financial reforms, diversification of risks, and containment of health costs are all objectives for governments in the best of times. The significance of aging is that it makes implementation of these policies more urgent.
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