©2016 by McGraw-Hill Education Limited. PUBLIC PENSIONS Chapter 11 ©2016 by McGraw-Hill Education Limited.

Learning Objectives Explain how an annuity can be used to smooth consumption. Explain the problem of adverse selection in the market for annuities. Describe the moral hazard problem known as the Samaritan’s dilemma. State the difference between pay-as-you-go pension financing and a fully funded pension. Illustrate the wealth substitution effect on savings in a diagram of the life-cycle model.

Learning Objectives (cont) Summarize the evidence on the effect of a pay-as-you-go pension system on savings. Distinguish between the Old Age Security program and the Canada/Quebec Pension Plan. Summarize the factors leading to increased contribution rates in the 1998 reforms to CPP. Describe why the CPP program has led to an intergenerational redistribution.

Introduction The Canadian retirement income system rests on three “pillars”: The Old Age Security program The Old Age Security (OAS) pension and the Guaranteed Income Supplement (GIS) The Canada and Quebec Pension Plans The Canadian Pension Plan (CPP), Quebec Pension Plan (QPP), and earnings related pension schemes Tax-assisted private savings and pensions The Registered Pension Plan (RPP) and the Registered Retirement Savings Plan (RRSP)

Public Intervention in the Provision of Retirement Incomes LO1, LO2 Public Intervention in the Provision of Retirement Incomes Adverse selection in the market for annuities Annuity Consumption smoothing Asymmetric information Adverse selection Paternalism Redistribution Miscalculation and decision-making costs

Public Intervention in the Provision of Retirement Incomes (cont) LO3, LO4 Public Intervention in the Provision of Retirement Incomes (cont) The Samaritan’s dilemma Moral hazard Inflation indexation Pay-as-you-go financing versus fully funded pension

Growth of Total Wages and Salaries and Real Interest Rates Figure 11.1

Effects of Public Pensions on Economic Behaviour Savings Behaviour Wealth substitution effect Public pension wealth Retirement effect Bequest effect

Budget Constraint for Present and Future Consumption LO5 Budget Constraint for Present and Future Consumption N |Slope| = 1+r Future consumption (c1) D I1 + (1+r) S (1+r)S Endowment point (A) B I1 (1+r)B S F I1 - (1+r) B M I0 - S I0 I0 + B Present consumption (c0) Figure 11.2

Utility-maximizing Choice of Present and Future Consumption Future consumption (c1) E1 c1* iii ii A i I1 Saving M c0* I0 Present consumption (c0) Figure 11.3

Crowding out of private saving due to Public Pension LO7 Crowding out of private saving due to Public Pension N Future consumption (c1) E1 c1* iii R ii A i I1 (1+r)T T Saving before Public Pension M c0* I0T I0 Present consumption (c0) Saving after Public Pension Figure 11.4

Effects of Public Pensions on Economic Behaviour (cont) LO6 Effects of Public Pensions on Economic Behaviour (cont) Empirical evidence on savings Retirement decisions Implications

The Old Age Security Program LO7 The Old Age Security Program Old Age Security (OAS) Guaranteed Income Supplement (GIS) Universal versus targeted income transfers Population aging

Percentage of the Population Aged 65 and Over Figure 11.5

The Canada Pension Plan LO7 The Canada Pension Plan Canada Pension Plan (CPP) and Quebec Pension Plan (QPP) Retirement benefits A contributor age 65 is entitled to a pension based on the following: CPP pension = 0.25 x (average YMPE for the previous five years) x (average ratio of pensionable earnings to YMPE) where YMPE is the yearly maximum pensionable earnings Disability benefits Survivor benefits

Contributions A self-employed individual whole pensionable earnings are less that the YMPE made contributions according to the following: CPP contribution rate x (pensionable earnings – YBE) where YBE is the year’s basic exemption

Analysis of the CPP Contribution Increases Table 11.1

LO8 The 1998 Reforms to the CPP Table 11.2

The 1998 Reforms to the CPP (cont) LO8 The 1998 Reforms to the CPP (cont) Financing and investment changes Benefit changes Assessment

Intergenerational redistribution through the CPP LO9 Intergenerational redistribution through the CPP Table 11.3

Chapter 11 Summary Canada’s retirement income system consists of three pillars: Old Age Security, the Canada and Quebec Pension Plans, and tax-assisted private savings and pensions. Public provision of pensions can be justified on the basis of market failure including adverse selection in the market for annuities, paternalism, redistribution, decision-making costs, the Samaritan’s dilemma, and the absence of inflation indexation with private pensions. With pay-as-you-go financing, the current working generation pays the pension of the retired generation. Pay-as-you-go financing is superior to a funded pension scheme when the growth rate of total real wages and salaries exceeds the real interest rate on assets held in pension funds.

Chapter 11 Summary (cont) Pay-as-you-go pensions may reduce private saving, the wealth substitution effect, or increase saving, the retirement and bequest effects. The percentage of retired older workers has increased dramatically since the 1950s, and the introduction of the public pension programs may have contributed to this trend. CPP contribution rates increased sharply with the 1998 reforms because of population aging, the slow-down in the growth rate of real wages, the enhancement of benefits that occurred in the 1970s and 1980s, and increases in disability claims. The CPP has resulted in a large intergenerational transfer of income.