Research Department Bank of Israel Pension Policy Design and Income inequality: Assumptions and Reality in a World of Multiple Policy-Instruments Adi Brender Research Department Bank of Israel Seminar on: Aging, Retirement and Pensions: Trends, Challenges and Policy - March 2018 The opinions and analysis presented in this lecture do not necessarily reflect those of the Bank of Israel

Income Profiles Assumption: Reality: Significance Examining the average is good enough. Wages increase monotonically (weakly) over the years. Pensions need to replace a (high) proportion of the last wage. Reality: Wage patterns differ between people Low income at early years is associated with flatter wage profiles (1%-1.5% real avg. annual differential) and with spouses with lower wage or employment tenure. Significance Different required contribution rates. Given a (more or less) fixed monthly social security old-age allowance, low income individuals need to contribute even less.

Income distribution within cohorts is persistent Wage distribution of employees aged 35-50 in 2000 who worked in 2015.

Work Status Given the Spouse's Income For a given (lump-sum) OAA, a non-working spouse implies lower household income in working years and lower required replacement rate.

Individuals or Families? Assumption (or common practice) Pension calculations can be based on individual incomes Reality People live in families Not all adults (especially women) work all the time Employed people have children Pay mortgages Live in couples when they retire Significance Smoothing “standardized” income? Accounting for liquidity at the contribution stage Accounting for spouse’s social security Old-age allowance

Family Characteristics of Employees Israel 2005: Tax records sample

There is Such thing as “Too Much” Savings 30%-35% 6%

How did it play out in policy People should save to secure sufficient resources for their post-retirement years. The OAA in Israel provide reasonable replacement rates for many low-income individuals. Given their flat income profiles and family characteristics, for these people pension savings hurt income smoothing, and reduce their net social security benefits. High-income individuals enjoy tax benefits equivalent to the social security benefits of low-income ones; mandatory pension savings unbalance the system against low-income households. Mandatory savings applied to the low-income household – most high-income ones saved anyway. The “correction”: phasing-out OAA represents a regressive move, This was not what supporters of the program believed.