Chapter 12: Public Pensions  Historically, families cared for the elderly,  In modern society, elderly care has fallen on society  Retirement income is broken into 3 categories: 1) Old Age Security Program ($29 billion in 05-06, financed out of government revenue) 2) Pension Plans ($32.8 billion in 05-06, financed by payroll taxes on employees and employers) 3) RPP and RRSP ($57.7 billion, covered in Econ Economics of Taxation)

Chapter 12: Public Pensions  Why Public Pensions  Effects of Public Pensions  Old Age Security Program  Canada Pension Plan  Conclusion

Theory - Why Public Pensions? The justification for publicly provided retirement income include the “usual suspects”: 1) Paternalism 2) Redistribution 3) Adverse selection And Public Pensions Carry 2 additional considerations: 4) Inflation and Timing 5) The Samaritan’s dilemma

1) Paternalism Public retirement income due to a sense of paternalism comes from 2 sources: a) People who don’t plan for the future (due to nearsightedness or high discount factors) b) People who inaccurately plan for the future (not considering future costs or inflation)  Is it right for the government to force saving for old age?

2) Redistribution Old Age Security Program has redistributive elements because: a) It is funded out of taxes, which are redistributive b) Old Age Pension has a clawback c) The Guaranteed Income Supplement (Low income add-on to the Old Age Security) is a NIT

2) Redistribution  This setup is preferable to welfare because: i) The elderly have unique characteristics which are best met by a unique plan ii) Income support through a “pension” is less stigmatic than collecting welfare iii) Intergenerational redistribution is allowed for (if one generation is in a recession and the next is well off)

3) Adverse Selection Retirement could be funded through a life ANNUITY, where an individual pays an upfront cost for a yearly income until they pass. This suffers from ADVERSE SELECTION some (healthy women) live longer and want an annuity more than others (unhealthy men) who live shorter The private market would result in high costs, low participation, and higher costs for women Through mandatory government pensions, adverse selection is avoided and statistical discrimination is also avoided

4) Inflation Private annuities are unable to guarantee a yearly income that increases with inflation Government pensions, however, automatically adjust to inflation as taxes automatically adjust with inflation

4) Funding Timing Private pensions have to be funded by a pensioner’s past contributions (grows with r) Public pensions can be pay-as-you-go, funded by current payments (grows with growth of wages and salaries)  This is better if wages grow faster than interest rate, which occurred in 1960’s and 1970’s  Since 1980’s wage rates have grown slower than the interest rate  This financing caused huge problems, resulting in major changes in 1998

5) The Samaritan’s Dilemma Society wants to take care of the elderly, BUT, if a young person knows he will be taken care, of, he has an incentive NOT to save for the future. The Canada Pension Plan, RPP, and RRSP portion of Retirement Income, through required payroll contributions, forces individuals to work towards their retirement income somewhat.  Perhaps the Old Age Security Program still suffers slightly from this attitude

Theory - Public Pensions and Economic Behavior Pensions may have an impact on two areas of economic behavior: 1) private savings 2) work effort (through retirement age) PRIVATE SAVINGS are influenced through public pensions through 3 effects: a) Wealth substitution effect b) Retirement Effect c) Bequest Effect

1a) Wealth Substitution Effect To analyze the wealth substitution effect, one needs to examine the LIFETIME BUDGET CONSTRAINT and LIFETIME UTILITY: -A person’s lifetime is summarized in two periods: 1) Now (when you work) with income I 0 and consumption c 0 2) Future (retirement) with income I 1 and consumption c 1

1a) Wealth Substitution Effect -A person’s consumption can: 1) Occur entirely in the period income is made (THE ENDOWMENT POINT) 2) Increase in the future. Sacrificing savings S now produces extra consumption S(1+r) in the future 3) Increase now. Borrowing B now reduces consumption by B(1+r) in the future This gives us the INTERTEMPORAL BUDGET CONSTRAINT:

INTERTEMPORAL BUDGET CONSTRAINT

Lifetime Utility  Using a lifetime indifference curve and tangency, we can see how much a person will save or borrow  In this case someone saves

1a) Wealth Substitution Effect  A public pension plan forces savings for a benefit in the future, moving the endowment point up on the budget constraint  An individual therefore DECREASES private savings to reach their optimal lifetime consumption  WEALTH SUBSTITUTION EFFECT – Individuals save less in anticipation of the fact that they will receive public pension benefits after retirement, ceteris paribus

1bc) Retirement and Bequest Effects  RETIREMENT EFFECT – Pensions induce people to retire earlier, resulting in fewer working years and more retired years, INCREASING savings during working years  BEQUEST EFFECT – Public pensions shift income from children (workers) to parents (retired). People therefore INCREASE savings to make up for this and leave an inheritance to their children

Savings results  Why Do We Care? -Because Canadian pensions are funded in a pay-as-you-go fashion, their savings don’t result in investment, whereas PRIVATE savings does lead to investment (and therefore economic growth)  Empirical Results? -Studies have shown pensions both increasing and decreasing savings (often calculated through the increase or decrease to consumption)

2) Work Effort/ Retirement Age  Pensions give an incentive to retire early:  They enable early retirement  Their “clawback” makes work less attractive  From 1960 to 1999, age men in the labor force fell from 87% to 61%  BUT other factors also affect retirement age (rising incomes, changing life expectancy, changing occupation demands, inflation, wealth accumulation)

Public Pension Implications  Public pensions MAY:  Encourage early retirement  Reduce private savings BUT Is the loss in efficiency may be worth income security for the elderly?

Old Age Security Program History Old Age Pension Act let the federal government pay half (75% in 1931) of provincial pensions Old Age Security Act gave $40 a month to Canadians over – Benefits increased (dip in benefits after 1967 due to only partial indexing to inflation) 1970 – eligibility age reaches 65 (slow reduction to this point)

Old Age Security Pension Benefits (2006 Dollars)

Old Age Security (OAS) & GIS OAS is taxed as an income, and clawed back $15/$100 above a threshold ($63,511 in 2007)  The full pension requires living in Canada for 40 years after age 18, and was $492 per month in June 2007 The Guaranteed Income Supplement (GIS) started in 1967 as a NIT with G=$621 for a single person and $410 for a married person, with a clawback (t) of 50% (excluding OAS)

OAS & GIS & The Allowance  OAS and GIS guaranteed $1113 in June 2007  GIS equals zero at yearly income of $14, 904 (June 2007)  The Allowance (started in 1975) is paid to the spouse of an OAS recipient, widow, or widower between age 60 and 64 (lived in Can 10 yrs)  $907 allowance in June 2007, with 75% clawback (excluding OAS)

OAS & GIS & The Allowance  In :  4.2 million people received OAS  1.6 million people received GIS  97,000 people received the Allowance  In , $29 billion in payments where divided as follows:  76% for OAS  22% for GIS  2% for the Allowance

OAS & GIS & The Allowance  The Old Age Security Program and Canada Pension Plan has reduced senior poverty greatly :  Senior headed families in poverty has decreased from 41.1% (1969) to 7.1% (1994)  Senior individuals in poverty have decreased from 69.1% (1969) to 47.6% (1994)  But OAS may have problems…

Universal or Targeted Transfer  Originally (1952), OAS was a universal benefit for seniors (they all built this country, they should all benefit)  Some argue this is inequitable, as some taxes will come from low incomes and be transferred to high  They argue that this transfer is only equitable if funded by a tax that highly focuses on the rich  And is therefore even more distortionary  In 1989, the clawback was introduced (but 15% is a very weak clawback)

Percentage of Population over 65 Some studies expect OAS/GIS expenditures to triple from 2001 to Others claim the burden MAY not be severe, depending on future economic growth and elderly taxes

History - Canada Pension Plan  The Canadian Pension Plan (CPP) and Quebec Pension Plan (QPP) started in 1966  CPP is financed in a pay-as-you-go fashion through a mandatory payroll tax  6.3 Canadians received $32.8 billion in  The CPP includes disability benefits  75% of their age 65 CPP payment until they turn 65  Additional benefits if caring for children below age 18 or 18 to 25 and attending an educational institution

The Canada Pension Plan  The CPP has a one-time death benefit payment (maximum $2500)  CPP also has a survivor benefit  Fixed rate plus 37.5% of deceased CPP payment for survivor or below 45 with dependent children (max $ per month in 2007)  This increases to 60% at age 65  CPP’s orphan benefit is paid to children under 18 or and attending an educational institution full-time

CPP Benefits Calculation CPP Pension = [(average YMPE for last 5 years) +(average ratio of pensionable earnings to YMPE)]/4 YMPE =yearly maximum pensionable earnings =average industrial wage  The ratio is calculated (omitting some years) to a maximum of 1, resulting in maximum pension: (average YMPE for last 5 years)/ 4

Contribution Increases  CPP is pay-as-you-go, and contribution was 3.6% from 1966 to 1982, resulting in a surplus put in an invested emergency fund  After 1983, 3.6% caused a shortfall  Contributions increased 0.2% from 1987 to 1996  In 1996 the contribution rate of 5.6% was less than the needed rate of 7.85%  In 1966, the needed 2030 rate was expected to be 5.5%, but many factors increased that expected needed rate to 14.2%:

Contribution Increases  Demographics=birth decrease and life expectancy increase  Economics = productivity (wage) growth is lower than expected

1998 Reforms  To avoid 14.2% contributions, sweeping changes were made in 1998: 1)Financial: Exemption to paying CPP contributions frozen at $3500 yearly income and emergency fund invested better (stocks vs. government bonds) 2)Benefit changes: (see chart)  These changes result in a 9.9% contribution rate in 2003, lasting until 2099 (Note: the overview earlier takes all of these changes into account)

1998 Reforms Results  These reforms may work, or unforeseen (demographic?) shocks may require higher contributions  Many argue for a higher retirement age (US retirement is 67), and criticize the reforms for not starting this trend  The reforms trade higher contribution rates for higher political viability of the CPP in the future

Conclusion  OAS acts as income redistribution for elderly  CPP is an earnings-related public pension scheme  CPP (but not the pay-as-you-go format) is justified by paternalism, redistribution, the Samaritan’s dilemma, adverse selection, inflation and timing  These programs have severely decreased poverty among the elderly  Great reforms had to be made to adjust for a pay-as-you-go funding scenario

Important Note Pension programs tend to be more popular than welfare programs, because everyone will grow old, while not everyone will require welfare.

Chapter 12 Conclusion  Canada’s Retirement System consists of OAS, CPP, and tax-assisted savings  CPP is justified by paternalism, redistribution the Samaritan’s dilemma, adverse selection, inflation, and timing  Pay-as-you go is better than a funded plan when real wage growth exceeds real interest rates (which hasn’t been the case lately)

Chapter 12 Conclusion  Public Pensions reduce savings (Wealth Substitution Effect) and increase savings (Retirement and Bequest effects)  The net result is unclear  CPP tends to encourage earlier retirement  CPP contribution rates have soared over the years, and were held back to 9.9% only due to extreme 1998 reforms