Global Aging and the Future of Funded Pensions Richard Jackson Center for Strategic & International Studies 2009 FIAP International Seminar Warsaw May 29, 2009

Demographic Indicators Fertility Rate Life Ex. Median Age Elderly Share Total Pop. Change Europe %23%29%-14% Japan %31%39%-22% United States %19%20%+40% Sub-Saharan Africa %4%5%+155% Islamic Belt %7%12%+91% Developing East Asia %17%25%+0.8% South Asia %9%13%+71% Latin America %11%16%+66% Source: UN (2007) The world is being overtaken by an unprecedented demographic transformation.

Part I The Economics of Global Aging

 FISCAL BURDEN — rising old-age dependency ratios and benefit costs  ECONOMIC GROWTH — stagnant or contracting workforces and more slowly growing GDPs  SAVINGS RATES — declining savings and threat of capital shortages Three Economic Challenges.

 Falling fertility and rising longevity translate directly into a falling support ratio of workers to retirees.  A falling support ratio in turn translates into a rising cost rate for PAYGO retirement systems. Fiscal Burden

 Few countries will be able to raise taxes enough to cover more than a fraction of the age wave’s cost.  Balancing PAYGO systems will require large benefit adjustments—and is likely to meet political resistance from aging electorates.  As countries reduce the generosity of PAYGO benefits, they must fill in the retirement income gap with funded savings.  The alternatives to tax hikes and benefit cuts: cannibalize other public spending or let fiscal deficits grow. CSIS “Current Deal Projection”* Public Pension Expenditures, as a % of GDP Retirement Age Hike Required to Stabilize Costs Retirement Age Hike Required to Stabilize Costs Benefit Cut Required to Stabilize Costs Canada**4.4%9.7%1055% France12.8%22.1%842% Germany11.7%22.6%948% Italy14.2%27.6%1049% Japan8.7%20.2%1157% UK6.6%11.2%741% US6.1%11.0%744% Source: The Graying of the Great Powers (CSIS, 2008) *Projections assume retirement ages remain unchanged and benefits continue to replace the same share of wages they do today. **Projection for Canada ignores current trust-fund build up.

 The slowdown in workforce growth will translate into slower growth in GDP and workers’ taxable payroll.  Productivity and real wages may also grow more slowly as societies age, further reducing economic growth.  Productivity growth may depend on the level of aggregate investment, which in turn depends on growth in the labor supply.  Aging workforces may also be less flexible, less mobile, and less entrepreneurial. Economic Growth

 The lifecycle consumption hypothesis predicts that savings rates will fall as more of the population enters its harvest years.  Mounting fiscal deficits may exacerbate the decline in private savings rates.  The specter of a “Great Depreciation” in financial markets as postwar baby booms retire is overstated.  Instead, fast-aging countries are likely to become more dependent on capital imports from younger and faster-growing countries. Savings Rates Adults Aged 20 & Over by Age Group, as a Percent of All Adults Source: UN (2007) Europe Age % 23%20% 18% Age % 45%43%40%38% Age 60 & Over 27% 32%37%40%44% US Age %28%26% Age %42%41% 40% Age 60 & Over 23%30%33% 34% Japan Age %18%17%16%15% Age %41%38%34%33% Age 60 & Over 33%41%44%50%52% Developing East Asia Age %29%23%22%20% Age % 46%42%39% Age 60 & Over 16%23%31%36%40% Latin America Age %35%32%31%29% Age %46%45%43%41% Age 60 & Over 15%19%23%27%30%

 In aging societies, funded systems: — help take pressure off public budgets — will likely enjoy a widening cost advantage over PAYGO systems — can help maintain adequate rates of savings and investment  Caveat: The slowdown down in potential GDP growth may also reduce the long-term rate of return to capital.  Nonetheless, countries with funded systems can invest in younger and faster growing societies with higher rates of return; countries with PAYGO systems cannot escape the tyranny of their own demography. The economics of global aging gives funded systems decisive advantages over PAYGO systems.

Part II The Cost Advantage of Funded Systems in Aging Societies

 The faster the aging trend and the slower the rate of real wage growth, the greater the advantage of funded pension systems over PAYGO systems.  Given Chile’s aging trend, a personal accounts system will deliver higher benefits under almost any reasonable set of real wage growth and rate of return assumptions. Personal Account Replacement Rates in 2050 versus PAYGO Replacement Rates Assuming the Same 10 Percent Contribution Rate* Real Wage Growth Rate 3.0%2.5%2.0%1.5%1.0% Real Rate of Return 3.0%23%25%28%31%34% 3.5%26%29%32%36%40% 4.0%31%34%38%42%47% 4.5%35%39%44%49%55% 5.0%41%46%51%57%64% 5.5%48%53%60%67%76% 6.0%56%62%70%79%89% PAYGO 31%29%28%26%25% *PAYGO calculations assume universal coverage, a retirement age of 65, and price indexation; personal account calculations assume a 40-year career, a retirement age of 65, and administrative charges equal to 0.5 percent of assets. Source: UN (2007) and CSIS calculations Outperforms PAYGO CHILE: Stylized Replacement Rate Projections.

CHILE: Contribution Rate Illustration.

 Given Poland’s more extreme aging trend, personal accounts will far outperform a PAYGO system under virtually any set of assumptions. Personal Account Replacement Rates in 2050 versus PAYGO Replacement Rates Assuming the Same 10 Percent Contribution Rate* Real Wage Growth Rate 3.0%2.5%2.0%1.5%1.0% Real Rate of Return 3.0%24%26%29%32%36% 3.5%28%31%34%37%42% 4.0%32%35%39%44%49% 4.5%37%41%46%51%57% 5.0%43%48%53%60%67% 5.5%50%55%62%70%78% 6.0%58%65%72%82%92% PAYGO 20%19%18%17%16% *PAYGO calculations assume universal coverage, a retirement age of 65, and price indexation; personal account calculations assume a 40-year career, a retirement age of 65, and administrative charges equal to 0.5 percent of assets. Source: UN (2007) and CSIS calculations Outperforms PAYGO POLAND: Stylized Replacement Rate Projections.

POLAND: Contribution Rate Illustration.

 Despite China’s rapid aging, high real wage growth reduces the cost advantage of a funded pension system.  Yet even in China, personal accounts are likely to outperform a PAYGO system as its economy develops and real wage growth slows. Personal Account Replacement Rates in 2050 versus PAYGO Replacement Rates Assuming the Same 10 Percent Contribution Rate* Real Wage Growth Rate 6.0%5.0%4.0%3.0%2.0% Real Rate of Return 3.0%15%18%21%25%30% 3.5%17%20%24%29%35% 4.0%20%23%27%33%41% 4.5%22%26%31%38%47% 5.0%25%30%36%44%55% 5.5%29%34%42%51%64% 6.0%33%39%48%59%74% PAYGO 35%32%29%27%24% *PAYGO calculations assume universal coverage, a retirement age of 65, and price indexation; personal account calculations assume a 40-year career, a retirement age of 65, and administrative charges equal to 0.5 percent of assets. Source: UN (2007) and CSIS calculations Outperforms PAYGO CHINA: Stylized Replacement Rate Projections.

Part III New Challenges for Funded Pensions

Global aging poses significant challenges for personal account systems.  Slower economic growth may lower long-term rates of return in fast-aging countries.  Although pension funds can offset lower returns by investing in younger and faster growing countries, the room to do so will steadily diminish as the “second wave” of global aging sweeps the developing world.  Aging workforces may also be more risk-averse, putting downward pressure on returns.  Widening fiscal deficits in countries with PAYGO systems may increase inflation risk.  Rising longevity will gradually lower replacement rates.

 Official projections have repeatedly underestimated the potential for future gains in life expectancy.  Actuaries tend to be longevity pessimists, while demographers tend to be longevity optimists.  Longevity risk is an equally serious problem in all pension systems. The question is who should bear the risk: workers or retirees?  PAYGO systems are increasingly shifting longevity risk to retirees through various types of indexing (Sweden, Germany, and Japan).  In aging societies, higher retirement ages are not just inevitable, but desirable. The implications of rising longevity. UN Projections of Life Expectancy at Birth in UN Projections of Life Expectancy at Birth in Revision 2006 Revision Canada France Germany Italy Japan UK US

We live in an era defined by many challenges, from global warming to global terrorism. None is as certain as global aging. And none is likely to have such a large and enduring effect on the shape of economies, societies, and the world order.