Marek Góra Warsaw School of Economics Polish Pension Group PENSION TRANSFERS VS. PRODUCTION FACTORS: THE CHALLENGE OF THE 21ST CENTURY

THREE LEVELS OF ANALYSIS Level 1 Pension system: Social goals and economic fundamentals - GDP divided between generations, population structure Level 2 Method: Basic arrangements for acquiring pension rights in terms of future GDP - DB, DC, private, public, financial markets, annuitization, type of management Level 3 Regulations: Technicalities of institutions - very many various institutional arrangements

INTERGENERATIONAL EXCHANGE (1) The pension system is an institutional framework for intergenerational exchange. In order to finance retirement consumption pension rights need to be exchanged for a part of the real product (irrespective to the form the rights are expressed in). The pension problem we face is not the problem of the scale of GDP but the problem of how to divide current GDP between pensions and production factors.

INTERGENERATIONAL EXCHANGE (2)

Demographic dividend refers to the extra growth and revenue made possible when the working-age population expands. The government can collect more revenue without raising taxes and finance more programs (including pension systems). The costs of running deficits falls because tax revenues are rising due to the population growth. This is temporary, thou. DEMOGRAPHIC DIVIDEND

 Currently existing pension systems were designed in times when demographic dividend was positive and large.  Pension systems have weak automatic adjustment mechanisms. Political decisions needed instead.  In late 20th century the dividend turned negative as the working population shrinked as a percentage of the total population, and older cohorts expanded. That is continuing and expanding.  Politicians are afraid of saying people the truth: pensions will be decreasing.  Consequently we are loosing control over proportions of GDP spent on pensions and production factors. DEMOGRAPHIC DIVIDEND: FROM STRONG PLUS TO INCREASING MINUS

POPULATION STRUCTURE BY AGE 7

WHAT CAN WE DO? Very little room for manouvre: Productivity growth Fertility increase Immigration The above can help but only a little. Redesigning institutions (automatic adjustment) is needed in order to come back to the intergenerational equilibrium.

INTERGENERATIONAL EQUILIBRIUM Each generation is first a working generation that buys pension rights, and afterwards a retired generation selling accumulated rights. If each generation’s welfare is equally important then it is the only Arrow-Debreu equilibrium (Nash equilibrium if we define generations as players) that is Pareto optimal. If one generation received more than it paid in, then another generation would receive less than it paid in. In such situation, preferences are inconsistent in the period of participation, hence, there is no equilibrium at all, or the system prefers one generation over others (allocation not being Nash equilibrium).

GDP DIVIDED BETWEEN PENSIONS AND PRODUCTION FACTORS GDP 1 GDP 2 GDP 1 T1T1 R1R1 R2R2 T2T2

AT-RISK-OF-POVERTY RATE BY AGE CHANGE (2005=100%) Total EU (27 countries)100%85%101%104%108%103% Euro area (17 countries)106%80%105%114%119%114% Germany128%105%135%131%127%143% Spain105%74%110%118%140%108% France102%65%83%110%128%124% Italy96%73%90%109%104%105% Poland86%195%101%76%84%77% United Kingdom90%86%92%95%85%89% Greece103%76%95%117%129%113% Portugal92%76%94%97%117%95% Sweden136%153%137%133%116%128% 11

AT-RISK-OF-POVERTY RATE BY AGE (ENTIRE RATE=100%)

CHANNELS OF REDISTRIBUTION If redistribution is financed via the budget then: Broader redistribution base; Social needs can be better addressed (adjustability); Pension system istransparent.

KEY GOAL FOR PENSION REFORMS Key objective is to protect remuneration of production factors (net value of), which means to stop the increase of expenditure on financing pensions (in terms of GDP). The goal is to keep the entire pension system within the framework that can be summarised as: PV(B) = PV(C) The above mean a redution of ex ante pension expectations (expressed in relative terms). The only other option is to adjust pensions ex post, which means reduction of pension levels in absolute terms.

PENSION EXPECTATIONS Reduction of pension expectations ex ante protects remuneration of production factors which contributes to stronger GDP growth, hence this also contributes to higher welfare of both the working and the retired generation Pension expectations kept at inflated levels require additional reduction of the remuneration of production factors, which slows down growth and reduce welfare of both generations. Eventually pensions will have to be cut ex post anyway.

A NEED TO RETHINK In terms of the actual and projected population structure in the 21st century the traditional approach to pension systems seem inappropriate. So rethinking is needed. Intergenerational fairness Effectiveness of redistribution channels Direction of redistribution channels Old-age pension is a necessary bad, not good. Remuneration of economic activity is the good.