Measuring the Impact of Pension Reform on Old Age Incomes: a microsimulation approach for Ireland

1. Measuring the Impact of Pension Reform on Old Age Incomes: a microsimulation approach for Ireland Elisa Baroni and Cathal O´Donoghue IFS Seminar, April 10th 2007

2. Research Question “The world Population is growing older… …Will the old grow poorer ?”

3. PhD Research Objectives • Theoretical: • To identify economic criteria for evaluating pension systems and pension reform, in the context of population aging • Empirical: • To quantify the effects of demography + pension systems + pension reforms on future poverty + inequality, for aging countries (Ireland, Sweden) • To develop micro-simulation tool for theory validation and policy making

4. Aging • Population Aging = lower mortality + lower fertility + higher life expectancy • By 2050, in EU:  proportion of +65 projected to double • average projected increase in dependency ratios (Old / Young, Pensioners / Workers) from 24% to 49% • average projected increase in retirement years • average projected increase in pension expenditure by 3-5 %

5. Economic Consequences ofAging • Higher pension / health care costs ? • Higher taxes ? Lower Savings ? Lower Private Transfers ? • Lower Output Growth ? • Higher pensioner poverty ? • Higher inequality ? • Aging implies more pressure for redistribution from shrinking active population to growing inactive population, especially in PAYG pension system: • PAYG:PNt = t (WL)t

6. Aging and Pension System Pension Systems redistribute resources for: • Insurance / Income Security / Consumption Smoothing • Poverty Reduction • Inequality Reduction • Aging can undermine the performance of a pension system relative to its aims • Aging motivates Pension Reform

7. Economic Principles of Pension Systems and Pension Reform • Efficiency: impact of system on aggregate savings / labour supply / growth • Equity: impact of system on income distribution, e.g. between generations • Financial Stability: impact of system on public finances • Political Sustainability: is the system going to be supported by future generations ?

8. What Future ? • Future welfare of pensioners will depend on complex interactions between Demography + Labour + Pension System. • Aging can affect sustainability / efficiency / equity of a Pension System • Pension System can also induce behavioural changes e.g. increased retirement age which can counterbalance demographic effects • Economic consequences of Aging and Pension System need to be analysed together net effects. • We need a model for net effects  what pension system is better to address consequences of aging?

9. Approaches to Aging and Pension Reform

10. I. The TheoryTypologies of Pension Systems • Pension Pillars = Public + Occupational + Private • Each Pillar can vary in: • Type of Benefit: Defined Benefit vs. Defined Contribution • Degree of Actuarial Fairness: Non-Actuarial (DB) vs. Actuarial (DC) • Type of Financing: Funded vs. Unfunded • A Pension System consists of a given combination along these 3 dimensions • Pension Reform usually entails moving along any of these dimensions.

11. Typologies of Pension Reforms • Parametric Reforms: • Changes to retirement age, replacement ratio, contribution rate, indexing, or taxation of pensions • Systemic Reforms: • Changes to system structure or financing of the system • Moving to Funding • Making benefit more actuarial (DC)

12. The Economics of Pensions • Conditions for Balanced + Equitable DB Public PAYG: • t (WL)2t = (NP)1t t*=(P/W) / (L/N)= implicit tax rate • t (WL)2t = (NP)2t+1 / (1 + r) r* = P2 / c (W)2 = c(WL)jt+1 / c (WL)it – 1 r* = g (Samuelson, 1958) = implicit rate of return_ • Aging (L down and N up) + (DB) PAYG ….. • affects system balance: c up or P down (unless W up) • can harm growth if raising c, discouraging savings and work, or raising national debt. • can increase old age poverty if lowering P • can redistribute unfairly between generations if r ≠g • can be politically unsustainable

13. Economic Theory: Systemic Reforms • Making PAYG term actuarial (DC) Pt+1, i = (1 + g)*c (W)t,1  ti = cj (1 + r)/(1+g)  for (r=g), t = c, no tax  otherwise lower effective tax  less distortion • Moving to Funded system  Pt+1, i = (1 + r)*s(W)t,1  s > r  no explicit tax, no distortion, more savings + growth, less costs.

14. II. The Policy Approach • “Anglo-American” view: • PAYG unsustainable in face of Aging • PAYG create disincentives to savings (Feldstein, 1974), labour supply and growth • PAYG can be regressive and inequitable • PAYG are politically unsustainable • Funding stimulates savings, investments + growth, esp. if privately managed • “Multi-Pillar” Model (World Bank): • 1st: Minimum State Pension (flat) • 2nd: Mandatory Occupational Pension (funded) • 3rd: Voluntary Private Pension Savings (“ “ “)

15. II. The Policy Approach • Opponents of the Anglo-American view claim: • Transitional costs: implicit tax τ reduces rate of return s of funding (Sinn, 1999) • Funding penalises low income workers • Funding requires some handling of stock market risks • Funding is not a necessary condition for fiscal sustainability, problem is type of benefit offered (DC might solve it) • Funding ≠ increased savings: (mandatory) pension savings could crowd out voluntary savings  net effect ? • Link between funding and output growth controversial • Funding is not immune from Aging • If more savings + more pensioners: higher demand in asset market from retirees  higher annuity prices + lower returns (unless output grows enough)  more pensioner poverty ? • Key for aging is output growth and productivity (e.g. through labour market interventions, not pensions)

16. III Dynamic Microsimulation & Pension Reforms AIMS: • to simulate income distribution under pension system P • to simulate future public + private pension accumulation and de-cumulation over the life cycle, under pension system P,given population changes • to simulate effects of reforms to P on (life-cycle) incomes distribution + costs.

17. III. Dynamic Microsimulation • Use longitudinal micro data as inputs to simulate future synthetic “histories” for every individual in the population, by (yearly) simulating stochastic life transitions (education, marriage, fertility, labour market status) + exogenous parameters (e.g. macro assumptions and policy rules)  future distribution of key variables e.g. disposable income. • Effects of different policies can be measured together with effects of demographic or economic changes (e.g. aging or labour participation). • Suited for redistributive analysis of pensions (since pension is tied to life earnings history, life expectancy etc)  who gains and who looses

18. Original PhD Contributions • Using LIAM dynamic micro-simulation model to produce distributional analysis up to 2050 under actual and simulated pension reforms in Ireland. • Adapting LIAM to Swedish data and producing a comparative analysis between the Irish and Swedish pension systems.

19. END Part IQuestions ?

20. PART IIAging in Ireland • Currently, Ireland is young: + 65 “only” 11.1%. But… • Proportion of +65 projected to be 28% by 2056. • Dependency ratio (L /P) will increase  from 5 down to 2 working age people per pensioner by 2050. • Pension Bill projected to increase from 2.2% to 9% of GNP by 2050

21. Irish Pension System • State pension • 80 % of +65 receive it • 80% of total income for 3 bottom deciles of retirees. • Benefits are flat rate + offer low replacement rate: • ca. 30% of average industrial earnings, • below the poverty line in 2004 • Not indexed to earnings • Occupational + Private Pensions • 22% of + 65 receive it • 6% of total income of +55 on average • Average drop in disposable income at retirement 50%

22. Pensioners’ Poverty in Ireland • Since 1990s, highest poverty risk in EU for elderly (36 – 40%), excluding housing assets • Occupational Pension Membership among current workers low (50%) • Personal Pension Saving low (13 % of workers)

23. Pension Reforms in Ireland • 1998 Objectives: • Ensuring Adequacy of Pensions: √ • RR at 50% of pre-retirement income • State Pensions at 34% of average industrial wage • Indexing State Pensions to Earnings • Increasing supplementary pension Coverage to 70% by 2013 • Addressing Financial Sustainability by introducing some Funding in public pension system √

24. Simulated Reforms • Parametric Reforms: • Increasing / Indexing State pensions • Introducing an earnings related State pension • Raising Retirement Age • Indexing pensions to life expectancy • Systemic Reforms: • Move to mandatory funded system • Apply Pension system from a different country  Dynamic Micro-simulation model to quantify effects of existing + suggested reforms and compare

25. Output Measures • For each reform, we compare with baseline in terms of : • Life Time Redistribution / Inequality: • Income Replacement Ratios • Incomes over Life Cycle • Gini • Poverty • Poverty Head Count • Poverty Gap • FGT Index • Poverty Efficiency Measures

26. Part III: The LIAM Model Output Data, t + 1 (up to 2050)

27. Pensions Model in LIAM • For working age individuals  must simulate pension coverage: • Is person accumulating State Pension rights ? • Is person member covered by an Occupational Pension plan? If so which are plan characteristics / contributions ? • Is person saving in a Personal Pension ? How much? • For retirees  must simulate pension participationand retirement income: • Is retiree receiving what type pensions ? How much from each type? Replacement rate ? • For deceased  must simulate pension inheritance by spouse / dependents • For all  must back simulate relevant work history

28. Pension Estimations • Historical Panel: from 1939 – 1994, imputation or estimation of missing values based on LII (past work + earnings + pension history) • Public Pension Eligibility + Amount: based on S.I. contributions (incl. before 1996) and family characteristics • Membership to Occupational or Private pension: based on fixed effect Logit f( sex, educ., age, employment characteristics, firm size, occ. change and work status in previous year) on LII  Pseudo R2= 0.76. Aligned to 2002 CSO statistics. • Amount of 2nd/3rd Pillar Pensions: based on total predicted contributions + annuity price (DC) or final benefit formulas B)

29. Historical vs. Simulated Pension Membership

30. Intended PhD Structure I • Part I • Pension Systems and Pension Reform in an Aging Society √ • Part II • Aging and Elderly Living standards in Ireland √ • The Irish Pension System. √ • Part III • Dynamic Microsimulation of Pension Systems • Our model: LIAM • Baseline Study: Simulating the long term effects of the Irish Pension System: Baseline assumptions and results using LIAM • Reform Study: Simulating Irish Pension Reforms: Results under hypothetical reforms / assumptions, and comparisons with baseline. • Part IV • Comparative Pension Systems Analysis using LIAM: Results from Sweden and Ireland. Separating the effect of different institutional, demographic and labour market characteristics on poverty risks.