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The Macro-Economics of Pensions

The Macro-Economics of Pensions. Adair Turner September 2 nd , 2003. Pensioner Income as a % of GDP. Today. 2030. If we assume Average retirement age unchanged Average pensioner income a constant proportion of average income. 13.5.

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The Macro-Economics of Pensions

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  1. The Macro-Economicsof Pensions Adair Turner September 2nd, 2003

  2. Pensioner Income as a % of GDP Today 2030 • If we assume • Average retirement age unchanged • Average pensioner income a constant proportion of average income 13.5 Roy Waterhouse 26-8-03:MS Graph chart, withlabels, dotted lineand totals on topannotated 9.3 Private +4.5 State 1

  3. Pension Claims Against Future Output –Three Current Models Double-click tableto edit 2

  4. TwoNear Equivalences DC scheme invested in corporate bonds Compulsory DC scheme invested in Government index linked bonds and and Tax financed PAYG DB average salary scheme • Still different in respect to • Life expectancy risks • Diversification of bond portfolio • But similar since DB schemes are bond-like liabilities If the rate of return on index- linked government bonds is equal to rate of growth. 3

  5. Key Question: How Best To Structure Pension Claims? Against Future GDP PAYG Funded in government bonds Against Future Profit Slice of GDP DC in equities DB DC in corporate bonds 4

  6. Two Possible Routes To Increased Pensioner Income • Investment and future output unchanged, but some other group of savers relinquishes a matching claim on future assets and profits • Savings and investments increase, and as a result, so does future output 5

  7. Real Return On Large Stocks: US 1926 - 2000 No. of 20 Year Periods with Return in Range (57 Periods) Median 7.9 Mean 7.2 MS Graph chart ____________________ Source: Ibbotson Associates: 2002 Yearbook 6

  8. Real Return On Large Stocks: US 1926 - 2000 No. of 5 Year Periods with Return in Range (72 Periods) Median 8.55 Mean 7.64 MS Graph chart ____________________ Source: Ibbotson Associates: 2002 Yearbook 7

  9. Real Returns on Large Company Stocks: US 1926 – 2001 No. of 30 Year Periods with Return in Range (47 Periods) Median 7.04 Mean 6.86 MS Graph chart ____________________ Source: Ibbotson Associates: 2002 Yearbook 8

  10. Real Returns on Large Company Stocks: US 1926 – 2001 No. of 50 Year Periods with Return in Range (27 Periods) Median 6.99 MS Graph chart ____________________ Source: Ibbotson Associates: 2002 Yearbook 9

  11. Claims And Risks Double-click tableto edit 10

  12. Dividend Valuation Model: Inherent Uncertainty p = equity risk premium g = rate of growth PV = Rational value of equities D0 = Current year dividends r = risk free rate D0 (1 + g)2 D0 (1 + g)3 D0 (1 + g) + + PV = 1 + r + p (1 + r + p)3 (1 + r + p)2 D0 PV = r + p - g 11

  13. Risk Management And Risk Sharing In Funded Schemes • DC schemes – Managing the crystallisation risk • The DB to DC Shift • Is it concerning or desirable? • Is it inevitable? • Should DB schemes invest in equity? 12

  14. Risks In Final Salary DB Schemes Double-click tableto edit 13

  15. DB / DC Hybrids –Risk Sharing Alternatives Double-click tableto edit 14

  16. Who Killed DB? • Unanticipated increases in life expectancy • Slow response to 1980s and 1990s mortality declines • Increased life expectancy not matched by later retirement ages or increased contributions • Irrational exuberance, apparent “surpluses” and contribution holidays • Tax and residual ownership disincentives to very large surpluses • “Costless” tax increase of 1997 15

  17. How To Increase Resources For Future Pensioners Future pensioners claim higher share of future capital and profits …. Profits rise as % of GDP… Domestic investment rises and thus GDP (and GNP) Overseas investment rises and thus GNP (but not GDP) OPTION 1: With aggregate savings, investment and output unchanged Via increased savings, investment and output At expense of other savers OPTION 2: At expense of future workers OPTION 3: OPTION 4: 16

  18. Option 1: Pension Saving Up, Some Other Saving Down Either • Increased pension saving, but offsetting dissaving by the same people • Increased pension saving but offsetting dissaving by “others” 17

  19. UK Pension Fund Assets As a % Of GDP MS Graph chart ____________________ Note: Occupational schemes only 18

  20. % of UK Equities owned by individuals &UK pension funds 1963-93 MS Graph chart ____________________ Note: After 1993 the % owned by individuals continued to fall, but so too did the % owned by UK pension funds. But the growing category in 1993-2002 was overseas investors (1993: 16%, 2002: 32%), many of whom are pension funds; and conversely UK pension funds have invested more overseas. The overall pension fund role in the market has therefore probably continued to grow 19

  21. Savings Schedule 1 Savings Schedule 2 Capital Investment And The Marginal ProductOf Capital Rate of return Quantity of capital invested 20

  22. Fishing Boats, Fish And A Falling Population • Steady State • 1,000 population • 500 per generation • 500 working, 500 retired • Workers work • Half time fishing • Half time building a boat • Boats wear out over one working life • Demographic Change • 500 generation of retirees followed by 250 generation of workers • Retirees would like to sell 500 boats they have built • Workers only need to buy 250 boats Relative price: 1 boat = ½ of catch for one working life Price of boats, relative to fish, will fall 21

  23. Funded Pensions in Corporate Capital: Two Dimensions • Claim on future Cash Profits • Selling price of accumulated assets must equal the discounted value of future cash profits thereafter • Funded pensions are a claim on future profits • Inter-Generation Funds Flow • Value of Generation 1’s asset decumulation must equal Generation 2’s asset accumulation • Future pensioners consumption is financed from future workers’ consumption deferral 22

  24. Rising Longevity, Constant Fertility • Same trade-off in • each generation • No change in retirement age • G 1 saves more • Capital stock increases, returns decline • Asset prices unchanged since • G 2 has same target capital stock as G 1 • Required returns fall in line with actual • Different trade-off • G 2 chooses later retirement • G 1 saves more • Capital stock increases, returns decline • Asset prices fall since • G 2 has lower target capital stock than G 1 • G 2’s required returns have not fallen (relative to the no rise in longevity base case) 23

  25. Falling Fertility, Constant Longevity • Generation 1 keeps saving as before (since longevity unchanged) • In Generation 2, unchanged capital stock but less labour • Lower returns to capital • Higher real wages • Value of assets falls because • Returns down, discount rate unchanged • G 2 has lower target capital accumulation than G 1 24

  26. Demographic Impacts on Returns to Capital: Model Results Garry Young: Baby-boom generation -0.1% Increased longevity -0.1% Falling fertility -0.3% David Miles: Given future actual trends in UK demographics, returns fall: • 4.56% (1990) to 4.22% (2030) • 4.56% (1990) to 3.97% (2060) if PAYG phased out 25

  27. Financial Asset Prices – Transitional Effects Long-Term Impact – Higher Capital Stock – Lower Long-Term Returns Transitional Impact – Increased demand for initially sticky supply – Rising financial asset prices Increase in Aggregate Savings Rate Long-Term Impact – Fall in long-term equilibrium returns – e.g. 4.6%  4.2% Transitional Impact – From PV= – To PV= – Fall of 10% if r and p unchanged Fall in Anticipated Future Rates of Return 4.6 r+p 4.2 r+p 26

  28. Overseas Investment as the Solution –Conditions Required Other countries to invest in which have • Different demographics – dependency ratios not rising • Increasing numbers of productive and prosperous future workers able to: • Provide future output available for consumption • Buy capital assets from decumulating savers in the investor countries • + • Small numbers of domestic decumulating pensioners also trying to sell assets • Economic success – growingper capita GDP 27

  29. 60+ 15-59 0-15 Years Roy Waterhouse 26-8-03:MS Graph charts. This time, they have been doneas Stacked Bar charts, the X-axisrunning from 0% to 100%. To achieve the appearance of the charts, they are donein three rows, with the middleone containing the ‘real’ dataBlank values of equal amountsare put in either side (with thecolours changed to white),and the whole rowadds up to 100(see screen dump right). The bars then have to bere-coloured manually . The Legend is donemanually. Demographic Change in UK and China –UN Medium Variant % Population by Age Band 2000 2050 UK China 28 26

  30. The Fundamental Choice • Some mix of: • Future pensioners poorer relative to average income than today • Future workers must give up more consumption in savings, contributions or taxes • Retirement ages must rise Increasing longevity plus falling fertility 29

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